By: Kevin Doll
Posted: 5/17/2024
Evolution of Financial Advisors and Fee Structures
Can you believe the stock market is over 400 years old? Many things have changed over the years from trading platforms and technology to the types of assets you can buy and the way you can buy, sell, and hedge them. The financial industry has also evolved, including the way advice is delivered and even more important in our opinion, the way you pay for advice.
You may recall scenes from one of my favorite movies Trading Places with traders on the floor of the stock exchange calling out prices and writing tickets for orders. This is one of my first memories of financial markets where traders usually profited from the spread between the bid and ask prices, and it was a pretty cutthroat environment. Things have come a long way since then!
Commission Based Fees
Probably the most well-known fee structure and the most popular for a long period of time, is the commission-based fee. Whether it was a stock, mutual fund, insurance product, or annuity, the salesperson would make a commission based on the product they sold. Typically, the more they sold and the more they traded, the more they made. The commission model was lucrative but faced criticism due to potential conflicts of interest where higher commission products (and churning of accounts) were often sold even if they were not necessarily in the clients’ best interest. While this model still exists, you don’t see it as much with true financial advisors or money managers, but insurance and annuity salespeople still rely heavily on these commissioned products.
Asset Under Management (AUM) Fees
Commission-based advisors morphed into what is probably the most popular fee structure today, the Asset Under Management (AUM) fee. Under this model, advisors charge a fee stated as a percentage of the assets they are “managing” or advising on. A common fee may be 1-1.25% of the first $2 million of assets with a lower percentage charged on assets above those amounts. For someone with $2 million in investment assets, the initial fee could range from $20,000 to $25,000 per year. This model was a step in the right direction because advisors’ success is relative to the success of the client’s portfolio, promoting a shared interest in growth over time and likely recommendations for more suitable investments.
We still see several flaws and possible conflicts of interest in this model. First, the more you invest when you start a relationship, the higher your initial fee, regardless of the amount of work or time the advisor spends on your behalf. We liken this to a weighing machine. Your asset level is weighed (measured) and it determines your fee. Imagine buying a car and the price of the car is based upon how much money you make. The more you make, the more you pay. Absurd, of course. Then why should the amount of assets you have determine the fee you pay an advisor?
And if the advisor’s compensation is based upon the amount of assets you have, doesn’t this sound like the quantity-driven commission income referenced above? It’s really the only place where you pay a fee based on the level of assets you have. You saved these assets and the advisor had nothing to do with your initial accumulation. Additionally, as you save more or markets increase (which the S&P 500 has done about 95% of time over any 10-year period in the last 95+ years), your fee continues to increase, but the amount of time spent on your behalf usually does not change.
Over time, clients may contemplate various decisions like paying off a mortgage, taking an expensive trip, converting funds to a Roth IRA, making gifts to charity or children or paying for grandchildren’s college, or even investing in real estate or another alternative investment. Your advisor is hopefully helping you make these decisions in the context of your overall comprehensive plan, but any of the above decisions would likely result in fewer assets for the advisor to manage (meaning less fees collected) potentially leading to a conflict in the advice given as the advisor tries to keep the assets under their management so their fees do not decline.
True Fee-Only
While our industry has many rules, regulations, and oversight, there are also many aspects not mandated or regulated, often causing confusion for investors. While most are familiar with what a commission-based fee means, there is not much regulation in terms of who can call themselves a “fee-only” advisor. This is unfortunate because most investors have shifted and been told to look for a “fee-only” advisor. Technically, if you pay a set rate for the services provided and the only fee an advisor is paid is from you, they can call themselves fee-only. This includes the above advisors charging fees on an AUM basis, even though those fees can change without you ever having to agree to the change. I would tend to call that a fee-based model (a fee based on the amount of assets you have), but that is not currently how the rule works.
I would argue a true fee-only advisor should charge a flat fee for the work they do, a fee you’ve agreed to and that doesn’t change unless you agree to it being changed. Like any other service or product you buy, these fees may go up over time for things like inflation or a change in the scope of the work being done, but you should know exactly what that increase is and agree to it before it is implemented.
We believe a true fee-only advisor has fewer conflicts of interest than other models. The advice has nothing to do with any product being used or sold, how much you have invested, where those funds are invested, or any decision you make changing the amount invested. We believe this truly puts the client first and they never have to wonder if a decision was in the best interest of their plan or the advisor’s bottom line.
A note on fund fees
There are too many types of investments to dig into the details of each here, but unless you’re buying individual stocks, most investments have underlying fees investors never see as they are not outlined anywhere other than a prospectus. Mutual fund and ETF fees (separate from advisor fees) can range from .03% to 1.5% or higher and have a material impact on the long-term growth of your portfolio. Investors should be mindful of these underlying fees and whether they justify using more actively-managed funds versus lower-cost index funds. Using a modest active manager fee of 0.75% versus a typical index fund fee of 0.06%, the annual difference on a $2,000,000 portfolio is $13,800. Ignoring the fee difference on the growth of the initial $2M, $13,800 at 6% for 30 years equates to another $1,091,000 that could be in a clients’ account. As the saying goes, is the juice worth the squeeze?
We’ve spent a lot of time discussing advisor compensation, but it’s equally important to understand the advice you receive for the fees you pay. Always important to remember – not all advisors are created equally. Stay tuned as we unravel the distinct differences between investments and planning – and the advisors who deliver these services.
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