The world of financial services is far from transparent. Fortunately, it’s slowly improving as financial planning becomes more of a profession. But we still have a long way to go.
Today, there are three main types of Advisors; fee-only, fee-based, and commission based. Basically, fee-based and commission-based advisors have at least some reliance upon earning revenue indirectly from products you purchase. On the other hand, fee-only advisors earn 100% of revenues directly from client fees. With all of the confusing options combined with a lack of transparency, it’s difficult to understand what you’re actually paying.
To give you an idea, here are some of the typical commissions you indirectly pay financial advisors when you buy insurance and investment products.
Life Insurance Commissions
All types of individual life Insurance pay commission of 50% to 100% of the first year total premium. In years 2 and beyond, commissions drop to 0% to 15%.
Let’s assume you’re buying $1 million of life insurance. The whole life option costs $12,000/yr and pays first year commissions of 50% – or $6,000. In the second year, it pays 10% on the second year premiums – or $1,200. And in years 3 and beyond, it slowly scales down from 8% to 2% commissions on annual premiums (not the cash value) paid per year. The term life option costs $600/yr and pays 100% commissions on first year premiums ($600) and 0% in subsequent years.
If your advisor wants to earn more money, which do you think they’ll recommend?
Annuities pay somewhere between 5% and 10% commission on new contributions. Plus, some pay under 1% commissions on the balance (not new additions) each year thereafter.
Let’s say you recently switched jobs and your advisor recommended you roll over your old 401k to an IRA. He says this will be better than moving it to your new 401k because it comes with greater flexibility due to all of the available investment options. Plus, you’ll get a professional to help manage it.
The investment vehicle he recommends is an annuity (which happens to pay 6% in commissions on new deposits). Your old 401k balance is $100,000, therefore your advisor earns a commission of $6,000 on this transaction. Now it makes sense why he was so adamant that you roll it over to an IRA instead of your new 401k.
Long Term Disability & Long Term Care Insurance
Long Term Disability and Long Term Care Insurance policies pay advisors between 25% and 75% in commission on first year premiums — plus 5%-30% in renewal commissions on future year premiums.
You’re a young physician and your fee-based advisor offers to help you get your long term disability insurance set up without charging you. That’s nice of her! But the policy she recommends (which costs $6,000/yr) also happens to pay her 50% commissions on first year premiums (or $3,000) plus 20% in years 2-5 (or $1,200/yr). So it’s really not surprising why she recommended that you go with the more expensive “Cadillac” policy.
Commission Payment Terms And Early Cancellation
You should also know that some insurance companies pay 100% of first year commissions up front – even before it’s finalized. In this setup, advisors might recommend “test driving” the Cadillac option to get started. You can always back down upon approval if necessary. However, at approval, they become aggressive about sticking with the original plan (because they already got paid on it – if you reduce it, they’re forced to pay back commissions).
Most other insurance companies delay payout of first year commissions until it’s finalized. However, they still tend to payout 100% of the full first year commission at approval, even though you’re paying monthly premiums in reality. If you propose cancelling before the 13th month, the advisor is not going to like this idea. Why? Because they’ll be forced to pay back a portion of commissions if you cancel in the first year.
Finally, some insurers delay paying commissions until they’re actually earned. This eliminates the above conflicts. However if given a choice, most advisors opt for the front-loaded payout.
If you’re buying a product that only has one single premium (like an annuity or single premium life insurance), they typically pay the advisor immediately once it’s finalized. And if you back out early, normally the advisor doesn’t have to pay back anything. However, someone has to cover the commissions and it’s not going to be the insurance company. So you’re normally stuck with large withdrawal charges that effectively cover the commissions paid.
Most mutual funds offer many different share classes. There all basically the same investment but with varying expenses. For example, the American Balanced Fund offers 19 different share classes. The most common share classes are A, C and Institutional shares.
A Shares pay up-front commissions up to 5.75% on all new deposits when your total balance is under a certain level (typically $25,000 to $50,000). A share up-front expenses typically scale down the more money you have with the specific fund company. The ongoing annual commissions are typically around 0.25% of the total balance.
Let’s say you’re starting to fund two Roth IRAs for you and your spouse and plan to max them both out (2019 max is $6,000 per IRA). Your advisor recommends A Shares. If you buy them, you’re indirectly paying the advisor $690 on the buy transaction. In subsequent years, you pay $30.00 (if the balance stays at $11,000).
C shares don’t pay up-front commissions but, instead, pay ongoing annual commissions of 1%. If in the above Roth IRA funding scenario, you used C Shares, there would be an annual expense of $120 each year (assuming the balance stays at $12,000).
Institutional (or no-load) shares don’t pay any up-front commissions but pay between 0% and 0.25% annual commissions (the no-load terminology is a bit misleading). Although these funds have lower expenses, they can add up when the account gets larger.
If you have a managed account with $1,000,000 and own no-load shares with 0.25% annual commissions, that’s $2,500/yr you’re paying on top of advisory fees. Watch out for fee-based advisors like this that charge a percentage of managed assets AND use “no-load” shares with ongoing indirect commissions. That’s a big red flag and reason to get a second opinion.
Financial Advisory Fees
There are several ways advisors charge fees. And the fact that an advisor charges fees doesn’t necessarily mean they don’t earn commissions. Three of the most common fee arrangements are flat fees, asset management fees and hourly fees.
Flat fees are typically set based on circumstances and are paid in exchange for financial advice. It’s one of the least conflicted ways to provide financial advice unless the advisor is also earning commissions on product placement. If the latter exists, it’s a major red flag.
Asset management fees are set as a percentage of assets managed. Industry average is around 1%. Clients pay the advisor directly from their investment assets.
Hourly or project based advisory fees set based on time or on a project basis and typically range from $100-$500/hr depending on the advisor.
These fees and commissions often vary considerably based on the company and the Advisor.
What Do I Do with this Information?
This is not to say that these products don’t have a place in your financial plan or that all commissions are bad or that all salespeople are out to get you. That is not the case. Insurance is an important part of your financial plan. Investments are part of your financial plan. And, at the end of the day, most people who sell these products want to help you. BUT, you should be aware of the potential conflicts of interest out there. Be aware of your options. And don’t be afraid to ask about commissions and alternatives.
And if you’re not interested in navigating these decisions alone, give us a call. We can help.