As far as I can tell, the most common piece of advice when it comes to choosing a financial advisor is to find one who charges on a fee-only basis (as opposed to one who makes a commission on each transaction that you make).
The reasoning is that this aligns the advisor’s interests with your own, because (most of the time) the fee charged is a percentage of your account’s value. This is, to be sure, an advantage over situations in which the advisor is paid per transaction.
It’s an easy question to answer: Would you rather have your advisor’s compensation tied to how well your account does, or to how often you move your money around? It’s very reassuring to know that your advisor truly does have your best interests in mind.
Unfortunately, it’s also more expensive (usually, anyway).
This downside to this healthy alignment of interests is that it’s not free. Generally speaking, fee-only accounts are more costly for long-term investors who do not move their money around on a regular basis. Typically, fee-only advisors charge somewhere in the 1-2% range annually.
In contrast, when advisors work on a commission basis, they work with mutual funds that charge up-front sales loads. These charges vary as a function of how much you invest. (The more you invest, the lower the percentage of commission.) The highest sales loads are around 5.75%. It doesn’t take any advanced math skills to determine that even a 5.75% one-time commission is going to be less expensive than a 1% fee every year over a period of multiple decades.
So How to Choose?
Don’t get me wrong, I’ve got nothing against fee-only advisors. There’s clearly a benefit to having your advisor’s interests tied so closely to your own. I just think that it’s important to recognize that such a benefit doesn’t come without a cost.
I’m of the opinion that fee structure is not the most important factor when choosing a financial advisor. As I see it, there’s one other factor that far outweighs the importance of the rest. But we’ll save that for tomorrow.
I am, however, curious to know: How many of you work with advisors? And of those who do work with advisors, what type of compensation structure have you agreed to?
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{ 6 comments… read them below or add one }
Mike,
I’ll have an article publishing on Tuesday that talks a little more about fee structures for financial advisers. I bring up a few more issues than you mentioned, and I also discuss some other types of fee-only advisers.
I’ll send you the link when it’s up, or you can check it out on Tuesday morning.
Hi Paul. I look forward to reading your thoughts on the matter.
Mike,
(Incidentally, that is my favorite name for boys.) Good article. Choosing a financial adviser is a huge decision. You make a GREAT point when you state, “The reasoning is that this aligns the adviser’s interests with your own, because (most of the time) the fee charged is a percentage of your account’s value.” While it does cost more, you are also correct when you say that fee-based makes sense for long-term investors. The fact is, if you are short-term you aren’t an investor – you are a speculator, and then transaction based accounts can make sense.
I work as an adviser to financial advisers, broker-dealers, and banks. In many cases the discussion about fees and compensation is poorly handle by all parties concerned. Nice job for putting this topic in context. Check out my post from December 8 at http://www.michaelroby.com/blog.
We’ve chosen a fee only adviser who charges 1%. We moved the money we inherited from one of the big brokerage houses who not only charged more than 1% but charged us a premium for transactions, too. They never could (or would) tell us the formula they used for charging that transaction fee.
We plan to use this advisor for 1-5 years in order to solidify our portfolio according to our retirement and other life goals. We figure at that point we can take over the portfolio and maintain it during our retirement.
Nancy: Sounds like a great idea switching advisors from your previous one. If any business won’t tell you how their fee structure works, it’s definitely time to go elsewhere.
I agree, many people will preach about fee-only being the only right way to pay an advisor, but that is NOT true. If you have a simple portfolio that doesn’t change often, commissions can be cheaper. And there are advisors who you can pay a set amount for a financial plan or pay per hour.
In addition, a fee-only advisor doesn’t always have your best interest at heart. For instance, what incentive does he have to help you with anything outside that fee-based account? And his incentive would be to tell you not to pay down debt with money from that account, so that his fees don’t go down.
In reality, there is no right or wrong way to pay. Just make sure that you understand what the fees are, the positives of each one, and think about what works best for your situation.