Our financial decisions are consequential, it makes sense to have a trusted expert in our corner. However, it’s important to understand how your financial advisor earns their money and ensure their incentives are aligned with yours. Having a discussion around fees can ensure they are actually working for you, and not just selling financial products. Younger clients are increasingly exploring new financial advisory models that create better alignment.
These are the three basic remuneration models, although advisors may use a combination of these:
- Commission-based with highly misaligned incentives: Advisors earn commission from a product provider for selling their product (for example, retirement annuity or life insurance), typically paid upfront. Many large insurance and product providers in South Africa use this model to incentivise employees or independent advisors to sell their products. Misalignment occurs since advisors are rewarded for pushing products rather than solving the needs of their clients. The truth is not all clients need financial products, but advisors operating under this model can’t earn a living offering product-free advice such as reducing debt.
- AUM-based with misaligned incentives: AUM stands for ‘assets under management’. This model is only feasible for wealthier clients since it requires significant liquid assets to hand over to an advisor. The advisor receives a percentage of the value of your investments annually, typically after taking an initial fee. For example, if you invest R1m million the advisor charges 1% annually and 3% upfront. The ongoing fee starts at R10,000 per year and increases as the investment increases, while the upfront fee is R30,000. In some ways, this structure has better alignment, since advisors are incentivised to grow the assets under management to earn higher fees. However, misalignment occurs because advisors’ fees are tied to the value of the investment. Advisors are biased against reducing a client’s investments, even when it makes sense for a typical life event, like buying a property.
- Fee-based with highly aligned incentives: Fees are transparently determined and agreed upon between the client and advisor directly and are not connected to the sale of a product or the value of assets under management. This is a professional fee paid to the advisor for their time and expertise, similar to how you would pay for a consultation with a doctor or a lawyer. Typically, this takes the form of an hourly fee, fixed charges for certain services or the newest version, whereby a monthly subscription gives you access to a professional advisor.
A fee-based approach is best to avoid misaligned incentives. Advisors aren’t rewarded for pushing products or collecting assets and can only increase their reputation and business by providing great objective financial advice. They work for the client, not a financial services provider. If a client ends up needing a financial product, they can advise on that too, but there’s no incentive to sell them.
The vast majority of the financial advisory industry operates under the first two models, and it’s been that way for decades. These skewed incentives have had unfortunate outcomes for consumers, with financial advisors being more focused on pushing products and collecting assets instead of fulfilling the operative word in their title… advisor.
Younger clients shifting towards a subscription-based approach
Clients in the wealth-building phase of their life (the 20s, 30s and 40s) are rejecting the traditional models, wary of receiving conflicted advice and being sold unsuitable financial products. This new generation expects and demands objective, holistic expertise when it comes to financial advice and is increasingly looking to subscription-based advisors to deliver on that.
An advisor, free of the need to push products, is better positioned to guide clients more holistically across all life’s financial decisions including goal setting and tracking, budgeting, managing debt, buying property, starting a family, investing in education, planning for travel, planning for retirement and if needed, financial products.
The subscription-based approach is relatively new globally but has gained strong traction in markets like the US and UK. In South Africa, adoption is also at an early stage but is seeing strong growth due to interest from younger clients and a small innovative community of financial advisors that have embraced the model.