Financial advisers make money two ways: Charging fees to offer their (supposedly) expert advice, and by earning commission on the financial products they sell. Financial advisers are required to act in their client’s best interest, but unfortunately, many financial advisers give self-serving advice, to the detriment of their client’s portfolio.
Financial advisers usually charge one of two ways: a percentage of assets under management (AUM), or a fixed fee. Fixed fees are usually charged as a flat annual retainer fee, or an hourly fee.
- Assets Under Management: 0.5% to 2% of assets
- Fixed annual fees: $1,000 to $3,000
- Hourly fees: $100 to $400
Fee-based plans aren’t always as simple as they look — for instance, fee-based plan might include a recommendation for a financial product that earns the adviser a commission. Although financial advisers are fiduciaries, and required to act in their client’s best interests, that does not mean they’re required to recommend the cheapest securities. In an official interpretation of the Adviser’s Act, the SEC has stated, “When considering similar investment products or strategies, the fiduciary duty does not necessarily require an adviser to recommend the lowest cost investment product or strategy.”
Ask Your Financial Adviser the Right Questions
Financial advisers are not required to tell you how they’re being compensated for every type of financial product. For stocks, a financial adviser must disclose their commission, but for products like annuities and private placements, their commission is baked into the price, and you won’t know from looking at the paperwork how much your investor made from the sale.
It’s up to the client to ask the right questions to determine how much their financial adviser is making on their recommendations. The SEC recommends that clients ask their financial adviser pointed questions, including the following:
- What are all the fees related to this account?
- How can I reduce or eliminate some of the fees I’ll pay?
- How do the fees and expenses of the product compare to other products that can help me meet my objectives?
For the full list of SEC-recommended questions, see their Investor Bulletin here.
Are Financial Advisers Worth It?
Good financial advisors are worth the fee. They come up with an investment strategy and stick to it, instead of chasing the next best thing, as lay investors tend to do. Your financial advisor should know how to structure investments so that you pay as little in taxes as possible. Just like a good tax preparer, the amount they save you from costly mistakes should more than cover their fees. If this isn’t the case for your portfolio, you should scrutinize your financial adviser’s recommendations.
Plenty of investors know lots about how to sell financial products to their customers, and less about how to develop a solid financial strategy. These types of advisers are more likely to make unsuitable investment recommendations, because they’re prioritizing their commissions rather than the financial benefit for their client. One study from The National Bureau of Economic Research suggested that advisers have a hard time suppressing their own bias in favor of commission-driven portfolios, rather than well-diversified, low-fee portfolios.
Like anything commission-based, financial adviser income can fluctuate, and their commissions depend on the strength of the market. Broker misconduct often revolves around their attempts to game the system, by “churning” accounts and executing more trades than necessary, in order to increase their commissions.
Changes to the Financial Advisor Industry
There has been a major sea-change in how brokers and financial advisers make money in the past couple of years. Threats to their profitability have forced investment firms to change how they turn a profit.
Robo-advisers have inspired increasing speculation about the future of the financial advisor industry. Artificial intelligence — aka an algorithm that has been trained with an enormous set of data — can make fewer mistakes than a human adviser, and at a lower cost. The drawbacks: Robo-advisors don’t offer personalized plans, and they might not be the best option for someone with a lot of wealth to manage. There is also an element of emotional support that robots can’t offer. (As we’ve seen in so many elder abuse cases, many investors grow to see their financial adviser as a trusted friend.)
Apps like Robinhood Markets have started to compete with the traditional broker-investor relationship. By offering trading services for free, they’ve cut out the broker middleman. As Robinhood started to attract lots of new investors, financial services companies like Charles Schwab, TD Ameritrade, and ETrade had no choice but to follow suit and started offering zero-commission trades.
There is some debate over whether zero-commission, investor-driven trading will actually benefit investors. It’s still fairly new territory, although the decline in investor commissions has snowballed on for decades.
So, without commissions, and with an increasing demand for low-cost, automated investment management, how will financial service firms continue to make money?
Three Ways the Financial Industry is Making Up for Decreased Demand
- Payment for Order Flow
Payment for Order Flow (PFOF) generates income when brokers sell the right to make their client’s trades to wholesalers. There is a question of conflict of interest — what if the broker sends the security to the wholesaler that offers the highest fee, and not the wholesaler that will make the most efficient trade? The possible conflict of interest has prompted the SEC to consider banning this practice. After all, Bernie Madoff pioneered PFOF in the 90s, which should make anyone raise an eyebrow.
For now, regulators simply require brokers to disclose to clients how their transaction was handled, and how much their broker made in fees from the wholesaler. The hope is that this payment structure keeps the cost of investing low for mom-and-pop investors while keeping competition high.
- Uninvested Cash
Financial services companies like Charles Schwab Corporation and TC Ameritrade have seen an increasing percentage of their profits come from banking services, namely, lending out their clients’ uninvested cash.
- Margin Trading
BrokerCheck contains plenty of customer complaints about brokers utilizing unsuitable levels of margin. In the financial industry, “margin” refers to borrowing money from a brokerage in order to buy more stock. This might tempt someone who thinks they have the chance to make a lot of money on a particular investment, but it’s a risky move — and one that can generate a generous fee for the broker.
Investors: Don’t Blindly Follow your Financial Adviser’s Advice
It’s up to you to determine if your financial adviser is worth their fee. If you’re at all worried about whether your financial adviser has acted in your best interests, it’s worth getting a second opinion from a securities attorney.