No investor can control when the market goes up or down. And predicting when that will happen is nearly impossible, too.
When it comes to investment management, it’s critical to understand what is within your power to control and influence. Investment costs make a big impact on how much wealth you can build over time, and it’s one factor that you can control as an investor.Who provides you with investment management now? In addition to various investment fees, what you pay your advisor adds on to your costs. This isn’t necessarily a bad thing. The right advisor can help you create a plan, guide you along the way, and prevent you from making emotional decisions that could sabotage your nest egg.
What you need to understand is how your advisor gets paid. There are a variety of different fee structures investment managers can work under, and some are better for them than they are for you.
Know how to identify and work with a financial advisor who puts your best interests first and doesn’t have conflicts of interest within their own fee structure. Here’s what to look for.
How Does Your Advisor Make Money?
There are three main fee structures among financial advisors: commission-based, fee-based, and fee-only. Commission-based advisors are pretty easy to understand and distinguish. But fee-only and fee-based advisors can get confusing, and it’s so important to understand they are not one in the same!
Here are the major differences between the three ways that advisors can get paid for investment management:
Commission: If a financial advisor is compensated through commissions, they get paid when they sell you a specific product or execute a specific transaction. This means their personal financial interests are tied to the advice they give you.
Commission-based advisors can be wonderful people with the best intentions. But ultimately, the way they get paid presents a huge conflict of interest. Do they suggest what’s best for you, or what’s best for their own wallet?
Fee-Only: Fee-only financial advisors can only be compensated directly from their clients. This means they are paid directly by their clients and no one else. Their fees are usually charged through a set hourly rate, percentage of the assets they manage, or monthly fee.
This means the advice fee-only advisors give has no relation to compensation they receive.
Fee-Based: Fee-based advisors are a blend of the commission and fee-only pay structures. While they do charge a fee, they can also receive commissions. This puts the responsibility on you to know, each time, whether or not they’ll receive some sort of kickback if you open an account or put your money in a certain fund.
Fee-only advisors are the only advisors who have minimized conflicts of interest, making this option the most beneficial to you.
The Fees Matter: Your Advisor’s Investment Management Can Cost You
Just as compound interest works in your favor as you invest over the long-term, paying too much in investment fees year-over-year diminishes your investment returns over time.
The average cost of working with a financial advisor is 1%. Mutual funds and exchange traded funds (ETFs) can have expense ratios that are less than 0.10%.
If you use low cost funds, which have an average expense ratio of 0.20%, and pay about 1% to a financial advisor, your total fees are around 1.20% every year.
If instead your advisor uses expensive mutual funds with an average expense ratio of 1.50%, your all-in cost would be 2.50% (including the advisor fee). In this example, the more expensive funds would have to outperform the low cost funds by 1.30% each year on average just to break even and justify the more expensive costs.
Consider the Time Value of Money
Using the numbers above, let’s imagine you invest $100,000 today and don’t touch or add to it for 25 years. If the average annual return over that time period was 8% but you paid 2.50% in fees each year, your portfolio would only grow 5.50% annually over 25 years.
This would leave you with over $381,000 in 25 years.
If instead you only spent 1.20% every year in fees, your average return would be 6.80% each year.
After 25 years, you would have almost $518,000. That’s $137,000 more just by watching your fees and choosing an advisor who puts your best interests first and chooses low-cost index funds.
Don’t Forget About Fund Fees!
Don’t forget about the investment costs we discussed in the last post. You want to keep both your investment costs and your investment management costs low. Always be sure you know how much your investments are really costing you.
Similarly, you want to understand completely how your financial advisor is making money and how you will pay them for their services. Often the 1% is paid from your investment accounts.
While this may make sense, if you are young and just building your investments paying 1% from these accounts directly to your advisor can be a drag on performance. Instead, it may make sense to pay a fee, often on a monthly or quarterly basis, directly from your cash flow.
Fees matter and significantly contribute to how big your nest egg will be over time. You want to work with an advisor who is going to charge you fairly, act as a fiduciary, and always put your best interests first.
When looking for an advisor, be sure to ask them how they make money. Avoid advisors with conflicts of interest and who earn commissions. Look for an advisor whose billing structure matches your stage of life and consider whether using your investment accounts or your cash flow makes more sense to use when paying them.
Remember, good financial advisors will have no problem explaining their fees in an easy-to-understand and transparent way.
About The Author
Charlie Shipman left Wall Street and founded Blue Keel Financial Planning in 2014 to provide independent, fee-only investment management and comprehensive financial planning to professionals, small business owners, entrepreneurs and their families. His goal is to help clients align their finances with the lives they want for themselves and their families. Areas of expertise include: cash flow planning and budgeting, business planning, financial planning, portfolio management, estate planning and risk management. Charlie’s financial articles have been featured on MSN, Yahoo! Finance, Nasdaq, Money, The Motley Fool, Investopedia and NerdWallet. On the personal side, Charlie is an active board member for several community organizations in the town of Weston, CT, where he lives with his attorney-turned-entrepreneur wife, and their two absolutely amazing kids. Schedule a complimentary 30-minute Strategy Session to find out how much your investments cost you each year.