Many investors do not understand how their Financial advisor is compensated. With the initial implementation of the new DOL Fiduciary Rules mandating that advisors put their client’s interests first when working with their retirement accounts upon us, the issue of financial advisor compensation will be front and center. It is important that all clients fully understand how their financial advisor is compensated and how much this relationship is truly costing them.

The three basic compensation models 

Commissions: The advisor is compensated for the sale of investments, insurance, or other financial products. Compensation is paid by the firm that provides the financial product, usually a mutual fund or an insurance company. This may be in the form of an up-front charge, trailing (ongoing) fees or a combination of both. Other names for commissions include front-end loads (A share mutual funds are an example), 12b-1 fees that serve as trailing commissions on some mutual funds and commissions paid to advisors for the sale of insurance products.

Fee-based: Typically the advisor will charge a fee for putting together a financial plan for you. If you chose to implement the recommendations in the plan, such as the purchase of insurance, an annuity, or investments, the implementation will typically be done via the sale of commissioned products.

Fee-based has taken on a whole new significance in light of the new DOL fiduciary rules. Many firms have moved clients to fee-based or brokerage wrap accounts. The fee part arises from the wrap fee (typically a percentage of assets) charged to the client. Many of these accounts use mutual funds that throw off 12b-1 fees or other types of revenue sharing to the brokerage firm.

Fee-only: The advisor charges a fee for the services rendered. This can be one-time or ongoing based upon the nature of your relationship and the services rendered. Fees may be hourly, flat or retainer based, or based upon a percentage of the assets under advisement.

Why should you care how your advisor is paid? Because his/her compensation can impact the choice of the products recommended to you and your return from those products.

An advisor who is paid via commissions will likely recommend those products that offer him a commission or sales load. Sales people generally sell what they are compensated to sell. Commissions can therefore result in a huge conflict of interest for your advisor. Does she suggest the very best and lowest cost products or does she suggest those products that pay her the highest commission?

Fee-only advisors do not have this inherent conflict of interest because they are paid by the client, not the financial product provider. They are free to suggest the best investment vehicles and financial products for each client’s individual situation.

Should compensation be the only metric used to select a financial advisor?

Of course not, but the advisor’s compensation should be made crystal clear to you. When interviewing an advisor ask very direct questions.

Ask them to detail ALL sources of compensation. These might include up-front commissions or sales loads; deferred or trailing commissions; surrender charges if you opt out of the mutual fund or annuity too early; a wrap fee on your overall investment account; or a myriad of other fees and charges in various combinations.

This extends to fee-only advisors as well. Be sure to understand how much you will be paying for their advice and what types of investing costs you can expect to incur.

While you will not be writing a check for any commissions or product-based fees, make no mistake you are paying the freight. Excessive commissions or expenses serve to directly reduce your return on investment.

Once the new fiduciary rules go into effect, you may be asked to sign a form called a Best Interest Contract Exemption or BICE. The BICE form is used when the advisor seeks to use commissioned-based products, collect other types of revenue sharing or otherwise work with you in a fashion that is outside of the new fiduciary rules. Be sure to read this agreement carefully and to ask questions before signing it.

Approaching retirement and want another opinion on where you stand? Not sure if you are invested properly for your situation? Check out my Financial Review/Second Opinion for Individuals service.

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How is My Financial Advisor Compensated? is a post from: The Chicago Financial Planner