There are several different ways that financial advisors are compensated. In this post I will walk through the various business models and give you my somewhat biased opinion on the pros and cons of each. Let me start by stating that my belief is that the primary value of working with a financial advisor comes from the insights gained by going through the financial planning process, and the discipline that is provided by having an unbiased and knowledgeable third party help guide decision making. By ‘financial planning process’ I’m referring to developing and reviewing a financial plan that forecasts out cash flow through retirement (and may include other goals such as college funding, home remodel etc.). The purpose is to develop a savings and investing plan that will provide a high likelihood of meeting the client’s objectives. As I discuss the various models I will refer back to see how well each allows the advisor to accomplish this purpose.
The first divide that exits is between brokers who earn commissions and Registered Investment Advisers (RIA’s) whose compensation comes directly from their clients. One way commissioned brokers are compensated is via trading commissions. If you make a trade in your brokerage account, the broker dealer charges a commission. The advantage of the pure commission model regarding investment costs is that you only pay a fee when you make a trade. Thus, a client who prefers a buy and hold strategy and does little trading may save on fees if they set up a brokerage account with no asset management fees. But the commissions on a full service brokers can be quite high when you do make a trade. For example if you wanted to invest $40,000 in an ETF the commission might be $400 at a full service broker vs $9 at a discount brokerage. With that increased trading cost you are paying for the advice of the broker as to which trades to make. However, brokers who are compensated via trading commissions generally only provide limited financial planning services (since they are not compensated for that) which, as I mentioned above is where I believe the value of working with an advisor truly lies. There is also incentive for the broker to try and increase the amount of trading that is done to increase commissions (known as churning).
To deal with the issue of churning, the brokerage firms in the 1980’s also began offering what is known as “wrap” accounts. With a wrap account the client does not pay commissions on individual trades but instead pays a fee that is calculated as a percentage of the assets being managed by the broker (usually 1%-2%). This model is also known as Assets Under Management (or AUM). Comprehensive financial planning services may or may not be provided as part of the wrap fee depending on the size of account.
In addition to trading commissions or wrap fees, brokers also earn commissions from other sources primarily mutual fund companies. The two primary sources of commissions generated by mutual funds are one time upfront sales charges (often called loads) and ongoing back end commissions called 12b-1 fees that are part of the annual expenses clients pay who purchase these funds.
A big difference between brokers and registered investment advisers has to do with the standard of care to which they are held to in relation to their clients. Brokers are held to what is called a suitability standard, which means that they are prohibited from placing clients in investments that are clearly unsuitable for their situation (i.e. recommending a high risk alternative investment for retired couple on a fixed income). But there is no requirement that the investments recommended actually be in the best interest of their client, particularly when it comes to fees. For example, if there are two possible investment alternatives that meet the needs of the client and one pays a significantly higher commission to the broker but is more costly for the client, the broker is not obligated to disclose the lower cost alternative to the client. You are relying primarily on the integrity of the particular broker and integrity levels can vary widely. In addition, brokers are typically under pressure from their firms to hit aggressive targets for commission and fee income.
RIAs, on the other hand, are held to what is called a fiduciary standard which means they are required to always recommend alternatives that are in the best interest of their clients, even if that means their compensation is negatively impacted. Again, whether RIAs follow that requirement to the letter will depend on the integrity of the advisor. The New York Times recently published a good article called “Before the Advice, Check out the Adviser” which addresses this fiduciary versus suitability issue (a link to the article is at the bottom of this post).
So how do you tell the difference between a broker and a RIA? You can’t go by what advisors choose to call themselves. There is no standard out there with regard to titles. Financial Advisor, Financial Planner, Wealth Manager etc. are all interchangeable. Brokers and RIAs can call themselves whatever they want. Professional designations don’t necessarily help either. The Certified Financial Planner designation, which is generally perceived as the most respected financial planning designation, is open to both brokers and RIAs although there is a Code of Ethics that all CFP’s must adhere to. The best way I know of to tell the difference is to look at the fine print at the bottom of the front page of an advisor’s website. If it says FINRA or SIPC somewhere that means that you will be working with a broker. FINRA is the self-regulating organization for the broker dealer industry and SIPC provides protection for investors whose broker dealer goes out of business. Many of the big financial firms you have heard of employ brokers (Merrill Lynch, Morgan Stanley, Wells Fargo, UBS, Ameriprise, Edward Jones etc.) as well as the insurance companies (Northwestern Mutual, New York Life, Prudential etc.).
Next I will delve a little deeper into the various RIA compensation models. There are generally three ways in which clients are billed: Asset Under Management (AUM), Flat Fee or Hourly. The majority of RIAs operate under the AUM model in which a client is charged a fee based on the percentage of assets being managed by the advisor (similar to the wrap fee charged by the full service brokerages). A typical percentage is 1% but there is often a sliding scale where the percentage drops as assets increase. Clients of RIA’s must also pay trading fees at a broker dealer used by the RIA but RIA’s use discount brokers with very low fees. Most RIA’s also provide financial planning services as part of the fee. The primary reason the AUM model is the dominant model is that it is easy to understand, the interests of the RIA is generally aligned with those of the client, and for the RIA it provides a predictable stream of income.
However, I see a few problems with the AUM model. First, I think it puts too much emphasis on asset management. Often clients of RIAs who charge an AUM fee have an expectation that in order to justify the fees paid, their portfolio should outperform market indexes. However, academic research has proven that this is extremely difficult to do this and very few advisors are able to achieve this over the long term. Instead much of the value in working with an RIA, as I mentioned earlier, comes from the insights gained from reviewing the financial planning process and the discipline that is provided by having an independent and knowledgeable third party help guide decision making. But that value is “discounted” if the RIA’s compensation is determined solely on the performance of the investment portfolio.
Another issue I see with the AUM model is that, although somewhat rare, there are times when conflicts of interest can arise. For example it may make sense to liquidate a portion of a client’s portfolio to pay off a mortgage. This would cause the advisor’s compensation to decrease. Another example would be the decision on whether to rollover a 401K to an adviser managed account or to a new employer’s 401K. There may be situations where rolling over to a new 401K instead of the advisor managed account is the better option.
The final issue I see is one of fairness. As a general rule, the work and effort needed to manage a $2 million portfolio is the same as managing a $1 million portfolio but the former client may be paying twice the fees. While it is true that complexity generally increases as net worth increases, it is not linear and is not based solely on the size of the investment portfolio. Tax and estate planning issues are usually what cause complexity to increase.
The other ways RIAs are compensated is by charging a flat fee for services provided or fees based on an hourly rate. In my opinion, these are the fairest and most transparent methods of compensation to advisers, and a combination of these two models is what I have adopted. The challenge for me and others adopting this model will be to break through the clutter in the marketplace and get enough potential clients to understand the value. But I am confident that the word will get out and that the market will gradually shift in this direction.
Here is the link to the NY Times article I referred to above. http://nyti.ms/1D1ueoW