How do financial advisors make money?

Q: I’m thinking about consulting a fee-based financial planner but am not familiar with how that works. Are fees typically based on the amount of assets I have to invest? Or do some advisors have other forms of compensation that might be preferable? I’m curious how financial advisors get paid.

A: Financial advisors get paid in a variety of ways, and you should always ask upfront, early in your initial conversation, how he or she is compensated. It’s a fair question that you shouldn’t be embarrassed to ask. Understanding the financial advisor's compensation is crucial to making informed financial decisions as you work towards achieving your financial goals.

Ways financial advisors get paid

There are three main ways that financial advisors get compensated.

1. Commission-based

As the name implies, in this scenario, advisors get paid a commission when they recommend and sell certain financial products to their clients.

That’s the traditional way that stockbrokers and insurance agents are typically compensated. When you buy a mutual fund, stock, bond, insurance policy, annuity – whatever product they’re selling – they earn a commission from you.

It’s important to determine if there are any potential conflicts of interest. That way you can proceed with confidence that your investments are in your best interest. Ask to see their Form CRS, which should spell out any conflicts (you can see ours here).

2. Salaried advisors

Just like in many other professions, some firms pay their advisors a salary rather than being compensated with fees or commissions.

Salaried financial professionals offer a level of predictability in their compensation, which can sometimes alleviate concerns about advisor fees tied directly to product sales, but again, it's important to understand any conflicts that might influence their advice.

3. Client fees

In this scenario, the financial advisor earns fees based upon how much money they are managing for their client. For example, if they are managing $500,000 worth of investments with a 1% management fee, they would earn $5,000 for the year, though the fees are often paid quarterly.

In some cases, the management fee will vary depending on how much money is under management – the more money, the lower the percentage – while in others, the advisor’s fee schedule may allow them to earn extra “performance fees” should they hit certain benchmarks for returns.

Financial advisors can also charge hourly or flat fees for their work. This fee-only compensation model is common among registered investment advisors and fee-only financial advisors who focus on providing objective financial advice without receiving commissions from financial products.

Fee-based or fee-only?

Because there are a wide variety of ways that financial advisors can get paid via fees, it’s important to know the difference between a fee-based and fee-only compensation model.

A fee-based advisor can earn revenue both from client fees and from commissions. This means they can charge you fees directly related to managing your money and earn commissions on the side for financial products they sell you.

A fee-only advisor, by contrast, only receives compensation from the fees they charge you. They don’t get paid from commissions. Working with a fee-only advisor can help ensure that the financial advice you receive is in your best interest, without the potential conflicts associated with commission-based sales.

This is the approach we take at Edelman Financial Engines.

Our financial planners are fee-only advisors, and the fee is based on the value of your account. We chose this method many years ago for several reasons, the most important of which is that it places us on the same team: If your account drops in value, your advisor earns less, and if it rises in value, they earn more.

That’s sometimes not the case when working with fee-based advisors. Understanding the fee structure is crucial when planning your investment strategy and financial future.

It’s also important to understand that the way an advisor is compensated has nothing to do with whether or not they are a fiduciary.

What is a fiduciary?

A fiduciary is an individual who acts in the best interest of a particular person or beneficiary. In the world of financial services, that means fiduciary advisors must only buy and sell investments that are the best fit for their clients.

And when it comes to investment advice, every advisor at Edelman Financial Engines is a fiduciary. Our financial professionals are committed to helping you achieve your financial goals through comprehensive financial planning and investment management services.

How to ask the compensation question

Ultimately, it’s up to you to choose the best financial advisor for you. But here’s an important caveat: When you ask how the financial advisor gets paid, be sure to ask the question correctly. Do not ask, “What’s your fee?” If you do, he or she might reply, “Well, my fee is 1% of the assets under management.”

The problem: That’s an incomplete answer. The advisor might leave out the fact that the mutual fund being recommended charges an additional fee – meaning your total cost may be more than 1%.

That’s why you should instead ask, “If I hire you, how much will I pay all in?” Or “What will be my total cost for all expenses – your fee plus the cost of the products you recommend?”

Understanding the total financial advisor cost, including advisor fees and any additional fees associated with financial products or investment management, will help you make informed financial decisions.

With the appropriate wealth management, the total value of the advice you receive – from the convenience of not having to do all the work yourself to the ongoing access to comprehensive financial planning – should certainly make the fee worthwhile. A successful financial advisor can help you navigate your personal finance challenges and work towards achieving your financial goals.

It’s also vital to ask what the total services are that you will receive. It’s not enough for an advisor to help you with your investments. Ideally, your advisor should provide you with comprehensive wealth management services – guidance and education to help with employee benefits, insurance and tax planning, mortgages, estate planning, investment advice and portfolio diversification, college planning, elder issues and much more. A comprehensive view of your financial planning should address all aspects of your financial situation, not just your investment portfolio.

That’s what we can provide for our clients here at Edelman Financial Engines.

So, shop around – and be sure to get complete compensation information from anyone you interview and find out whether their goals are aligned with yours. We’re always happy to provide a no-cost, no-obligation consultation to help pair you with the right financial planner for all your wealth management goals.