Our Compensation How Do Financial Advisors Get Paid?Financial advisors may be compensated in four different ways:By the Hour or by Flat FeeAn advisor may be paid by the hour or by flat fee, either directly to the advisor by check or by debit from an investment account he or she oversees.A signed engagement agreement normally outlines the hourly rate and the type of work that the client will receive upon completion. In most cases, such agreements involve the provision of information and education only—not the implementation of strategies or financial vehicles. The expectation is that clients handle those steps on their own. If the client desires that advisor to implement the strategies he or she recommends, the fees charged directly to the client are usually reduced or possibly eliminated because the advisor then receives compensation through another method. Make sure you clarify this point if you decide to work with a fee-only advisor.By Asset-Based Management FeeThis fee is most common when you work with a fee-based advising firm. The compensation formula is pretty straightforward: the firm is paid a set percentage of your assets under management (AUM) with the firm. This fee may equate to 1 percent average AUM, but it could vary based on the firm’s business model.In this case, the firm is being compensated to make investment recommendations regarding your portfolio allocation as well as any other services it provides. Ideally, this management fee will end up being paid by the growth on your assets:Total PerformanceAdvisor CompensationImpact on Client’s AccountPortfolio grows by 5 percent.Advisor receives 1 percent.The client keeps 4 percent.The client keeps 80 percent of the growth.*Example used as illustration only, not indicative of any particular investment, actual results will vary.Total PerformanceAdvisor CompensationImpact on Client’s AccountPortfolio grows by 10 percent.Advisor receives 1 percent.The client keeps 9 percent.The client keeps 90 percent of the growth.*Example used as illustration only, not indicative of any particular investment, actual results will vary.As you can see, the fee-based advising model focuses on accumulation and performance-based results. But don’t lose sight of the amount of risk in the portfolio because losses to your portfolio do not normally change the advisor’s compensation. In other words, let’s say that your portfolio drops 10 percent. The advisor still receives the 1-percent management fee.Total PerformanceAdvisor CompensationImpact on Client’s AccountPortfolio declines by 10 percent.Advisor receives 1 percent.The client loses 11 percent.*Example used as illustration only, not indicative of any particular investment, actual results will vary.So the portfolio actually drops by 11 percent. The advisor is always earning revenue no matter what impact the investment performance (or lack thereof) has on your financial picture.Because this method of compensation is usually driven by the way the client’s portfolio is constructed, I’ve found it vitally important to the long-term advisor-client relationship to provide additional resources to clients beyond just investment management. Since no advisor or firm controls how the market or investments will perform in the future, I usually recommend that an advisor’s compensation not be solely tied to this method.By Commission on the Amount InvestedThe commission method is usually seen as transactional in nature because when a commission is paid to an advisor, the money comes directly out of the client’s invested principal.For example, a client invests ten thousand dollars into an individual security (like a stock). Assume that a commission of 3 percent is charged up front to new investors. Out of the ten-thousand-dollar investment, ninety-seven hundred dollars goes to work in the investment chosen, and three hundred dollars is paid to the advisor’s firm.In certain situations, this type of compensation can actually benefit the client’s financial picture because the commissionable product may have an effectively lower cost as money accumulates over time. If a client’s purpose for these particular monies is to generate growth through income, it may make sense to lower any long-term expenses associated with the strategy.One of the main fears of this method is that when advisors are compensated up front, they may have no desire to keep adding value for the client. I understand this perspective, but I like to remind clients that there is a difference between a salesperson and an advisor. This compensation method should not make you feel as though you were sold an investment. Instead, the financial vehicle you implement should be based on its appropriateness in your financial picture.Financial Institutions As IntermediariesOur financial institutions offer hundreds of financial products and services. Many banks, brokerage firms, insurance companies, and other financial intermediaries offer the public in-house advisors or salaried employees. The same products and services can be accessed through independent advisors. Certain companies may promote their own proprietary products to in-house advisors and provide additional compensation for those products, which creates a conflict of interest where it’s possible that the advisor’s interests are put ahead of the client’s. Of course, I could be a little biased toward independent advisors since I’ve spent my entire eighteen-year career in that space. However, I like to approach this topic from a factual position because I’ve met many high-quality advisors who take great care of their clients, and they come from all backgrounds. Again, transparency and open communication about compensation and suitability are vital to managing a client’s expectations.A question I get from a lot of clients is, “How is this method of compensation different from receiving a commission?” One difference is that when you choose to implement a financial vehicle, which may be an annuity or life insurance contract, 100 percent of your invested principal goes to work for you inside the financial vehicle. The compensation is coming directly from the product sponsor, which can include its marketing budget. This makes sense to the institution because its financial vehicle is not going to sell itself. An experienced financial professional has to assess your needs and determine if the particular vehicle is a fit for your financial picture. Plus the advisor should maintain a continuous relationship with clients, monitoring any changes in their situations that may impact the validity of the financial vehicle.Now it’s important to realize that just because the advisor is getting paid by the financial institution, it doesn’t mean the product or vehicle is free to the investor. The advisor’s compensation is paid from fees, expenses, and restrictions associated with the investment. This is no different from a real estate transaction in which you use a buyer’s agent. If the home sells for $300,000, who pays your buyer agent the 3-percent compensation for assisting you? The seller. The cost of the home does not change; you are still getting it for $300,000. The seller just receives 94 percent of the sale price ($282,000) at closing if the seller’s agent also gets 3-percent commission.If the client knows all of the fees and expenses associated with the financial vehicle, how the financial institution chooses to pay the advisor becomes a nonfactor—assuming there is transparency and open communication.Even though each client’s personal economy is unique, the financial vehicles that are suitable to create customized, one-size-fits-one solutions may be similar in an advisor’s practice. Based on the advisor’s comfort level with certain financial institutions or his/her knowledge in certain strategies, it’s possible that several clients could benefit from owning similar products or implementing similar strategies. Also, an advisor’s or firm’s total compensation can come from more than one of the four methods; there is no set formula for how an advisor should get paid. That determination is between the client and the advisor. In addition, the agreement can evolve over time as the client-advisor relationship grows.Finally, remember that there are no such things as perfect investments or ideal financial strategies. All that matters is that the financial vehicle(s) implemented is appropriate for your current financial picture and that you are satisfied with how your advisor is interacting with you to earn his or her compensation.