Why a Flat-Fee Advisor is Best for Retirees
Financial Advisor Compensation Structures
If you have not already, you will likely figure out that financial advisors go by dozens of different titles that do little to differentiate. Further, you will find that every firm is unique in its service offering, deliverables, and how they work with clients. Why then would we expect anything less when it comes to possible combinations and levels of fees? The good news is, when you boil it down, there are three primary ways financial advisors charge for their services:
- Commissions
- % of Assets Under Management
- Flat-fee
Compensation Structure Guides Financial Advisor Behavior
Financial advisors are human, and as such, they are influenced by incentives. Compensation is a powerful incentive for most. So naturally, you could expect a financial advisor's behavior to be driven by how they are compensated. It is exactly this connection between compensation and behavior that gives rise to conflict of interest. Being driven by their incentive, the advisor's behavior may not always be aligned with what is best for you as the client. Some financial advisors have the fortitude to fight their natural interests and recommend what is best for the client, and some do not. It is important to understand a financial advisor's incentives under the various three primary compensation structures to identify scenarios that may present a conflict of interest so you can diffuse it before it causes harm.
Financial Advisor Incentives Under Commissions
Financial advisors compensated by commissions must sell products to earn a commission and get paid. Under this incentive structure, an advisor will naturally be more focused on recommending securities or products they can earn a commission on by selling. Further, there is added incentive to recommend those securities or products that pay the advisor the highest commission. This is why highly commissioned products like annuities have earned a bad name from being oversold. Commissions earned vary in amount and structure and may come in the form of front-end commissions, back-end commissions, annual trailing fees, or mark-ups, to name a few. Often, the type and amount of commission being charged is unknown to the client because it often lacks transparency, and disclosing it to the client is only now loosely required.
Another behavioral trend driven by this incentive structure is that the advisor-client relationship tends to become more transactional in nature. Oftentimes, advisors under this compensation incentive structure will only talk to existing clients when there is an opportunity to sell them something. Otherwise, to make a living, they must spend most of their time seeking new clients to sell more products and earn more commission.
Obviously, financial advisors under this incentive compensation structure are not a very good match for retirees. This type of financial advisor most likely lacks the proper tools and incentive to help an individual plan for retirement. Retirement planning is way too complex for these advisors' limited scope products. Retirement planning entails developing an optimal strategy to convert retirement assets into sustainable income for however long the retiree lives while not overspending or underspending so the retiree can live a life of maximum contentment and happiness and free from regret and fear. See Thrive Retirement Specialists Insight entitled "Steps That Should Occur in a Proper Retirement Planning Process" for more information on this topic.
Financial Advisor Incentives Under % of Assets Under Management (AUM)
Financial advisors compensated by earning a percentage of assets under management (%AUM) apply a stated percentage to the size of the investment portfolio that is being managed. Fortunately and unfortunately, this has become the predominant fee structure in the industry now. Fortunate that this structure is a huge improvement for most individuals from the commission's structure, but unfortunate in that there is a better structure yet for most individuals. According to a 2018 RIA in a Box study, the average advisor under this compensation structure charges 0.95% of AUM.
Financial advisors under this incentive structure use the phrase "We do better when you do better." While this sounds nice and aligned, the reality is advisors here have a strong incentive to gather and keep as much of a client's investment assets as possible to maximize the amount managed and thus their fee. Is the portfolio growing because of their luck/skill, or is it just a natural function of markets rising and savings increasing? Why should someone with a $1 million portfolio pay $9,500 while someone with a $5 million portfolio pay $47,500 for the same basic service? Not only is this structure unfair and too expensive for most, but it also presents a material instance of conflict of interest.
Advisors under this compensation structure are driven by gathering and keeping investment assets. This behavior leads to a couple of issues. First is a practice known as "client segmentation." Client segmentation is a practice where the highest fee-paying clients (those with the largest portfolios) get the most attention, and those that pay less receive less time and attention. Second, the focus is always on the portfolio and making it bigger, which does not bode well for someone approaching retirement. The advisor may be inclined to take excessive risk in the portfolio to keep growing the assets. This type of advisor also most likely lacks the proper tools and incentive to help an individual plan for retirement. Retirement is about starting to spend down the portfolio to fund retirement. This is in direct contrast to this type of advisor's financial incentive. Retirement planning also entails looking beyond just the investment portfolio to consider all available assets, tools, and tactics to optimize one's retirement situation. % AUM-based financial advisors have no interest in assets, tools, or tactics outside of the investment portfolio. This leads to sub-optimal retirement situations and following overly conservative rules of thumb like the "4% Rule" that deprive retirees of higher potential quality of life while living only to pass leaving as much or more wealth than what they started with in some cases. It is these issues with the % of AUM compensation structure precisely that led me to leave a rewarding and stable career as a Chief Investment Officer of a large established firm to found Thrive Retirement Specialists, where it has become our mission to change this.
Financial Advisor Incentives Under A Flat-Fee
Financial advisors compensated by a flat fee receive a flat stated fee for their service. Flat fee structures include recurring flat-fee, non-recurring flat-fee, and hourly fee. To be fair, a potential conflict of interest can even exist for advisors working under this incentive compensation structure. An advisor who works on a flat-fee basis has an incentive to spend as little time as possible on the project, whereas an hourly-based fee provider has an incentive to spend as much time as possible on the project. While still technically presenting some level of conflict of interest, clearly, a flat-fee incentive compensation structure presents far less material conflict of interest. A flat-fee advisor presents the best option for most individuals, especially retirees.
A Flat-Fee Advisor is Best for Retirees
Planning for retirement is complex and requires an advisor to look at all assets, tools, and tactics available to make the most of a retiree's situation. A flat-fee advisor has no financial incentive to do anything other than considering everything and recommending only what is best for the client.
We are a flat-fee advisor and stand by ready to help if you need assistance in planning for retirement or refreshing your current retirement plan. If we can ever be of service, please feel free to reach out.