Dirty little secrets of financial advisor compensation models

Sean shares five secrets some financial advisors don't want you to know about in regards to their fees.

Transcript

Sean 0:00

In this video, we're going to talk about the dirty little secrets of the major ways that you can compensate a financial advisor, or the way an advisor is compensated, which could be the same thing, but depending on the structures in place, may not be directly lined up. In other words, an advisor can be compensated in ways that aren't directly from you, which again can be a problem, but we'll get to that. So the five main ways that we'll touch on are commission-based, assets under management or AUM, hourly, so paying an hourly professional rate, or a flat dollar amount per month or year. And free, in other words, you don't have to pay anything. So the first one we'll touch on is commissions. So the dirty little secrets of the problems with paying a commission-based advisor, probably the most straightforward in terms of not really a secret, because if you think about if you if the person you work with is paid when you make changes, you make transactions. Think about a real estate agent. If you make if you buy or sell a house, you're moving, your real estate agent will get compensated. So in the ideal world, they would like people to move more often versus less because they will get compensated. If they say, Hey, you should not move right now, there's not a good uh inventory out there, interest rates are too high, uh, your life scenario doesn't fit, they're not going to get paid. Now, in the long run, hopefully, because most people are not going to move or not move based on a real estate agent's thoughts, that will come back to them, they will be trusted and therefore get plenty of business to go around. And the same is true in the investment world. If you work with someone who gets paid to change your investments or invest new money when it comes in, um, I went through this early in my career. The obvious problem is you get paid only when you get new clients and they invest new money. Um, in other words, if you get a new client and they have an existing portfolio, it's very hard to say, yeah, I'm gonna take care of your money, but everything should stay the same because the advisor gets paid not at all. So oftentimes that lends itself to, well, we can do this or that, and we could tweak this. And you can certainly make an argument for why you might be able to do better, but the incentive for the advisor is or the broker doing the brokerage brokering of transactions is to make changes. And then once you have an existing client base, the only way the advisor gets compensated, if we do a great job of putting things in place as a financial planner, financial advisor, the only way we get compensated is if we make changes to the portfolio that we put in place that hopefully was strong and solid, or bringing in new money. So you're getting you're gonna end up paying attention to new money coming in, whether that's from new clients or existing clients, or uh moving things around. And certainly no portfolio, almost no portfolio, should never be changed. But there's a lot of research, data, and experience for me at least, that making changes does not always lead to better results in your accounts in your portfolio. So commission-based uh advisors or brokers have there's not really much of a secret, but there's definitely a conflict of interest to be considered. On the flip side, I have known and do know many advisors who do phenomenal work by their clients looking out for them, and that's how they get compensated and they make it work. And there's various ways to do that, which I I'll touch on in other videos. But um just you know, if you're getting if you're if the advisor is getting compensated for transactional uh transactions in your accounts, that that's what they will tend to focus on. Another dirty little secret is they probably aren't gonna care as much about the planning aspects, except as it leads to more transactions or more money. Now, again, there's exceptions to that, but keep in mind we all tend to do what we get compensated for or rewarded for somehow. So a commission-based relationship can work, but you need to think through what that means for you in if you're gonna have to worry every time there's a suggestion if it's uh to make a change, if that's to benefit the advisor or to benefit you. And if it benefits you, how much that friction of the cost of trading will eat up in your portfolio? Uh, the next dirty little secret uh compensation model or fee model is for assets under management. So AUM. So that has become more and more commonplace over the last 20 to 30 years. There's been a migration away from more commission-based advice and help to more assets under management or AUM help. So the dirty little secret is it's less directly of conflict to have uh commission based where there's get paid for changes. The downside of using an AUM model is the advisor is is paid to take care of the money, which is good because you you're kind of on the same page, but a lot of people will point out that if the account value goes down, um the advisor's compensation goes down, but you know, if it's a million-dollar portfolio and it goes down 10%, the client is down nine, is down$100,000, and the advisor is down$1,000 a year in compensation. So the the big hang up with the AUM model is you're paying an ongoing fee for the length of relationship. And ideally, you're getting ongoing service, advice, access to your advisor. Uh it covers the scope of all everything in your financial life or a lot of things more than just the investments. But the downside is if it's if it's compensation that's based on the investment portfolio, that's where your attention will tend to be, and and your advisor will tend to be focused there, even if they don't mean to be, even if they're trying to be more comprehensive. That's a thing that on a day-to-day, month-to-month basis, we see the fluctuations. It's hard not to think about that versus um making sure your beneficiaries stay up to date, thinking through uh retirement plan calculations, assessing your life insurance or long-term care insurance needs, um, making sure your estate plan is updated as you go through life. If people come in and out of your life through birth, death, divorce, marriage, how are you thinking through what can go wrong if you if you something happens, you die or disabled unexpectedly? Those sides of things should ideally be covered in a in a really comprehensive financial planning relationship. But if the compensation is only based on the assets under management, the investment portfolio, it can kind of get nudged to the side or or delayed and procrastinated and on, and then you do have a problem. If something happens and you know you have this great portfolio, but your beneficiary is your ex-spouse. Ouch, that's a painful, painful thing to go through if you can't fix it when someone dies, right? So uh it doesn't matter how much you make, if you leave it to the wrong person, or if you're paying more in taxes than you should. So AUM is, I think, a fairly straightforward way to do business. It's clean, it's simple. That's the way I tend to do things. So it's not that I don't like it, but the dirty little secret would be if you're focused, if the compensation is based around investments, um, think through whether or not you need someone only for the investments, or if you're looking for something more well-rounded. Uh, the next dirty little secret compensation model analysis would be around the hourly model. So attorneys and accountants, other professionals sometimes charge by the hour, right? So attorneys are probably the best corollary. Professional services, you're paying for expertise. Attorneys can be very pricey, but at least you know what you're paying, you're paying as you go for the time, which should correlate hopefully with expertise. Um, the downside is probably anyone that's worked with an attorney for any length of time, it feels starts to feel like you don't want to call them because what if you can figure it out on your own? What if it's not important and and you're having to pay for every time they pick up the phone? And ideally, most of us want our problem solved faster versus you know slower. So if you've solved the problem but it takes longer for the professional or the situation, an hourly model lends itself to being more expensive. Whereas, again, all things being equal, you know, we can't rush everything. But if if my plumber can fix my problem in five minutes or five hours, I'll pay extra. You know, I'll pay the same to get in five minutes. I don't I don't need him to be there for five hours. Um if he's getting paid 50 bucks an hour, I'd rather pay him 100 bucks for one hour than 250 for five hours all day long, right? Even if it's a hundred bucks an hour versus 50 bucks an hour for those two scenarios. So keep that in mind. If you have a real specific project-based need or specific question, you feel very comfortable about all your assumptions, all the next level questions that might come up, and you can just need that particular expertise, an hourly uh approach is phenomenal. But if it's an ongoing relationship and you feel like you'd rather have a comprehensive ongoing engagement, hourly is going to be that could be a problem given all the dynamics of an hourly uh advisor relationship. Uh, the fourth uh dirty little secret category would be flat fee models. So this is a fairly new but increasingly popular option is to have an advisor who charges a specific amount of dollars per year for a more comprehensive engagement. Um the great thing about this approach, it's sort of a direct attack or supplement or improvement in their eyes on the assets under management model. So if you have a million dollars, you pay, you know, if it's 1%, that's$10,000 a year coming out of your accounts. Um if you have$2 million, you pay, if it's still 1%, you pay$20,000 a year, which is, you know, even if it's coming out of your account, you don't really feel it. It's still a lot of money. A lot of money by anybody's definition. So a lot of the flat fee model positioning is hey, if you've got two million dollars, why should you pay twice as much as someone with a hundred with one million or four times as much as someone with$500,000 if the planning takes about the same amount of time? So the the marketing or the business model is hey, we'll find people with two million dollars instead of charging them$20,000, we'll charge them$10,000 or$8,000 or some amount that's a very reasonable professional uh compensation for the advisor, but it's way more cost-effective than the$20,000 for the$2 million net worth or asset client. So the downside is that we live in a market-based world, right? So a lot of times if there are if there are people who are still willing to pay an assets under management fee, um, as an advisor, you're gonna be more willing to work for those people who are willing to pay$20,000 versus the ones who are looking to pay eight. So, what does that mean to you? Well, it just means the supply and demand couldn't get out of whack. If if we presume that better advisors want to earn more income, um it's gonna be easier to find someone who's willing to do the work for$20,000 versus eight. Is it fair? The marketplace still says plenty of people are willing to have the money taken out of their account or their bank account, but usually their investment account, and they're willing to pay$15,000,$20,000 a year for a$2 million portfolio if they're getting comprehensive help, if they trust their advisor, all the things you hope you get at that at that investment. Um there are many, many, many more than there were five, ten years ago who you can get great advice for$8,000 a year,$7,000 a year,$5,000 a year on a$2 million portfolio. So they're out there, and I think that is a great model for the newer planner who's trying to build the business. Because, man, all things been equal, if someone's not working with an advisor and they see the offerings, I think it's great. But the dirty the little secret would be it might be hard to find that person because inevitably, if they're working with 50 clients and they're making$7,000 a year per relationship, they're going to get to the point where they don't feel like they need to add more clients and they may not have the capacity to service them. And in the model where you have more margin, more revenue for the same number of clients, you can hire staff or team to deliver the service to be an additional advisor to provide advice. There's going to be less of that. So the downside to the customer is there's less resources over time potentially or less availability. Now, a good advisor in that flat fee model can be more tech savvy, can be more efficient, etc. Maybe if they're newer in the profession, they're willing to work for a lower compensation as they're building out their practice, or they've they've accumulated their expertise in another field. Um I found one particularly successful and well-known flat fee advisor. He doesn't want any more clients. So he's built quite a following, but he's not able to help people directly and has no intent to hire or or or ever add clients. So his expertise is you know kind of limited. So that's the dirty little secret. The economics of the business as an advisor, as a business owner, might make it hard to find that next person that is experienced but still has capacity to help you on that ongoing, direct, uh, thorough relationship. So that's the dirty little secret of flat fee pricing. And then the fifth and final um fee or compensation model that's you know we'll talk about the dirty little secrets of is free. So again, I use free in quotes because usually to have the right expertise and attention and thoroughness, it's gonna be hard to find someone that'll do that for free. Um maybe you have a family member who's dedicated, has time on their hands, maybe they're retired or somehow retired or just loves this stuff, like I would tend to do for some family members. Um or you could, you know, if you take advice from a mass media outlet or books, um sorry, there's a I thought the mic camera had shut off. Books, media, one to many like Dave Ramsey, Susie Orman, Robert Kiyosaki, um any kind of online forum, the it's gonna be all over the map. I think books and educating yourself are a phenomenal investment of time and almost no investment of money for you know for books themselves. Um but when you crowdsource your your financial advice, it's gonna be difficult to take that sometimes and focus the the any inputs into a productive manner. So um the free advice, if you have a specific thing you want to input on, it can be helpful, but just be careful and not spinning your wheels in terms of time when if you invested a fairly reasonable amount of time to read books or to hire a professional on a limited engagement or bring a family member or friend to talk to a professional to have another set of eyes and ears. Um, I think free can be one of the most expensive ways to get advice because if you make mistakes or you deal with someone who thinks they know what they're doing, but they don't know the nuances of a particular net unrealized appreciation of companies stopping at 401k, or they don't understand how capital gains work in your non-retirement account, or they don't understand how the tax brackets work, or they don't understand the additional cost you might pay for Medicare if you if you're at certain income levels and you're not thinking about very different tax years and how how to have a strategy. Um most what most advisors do, a a well, uh a motivated, smart individual could could learn that over the course of a few years if they're reading and really into it. But there's also plenty of people that are simplifying to the point of missing very obvious to a good advisor potential benefits, right? So um free can be expensive. So that's the dirty little secret. Um, you don't always get what you pay for. Sometimes you get more, sometimes you get less, but um make sure your your expectations are calibrated appropriately, appropriately low if your all your advice is free. Um, if it's an education, that's a great investment at free. But if it's trying to make decisions, think through make sure you're not taking free advice and assuming it's perfect all the time, especially if it's crowdsourced on a social media platform. So those are the dirty secrets of the five of five very common um advisor compensation models. Hope you found it helpful and let me know if I can uh answer any specific questions. Thanks.