How to Pay an Investment Advisor
As we’ve seen in recent years, investment markets can be extremely volatile. You may decide to seek the help of an investment advisor to improve returns, reduce risk, or both. As is generally the case when you work with any advisor, you should get recommendations from people whose judgment you trust. Additionally, meet with several investment professionals before you make any commitments. Of course, your advisor will be compensated for work done on your behalf. Therefore, you should find out in advance how a prospective advisor will be paid. Here are the most common arrangements:
Many advisors are licensed to receive sales charges on securities transactions. You might pay commissions when you buy stocks, for example. Many mutual funds are “load” funds, with various types of sales charges.
Example 1: Mona Grant, a financial consultant, advises Jim Harris to invest $10,000 in ABC Mutual Fund, which has a 5% upfront sales charge. Thus, Jim actually owns $9,500 worth of ABC shares, and $500 goes to Mona.
If Jim is a buy-and-hold investor, this arrangement may serve him well. After paying $500 upfront, he might pay little or no extra compensation to Mona, even if he holds onto the fund for 10 years, 20 years, or longer.
On the other hand, investment professionals who get paid when a customer makes a transaction may encourage their customers to make unnecessary trades. To prevent such abuses, you can work with an advisor who comes strongly recommended for his or her integrity.
What’s more, not all investments have simple initial commissions. Mutual funds, for example, often have different share classes. You might pay a smaller upfront sales charge for some types of shares but pay ongoing fees in subsequent years. A trustworthy advisor will explain those options and let you decide which one you prefer.
Assets under management
As a client, you may pay fees rather than commissions to an investment advisor. Among several methods of assessing fees, the assets under management (AUM) technique is increasingly popular. In this arrangement, you pay a fee that’s directly related to the amount of investment assets for which the advisor is handling trades. An annual fee of 1% may be typical. That percentage may be higher for small accounts and lower for large accounts.
Example 2: Jenny Parker has $1 million invested with her advisor, Mark Thomas. The AUM fee is 1%, so Jenny pays $10,000 each year. The fee is collected quarterly; therefore, Jenny pays $2,500 every three months, assuming no change in her AUM. Mark offers a reduced fee of 8% per year for AUM in excess of $1 million.
Therefore, if Jenny’s assets increase by 10%, to $1.1 million, her asset management fee would increase only 8%, from $10,000 to $10,800 per year.
The AUM method has gained supporters for several reasons. It is simple for advisors to calculate and easy for clients to understand. The fee includes all transaction costs, so investors won’t worry that advisors will suggest unnecessary trades to boost commissions. With the AUM structure, an advisor’s compensation will increase if a client’s assets appreciate; thus, an advisor has a strong incentive to recommend investments that perform well.
However, the AUM approach comes with its own conflicts of interest. An advisor might suggest that a client invest in stocks, for example, rather than buy a vacation home because the advisor’s fee will be greater with more money under management. Beyond potential conflicts, an investor who sets up an investment plan and stays with it might wind up paying a hefty advisory fee each year, even though the advisor has made minimal changes. Moreover, advisors who charge by AUM may have a minimum account size, effectively shutting out many people who want help with their portfolios.
Some advisors charge clients a set annual fee, determined by an estimate of how much time and effort they’ll need to serve a particular client. This fee might rise or fall in future years as a client becomes more or less challenging to advise.
Such a system provides predictability of income and cost for the advisor and the client. Nevertheless, relatively few investment advisors use this method because it’s difficult to accurately predict how much effort each client will require in a given year.
A number of investment advisors bill clients by the hour, just as CPAs and attorneys frequently do. Hourly billing requires extensive recordkeeping by advisors and may inhibit clients from calling with questions for fear of incurring expenses. Even with these drawbacks, hourly billing has its advantages. Advisors benefit by being compensated for all the hours they spend with clients, and clients who require few hours of an advisor’s time each year benefit by only paying for the time spent on their accounts.
No system of advisor compensation is ideal for all clients. Indeed, some investment advisors have multiple compensation methods. They’ll discuss these methods with prospective clients and agree on an arrangement that’s most appropriate.
Not only should you know an advisor’s compensation method in advance, you also should know what services you’ll receive. Will an advisor simply manage your investments, or will that advisor offer comprehensive wealth management, from budgeting to insurance to retirement planning? Once you know what you’re paying for, you’ll have a better idea of how to pay for it.