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How Do You Pay Your Financial Advisor? If You Don’t Know, Ask

June 23, 2015
Advisors, Investing
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By Stephen Hart

Learn more about Stephen on NerdWallet’s Ask an Advisor

Understanding how and when your financial advisor gets paid is an integral part of establishing your relationship with that advisor. Many studies have shown that individuals often have no knowledge of the fee structure in place, with some even believing that their advisor provides services for free. Let me assure you: That is certainly not the case. Your advisor is making money, and it is essential to understand what you’re being charged. Only then can you decide whether you’re getting the service and performance you deserve.

Suitability vs. fiduciary

Let’s start at a higher level than the actual fees you’re charged. Financial advisors are held to one of two standards when working with clients: suitability or fiduciary.

The suitability standard requires advisors to recommend products or investments that are “suitable” for a client — meaning they generally meet the client’s need at that moment in time. Traditional brokers are often held to the suitability standard, and the bulk of their money comes from commissions, but more on that in a moment.

The fiduciary standard requires advisors to place their clients’ financial interests first — even ahead of their own. This standard comes with a requirement to truly understand a client’s current situation and future goals. It is the highest standard in the investment advisor industry. Individuals who hold designations such as CFP, are registered investment advisors or are members of the National Association of Personal Financial Advisors are all held to the fiduciary standard. If you ask advisors whether they are a fiduciary and the answer is anything but a resounding, “yes,” it means they’re probably not.

Commissions, fee-based or fee-only

In general, there are three pay arrangements for advisors. While any one of these three can break down into more-complicated arrangements, these are the three you need to know about:

  • Commission
  • Fee-based
  • Fee-only

Advisors who work on commission are going to be held to the suitability standard. Their pay is tied directly to the sale of a specific product, or to an extra transaction charge when making trades on your behalf. While there are many talented and honest individuals working on commission, it’s quite obvious that this is the arrangement most susceptible to a conflict of interest. If your advisor has two products that both meet the “suitability” standard, but one generates a higher commission, it’s pretty obvious which one you’ll be urged to buy. (It’s important to note that insurance products are completely commission-driven as well.)

A fee-based arrangement will typically be a mix of commissions and a charge for assets under management (AUM). So your advisor may charge 1%-2% of your total account balance each year, plus receive a commission based on certain products and transactions. Though this pay structure is not completely commission-driven, commissions may still play a role in the advisor’s recommendations.

The fee-only advisor will charge only for services rendered, and most charge simply a percentage of AUM. They may also charge a flat annual fee or an hourly rate. They are committed to accepting no commissions or sales loads and are held to the fiduciary standard. Some will charge a lower AUM fee but then have an hourly rate for anything outside of investment advice. Others may charge a higher AUM fee and include financial planning, tax advice and other services.

What does all this mean?

The bottom line is, never be afraid to ask how your advisor is paid and what kind of standard he or she is held to. If there is any lack of transparency in either of the answers, it might be a tip-off to look somewhere else. Too often we hear stories of people who have no idea how their advisor is paid and receive a convoluted answer, if any answer at all, when they ask.

This is your money. Don’t compromise.

Image via iStock.

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