Would you ever buy a house or a car without knowing the cost up front? Of course not. Yet Americans are put to this test every day when it comes to an even bigger financial decision — choosing a financial advisor to manage their life savings.
A surprising number of people have no idea how much they're paying their advisor, but this confusion isn't their fault. Fees can be torturously complex, buried in fine print or described so ambiguously that it's impossible to decipher them. Too often, an advisor hands a new client a 100-page brochure that lists every possible fee he or she might pay. With so much information, it takes a Ph.D. to figure out what you're actually being charged.
American investors are paying as much as 3.5 percent per year in advisory and fund fees. And while the difference between a 1 percent annual fee and a 3 percent annual fee may seem trivial, it can amount to more than $400,000 over the course of a lifetime – higher than the median price of a home in the U.S.
If you include missed appreciation — since money lost to fees doesn't grow and compound — that number jumps to more than $740,000. This is money that people could have used to retire earlier or fund their kids' college tuition, but instead, it was just given away without fully understanding why.
Here's the anatomy of a fee: Investment fees come in a variety of forms, based largely on the type of advisor. Most investors select from one of three provider categories: 1) registered investment advisor; 2) pure brokerage; or 3) a dual-registered broker that also acts as advisor.
Registered investment advisors are solely in the advice business. They typically charge a flat fee on assets under management and do not earn transaction income.
As their name suggests, pure brokerage firms historically existed to "broker" trades, not provide unbiased advice. They make most of their fees through sales commissions and other transaction charges.
Dual-registered firms operate as both an RIA and broker dealer. Under this arrangement, they charge a flat percentage of assets under management for advice, but also earn commissions or other financial incentives by selling products that they often manufacture. Dual-registered brokers freely move between their "broker" and "advisor" capacities, leaving it to the client to discern whether they're being objectively advised or being pitched a product.
Here is a summary of the types of fees typically earned by each type of advisor:
For investors who want to control fees and receive objective advice, it is important to know which category their advisor falls into. Typically, the RIA model is the most efficient. The alignment of financial incentives with your own, the transparent and level fee, and the legal requirement to act in your best interest are all important safeguards against losing your hard-earned savings to high and hidden fees.
That said, there are different flavors of RIAs. Some are ultra-low-cost providers with bare-bones service models, often relying heavily on technology. Others charge significantly higher fees, but provide a much wider range of offerings and comprehensive advice.
So how do you know which model is right for you?
For someone with a relatively uncomplicated financial life — a smaller portfolio, no children, a house they rent rather than own — a low-cost RIA option may be best. These services often provide a simple portfolio of mutual funds or ETFs based on your age, risk tolerance and planned retirement date. For many investors, that's enough.
However, as you become wealthier and life gets more complex, it usually makes sense to pay a little more for personalized and holistic financial advice.
This advice may include comprehensive financial planning, tax optimization and rebalancing, and help with college savings plans, estate planning and charitable giving. Smart decisions in these areas can add 1 percent or more to your annual after-tax portfolio return — which is often more than the additional cost of the services. Think not just about what you need now, but also what you will need in the future, to determine whether the extra services are worth the extra cost.
As a father of two young girls, I know how daunting it is to think about planning for events such as college and weddings while also trying to save for retirement. Many of us are making these critical financial decisions for ourselves and our families with incomplete information and minimal training.
The goal of the financial advisory industry should be to make it easier, not harder, to save for big life moments. Busy professionals shouldn't have to weed through fine print and should know how much they are paying for financial advice.
Investors need to get in the driver's seat, so do your research and start asking questions. After all, it's your money.
— By Jay Shah, CEO of Personal Capital