Should I Care How My Financial Advisor is Paid?

By John Spitzer, Ph.D. and Todd Houge, Ph.D., CFA

There are four common methods for compensating financial advisors: commissions on product sales, fees calculated as a percentage of assets under management, salaries paid by a financial institution, and hourly rates. In this article, we explore the potential biases introduced by each form of compensation and identify important criteria for investors to consider when working with an advisor.

Historically, one of the most common methods for compensating financial advisors is to charge a commission based on the products, such as mutual funds, tax deferred annuities, or insurance policies, sold to their customers. These commissions may take the form of a front-end load (a percentage of the initial investment paid to the salesperson), a back-end load (a percentage of the proceeds paid when an investment is liquidated), or a 12b-1 fee (an annual fee paid to the salesperson as part of the investment’s expense ratio).

We believe that commission-based compensation creates an inherent conflict of interest. The advisor has a strong incentive to promote products with higher sales loads or 12b-1 fees (commissions) and relatively little incentive to suggest products without sales loads or low annual fees. The advisor may also generate additional commissions by encouraging clients to frequently turn over or exchange investments. Thus, the clients of commission-based advisors may not always receive products that are the best fit for their individual needs.

More recently, a growing number of advisors now advertise their services as “fee only” to distinguish from sales commissions. Many fee-only advisors are compensated by charging the client an annual percentage of assets under management. A common arrangement is 1% of the first million dollars under management, with a declining percentage beyond that point.

Under this approach, a financial advisor has an incentive to grow the investor’s portfolio since a larger asset base will generate greater annual fees. On this basis, it is often argued that this form of compensation, in contrast to the commission-based approach, provides near-perfect alignment between the interests of the investment client and the financial advisor. We do not agree. We believe that the interests of the advisor are most closely aligned with keeping the assets under management.

To illustrate, consider a retiree with a $500,000 investment portfolio, under the management of an advisor who earns a 1% annual fee. The advisor considers using $400,000 to buy an immediate annuity that provides the client with a stable, monthly income for as long as she lives. However, purchasing the annuity will reduce the advisor’s annual compensation by $4,000 per year (1% of $400,000) and creates an incentive for the advisor to suggest alternative investments instead.

Another potential concern with the percentage of assets approach is that actual fees can become rather large as the portfolio grows in size. In our illustration above, the fee for a $500,000 portfolio is $5,000 every year. This is fine if one receives $5,000 worth of service every year. Yet, typically a portfolio that doubles in size does not necessarily become twice as complicated for the advisor to manage.

Some advisors are paid by financial institutions, such as banks, insurance companies or mutual fund companies.  These advisors also have incentives tied to assets under management. The parent institution generates revenue from the products it sells and employs advisors to help it grow the volume of assets. So the advisor has an implicit incentive (and possibly some explicit incentives in the form of bonuses) to increase the holdings of your assets managed by that particular institution.

If your advisor charges a percentage of assets or is salaried, be aware that he or she might ignore investments that would reduce the assets under the advisor’s control or away from the parent institution, even if such a move is a better fit for your situation. Investors paying a percentage of assets should also calculate the annual fees paid in dollars each year and consider whether the fees are commensurate with the service received.

Finally, there are a few financial advisors who charge clients by the hour or a flat fee, similar to accountants or attorneys. These advisors are also likely to provide relatively unbiased advice since their compensation is not linked to sales of a specific product or investments with a particular financial institution. Meanwhile, paying an advisor by the hour may actually be cheaper for investors with larger investment portfolios compared to the percentage-of-assets approach.

Although we favor the pay-by-the-hour approach, many investors find it difficult to directly pay for the financial advice. This difficulty may partially explain why commission-based and percentage-of-asset advisors are more popular – they give investors the perception that the fees are minimal, even though explicitly the total cost and conflicts of interest may be much larger.