One of my attendings in residency used to love to tell the story of Willie Sutton, a notorious bank robber who, when asked why he robbed banks, famously answered, “Because that’s where the money is.”
Look at the ads in medically-oriented publications, such as Emergency Medicine News, or on doctor-finance websites such as The White Coat Investor or Physician on Fire, and you’ll notice that many of them are for financial advisors. Why? Because that’s where the money is.
As medical professionals, we know that the cost of our services can be opaque and confusing. We may not know that paying for financial advice is often the same. AUM fees, loads, sliding scales, hidden commissions, and outright duplicity are the landmines of the financial advisory battlefield. This article will help you traverse this dangerous landscape without blowing up your investment returns.
How Are Financial Advisors Paid?
The first thing to accept is that financial advisors do not work for free and deserve compensation for their time, knowledge, and effort. You will either pay them directly or indirectly; what seems like a bargain upfront may cost you tenfold on the back end. My preference is to choose the method of payment that is the most transparent. I don’t mind paying for the value I receive, I just want to know what it costs ahead of time.
A financial advisor can be compensated in many ways, divided into three main categories: commission-based, commission & fees, and fee-only. Commission-based advisors do not charge any upfront or recurring fees but make all their money based on the products they sell you. This method creates a conflict of interest and is, fortunately, uncommon.
Traditionally, the most common compensation structure was a mixture of commissions & fees. With the advent of the internet and an increased awareness of personal finance, many advisors are now moving to a fee-only model, where they receive no commissions. However, an advisor being fee-only does not tell you much about what fees they charge, or how much they are. A select few will charge an hourly rate, some demand a flat yearly rate, while others will have a combination of different fees.
Commission-Based and Commission & Fees
When you choose a financial advisor, whether or not you allow them to invest on your behalf, you are paying for their recommendations. Most advisors do not pick individual stocks; instead, they recommend mutual or index funds. While all mutual funds have a management fee (expense ratio), some also have other fees called loads, which are commissions paid to your financial advisor. Front-loaded fees are charged when you buy, back-loaded when you sell, and level-loaded fees are charged yearly. Loads can be up to 5% of the purchase/sale price.
Financial advisors make money by putting you into loaded mutual funds, and they justify their actions by claiming that they expect these funds to outperform those without loads. There is no evidence that this is true. Loads also incentivize trading, which has been shown to decrease returns. The more your advisor buys and sells positions in your account, the more commissions they collect.
Financial advisors who earn commissions are incentivized to sell you products you may or may not need, the most common being insurance. For the vast majority of people, term life insurance is sufficient. It is cheap, plentiful, easy to obtain, and doesn’t carry a hefty commission. Yet financial advisors are notorious for recommending whole life insurance, which provides them a large commission.
Whether or not your advisor is exclusively compensated by commission or a mixture of commissions & fees, you must recognize that this arrangement carries an inherent conflict of interest. No matter how moral/religious/ethical, when it comes to money, incentives matter.
Fee-Only
It is getting harder for financial advisors to “justify” putting their clients in loaded mutual funds, as index funds/ETFs have gained widespread acceptance as superior investment vehicles due to their low expense ratios. This has led to the rise of the “fee-only” advisors, who promote themselves as a lower-cost, more ethical alternative.
However, a fee-only advisor, as defined by NAPFA, “is compensated solely by the client with neither the advisor nor any related party receiving any compensation that is contingent on the purchase or sale of any financial product,” which tells you they don’t receive commissions, but nothing about what fees they charge.
Types of Fees
Upfront Fees
Some advisors will charge a one-time, upfront fee. This fee covers their initial assessment of your financial situation. Reviewing your investment accounts, assets, liabilities, income, etc, takes time. This fee can range from several hundred to several thousand dollars, depending on the complexity of your finances.
Annual Fees
An annual fee is often based on how much money is being managed and/or the complexity of the client’s finances. These fees can range from a few to tens of thousands of dollars.
Hourly Rate
Pay for the advice and services you need? There’s a novel idea in the world of financial advice. While uncommon, there are financial advisors that charge for their services by the hour. To make this method economically feasible, the rate is often quite high, we’re talking $300-$1,000 per hour.
A La Carte Services
Another uncommon pricing strategy is the à la carte method, where you only pay for services you choose. Reviewing your current financial plan may cost $2,000, while a comprehensive retirement plan may cost $5,000. Pricing will vary wildly, but should be upfront and transparent.
Assets Under Management (AUM)
Imagine paying a lawyer 1% of your net worth every year to give you legal advice. The vast majority of people don’t need that level of legal attention. There may be a select few that would benefit, but most people are much better off paying for legal advice/representation when they need it. The same goes for financial advice.
AUM fees are a percentage charge for every dollar the financial advisor manages. Most financial advisors charge from 0.5% to 2%. The fee typically gets lower the more money you have invested with the advisor. For example, $500,000 with a 1.5% fee is $7,500 annually, $1,000,000 with a 1% fee is $10,000 annually, and $5,000,000 with a 0.5% fee is $25,000 annually.
AUM fees can also be called “advisory fees” or other terms, but will always be a percentage of assets managed.
I have three major issues with the AUM model. First, it simply isn’t a good value proposition for the investor. Basic financial advice, such as how much to save, what accounts to set up, and what to invest in, is extremely valuable to you as you start your career. Although you can get the information for free on ours and other sites, it is also worth paying for. Once you have everything set up correctly, though, the hard work is done. The less you mess with your portfolio during your 20-30-year working career, the better! While it may be worth paying 10k for advice when starting out, it isn’t worth paying that or more every year to maintain what you’ve already set up.
Next, the AUM model incentivizes investing in securities above all else. Investing more money in stocks and bonds is often, but not always, the best advice. Want to get into real estate investing or start a business? Not advised.
Finally, AUM fees, like herpes, is the gift that keeps on giving. $5,000 paid in year 1 would become $50,000 in 30 years at 8% interest. Paying an AUM fee every year turns into an incredibly expensive, painful lesion over time.
Warning: Fee-Only May Not Be What It Seems
Like many things in the world of financial advice, what constitutes “fee-only” is nebulous. What we want is someone who will give us financial advice for a set amount per hour, like a lawyer or an accountant. Using this idealized concept, many personal financial pundits promote “fee-only” advisors as a safe option for the savvy investor.
Unfortunately, more and more financial advisors promote themselves as fee-only but still charge high AUM fees. They’re not technically lying. AUM fees are fees. They are using “fee-only” as a buzzword and will explain that they don’t use loaded mutual funds and won’t try to sell you insurance products. While that is undoubtedly a better option than paying commissions, it doesn’t solve the devastating effects of AUM fees. So, when you hear the term “fee only,” understand that you need to do further research into what they actually mean by that term.
One of my favorite podcasts is The Money Guy Show, hosted by two “fee-only” financial advisors. The show is informative and entertaining, and I recommend it frequently. However, there is a reasonable case to be made that the entire podcast is a well-designed funnel to get you into their wealth management services. You see, the hosts are affable, charismatic, and educational, but also happen to be partners in an advisory firm that charges AUM fees. The show gives free financial advice, only suggesting you take the relationship “to the next level” when you have achieved an investable net worth between $500,000 and $1,000,000. Because that’s where the money is.
The Effect of AUM Fees
As Warren Buffett famously stated, “Performance comes, performance goes, fees never falter.” You should aim to keep the fees you pay to an absolute minimum. AUM fees are the most pernicious, as you never have to write a check to your advisor, yet they continue year after year, growing with your net worth, and compounding over time.
The following table demonstrates the profound effect of AUM fees on a typical medical professional’s portfolio. This portfolio represents a $50,000 annual investment into a retirement account that earns an 8% yearly return. A 1% fee will cost you $1M over 30 years, or 17% of the total. A 2% fee costs you twice that.
Not convinced this is real? Read about my results with professional money management at “Your Financial Advisor Isn’t Your Friend: My Experience With Professional Money Management.”
Conclusion
Whether you are paying commissions, commissions & fees, or just fees, financial advice is expensive. While “You Probably Don’t Need a Financial Advisor,” I hope I have illuminated the murky way they are compensated.
If you use an advisor, I recommend that you stick with one that is fee-only. Why worry about commissions and the accompanying conflict of interest? Unfortunately, finding a fee-only advisor is just the beginning. You must know what types of fees they charge and how much they are. As the saying goes, make sure you read the fine print.
As more and more advisors finally admit that they cannot beat the low fees and market returns of index funds, AUM fees become harder to justify. My advice is never to pay AUM fees. If compound interest is the mechanism through which the stock market creates investor wealth, assets under management fees are the opposite; anti-compound interest, wealth-killing poison.
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