"I’ve thought about using financial advisors before, but the fee structure make no sense to me. I will not consider using anyone except fee-only advisors, but I do not understand why so many of those include AUM (assets under management) as part of the fee?"
I absolutely love your question and I’m sure some people will think I made it up to get on my soapbox but you and I know that isn’t the case. What I also know is that you question touches on THE MOST IMPORTANT part of hiring a financial advisor/planner and that is how are they compensated?
How a financial planner is compensated can tell you just about everything you need to know about their business and if they are in it for themselves or their clients. You’ve already touched on a very important point and that is that you will only consider a fee only financial planner. Let me elaborate briefly on how important that is for other readers that aren’t familiar with the term fee only. Fee only means that we only accept compensation from our clients. This means that we do not earn commissions for selling products such as mutual funds, annuities, and life insurance. We do not receive bonuses from employers for investing client’s money in certain investments. We do not even accept referral fees for referring clients to other professionals. All of this is because we believe that if the only person paying us is our clients then we are certainly only going to represent their best interests.
I agree 100% with your incredibly insightful thoughts about AUM. What exactly is AUM or assets under management? An example is probably best. Let’s say you have a $50k Roth IRA and a $50k traditional IRA at Scottrade. You go to a financial planner and they suggest you move these accounts from Scottrade over to them and then they will manage these investments for you. The fee that they will charge you is based on a percentage of these assets. The industry standard has been 1% but this does vary from firm to firm. Assuming the fee for this would be 1% of the $100k or $1000. Now keep in mind most fee only firms will not take you on as a client if you ONLY have $100k because their $1000 fee would be too small (in their opinion). This is why you often see minimum such as $500k or $1M before some firms will work with you.
Now let’s talk about some of the HUGE drawbacks to this sort of engagement regarding the serious conflicts of interest that it presents. The first has to deal with whether or not to roll over “old” 401k’s. If you’ve read some of my other posts on this topic you will understand why it is often better to leave your “old” 401k where it is as opposed to moving it. Why then is the default recommendation to move it. It’s simple. Let’s say your “old” 401k has $200k in it. If you roll it over to your traditional IRA with your financial advisor, he/she will earn the 1% fee or $2000 per year. If you leave it where it is, he/she earns $0. You can see the HUGE conflict of interest here and how can you trust the advice that is being given in this situation?
Another of those HUGE drawbacks regarding AUM pertains to dealing with loans and debts. Let’s say you have $10k in cash that is available to invest but you also have a car loan, student loan and mortgage with PMI. Without more information, it is impossible to determine what to do with that $10k—invest it or pay down a loan. However, you can probably already see the conflict of interest. If the $10k is invested, the financial advisor makes another 1% or $100 versus if you pay down the loan, the financial advisor makes $0.
At this point, I hope I have demonstrated two things. The first is that a fee only financial planner is the only way to go when hiring a financial planner. The second is that you need to completely understand how they are compensated. A compensation model based on AUM has numerous conflicts of interest. Now for my plug: My compensation model is unique to the financial services industry. If you are considering hiring a financial planner, I encourage you to meet with me so that you can understand how I truly represent your best interests. I am located in Austin, TX, but I have clients throughout the country. Virtual conferencing allows easy communication from Austin to you.