When you are looking to hire a financial advisor, there are a lot of variables to consider: the advisor’s experience, investment style, management philosophy, history of complaints, and list of available services are just a few. You also need to consider how they charge for their services.
Traditionally, there have been two business models in our industry. A financial advisor can either earn a commission on the products they use in a client’s account, or they can charge the client a fee for service. Occasionally the fee is a flat dollar amount per year, but more often, it’s a percentage of the balance of the client’s account.
The vast majority of financial professionals still go the commission route, and for the first seven years of my career as an advisor, that was the way I did the majority of my business, as well.
When we created nVest Advisors, however, we opted to become a fee-only financial advisory firm. We did so because, I firmly believe, it allows for the best situation for a majority of the clients we seek to serve. Let me explain the difference:
The “old” way: commissions
Let’s say you want to start investing for the future. You open an IRA or brokerage account, and sit down with a fresh-faced, dazzlingly-dressed financial advisor. You explain your financial situation and goals to the advisor, and they return with a plan that includes a product or series of products that are suitable investments for your needs. You give the go-ahead, and the advisor places you into those products (be they a collection of stocks, a ladder of bonds, some mutual funds, a variable annuity, or any combination of those).
Under the old model, each of those transactions comes with some kind of charge to you, the client. A stock will have a commission, a bond will have a mark-up. Mutual funds typically charge a up-front sales charge, often as high as 5.75%, and still charge ongoing 12b-1 (marketing) and management fees. Annuities carry several fees, some obvious and some a little harder to find in the contracts. These investments then impart some of that commission to your broker.
The issue we have with the old commission model is two-fold:
First, it doesn’t matter whether the advisor’s product selection works or not – they still got paid. Performance doesn’t affect the broker’s pay – the movement of money did. Let me give you one scenario. You buy a stock from your broker (and pay a commission). Let’s say the market is bad, and the stock tanks and stays down all year. At some point, behavioral finance tells us you will reach a point when you finally get tired of the loss and want to get out. You call your broker up to sell it, which he gladly does, charging you another commission to sell this losing stock.
So you lost money all year, but the commissioned broker made money. Twice.
The second issue is that there is little or no incentive given to a commissioned advisor to continue to serve the account, because few products provide any further financial benefit to the advisor once the sale is made. So the only way the advisor living on commission will be paid again on your account, is to move you from one investment product into another.
And therein lies the danger of commissioned financial services: the commissioned advisor is paid to MOVE money, not to GROW it.
With that in mind, is it any wonder why most of the investing world, including all of the financial media, hypes “hot new investments”, or allows you to become nervous about world events a few times a year? It’s because money moves on emotion: greed and fear rule your investing decisions, whether you believe it or not. And when you get fearful (or greedy), you move money. And when you move money, commissions are generated.
The “new” way: fee-based account management
The other option, the one we have decided is in the best interests of both our firm and our clients, is to do away with commissions on transactions, and instead charge the account a fee for management and investment service. At nVest Advisors, our fee is a set percentage of the balance of the account. In our model, our clients pay a fee for service, but you get all the financial products for free.
Here’s the difference between fee-based management and commissioned sales, in a nutshell:
For the sake of easy math, let’s say you have a $100,000 IRA and your fee-based advisor agrees to manage that IRA for 1.5% per year. That means your advisor will earn $1,500 that year to manage your account – just over $100 per month.
If after a year your account grows from $100,000 to $150,000 (from new deposits and investment performance), the next year, the advisor is paid again 1.5% of that account balance. His next year fee is $2,250. The advisor earned a pay raise because the account GREW, not because you bought a particular product.
Conversely, let’s say the account started out at $100,000, but a poor market that year saw the value of the account drop to $80,000. The advisor takes a pay CUT, because the account value dropped.
The advisor does not earn a big up-front commission placing you in a particular financial product. In fact, because your advisor earns his or her pay based on the account balance, the advisor is financially motivated to grow your account. This is radically different from the commissioned broker, whose motivation is to move money from one product to another.
Fee-based advising, we believe, finally puts you and your advisor on the same team: you both benefit if the account value grows.
The ethical dilemma of commissions
Another issue that always vexed me as a commissioned broker was deciding how often we could justify making changes in a client’s account, because every time we touch a commissioned account, it costs you money.
If they are ethical, the commissioned advisor should place you in as few financial products or companies as possible to maximize your breakpoints, and then trade your investments only when absolutely necessary. This forces the ethical commissioned advisor to be slow to recommend changes based on world events and market movements. Although we may be looking at your account often, we won’t often make changes (if we are ethical), because doing so causes you to pay more in commissions and sales charges.
By the way, I’m not at all saying there are not terrific, wholesome, and totally ethical advisors working on commission, who can do a marvelous job for their clients. There are many out there – some I am extremely proud to call friends. I am saying, however, that the institution that created commissioned financial sales does not always have the client’s best interest in mind, and they force the commissioned advisor to consider his or her income when they are looking at which products to use.
One example that comes to mind happened to me while I was a newly-minted advisor at a large regional wirehouse. An 83-year old woman had $30,000 to invest in a bond ladder, which I could do for an average markup (commission) of about 1.25%. The firm suggested I look at a bond unit investment trust that paid the firm 4.5% (plus minimaly disclosed revenue sharing with the firm who created the investment product). Since I was making a whopping 38% of my gross commission, and on a production quota, I felt my first serious pang of ethical dilemma as a financial advisor, as I weighed the compensation difference. (By the way, she got the bond ladder.)
With fee-based account management, that kind of conflict of interest is a thing of the past.
Now we can trade your account based on a strategy, re-balance your account as often as needed, and respond quickly to world events, because you pay us for service, not for transactions. That same elderly client may pay 1.5% for management, but the advisor is free to do whatever is needed to grow the client’s account.
Because we don’t need to worry about breakpoints, we don’t have to use only one or two fund families to get the job done -we can seek out the “best in class” investments, whatever and wherever they are. We can trade our client accounts regularly. We can be responsive to world events. And most importantly, because we aren’t compensated by financial companies selling expensive, fee-loaded investments, we can hunt for – and use – the lowest cost investments that will accomplish our investing strategy.
So which way do I go?
Fee-based management isn’t for everyone. If you are a “buy and hold” investor, keeping investments for many years, it is likely cheaper to pay an up-front commission than it is to pay for ongoing fee-based management. But if you are like most investors, you care less about what you own, or for how long, and just want to know that your money is being attended to by a professional. You can do it either way, but we believe most clients wanting active management of their accounts do best in fee-based management.
If you’re looking for an advisor, or are new to fee-only financial services, I encourage you to give us a call. Feel free to schedule a hassle-free, no-pressure consultation today to discuss your options and get your questions answered.