Financial Advisors (Part 3): The Four Ways Advisors Charge For Their Services

Taylor Schulte: Hey everyone, three quick things before we start today's show.

First, thank you for your patience these last few weeks. There were some personal and professional things in my life that needed extra attention, including an unfortunate death in the family, and I just needed to take a deep breath and hit the reset button. But we're back, it's a new year, I'm excited, and I have some great episodes lined up for everyone. So, thank you again for hanging with me.

Second, you might have noticed that episodes have been published on some different days of the week recently. Internally, we have been experimenting with some different publishing days to see what seems to work best for our listeners, and have landed on a Wednesday publish date going forward. So, barring any technical difficulties on the editing side, this show will be published on Wednesday mornings beginning next week.

On Thursdays, as many of you know, the Stay Wealthy newsletter will continue to hit your inbox. And if you're not subscribed yet, just head over to youstaywealthy.com/email.

Lastly, a big thank you to everyone who took me up on my ‘buy one, give one' offer last month. You will be hearing from my team soon on next steps, I promise. And if you happened to miss the offer – or you got distracted during the holidays – I've decided to extend it until the end of January. In short, if you pre-order a copy of my upcoming book, More Than Money, I'll match your order and send you a second copy that you can give away to someone you think will appreciate it.

All proceeds from the book are being donated to non-profit organizations supporting financial literacy, so nobody is making money from these book sales. If you're interested, I'll add detailed instructions and links in today's show notes which can be found by going to youstaywealthy.com/176.

Ok, onto today's show.

Welcome to the Stay Wealthy podcast! I'm your host Taylor Schulte and today I'm tackling part 3 of our series on financial advisors.

Specifically, I'm diving into the different ways financial advisors charge for their services.

In fact, there are four main fee structures you might come across when interviewing advisors. And I'm breaking down all four, what you need to know about them, and their pros and cons.

Once again, for all the links and resources mentioned today, head over to youstaywealthy.com/176.

I firmly believe that you get what you pay for when spending money on goods and services. There are exceptions, of course, but in general, and across a large enough sample size, I expect the value I receive from something to be in line (or even exceed) the dollar amount I pay for it.

If I choose to pay $1,000/night to stay at a Ritz Carlton because I enjoy luxury hotels, I would absolutely expect to receive more value than if I stayed at the Super 8 across the street for $150. But that's me. Others might see spending $1,000 for a luxury hotel as a giant waste of money and just another place to close their eyes for the night. Everyone measures value differently.

Everyone also values their time differently. I might want to spend my free time playing golf or hanging with my family and, in turn, hire someone to handle my weekend yard work. But you might LOVE your weekend yard work – it might energize and fuel you – and you might never consider paying someone to do it for you.

Lastly, everyone has different levels of complexities. My tax picture might require an experienced CPA who charges $10,000/year, while you might be able to file your basic tax return with your eyes closed and skip paying a professional.

Everyone measures the value they receive from a product or service differently. Everyone values their time differently. And everyone has different levels of complexities. Nonetheless, the value you receive from something or someone – however YOU measure it – should be in line or even outweigh the cost.

With this in mind, when it comes to evaluating the cost of a service, what's most important, is that the costs are transparent AND they are explained in a way that you can understand.

And, in the world of financial advisor fees, this is where things get a little murky and complicated. Because, unfortunately, fees are not always transparent, and they are not always explained or communicated well. Sometimes the fees are intentionally structured or explained in a confusing way so that retirement savers don't actually know what they're paying or even how they're paying it.

You might have thought I was kidding in part one of this series when I said there are financial advisors – or financial advice services – who claim to charge no fees at all. But that wasn't a joke, unfortunately.

While I can't control how all 300,000 advisors in this country structure and communicate their fees, I can do my part to educate retirement savers so that, if and when they need to hire a financial advisor, they are equipped with the knowledge and information required to make the best decision for them and their family.

So, that's my goal today. To educate. And to provide you with CLEAR information about the different ways a financial advisor might structure their fees so you can make an educated and informed decision if and when you decide to work with one.

My goal is also to be as objective as humanly possible given that I'm a practicing financial advisor and I have my own personal opinions about this topic. But I'm doing my best to set those opinions to the side today..to give you the information straight and to let you decide for yourself what aligns best with your needs, your values, and your situation.

On that note, there are three things I want to emphasize before we dissect the different ways financial advisors might charge for their services:

1. Contrary to what you might read or hear, there is no perfect, one-size-fits-all fee structure. Every fee model can be a disservice to someone.

2. Every fee model contains conflicts of interest.

3. There is no such thing as a free service or a financial product that doesn't contain fees. Unless, of course, you are literally taking advantage of a pro bono advice offering through an organization like the Foundation for Financial Planning.

By the way, these three things are not limited to financial advisors. We can make the same observations about fee models for doctors, attorneys, real estate agents, and any other service professional.

So, again, what is most important is that the fee structure is transparent, we understand it, and the value we receive – however we choose to measure that value – is in line with those fees. If you want premium wealth management services from an experienced advisor who specializes in working with people in your exact situation, you should expect to pay more – and receive more value – than if you hired a generalist with very little experience with a short list of services.

With all of that in mind, let's get into it. Let's review the four different ways a financial advisor might charge for their services. As always, in the spirit of keeping things simple, I'll propose that there are two categories of fee structures used by advisors – transactional fees and ongoing fees.

In the transactional fee category, we have the commission-based fee schedule and the hourly or project-based fee schedule. And I refer to these fee models as transactional because they are limited-term engagements. You aren't committing to paying ongoing monthly, quarterly, or annual fees. You are paying a single fee in return for a single product or service.

As a result, you can decide for yourself how frequently you want to engage with that transactional advisor, knowing that each time you do, you will pay a fee.

In the ongoing fee category, we have annual retainer fees (also referred to sometimes as “flat fees”) and the percentage of investments being managed fee (also commonly referred to as an AUM or Assets Under Management fee). And I refer to these as ongoing fees because you're committing to an ongoing service model. You're paying a pre-determined, ongoing fee with the intention of being a long-term consumer of the services being provided.

So, two categories and four different ways a financial advisor might charge for their services. And as previously noted, there is no perfect one-size-fits-all fee structure. Each one has its benefits and drawbacks. Choosing the right financial advisor and the right fee structure will depend on your unique needs, goals, and situation.

Let's break each one down by starting with the transactional fee category.

The first fee schedule in the transactional category is commission-based. A commission-based financial advisor only gets compensated if you buy a financial product from them. In general, the more dollars you use to buy that product, the higher the commission the advisor receives. And that's because the commission is represented as a percentage.

For example, if you invest $2MM into a commissionable variable annuity product, the commission-based advisor will get a larger commission check than if you invested $1MM into the same annuity. A 5% commission on a $2MM annuity purchase is more than 5% on a $1MM purchase.

Similarly, if you allocate $100,000 of your hard-earned money into an A-share mutual fund, the advisor will get paid more than if you only allocated $50,000.

It's really not all that different than a real estate agent who receives a higher commission for transacting with more expensive homes. And just like a real estate agent, a commission-based advisor is naturally incentivized to encourage not just larger transactions but also more transactions. The more transactions they fulfill, and the larger those transactions are, the more money they make.

Which can potentially leave a client wondering if the recommendation (or recommendations) they're being given by their advisor are truly in their best interest. In other words, is the financial advisor recommending that you buy more of this mutual fund or buy this annuity or buy this insurance policy because it truly is the best thing for you? Or are they just trying to meet a sales quota or make more money for themselves?

Now, this doesn't mean that financial advisors who earn commissions are bad or dishonest or that you should rule them out. Because there are some clear benefits to this fee model. Let's review the three main pros of working with a commission-based advisor.

1. The commission you pay is a one-time fee. You pay for things as you need them and you aren't committed to paying ongoing fees every quarter or every year. Over long periods of time, depending on your needs, paying a one-time fee or commission can be beneficial and could outweigh paying ongoing fees to an advisor.

2. Commissions are often built into the economics of the product being sold, so you don't typically have to write a check out of pocket. In other words, you'll end up with a slightly smaller insurance benefit or a smaller starting investment account balance because of the fees built into the product – you're not having to disrupt your cash flow and write a check out of pocket to pay for it.

3. For households with a lower net worth, a commission-based fee model can improve their access to financial advisors and financial advice. As you may have experienced firsthand at some point in your life, many full-service wealth management firms require large investment account balances or a certain level of net worth to work with them. Since most commission-based advisors don't have these sorts of requirements, they often become a viable option for investors who need help and guidance but don't meet the minimums of specialist firms offering premium services.

There are, of course, some drawbacks to this model as well. This is not exhaustive but the three main cons to highlight are:

1. While commissions are technically required to be disclosed, they can sometimes be disclosed in a way that is hard for someone to understand. And in some cases, the disclosure can get so crafty that it suggests there aren't any fees at all since the consumer isn't required to write a check out of pocket.

2. Since the advisor only gets paid when a client buys or sells something, commissions can encourage, or even incentivize, unnecessary transactions. For example, swapping an old annuity for a new one may not provide any additional benefit to you, but it gives the advisor another one-time commission.

3. Lastly, number three – and we'll talk about this more before we wrap today's episode – but commission-based advisors aren't required to adhere to the fiduciary standard. In other words, they are NOT legally required to put your interests ahead of their own. They don't have to shop the marketplace and recommend the highest quality product at the best price. As long as the stated objective of the financial product matches your stated goal (i.e., income or growth), matches your tolerance for risk, and the proper disclosures are made, they can sell you that product.

So, naturally, you might now ask, what is a typical commission being charged by a commission-based financial advisor?

Well, as noted, commissions largely depend on the amount of dollars being transacted, the type of product being purchased, and the firm selling those products. But in general, commissions can range anywhere from 1% to 10% of the dollars used to purchase the product.

In other words, if you allocate $500,000 to a variable annuity that pays the advisor a 6% commission, they will receive $30,000 of compensation. And while you aren't paying them a $30,000 fee out of your pocket, I want to emphasize here that you are paying the fee and you are contributing to the compensation of that advisor.

The fee is just built into the economics of the product you're buying from them. I.e., the guarantees and benefits contained in your variable annuity are being reduced by at least that amount to ensure that commission can be paid to the advisor and the insurance company remains profitable. Maybe instead of a 7% guaranteed living benefit growth rate, it's 5%. Or maybe the mutual funds inside the annuity are a unique share class with higher expense ratios allowing the insurance company (and your advisor) to get a share of that revenue.

You would never know these things because the product offering just discloses what's being offered…not what could have been offered if the commission paid to the advisor was lower. Again, my goal is not to be critical here – everyone deserves to be paid fairly for the work they are doing. I just want to emphasize that just because you aren't cutting a check to the advisor out of your pocket, it doesn't mean you aren't paying them for his/her time and assistance.

By the way, commissions are not restricted to insurance products. Many brokerage firms and their financial advisors still sell commissionable investments, like A-share mutual funds, structured products, and alternatives. They also sell individual bonds, like municipal bonds and corporate bonds.

Once again, the commission you're paying them when you buy a municipal bond is baked into the economics of that purchase. The bond might have paid a 5% coupon instead of 4% if the commission was lower. You would never know that because fees aren't always easy to find and interpret on your own.

And by the way, this applies to do-it-yourself investors buying individual bonds through a discount brokerage like Schwab or Fidelity. It also applies to buying individual stocks and ETFs – a hidden fee known as the bid/ask spread. So, just because a financial advisor isn't doing the purchasing for you, the brokerage firm or custodian is still clipping a fee on every bond/stock/ETF transaction and it isn't always completely transparent.

In summary, commissions and commission-based advisors aren't bad. They fill a need and can be a good solution for some people based on their needs and goals. The challenge is that sometimes understanding exactly what you're paying and/or what you're giving up is hard to find. So, when in doubt, ask as many questions as needed so you can make an informed decision with your hard-earned money and the professional or professionals you consider working with.

Ok, the second transactional fee model is hourly or one-time project-based fees. While there are some differences between hourly fees and project-based fees, I consolidated them into one category because they, more or less, accomplish the same thing. They are limited-term engagements that allow you to pay a transparent fee in return for a service.

While hourly fees and project-based fees are transactional in nature and could therefore be considered a commission, there are really two big differences that separate them from the commission-based fee model we just reviewed:

1. Hourly or project-based fees are paid out of pocket by you, the client, and therefore are represented in dollar terms. The formula used by the advisor to come up with the proposed fee might be based on a percentage of your income or net worth or investment value, but at the end of the day, you will know the exact dollar amount being earned by the advisor because you will be cutting the check out of your pocket.

2. An hourly or one-time project-based fee is being paid strictly for financial advice, not in return for the purchase of a financial product like an annuity or mutual fund or basket of municipal bonds. In fact, these advisors won't implement any recommendations at all, including the processing of a Roth conversion or the reallocation of your investments. An advisor who is 100% dedicated to offering hourly or one-time project-based fees is doing so to serve the needs of people who are ONLY interested in short-term, transactional advice.

As noted in last week's episode, these advisors are often referred to as advice-only advisors. They tell me what lawn mower to buy and when and how to mow my lawn, but they won't actually show up to my house and do the work for me.

Before we talk about typical fee ranges and the pros and cons of this fee model, you might be wondering what the difference is between hourly and one-time fees, or why one advisor might choose to offer one over the other. It's really just a personal preference determined by the financial advisor and is often tied to the type of advice they give and the people they specialize in helping with.

It's not all that different than the legal world. Some estate attorneys charge an hourly rate to write your estate documents and others quote a one-time flat fee. Those attorneys quoting a flat fee typically work with one single demographic and have a predictable, streamlined process for writing estate documents, where the hourly attorney might not be able to accurately predict the time and resources that will be required because every case and every client looks different.

Or, they might just have a personal preference to bill by the hour so they never have to think about the complexity of the situation and how to price it.

Ok, so what is the typical fee range one might expect to pay for advice – either by the hour or as a flat one-time fee?

According to a 2020 study by Derek Tharp at Kitces.com, the median hourly fee for a financial advisor who also has their CFP designation was $250/hour. And while the Kitces study shows hourly fees for Certified Financial Planners topping out around $320/hour, based on my personal experience, it's not uncommon for the top end of hourly fees to hover around $500/hour for more experienced advisors.

And, while less common, there are advisors who charge closer to $1,000 an hour. In addition to experience, those premium-priced advisors typically have a very specific set of skills and specialize in working with a certain type of individual. More like a brain surgeon than a general practitioner.

As for one-time project fees, the median fee for a standalone comprehensive plan in 2020 was $2,500, according to the same Kitces study. More complex plans or projects, however, were shown to top out at $15,000 which closely aligns with my personal experience talking with advisory firms around the country.

So, somewhere between $200-ish/hour and $1,000 per hour for hourly advice and $2,000-ish and $15,000 for a comprehensive one-time standalone plan answering your big questions.

Once again, there is no perfect fee model and each contains its own set of benefits and drawbacks. Let's first talk about the three main pros of hourly and one-time project-based fees:

1. First, as previously noted, fees are quoted in dollar terms and paid by you, out of pocket. This eliminates the chance that the fees are hidden or presented in a confusing way. While you may not think the fee is fair or in line with the value being delivered, it is transparent and easy to understand, and that is a huge positive.

2. This fee model fills a gap in the financial advice profession, serving people who don't want help with the heavy lifting, implementation of advice, and/or ongoing maintenance of a financial plan. They can lean on a professional when and if they have a question or a pain point to address without committing to an ongoing relationship and without giving up control of their investments and the execution of their ongoing planning tasks.

3. Since the advisor doesn't benefit from the advice being given or a product being purchased, it reduces a layer of conflict and, in some cases, might allow the client to better accept the recommendations at face value. They don't have to question if the advice being given is in their best interest because the advisor giving the advice doesn't benefit at all from them implementing the advice.

The car salesperson only gets paid if you buy a car, so they are incentivized to sell you the car. But the hourly advisor or project-based fee advisor doesn't have any incentive to convince you to implement the advice being given. If you sell Mutual Fund A and buy Mutual Fund B based on their recommendation and advice, it doesn't change how much money they make. If you decide not to process a Roth conversion or make a charitable donation to reduce your tax bill, it doesn't change how much money they make.

Ok, those are the pros to this fee structure. Let's now talk about the three main cons or drawbacks to take into consideration.

1. First, this fee model is transactional. Like a commission-based advisor is incentivized to sell more products, an advisor operating under this model is incentivized to bill more hours or take on more clients and more projects. This can lead to either the advisor creating unnecessary work to earn more money OR it can lead to them taking a more reactive role in their client relationships.

In other words, because they might be working on (or looking for) the next transaction, they may not be proactively reaching out to you to discuss new planning opportunities or how recent changes in the tax law this year will affect your situation or affect the advice you were previously given.

2. Number two, in a similar vein, if you're in a reactive and transactional advisor relationship, you might have to accept that you will need to take on the responsibility of reaching out to them to ask questions, learn about opportunities, and get your plan or prior recommendations updated. And because reaching out to them will trigger a bill, you may decide not to reach out and either try to figure it out on your own or roll the dice and hope things will work out ok.

This happens a lot in the legal world – people don't want to contact their attorney to update their estate documents or ask a question because it generates another bill. So they kick the can down the road, and in some cases, wait until the problem or pain point is so big that it's even more costly and time-consuming to fix.

3. Lastly, and we've talked about this at length before on the show, financial plans and, in many cases, recommendations made by financial advisors are outdated shortly after they are delivered. And without any ongoing commitment to keeping the financial plan updated throughout the year, you could potentially be at risk of your plan not keeping up with your rapidly changing life. Changes to tax laws, investment fees, estate laws, or the economy can also dramatically change the advice that was previously given under a limited-term or one-time agreement.

These drawbacks don't mean that this fee model should be ruled out – just know that if you prefer and choose a transactional fee model that often relies on you to be the proactive person and requires you to implement all of the recommendations, you will likely want to create a process and system for keeping your plan and the advice you were given up to date.

Ok, so those are the two primary fee models in the “transactional” fee category. For some, paying for advice or paying for products on a transactional basis is appealing and fitting for their situation. For others – while it might have been interesting to learn about these options – you might need and want more from a financial advisor.

You might need more help, more guidance, and a more proactive relationship. You might also need and want less to fall on your shoulders. You might want to spend less time managing and maintaining things on your own, and instead, delegate the responsibilities to a professional so you can spend time doing the things that matter most to you. And that's where ongoing fee structures can fit in.

Once again, in the ongoing fee category, we have annual retainer or subscription fees (sometimes referred to as a flat annual fee) and then we have the percent of investments being managed or AUM fee.

Let's start with the former. Annual retainer or subscription fees can also be referred to sometimes as a “flat fee” or a flat annual fee. I know, I know, more industry jargon. But it's really pretty straightforward and easy to identify.

Under a flat fee or annual retainer structure, you will agree to pay your financial advisor an annual dollar amount in return for ongoing comprehensive financial planning advice, investment advice, AND the implementation and monitoring of their recommendations. Instead of telling you what lawn mower to buy, they'll buy the lawn mower for you, mow your lawn, and in most cases, maintain every square inch of your yard throughout the year.

The annual fee paid to the financial advisor is represented and quoted in dollar terms and typically broken up into monthly or quarterly payments. It's also either debited from your checking account or charged to a credit card – it's not hidden inside of any products or built into the economics of an investment.

It will be very clear what your fee is, how often you're paying it, and where it's being paid from. Just like hourly fees or one-time project fees, annual retainers or subscription fees are based on the scope of work, the complexity of the client, and the experience/expertise of the financial advisor. Internally, the financial advisor might base your proposed fee on a percentage of your income, a percentage of your net worth, a percentage of your investable assets, or some combination of all three. Regardless of their methodology, the annual retainer (or flat fee) will be proposed to you in dollar terms.

And while some advisors operating under this fee model might limit the scope of their services, most would fall under the “full-service” category I referenced last week. They are doing all of the heavy lifting for you on an ongoing basis in return for a flat annual fee quoted in dollar terms and billed on a monthly or quarterly basis.

You might be familiar with this sort of fee model in the medical world, where it has become increasingly popular to skip traditional health insurance and instead pay a recurring monthly or annual out-of-pocket fee to a doctor (or a doctors group) in exchange for unlimited visits, 24/7 access to services, little to no wait times, and more.

This fee structure and service model is commonly referred to as concierge medicine or, more precisely, “Fee for Care” (FFC). Just like the fee for care model has benefits and drawbacks, so too does the annual retainer or annual flat fee model offered by some financial advisors.

But before we dig into the pros and cons, let's first touch on the typical annual retainer fees being charged by financial advisors who offer this fee structure. According to the same 2020 Kitces.com study referenced earlier, the median annual retainer fee was $4,000 per year or, if broken up into monthly payments, about $333/month. And while the top end of fees hovered around $8,000/year, the study reported some advisors charging $40,000+/year for their services.

Part of the reason for the wide range in pricing is that this is a relatively new fee structure with a very small percent of advisors offering it. So the sample size being looked at is much smaller than more traditional fee structures that are widely adopted, and in turn, the data isn't as reliable.

That said, similar to the hourly fee model, advisors who have more experience, have credentials like the CFP, and more importantly, are specialists in helping people in very specific situations are those that have higher retainer fees. Of course, the complexity of the clients they work with and the scope of their services being offered will influence the annual retainer fee as well.

So, while the range of fees under this structure is fairly wide, and the sample size of advisors offering this fee structure is still fairly small, I'd say somewhere between $4,000/year and $15,000/year is what most clients would expect to find when exploring this fee model. Also, it's fairly common for financial advisors charging annual retainer fees or flat annual fees to also include an annual inflation adjustment in their fee agreement since $15,000 today is not the same as $15,000 tomorrow, as we all have been reminded of recently.

Ok, let's dive into the pros of this fee structure:

1. First, annual retainer fees, or flat annual fees, provide more access to financial advisors. As discussed when we reviewed the commission-based fee structure, not everyone has large investment account balances to turn over to a financial advisory firm to professionally manage and oversee.

A person's net worth might be tied up in their business, a company 401k plan, in real estate, or in other illiquid private investments. Someone could literally be worth hundreds of millions of dollars and not have any traditional investment or retirement accounts for a financial advisor to manage.

There are also many successful professionals with six and seven-figure incomes who have the means to pay a premium fee to a financial advisor out of pocket, but they don't have a sizeable nest egg yet. Up until recently, these people didn't have much of an option for hiring a full-service, experienced financial advisor.

Now, with the growth of advisors offering this fee structure, everyone from 22-year-olds riddled with student loan debt to 60-year-olds transitioning into retirement have access to financial advice under this sort of model if it proves to be fitting for them.

2. Similar to hourly fees and project-based fees, the annual retainer fee structure is transparent and easy to understand. The fees aren't baked into the economics of a financial product or hidden in fine print on page 87 of the contract. They are discussed upfront, proposed in dollar terms, and automatically debited directly from the clients checking account or credit card.

Every month, or every quarter, the client can see exactly what they are paying their financial advisor, allowing them to determine if expectations are being met and if they are getting the value and service from their advisor that they need. Because of this transparency, the client also doesn't have to question how their advisor is being paid and if their recommendations are truly in their best interest.

In other words, the advisor doesn't get compensated more if you take action on their recommendation to buy life insurance or go ahead with a Roth conversion or agree to contribute more money to your investment accounts.

3. This fee structure allows for more pricing flexibility and service models offered by the advisor. As a result, some financial advisors have different annual retainer fees for different service models. Maybe you need and want a long-term, ongoing relationship with a financial advisor but you don't need the full suite of wealth management services.

For example, maybe you need ongoing financial planning, tax planning, and good old-fashioned accountability, but you want to manage your investment accounts on your own. Some advisors that offer annual retainer fees provide options like this for you to choose the service model that most aligns with your needs, goals, and preferences.

Ok, let's now review the cons or drawbacks of this fee structure:

1. First, annual retainer fees or flat annual fees, as mentioned, are paid out of pocket by the client, either by an automatic direct debit from their checking account or credit card. In other words, the fee is paid directly from the client's cash flow – it's not baked into the economics of an investment product or debited directly from their investment accounts.

While paying fees out of pocket isn't necessarily a bad thing, not everyone has 5 or 10 or $15,000 of free cash flow every year to pay a financial advisor. And just like other monthly fees such as Netflix subscriptions or country club memberships are often the first to be cut when going through difficult financial times, monthly or quarterly retainer fees paid to a financial advisor out of pocket can also end up on the chopping block.

And parting ways with your trusted financial advisor during tough financial times might be like firing your doctor when you're in bad health or ditching your attorney when you get sued…not necessarily the most ideal timing. The transparency and saliency of fees is absolutely a good thing, but unfortunately, this fee structure can also cause more fee sensitivity and change our perception of the value being received.

2. If you pay a financial advisor a flat annual retainer fee that includes the management of your investments, the advisor isn't incentivized to grow your portfolio. Yes, they might be incentivized because they're a fiduciary to their client and it's the right thing to do, but they don't earn more money if they help you earn more money.

Similarly, if your investments lose value – if we go through another 2008/2009 event in the markets – the amount you pay your flat fee advisor doesn't change either. Your investments could drop in value by hundreds of thousands of dollars (or millions of dollars), yet the $15,000/year you're paying your flat fee advisor won't change as a result.

Now, that might not be an issue depending on your needs, preferences, and your specific situation – especially if you hire an advisor to do more than just manage your investments. Just a potential drawback to take into consideration.

3. Annual retainer or flat annual fees can potentially lead to unintentional underservicing or even overservicing. Here's why: Typically, when someone hires a financial advisor with an ongoing fee and service model, their intention is that they will be working together for a long period of time. Maybe forever. And, when you work with someone for a long period of time, it's normal to go through different periods of life – somewhere you need a lot from your advisor and others where you don't need them much at all.

At some point during the lifetime of the relationship – and because flat annual retainer fees can be difficult to price properly upfront – the advisor might feel like they aren't getting paid fairly for the amount of time and work they are doing.

In addition to many other feelings, this could lead an advisor to pump the breaks on doing more work that month or that quarter or simply not be as responsive. Unlike a transactional advisor, more work doesn't mean more money, making situations like these tough to reconcile in the moment.

On the other end of the spectrum, when things are calm on the client's end, the client might feel like they are overpaying their financial advisor. The “what have you done for me lately” question starts to creep into the client's mind, especially when they see their credit card being swiped for $1,000 each month. And after investing a significant amount of time to find the right advisor and build a strong relationship, the last thing you want is any sort of animosity to creep in and cause friction, or worse, lead to the parting of ways.

This can, of course, be solved by setting proper expectations and addressing these potential issues out of the gate. It can also be solved by the financial advisor and the implementation of a proper service model. But it's a downside to any retainer model in any industry to take note of.

Alright, let's wrap up by reviewing the second ongoing fee structure to consider – the percentage of investments being managed or sometimes referred to as an Assets Under Management Fee or AUM fee.

This is, by far, the most common fee structure adopted by the financial advice industry. Everyone from the discount brokerages like Vanguard, Fidelity, and Schwab to robo-advisors like Betterment, Wealthfront, and Personal Capital to giant publicly traded advisory firms and small, local independent firms.

If you're not familiar, in short, this fee structure is represented as a percentage and applied directly to investment and retirement accounts being managed by your financial advisor. For example, if you have a retirement nest egg of $1 million and a financial advisor under this fee structure charges 1% per year for their services, your annual fee would be 1% multiplied by $1M, or $10,000 per year.

There are four things to highlight here before we go any further:

1. The percentage fee is broken up into four quarterly payments. So, if the advisor's fee is 1% per year, they will charge 0.25% each quarter (or every three months).

2. Unlike the last two fee structures we reviewed, this fee is debited directly from your investment and/or retirement accounts. To keep it simple let's say you have $500,000 in a taxable brokerage account and $500,000 in a Traditional IRA. Each quarter, 0.25% of each account's account balance would be debited from each individual account. So, $1,250 would be debited from your brokerage account (that's 0.25% times $500,000) and $1,250 would be debited from your IRA.

In total, your quarterly fee would be $2,500, but the percentage fee is applied to – and automatically debited from – each individual investment account.

3. Because the fee is a percent of the investment account balances, it can and will fluctuate from quarter to quarter. For example, let's say we go through a difficult time period in the markets and your two hypothetical investment accounts I just referenced – your $500k brokerage account and $500k IRA – drop in value.

To keep the numbers simple, let's say each account is now valued at $400,000 after a rough quarter in the market. Well, as a result, your next quarterly fee will also be lower. Instead of $1,250 per account, it would be $1,000 (0.25% times $400,000). On the other hand, when and if your portfolio balances increase, so too will your fee. For that reason, many financial advisors using this fee structure offer discounts or breakpoints as your portfolio grows in value.

4. Lastly, this percentage fee we are discussing is strictly applied to your basic investment and retirement accounts. Brokerage accounts, IRAs, Roth IRAs, 401ks, 529s, and other traditional accounts you are familiar with. It is not applied to the value of a client's home or business or other non-traditional assets that would be an asset on your net worth statement. Those additional complexities, if they exist, may influence the proposed fee by your advisor and may introduce additional fees in some cases, but they aren't typically included in the traditional percent of assets fee structure we're discussing today.

So, why might a financial advisor who offers ongoing, comprehensive services – including retirement planning, tax planning, insurance planning, estate planning, and more – why might an advisor who provides these full suite of services base the client's proposed fee on just the value of their investment and retirement accounts? Managing a client's investment accounts is just one piece of the financial planning puzzle and one piece of a full-service offering, so why does that one piece determine the fee?

We'll discuss more when covering the pros and cons, but in short, advocates of this fee structure would argue that the size of someone's investment portfolio is a pretty good proxy for their overall complexity. That a person with a smaller nest egg likely has fewer moving parts and complexities than someone with a large nest egg. And like all fee structures we've discussed today, this one is certainly not perfect.

But given how widely adopted it is, and the surprising fact that the percentage fee charged by advisors has only gone up over the years (not down), suggests that it does seem to be a pretty good and fair indicator for the complexity of the client and the work that is required. It also suggests that there is an increasingly strong demand from retirement savers for this type of fee structure.

Now, I referenced 1% as a fee in my earlier example because it's a round number and makes for easy math. But percentage fees charged by financial advisors under this fee structure vary quite dramatically. And like every other fee structure we have reviewed, the fees charged by a financial advisor are highly dependent on the services they provide, their experience and expertise, who they specialize in working with, how specialized they are, and the number of clients they serve.

A more experienced advisor who limits the number of clients they work with and is more of a brain surgeon than a general practitioner will likely charge a higher fee than an advisor who works with every type of person and serves thousands of families.

But let's look at the data and the same fee study I've been referencing throughout this episode to put some actual numbers to this.

According to this 2020 study, the median fee for clients with portfolios up to $1M portfolio is actually right at that 1% figure or $10,000 per year. And for what it's worth, the large, publicly traded advisory firms we all know by name had a slightly higher median fee of 1.1%.

And, as previously mentioned, most advisors typically provide discounts or breakpoints to clients as their portfolios grow in value. In this study, the median fee for $2M portfolios was 0.90%, for $3M portfolios it was 0.85%, and for $5M portfolios is was 0.78%.

Again, these are median fees. In the 90th percentile of advisors participating in this study, fees climb up to 1.50% for portfolios under $1M and hover around 1% at the $5M portfolio level.

Now, this particular study is looking at full-service financial advisory firms. If we look at discount brokerages or robo advisor services, fees are certainly much lower. According to the Value Penguin blog, the median robo-advisor fee for a $1M portfolio is 0.30%, $7,000 per year less than the traditional full-service advisory firms measured in the Kitces study.

As I've mentioned likely too many times by now, you get what you pay for and the fee you pay should align with the services and the value you are receiving. The fees offered by discount providers are lower for a reason. Fewer services might be offered and the advisor you work with – if it's not a robot – might work with thousands of families instead of 100.

I did a multi-part series on robo advisors here on the podcast which I'll link to in the show notes, but in short, this is not a knock on robo advisors or discount brokerage firms. These are great options to consider depending on your particular needs. I just don't want people to mistake lower fees for a great deal. We're not shopping for groceries here.

By the way, for the last decade or so, many have argued that robo advisor fees and discount financial planning offerings by firms like Vanguard would put pressure on full-service financial advisors, causing traditional advisors to lower their fees. However, we've actually seen the opposite happen.

Fees charged by traditional full-service financial advisory firms have increased in the face of discount service offerings – which tells me that these discount offerings have reinforced the value that an experienced, comprehensive financial advisor brings to the table. The rise of robo-advisors has helped to draw an even more clear line between discount services and highly customized full-service wealth management offerings. Similar to the line that H&R Block helped to draw in the accounting world or Legal Zoom helped to draw in the legal space.

All that aside, and in summary, percentage of investment management fees typically ranges anywhere from 0.70% to 1.5% per year with the median fee sitting at 1% for those with a $1M nest egg. There are certainly firms that charge more and others that charge less, but that range seems to remain fairly consistent year over year and is likely what you would expect when interviewing a full-service financial advisory firm offering this fee structure.

With that, let's get into the pros of the percentage of investment or percentage of AUM fee structure

1. First, unlike flat annual retainer fees, hourly fees, and one-time project-based fees, a percentage of assets fee is deducted directly from a client's investment accounts and is not paid from cash flow. In other words, the client isn't having to write a check out of pocket to their financial advisor each month or quarter, or every hour. So long as they have an investment account balance, they will be able to find and pay for a financial advisor.

As a result, this fee structure is widely viewed as a benefit for those that have investment and retirement accounts but not a high income (like a retiree or entry-level employee), providing a viable path to getting access to ongoing financial advice.

2. To preface the second pro, I just want to emphasize that this is not advice, this may or may not apply to you or be a benefit to you, and there are some important nuances to discuss with your trusted advisors. With that disclosure out of the way, given that the percentage fee paid to your advisor is being applied to and deducted from each of your investment accounts, to the surprise of many, retirement accounts like IRAs and 401ks are able to pay their portion of the percentage fee with pre-tax dollars and without penalty.

For example, if you have $1M in a Traditional IRA and your financial advisor charges 1%, your annual fee as we mentioned earlier would be $10,000 per year. And that $10,000 per year is being deducted directly from your Traditional IRA, a pot of money that has never been taxed–which effectively allows the fee you pay your advisor to be paid with 100% pre-tax dollars.

To be extra clear, the fee being deducted is not taxed. It is deducted and withdrawn without tax or penalty. In case you're wondering, yes, the IRS does allow for this, it's not some magical loophole, but it's important to note that the fees being deducted from a pre-tax account like an IRA must be directly associated with that account.

For example, if you have $1M in an IRA and $500,000 in a taxable brokerage account, you can't pay the 1% fee associated with the taxable brokerage account from the IRA to try and maximize the tax benefit. However, even in that situation, ⅔ of the client's total annual fee is still being paid with pre-tax dollars. Again, there are nuances to take into consideration, and this is not tax advice, so be sure to review with your trusted advisors before coming to any conclusions of your own.

3. Lastly, number three, an advisor's compensation under this fee structure is closely aligned with your portfolio balances and the performance of your investments. In other words, they earn a little more compensation when your investments they are managing increase in value, and they earn less when your investments go down in value.

As one firm with this fee structure often says, “we do better when our clients do better.” And while investment performance is just one piece of the financial planning puzzle, many investors and retirement savers very much appreciate the alignment between their advisor's compensation and the status of their investments.

In addition, unlike the transactional fee structures we reviewed, a client working with an advisor under this fee structure is paying their advisor an ongoing, predetermined percentage fee. So, if the advisor recommends that the client sell mutual fund A and buy mutual fund B, the client is likely less inclined to question the advisor's recommendation. The advisor does not earn a commission or make more money by recommending that investment change.

In fact, if that investment recommendation they make results in poor performance, the advisor's compensation is actually reduced. In addition, if the advisor is also a “fee-only” financial advisor 100% of the time charging a percentage fee, they aren't earning additional compensation on all of the other planning advice they give and implement for clients throughout the year. Things like annual Roth conversions, buying long-term care insurance, charitable giving, dynamic withdrawal strategies, etc.

The client – assuming they trust their advisor – doesn't have to question if these recommendations are in their best interest or not because the advisor doesn't benefit or make more money from them taking action. The advisor is legally bound by the fiduciary standard to make recommendations in the best interest of the client.

By the way, the term “fee-only” is wildly misunderstood, and this is something we'll cover in more detail next week. But it was important to highlight here because many independent advisors that charge a percentage fee are also 100% fee only and don't earn commissions or additional compensation in any other way – mitigating some very big, important conflicts of interest.

Ok, onto the three main cons of this fee structure:

1. First, like every fee structure we've discussed, charging a percentage fee does contain conflicts of interest. The most obvious is that the more of your investments the advisor is managing, the higher of a fee they are being paid. While this issue is often overcome by extending fee discounts and breakpoints as the portfolio balance grows or more money is added, the conflict that can occur can come in the form of other recommendations an advisor might make.

For example, let's say you ask the advisor if you should invest your savings with them or use your savings to buy a home or even pay down the mortgage on your existing home. It's possible the advisor wrongly recommends that you invest your savings with them because they will make more money as a result. Or, maybe you have an investment account at another institution that has access to a unique set of investments or low-cost investments that can't be found anywhere else.

An advisor who isn't looking out for your best interest might suggest that you move that investment account to their firm, knowing that it will result in them making more money. Now, the one way to combat this conflict is to ensure that your advisor who is charging a percentage fee adheres to the fiduciary standard – that they are legally bound to make recommendations in the client's best interest.

We will get into this more next week, but some advisors will say that they adhere to the fiduciary standard when it's not necessarily true. If you want to be certain, I will link to a document that you can ask them to sign in the show notes. I call it the Letter Your Broker Won't Sign. And if they won't sign it, you will know that they don't adhere to the fiduciary standard and that this conflict of interest we just discussed will be present in your relationship.

2. Since the percentage fee is only based on the value of your investment account balances, it may not represent an appropriate fee for you and your situation and may cause confusion. While this fee structure has proven to be a good proxy for complexity, there are certain situations where someone has a million dollars in their investment accounts, yet paying a financial advisor 1% or $10,000 per year isn't justifiable.

This fee structure is a pretty good proxy, not a perfect proxy. And that's something you will need to determine when considering a financial advisor under this fee structure or any fee structure for that matter. In addition to the fee not being appropriate for everyone, the fee being a percentage of the investment account balances may cause confusion, and potential friction, in the client-advisor relationship.

For example, it would be very easy for a client to get hyper-focused on the performance of their investments in relation to the fee they are paying because the fee is quite literally a percentage of their investment account balance. They may wonder why they're paying their advisor $10,000 per year when their investments are losing value. Or they may wonder why they are paying their advisor $10,000 per year when they simply choose a handful of low-cost index funds and rebalance the account 1 or 2 times per year.

As previously noted, this percentage fee, when charged by full-service financial advisory firms, typically compensates the advisor for all of the services they are providing. Not just investment management, but also the retirement planning work they're doing, tax planning, insurance planning, social security optimization, behavioral coaching, etc. But since the fee isn't directly aligned with or attributed to those other services, it can cause friction in the relationship and hinder the clients' ability to match the fee they're paying to the value of the services they are receiving.

3. Lastly, con #3, the fee being represented as a percentage can result in a client overpaying their financial advisor. For example, when proposing a percentage fee, the client isn't always equipped to translate the fee into a dollar amount. They may not immediately realize that a 1% fee equals $10,000 per year. When the percentage fee is translated into a dollar amount, the client may realize they are paying for a higher level of service than they really need or they might determine that the value they are receiving from their advisor doesn't outweigh the dollar amount they are paying.

A fee represented as a percentage is less transparent than a fee represented in dollar terms and can lead to confusion and perhaps overpaying for services a client doesn't need or want. This fee structure can also be challenging for the client to audit and confirm that the fee they are being charged each quarter is accurate. And that's because the calculation method isn't always as simple as 1% multiplied by the current account balance.

Many advisors use a method known as “average daily balance.” I.e., charging a percentage quarterly fee on the average daily balance of the account. This method, while very fair, takes into account contributions and withdrawals each quarter and applies a pro-rated fee depending on how long the funds were in the account. The math can be tricky for someone to follow and audit and can introduce confusion and a lack of confidence in a relationship that is intended to be transparent and respected and highly valued.

One way to combat this is to request a detailed invoice each quarter, breaking down this calculation. Most advisory firms use a third-party service to calculate fees and process their billing, and these services can easily spit out a detailed invoice. In fact, many advisors proactively send these invoices to clients each quarter to avoid any confusion and maintain the level of transparency that they know is important in a client-advisor relationship.

When discussing fees about any product or service, it's natural for people to try and think about what fee structure provides the most bang for your buck. What fee structure allows me to get the most value and the best price? Interestingly enough, what studies on fees have shown, including the Kitces study I referenced a number of times today, is that all fee structures, more or less, end up in the same general range.

Michael Kitces made the following point in a recent interview. He said,

“If I take the average amount of revenue that an advisor gets paid for the number of clients they have, and then I add up how many hours they actually spend servicing their clients because we do some time-tracking studies around it as well, it comes out to be about $250 to $300 an hour on average. Obviously, there's a range. But the average advisor's percentage of AUM fees divided by the average number of hours the advisor services their clients, you end up at about $250-$300 an hour.”

That hourly rate is in line and competitive with the average hourly rates we discussed earlier in this episode. Which reinforces my point that it's not about what fee structure is best or why one is better than the other, it's about the client and what their needs are. Each fee structure serves a purpose and serves an important role in the financial advice profession.

While it can be confusing, I'm grateful for the number of options retirement savers have when exploring a relationship with a financial advisor. I do firmly believe that everyone - including financial advisors – should have a financial advisor. But I don't believe that every service model or every fee arrangement is fitting for everyone.

There is no perfect, one-size-fits-all fee structure. Every fee model can be a disservice to someone. Every fee model contains conflicts of interest. And there is no such thing as a free service or a financial product that doesn't contain fees.

As noted at the top of today's show, what is most important is that the fee structure being offered is transparent, we understand it, and the value we receive – however we choose to measure that value – is in line with those fees.

For all the links and resources mentioned today, including a copy of the Letter Your Broker Won't Sign, head over to youstaywealthy.com/176.

Thank you, as always, for listening and I will see you back here next week.

Episode Disclaimer: This podcast is for informational and entertainment purposes only and should not be relied upon as a basis for investment decisions. This podcast is not engaged in rendering legal, financial, or other professional services.