Pros and Cons of 6 Fee-Based Options for Financial Advisors

The American College of Financial Services
December 9, 2016

One of the biggest changes in the financial services profession since the Conflict of Interest Rule was finalized has been the shift from traditional commission-based compensation towards fee-based and hybrid models.

Unsure or undecided on the most optimal compensation structure for your practice in a post DOL Rule environment? Below is an overview of six fee-based options used by financial advisors.

An advisor calculating pros and cons of fee-based options

1) Flat Percentage Rate

One of the most straightforward compensation models is for advisors to charge a percentage of the assets that he or she manages. For example, an advisor might charge a flat one percent on AUM. On a $1 million portfolio, the advisor would receive $1M x 0.01 = $10,000.

The advantage of a flat percentage rate is that calculating the fees on portfolios is transparent and simple for both the advisor and the client. However, a concern about using the flat percentage model is that wealthier clients with larger portfolios pay more in fees simply because they have more assets, and presumably not because the advisor asserts additional effort in managing the larger portfolio. Although it can be argued that managing a large client portfolio requires more time than one with less assets, the relationship is often not linear where an increase in portfolio size does not equate to a proportional increase in time demands.

Some experts and investors assert that flat fee advisors may be motivated to seek clients who have larger portfolios, but once the assets are under management and generating fee revenue, there’s less motivation to manage above and beyond baseline parameters. Advisors are instead incentivized to acquire revenue opportunities from new clients rather than producing incremental fees increases through superior performance within existing accounts.

2) Percentage Tiered

As a way to remedy some of the concerns about the flat percentage rate compensation model, some firms create a tiered fee structure based on AUM breakpoint amounts. For example:

  • An advisor might charge one percent on AUM up to $1 million, and then
  • Only charge 0.75 percent (75 basis points, or bps) on AUM over $1 million

In other words, a client with a $2 million retirement portfolio would pay $10,000 on the first million and $7,500 on the second million, for a total of $17,500 in fees per year. This approach recognizes the economies of scale that exist with larger portfolios.

Like the flat percentage rate, the tiered percentage model is sometimes criticized for  incentivizing advisors to help clients maintain the largest portfolio possible. As a result, advisors may discourage using portfolio assets to purchase goods or services or to pay down debt, because doing so directly reduces their compensation. Some worry that advisors will be motivated to maintain large portfolios well into a client’s retirement, even though this can limit the enjoyment received from the fruits of their accumulated wealth.

3) Annual Rate or Retainer

One of the risks of charging based on managed assets is that when equity markets decline, an advisor’s revenue also declines. To protect against unsteady income, some advisors instead charge a fixed annual rate or a set retainer, typically paid on a monthly or quarterly basis.

This compensation approach can also be beneficial for clients who want to pay a predictable amount each year. In exchange for decreased revenue risk, they offer clients a set, fixed cost that will not fluctuate despite varying market returns.

A prevalent concern with the retainer approach is misalignment of the advisor’s incentives and portfolio performance, which presents questions of whether a client's best interest is the fundamental factor in decision making.

4) Hourly Rate

Some advisors choose a more traditional approach to delivering professional services — the hourly rate structure. Depending on experience, the services provided and the supporting staff members helping the advisor deliver those services, the hourly rate can be a flat blended rate or a variable charge.

For example, an advisor might assess a flat $150/hour for the time they or any of their team members spend with the client or working on a client’s account. Rather than assessing a higher hourly rate for their time and a lower hourly rate for the support of let’s say, a Junior Analyst or Administrative Assistant, they create a blended charge that averages the combined rates of each person. A blended rate has the advantage of simplicity with regards to billing.  Other advisors assess a unique hourly rate for each person on his or her team. The advisor’s time is more highly valued because of his expertise and experience, while supporting team members with less experience or who might play a less strategic role for the client carry a lower hourly charge. Some clients are more comfortable with this structure because they are wary about overpaying and prefer seeing a lower rate assessed for certain work executed. But similarly to other fee based options, the hourly rate model presents potential conflicts of interest.

Since advisors receive compensation for their time, clients ultimately bear the consequence of extensive or unnecessary effort invested in the account.  Inefficiency or poor time management can equate to a higher invoice even though the work should or could have been completed more quickly.  Maybe even more problematic is clients who are hesitant to call when they have a question or who avoid an optimal cadence of meetings to limit hourly fees.   

5) Fixed/Flat Fee

Some advisors choose to charge a fixed or flat fee based on a particular service or project. Depending on the scope of work required for a client, the flat fee might be the sole fee model or it can be combined with another option, such as the hourly rate model.  For example, an advisor might charge $2,500 to create a comprehensive financial plan or retirement income plan, and then supplemental guidance about budgeting or estate planning is billed by the hour.  Fixed fees are easy to explain, “productizing” an advisor’s service in a retail-based way that clients are accustomed to, but this model has inherent flaws presenting a potential conflict of interest dilemma.

Advisors who use the flat fee approach receive the same compensation regardless of the amount of time they spend on a particular plan or project, so they may be incentivized to spend as little time as possible to maximize profitability. Clients who fall victim to this mentality may receive subpar guidance.

6) Hybrid Model

Many firms choose a combination of the previously described compensation models. They may offer clients a variety of options so they can pick a model that works best for them. Firms might also scale their fees or services based on the compensation model selected.

For example, a client deciding to develop a plan and then to retain the advisor for ongoing investment management services might receive a discount on the upfront costs of their financial plan. Some firms are now requiring new clients to have a financial plan created before receiving additional investment management work. Hybrid models are increasingly popular because they empower the client, optimizing their comfort levels and creating a stickier, long term relationship.   

What Fee Option is Best for Your Practice?

Although all compensation models have conflicts of interest to overcome, some models present more conflicts than others. While the flat percentage rate model is still the most common fee structure for advisors and wealth managers, that doesn't mean it is the best option for all advisors.

When choosing a type of compensation model, advisors must consider several things including what type of client they wish to serve and the kind of advice to provide. Some financial advisors create comprehensive financial plans, some offer retirement income planning services, and other advisors provide a combination of financial planning, retirement income, and wealth management services.

Good and reputable advisors exist under each compensation model. Understanding the fee options will help you choose the one that best aligns with the goals and needs of your practice.

Transitioning to or offering a fee based model is just one of the many considerations advisors are focused on in a post DOL Rule environment. Gain a better understanding of complicated financial planning and retirement income issues so you can answer your clients’ questions with confidence and expertise. Access the slideshare Retirement Planning for Longer Life Expectancy.