Decoding Financial Advisor Compensation Models

Many people ask us the difference between fee-only and fee-based compensation models for financial advisors. They also want to know how project fees, asset-based fees, and hourly fees work. For the average investor, the compensation models of financial advisors can feel downright confusing.

Few other industries have so much variation when it comes to paying a professional. When you hire an auto mechanic, you pay for parts and hours of labor. When you hire a piano teacher, you pay per lesson or for a set amount of time. All these methods are straightforward and easy to understand.

Unfortunately, the financial advisory world is a different ballgame. Payment models vary from firm to firm and, sometimes, from client to client (depending on client needs, services rendered, net worth, etc.).

Since payment models for financial advisors are sometimes complicated, misinformation abounds. Consumers might fall for “special offers” or “guaranteed returns.” Or they might believe they are entitled to free financial planning because large brokerage terms do this for “free.” However, there’s no such thing as a free lunch—those big firms are making their dollars somehow. Many of these large brokerage firms use 10-20 questions to be analyzed by a robo-advisor, which is NOT financial planning. Genuine financial planning is comprehensive, multi-layered, and involved. For most people, quality financial planning is worth the price tag.

But how can clients determine if a pricing model is fair? And how will they know if a particular pricing model is right for them? To clarify the confusion, let’s talk about different ways a financial advisor could be compensated AND which methods make sense for certain types of investors.

Two Compensation Models to Avoid

There are several legitimate, ethical compensation models for financial advisors. However, before discussing those, I want to touch briefly upon two models to avoid: commission-based and fee-based.

Should you Combine Finances and Collaborate on Financial Decisions?

Conversations about debt, budgeting, or investment strategies typically aren't great first-date material. It isn't romantic to ask a potential partner about their 401(k) contributions or to grill them about their debt tolerance. Save these talks for later when the relationship is well established and you're becoming increasingly part of each other's lives.

But what if those conversations never happen?

What if you end up marrying this person, sharing a household, having children, and filing jointly on tax returns every year…but you've never taken the time to sit down and discuss your finances in any depth?

This communication gap happens far more frequently than you might realize. People can live together for years without discussing their investment philosophies or debt tolerance. They can live alongside someone for decades and never truly know their thoughts on money management or financial goals.

Having honest, open conversations about finances and collaborating on financial decisions is critical. Even if you're not married, talking about money is essential. Sharing your views on your finances is vital for building trust and understanding between two people and paving the way for a strong and healthy relationship. Money is the foundation of many major decisions you'll make together, such as sending your kids to college, buying that lake house, planning vacations, and strategizing for retirement, so having a shared understanding will help you prepare for those eventualities and make decisions that best suit you both.

Let's discuss why and how to share financial information, make unified financial decisions, and combine finances with your significant other. Failing to do so could be incredibly costly.

Why Request a Fiduciary Oath?

Getting a commitment in writing demonstrates the gravity of an agreement or situation. When you get married, you sign a marriage license. When you buy a house, you sign a purchase agreement. When you download a new version of a Mac operating system, you agree to the written terms and conditions. Written agreements are commonplace, so it would be straightforward to ask your financial advisor, or potential financial advisor, to sign a written statement of fiduciary responsibilities―also known as a fiduciary oath.

A fiduciary oath is a statement signed by a fiduciary that outlines the fiduciary’s duties and responsibilities in writing. Groups such as The Committee for the Fiduciary Standard, founded in 2009 after several infamous financial crises, have emphasized the importance of signing an oath to clarify the relationship between the fiduciary advisor and the client. This document can help clients determine if a financial advisor is acting as a fiduciary.

Why Seek a Fiduciary?

A professional fiduciary is held to a higher standard of customer care than a broker, insurance salesperson, or bank representative. Fiduciaries are legally obligated to put their client’s best interests first and adhere to a fiduciary standard of care.  Brokers or other product salespeople are only held to a “suitability” standard. The suitability standard does not prevent profit-seeking activities, and invisible costs can pile up. Retirement plan expert Scott Simon eloquently explains in his article, "Why I’m a Fiduciary."[1]

Brokers, bankers, and other professionals who deal with product sales can call themselves whatever they wish, confusing the public. They may use titles like wealth manager, financial advisor, money manager, or something similar. Titles generally are not regulated.

Define Your Objectives to Choose the Right Financial Advisor

In the late ‘90s, my wife and I began hunting for a new house. We loved our little home near the south end of Lake Harriet in Minneapolis, but it was quickly becoming too cramped for our family of five. There was always a toy underfoot, and it constantly felt like we were tripping over each other.

At the time, the housing market was very tight. There wasn’t much on the market, and houses tended to be snapped up quickly. Because of housing market conditions, we kept our criteria minimal, only telling our realtor that we wanted a place near Lake Harriet. That’s it.

I’m sure I toured at least 30 houses over several weeks. Every time we stepped through the door of a new place, my wife and I felt hopeful, but our optimism was usually quashed immediately. Nothing was quite right—too small, too big, too run-down, insufficient space in the kitchen or living room, not enough bedrooms, a cramped yard, a busy street. We were striking out left and right.

Then, we decided to take a different approach. Instead of being loose with our criteria, I made a spreadsheet that detailed exactly what we wanted—our needs, wants, and “nice to haves.” My wife and I put a lot of thought into our chart, making sure to list all the factors that were important to us. We knew we needed five bedrooms, two bathrooms, a house in good repair, and someplace located close to Lake Harriet. In the “wants” column, we listed items such as a garage and a big yard because they were not absolute necessities for us. In the “nice to have” column, we listed features such as a swimming pool and a sauna.

After defining our list, we brought it to our realtor. I worried he might think we were seeking a unicorn, but instead, he surprised us by saying, “I think I have the perfect house for you. It’s not yet on the market, but I think I can convince the owner to let you take a look.”

Once we had permission to tour the house, my wife and I visited it. As soon as we stepped through the door, we knew it was the one. It ticked all the boxes on our “needs” list, fit most of the criteria on the “wants” list, and had a few of the “nice to haves.” It even had a sauna! We’ve lived in that house for 25 years. It’s where our three kids grew up, where we hosted friends and family, worked, relaxed, and made memories.

I learned through this experience that dialing in your needs, wants, and nice-to-haves when making a significant decision is incredibly valuable. This applies to buying a house or car, choosing a new doctor, or—and maybe you saw this coming—choosing a financial advisor.