How Securities Brokers, Investment Advisers and Insurance Agents Get Paid
Here’s the answer to the second part of last week’s reader question about fees and how financial advisers get paid. The products and services advisers choose to offer will determine how they are compensated. Some mutual funds and insurance products, for example, have a commission “built-in” for the adviser. Other services, by their very nature, necessitate a fee be charged to the client. Here’s a break-down on how the three most common types of advisers get paid:
Securities brokers (also called securities agents, registered representatives, stockbrokers, or simply “brokers”) are employed by broker-dealers and are paid commissions to sell the firm’s products. Depending on their broker-dealer, brokers might be paid a commission three different ways:
1. Brokerage Transaction: Stocks and bonds are sold by broker-dealer firms to customers for a commission. The firm’s fee schedule will tell you what the commission will be for various transactions. Of course, you can certainly ask what the brokerage firm’s commission will be and how much the broker will get before authorizing a trade to be placed.
2. Dealer Markup: A broker-dealer firm can also make money (or lose) by selling investments they acquired for their own portfolio. If you buy 1,000 shares of a $10 stock that costs the broker-dealer $2 per share, the firm could make $8,000 profit on the transaction. This is called the “dealer markup.” Again, two simple questions will clarify the financial compensation: 1. How much will the firm make from the transaction? and 2. How much of that amount will the broker receive?
3. Investment Product Sale: Broker-dealers enter into “selling agreements” with various companies to distribute their investment products to investors. When a broker sells one of these securities products to a customer, he gets a portion of the commission received by the broker-dealer. Two good examples of products that are sold by brokers for a commission are mutual funds and variable annuities. “Load” Mutual Funds pay commissions to broker-dealers for selling their funds to customers. For “A” and “B” share funds, the broker-dealer gets a 3 to 5% commission (depending on the size of the transaction). “C” share mutual funds typically pay broker-dealers 1% a year. Insurance companies typically pay 5 to 7% in commissions to broker-dealers for selling their variable annuities to investors. The broker-dealer firms share a percentage of the commissions with their employed securities brokers.
There are two primary types of services for which advisers collect a fee instead of a commission: financial planning and investment advice. Under federal and state securities rules, an adviser must be a representative of a Registered Investment Adviser (RIA) firm to provide these two types of services. Investment advisory firms are registered either with their state division of securities or the Securities and Exchange Commission (SEC). RIA firms may be independently owned and operated by an adviser. Many broker-dealers also offer RIA planning and investing services.
Financial Planning Services: Some advisers charge an hourly fee, while others simply charge a flat fee for planning. Depending on the complexity and the amount of planning to be done, you can expect to pay a planner $500 to $5,000. Before committing, ask to see an example of the work they’ll do for you. If you do hire a planner to prepare a customized plan for you, the planner will ask you to sign an agreement. Read it carefully to understand exactly what will be done. Make sure that you aren’t paying a fee just so the adviser can prepare insurance and investment proposals for you. There are less expensive alternatives. It isn’t unusual for advisers to include financial planning at no additional charge when they are hired to manage a client’s assets for a fee.
Investment Advice: What is investment advice? Essentially, it is telling clients how they should allocate their investment portfolios and which individual securities they should buy and sell. In this capacity, the adviser acts as a fiduciary. He shouldn’t have a bias about the investments the client has in his portfolio, only that they are the best choices. Investment advisers do not usually hold (take custody of) the money they manage. Investment advisers will typically help their clients set up a brokerage account where the adviser will have the authority to place trades, but not take money out. Firms like Fidelity, TD Ameritrade, and Schwab have dedicated departments to support investment advisers. Billions of dollars are managed this way.
Most investment advisers charge clients around 1 to 2% per year, based on the value of the portfolio they are managing. If an investment adviser charges 1.5% to manage a $200,000 account, the fee would be $3,000 per year or $750 per quarter.
While some “no-load” insurance products have begun to emerge, most insurance agents are paid a commission for annuities and a variety of other insurance products. For any product you consider purchasing, you’ll want to ask how much the total commission will be and how much of it the agent will receive (if the agent is working for a financial firm or insurance agency). Also ask about any fees associated with the product.
Fixed Annuities: The commission on fixed and immediate annuities varies by product and company, but usually falls in the 3 to 7% range. Commissions on immediate annuities are 2 to 3%. With both products, the commission is based on the amount the buyer puts into the annuity (the insurance company pays this commission to the agent). While I have seen several “no-load” variable annuities, I’m not aware of any “no-load” fixed or immediate annuities.
Long-term Care and Disability Insurance: Agent compensation is usually a one-time payment equal to 40 to 60% of the policy’s annual premium. I am not aware of any “no-load” versions of either product or any companies that sell such policies directly to the consumer.
Permanent Life: One of the oldest forms of insurance, permanent life insurance still clings heavily to its roots of being available exclusively through licensed insurance agents. Agents are paid a front-end commission (by the insurance company) that is equal to 50 to 90% of the policy’s annual premium. A few companies have introduced “no-load” life insurance, but it hasn’t gained much acceptance in the marketplace.
Term Life Insurance: Whether you buy it in person, over the phone, or on the Internet, you are still dealing with a licensed insurance agent or agency who is paid a one-time commission equal to 50 to 130% of the policy’s annual premium (the insurance company pays this commission). I am not aware of any “no-load” versions of term life insurance or any insurance companies who sell their policies directly to the consumer.
Asking a broker or agent how much he or she will be paid for helping you with your investment and insurance products is prudent, not rude. Don’t be shy about it. Knowing how an adviser is compensated can help you understand 1. how much your business is worth to the adviser and, as a result, how much attention you should expect, 2. how the product is built and how it may perform (a very high commission has to come from somewhere) and 3. the adviser’s motivations and the possibility of bias. If an adviser is hesitant to answer your questions about compensation or fees, you may be working with the wrong person. When you buy or sell a house, you know upfront what the realtors earn for their assistance. Working with a competent adviser should be a similar experience, and he should be just as candid about his commissions and fees!
David D. Holland, a CERTIFIED FINANCIAL PLANNER™ practitioner, hosts a weekday radio show at 9AM on AM1380 Ormond Beach, AM1230 New Smyrna Beach and AM1490 Deland. He has also authored two books in his Confessions of a Financial Planner series. Holland offers investment advice through Holland Advisory Services, Inc., a registered investment adviser in Ormond Beach. He can be contacted at (386) 671-7526. Email your financial questions to info@DavidHolland.com.