When physicians search for financial professionals to work with, it’s important to not only consider the services that professionals offer and their financial expertise but also how they earn compensation.
Fees are an often overlooked aspect of investing and financial planning, as they can severely cut into gains and counter some of the effects of even the best-performing financial strategies. Plus, the way in which a financial professional receives compensation can create different conflicts of interest that you should consider before allocating your hard-earned money.
Some of the more common ways that a financial professional such as an Investment Advisor Representative (IAR) within a Registered Investment Advisor (RIA), a broker-dealer, or an asset manager may be compensated include the following, either via a combination of compensation methods or standalone models:
- Hourly fees: Some financial professionals charge an hourly rate for their services, whether that includes building a financial plan, providing tax advice, or many other types of services. While this fee type is not all that common among financial advisors, you may find other financial professionals such as accountants or estate planning attorneys who charge an hourly rate.
- Flat fees: Instead of pricing services on an hourly basis, some financial professionals charge flat fee rates, such as having one set fee to build you a financial plan. This can be similar to physicians being compensated a flat rate for performing a service rather than earning an hourly wage.
- Percentage-based advisory/management fees: With percentage-based advisory fees, the amount you pay depends on the amount of your assets for which a financial professional provides services. For example, a financial advisor might charge an annual rate of 1% of that client’s assets under advisement, meaning a client with $1 million in assets would pay $10,000 per year, whereas a client with $500,000 in assets would pay $5,000 per year, which helps account for the complexity of managing larger accounts. However, fees generally come down with more volume, essentially to provide a bulk discount. For example, you may pay 1% on your first $1 million managed by a financial advisor and then 0.75% on the next million.
In addition to advisors charging percentage-based fees for their own services, pay attention to additional percentage-based management fees that you may have to pay to other financial professionals such as asset managers. For example, a mutual fund or exchange-traded fund (ETF) generally charges a percentage-based fee for their investment management services. Thus, if your advisor charges you 1% for the service of advising you on how to manage your money and then invests your assets in mutual funds charging 1%, you would generally have to pay both fees.
While percentage-based fees may seem expensive, this is a popular model that can often align interests and lead to greater overall performance—the more your account grows, the more the financial professional makes. And if you pay attention to all aspects of fees including advisory and investment management fees, such as by finding a fee-conscious advisor that invests in low-cost ETFs, you can often obtain good value.
- Performance fees: Some investment managers such as private equity funds and hedge funds may charge a performance fee in addition to management fees. A performance fee is generally a percentage-based fee that compensates the fund manager for investment gains. So, if a fund performs exceptionally well, the manager can share in that performance, which would reduce the investors’ overall performance.
- Commissions: Commissions are another common form of compensation, which may be used to keep percentage-based fees low but can create certain conflicts of interest. For example, an investment fund or insurance company may pay a financial advisor a commission for selling you a particular financial product, which then creates an incentive for the advisor to sell you that product. Certain regulations aim to protect investors from being misled in this regard, but investors will have to decide for themselves whether they’re comfortable with commission structures.
- Load fees: A load fee is essentially an additional transaction fee that may apply to buying and/or selling products like mutual funds, and it can vary as a percentage based on the amount invested. The load fee may be collected by the investment fund, or a financial professional who sells you the product may also receive compensation from the load fee.
- Markups/markdowns: Another way advisors, investment managers, or other financial professionals can be compensated is to markup the cost of products or markdown the amount an investment is sold for to then gain revenue from the difference. This is similar to how you would pay a markup on everyday purchases like groceries or clothes, which is the difference between a manufacturer’s price and a store’s price.
- Wrap fees: Some financial professionals charge an all-in-one wrap fee, which can cover advisory services, commissions, etc. for one inclusive cost.
Look Beyond Upfront Costs
As these examples show, financial professionals can be compensated in a number of ways, which can affect how they market themselves. A fee-only advisor only receives fees from clients rather than from financial companies, so you might only pay a percentage-based advisory fee, for example, without the advisor making any money from commissions. Conversely, a commission-based or fee-based advisor could receive a mix of commissions and client fees.
When deciding what type of financial professional to work with, it’s important to look beyond upfront costs such as advisory fees to understand whether that professional also receives compensation through commissions, which could create conflicts of interest that affect your overall performance. You also want to look beyond initial advisory fees to consider how an advisor’s investment recommendations, for example, can trigger different levels of percentage-based management fees.
There are pros and cons to all different types of compensation structures, so it’s important to consider what you’re comfortable with and ask any financial professional you work with to clarify how they are compensated.