Advisory fees are an important factor to consider when hiring a trusted advisor to fit your needs. The two types of fee structures usually offered by investment management advisors are known as fee-only and fee-based. Though the differences may not be obvious, they are crucial to understand. The type of fee structure impacts how you will be paying for services and affects your portfolio and your long-term financial plan.
Fee-only advisors are compensated exclusively through the advisory fees wealth management clients pay them. The typical fee structure for fee-only advisors is usually a percentage of assets under management. These values can be either a fixed percentage or a progressive structure. For example, a financial advisor might charge a client worth $5mm the following rates: (1) a 1% fee on the entire $5mm or (2) a gradual structure such as 1.2% on the first $1mm, 1% on the next $2mm, and .8% on everything above that. Other fee-only structures include hourly compensation or a flat fee for services. Though not as common, advisors can also charge performance-based fees to be paid by the client. These fees are typically determined by a client’s portfolio performance in comparison to a benchmark (e.g., against the S&P 500 for Large Cap US equity-based portfolios).
Fee-based advisors are compensated similarly to fee-only advisors. The difference is that fee-based advisors can also be compensated via commissions from the sale of investment products to their clients, such as insurance products and mutual funds. They can also earn brokerage commissions when acting as a broker-dealer (an investment salesperson) for a transaction. Investing in such products could potentially result in double paying of fees so it’s essential to understand the nature of your advisor’s fee structure prior to entering a relationship.
Why the Differences in Structure Matter
Though all advisors have the fiduciary duty to act responsibly in the best interests of the client, we believe that fee-only advisors tend to pose less conflicts of interest when providing portfolio recommendations for clients. Because fee-based advisors earn commissions, they are expected to sell products that are best suited for a client’s portfolio. This structure can pose conflicts of interest, as fee-based advisors are incentivized to recommend products that earn them higher commissions, which may result in clients owning investment products that are not the most cost-effective options available in the marketplace.
Another key factor is the overall amount of expenses incurred by the client. Because fees are deducted from the amount invested, the compounding effects of this reduce the true potential of portfolio returns in the long run.
To understand the long-term impacts of these costs, look at this example provided by Vanguard1
- Imagine you have $100,000 invested. If the account earned 6% a year for the next 25 years and had no costs or fees, you’d end up with about $430,000.
- If, on the other hand, you paid 2% a year in costs, after 25 years you’d only have about $260,000.
- That’s right: The 2% you paid every year would wipe out almost 40% of your final account value, so 2% doesn’t sound so small anymore, does it?
The long-term effects of paying high fees have a significant impact on overall portfolio growth. Fee-based advisors tend to have layers of fees, as they charge you a standard advisory fee for providing service plus underlying commissions earned from the sale of potentially expensive products. Although fee-only advisors tend to be favorable, it may make sense to have a fee-based advisor if the fees are fair and reflective of the work being done.
What Questions Should You Ask Your Financial Advisor?
Having a thorough understanding of the structure of the fees paid to your financial advisor or wealth manager will help you not only understand the long-term implications on the portfolio, but also any potential conflicts of interest. It is important to understand how your financial planner is compensated and clarify if they do gain commissions from products recommended to you. Talk to your advisor to understand the impact of fees, potential conflicts of interest, and which structure may be right for you.
In addition to compensation, there are other factors to consider when choosing an advisor, such as aligning with a wealth management firm’s approach and values and more. At Columbia Pacific, we consider ourselves relationship managers, which we believe goes above and beyond the traditional role of a financial advisor. You may contact our CPWM team anytime to discuss your questions and learn more.
Important Disclosure Information:
Different types of investments involve varying degrees of risk, including the risk of loss of your entire investment. Past performance is not indicative of future results. All opinions expressed herein are current only as of the date hereof and CPWM and its employees can give no assurance that the performance of any specific investment recommendation or investment strategy discussed herein, whether directly or indirectly, will be profitable, or that it will be equal to any historical performance level discussed herein. The discussion or information contained herein is not intended to be, and should not be deemed as, personalized investment advice. The recommendations made may not be suitable for your specific individual situation and we encourage you to discuss with your financial professional before undertaking any investment strategy or recommendation contained herein. The discussions contained in this blog is current only as of the date hereof and may change due to a number of factors, including varying market conditions.