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How Do You Pay Your Financial Advisor?

The question of how to pay a financial advisor comes up frequently in personal finance literature. Typically, the discussion focuses on conflicts of interest and goes something like this:

  • Commission-paid advisors have very large (perhaps insurmountable) conflicts of interest with their clients,
  • Advisors who charge a percentage of assets under management have smaller, though still meaningful, conflicts of interest with their clients, and
  • Advisors who charge hourly fees or who use a fee-for-service system have few conflicts of interest with their clients.

That’s all well and good, and I’d agree with such analysis. But I think there’s also something to be said for a simple common sense approach:

Is your advisor’s fee-structure a good match for the type of service he/she provides you?

Financial Advisors as Doctors

By way of analogy: You probably don’t pay your doctor an annual retainer. Nor do you pay an annual fee that’s a function of how much you weigh or how tall you are.

Most likely, you pay per visit. Why is that?

I suspect it has something to do with the nature of the service your doctor provides: an annual checkup, plus consultations when a specific need arises. In other words, most days, you don’t need your doctor to do anything for you.

The same goes for investing. From day-to-day, managing a portfolio requires very little work. And for many of us, that work can be almost completely automated.

That said, an unbiased advisor who can answer the more complicated questions and point out possibilities for planning is surely valuable. For example:

But the nuts and bolts of investing and portfolio management is simple:

  1. Select an appropriate asset allocation.
  2. Minimize costs.
  3. Rebalance according to an explicit plan in order to keep your risk level where you want it to be.

Call me crazy, but I don’t see much need for ongoing help with that.

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Comments

  1. You aren’t crazy…in fact you hit the nail on the head. I charge .4% of assets. I plan to manage the assets for a year or so and seek to hand over the management of the account to the client if they feel comfortable. Over that period I educate the client on how to manage the portfolio.
    The setup is sometimes complicated. Assets need to be sold, cost basis needs to be taken into account, location of assets needs analysis (interest bearing assets in qualified accounts, qualified dividend assets in taxable accounts etc.).
    Once the account is setup with low cost ETFs the hard lifting is somewhat done. After that it is a matter of guiding the client through rebalancing and talking about emotions and investing. For the latter I make myself available on an hourly basis.

  2. I would compare financial advisers to lawyers rather than doctors. Some legal services are also based on the amount of money involved in the case, other services are rendered on an hourly basis. Having said that, if financial advisers are really interested in the well-being of a client, they should not try to enrich themselves with high fees. I like the fee structure of DIY Investor. This structure should work very well for his or her clients.

  3. While paying only for specific hours or services is undeniably efficient, I think there are good reasons for fee-only advisors – and their customers – to choose an assets-under-management approach. While conflict of interest should always be avoided where possible, lack of interest can be a problem as well. For example, on an hourly/service model:

    1. Does the customer avoid utilizing the advisor? After all, the costs are immediate and tangible, and the benefits are often uncertain and postponed. Humans don’t tend to make good long-term decisions in such cases.

    2. Does the advisor limit the amount of work they do because of the client’s current budget? An assets-under-management relationship creates a potential long-term reward for the advisor who “invests” time and effort into the client beyond what is justified by today’s fees.

    3. Will the advisor go out of their way to pick up small, incremental returns? Advisors know better than they will likely bill for, simply because it would look like trumped-up work. Implementing a more sophisticated rebalancing mechanism, for example, *might* pick up an additional 0.10% annual return. That kind of thing can be difficult to bill for and may simply fall by the wayside. An assets-under-management advisor has skin in the game and therefore a motivation to do the very best they *know*, rather than just the very best they can *bill for*.

    Also consider that when an assets-under-management advisor includes a minimum fee on the lower end, and starts scaling the fee rate down above $1m or so – both very common – what they really have is a hybrid approach. It recognizes that the assets model breaks down at both ends of the spectrum.

  4. Hi Ethan.

    I certainly agree with your point #1. An hourly advisor may get not get used as much as he/she should.

    And I tentatively agree with point #3. (The “tentative” being the result of my natural skepticism of advisors’ ability to earn incremental returns.)

    But I don’t think I agree with point #2. I’d argue that it’s actually a good thing if an advisor scales his work to fit his clients’ respective budgets. Otherwise you end up with a situation in which some clients (those with more assets) are simply subsidizing the work done for smaller clients.

  5. Good point on #2. In theory the advisor would be investing their own energy in the client, but it would appear that the more lucrative clients were making this possible. On the other hand, most businesses see a wide range of profitability in their customers – from significant profits all the way to significant losses – and we don’t often label that “redistribution” in a negative sense. This is because we see the gains from profitable customers as legitimate and reasonable, which the business can spend as it sees fit. Perhaps that is the better way to frame this question: when do asset-based fees become unreasonable, and how should advisors deal with this problem? That sounds a lot more like your own recommended question: “Is your advisor’s fee-structure a good match for the type of service he/she provides you?”

    One thing to point out about assets-based fees is that, certainly, they are going to provide larger revenue for the advisor than hourly fees would have done in some – even many – cases. But that is only to be expected, and is not necessarily a bad thing. The idea is that giving the advisor skin in the game has benefits, much like giving stock options to employees has benefits. There are significant reasons to think this. If you pay me $100/hr to help you build a budget, I’m not being compensated to care whether you stick to it. (I ought to care anyway, but that’s a given. We’re trying to figure out how the compensation scheme can reinforce the desirable behavior.) On the other hand, if I am paid a percentage of your nest egg and the budget we develop has you adding $500/mo to that nest egg, I care a great deal whether you stick to your budget.

    Of course, this a unique audience. The average reader of this blog might indeed be better served by, at most, the service described by DIY Investor above. I think the best conclusion I can draw from this discussion is that asset-based and time-based fees both have potential weaknesses that customers must keep an eye on, even when the structure *is* a good match for the type of service being provided. The fee structure can, at best, reinforce the advisor’s fiduciary role without introducing any large conflicts of interest. It cannot create fiduciary behavior out of thin air – only your advisor can do that, and only you can demand it.

  6. This whole fee discussion fascinates me because I feel that this is an area where people are giving away their nest egg. If you walk into a typical RIA firm and announce that you have $1.0 million and you need help managing it you will typically pay between 1% and 2% of assets, i.e. $10,000 – $20,000/year. The advisor then, many times will buy mutual funds that charge, on average 1.4% and have a lot of turnover. At the end of 20 years a lot of the nest egg has been eaten up by fees.
    One point that isn’t considered is that the advisor’s fee is usually deducted from the accounts. In other words the client doesn’t explicitly wrote a check. To me this is similar to studies where people who use credit cards can’t recall the prices they paid for things as well as people who paid cash.
    And here’s something a lot of people don’t realize – what the advisor does to get that $10,000 to $20,000 is usually not that much!

  7. Yep. Anyone who has over $800k, doesn’t require a local office, wishes to follow a passive asset-allocation strategy and is seeking investment management only (not ancillary financial services) would do well to consider Portfolio Solutions ( http://www.portfoliosolutions.com/ ).

    They charge only .25% per year for that service and they have access to DFA funds. Below $800k their minimum fees kick in, but even at $200k you are only paying 1% per year. One of their principles, Rick Ferri (a very good author), is rather dismissive of advisors that charge higher fees. But as an Advisor that is just getting into the field I can attest that 1% hardly translates into wild profits. As with all businesses, outsiders tend to significantly underestimate the costs and time involved. That said, I’m not surprised that a large company with automated systems can drive their fees down toward the .25% mark.

    I am still working on setting my own rates, but I believe they will be .9% and a diminishing rate above $1m. Do keep in mind the other complexities that arise in larger accounts: the tax repercussions of a single transaction can dwarf the advisor’s entire annual fee; estate planning complexity increases, individual bonds start to have worthwhile advantages, etc. Responsible, full-service advisors of wealthy clients are often doing far more than implementing an investment strategy. Every asset-based service I’ve seen below the .75% mark has a significantly reduced scope of service.

  8. You’ll do ok charging .9% to 1%. You’ll be below the going rate and there will be accounts where you’re underpaid! My view is that more complex approaches to investment management are not needed. In fact, DFA funds add to the cost. You do need to know the basics of tax planning, financial planning etc. For example, if a client’s primary goal is not to run out of money etc. then you’re thinking annuity. If your client wants to leave a hassle free inheritance you’re thinking Roth conversion etc. In my case, if a client is loaded up with company granted stock options and is seeking a tax efficient way to exercise the options I just punt them over to a real good financial planner who will charge them to do a full blown analysis.
    In terms of bonds I have never seen any evidence that individuals, unless they are $10 million and up, will do as well with individual bonds as with bond ETFs. I spent a career managing bonds for institutions so know a bit about how investors are picked off buying in principle amounts below $1.0 million.
    My scope of service is definitely limited – I focus on getting the best investment management of the client’s assets on a net basis-period,

  9. One issue I have with the AUM model is the built-in annual raise for the adviser. If the average account returns 8% per year, the adviser’s average cost of living increase amounts to 8% (sliding scale not withstanding).

    I don’t know of too many professions with a built-in COLA (on average) of > twice the recent historical inflation rate. And what about the situation where the market crashes and/or a client starts withdrawing significant amounts. The advisor’s fee goes down, perhaps significantly. Why? I don’t take the credit when markets go up and I don’t take the blame when they go down and my fee schedule reflects that fact.

    As for whether someone needs an adviser or not, Bill Bernstein proposes these four necessary prerequisties in his recent book, The Investor’s Manifesto:

    1) Do you have an interest in the process? (this, by the way is a necessary but not a sufficient condition.. plenty of people have an interest but still stink at investing).
    2) Do you have math ability far beyond simple arithmetic including an understanding of the laws of probability and a working knowledge of statistics? (for example, do you know the difference between geometric and arithmetic averages and how the difference affects your returns?)
    3) Do you have a firm grasp of financial history from the South Sea bubble to the Great Depression? (example: when was the worst historical year in which you could have retired? The answer is 1966; if you didn’t know that, you don’t have a firm grasp of financial history).
    4) Do you have the emotional discipline to execute your planned strategy faithfully, even at the apparent end of capitalism as we know it? (every study ever conducted shows an overwhelming tendency for people to buy stocks at all-time highs and sell them after huge declines… buy high, sell low. Bad recipe)

    He estimates that a small percentage (single digits) of the population possess all of these requisite requirements.

  10. Even .4% of a $500,000 portfolio still comes out to $2000. I have made an effort over the past 10 years to avoid fees, investing in index funds that charge as little as possible. What would I be getting for my .4% that I don’t get now, from reading books like the Bogleheads guides and forums like this one? I know how to allocate and rebalance. I know not to sell in a panic when the market drops. I know to move more into bonds as I get older. I know where all my money is located.

    That .4% I’m paying to an advisor cuts meaningfully into my returns, and I have yet to be convinced I need such a service. On the other hand, if I could find someone who knew his stuff and didn’t have a conflict of interest, I could see paying $500-1000 for a one-time meeting to help plan my retirement. But then again, I know already than an SPIA might be a good option if a 3-4% withdrawal from my portfolio is inadequate.

  11. Great question. Answer: probably nothing. We would sit down, chat for a while, I would stand up and shake your hand and say you’re on the right track.

    But 9 out of 10 people don’t have your knowledge and they don’t want to spend 10 years reading Bogle and personal finance blogs to get the knowledge. Their taxable accounts are loaded, for example, with CDs on which they are paying taxes on the interest, they have load funds and actively managed funds with super high turnover rates, they have concentrations in individual stocks, they have no idea on their performance and they have accounts all over kingdom come.

    In a number of cases the .4% pays for itself. I feel I can show approximately 1 out of 3 how to manage their own assets after approximately one-year. This of course is where the big savings come. In my other job people were handing over millions to manage and paying 1% -these are the people I’m trying to reach.

    Incidentally, although I am not a CFP I’ve hung around CFPs enough to have gotten the basics. Also, there are great retirement planning tools online that you can use and avoid the fees you mentioned.

  12. OK. I have a horse in this race so forgive me — or dismiss me.

    But my experience tells me that some (not all) folks need a buffer between themselves and their money.

    The people I deal with don’t want to be educated on how to do this themselves any more than I want to be educated on how to repair my car.

    Also, I don’t use a passive model so I can’t comment on people paying an advisor to implement that investment strategy.

    I’ve seen so many smart people make HUGE mistakes because they don’t have an advisor it’s ridiculous. A good advisor is worth every cent she or he charges.

  13. Trevor Hammond says:

    This whole conversation fascinates me, and I really enjoy the pros and cons from everyone contributing. As a financial coach and long-time mortgage planner, my focus and expertise is around helping families borrow smart, manage their liabilities to improve cash flow, improve cash flow…and then refer them to a trusted investment advisor when they are ready. But the question of “how do they get paid?” and “Which way is best” is always asked, so I spend a lot of time at least educating clients and the members of our on-line coaching program how all of this works…without being biased. My goal is to make sure consumers know their options, and it really seems to come down to the Advisor themselves…integrity, trustworthy, and always keeping the client’s best interest first. That being said, even I am not 100% confident about all the “behind-the-scenes” fees being racked up on the commission side of things.
    Keep up the comments, as I appreciate the input from those in the field. If anyone on here (Mike?) would be interested in providing some education for our online coaching clients (all around the country)…please let me know. Our program is designed to bring expert financial guidance to the majority of families across the country that can’t afford it or don’t have the resources (oh, about 95% of the country!) Every month we interview experts from around the country, record it, and make it available for the Members…along with weekly coaching articles that educate. We have professionals licensing our program from around the country and giving to their clients, so I’d love some additional experts helping the cause!
    Great blog!!

  14. I’m not sure we’re that far apart and where we disagree it’s a matter of experience and reading the evidence.
    If you think you can find someone who can beat the market then we disagree. The evidence I’ve seen shows that 10% outperform over the long term. So you got a 1 in 10 chance. But if you think you can beat the odds then go for it.
    Many times the advisory role versus the investment management role gets mixed up in these conversations. I totally agree that HUGE mistakes can be made if people try to do it totally on their own. A case in point is the Net Unrealized Appreciation issue. People pay unnecessary taxes by rolling over company stock into IRAs. The man in the street would not know this. Every good financial advisor/investment manager does.

  15. You apparently think those minimum fees are no big deal – “even at $200k you are only paying 1% per year.” Or, from the horse’s mouth:

    “The Portfolio Solutions management fee is 0.25% per year, subject to a $500 per quarter minimum fee per household. There are no start-up fees, annual administration fees or hidden costs.”

    That means the small investor is forking over $2000 every single year even on a $100,000 account. That’s 2% of one’s assets per year, or eight times the .25% the investor over $800K would pay. And for what? To be told the same things Ferri says on the Boglehead forums or in a PDF you can download from his site for free? Your post is clearly directed towards what rates to charge, but my goal is to keep my fees low, and that $2000 each year translates into a pretty hefty chunk of change for a less well-heeled client to pay – money that could be better used funding a 401(k) or Roth IRA.

  16. I didn’t say it worked at $100k, and I only actually recommended it to people investing $800k. My reason for calling out the $200k level was that, at 1%, it would match what many advisors charge as their standard fee. *I* certainly don’t want to pay 1% for advice and management. But I just as certainly don’t want most of my friends and relations trying to go it alone. I know they would cost themselves far more than 1% a year via all manner of rookie mistakes.

  17. I believe the fair thing would be to charge a lower fee for smaller accounts, which are likely to be less complicated anyway. Or charge a one-time fee – again in proportion to the size of the account, and not charging lower-assets people a higher percentage – for a review as needed. That would be fair, in accordance with Mike’s “Advisors who charge hourly fees or who use a fee-for-service system have few conflicts of interest with their clients.”

    But for someone of modest means, that $2K charged by Ferri (who, we are told, “is rather dismissive of advisors that charge higher fees” while charging pretty hefty fees himself) could easily be 50-75% of their monthly takehome pay.

  18. DIY Investor says:

    My advice: only use fee only Registered Investment Advisors (RIAs). Ask them for a copy of their ADV. Read it carefully.
    If they are not an RIA then they are a broker. A broker’s allegiance is to to their company. Their purpose is to increase company profits. Many do this by pushing the highest commissioned products. They are not held to a fiduciary standard.
    The following gives details on fiduciary standard:

    http://rwinvesting.blogspot.com/2010/06/essential-info-for-every-investor.html

    You’re definitely asking the right questions.

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