To its credit, the financial industry has been playing around with different pricing structures — and mostly, for good reasons.
4 Ways Financial Advisors Get Paid
To understand where we are in history, here’s a short overview of how financial pros get paid:
1. Brokerage: This transactional model meant brokers got paid when they bought or sold something for a client.
- Benefit: buy and holders don’t have to pay a whole lot if they don’t transact all that frequently. Brokers have to work hard to demonstrate value. Idea generation is the name of the game. Typically, brokers have to provide assistance, even if they don’t get paid directly for it.
- Detriment: Brokers are incentivized to trade. Unscrupulous brokers can recommend trades that mean more to their own revenue streams than they do to that of their clients.
2. Fee-based: A fixed percentage (usually declining as assets went up) charged to clients based on a percentage of their assets.
- Benefit: Partial alignment of incentives. Advisors are not incentivized to transact, but rather grow their asset bases. This typically leads to advisors providing high-level portfolio advice without churn.
- Detriment: While incentives are aligned, they’re only partially so. Good advice is rewarded while the opposite punished. Asset levels drop and fees are lower (the same can be said in a bear market even with good advice). Advisors can take on too much risk in order to generate growth.
3. Fee-only: Becoming more popular in the U.S. (can’t speak for other geographies). Advisors charge, as lawyers do, by the hour or project.
- Benefit: No one is trying to sell products, just advice. Seen as more “pure” advice.
- Detriment: Pay-as-you-go creates a disincentive to continuous portfolio management. Like anything a-la-carte, customers don’t like continuously paying.
4. Performance-based: Popular with hedge funds, investment advisor shares in profits.
- Benefit: by sharing in profits, prevailing wisdom is that investment advisors get paid when they perform. If they don’t, no lunch money.
- Detriment: They’re expensive. Typically, hedge funds charge something close to a 2% yearly management fee + 20% of profits (there can be a high-water mark as well — a certain gain that must be met before profit sharing kicks in). In an account worth $100k with a 10% gain, investors would pay $2k + $2k (20% of 10%*$100k) or 4%.
Nothing is completely clean
I hope it’s clear that no pricing structure does away with perverse incentives. Even fee-only, which is being touted as a better way forward for investors, has the perverse incentive of making investors cling to the teat– like psychologists and lawyers, fee-only creates a dependence to pay for ongoing advice. This ongoing, pay-as-you-go model could theoretically be more expensive for investors. Have you ever heard of a psychologist saying, “That’s enough. You don’t need any more help. Leave.”?
There are many well-meaning, honest advisors using all different models who are sensitive to fees and attempt to reduce overall payments for their clients. In my *humble* opinion, there isn’t any model that is free of conflict. Professionals should get paid for their advice and the different pricing models enable them to put food on the table for their families.
Recent discussion of performance-based fees being the way forward doesn’t do the issue justice. If very few advisors are able to consistently beat the market, what are investors paying for? A strong case could be made that they’re paying for the lesser of two evils — doing things on their own may produce worse results. In some weird way, they’re paying financial advisors to keep them out of worse trouble.
Other things, like retirement planning and fixed income investing, require specific skill sets. Instituting performance-based models means that the advisor or industry is saying that outright performance is the sole purpose behind why investors need professional advice. I’m not convinced — the industry and investors aren’t convinced either which is probably why we haven’t seen more of this for retail investors.
So, what next?
But all this raises an important discussion — what is the role of the investment advisor? Certainly, the investment advisory profession could only gain from some type of formalization process that results in certain standardization. One recent article describes 5 certain trends that have established the groundwork for a way forward. Pure brokerage services have been commoditized while the need for good financial advice has only grown.
Of course, this has captured Washington’s attention (as every good crisis does). Hidden fees and costs are just one criteria to think about as we advance the profession and the act of investing.
