In my first post, I wrote about how most people could benefit from working with a financial advisor and how trying to go it alone may cost you, potentially in ways you aren’t aware of. In my next series of posts, I want to give you some things to think about when looking for a financial advisor, or evaluating your current one. If you’re looking for “5 questions to ask a financial advisor,” this is not that; there are plenty of those articles out there already. Rather, my goal here is to educate and provide useful insight in order to bring more transparency and understanding to financial advice.
As a quick disclaimer, this post is in no way intended to be unbiased. I started my business with strong feelings on what is right for clients and this article (and subsequent ones) will reflect those ideas.
Today we’re talking fees. And while there are different types of fees in investing, for today’s purposes, I’m specifically focused on fees that financial advisors earn.
Why should you care? Well, you don’t like to drastically overpay for other expenses in life, like car insurance, hiring an electrician, or interest on your mortgage, right? The same should go for what you pay an advisor. Having an advisor is a good investment in your financial well-being, but not giving their cost enough thought could mean hundreds of thousands or even millions of your hard-earned dollars being transferred to your advisor’s pocket over time. If the next five minutes of your time is worth that kind of money, read on.
To put as plainly as possible, fees matter. That’s right, I put it in bold, underlined it, and even italicized it for some extra pizzazz, so you know I mean it. Yet even as agreeable as that might seem, this is an area that is not well understood and is far too often overlooked by investors. In fact, the majority of people I come across don’t have the slightest idea what they’re paying their advisor, even if it is one of their most significant expenses. And I don’t come across many advisors who are voluntarily detailing their fees to clients, even if they talk about transparency. So, if you’re reading this and thinking “hmmm, how much do I pay Bob?”, you’re not alone.
I don’t lay this entirely at the feet of investors or advisors. Rather, it’s my belief that most of the issue lies with how fees are expressed and how they’re paid. I’ll explain that more below, but before we go any further, let’s quickly look at the common ways advisors can be compensated today:
Assets under management (AUM) based – You pay the advisor a percentage of assets they manage for you. This percentage can and will vary from advisor to advisor, but it’s generally a safe assumption that if you have a $1 million portfolio, you could expect your fee to be 1% of AUM. Put another way, you pay the advisor $10,000/yr. Because the fee is tied to the value of your portfolio, which will fluctuate based on your contributions/withdrawals and market performance, the actual amount you pay will be different each billing cycle. This is easily the most popular model today (more on that later).
Commissions – The advisor earns a commission each time they transact (buy/sell) in your account. The commission earned can be substantially different, based on several factors, but just by way of a common example, if you purchase $10,000 of a mutual fund and the up-front sales charge (commission) is 5%, the advisor earns $500 for making the recommendation and placing the trade and the remaining $9,500 gets invested in the mutual fund. They might also earn a small trailing commission from that same sale, which you don’t see, but is instead reflected in the price of the mutual fund. Commissions (handsome ones at that) can also be earned by selling insurance policies or annuities.
Subscription – You pay the advisor a fixed monthly, quarterly, or annual fee for services rendered. Think Netflix or Amazon Prime. Depending on who you’re working with, how much money you have, and what kind of services they are providing, this can also vary significantly between advisors. This structure was previously unheard of, but is rapidly becoming more popular.
Hourly or Flat Fee – Fees are paid based on an hourly rate or as a one-time fee for work performed. These types of fee would generally be more geared only towards financial planning services, but might not include ongoing investment management.
Quick note – advisors aren’t being paid in two different ways on the same dollars. In other words, they aren’t receiving and AUM-based fee and earning commissions on that same money, it’s one or the other. Yet it is possible that they could earn an AUM-based fee for one account, earn commissions on a different account and charge a financial planning fee separate from both of those.
Before diving any further into this topic, in the interest of full disclosure, I use two of these models in my business – the subscription model for ongoing relationships and a flat-fee for a single-engagements. I’ll explain why I chose this structure later on. First, let’s talk about the most popular model in the industry today – the AUM-based model.
The AUM-based model has become the industry standard over the last number of years, largely at the demise of the commission-based model. Under the AUM model, advisors don’t make money based on transactions, so they have no incentive to over-trade your account. And if you, as the client, make more money, they make more money. With the AUM model, interests are now aligned and the over-trading incentive has been removed. Problem solved, right? Wrong.
Allow me to illustrate the AUM-based model by way of analogy.
Imagine you’re putting in a gas-burning firepit in your backyard, so you need a plumber to run a gas line for you. The plumber comes out, takes some measurements, asks a few questions, but is mostly interested in what the value of your home is. You think, why does that matter? You’re doing the same amount of work, regardless of the house value, aren’t you? You would understand being charged more if they needed more copper tubing, or additional labor, but naming their price based on the value of your home? What sense does that make?
I don’t know any plumber that charges like this. If they did, people with expensive homes would rightly question why they’re paying so much and people with inexpensive homes would wonder why they can’t get anyone out to do the work. Yet, this largely describes the AUM-based model.
AUM-based advisors are compensated based on amount of money they manage on your behalf. So, if you don’t have “enough” investable assets, they probably won’t work with you. But for arguments sake, let’s say you have enough. If their fee is 1% and you have $500,000, you pay $5,000/yr. If you have $1 million, you pay $10,000/yr. Some advisors tier their fee, so if you have something on the order of $2 million, the first $1 million would be billed at 1% and the next $1 million would be billed at something like 0.80%, resulting in an effective fee of 0.90%, or $18,000/yr.
Yet, similar to the plumber, isn’t it unfair to price services solely based on the value of your portfolio? Shouldn’t it largely be based on the amount of work they do for you?
I can already hear the rebuttal from AUM-based advisors. “Wealthier clients have more complex needs, therefore, require more work.” Yet, I don’t dispute that. At varying degrees, more wealth does require more service and advice, yet I will argue until I’m blue in the face that working with a $1 million client is not double the work of a $500,000 client, nor is a $2 million client 90-100% more work than a $1 million client. This is particularly the case if the money will be invested in a similar manner regardless of it is a $500,000, $1 million or $2 million portfolio. So why is the $2 million client paying 90%, 100%, or 200% more? I know why, because it’s easy…
It’s been my observation that when clients hear fees quoted as a percentage of assets, it hardly registers as a cost to them. It doesn’t sound like much to hear “our fee is 1%.” You think, “1%? That seems like hardly anything!” But what if instead of saying “1%,” they say “$833.33/mo”? That probably sounds like a much harder pill to swallow, but on a $1 million portfolio, it is equivalent to 1%. What’s more, being quoted 1.5% versus 1% may sound like a negligible difference, but that is, in fact, a 50% higher fee! It’s the equivalent of being charged $1,250/mo, instead of $833.33/mo. When you multiply that difference, plus growth, over decades, you’ve transferred hundreds of thousands of dollars more of your hard-earned savings to your advisor’s pocket, all because there wasn’t much thought put into what a percentage fee means in dollar terms.
Another reason it is easy is because in the vast majority of cases, these fees are being deducted from your portfolio, rather than coming out of your checking account. This isn’t a bad thing; in fact, it’s often advantageous to pay for fees out the portfolio. Nor is it exclusive to the AUM model. Yet, it often results in people being much more price insensitive than they should be. I often argue that if clients had to write a check every month to their advisor, they’d quickly start to question if it’s worth how much they’re paying. I’d bet that the $2 million client in my example above would start dry heaving after the third or fourth $1,500 check they wrote. Portfolios do an excellent job of disguising high fees.
There’s also some conflict of interest with this model. When an advisor is solely compensated by how much money they manage for you, it stands to reason that any advice they provide could be influenced by that fact. If you take money out of your investments to buy real estate, pay down debt, or for any other reason, it means less money under their management, therefore, less income for them. It’s reasonable to expect that they might be tempted to dissuade you away from anything that results in them losing assets.
In a nutshell, I feel there are many issues with an AUM-based model, not the least of which is that it leaves many people unable to get advice and those with money paying far too much. But I don’t necessarily blame advisors for this. Rather, I think the industry at large has done an excellent job of conditioning both advisors and clients that this is how fees should be paid. Yet, is this how you pay for anything else in life?
So why did I choose a subscription-based model?
First, it is incredibly transparent. I tell you exactly the dollar amount that you pay me and I don’t earn money in any other way.
Second, I believe financial decisions are made throughout all stages of life, not just when you become wealthy. The subscription model allows me to profitably work with anyone willing to pay for advice, regardless of where they stand financially. Maybe you’re trying to get your finances in order and you need help developing a strategy to pay down debt, building an emergency fund and staying accountable to the plan, but investments aren’t much concern yet. Perhaps you’re doing well, but don’t know where you should be directing your savings. 401k? IRA? HSA? Pre-tax or Roth? Maybe you’ve done a great job saving over the years and are thinking about retirement, but there is nothing especially complex about your situation. Or, if you’re very fortunate, you’ve done so well that some advanced planning strategies need to be implemented. In any event, I don’t have to turn someone away simply because they don’t have “enough.”
Third, I feel it is the best way to align with the actual needs of the client. Just because you’ve managed to save a lot of money, recently rolled over your 401k, or the market had a great year, it does not mean you should automatically pay me a lot more, particularly if my workload has not changed. If your situation becomes more complex, I believe that is when a higher fee can be justified.
Finally, I believe it minimizes any conflicts of interest. I have no incentive to recommend a particular transaction, product or strategy over another. Also, if you want to take money out to pay down debt, buy a 2nd home, or put your grandchildren through college, I won’t be worried the impact to my income. This frees me to do only what I feel is best for clients.
Fees are a dry subject, but I cannot understate their importance; your financial future deserves some thought about them. And while I am certainly more critical of some fee models, I do wholeheartedly believe that it’s possible to be fair and transparent with any model. My intention here is not to get you to think that certain advisors are shady because they charge a certain way, or that those who align with my philosophy are necessarily better. Rather, my hope is to get you to pay attention. It ultimately doesn’t matter if you choose an AUM, commission, subscription, hourly, or flat-fee based advisor.
What matters is that you know how much you’re paying them, how that could change based on the size of your portfolio, what could influence their advice, and how their fee compares to different advisors/models. If you fully understand how your advisor is getting paid and have evaluated the alternatives and are still comfortable, great. But if you’re like most people I’ve come across and have no idea what you pay, you should ask. If they are not willing to be fully transparent with regard to fees, they don’t deserve your business.
One last point. If you think that paying high fees somehow equates to better advice or superior results, I cannot emphasize enough how wrong that belief is. There is absolutely no guarantee that paying a high fee is going to get you better advice and in regards to performance, higher fees often lead to worse results. This leads to my next post, which is another area of investments that is not well understood: performance.