Conflicts of Interest Hidden in Financial Advisor Fees

Many things set financial advisors apart from one another. Education, personality, and investment philosophy are just some of the ways that a potential client can evaluate the decision to pursue an advisor relationship. I have written before about whether financial advisors are needed or the difficulty in reading their disclosures, but what I haven’t talked about is how relevant the types of fees an advisor charges are to the relationship.

I have listed below the standard fee structures used by financial advisors along with some discussion related to the pros and cons of each. Some do a good job aligning the interests of advisor and advisee, others not so much.

This post is part of my Don’t Get Screwed series.

The Worst: Commissions

No question about it, an advisor who provides investment advice for a commission creates a ripe opportunity for agency conflict. Sure, it is possible that an advisor can provide quality advice under a commission pay structure, but the incentives are not aligned, and eventually there will be a time where the advisor must choose between his income and his client’s.

In a commission based fee structure, the investment company pays the advisor for selling financial products to an investor. Maybe he invests them in mutual fund A or insurance plan B. The investor doesn’t pay directly for this advice, but the advisor will get a kickback from the company providing fund A or plan B.

The advantage of this type of fee structure is there is no money exchanging hands between the investor and the advisor. While this does make a great sales pitch, the investor does eventually pay because the fees charged on the investment product now have to be higher to pay the advisor’s commission.

The main issue with the commission fee structure is the misaligned incentives. There is a huge agency problem. To get paid, the advisor must recommend products that offer a commission. If a good product exists that does not offer a commission; the advisor would have to decrease his compensation so that the account can be invested in the better product.

This is the misaligned incentive.

Ideally, the investor would want the advisor’s compensation tied to the success of the investment outcomes. This is not the case.

The advisor gets paid up front no matter the quality of the investment product. The high commission is one of the many reasons why whole life insurance policies turn out to be such bad investments. They are sold hard by “advisors” because of the large commission, but the investor ends up paying for this high commission with a product infested with high fees and low returns.

What they make you think is better: Assets Under Management (AUM)

Assets under management is a simple fee structure and its fee-based, not commission based, so advisors tout this as a better alternative to commissions because of its aligned incentives. In an AUM fee structure, the investor pays the advisor a percentage, usually 1% per year, of assets under management. If an investor has a total of $500,000 in investments, the advisor will provide investment management of these assets for $5,000 per year.

If you are thinking “WOW! That’s a lot”, You are right. This 1% per year adds up quick and eats away at investment returns.

To make matters worse, paying for investment management assumes that these advisors will be actively managing the portfolio. Active management has major flaws and subpar returns relative to passive management, or index investing. This is no secret and has been researched by academics for decades.

I won’t go into too much here, but for more information check out this post I wrote about beating an efficient market.

Active management combined with an AUM fee structure creates a no-win scenario. Either an investor pays 1% per year for an advisor to not beat an index fund, or the investor pays 1% per year for an advisor to invest in index funds, something that can be done in less than 15 minutes with a Fidelity or Vanguard account.

The proposed benefit to the AUM model is that it attempts to align incentives for the advisor and investor. The more money in the portfolio, the more the advisor makes. The advisor is incentivized to make money and not lose it. However, this also incentivizes the advisor to convince the investor to increase their investment balances even if this may not be in their best interest.

If the investor has a volatile income stream and should have a large emergency fund or the investor wants to invest in rental properties, the investment account values would decrease. In both of these cases, the advisor’s compensation is adversely affected. The advisor now has reason to convince the investor to invest in the market opposed to using the cash for other things, including keeping it in cash.

Fixed Planning Fee

In a fixed planning fee service, the advisor produces a financial plan for an investor for a flat fee ranging from $500 to $3000 depending on the complexity of the requested plan. So far, this is the best option. The advisor is paid for a service, just like any other service provider. The risk is that the advice is not worth the thousands paid, similar to any consultation.

The benefit of this compensation structure is that there are no competing incentives when it comes to investment choices. If the advisor has to choose between fund A and fund B, the choice can be made wholly on the benefit to the client. Also, if the advisor thinks the investor should pay off their house or loans, then this can be recommended without worry that the advisor’s compensation will drop based on a lower AUM.

Overall, a fixed planning fee offers the benefit of aligned interest with a relatively low cost compared to an AUM fee approach.

Hourly Rate

The hourly fee is as simple as they come. Investors pay a flat hourly rate for their financial planning questions and services. Sometimes this is combined with a retainer model, much like a law office. The fixed rate model and hourly rate model are essentially two ways of describing the same fee structure with the same benefits. An additional that separates the hourly rate form the fixed rate model is that an investor can consult an advisor for smaller, more detailed questions that do not involve an entire financial plan.

Paying the Bill

Financial advisors catch a lot of flack around personal finance blogs. I understand that. It is easy to hate on someone for providing advice or service for a fee for something that can easily be done independently.

I am a firm believer in taking control of your own finances and understanding how to save and invest.

That said, I know there are some people who dread finance and dealing with money. For these people, pay attention to the fees that you are charged. There is nothing wrong with paying a fee for advice but think about the advisor’s incentives and how a particular fee structure will affect your goal of financial independence.