Summary
- They are paid through fees and commissions.
- Fees are a percentage of the assets they manage for you.
- Commissions are a one-time, lumpsum payment for a product that’s usually based on a percentage of the assets that are initially deposited or a premium paid.
This is an abundantly popular question with a lot of fog surrounding it, but I can most certainly shed light on this by telling you exactly how it all works. This is not supposed to be a secret from anyone, and I say this because most people find it to be a mystery. It can become very difficult to interpret on your own through all the fine, legal print that comes with all your paperwork when opening an investment account. There are multiple ways they get paid too, so it’s not always one way or another. Sure, there’s a lot of negative stories out there that will dissuade you from wanting to work with one. Just like any business there’s going to be some unhappy customers who will voice their experiences. That doesn’t mean you’ll have the same experience or shouldn’t do it. Is your time worth learning how to manage your own investments or would you rather have a professional do it for you?
The short answer… fees and commissions. Fees pay the advisor a percentage of the money they manage while commissions are a one-time payment for the purchase of an investment. I’ll break this down into specific examples to better understand how it works and provide reasons why you and the advisor would choose one over the other.
Let’s start with commissions. This word generally has a lot of negative emotions trailing behind it that come from the consumer end of any sales process. There’s always someone out there who unfortunately is trying to exploit another person to buy something they don’t need simply to earn commissions. This is true for any commission paying job like someone who sells gym memberships, automobiles, real estate, etc. On the other hand, the person paying for the product or service wants to pay less than what the price tag says. Leaving all the negative behind, let’s say you’re working with the most trustworthy and honest advisor in existence. How is that person getting paid when it comes to commissions? It primarily relies on the investment strategy and the type of account that’s set up. If the plan is to buy and hold investments for a long time with infrequent transactions, you’ll want an account that charges per transaction, i.e. commissions. The reason for this is because if you were paying a percentage-based fee, those on-going fees will easily become much more expensive than simply paying per transaction. If you have a brokerage account and ask your advisor to place a trade for a stock in your account, you’ll pay a flat transaction fee for that trade. Yes, you can do this yourself at no cost without an advisor. However, the reason you’d likely have an advisor do it for you is because you’re receiving advice and recommendations to purchase or sell that stock. Another example of commissions received by advisors is the sale of a term life insurance policy. The life insurance company issuing the policy typically pays the advisor a pre-determined percentage of your first year’s annual premium. After that, the advisor will not see any compensation from that product again.
Then there’s the more popular option that advisors like to use, fees. This option is favored for seasoned advisors because they generally have more clients and more assets to manage versus a new advisor who does not. Compensation from fees generates consistent income for the advisor compared to a commission that only pays them once. These fees can be paid in a multitude of ways such as monthly, quarterly, or annually. Fees will generate more advisor income over time compared to a commission because it’s always paying them as long as your account is open. Being a client for 10, 20, 30+ years you can easily imagine the benefits to the advisor. What fee should you be paying an advisor to manage your money? Before answering that, my personal stance on fees for any service rendered is to pay for what you get. If I hire an advisor to knock it out of the park and that gets accomplished, I will gladly pay their fees. If they’re significantly underperforming and I’m paying the higher fees, then there’s a problem. The long-standing industry average for fees charged by an advisor is 1℅ however that’s changing. The general belief has trended to the advisor’s time being more valuable, so you’ll find 1.25℅ is a more accurate standard. I’m not going to name specific firms, but you can easily Google “what advisory fees does [company name] charge their clients” to find out where they stand. Don’t buy into commercials that explain why they’re different from others. All financial advisors offer the exact same types of products and investments; you just need to find someone you like working with. An important note to be aware of is Regulation BI (Best Interest). This is a federal regulation adopted in June 2019 under the Securities Exchange Act of 1934, making it a requirement for your advisor to do what is in the “best interest” of you when making recommendations and investing your money. There shouldn’t be an advisor anywhere that isn’t always doing that regardless of a federal requirement; however, there’s always a bad egg somewhere. Continuing our fee conversation… Is that fee fixed or is there any wiggle room on it? Almost always it’s negotiable but money talks. Without a doubt, the more money you give your advisor to manage, the lower that fee will go. There are a floor and a ceiling, so you and the advisor will have limits on how far that fee can go in either direction.
I want to share with you information that is not commonly talked about on how advisors are compensated. I’m sure this is intuitive when you hear it, but the advisor does not get paid the full amount of commissions and fees charged. Usually no more than half goes to pay the company, managers, support staff, office space, etc. Typically, a new advisor just getting started will earn 50% of the fees and commissions they charge. How an advisor earns a larger percentage is based on the overall revenue they bring into the firm. The more revenue they bring into the firm, the greater the piece of pie they get from it. Here is a basic example of how commissions and fees work:
Commissions:
You give an advisor $100,000 to invest in an annuity. The commission paid on an annuity is 6% of the initial deposit, but only 50% goes to the advisor.
$100,000 x 6% = $6,000
50% advisor compensation = $3,000
Fees:
You give an advisor $100,000 to invest in a diversified stock portfolio. They charge you 1%.
$100,000 x 1% = $1,000
50% advisor compensation = $500 recurring per year
6 years x $500 = $3,000
For conversation’s sake, let’s assume there was zero growth or loss in your account. The one-time commission pays the advisor a larger upfront compensation but never receives compensation from it again. Fees pay the advisor less initially however they are earning that on-going. In this example, after 6 years, charging on a fee-basis will be more valuable to the advisor. In a real-life scenario, your account would likely increase in value, making the 1% earned on a larger account value thus creating more income for the advisor. As the advisor manages more money for more clients, that income stream will continue to grow. For an advisor charging commissions only must continually sell investments to earn income. You can see why an advisor would prefer to charge fees over commissions. That doesn’t make commission investments bad for either the advisor or the client. There are certainly beneficial scenarios for those types of investments. My point in explaining this isn’t to discourage you from working with an advisor or having preference on how they’re paid. It’s purely for education and transparency in their compensation that I’m hopefully describing in more detail that you would normally find otherwise.
