Insight into how financial advisors charge for their services
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Survey data shows that, generally, investors do not understand how much their advisors charge for their services.
This is clear from a recent survey from State Street Global Advisors and one from Rebalance IRA, which found more than half of Americans incorrectly thought they paid no fees or minimal fees to manage their retirement accounts. In addition, SEI Investments Company performed a survey of the mass affluent 5 years ago and found 38% were either wrong or confused about how they were paying their advisors. Finally, Cerulli Associates and Phoenix Marketing International released a survey 10 years ago, which discovered that nearly two of every three investors in the survey were confused about how they were paying their advisors.
Why the confusion? The financial services industry must take accountability and do a better job of disclosing fees. While we may not be able to reform the entire industry with a single article, we will attempt to provide clarity on the topic and answer a few of the most common questions.
Three pay models
How do advisors get paid? The financial industry has three basic models for advisor compensation.
- Fee only: An advisory fee based on a percentage of assets under management. The advisory fee typically ranges from 0.5% to 2% of the amount invested; the rate is generally influenced by asset size and services provided.
- Commissions: A sales load or transaction fee tied to the product sold to the investor. The potential for a conflict of interest exists —a broker could be tempted to recommend an investment offering the highest personal payout.
- Fee-based: Advisors receive compensation from either model. The advisor may choose which method of pay or could even provide the client with an option to determine how they would like to pay for advice.
Investors are often uncomfortable discussing fees and asking how an advisor is compensated for the services provided. But discussing fees with your advisor is not unreasonable. In fact, it should be encouraged and part of any routine review of your financial plan. Your advisor should be able to provide a clear, concise description of how they are paid. If your advisor cannot clearly explain his or her fees and compensation, you should reevaluate the relationship.
Additional fees
Other than the fee your advisor charges, you might be subject to additional fees as an investor. Whether you utilize an advisor or not, you are likely paying several of the following fees:
- Expense ratio: Mutual funds and exchange-traded funds carry an expense ratio. This is generally a small percentage of your invested assets. Revenue sharing arrangements may exist, particularly with discount brokerage firms. High expense ratios are one of the most common ways of discretely compensating brokers.
- Transaction fee: Your account is charged every time you buy or sell. Such an arrangement is common in the traditional brokerage model. This charge is also known as a commission.
- Plan fee: Common in 401(k) or company-sponsored retirement accounts, your plan provider may charge this fee for holding your assets or providing plan administrative services.
- Wrap fees: Prevalent in a brokerage model, a broker may invest your funds in a basket of individual stocks, and you will pay fees to a third-party manager. A portion of these expenses will be passed on to your advisor as compensation.
- 12b-1 fees: Assessed by a mutual fund, the fee provides compensation to a broker or brokerage firm and is paid directly from the fund company.
- Sales loads or redemption fees: Sales loads are taken from your initial investment and passed on to the broker. Back-end redemption fees may be assessed when an investment is not held for a predetermined period. Redemption fees are typically attached to 12b-1 fees or a high expense class of mutual fund shares. The redemption charge is created to ensure a minimum rate of compensation for the broker, allowing the investor to bypass an upfront charge on the investment.
The various types of fees can be confusing, soit may be helpful to walk through a few scenarios.
Example: Client A contacts his broker and expresses an interest in investing $50,000 in U.S. growth stocks. The broker invests the client assets in Fund XYZ, which charges a sales load of 2.75% with operating expenses of 0.68% annually ($340 on a $50,000 investment). The client will immediately pay a one-time fee of $1,375 on the trade on top of the recurring fund management fee.
Client B contacts her registered investment advisor with the same request. The investment advisor purchases an ETF with a gross expense ratio of 0.18% ($90 annually on a $50,000 investment) and pays no commission on the trade. This client pays her advisor a management fee of 1% of the assets, which equates to $500 per year on $50,000.
In our realistic example, the front-loaded fees and higher fund expenses paid by Client A are significant enough that it would require a commitment of nearly 6 years to this fund family before that commission is equal to the sum of advisory and ETF fees paid by Client B.
What about the discount brokerage model? How could the revenue-sharing arrangement impact your cost of advice?
Example: Discount brokerage firm XYZ offers to manage client assets at a reduced cost of 0.8% of assets under management for Client A. The representative at XYZ purchases $150,000 of retail shares of a bond fund with an operating expense of 0.75%. The representative does not receive compensation for choosing this fund; however, her firm (XYZ) receives revenue sharing directly from the fund company. A registered investment advisor for Client B charges 1% for his services and purchases institutional shares of the same fund with an operating expense of 0.46%. Registered investment advisors often have access to the lower cost iShare offered by certain mutual fund families. In this scenario, the “discount” brokerage relationship results in a slightly higher cost to Client A because of hidden revenue sharing, despite charging a lower management fee for their service.
Next steps
The comprehensive list of fees and expenses a physician could pay his or her advisor is extensive. It is easy to see why many investors are confused and frustrated with their attempts to determine the cost of their advisory relationship. Nonetheless, it is essential that all investors, including physicians, gain a clear understanding of what they pay their financial advisors.
You can start by asking three simple questions: What am I paying you to manage my assets? What is the blended fee of my underlying investment products? Do you receive compensation from any of the investments you purchase on my behalf? This should get you the information you need to understand what you are paying.
If you are not receiving answers to these questions, OJM Group’s Wealth Management Team is willing to perform a fee audit to help you understand what you are paying your advisor and if the amount is reasonable. The authors welcome your questions.
References:
https://newsroom.statestreet.com/press-releases/press-release-details/2021/State-Street-Global-Advisors-Survey-Majority-of-Investors-Dont-Fully-Understand-Investment-Costs/default.aspx
https://www.prnewswire.com/news-releases/over-half-of-americans-surveyed-falsely-believe-they-pay-low-or-no-fees-to-manage-their-retirement-accounts-301243712.html
https://www.thinkadvisor.com/2016/02/04/higher-fees-wont-spook-most-advisory-clients-sei/.VrpRXO1-tZc.twitter
For more information:
Wealth Planning for the Modern Physician: Residency to Retirement and Wealth Management Made Simple are available free in print or by ebook download by texting HEALIO to 844-418-1212 or at www.ojmbookstore.com. Enter code HEALIO at checkout.
David B. Mandell, JD, MBA, is an attorney and founder of the wealth management firm OJM Group www.ojmgroup.com, where Bob Peelman is a partner and director of Wealth Advisors. They can be reached at mandell@ojmgroup.com or 877-656-4362. You should seek professional tax and legal advice before implementing any strategy discussed herein.
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