Advisor Compensation 101

150 150 Northstar Financial Planners

By Steve Tepper, CFP®, MBA

There’s big news in my world: After several months of searching, I have a contract to buy a condo downtown. Without a doubt, my real estate agent’s most important quality throughout this process has been patience! I changed my mind about price range, view, amenities, buying or renting, and many other specifications large and small. When I finally found a property I was interested in, I insisted on reviewing all of the condo association and management financials before making an offer. (Hey, that’s what I do!) And then, just 10 days before my current lease expired, I signed a purchase contract because why not wait till the very last minute?

All this time, through all the other property viewings and failed negotiations, I never paid the agent a dime. And in fact, I never will pay him a dime. Oh, he’ll get paid, but not by me. And yet he worked diligently as my agent, representing me and putting my best interest ahead of his own or the interest of the seller, who will, in the end, be the person paying him for all of his hard work.

As far as compensation goes, much of the financial services industry works the same way as it does in the world of buying real estate. You hire someone to manage your business and to act in agency for you, and you never pay them.

And yet, as our clients well know, we are staunch advocates for a completely different advisor compensation model, the fee-only model in which our clients, and only our clients, pay us for our services. We do not accept payment from any other party.

So how are the two industries different? Why does real estate work so well with a “no-fee” model, while investment management doesn’t? Several reasons:

Large selection: Real estate agents search a comprehensive database called the MLS, or multiple listing service, to find a home that matches your specifications. According to the National Association of Realtors, about 89% of sellers use a real estate agent, which means almost all homes for sale end up listed on the MLS, and almost all home sales will result in a commission paid to the buyer’s agent. So your choices aren’t limited because you aren’t paying your agent.

Similarly, when your financial advisor is compensated by someone else, the advisor will look at only a subset of possible investments—the ones that will pay a commission. But in the financial world, that isn’t 89% of investments. Excluded would be almost all individual stocks and bonds as well as almost all no-load and low-cost mutual funds.

No “hidden” costs: Generally, the only investments that pay your advisor a commission are high in price to the owner of the fund, and most assess penalties if the investment is sold too quickly, which can be anywhere from five to 15 years, or more! Clearly, the “free” investment management offered by a commissioned advisor is not free at all. You’re just paying someone else, and often, you end up paying much more than if you just paid the advisor for their advice and services.

By contrast, there are no fees or commissions that must be recovered by anyone when your real estate agent helps you buy a home. The commission is taken from the payment you make to the seller and divided between the seller’s broker/agent and buyer’s broker/agent. The seller keeps what’s left and has no recourse to recover that commission from you or anyone else later.

Imagine if real estate worked like the financial services industry. The seller would pay your agent a commission, then charge you a fee equal to 1 or 2% of the value of the home each year. Then if you decided to sell the home after three years, they’d charge you a 5% or 7% penalty. Who would buy a house under those terms? Nobody. But that’s how most investors invest their money.

Motivation to get you a low price: Your real estate agent’s primary goal is the same as yours: to help you find a home you like and can afford, and help you through the process of purchasing it. Your agent’s compensation is a function of the value of the home, so there is also an incentive to sell you as expensive a home as possible. However, “overselling” has a potential downside for an agent, and the downside could easily overshadow the added compensation.

Two numbers that agents love to share with you are their “sale price to list price” ratios. One number is how high a selling price they get when they act as the seller’s agent, and the other is how low a price they get when they act as the buyer’s agent. For example, if an agent is helping someone sell a $250,000 home, the agent will try to get that amount, or more if possible. If the sale price ends up being $250,000, they get 100% of the asking price. If they can average 100% or close to it over all of their sales, they’ll probably be able to sign on more sellers than if their number was only 95% or 90% or lower. Makes sense, right?

But most agents represent sellers and buyers in different transactions, and agents don’t want to tell prospective buyers their sales are at 100% of asking price. When an agent acts as the agent for a buyer, they will try to get as low a price as they can to drive down their buyer’s sale-to-list ratio. If you end up paying $240,000 for a home listed at $250,000, that’s a 96% ratio, and the lower the better, both for you and for the agent to attract more potential buyers.

The agent does lose money when they help you get a lower price, but let’s look at how much. In an average transaction, there is a 5–6% commission, split between the seller’s and buyer’s agent. While it doesn’t have to be an even split, it often is. But that half doesn’t all go into the agent’s pocket. Agents work as independent contractors, associated with brokers like Coldwell Banker or Century 21. When the sale is closed, the broker receives the commission and then pays the agent a percentage. That percentage can be 70–80%, or even more; but often, the higher it is, the more “other charges” the broker will charge to the agent.

So to make a short story long, a reliable estimate would be that about 2% of the purchase price ends up as compensation to the buyer’s agent. On a $250,000 sale, that’s $5,000. Now, what happens to the numbers if the agent helps you get the home for $10,000 less, or $240,000? They end up with $4,800. They’re out $200, but that “lost” money bought them a lower sale-to-list ratio. Sounds like a pretty effective marketing expense to me!

There is no similar mechanism in financial services. The more your advisor sells, the more commission they earn. There is no “magic ratio” that they can show to demonstrate they are going to act in your best interest.

Conclusion

In general, your goals are pretty well aligned with your real estate agent’s in a purchase transaction, even though you don’t pay them. That isn’t the case when hiring a financial advisor who is paid on commission.

Special thanks to my real estate agent, Dean Ehrlich of Remax Park Creek, whom I met through a professional networking group—BNI Profit Partners. If you are looking for a trustworthy, hard-working, experienced agent to buy the house of your dreams or sell the house of your nightmares, he has my highest recommendation. You can reach him at Dean@DeanSellsFlorida.com.

Referrals through a BNI chapter are not done on a “solicitor” basis. No compensation is given from the member receiving a referral to the member generating the referral.

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Northstar Financial Planners

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