How Advisors Get Compensated

Early in my career, I worked at a discount brokerage. We were paid mostly in salary with some incentive pay based on how many transfers we brought to the firm and how much was invested into fee-based asset management portfolios. I had a client looking for safe investments to put some cash into. He didn’t want any risk and preferred cash or cash equivalent things. I discussed the .01% interest we were paying on cash, the short-term CDs we had, and characteristics of a short-term bond managed portfolio. Those options didn’t fit what he was looking for and paid a lower rate of return than some online banks were. He then asked me, “What would you do?” Again, I reiterated the three options that my firm offers, which I would get paid incentives on if he did. He got quiet for a moment and then said something I have tried my best to do ever since. He said, “The right answer is to do what will get the best return for me.”

A Short History of How Advisors Get Compensated

How did we get to this current relationship between advisors and clients and where an advisor’s paycheck comes from? Let’s take a short walk through the history.

For a long time, financial advisors were known as stock brokers. They charged commissions for placing trades. They were always happy to give stock recommendations to get someone to get them to place a trade. The more trades they placed, the more money the broker took home. This was a flawed compensation model. Because it puts the success of the advisor and the success of the client on different things. Clients made money if the stocks they bought increased in value, and brokers made money when clients placed trades. Churning became a problem and is still a part of ethical training and discussions in the industry.

Then came the age of Assets Under Management (AUM) models. This was a big step in putting the client’s and advisor’s success on the same page. Clients paid for the investing management, and advisors got paid for how much money they managed. As AUM increased, the advisor made more income through appreciation or adding more assets from the client. In this model, people paid for asset management, not financial advice.

More recently, people found they needed guidance through complicated financial situations. Answering questions like “Can I retire?” “how do I make sure my estate is set up correctly?” or “How can I effectively manage my tax bill?” became more important for people. Since investors were already paying their asset managers, they wanted the asset manager to have the answers. Advisors who traditionally were managing money started adding services to meet this need. Concurrently, investing costs have also decreased substantially. Low-cost ETFs, commission-free trades, and robo-advisors are some innovations that have made investing more affordable. These asset managers were able to capitalize on the lower investing costs and shift some resources to answering financial planning needs. However, advisors’ compensation has stayed tied to how much the advisor manages and is not attached to the advice.

Do AUM Fees Cause Conflicts of Interest?

I want to point out early that there are so many really good advisors who work under the AUM model. They are true fiduciaries, putting their clients' interests before their own, and they don’t consciously let their income sway their advice.

Since the AUM fees are tied to asset management, advisors' focus is still on billing client assets and not on the depth and quality of their advice. Advisors are incentivized to do as little as they can in the planning area and focus on increasing their AUM to make money.

In what ways could the AUM model create conflicts of interest?

• Financial planning becomes a means of getting more assets to manage and ignoring other possibilities that could “be in the best interest of the client.”
• Advisors make recommendations to invest instead of paying off debt.
• Advisor not recommending investment products outside their firm because they don’t get compensated on that recommendation, even if they are superior.
• Doing financial planning “lite” to spend more time gathering AUM instead of taking the time needed to do good financial planning
• Not recommending delaying taking social security when it’s the best option. This means withdrawals from the billable assets can be delayed. Advisors make this recommendation or let the client believe it’s the best option so the advisor can bill on more assets longer, even when it would have worked better to withdraw from the billable assets while waiting for higher social security payments later.
• Rolling over a 401k to an IRA even if the 401k plan is lower cost and a better investing fit because the advisor can’t bill on the 401k.

The Solution

We need to align the client’s success with the planner’s success. If we untie compensation from investing and AUM and tie it instead to the advice, which would include investing recommendations, that will better align the advisor’s planning and investing advice with what is best for the client. No matter where or what that is or where they are invested. That way, advisors won’t be stuck between where their pay comes from and “doing what is in the client's best interest.” Flat-fee advisors have started to fill this area. Since they are compensated for the planning and advice, they can make unbiased recommendations on insurance, estate, investing, tax, rollover, and other areas that matter. Then, they can survey the whole market to help identify the best places to implement the recommendations, regardless of AUM.

Conclusion

The world of financial advice has come a long way since the early days of the stockbroker. Through the years, the industry has changed a lot to better focus on clients and their needs and remove conflicts of interest. We are at a time when this alignment between clients and advisors is taking a giant leap forward. With low-cost investing and unbiased client-centric advice available, there has never been a better time to be an investor.

Alan B. Faerber CFP®, CRPC®