Question 3: How are financial advisors paid?
There are several potential revenue streams for financial advisors, including:
Percentage of Assets Under Management (AUM)
These types of payments are not mutually exclusive. For example, an advisor may both charge an hourly rate and collect commissions on the products they sell. Be careful to clarify all of the revenue streams leading to a potential financial advisor before you consider hiring one, since certain types of revenue streams can result in bias.
It has been well established that doctors with financial conflicts of interest (e.g., from the pharmaceutical industry) exhibit biases in their practices. Commissions are a form of financial conflict of interest for advisors; accordingly, advisors who sell products for which they receive commissions are at high risk of exhibiting biases in their advice to you. If your advisor is paid commissions, you may be talked into buying a product that makes the advisor more money, rather than the one that is best for you. For this reason, we recommend keeping your advice and your purchases separate. Ask any potential financial advisors if they are paid on commissions; if they are, consider a different advisor.
Percentage of Assets Under Management
Advisors who are paid a percentage of assets under management (AUM) take a cut of the total amount of money that they manage for you. While in this model the investment incentives of the advisor align with yours (i.e., the more they grow your portfolio, the more valuable their cut becomes), there are many problems with this model, several of which are detailed in the following paragraphs.
First, most advisors who use an AUM payment structure require clients to have a minimum amount of money to be managed (thus ensuring a minimum amount of their cut). Most residents with small or non-existent investment accounts will not meet these minimum amounts and thus won’t qualify for their services.
A second problem with this model occurs on the other end of the spectrum, when you have a large amount of money invested. In this case, the cut that you end up paying the advisor can become very large and is very unlikely to be worth the cost (e.g., an AUM fee of 1% on a $3 million portfolio is $30,000 – do you really think your advisor is adding $30,000 of value to that portfolio every year?).
Finally, while the advisor will make more money if your portfolio grows faster by getting better returns, this doesn’t mean that AUM advisors are dedicating all of their time to make sure they get you every last bit of return they can. Consider this: An AUM advisor’s return on obtaining a new client with the same portfolio size as you is 100 times greater than his or her return on getting you another 1% out of your portfolio (i.e., 1% of a new client’s $1,000,000 portfolio would be $10,000, whereas making you another 1% on your portfolio would only increase his or her cut by $100, which is 1% of the extra 1% he or she made you on your $1,000,000 portfolio). How would you spend your time if the yield on one project was 100 times that of another?
In summary, sure, the investment interests of AUM advisors do align with those of their clients, but the degree and significance of this alignment is easy to overestimate.
Retainer fees are payments made at a regular interval for a set of financial services. When used exclusively, this arrangement can be used to avoid the conflicts of interest that come with commissions and the runaway costs that come with the AUM fee structure. In spite of these benefits, residents are unlikely to have financial circumstances changing rapidly enough to warrant having someone on retainer. It is much more likely that residents seeking financial advice just need a one-time roadmap and a point in the right direction.
Hourly Rate / Flat Fee
An hourly rate or flat fee structure will be appropriate for most residents. There are a limited number of financial decisions that need to be made during training (e.g., strategies for loan repayment, insurance, and investing); once a strategy for approaching each of these issues has been established, it is unlikely that residents will require additional advice. For this reason, a one-time meeting with an hourly or flat fee advisor is likely the most appropriate and cost-effective way for residents to obtain professional financial advice.
Advisors described as fee-only are only paid by you (i.e., they are not paid commissions by outside companies for selling you products). Fee-only advisors can be hourly, a flat fee, a retainer fee, or a percentage of AUM.
Advisors who are fee-based may collect reimbursements from other sources, including commissions on products they sell you, in addition to the fee(s) that they charge you directly. As discussed previously in the context of commissions, this outside revenue stream causes a conflict of interest and can lead to biased advice. Be sure to clarify how prospective advisors are paid to make sure you understand the full cost and any potential biases associated with their services.
Fee-only vs. Fee-based
Note the important distinction between these payment schedules:
Fee-only advisors are only paid by you, whereas fee-based advisors get paid by you and may get reimbursed for selling you certain financial products.
Since there is a conflict of interest that comes with the commissions of fee-based advice, fee-only advisors are generally preferable to fee-based advisors.