The Ways a Financial Advisor Earns Money

As you consider hiring a financial advisor, it's helpful to understand how that advisor generates income. Understanding the income generation model the advisor uses helps you understand what fees you'll pay and with what periodicity.

The "Assets Under Management" model - Using this structure, the advisor charges a set percentage of your account total per year. Typical charges in the industry center around 1%, meaning that you'll pay $1K per year for the advisor to manage $100K of your money. In this model, advisors have less incentive to take on smaller accounts and more incentive to manage larger ones. This arrangement is similar to an insurance policy on an expensive piece of jewelry - a fixed percentage charge based on the value of the item. Just like the insurance policy, you pay every year under the AUM model.

The "Flat Fee" model - This fee structure is a fee-for-service arrangement, not unlike exchanging money for an oil change or a personal training session. It primarily differs from the AUM model in that it is a one-time charge. That charge pays for a one-time service, like developing a personalized investment plan. There is no ongoing account monitoring or periodic advice provided like in the AUM model. The flat fee charged can be generated by the service provided (an investment plan for $1K) or by the hour (say $200 per hour multiplied by the billable hours, similar to an attorney's billing structure).

The "Commission" model - In this model, the advisor earn commissions from fund providers to sell certain mutual funds or other investment. This model aligns the interests of the parties providing the investment instrument with the investment advisor. The interests of the investor aren't necessarily represented in this model.

Investment advisors may combine multiple models when servicing clients. A commission-only advisor will earn fees only from the commissions on products sold and won't charge a separate fee. Conversely, a fee-only advisor won't accept commissions, but may combine the AUM and Flat-fee models. A fee-based advisor will accept both client fees and commissions.

Once you understand the type of advisor you're working with, you'll better understand his incentives in working with you. As Warren Buffet's long time business partner has said, "Show me the incentive and I'll show you the outcome." The better your understanding of incentives, the better chance you'll have of making decisions that lead to the outcome you want.