Advisors may be compensated in one of several ways:
Fee-Only vs. Fee-Based
Many consumer activists feel that to be truly objective, advisors should be fee-only, which means they don’t accept commissions or any external compensation that doesn’t come from you. In other words, you should be their only source of income. They may charge you a single all-inclusive annual AUM fee, or by the hour, or with a one-time all-in fee, but they won’t receive commissions or kick-backs or any compensation from other parties.
The other compensation types are considered more susceptible to abuse. For example, a broker compensated on a commission basis may recommend unnecessary transactions in your account to earn multiple commissions. Or, an advisor may urge clients to buy only those mutual fund investments that make the advisor eligible to receive a payment from the mutual fund company. This creates conflict for the advisor, who benefits from recommending products that are not the best choices for you.
In addition to the “fee-only” and “commission” compensation mechanisms, there is the “fee-based” category. Fee-based, which sounds confusingly similar to fee-only, usually indicates compensation is a combination of AUM fees and commissions. The term fee-based appears to have been purposely selected by non-fiduciaries to confuse consumers seeking fee-only service.
AUM fees can be appropriate as long as they’re not excessive, and the client receives good value for the fees paid. This begs the questions: What is value and how do we define excessive fees?
There are several ways in which advisors can add value and justify their existence:
Many advisors are very good at the items on the list, above, but the value they add can be undermined by excessive fees.
What are excessive fees?
This is a somewhat subjective issue, since as noted above, an advisor can add value that isn’t directly observable in terms of annual return or nest egg growth. Only you can decide whether an advisor’s fees are justified by the total value she adds. Having said that, some fee levels are clearly too high. I have yet to find an advisor providing retail services who can justify charging annual fees in excess of 1% of AUM. Accordingly, any fee above 1% is your unequivocal signal to walk away.
But that doesn’t mean that a fee of 0.90% is acceptable. In the time value of money section we learned that even a small annual fee applied over 30 years can devastate your next egg. A 1% annual fee can deprive you of 17%-20% of your accumulated nest egg. A 2% annual fee can cost you 30% or more of your accumulated nest egg! The bottom line is that you want your fees to be as low as possible.
Remember that the management fee quoted by the advisor is likely in addition to annual expense ratios charged by the funds the advisor recommends. As noted in the investing basics chapter, mutual funds may charge management fees, trading fees, and marketing fees, all in addition to fees you pay an advisor.
If you manage your own investments you only need to pay the annual management expense fees of the funds you select, and or commissions for purchasing securities (many trading platforms waive commissions). All this can be done with total fees on the order of 0.25% to 0.4% annually.
Some robo-advisor firms—those that use computer algorithms to manage your assets—will charge total fees in this range. Your average annual fees could be even lower if you use the lowest cost indexed exchange traded funds—with annual fees of 0.1% or less. Some asset management companies are now even touting zero-fee funds.
Remember to always confirm the management fees on funds that interest you. Then you can decide how to proceed.
The fees you pay have a huge impact on your long-term prosperity. Zealously and continuously act to reduce these fees. Any advisor who fails to acknowledge this imperative represents a danger to your financial success.
Hidden Perks & Conflicts
We know advisor compensation can create serious conflicts. One example stated earlier is that of a broker who tries to get you to constantly buy and sell stocks, thereby generating multiple commissions, in a process known as account churning. Another suspect mechanism is that advisors may win cruises or all-expense paid trips to exotic locations by meeting sales goals. Consider an agent employed directly by an insurance company, who is allowed to sell products offered by rival companies. He will likely mention this “freedom” upfront to appear objective.
What the agent conveniently doesn’t say is that if he generates some threshold (say $100,000) in commissions from his own employer’s products, he gets an extra cash bonus or is eligible to go on a free cruise with his spouse. He may also receive a ring or a gold watch denoting that he’s a member of some elite circle of salespeople within his firm. There are also industry-wide awards for agents who meet certain productivity goals. Such highly coveted distinctions are prestigious within the industry and give agents bragging rights. These perks persist because historically they’ve proven to be highly effective in motivating competitive salespeople.
All this boils down to the aforementioned agent insisting that you’re being presented with an objective selection of competitive insurance products, while he secretly has every incentive to subtly steer you to those products that add to his cruise-eligible sales.
The insurance company will insist that it is footing the bill for the cruise (or the gold watch, or the successful-salesman-bonus), but obviously this isn’t accurate. Those perks are being funded by you. The insurer could cancel the cruise and lower your cost of buying insurance. Instead, your agent gets to go on a cruise at the expense of your child’s 529 college savings plan, or your IRA contributions.
Wouldn’t you prefer to purchase your financial products and services from a company that keeps prices low, instead of giving extra perks to sales people who have already received hefty commissions for serving you? How many advisors do you think ever say: You know what, I don’t need to go to Bermuda on an all-expense paid trip. Instead, let’s refund my clients some of their fees?
Early in the process ask how a prospective advisor will be compensated. Reject anyone whose fees are too high, or whose compensation mechanisms are rife with potential conflicts.
 Wealthfront and Betterment are examples of robo-advisory firms.