The financial services industry is great at making you feel good while ripping you off. They’re also great at confusing you so much that you can’t even figure out how badly you’re getting ripped off. To make smart financial decisions, you need to realize how your “advisers” are getting paid and how their pay structure may affect the advice they give you.
These advisers can include stock brokers, bankers, realtors, financial planners, insurance agents, lawyers, and accountants. Different compensation methods can create various conflicts of interest—situations where your best interests are not the same as your adviser’s best interests. This is a long article, but what you’ll read here can save you many problems and oceans of money.
These advisers get paid a commission when you buy a product. The products they sell can include stocks, bonds, mutual funds, insurance policies, annuities, real estate, mortgages, other loans, and much more. (When you take out a loan, you’re essentially buying a product and the banker typically gets a commission or bonus.)
The problem with this compensation structure is that the advisers are influenced to sell you products that give them a higher commission. This could mean selling you inappropriate or sub par products with high fees, telling you that you need permanent life insurance coverage, convincing you to buy the most house you can afford, or encouraging you to take out the biggest loan the bank will let you. You often don’t realize the cost of these decisions because the commissions are rarely disclosed in an honest, upfront, and easy to understand manner. It may seem like you’re getting cheap or free advice, but you end up paying much more in the end because of the commissions that are built into the products you buy.
Commission-based advisers are also much more likely to persuade you to make many transactions (buying and selling investments many times) because this increases their pay. There are strict rules against “churning” in investment accounts, so be sure to seek help from the government or a lawyer if you believe your account is being churned.
While there are some commission-based advisers who are trustworthy and do give their clients good advice, you’re best served by steering clear of commission-based advisers whenever possible. If you must work with someone who earns their fees by commissions, make sure you get full disclosure on their compensation and always get a second or third opinion on their advice. Do your homework, and you can avoid getting ripped off by commission-based advisers—but there are often better ways you can get help with your financial decisions.
Fee-based Percentage of Assets Advisers
Fee-based percentage of assets advisers are paid a percentage of the assets they manage for you. This business model is also called the assets under management (AUM) model. This is generally seen in the investment world, though it can crop up in other areas. The typical fee is about 1% of your assets, but this can vary wildly between advisers. It’s important to keep in mind that this fee is almost always in addition to the fees in the products you purchase.
The first conflict of interest with fee-based AUM advisers is the fact that they get more money when they manage more of your assets. They’ll often encourage you to transfer more of your assets to them and justify the advice with some compelling reasons. However, it isn’t always best for you to move your assets to an AUM adviser. Additionally, when you take money out of your account the adviser’s fee goes down. If you’re weighing the decision to pay off a loan with money the adviser is managing, how likely do you think it is that he will tell you to pay off the loan? If you pay off the loan, the adviser gets a pay cut.
The next problem with fee-based AUM advisers is cost. When you pay 1% of your assets in management fees every year, the total cost can really add up. Let’s assume the adviser takes a 1% fee at the beginning of each year and your investment returns are 8%. Over 25 years, you’d pay $62,527 in fees for every $100,000 you had invested at the beginning of the 25 year period. Over a 65 year period, you’d pay $1,104,280 in fees for every $100,000 you initially invested. Most advisers will justify this cost by saying that you wouldn’t have received 8% investment returns if they hadn’t been there to advise you along the way. While this may be true, you can duplicate their results if you educate yourself enough about the long-term history of the markets and learn how to avoid stupid mistakes. You can also look into using an hourly or flat-fee adviser for a better deal without having to learn everything on your own.
During retirement, these costs can be especially hazardous. My research has shown that a 5% withdrawal rate is probably safe for most people. If you have to pay an investment adviser a 1% fee to manage your assets, your safe withdrawal rate goes down to 4%. This means a $1,000,000 would only provide you with a $40,000/year income if you’re paying an investment adviser. Alternatively, you could have a $50,000/year income if you didn’t have to pay 1% of your assets to the adviser every year.
The AUM model also isn’t very fair to the clients. If Bob has $100,000 and Joe has $200,000, Bob only has to pay $1,000/year but Joe has to pay $2,000/year. Why does Joe pay more? It’s only because he has more money. How is this fair for the clients? Having worked in the investment industry, I can personally tell you that not much more work goes into managing Joe’s $200,000 portfolio versus Bob’s $100,000 portfolio. Why should Joe have to pay twice as much for the exact same services? He shouldn’t, and that’s another reason why I am not too fond of the AUM model. Fee-based AUM advisers will try to justify this problem with different arguments, but there’s rarely a legitimate argument that would hold up when viewed by an unbiased party.
Finally, fee-based AUM advisers are generally restricted to working only with wealthier clients. It’s much more profitable to spend 10 hours working with someone who has $1,000,000 than to spend 10 hours working with someone who has $100,000. This means young people and late starters with little money saved up are going to have a hard time getting a fee-based AUM adviser to work with them.
Fee-based AUM advisers usually give much more appropriate advice to their clients than commission-based advisers, but there are still many conflicts of interest and problems with this compensation structure. Advisers using the AUM model like to advertise that their compensation structure eliminates many conflicts of interest present in the industry, but you should be aware that it does not eliminate all possible conflicts—no compensation structure can do that.
Fixed-fee advisers are paid a flat fee to provide certain services you agree upon. There are few of these advisers around, but their fee structure can eliminate many of the problems with commission-based and fee-based AUM advisers. You may also hear this fee arrangement referred to as a “retainer”.
You’ll want to ensure that the flat fee you pay fixed-fee advisers is the sole source of their compensation. If the adviser still receives commissions for any products you may buy, then they will still have a conflict of interest in selling you the highest-paying products.
You’ll also want to make sure you do not pay for more services than you really need with a fixed-fee adviser. Because these advisers are charging a flat fee, you can end up overpaying if you do not fully utilize the services and time included in the package. This is especially true for those who have a simple situation or for those who have the biggest areas of their financial plan implemented already. Since fixed-fee advisers often charge upwards of $1,500 or $2,000/year, it may not make sense to use them if you do not need much help.
Since fixed-fee advisers are paid a flat fee, it is to their benefit to spend as little time as possible on any one client as this maximizes their hourly rate. While this is short-sighted, it is still a possible downfall of using fixed-fee advisers. If you feel your fixed-fee adviser is not providing the level of service you agreed upon, you should confront him or her to get an explanation. If you’re not happy with the service, you may want to change advisers.
The major benefit of fixed-fee advisers is that they will not be tempted to advise that you purchase high-fee products or to put more money under their management. Since their compensation structure is separated from your assets, they are able to focus on your best interests when they provide advice. You’ll still want to make sure you’re not paying for more than you receive, and you should carefully consider any personal finance decision no matter where your advice comes from.
Fee-based Hourly Advisers
Fee-based hourly advisers get paid an hourly rate for the time they spend working on your situation. This time could include meetings with you, researching your situation, completing paperwork for you, or meetings with your other advisers. Most accountants and lawyers work under this compensation method, but you will hardly find this fee model in the investment, insurance, banking, or real estate industries. Fee-based hourly advisers eliminate many of the conflicts of interest present in commission-based and fee-based AUM models, but they are not without their issues.
Because fee-based hourly advisers are paid for their time, they may try to give you complex advice to justify their fees and keep you dependent on meeting with them. If you feel like your fee-based hourly adviser is giving you the runaround, be upfront and let him or her know that you need a better explanation of why the advice is so complicated. If the adviser does not try to educate you, it’s probably time to seek another adviser. Any adviser should be more than willing to educate you about what is going on in your financial situation. If not, they could be hiding something or trying to keep you dependent on their advice.
You may need to be more involved with your finances if you use a fee-based hourly adviser. Since you are paying the adviser by the hour, your costs will be lower if you can do as much as possible yourself. The fee-based hourly adviser should be willing to provide you with any instructions you need to complete simple tasks on your own. This could include setting up accounts, transferring assets between accounts, placing trades, purchasing products, or meeting with other professionals as needed. If you need help, you can always ask the adviser to assist you but your costs will be much lower if you do most of the grunt work yourself.
With a fee-based hourly adviser, all clients are treated the same because they all pay the same amount per hour of the adviser’s work. These advisers can work with people who have few assets or people with a high net worth. As long as they only receive their compensation from you, they won’t be tempted to advise that you purchase high fee investments. On the contrary, they are likely to give you the best advice possible for your situation because they know that exceptional advice and education is the only thing that can really keep you coming back for their help.
Other Things to Keep in Mind
You might find an adviser who uses some combination of these fee structures. Proceed with caution! The more complicated the adviser’s compensation the harder it is for you to understand exactly how he is getting paid. With any type of adviser, make sure you get full disclosure of their compensation in writing.
Never be afraid to get a second opinion on your adviser’s recommendations. You can easily go to a fee-based hourly adviser for a one-time project when you’re making a major decision. For a few hundred dollars, you can get this second opinion and avoid a much more costly mistake. Even better, you could do substantial research on your own so you learn in the process and understand the situation better.
Always remember that your advisers should be teaching and educating you throughout the process. If the adviser is reluctant to explain his recommendations, I would be very wary of trusting him. By finding an adviser who is a true teacher at heart, you can be more confident that the adviser is honest and trustworthy. The best adviser should be working to make himself completely unnecessary at some point!
Don’t fall for slick marketing, a round of golf, free dinners, or nice gifts! Advisers who spend a lot of money in these types of “client appreciation” or advertising areas are simply using the money you pay them to give you “free” stuff just to make you feel good about getting ripped off. You should remember that the adviser is not going to give you so much “free” stuff that they don’t make a profit. While it may feel good to get that “free” round of golf or gift card to your favorite restaurant, you should never forget that you’ve already paid for it when you paid the adviser’s fee. Don’t fall for the illusion that it feels good to get ripped off! If you really want those things, pay for them yourself and stop paying through the nose to get it from your advisers.