You guessed it: It depends.
You can ask ten people and get ten different opinions about this issue; but, after more than twenty years in this business – having begun in a Wall Street big name `wire house’ and gradually changing my business model from stockbroker to independent broker to independent planner/broker to independent planner/broker/advisor to independent planner/advisor and having spoken with hundreds of other advisors over the years at scores of industry conferences and conventions – this is my own humble opinion:
There’s no one right answer. There’s only the one that’s best for YOU.
You have to do some analysis – and it helps if you can use a computer spreadsheet. But, it might be worth remembering what your parents probably told you many years ago: There is no free lunch.
If you’re thinking of using a financial advisor to get investment help, it should come as no surprise they will be compensated. Typically, this is what you can expect to find:
- Registered investment advisors (RIAs) charge fees and have fiduciary status, so must perform to a fiduciary standard, i.e., recommendations must be in the best interest of the client.
- Registered representatives (RRs) – You know them as stockbrokers and others who may be independent ‘advisors’ or ‘consultants’ – sell investment products and earn commissions. They use a ‘suitability’ standard, i.e., as long as the recommendation is suitable, it passes the test.
- Dually-registered as both RIAs and RRs. Typically, they tout the fiduciary ‘standard’ during the planning stage, but often switch to the ‘suitability’ standard during the recommendation and implementation stage.
What’s best? Hype and arguments aside, I personally don’t believe most advisors’ integrity is dictated by the form of their compensation. It’s a factor to consider, of course, but I wouldn’t make it a deciding factor. There are many quality competent advisors operating within each of these business models.
Each model has its advantages and disadvantages. While I believe the fee model may present fewer obstacles to portfolio rebalancing, the commission model often makes it possible for smaller investors – people who may be less likely to pay fees – to get the help they want.
Back to our original question: Which model is most cost effective when using an investment advisor.
Take a look at your portfolio size and compare what the fee advisor is charging against what the commissioned rep is selling.
Example #1: Suppose you have only $50,000 and you want a growth fund.
- The commission approach: It wouldn’t be uncommon or surprising to see a load of between 3-5% for this sale. So, if the load were 4%, the client would be paying a $2,000 commission up front. It wouldn’t be a surprise to see ongoing 12b-1 fees of 0.25% annually ($125, assuming no growth) which, frankly, is pretty reasonable annual compensation to have a rep answering questions and servicing the account. The upfront commission provides compensation for all the up-front work, including the account opening.
- The fee option: It’s become common for many, certainly not all, advisors to charge somewhere in the neighborhood of 1% of assets annually – this usually depends on the size of the portfolio – and then go DOWN as the asset levels increase.Back to our $50,000 client: I think it’s fair to say few fee-only advisors would look forward to doing all the initial planning and research – and paperwork, including compliance issues – for $500, and then have to wait a full year to be paid in full. This is the reason many fee-only advisors charge planning fees; but how many people with $50,000 would pay the freight? Not many I think.
Example #2: Suppose you have $600,000 in your nest-egg and need help
- The commission approach. This can get dicey. In the commissioned world, it wouldn’t be surprising to see `free’ planning services result in a recommendation of fully-disclosed low-cost investment products mixed with some undisclosed (hidden) high-cost products. I know people personally who, in their past, had invested as much as $1 million with a commissioned broker, having no idea they’d actually paid as much as $40,000 in hidden commissions up front – in the first 90 days – simply because many of the products looked ‘free’ to them! There was no charge for planning. Yes, unfortunately, this does happen.I doubt the above experience is the `norm’ but, let’s face it: If only 20% of your $600,000 account is placed in products with undisclosed hidden costs and paying 6% commissions, you’ve paid $7,200 in front on just 20% of your assets… that’s 1.2% of all of your invested assets right there! Even if the balance of the portfolio carried only a 1% charge, you’re still paying a total of $12,000 in the first year on your $600,000 portfolio – about 2% of assets.Is all this bad? It depends. The investment products you receive just may be worth it! And, let’s face it, quality planning for that size portfolio, even with sophisticated software, still takes time simply because the investment screening requires more than simple button-pushing.
The point is you should KNOW what you’re paying and what you’re getting so you can make an informed decision. It’s also important – I think – to know if the products and managers involved are proprietary (in house) or from third-parties. It’s also good to know what other products and managers were screened-out by the advisor and why. Remember: Two identical products might pay two different commissions.
- The fee approach. Generally not as dicey because of the straightforward service agreement with fully-disclosed charges with no product sales. But, still, RIAs differ in their charges and services. Some will charge a one-time retainer to do your plan as well as an annual advisory fees for ongoing management oversight and portfolio consulting. Others may not charge for the plan but will likely require a higher asset minimum to justify the time and may require that assets be placed on deposit before any work begins.
If there’s a planning retainer required, the amount will often depend on the complexity of the plan and the time involved. Annual advisory fees can also vary, depending on the firm’s asset minimum. Wherever they begin, the annual fee generally goes down as assets increase.
Each RIA sets its own fee schedule, but you will find that most RIAs take pride in providing complete transparency and full disclosure. Since they’re not compensated by commissions, they use non-commission investments and also like to use institutional money managers for the value they can often add. One of the benefits of institutional management is that their charges typically go down (as a percentage of assets) as portfolio value increases – something that doesn’t occur in mutual funds. If you’d like to learn more about mutual fund costs, you can download our report here.
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Jim Lorenzen is a CERTIFIED FINANCIAL PLANNER® and an ACCREDITED INVESTMENT FIDUCIARY® in his 21st year of private practice as Founding Principal of THE INDEPENDENT FINANCIAL GROUP, a fee-only registered investment advisor with clients located in New York, Florida, and California. IFG provides fee-only financial and retirement planning, as well as investment advisory and wealth management services for individual investors. IFG also does not provide tax or legal advice. Content contained herein represents the author’s opinion and should not be regarded as investment advice which is provided only to IFG clients upon completion of a written plan.
