Derek Sivers famously once said “If [more] information was the answer, then we’d all be billionaires with perfect abs.”

But that’s not human beings work. It’s usually not about information but human behavior. And our lizard brains, as much as we don’t like to admit it, are in control.

And that’s the big reason why financial advisors are able to charge a percentage of assets under management.

If we know that 1% is too much to pay someone to manage our investments, why do so many people do it?

In fact, why do so many people pay even more than 1% each year? Sometimes 1.5% or even 2%?

Rather than scoff at those people, I want to try to understand.

There’s a reason why there are so many commission-based advisors.

Fee vs. Commission-Based Advisors

First, a quick vocabulary lesson and context.

Financial advisors come in two main compensation types – fee-only or commission-based.

Fee-only advisors charge you a flat or hourly fee for their services. You might pay a “set up” fee for the initial analysis and then a flat annual fee, which includes quarterly meetings and a few ad hoc phone calls.

Commission-based advisors charge you a percentage of your assets that they manage (assets under management, or AUM).

• Fee-based advisors are an amalgamation of the two – they charge a fixed fee like fee-only advisors but they can also earn commissions. They fall within the commission-based advisors category despite having “fee-based” in their name.

Fee-only advisors have a fiduciary duty to put your best interests above those of any other person or group. If they recommend products or services, it has to be for your benefit (and not because they’re getting a commission).

Commission-based advisors only have to follow the suitability rule – they can sell you any product or service as long as it suits your needs (goals, objectives, etc.). It’s a slightly lower bar.

• Fee-based advisors may be bound by a fiduciary duty when they’re advising you but when they sell you products and services, they may only have to meet the suitability rule. Gets a bit muddy here.

If you are unsure what type of advisor you are working with and to what standard they are held to, you can look them up on the SEC website and the NAPFA Advisor search.

The knock against commission-based advisors has two parts:

1. They are expensive, because paying someone 1% a year significantly reduces the returns on your portfolio.
2. Some commission-based advisors are paid a commission by brokerages, mutual funds, and insurance companies when the advisors sell their products and services.

But today, we’re not here to argue whether fee-only advisors are better or not, I want to understand why commission-based advisors are still so popular.

And one thing is clear, it’s not about the math – everyone knows paying 1% each year is going to cut into your returns.

If you invested $6,000 a year into a fund that had a rate of return of 8% for 40 years, you’d end up with about to $1.67 million. Pay a 1% fee and it’s only $1.28 million – a difference of nearly $400,000.

What is the benefit of commission-based financial advisors?

What are you paying for?

Financial advisors offer two main benefits:

1. A Financial Plan – What you need to do to achieve your goals
2. Peace of Mind – Someone to talk to when you have a problem

What are you NOT paying them for?

1. Investments – You don’t need them for access to investments, you have access that to already. Vanguard, Fidelity, whatever, etc. They may have access to specialized funds or investment opportunities but most people don’t need those. And they aren’t really that special, they’re just gated.
2. Predicting the future – because no one can do that!

What don’t you get? You don’t get better performance. Actively managed mutual funds can’t beat the market, your financial advisor’s mix of investments is likely not beating the market (and definitely not beating it once you deduct their fee).

Here’s a story from a reader, Scott, about his experience of a AUM-based vs. fee only advisor:

A few years ago, we were searching and interviewing a few advisors. During our conversation we asked about how the Health Savings Account plan we had set up should be incorporated into our plan.

2 fee-only advisors both said the same thing. Put the minimum in. They are nice to have for medical purposes, but that’s about it.

From my own research I knew these accounts could be much more beneficial. We kept searching, not thinking we had found the right fit. For the HSA reason, and a few others.

Funny story, a woman from Boston we had met in Spain while on our honeymoon, and who my wife had remained in contact with afterwards, reached out and one day and referred us to a planner in her professional network that lived in our area. 

This planner’s response was much different regarding the HSA account. She encouraged us to put as much into as possible. And showed us how to invest the excess savings into mutual funds. Talked about the tax savings… a much different response

I realized later the other planners were incentivized by growing their AUM. Our current advisor who we pay a flat monthly rate and have regular access to was not.

We all know the value of having a plan. But you can build a financial plan on your own or with a fee only advisor. The advisor is there to guide you through that process and ensure you do the whole thing. It’s like using a tax preparer over tax software (but again, you can just pay a flat hourly or annual rate).

But maybe you don’t trust yourself to build that plan. Or you don’t trust that you’ll stick with the plan. Either way, we can agree that it’s not about the plan… it’s about confidence and peace of mind.

How Much Is Peace of Mind Worth?

There’s value in having a question and being able to ask a professional for their opinion and their advice. And trusting that they have the correct answer and that you don’t need to fact check them.

This is how I look at insurance. I’m required to get auto and homeowner’s insurance but we also have umbrella insurance to cover everything else. Insurance is literally buying the confidence that an accident won’t ruin you financially. It’s a figurative safety net.

But you can just hire a fee only advisor for this.

Is It Worth It?

That is the question you have to ask yourself. And only you have the answer.

The main reason for going with a financial advisor, regardless of fee structure, has to do with getting confidence that your plan is correct in a world of uncertainty. We won’t know what will happen in the next few weeks, let along the next few years and decades.

A financial advisor can also be a voice of reason and potentially a barrier to prevent emotional decision making. If you have to talk to your advisor before making a chance to your portfolio, you’re less likely to panic and make a quick decision.

Can you get that from someone you pay a flat rate or do you need to pay a percentage of assets under management?

Perhaps. And I’ve never worked with someone who charged a management fee, I’ve only worked with an advisor who charged a flat annual fee.

In my research, I read this insightful AMA on Reddit in which a wealth advisor shared what it was like to work with high net worth individuals. One of the biggest mistakes he (no idea if it was a he) was how much emotions played a role in decision making. He also said most people don’t need active portfolio management and most of his work was advice in other areas like business transactions, tax planning, etc.

In other words, it seems to make more sense for someone with a more complex financial situation where you might be paying based on assets under management but the advisor is a resource that extends far beyond that. I still struggle to understand why this can’t happen with someone you pay hourly, like a lawyer, but it appears simply to be the conventions of the industry.

It’s also quite possible that you get a better advisor if you go with one that you pay more. You could argue that in a world where a strong advisor could pick one or the other, they would pick the one where they’re compensated more. In fact, you’d want your advisor to be wise enough to pick the one that pays him or her more!

The point of all this is to help you understand why some people would pay a commission-based advisor rather than a fee only advisor – I still don’t, to be honest.

Though the idea that you could get a better advisor by paying more does make sense to me, even if I’m not personally convinced.

The only thing I can equate this to is handbags. It’s why someone would pay for a Hermes or YSL bag vs. a Coach or Michael Kors bag. You’re not just buying a bag and you’re not just buying a financial plan or advice, you’re paying more for a reason beyond the financial ones.