Updated: Mar 12, 2019
When it comes to selecting a financial advisor, there are a lot of things that you should take into consideration. I think something very important for individuals looking for a financial planner is to understand the different compensation structures advisors commonly used. Let’s look at the 3 most common fee structures.
1. Commission-Based planning
This used to be one of the most common methods of advisor compensation. How this method works is you don’t pay your advisor directly for his or her services. Advisors get paid by the product companies after you make a purchase. The best way to illustrate how this works is with an example.
Jerry is retiring from his job. During his time at his former employer, Jerry participated in the company 401(k). When Jerry left his former company, he had a balance of $500,000 in his 401(k). Jerry decided to meet with a financial advisor that was commission-based. After meeting with his advisor, they came up with a plan they both felt comfortable with. The advisor has recommended $200,000 in a variable annuity with an income guarantee and $300,000 in Class A Mutual Funds. Jerry also has a pension benefit from his former employer. If Jerry were to pass away, his wife Jane would no longer be able to collect that benefit. Jerry and his advisor determine it makes sense to have a universal life insurance policy to provide income replacement for the pension should Jerry die early in retirement. The insurance policy will cost $6,000 a year. When Jerry implements those recommendations, he will not make payment to his advisor, but that doesn’t mean the advisor is not getting paid. The advisor would get compensated something like this:
$200,000 in the variable annuity could be subject to a surrender charge (also known as CSDC, contingent differed sales charge). A surrender charge is a penalty paid by the investor for leaving an investment too early. Most annuities usually have some amount of funds that are not subject to the surrender charge every year. An example of this could be 10% not subject to the surrender charge every year. Surrender charge time frames differ depending on the company and product. Jerry does not pay anything up front, so all $200,000 goes into the variable annuity. During the first year, $180,000 is subject to surrender charge and the surrender charge will go away after 8 years. The advisor in this situation would be paid a commission from the annuity company. The percentage depends on the product company, length of surrender charge, and complexity of the annuity. In this example, the advisor earns 7% commission on the annuity sale and is compensated $14,000.
The $300,000 in Class A Mutual Funds work different. There is no holding requirement for these funds, however; Jerry would have to pay an upfront fee to buy the mutual funds. The more money that gets put into the mutual funds, the lower the up-front fee usually is. There are levels of investments called breakpoints where the front-end charges go down. One of the largest mutual fund companies around is American Funds. When investing in equity based mutual funds, their fee and breakpoint schedule is as follows:
In Jerry’s case, he purchased $300,000 of Class A Shares. It is important to note Class A Mutual Funds are not charged at a marginal rate, and once you reach a break point, the entire purchase is charged the lower rate. For Jerry, his $300,000 falls in the 2.50% range. Jerry pays the mutual funds company a total of $7,500. The financial advisor does not get the full 2.50%. American Funds pays the advisor $6,000 and American Funds keeps the other $1,500. When Jerry's funds arrive, his opening balance will be $292,500.
Lastly, we will discuss the life insurance policy that Jerry has implemented. Compensation for life insurance policies is based off premiums that you pay. Generally, life insurance commissions are based off something called a target premium or planned premium. In this case, the target premium is $6,000 a year. The advisor will get compensated 90% of that target premium or earn $5,400.
In summary, the financial advisor would earn the following in commissions:
$14,000 in annuity commissions + $6,000 in mutual fund charges+ $5,400 in life insurance commissions for a total of = $25,400.
As you can see in this example, despite Jerry not writing a check directly to his advisor, his advisor is compensated in this arrangement from the product companies.
2. Fee-Based Planning
A fee-based planner works differently than a commission-based planner. The biggest difference is a fee-based planner can charge a client directly for advice. This is usually done by way of a monthly retainer, hourly rate, or an asset under management fee. In our previous example, if Jerry met with a fee-based planner, his compensation could have looked something like this:
Jerry meets with his fee-based planner, and they decide to do a few financial projections to help come up with recommendations. This advisor charges an upfront planning fee of $1,000 for all the financial projections that he prepared for Jerry. In order to continue to maintain and update the projections to make sure Jerry stays on track, the financial advisor also charges $100/month as a retainer. While constructing the financial plan, Jerry and his advisor decide on the following plan:
Jerry is going to purchase $150,000 in a variable annuity for income and $350,000 in an advisory account. The new advisor also recommends a life insurance policy to protect the loss of income from the pension if Jerry were to pass away which is $6,000/yr. in premium.
The advisor would get compensated the same way on the annuity recommendation and the life insurance policy as the commission-based planner. There would be a 7% commission on the annuity for a total of $10,500 and 90% of the target premium on the insurance which would total $5,400. The advisory account works different than the Class A Mutual Funds. The following is an example of a fee schedule for an advisory account.
Jerry would not pay an upfront fee to get into these investments. Instead, the fee gets charged to him on an ongoing basis. Usually, this is deducted every quarter. Another difference between this model and the Class A Mutual fund model is the advisory fee model usually does not have breakpoints. In this case, your first $100,000 would be subject to the 1% charge whether you had $100,000 invested or $1,000,000 invested. For Jerry, his fee would be calculated the following way:
$100,000 x 1% = $1,000
$150,000 x 0.75% = $1,125
$100,000 x 0.70% = $700
So, the total of $350,000 would be subject to a fee of $2,825 every year. That gives Jerry an effective fee rate of 0.81%.
As the account value grows over time, the total amount of the fees paid goes up, but the overall percentage a client pays goes down. In other words, as you make more money in your account, your advisor makes more money and your fee as a percentage decreases. Likewise, if your account value declines in value, the advisor makes less money, but your fee as a percentage increases to a maximum of 1% in this example.
In total, the fee-based advisor was compensated the following:
$10,500 in annuity commissions + $5,400 in life insurance commissions for a total of = $15,900 in commissions.
The advisor also collected $1,000 in upfront planning fees and collected $1,200/yr. in a retainer and $2,825 in assets under management fees for a grand total of:
$16,900 in upfront fees and $4,025 in ongoing fees.
With the ongoing fees, the client (and usually the advisor too) are free to end the relationship at any time and stop charging. The monthly retainer is paid directly to the advisor from the client.
3. Fee Only Planning
The last method of compensation is probably the most straight forward. A client pays the advisor directly for the planner’s advice either through an asset under management charge, a monthly retainer, or an hourly rate. The advisor could also use a combination of all three methods. The main difference between a fee-only planner and the other 2 methods is a fee-only planner accepts no commissions from product companies. If a fee-only advisor recommends an annuity, it is a fee-only annuity that charges an ongoing asset under management fee but has no surrender charge. Fee-only planners do not offer Class A Mutual funds and do not sell life insurance policies directly. Fee-only advisors’ often partner with other firms to implement insurance products so the client is not left to figure it out on their own after the recommendations were made. Fee-only advisors are also held to something called the fiduciary standard. The fiduciary standard is different from the suitability standard of commission-based planning. The suitability standard states the advisor must make recommendations that are suitable for their client. They do not necessarily have to be in the client’s best interest. However, the fiduciary standard states the advisor must act in the client’s best interest.
If we return to the example of recently retired Jerry, the fee only advisor could get compensated in the following manner. The advisor charges a $1,000 up front planning fee for running financial projections and a $125/month retainer for maintenance of the financial plan. Jerry and his advisor use a combination of annuities and advisory-based investments to build his portfolio. They also decided on getting a life insurance policy to protect his pension.
The advisor would collect an asset under management fee the following way:
All $500,000 would be subject to the assets under management fee. There would be no surrender charge or up-front sales charge. In this case Jerry would pay:
$100,000 x 1.00% = $1,000
$150,000 x 0.75% = $1,125
$250,000 x 0.70% = $1,750
His $500,000 invested would generate a $3,875/ yr. fee for an effective fee rate of 0.78%. This would be taken out of the account most likely every quarter.
The insurance policy to be implemented to protect the pension would not generate any compensation to the fee-only planner. In summary, the fee only planner would earn:
$1,000 upfront directly from Jerry. Jerry would pay $3,875/yr. from his investment accounts and another $1,500 directly from Jerry to his planner for an annual charge of $5,375. Both parties are usually free to walk away from the agreement at any time.
It is important to point out that these are just examples of fee structures. This does not mean your planner charges these same rates or earns the same percentage of commissions. Generally, commission-based planners have the most conflicts of interest and upfront costs but the lowest ongoing charges. They have the most conflicts of interest because they are incentivized to sell products in order to earn compensation. Fee-only generally has the least conflicts of interest, lowest upfront costs, but the highest ongoing charges. Fee-only has the least conflicts of interest because particular product implementation usually has little impact on the advisors compensation. Fee-based is of course a combination of the two. Every client has different needs and goals. The important thing to take away is to learn how your advisor is getting compensated and evaluate if that is the best fee structure for you.
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