We will address three questions to answer this debate.
What is the quality of the financial planner and the advice you are receiving
If the quality of a financial planner is the same, will your net worth grow faster if you pay higher or lower fees throughout your life?
Can a financial planner earn you a higher return by trying harder or being more incentivized to grow your portfolio?
Are You Receiving The Same Quality Financial Planning?
The quality of financial planning ranges from person to person but you can look for a few things to lower the odds of working with a bad financial planner. Look for someone who is only paid by you, no sales commissions, back end incentives, or other clients besides yourself and others like you. Also, look for someone who, at a minimum, has the CFP (Certified Financial Planner) certification. You should receive comprehensive financial planning advice that accounts for all of the subsects of your financial life. Just as commissions may incentivize an annuity/insurance salesman the fee structure of a 1% aum advisor may incentivize them to always see the stock market as the solution to your problem. When in reality it would be better to pay off debt, keep cash at home, give away money, or invest in something outside of the stock market.
Does a Lower Annual Fee Make a Difference?
If the quality of financial planning/investments is the same, and your fees are lower with a flat fee financial planner vs. a financial planner who is paid 1% AUM (assets under management) your net worth will be higher if you receive the same service for a lower fee. Which service provides the lower fee? As your portfolio grows the flat fee financial advisor tends to save you the most. For instance, if a flat fee financial planner charges $500/month and your portfolio is worth $1.2 million at a 1% AUM (assets under management) shop, you would pay $1,000/month or 100% MORE than the flat fee advisor would charge. This is money that you could spend on a vaction, kids college, nicer car, mortgage, or anything else you want. And you would be better off for it.
Can A Financial Planner Earn A Higher Return If Incentivized?
The argument I sometimes hear is that the financial planner who charges 1% of the assets they manage is more incentivized to grow their assets because their fee increases with portfolio growth. I agree with you if we are discussing a job where someone has 100% control over the outcome, such as manual labor jobs. However, with something like investing, the odds of outperforming, even if you're paid more to do so, is incredibly difficult and unlikely. We can verify this by looking at active mutual fund managers and their historical ability to outperform the stock market.
Excerpt from The New York Times:
"It found that not a single mutual fund — not one — managed to beat its benchmark in either the U.S. stock or bond markets regularly and convincingly over the last five years. These results are even worse than those of 2014 and 2015, when I last examined this subject closely."
"The S&P Dow Jones team looked at all the 2,132 broad, actively managed domestic stock mutual funds that had been operating for at least 12 months as of June 2018. (The study excluded narrowly focused sector funds and leveraged funds that, essentially, used borrowed money to magnify their returns.)
The team selected the 25 percent of the funds with the best performance over the 12 months through June 2018. Then the analysts asked how many of those funds remained in the top quarter for the four succeeding 12-month periods through June 2022.
The answer was none."
Most CFPs (Certified Financial Planners) received a similar education program and collect market data from similar sources to invest their clients' dollars. Meaning, their portfolio allocation is likely to be somewhat similar. However, you could always ask the two advisors for examples of their portfolio asset allocation (not the actually ticker symbols) in order to see if there's a large difference between the two. Most advisors won't provide ticker symbols until you are a full time client.
When Does a Flat Fee Advisor Not Make Sense?
When assets are low and your are just building your net-worth the flat fee financial advisor may be more expensive than an AUM financial advisor.
Is A Flat Fee Financial Advisor Better? or Worse?
We could talk for days about different investment management practices and what are the best questions to ask a prospective advisor. However, the core argument here is that your net worth will be higher if you receive similar financial advice at a lower cost. Smart Asset writes more about the differences between the two HERE.
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