As shocking as it may seem, most financial professionals do not work for free. Unfortunately, the industry does not make discerning exactly how, or how much, an advisor gets paid as clear as it should be. I say, “should be,” because, in any business transaction, when the manner and method of compensation is not clear to the consumer, the risk of hidden biases and conflicts of interest can become a serious impediment to prudent decision making.
This article will shed some much-needed light on how advisors get paid, focusing on the three methods of compensation most prevalent in the field. Through this discussion, we will “follow the money” as it winds its way from your investment account to the advisor’s bank account. Along the way, we will occasionally pause to illuminate areas of concern investors need to be aware of.
As a disclaimer, the following information will be general in nature. Not all investment vehicles fall into just one of these categories, and not all advisors rely on just one of these compensation methods to get paid. The universe of business models and investment strategies is broad and diverse with most advisory firms offering an array of options from which clients (hopefully) have the freedom to decide the ideal arrangement for their circumstances.
“Commission” typically means the client will not see any form of compensation pulled directly from their accounts for delivery to the advisor. Instead, payment comes from the operating profits of the company with whom you decide to invest your assets. Some consumers may find this appealing as it creates the sense that there is no direct cost for the services provided. This, however, is not the most accurate way to view the scenario. If the advisor is being paid from the profits of the corporation, where do you think those profits are generated? They come from you, the end-user. Here’s an example of what I mean:
Let’s say you decide to buy a fixed-indexed annuity, most of which are commission-based products. One great feature of these types of contracts is that they have the potential outperform traditional ultra-conservative alternatives like CDs and money market funds (and even some market-based accounts in the right environment), all without the risk of “losing” money and no fees getting pulled from the account. Sounds like a great deal, right? Well, when it comes to fees, make no mistake about it, they are still there- just not in the traditional way many understand the word.
Most annuities contain two features designed to ensure the issuing company will retain enough revenue to pay the advisor/agent a commission: One is the “surrender period.” This is a span of time, ranging anywhere from 2 to 15 years, during which the contract owner (that’s you) will have to pay the insurance company a portion of any distribution amount exceeding an annual “free withdrawal” limit (typically 10% of the contract’s accumulation value). The amount of this “surrender penalty” varies by company and the account selected, but it generally starts at a higher percentage of the excess distribution, over 20% in some cases, then gradually declines each year the contract stays in force, ultimately dropping to zero at the end of the surrender period. In light of this version of a fee, anyone considering an account to which it may apply should be reasonably confident they will never exceed the penalty-free annual distribution amount during any year the contract remains in the surrender period.
The second way issuers generate profits from fixed-indexed annuities is by retaining a percentage of the underlying asset growth each year. As a simple explanation of the complex mechanics of these types of accounts, interest is typically credited during years of positive performance of an underlying market index or indices upon which the accumulation method is based. However, in most accounts, the upper range of annual performance will be “capped” by one of several methods employed by the issuer.
To see how this might look in a real account: If your annual growth was based on the performance of the S&P 500 Index, there might be a cap in place of, say, 6% for the year. If the index goes up by 5%, since the increase fell under the cap, you get to keep all the gains. If, on the other hand, the index goes up by 16%, guess who keeps the extra 10%? That’s right, the issuing company. Over the long-run, you can see that this could be a lucrative proposition for the company.
Lest it sound like I am no fan of annuities, that is hardly the case. In the right circumstances, they can be an excellent fit for a client’s portfolio. And, of course, we should always remember that in years when the market goes down, you don’t participate in any of the decline in these types of accounts; a feature which may be quite appealing for the more risk-averse consumer.
The point I want to make clear about commission-based vehicles is that there is always an element of cost to the consumer. It may not necessarily be labeled a “fee,” but the expense is there and you should not purchase one of these contracts, be it an annuity or anything else, until you have a solid grasp on how the cost structure works. Fortunately, all of this information is spelled out concisely in the product disclosures you must sign before opening an account and again in the actual contract once it is issued- Read all of it! Knowing this information in advance will go a long way towards preventing unpleasant surprises down the road.
Now that we’ve seen how commissions work from your end, let’s discuss what it looks like from the advisor’s side of the table. Unlike the myriad disclosures you’ll find about how the investment may wind up costing you in penalties and/or performance caps, determining just how much the advisor will make if you decide to open an account is not so easy. In fact, up until very recently, unless you specifically ask the question, there was no way to know what the agent would earn as it was not a required disclosure. And even if you did ask, depending on the governing body under which the advisor is licensed, they weren’t even required to give you an honest answer. Again, thankfully, this is all changing, but there are still certain classes of financial professionals and transactions which enforce no such requirement- so buyer beware.
As far as the amount paid to the writing agent, that can vary greatly by the type of contract you are purchasing. Generally, most commission-based vehicles pay a certain percentage of the initial, or, in some cases, the first-year premiums or contributions made to the policy. Here are some typical ranges:
For fixed and fixed-indexed annuities, the gross payout to the writing agent can be anywhere from 2-8%. For life insurance policies, this figure can be much higher depending on how premiums are paid. If you are making a large cash-value exchange from one policy to another, the range is similar to annuities at around 2-8% of the contribution. However, if you are making periodic payments, that number can be as much as 100% or more of first-year premiums.
If those numbers seem unreasonably high at first glance, clients should bear in mind that these are generally one-time or first year-only payments. If you engage in a relationship that spans several years, or even decades, your advisor may be providing these ongoing services without receiving any additional income.
Before we get to the next compensation method, I’ll mention one other form of commission relating to securities, or, more specifically, mutual funds purchased directly from the investment company (non-brokerage). These types of accounts are characterized by what is known as a “sales load” on the front or back-end.
A front-end load is a certain percentage that is subtracted directly from your initial investment by the investment company, a portion of which is paid to the advisor. The industry standard for front-loaded funds is typically around 5.75%, an amount that may decrease based on the size of the initial investment and type of fund purchased. You’ll know you can expect a front-end sales charge if you are purchasing A-Class shares of a mutual fund outside of a brokerage account.
A back-end load, also known as a contingent deferred sales charge or CDSC, functions more like a surrender period in that the investment company won’t charge anything up front, but may retain a portion of your distribution if it occurs within the designated CDSC period. There was a time when a CDSC duration could be as long as six years for B-Class shares, but those are largely extinct these days with only C-Class shares remaining. Class C shares charge 1% on assets withdrawn within one year of the initial contribution.
In addition to the sales load, there is also something called a 12b-1 fee, which us insiders call “trail commission.” This fee is embedded into the ongoing performance of your account, so you don’t necessarily see it as direct reduction of your account value at the time of a transaction. Unlike the sales loads, this fee is based on the current account value, not what you put into it. For Class A shares this fee is 0.25% annually and 1% annually for Class C shares. Trail commissions function much more like the next compensation method we’ll discuss than traditional commissions.
Asset-based fees are rapidly becoming the standard for most advisory offices, particularly those servicing mid-sized households with investable assets ranging from $250,000 to $2.5 million. Unlike commission-based compensation, this method is fairly straightforward and easy to understand as simplicity and a high degree transparency are the defining characteristics.
In a typical arrangement, accounts are assigned to a standard fee-schedule established by the advisor’s firm. Smaller accounts will often be charged a higher fee which gradually declines according to designated “breakpoints” as the value of the portfolio increases. Fees may start as high as 2.5% annually, falling to 1% or less for larger accounts. Like trail commissions, this fee is applied on an ongoing basis and calculated based on the account value during each billing cycle.
One perceived advantage to an asset-based fee is that, in theory, it will encourage the advisor to focus on building and reinforcing the client relationship over time, as opposed to the initial phase of the engagement, which may get the most attention under an up-front commission scenario. Additionally, since the advisor’s compensation is continuously and directly correlated to the value of client’s account on an ongoing basis, the advisor has a vested interest in attempting to keep balances growing.
Though likely not the most prevalent in terms of the number of clients utilizing it, this is the method applied to the most invested dollars as it is the preference for most high net worth investors. Under this arrangement, clients pay the advisor a flat fee based on the number and scope of services provided. Portfolio management, along with financial, tax, and retirement planning are typically included in the menu of offerings, with clients selecting one or a blend of services needed from the advisor.
Many believe this to be the ideal form of compensation in that it virtually eliminates all conflicts of interest other than the advisor’s desire to maintain a strong client relationship. From our experience, high net worth investors will find the fee for service arrangement most appealing if for no other reason than it is the method they are most accustomed to with other advisors like CPAs and attorneys. However, it may still be the most prudent option for clients with as little as $1 million in investable assets.
The important thing all consumers of financial services need to remember is that you have the right to ask prospective advisors to explain which compensation methods are offered at their firm and, more specifically, exactly how much the advisor will get paid based on the course of action you pursue. And don’t let sticker shock have undue influence on your ultimate decision about who you will hire. One way or another, someone will get paid to service your account. Your task will be determining how much of an impact the costs, in whatever form they may take, will have on your long-term performance and then making the decision about whether you feel the added-value is worth the expense.