How Your Financial Advisor Gets Paid: One of the Most Important Questions to Ask

Early in my Wall Street career (but not in business school nor my pre B-school career, somehow) I learned one of the most important lessons I ever learned in business: if you want to understand why different professionals do what they do and don’t bother doing other things you might want them to do, look at how they get paid.

The lesson may seem obvious, but I’m surprised how often its consequences are not, or how often people want to be too polite by assuming motivations can’t be that simple.  Certainly, many salespeople have principles, and many I’ve known who have steered customers to competitors they feel would do a better job (for the benefit of the customer at their own expense), but such cases are remarkable precisely because we can’t count on them happening.  It should remind us of one of my favorite Warren Buffet quotes “never ask a barber if you need a haircut“.

In the hopes of bringing a higher level of clarity and respectability of my own field of managing clients’ money and providing financial planning with the goal of making them wealthier, I list here some of the main ways financial professionals get paid:

  • Commissions: Brokers, as well as many financial advisors across Asia, are still primarily paid on commissions from products they sell to clients.  Those products may include mutual funds, insurance policies, unit trusts, land banks, real estate, and private investments, and rules for disclosing those fees vary by product and jurisdiction.  There is nothing inherently wrong with the commission model, and its defenders often say that allows clients to only pay for advice they act on, just as you only pay Starbucks when you buy a coffee to enjoy in one of their chairs, but it is hard to ignore the incentive for the client to steer clients towards products bearing the juiciest commissions.  The commission model also provides an incentive to “churn” or drive clients to trade more often than they otherwise would, in order to generate more commissions.  Note that some commissions may be in addition to other fees listed below.
  • Fixed hourly fee:  On the opposite extreme, there are financial advisors who charge a fixed hourly fee to provide financial advice, either during a paid consultation or for additional work that needs to be done for the client (getting a value on a property or analysis of a mutual fund portfolio, for example).  This is similar to the model used by many law firms, and provides a very a-la-carte way of hiring advice with no attached incentive to sell any product, but that fee needs to be paid whether the advice is acted on or not.
  • Assets under management fee:  A model used by many private banks, wrap accounts, and multi-family offices is to charge a percentage of the value of the customer’s account per year, the same way a bank would charge interest on a loan.  The percentage can vary wildly by account size and level of service required (as low as 0.1% for enormous institutional accounts on an index-like mandate to 3% or more on some wrap accounts), but provides the advisor with an incentive to properly take care of the assets under management in proportion to their size, especially with the aim of taking such good care of the assets that the customer or the customer’s referrals would want to put more assets under the care of the advisor.
  • Performance fee: This fee structure is most popular with hedge funds, although some separate account managers (including us) offer it as an option to qualified accounts.  Performance fees have the appeal of the customer only having to pay when they make money (say 20% of the profits on a quarterly basis), and these profits are often measured only over a “high water mark” (so that if the account goes from 100 to 110 back to 105, the next performance fee is only charged when it gets back over 110).  It is often feared that performance fees create an incentive to take extra risk, but the high water mark also creates the incentive to not let the account go below the high water mark.

These are just four of the most common fees financial professional charge clients they advise.  Hopefully this helped clarify one of the most important questions to ask your financial advisor and what incentives to look out for.

Until next time,

Tariq

+852 9476 2868

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