How Financial Advisors are Paid, and Why It Matters
Managing your own money can be overwhelming. How do you know you’re making the right decisions? Are you saving enough? What is Crypto, or NFTs? Where is the best place to be saving your money? These are just a few questions you may need a financial advisor to answer, and they can also help you navigate the market as well as different tax and investment strategies. No matter your level of money management experience, as an individual, you have limited resources to research, trade, and manage things on your own. So, it is important to hire a financial advisor for guidance. If you are currently working with, or are considering working with an advisor, there’s one other question you need to be asking: How does my Financial Advisor get paid?
There are a few ways that a financial professional can operate their business. This article outlines 4 of the major business structures in the financial industry and tells how your advisor’s compensation might look in each structure. Understanding the structure of your financial advisor’s practice will help you understand the motivation behind their advice.
Broker-Dealers. This is a very common structure for a financial professional to operate his or her business. A Broker-Dealer relationship is usually through an insurance company. The advisor essentially gets access to a turn-key operation. Technology, trading, product selection, and compliance are all provided to the advisor through the broker. A “BD” relationship is typically transactional. By definition, a broker facilitates transactions on behalf of an individual, and a dealer facilitates transactions for the business. This means that your advisor is compensated through the transaction fee of an investment or the sale of an insurance product. Regardless of the performance, quality, or cost of your investments, if there are transactions in your portfolio, your advisor is receiving a commission. This may make sense for an investor who is more of a do-it-yourselfer or someone that isn’t making very many transactions. Be aware that this can create conflicts of interest. Not all advisors that are working with a broker-dealer are unscrupulous. In fact, you may find that most are running a professional practice. However, when your practice depends on a platform that is being provided to you by a larger company, this tends to limit the advisor’s options and oftentimes the investments being provided have inflated costs and participate in revenue sharing.
Custodians. Custodians are usually a third party that has custody or holds your cash and investments. There is a limited opportunity for professional advice here, but it could be a low-cost option to someone who is sophisticated enough to manage their own investments. Custodians are compensated on the cash position your account holds. Much like a bank, if you hold cash in your account, the institution is lending that money out to other investors for an interest rate and crediting a very small percentage to your cash position. There may also be trade fees when transactions are placed to generate revenue and cover administrative costs for the custodian.
Wirehouses. A wirehouse is typically a widely recognized household name. These are generally large firms with multiple branches and offer a wide array of services to their investors: investment management, personal banking, and insurance products to name a few. The business model behind a wirehouse is to be involved in every aspect of your financial life and accumulate as much of your personal assets as possible so that your relationship with the institution is further solidified. As a consumer or client of a wirehouse, your relationship is with the corporation rather than the advisor you may be working with at the time. As far as how wirehouses compensate their advisors, they may pay a salary or charge a fee on accounts that meet a high minimum investment. In either scenario, the advisor works for the firm, not for the client, and may be incentivized by higher salaries or corporate bonuses. The convenience of having all of your financial services in one place is very appealing, and it is easy to trust a name you’ve heard for decades, but this structure opens your advisor and the firm they work for to a number of conflicts of interest.
Independent Registered Investment Advisor (RIA). RIAs operate on a fiduciary standard, meaning they are legally and morally obligated to act in your best interest as the client. A fully independent RIA offers a suite of services that are designed to help their clients with things like financial planning, investment management, and retirement planning. Rather than being compensated for product selection, the number of accounts they open, or commissions through trading, an advisor of an RIA is paid for their advice directly by the client. This may be a one-time or recurring financial planning fee paid out of pocket or based on a percentage of the assets the advisor is managing for you. Your independent RIA advisor should be open with you about how they are compensated and what you are paying for their advice. As a fiduciary, these advisors are required to disclose any potential conflicts of interest they might have. RIAs are typically self-regulated. While they answer ultimately to the Securities and Exchange Commission (SEC), compliance and supervision are often “in-house”. Being self-regulated makes RIAs more nimble, but it also means there is less governance compared to other structures. There is a high level of trust when working with an RIA, so you want to ensure your advisor has a clean regulatory background and carries the education that qualifies them to provide you advice.
Each structure has its pros and cons depending on the level of service and advice you need. In all cases, you can reference brokercheck.finra.org to search your advisor and what licenses they hold, as well as their regulatory background. Advanced degrees or designations are also a good indicator of the quality of advice from your advisor. The two most widely recognized designations for the financial industry are the CFP® and ChFC®.
To summarize, a financial advisor can be compensated through commissions, a salary, fee-based revenue, or any combination of these. Where your advisor gets their paycheck has an effect on the advice they provide. With an understanding of how your Financial Advisor runs their practice and how they are paid, you can make a decision on hiring the right person to help meet your goals and objectives.
This commentary on this website reflects the personal opinions, viewpoints and analyses of the Financial Strategies Group, Inc employees providing such comments, and should not be regarded as a description of advisory services provided by Financial Strategies Group, Inc or performance returns of any Financial Strategies Group, Inc Investments client. The views reflected in the commentary are subject to change at any time without notice. Nothing on this website constitutes investment advice, performance data or any recommendation that any particular security, portfolio of securities, transaction or investment strategy is suitable for any specific person. Any mention of a particular security and related performance data is not a recommendation to buy or sell that security. Financial Strategies Group, Inc manages its clients’ accounts using a variety of investment techniques and strategies, which are not necessarily discussed in the commentary. Investments in securities involve the risk of loss. Past performance is no guarantee of future results.
Written by Justin Meyer