How financial advisers are paid

People who give financial advice are paid in several different ways, and the method affects both what a client pays and what incentives the professional has. The SEC makes a point that is easy to miss: even when a client does not pay a professional directly, that person is still getting paid, often through costs built into a product. This post describes the common arrangements.

Two kinds of firms

Many financial professionals who deal with the public work for a broker-dealer, an investment adviser, or a firm registered as both.

The SEC's relationship summary page describes the difference. Brokers provide services that are generally transactional: carrying out orders and recommending specific investments. Advisers provide services that are generally ongoing: continuing advice, monitoring and, in some accounts, making trades on the client's behalf. The way each is typically paid follows from that difference. The legal standards that apply to each are covered in what a fiduciary is.

Transaction-based compensation

A broker is typically paid when a customer buys or sells something.

• Commissions. A charge for carrying out a purchase or sale.
• Markups and markdowns. When a firm sells a security, such as a bond, from its own inventory, it may sell at a price above the market price, or buy from a customer at a price below it. The difference is the firm's compensation.
• Sales loads. Some mutual funds charge a percentage of the amount invested, at purchase or at sale, to compensate the selling professional. See fund fees and expense ratios.
• Ongoing payments from products. Some funds pay continuing distribution fees, called 12b-1 fees, out of fund assets to firms that sell their shares.
• Surrender charges. With a variable annuity, the SEC notes, a charge for early withdrawal compensates the professional who sold it.

The SEC observes that a person may prefer transaction-based fees if they do not trade often or plan to hold investments for long periods.

Asset-based fees

An investment adviser is typically paid an ongoing fee calculated as a percentage of the value of the account. The fee is charged whether or not any trades occur.

A hypothetical illustration, as arithmetic only: an annual fee of 1% on a $300,000 account is about $3,000 a year. On a $400,000 account the same percentage is about $4,000 a year. The dollar amount moves with the balance.

The SEC notes that an asset-based fee may cost more than transaction-based fees, and that a person may prefer it if they want ongoing advice or want someone else to make investment decisions.

Asset-based advisory fees are in addition to the internal costs of any funds held in the account.

Other fee arrangements

• Hourly fees for advice, billed by time.
• Flat or fixed fees for a defined service, such as a financial plan or an annual review.
• Subscription fees, a recurring flat amount for ongoing access to advice.
• Wrap fees, a single bundled fee covering investment advice, trading costs and administrative expenses.

Advisers may also earn a combination of client fees and commissions. Firms registered as both broker and adviser may offer several account types, each paid differently.

Labels such as "fee-only" and "fee-based" are widely used in the industry to describe these arrangements. They are industry terms, and firms do not all use them the same way, so a firm's disclosure documents are a more reliable guide than the label.

Each model has its own conflicts

The SEC says of both brokers and advisers that the way they make money creates some conflicts with their customers' interests. The conflicts differ by model. The table uses examples from the SEC's releases on Form CRS and Regulation Best Interest.

Hourly, flat and subscription fees are not shown in the table. A firm's own disclosure documents describe the conflicts that apply to its arrangements.

This is why a recommendation to move money, for example from a workplace plan into an account the professional manages, is worth understanding from both sides. The guide to old 401(k) options lays out the choices involved.

A conflict does not mean the advice is wrong. It means the client benefits from knowing the conflict exists.

Where compensation is disclosed

• Form CRS (relationship summary). A short document that broker-dealers and investment advisers must give retail investors. It covers services, fees and costs, conflicts of interest, the standard of conduct and disciplinary history, and it uses similar headings across firms to make comparison easier.
• Form ADV Part 2 (the brochure). Investment advisers provide this before or when a client signs an advisory agreement. The SEC says it must include how the adviser is compensated, its fee schedule, whether fees are negotiable and its conflicts of interest.
• Account agreements and fee schedules. These list account-level charges such as maintenance, transfer and inactivity fees.
• Statements and trade confirmations. These show what was actually charged.

Questions worth asking

SEC investor bulletins, including the one on how fees affect a portfolio, suggest questions such as these.

• How do you get paid: by commission, by a fee based on assets, or another way?
• Do you earn more if I choose one product over another?
• Do you get paid even if you make no changes to my investments?
• Is this a brokerage account or an advisory account?
• What will I pay in total each year, including the costs of the investments themselves?
• If I invest $10,000, how much goes to fees and costs, and how much is invested?