How is your financial adviser paid? It pays to ask

The new fiduciary rules issued on April 6 by the U.S. Department of Labor (DOL) will change how your financial adviser gets paid for providing investment advice. These rules require advisers to put your interests first when making investment recommendations for the retirement savings you have in IRAs and 401(k) accounts. The new rules have the potential to save retirement investors thousands of dollars each year.

One important goal is to mitigate situations where the type and amount of payment to the adviser becomes an incentive to provide advice that's not in your best interests -- so-called "conflicted advice compensation." Another important goal is to have advisers paid "reasonable" compensation for their services. This doesn't necessarily mean the lowest fees but rather that the compensation is appropriate for the level of service provided.

The new rules will require potentially lengthy and complicated disclosures to investors in 2018 and after. These disclosures will describe how the financial institution is acting in your best interests, how your adviser is being paid and any potential conflicted advice compensation.

But you don't need to wait until 2018 to ask your adviser about compensation or any potential conflicts that may arise. And understanding the basics of adviser compensation will help you interpret the disclosures you may be asked to sign in 2018.

Basically, an adviser can be paid three ways, each creating potentially different influences on the advice you might receive.

1. Commission or sales charge.Your adviser can be paid a percentage of the amount you invest in insurance or investment products. This method may tempt advisers to direct you to the investments or insurance policies that pay them high commissions. They may also be tempted to churn your account, which means to buy and sell your investments frequently to generate commissions on every sale and purchase. These are situations that the DOL hopes to prevent with its new fiduciary rules.

Commissions can range from 2 percent to 10 percent or more, so on a $100,000 transaction, your adviser could receive $2,000 to $10,000. In some cases, the commission is subtracted from the total amount that's invested. Some products, however, are billed as "no cost" and apply all of your savings to the specific investment or insurance product. In these situations, the financial institution pays the commission to the adviser based on revenues it receives from these products.

As a result, when you ask how your adviser is paid, don't ask if your investment is reduced by commissions. Instead, ask if the adviser earns a commission on your investment. If your adviser is getting a commission, ask how the adviser will be able to place your best interests first when making recommendations.

Commissions and sales charges are still allowed under the new rules, but the financial institution will ask you to sign a legal disclosure called the "Best Interest Contract," or BIC.

Advisers may hand you a contract saying they can't start working for you until you sign the BIC. While you may be tempted to skip over the pages of legal print and quickly sign, take the time to review the document and understand the basic concepts. If you have any questions, ask your adviser.

2. Fee based on a percentage of assets under management. The most common fee-based arrangement is to charge you a percentage of the assets you have under the adviser's management. One percent is a typical charge, although lower or higher charges are also common. In theory, an adviser should be unbiased in buying and selling investments, but the potential for conflicts still exists in certain circumstances, such as:

  • Whether to roll your 401(k) account (where your adviser doesn't receive any compensation) into an IRA (where your adviser can earn a fee).
  • Whether to buy an annuity that reduces assets under management and, as a result, reduces the adviser's compensation.

One percent may sound like a small number, but the costs can certainly add up over time. Let's look at an example. Suppose you have $500,000 in retirement investments. If you're paying 1 percent in fees, you'd fork over about $5,000 a year. After 10 years, you would've paid your adviser $50,000. If you're retired for 20 years, which is certainly possible, you'll pay $100,000. Do you really need to pay one percent, year after year?

It remains to be seen whether advisers who charge a percentage of assets under management will require you to sign a BIC, or if they can use a simpler disclosure as a so-called Level Fee Fiduciary.

3. Hourly or flat fee.In this situation, you pay the adviser by the hour or a flat fee for a specified project. Typical hourly rates range from $150 to $300, while a typical project fee could be $1,000, $2,000 or even more. Although these hourly rates or flat fees may sound high, they may work out to be less than 1 percent of your assets under management.

These fees are most comparable to the amount you might pay an attorney for estate planning or other legal matters, or to an accountant for tax advice. In many cases, an hourly fee adviser will give you a fee quote for a specific project, so you'll have a very good idea how much you'll spend in total.

This method of compensation provides the least incentive for conflicted advice, although the DOL rules still require that the charges are reasonable for the services provided. Most likely an adviser charging an hourly or flat fee won't ask you to sign a BIC and will instead be considered a Level Fee Fiduciary.

The bottom line: You're just being a good consumer when you ask about adviser compensation for the services you get, and you don't have to wait for the new rules to go into effect.

Plenty of skilled advisers with integrity earn commissions or charge a percent of assets under management, and will provide good value to you. Your job is to shop carefully to find that person.

Being asked to sign a BIC should be a warning to pay close attention. Ask your adviser to explain in ordinary English how your interests will come first. Don't be shy -- it's your money, and your retirement is at stake.

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    Steve Vernon helped large employers design and manage their retirement programs for more than 35 years as a consulting actuary. Now he's a research scholar for the Stanford Center on Longevity, where he helps collect, direct and disseminate research that will improve the financial security of seniors. He's also president of Rest-of-Life Communications, delivers retirement planning workshops and authored Money for Life: Turn Your IRA and 401(k) Into a Lifetime Retirement Paycheck and Recession-Proof Your Retirement Years.