Anyone contemplating working with a financial advisor needs to understand how they’re actually going to be paying for the service they receive—and for many investors, this isn’t a well-understood part of the equation.
A lot of young people, for instance, first get involved with investing through an advisor at their bank—but may be under the mistaken impression that this is some type of free service. Make no mistake about it, advisors must always be paid for the work they do (and rightfully so). But there are many different ways that advisors can be compensated, and that’s where things can get a bit murky.
As I’ve mentioned in previous MoneySense articles, both advisors and media can be a bit sloppy with cost terminology, so let’s set the record straight before proceeding any further. There are four main cost models to consider:
- Salary + Bonus
We’ll examine the first three in more depth (the last is self-explanatory)—but before we do, I’ll start out by explaining the difference between commissions and fees. Simply put, commissions originate from products (that is, they’re dependent on product), whereas fees originate from the client (independent of product).
Commissions, for instance, can be generated from individual stock and bond transactions, mutual funds (which often come with additional sales charges known as “loads”) and more.
With mutual funds, you might—or might not—be aware that the fund company may make ongoing payments to your advisor and their dealer to compensate them for servicing you as an investor in those funds. For example, most equity mutual funds pay a trailing commission of 1% of the amount invested, which is split between the advisor and dealer. These commissions make up part of the management expense ratio (MER) of the fund. Since mutual fund returns are posted net of expenses, if you had a fund with an MER of 2%, and the published return is listed as 4%, the fund actually earned 6% before expenses.
Currently, these expenses are not detailed on your regular client statements, so you would have to ask for these costs to be calculated and broken down to see who is making what off of your holdings. Because the ongoing payments originate from product, these payments are commissions. Ergo, there is no such thing as “trailer fees,” only “trailer commissions.”
Fees, on the other hand, are generated when you get a bill, or automatically have cash withdrawn from your account according to a written agreement. You’ll get a bill if your advisor charges by the hour, or a flat project fee. But far more common is a fee based on a percentage. For example, you might agree to pay 1% of your account value per year for advice. Generally speaking, these charges will show up on your account monthly or quarterly, and your advisor will ensure that there is ample cash in your account to cover these automatic, itemized charges. No matter what products you hold, the fee for advice gets deducted—and note that any product costs like MERs for F-class mutual funds (which are stripped of trailer commissions and sales charges) or ETFs would be over and above the advice fee.
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As you can see, fees fall under two sub-categories: a percentage of assets under management model, or a “fee-for-service” model. Under the former, your costs are based on how much you have invested. Under the latter, it’s the hourly rate or flat fee per project.
It’s also very important to note that most people confuse “fee-only” as “fee-for-service.” Some find it desirable to pay by the hour or through a flat project fee, and think that advisors advertising themselves as fee-only advisors fit that bill (no pun intended). In reality, a commission-based, a fee-based or a fee-only advisor could offer you services on an hourly rate.
“Commission-based” simply means that advisors generate the majority of their income from commissions, but may generate fees as well. Similarly, fee-based advisors generate the majority of their income from fees, but may earn commissions here and there as well.
A fee-only advisor means 100% of their income only ever come from fees—be it through a percentage of assets or a fee-for-service model.
Now that we understand a bit more about the main models of cost, we can start to explore what you should actually be getting in exchange for them.
Go back to:
Part 1: How to measure the value of financial advice »
Or proceed to:
Part 3: What kind of financial advice do you actually need? »
Part 4: How your own bad investing behaviour costs you »
Part 5: The right financial advisor model for you »
*MoneySense Approved rating is created for information purposes only and is not intended as financial advice. MoneySense Approved is not responsible for any advice or other communication provided to an investor by any Financial Advisor. Rogers/MoneySense makes no representations or warranties as to the suitability of any particular Financial Advisor and/or investment for a specific investor. Visit moneysense.ca/approvedmethod for full methodology.