I happen to drink tea more often than coffee and ironically my favorite flavor is English Breakfast. You may recall that the Boston Tea Party occurred on December 16, 1773 as a means to protest against unfair taxes on local tea merchants while the British East India Company was allowed to sell their tea on a tax-free basis. Thus the phrase "taxation without representation" came to be know as a signal of economic and political frictions. Another form of this misalignment of priorities is the manner in which your "financial advisor" is compensated. I sat on a committee in Boston last year working on new disclosure requirements for fees charged by registered investment advisory (RIA) firms. Here is a short list of some of the common ways to charge a client.
- Pay For Products - This is the traditional brokerage model whereby financial advisors are compensated for "selling" products to clients. The benefit for the consumer is that they only pay when action is taken on their behalf. The drawbacks to this approach are that the advisor only needs to provide "suitable" products and they have absolutely no incentive to help grow and protect client net worth.
- Pay For Assets - This is the traditional model used by most RIAs. The client pays a certain percentage (usually roughly 1%) of assets to the advisor per year. The incentives here seem fairly well aligned since the advisor gets paid more when client assets increase and they get paid less when a client loses money. The main challenge with this approach is that the advisor has the incentive to take on only wealthy people - who may not need as much help in reaching their financial goals. They may already be pretty close to their "destination."
- Pay For Income - This is a relatively new compensation model that charges a client based on their current before or after tax income. It is geared toward young professionals who may be burdened with student loans and/or just starting to invest for their future. The incentives for the advisor in this approach are to help maximize income (over which they may have very little control). A family with more than one earner would typically pay more for the complexity of their financial affairs. This model sometimes includes tax preparation services to help better align the outcomes.
- Pay For Performance - This is also a very old compensation model used primarily by private equity and hedge fund managers. Clients "allowed" into this closed circle are typically accredited investors (minimum contribution starts at $1,000,000) who are willing to pay roughly a 2% annual asset fee plus roughly 20% of the annual profits. The incentives here are for the managers to swing for the fences in seeking higher returns. Clients typically do not get a "refund" of fees if the losses in any year overwhelm the annual asset based fee.
- Pay For Service - This compensation framework is relatively new. It is modeled off of the idea of paying a monthly flat rate similar to the way we pay a utility bill. There could be a "setup" charge to get things started for each client. Clients could pay different service levels depending on either their financial complexity or their desired frequency of interaction with the advisor. Again, this compensation model allows an advisor to serve clients regardless of their income or asset levels. It also often stresses the importance of financial planning before investment advice.
- Pay For Time - This is the traditional model used by many law firms whereby a retainer is paid before work is started and the client is billed for the time spent working on their behalf. In a perfect world, this may be the fairest and easiest fee structure to understand. The incentives here are to possibly "round up" in time spent and a client may very well feel "nickled and dimed" by every 5 minute phone call that shows up on the invoice.
One of my newer clients told me that their (now) former advisor would not tell them how much they were paying the advisory firm for the services rendered. My (then prospective) client asked me to try and figure out from the holdings in their portfolio just how much they were paying their advisor on an annual basis. After some digging, I determined that the client paid over $15,000 to get into their current investments and enjoyed an annual fee of almost $2,000 per year. This information was buried deep inside the prospectus of each portfolio holding. Needless to say, this client was shocked at how much money they gave to their former advisor when they could get better service elsewhere for less than $1,000 per year. Here is a rundown of what they paid.
The bottom line is that there is no ideal way to charge a client. Each client should know how much they are paying their financial advisor and what the incentives are for their advisor. If your advisor is unwilling to tell you what they are paid and how that compensation aligns with your goals as a client, grab your wallet and run before you start a revolution!