Financial advisor compensation is a topic with many opinions. In our investment practice we do not use the same compensation arrangements with every client because there is not a one-size-fits-all method.
That said, let's compare and contrast a few of the more common methods whereby clients compensate their advisors.
To review this subject properly we need to look at both the quantitative and qualitative aspects of compensation.
Meaning both the hard dollars you pay and the philosophical aspects as well.
The two main methods of advisor compensation are transactional and fee-based asset management. Transactional or "commission based" advisors tend to utilize things such as "A" share mutual funds, annuities, exchange-traded funds and stocks. A commission is charged to the client when the transaction occurs and the advisor gets a portion of that money as compensation.
Purchasing "A" share mutual funds entails a one time commission when you purchase them then ongoing management fees charged by the mutual fund company. Typically if you are investing less than $50,000 the commission is pretty steep, frequently being over 5 percent.
Proponents of this method argue that over the long haul it will end up being the least expensive way to invest due to lower ongoing internal fees which is possibly true.
They also point out that if you have larger dollar amounts to invest then you can qualify for discounts called "break points" and thereby the upfront "hit" is reduced in percentage terms.
The downside to this method is that even with discounts you are paying a pretty hefty premium in advance of an uncertain outcome.
And that in order to qualify for discounts you have to pool all your money with just one mutual fund company which may make it difficult to properly diversify your portfolio across many asset classes.
How long it takes investors to overcome an upfront commission depends on how much commission they pay and how the investment performs afterwards.
Based on our calculation, with all things being equal, an "A" share investor breaks even from the upfront commission at about seven (7) years.
Fee-based asset management means that you are paying, as the name implies, a management fee, typically as a percentage of the amount of assets the advisor is managing. That is frequently billed "quarterly in advance."
So for example if you invested $100,000 and the management fee was 1 percent then you would be billed $250 at the beginning of the first quarter (100k x 1% / 4).
From an economic stand point the more active you are in changing investments around the better the deal is for fee-based asset management. Conversely if you just want to buy and hold something then "A" shares might be for you.
You would need to ask yourself if you can plan to hold the investments for at least seven years to recoup the upfront commission.
Especially given that Vanguard founder Jack Bogle calculated that the most recent data says that the average mutual fund holding period is about four years.
From a philosophical stand point we prefer fee based asset management to commissions for the following reasons:
- It implies that the advisor is taking a long term perspective on the client relationship where they get smaller amounts of compensation over longer periods of time.
- You are not "pre-paying" for an uncertain outcome. It's a pay as you go arrangement.
- In a fee-based relationship your advisors compensation is directly tied to your investment's performance. The more you make the more they make and if you lose money their fee-based income goes down. Our clients like that a great deal.
- Fee-based asset management eliminates any transactional conflicts of interest.
Whatever method you use to compensate your advisor be sure you understand how it works and the compensation philosophy of your advisor.