When choosing someone to manage your life savings, understanding how they get paid is one of the most critical factors. Financial advisory services are often categorized as a "credence good" — a type of product or service whose value is difficult for the consumer to assess, even after consumption. That means you might not know whether you received good advice until many years later, if at all.

Because you are entrusting your long-term financial wellbeing to someone else, the structure of their compensation is really important. It not only affects your costs but also influences the incentives that guide their recommendations. There are several common models that financial advisors use to charge for their services, and each carries different implications.

Fee Structures

1) AUM Fee Model: This is the most prevalent approach, where advisors charge a percentage of the assets they manage on your behalf, known as the Assets Under Management (AUM) fee. According to a 2024 study by Kitces Research, advisors typically charge around 1.00% for portfolios up to $1 million. This percentage tends to decrease as the portfolio size increases, falling to about 0.85% for portfolios between $1 and $3 million, 0.65% for $3 to $5 million, and 0.50% for assets exceeding $5 million.

2) Flat Annual Fee: This is where advisors charge a set amount regardless of the size of the portfolio. This fee can vary widely, typically ranging from $1,000 to $10,000 depending on the complexity of the services offered.

3) Hourly Fee: Some clients may opt for an hourly fee arrangement, often ranging from $200 to $500 per hour, which is particularly useful for those seeking one-time advice or help with specific financial issues.

4) One-Time Planning Fee: This is usually charged for the creation of a comprehensive financial plan and can cost between $1,000 and $5,000.

5) Commission-Based Fees: This is where advisors earn money by selling financial products such as insurance policies, mutual funds, or annuities. While this model can seem more cost-effective initially, it may also lead to biased product recommendations if higher-commission items are promoted over more suitable, lower-cost options.

Measuring the Cost of Fees

To understand the long-term impact of advisor fees, consider a hypothetical example. Suppose you invest $100,000 at age 25 and achieve an average annual return of 8%, net of fund costs. If you pay no advisor fees, your investment would grow to approximately $2,172,452 by the time you reach age 65. However, if you pay a 1% AUM fee annually, your ending balance would be around $1,497,446. Over four decades, that 1% fee could cost you $675,006 in lost growth. This illustrates how even a seemingly small annual fee can have a dramatically negative impact on your long-term wealth by reducing compounding returns.

Additionally, it's important to note that under current U.S. tax law, financial advisor fees are generally not tax-deductible for individual investors. Prior to 2018, these fees could sometimes be deducted as miscellaneous itemized deductions, but the Tax Cuts and Jobs Act suspended that provision through 2025. There are a few exceptions—such as fees related to business advice or when paid directly from certain tax-advantaged accounts—but for most individual investors, the cost of financial advice must be absorbed without tax relief.

Considering Incentives

Different fee models also influence advisor behavior in various ways. For instance, advisors using the AUM model are financially motivated to increase the assets they manage. As a result, they may be reluctant to recommend strategies that involve moving money out of managed accounts, such as paying off high-interest debts, purchasing rental properties, or investing in long-term care insurance. In contrast, advisors who charge a flat fee, hourly rate, or one-time planning fee may offer more neutral advice since their income doesn't depend on asset retention. However, these models shift the responsibility back onto the client to implement and stick with the plan.

Commission-based compensation brings its own set of challenges. While it can appear inexpensive upfront, it may lead to product recommendations that are better for the advisor than for the client. Products with high commissions may be pushed even if they aren't the most appropriate choice.

A Key Question to Ask the Advisor

Before engaging a financial advisor, it is essential to ask how they are compensated. Transparency is critical. Reputable advisors will clearly explain their fee structure and how it might affect the advice they give. Evaluating these incentives helps you understand the lens through which they might view your financial situation. It's also wise to conduct a cost-benefit analysis of the advisor's fees over the long run and compare that with the value they are likely to provide.

Finally, consider working with a fiduciary—an advisor who is legally obligated to act in your best interest. Fiduciaries are more likely to offer objective advice tailored to your financial goals, rather than being swayed by potential commissions or the desire to grow AUM.

Choosing a financial advisor is a major decision with long-lasting implications. Understanding how they are compensated is fundamental to ensuring their incentives align with your financial goals. Ask tough questions, do the math, and always keep your long-term interests in mind.