Exploring How Financial Advisors Make Money
Many people often wonder how financial advisors earn their income. The truth is, financial advisors have a variety of compensation models that determine how they make their money. Understanding the different compensation models used by financial advisors can help you choose the right advisor for your needs. In this article, we will explore the various ways in which financial advisors make their money, the pros and cons of each method, and recommendations for choosing the right financial advisor based on their compensation model.
Commission-Based Financial Advising
In a commission-based model, the financial advisor earns a commission for selling financial products such as mutual funds, insurance policies, and annuities to their clients. The commission percentage varies depending on the product sold. For instance, the commission percentage for selling an insurance policy may be higher than that of selling mutual funds. Commission-based financial advising is a common compensation model in the financial industry.
The advantage of commission-based advising is that it’s often free for clients. However, there’s a risk that a financial advisor may recommend a product that benefits them more than their client. The client may end up buying a product that doesn’t meet their needs, but provides a higher commission for the advisor.
Fee-Only Financial Advising
A fee-only financial advisor charges a fee for their services and doesn’t receive commissions from selling products. The fee may be hourly, flat-rate, or a percentage of assets under management (AUM). Fee-only advising is becoming increasingly popular in recent years.
The advantage of fee-only advising is transparency and objectivity in financial advice. Clients don’t need to worry about conflicts of interest or an advisor pushing them to buy products to earn a higher commission. However, this model may be more expensive for clients, especially if they have a large portfolio of investments.
Hourly Financial Advising
In hourly financial advising, clients pay for the financial advisor’s time. This model may be ideal for clients who need occasional advice on specific financial matters, such as tax planning or estate planning. The advisor may also provide a financial plan for the client.
The advantage of hourly advising is that clients pay only for the services they receive, and there’s no risk of hidden fees or commissions. However, clients need to keep track of time spent with the advisor, and it may be more expensive than other models if the financial plan is complex.
Retainer-Based Financial Advising
A retainer model involves the client paying the advisor an upfront fee, usually on a monthly or annual basis. The fee covers a broad range of financial advice and services that the client may need. This model may be suitable for clients who require comprehensive financial planning and advice. It may be more cost-effective than hourly advising for clients with complex needs.
The advantage of retainer-based advising is that the advisor and client have a consistent relationship and the client can access services as needed. The downside is that it may be expensive for clients who require infrequent advice.
Percentage of Assets Under Management
In a percentage-based compensation model, the financial advisor charges a percentage of the assets under management as their fee. This model is often used for investment management, where the advisor manages the client’s investment portfolio. The percentage charged is usually in the range of 1% to 2% of the portfolio value.
The advantage of this model is that the advisor’s interests are aligned with the client’s, as the advisor earns more if the portfolio performs better. The downside is that the cost may be high for large portfolios and may not be suitable for clients who don’t require investment management.
Referral-Based Financial Advising
In a referral-based model, financial advisors receive a fee for referring clients to other financial professionals, such as insurance agents or estate attorneys. The fee may be a flat rate or a percentage of the fees charged by the professional referred. This model may be suitable for clients who require additional financial services beyond what the advisor can provide.
The advantage of referral-based advising is that clients can access specialized services they may need. The downside is that the fees charged by the referred professionals may be higher, and the advisor may push clients towards those who pay higher referral fees.
Combination of Methods
Financial advisors may use a combination of compensation models to earn their income. For instance, an advisor may charge a percentage of AUM and also receive commissions for selling certain financial products. Alternatively, an advisor may charge a flat fee for comprehensive financial planning and also charge an hourly rate for occasional advice.
The advantage of combining methods is that the advisor can tailor their compensation model to suit the client’s needs. The downside is that it may be more complicated for clients to understand how their advisor earns their income.
Conclusion
Financial advisors have different compensation models that determine how they earn their income. Each model has its pros and cons, and clients should choose an advisor based on their needs and preferences. Commission-based advising is often free for clients, but may be biased. Fee-only advising is transparent and objective but may be more expensive. Other models such as hourly, retainer-based, percentage of AUM, or referral-based may be suitable for clients with specific needs. Finally, advisors may use a combination of methods that may suit clients who require different types of financial advice.
