Advisor Fees

Advisors may be compensated in one of several ways:

• annually, as a percentage of total assets you (the client) entrust to them (this compensation is  referred to as a percentage of assets under management, or AUM)
• by commissions, which are paid on each recommended and executed transaction
• by the hour,
• or with a one-time, all-encompassing fee.

In some cases, advisor fees are not paid by you directly. For example, some advisors are paid their commissions or fees partly or fully by the firms whose products they sell. These costs are often passed on to you, however.

To be truly objective, many investors feel that advisors should only charge one-time fees or by the hour, and never accept any external compensation; in other words, you should be their only source of income. The other types of charges open up avenues for abuse. For example, an advisor may recommend too many unnecessary transactions and make money for each transaction. Or an advisor may urge clients to buy only those investments that result in an advisory fee. NAPFA-registered advisors shun external compensation and are fully committed to being paid only by you, the investor. According to the NAPFA website, which explains members’ commitment to fee-only services, “Fee-Only compensation indicates that an advisor never accepts commissions or compensation of any kind related to the products he or she recommends.”

A common counter argument put forward is that advisors paid on the basis of a percentage of assets under management do care about a client’s interests because, the more the client’s portfolio grows, the more the advisor’s fee grows, too. There is some truth to this, but advisors can still earn lucrative salaries even when individual client wealth declines. How? By signing up new clients, advisors ensure that their overall assets under management and therefore their fees grow, even when the wealth of an individual investor decreases. It’s easier to build fees by gathering more assets (i.e., signing up new clients) than it is to increase existing client wealth by beating markets. Advisors don’t really fully feel the client’s pain. In a downturn, it is only their earnings for a single year that suffer directly, while a client’s nest egg may be severely depleted, costing them many years’ worth of earnings.

A cleaner arrangement would be one in which the advisor is compensated on the basis of a percentage of the return secured for the client, rather than as a percentage of the client’s wealth. The former fee structure would be far more effective in truly aligning advisor and client interests.

While fees may seem relatively small calculated on an annual basis, they can be very damaging to long-term wealth creation. In Chapter 9 of Play to Prosper: The Small Investor’s Survival Guide I provide an example of this. For the moment, it’s sufficient to state that when searching for an advisor, do everything in your power to reduce fees.

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