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Why a Fee Based Financial Adviser Makes Sense

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Money is a tough skill to master. The brightest economic minds in the world can’t figure out the investment markets, world political leaders with an unlimited supply of brilliant advisers can’t keep their country out of crippling debt, Bank of America, the 2nd largest bank in the world holding 12% of all American citizen’s money has lost 55% of its market value in less than one year, and the average American is more than $10,000 in debt with states like Delaware averaging more than $20,000 in debt per resident.

Money isn’t easy to manage yet very few people seek help. Less than 20% of Americans have a financial adviser, only 17% have a financial plan and only 56% of affluent Americans seek financial help.

If we as a nation and world can’t manage our money, why aren’t we seeking help from a financial adviser? Sadly, it’s because people don’t trust advisers. Some studies show that as much as 70% of people who have or had a financial adviser don’t trust their recommendations. Some of the problem may come from the type of adviser that a portion of that 70% employed.

Let’s set up a hypothetical situation: You are a doughnut salesman. Each morning you receive various deliveries from different doughnut makers and at 6am you open your fully stocked store. People come in and ask you for a recommendation of your favorite doughnuts and you normally recommend Joe’s Doughnuts. If the customer doesn’t like those, you recommend Bill’s and as a last resort, once all of the other doughnuts have sold, you sell Jake’s.

What your customers don’t know when they’re asking for your opinion is that Joe takes 10% off of your bill if you sell all of his doughnuts within 5 hours. Bill gives you an 8% bonus and Jake doesn’t believe in that so he doesn’t pay anything. It’s in your best interest to push Joe’s doughnuts. What if the reason that Joe’s doughnuts have a higher payout is because they don’t taste as good as Jake’s? Jake may know that people love his doughnuts so he doesn’t need to offer incentives to sell his product.

The doughnut shop owner on the other side of town purchases doughnuts without any type of incentive so it’s in his best interest to only purchase the highest quality doughnuts. His opinion is not financially motivated and he only has to think about the good of his customers. (And by the way, his customers love Jake’s doughnuts)

If you understand our doughnut business, you understand the difference between commission based financial advisers and fee based advisers. Commission based advisers have an incentive to recommend certain products and although it would be unfair to say that all commission based advisers think about their best interest before yours, they have to stay in business and they have to feed their families. It would be difficult to pass up the higher commissions on one product versus the lower rate on another. Often, commission based advisers also receive a fee but that isn’t the same as a fee based adviser.

Fee based advisers receive a set fee based on an hourly rate, a flat fee for certain services, or a percentage of your assets. For ongoing management of your money, the adviser may receive 1.5% or 2% of your portfolio as a fee. The advantage of this arrangement is obvious. The more money your adviser makes you, the more money they make. (The happier the doughnut store owner makes his customers, the more doughnuts they will buy.)

Bottom Line
Counting on somebody to think of your best interest over his or her payout is not a chance you want to take. By hiring a fee based adviser, you remove nearly all of the motivation to think of their best interest over yours. Of course, you should be highly selective of any adviser and just like any service oriented person you should rely on word of mouth and other positive reviews.

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11 Responses to “Why a Fee Based Financial Adviser Makes Sense”

  1. tom says:

    “For ongoing management of your money, the adviser may receive 1.5% or 2% of your portfolio as a fee.”

    Way to high of a fee. When looking for a fee based financial adviser, look for one who charges low fees. I’m talking .25% of your total portfolio on an annual basis.

    A fee based adviser who assesses a 1% fee on a $1M portfolio takes $138,000 over 10 years compared with $36,000 (assuming 7% annual return). 1% is even absurdly high.

  2. DIY Investor says:

    Fee based registered investment advisor is definitely the way to go. There are services that charge well less than 1%. Fees can mount up to a lot over the years.

  3. harry says:

    This is just like the situation with realtors. It is in the best interest of your realtor to close the deal for the highest price and in the shortest amount of time! That way they make the most. While there are some realtors that may look out for the buyer’s interest, I think most may subconsciously or consciously work against you.

  4. Britton says:

    A crucial point that has been left out of the discussion thus far: there is a difference between “fee-based” and “fee-only”. “Fee-based” means that while the adviser’s fee is based on a percent of the assets under management, they *also* receive commissions for products sold.

    In this way, they can charge you much less than a fee-only adviser, but they are still highly incentivized to sell certain products, such as variable universal life insurance policies.

    Tom and DIY — which services in particular are you speaking of? Looking around, I don’t think I’ve ever seen a fee-only adviser who charges less than 1% for accounts under $1 million, although admittedly, my research is by no means exhaustive.

  5. Scott says:

    But every time I’ve asked a financial advisor for his help, he says he has a minimum of one million dollars in investments before he’d talk to me. So I am not sure where I am supposed to seek help.

  6. timparker says:

    Tom

    Independent fee-based or fee-only advisors do not get a lot of $1 million portfolios. I know a lot of fee based advisors and I’ve not met one who says they have more than a hand full of high net worth clients because those clients split their money between various managers. The high net worth go to wirehouses. Yes, fees for the high net worth are not that high.

    Assuming that most readers don’t have $1 million to invest with one manager, the fees have to be that high. A $100,000 account would net $2,500 annually at .25% and for many advisors, the bulk of their practice isn’t $100,000 clients. Breaking even for the advisor takes $1M to $2M at 1% fees.

    Fee based can earn commission but fee only advisors who charge even 2% investing in equities/etfs and bonds primarily, are saving their clients far more than 2% by using virtually no-fee vehicles other than trading costs and small management fees in the etfs.

    Finally, there are contractual minimums that all advisors have as far as fees. They can often not go below .5%.

  7. Jay says:

    Tim,
    I think you are off by a factor of 10…a $100,000 account at 0.25% would only net $250 a year, not $2,500.

    Tom…how much personal service do you think you can get each year from a financial advisor for $250? Thats roughly equivalent to 4 hours from a masseuse or a personal trainer, 45 min from a good lawyer and probably about 45 seconds from a medical doctor. To make a decent living I would have to have 500 clients with an average balance of $200,000. Assuming an advisor could even find 500 people willing to work with them, and that they worked 50 hours a week, (3 weeks vacation) there is no way to effectively manage a family’s life-long financial plan by dedicating only 4.9 hours per year to each client who is only paying him $500.

    Not sure what you do for a living, but I’m going out on a limb and say that you are an engineer…how much consulting would you do for $500? Heck, you can’t even get a couple of guys with chain saws to cut down a tree for less than $500. Services that charge less than 1% do it by providing less service. You get what you pay for. I think that looking for the lowest fee will simply get you the advisor with the poorest service…hence the 70% of folks who don’t trust their advisor…they didn’t hire for competence. If you need Lasik surgery, are you going to shop around for the lowest price, or are you going to find a reputable doctor who will not leave you blind…

  8. shiftomnimega says:

    Interesting notes:

    Delaware casinos started offering table games May 2010. Wonder if that is a consideration in this figure.

    If a financial adviser isn’t offering index funds, then you’re looking at 1.5% to 2% expense ratio for each fund and then 1.5% to 2% of whatever’s left for his fee. Considering that there is no guarantee that money will grow I would say it is worth the time to learn how to do it yourself.

    • Jay says:

      Actually, a fee based advisory account can use index funds, ETF’s, and Institutional class shares which typically have expense ratios of less than 1% in most asset classes. Add the 1.5% advisory fee and ask yourself this…will a competent advisory account make up for more than 2.5% of you trying to learn it as you go? In most cases, the answer is decidedly, YES. Don’t confuse the selection of a decent mutual fund with the professional management of a portfolio and a long-term financial plan. Most people can barely balance their checkbook, let alone project future retirement costs and craft a savings rate and reasonable risk adjusted investment return indexed for inflation for the next 40 years…and have the fortitude to continue to follow the plan when the markets fluctuate by triple digits.

      A good financial advisor is a professional and should be compensated for their expertise. I think there is a UTube video showing how to remove an appendix…I will do it for you much cheaper than the hospitall, come on over! This whole nonsense about do it yourself because its cheaper is a myth that far too many people cling to. You know that 80% of people claim to be better than average drivers? Reality is that over the past 20 years, the “average” investor has underperformed the S&P 500 by over 5%.

  9. timparker says:

    Jay

    I can count, really I can! :) Thanks for the catch. Also, I really like the points you made. Great perspective. Have you ever read Tested in the Trenches? Great book about how to build a FA business. One of the guidelines in the book is to not have more than 100 clients which is another reason why fees have to be higher than 25bps. It is true that if you want somebody actively managing your money, you need to have enough to make it worth their time.

    By the way, (not to Jay) just because a fee based or fee only advisor CAN take on high fee instruments doesn’t mean that they SHOULD. The advisors I know and respect are the ones who try to give their fee back to their clients by using instruments with low or no fees.

  10. govenar says:

    Even without the issue of not trusting financial advisers that get commissions, I just don’t think the majority of them really know how to give you better returns than the average index fund you could invest in yourself.


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