Video Transcript:

Hey everybody this is Stu with Open Doors FP.

 

Thank you for joining us here today as we explore the various ways that advisers and investment professionals can be compensated.

 

There are quite a few out there and when choosing a financial advisor or investment professional it's key to understand the various ways we can be compensated.

 

Please take a look and let me know if you have any questions.

 

Down below is a list of some common ways that advisers are paid.  This includes commissions, assets under management - or AUM for short - maintenance and administrative fees, and fixed fees.  Fee-only versus fee-based advising and we will explain the difference later. Mutual fund and ETF fees are represented as expense ratios.  Then on insurance and annuity-type products, you will sometimes have mortality and expense fees.

 

Commissions are a fee that is charged as a percentage of whatever is sold to you.  With insurance, this is usually a percentage of the premium you pay.  Investment professionals who charge commissions, and Open Doors FP does not charge commissions, they take a percentage of whatever investment product they sell you.  For example, let's say you buy an A class mutual fund and there are different classes and not all of them carry commissions, it's more for illustrative purposes.

 

They can charge up to 8 ½ percent of whatever money you put into that product and whatever money that is paid towards that commission is not actually going into the investment, that goes to the salesperson.  Now a more common setup you will see on the market is usually between 5 and 5.75% and this is charged usually upfront.  Then, a small ongoing fee of .25% a year.

 

Common types of commissions include insurance products as stated before like life, health, home and auto, or whatever it may be, and some mutual funds.  This depends on the investment professional you work with. Some stock traders do still charge commissions and trading fees although for the most part a lot of that has actually gone away in the markets over time so if you do have these fees on your accounts, it may be worth considering if it's worth paying those costs and commissions or looking elsewhere.

 

Aside from commissions, the other traditional way that advisers charge clients is through asset under management or AUM fees.  With this model, an advisor will charge a percentage of whatever they manage for you.

 

For example, at the bottom of the screen the first million could be charged at 1.5% the second million at 1%, and then anything over that at 0.50%.  The reason the 1.5% fee on the first million is higher is that there's typically more work done in the earlier stages of advising before your account grows.  But, on average I find most of these fees typically come out to about 1%.

 

What is Open Doors FP's approach to the AUM model?  We believe that after a certain dollar amount is charged the value you receive for your fee paid decreases.  In an effort to charge you a fair fee, below shows our fee schedule.  The first million is 1%.  The second million is .7%.  And basically, anything above 2 million is done it cost.  Why is that?  In my experience, charging large fees above $2,000,000 is unfair to the client.  The amount of value an advisor adds beyond this point is often minimal for the fee charged.

 

There are some benefits to AUM model fees that are deducted from your investment account such as this method doesn't drain your bank account, or emergency fund, by worrying about paying fees out of your pocket.  As a tax benefit, fees paid from an IRA are taken on a pre-tax basis.  Now, what does that mean?  It basically means if your tax rate was 25% on a federal basis, paying fees from your IRA account directly saves on taxes.

 

Let's say your fee is $4,000.  To take money from an IRA first and then pay that fee, you would have to take a distribution of $5,333.33 paying that 25% in taxes just to pay that $4,000 fee. By taking the fee directly from your account you only pay the $4,000 and not that tax bill so you save that $1,333.33 that's paid to Uncle Sam.

 

Here's a chart that shows the information in a different way.  On the left, you have directly paying the fee from your account and on the right, you have your fee paid after an IRA distribution is made and that tax bill is due.

 

 

Clearly, the winner is having the fee taken directly from your IRA account.  This is a great way to pay your fees on a tax-advantage basis. 

 

On some accounts there exists a maintenance, or, as we call this in the industry, a nuisance fee.  They usually are some type of annual fee on the account itself simply just for having an account open.  For example, one I've seen that's kind of common can be $95 just for having your account; now, these are not as common as they once were but they do still exist and much like paying commissions and trading fees for stocks you really don't need to do this, so if you do see these fees on your account it may be worth exploring other options.

 

Administrative fees: these are usually more common in 401K type accounts.  Because there's some additional background work that has to be done to meet compliance with retirement laws.  This fee is usually an add-on fee in addition to your AUM fee for your Investments for your 401k, any maintenance fees, and then also the investment cost itself which is that expense ratio we will get into a little later.

 

Admin fees can be pretty expensive and sometimes in excess of 1% of your account value, and in addition to all the other fees that can be pretty costly.  While you're still working it's kind of unavoidable and you just have to eat it.  If you ever switched jobs or if you reach a certain age where you're able to roll that 401k over if it's an expensive one, it may be worth exploring rolling that to an IRA or some other type of investment account.

 

When you hear the term fix fee, what does that mean?  This is more common for those who offer financial planning but don't directly manage your investments.  This can be charged in a few ways.  It can be due all at once as a project fee where services are provided, your fee is paid, and then you go your separate way from your advisor.  It can be an hourly fee, and this is more like the lawyer model where you are billed per hour of service and that can easily rack up for more complicated projects, or quarterly fees where you pay a set fee determined ahead of time by contract every 3 months.  Traditionally, the client is given unrestricted access to the advisor as things come up.

 

We may have a monthly fee which same setup as a quarterly fee except the fee is charged every month.  Usually, these types of contracts can be terminated at any time.

 

One of the main industry terms that can be very confusing to somebody doing research on this topic is what is a fee-only advisor VS a fee-based advisor.  Fee-only advisor only receives these two types of fees:

Fixed fee,

or AUM or asset-based fee

 

Fee-based advisors like fee-only advisers can receive AUM or fixed fees but they can also charge Commissions and any other type of fee, and they can be a little less transparent at times, so it's good to do your research to make sure you know what you're paying your advisor.

 

Open Doors FP is a fee-only firm because we believe it provides the least conflict of interest in the service of our clients.  And, it removes the motivation to sell you products that may not be best for you because we owe you a fiduciary duty.

 

Expense ratios for mutual funds and exchange-traded funds or ETFs.  Basically, behind the scenes cost.  You'll never actually see these deducted from your account value, it's done in the background before the return is calculated and given to the client.

 

I want to take a second to de-bunk a common myth and that's that ETFs are always cheaper than mutual funds.  And maybe back in the beginning that was a little more true although now that really is not.  For example, Vanguard has a small company mutual fund and the mirror Image small company ETF and they both have the exact same .05% cost.

 

I do want to point out a slight edge that ETFs can have over mutual funds.  That is in the form of trading fees.  Some mutual funds, although a lot of them don't have this anymore, do have a small trading fee associated with them.  Whereas ETFs like stocks mostly trade for free on the open market.  These aren't things that you'll see in your account because they're taken in the background.  Open Doors' approach is that we select low-cost mutual funds and ETFs that suit client needs.

 

With tens of thousands of investment options out there.  There's no reason to pay large mutual fund and ETF fees so it's important to choose low-cost investment options.

 

Mortality and expense fees: these are mainly going to apply to insurance-type products like annuities.  This can easily be greater than 1% and is in addition to any investment management fees, any mutual fund and ETF fees, any expense ratios, any administrative fees, any account maintenance fees, and any commissions that you may pay when you purchased the product to begin with.  Actual fees vary by product and it's important to do your research.

 

Basically, they're charging you an expense for the risk that they may have to pay you more based on your lifespan than they meant to in their statistics.  If you do you buy these products it is important to make sure you understand all the costs associated with the product from your salesperson.

 

We have covered a lot of details about the various ways that advisers are paid today.  As a result, we created a one-page downloadable PDF that summarizes these topics.

 

You can find it at the following link: https://drive.google.com/drive/folders/1sjQuek2zl6b0AR4z8THRGYM9QS4hdVvX?usp=sharing

 

That's it, for now, thank you for joining us.  To take your next steps, please follow this link to our contact page to schedule a meeting.