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Just how are you paying your financial advisor?

Most people confuse “fee-only” as “fee-for-service” but they’re not the same
BY PREET BANERJEE


Anyone contemplating working with a financial advisor needs to understand how they’re actually going to be paying for the service they receive—and for many investors, this isn’t a well-understood part of the equation.

A lot of young people, for instance, first get involved with investing through an advisor at their bank—but may be under the mistaken impression that this is some type of free service. Make no mistake about it, advisors must always be paid for the work they do (and rightfully so). But there are many different ways that advisors can be compensated, and that’s where things can get a bit murky.

As I’ve mentioned in previous MoneySense articles, both advisors and media can be a bit sloppy with cost terminology, so let’s set the record straight before proceeding any further. There are four main cost models to consider:

  1. Commission-based
  2. Fee-based
  3. Fee-only
  4. Salary + Bonus

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We’ll examine the first three in more depth (the last is self-explanatory)—but before we do, I’ll start out by explaining the difference between commissions and fees. Simply put, commissions originate from products (that is, they’re dependent on product), whereas fees originate from the client (independent of product).

Commissions, for instance, can be generated from individual stock and bond transactions, mutual funds (which often come with additional sales charges known as “loads”) and more.

With mutual funds, you might—or might not—be aware that the fund company may make ongoing payments to your advisor and their dealer to compensate them for servicing you as an investor in those funds. For example, most equity mutual funds pay a trailing commission of 1% of the amount invested, which is split between the advisor and dealer. These commissions make up part of the management expense ratio (MER) of the fund. Since mutual fund returns are posted net of expenses, if you had a fund with an MER of 2%, and the published return is listed as 4%, the fund actually earned 6% before expenses.

Currently, these expenses are not detailed on your regular client statements, so you would have to ask for these costs to be calculated and broken down to see who is making what off of your holdings. Because the ongoing payments originate from product, these payments are commissions. Ergo, there is no such thing as “trailer fees,” only “trailer commissions.”

Fees, on the other hand, are generated when you get a bill, or automatically have cash withdrawn from your account according to a written agreement. You’ll get a bill if your advisor charges by the hour, or a flat project fee. But far more common is a fee based on a percentage. For example, you might agree to pay 1% of your account value per year for advice. Generally speaking, these charges will show up on your account monthly or quarterly, and your advisor will ensure that there is ample cash in your account to cover these automatic, itemized charges. No matter what products you hold, the fee for advice gets deducted—and note that any product costs like MERs for F-class mutual funds (which are stripped of trailer commissions and sales charges) or ETFs would be over and above the advice fee.

In the next part of this series , we’ll explore what kind of financial advice you need.


Originally published at MoneySense.ca, where you’ll discover more helpful information about financial advisors and planning.