Introduction

While managing a 401(k) plan can be daunting, seeking professional advice from a 401(k) advisor can prove invaluable. However, it is essential to understand how advisors are compensated to make informed decisions about whom to trust. This blog post will delve into how 401(k) advisors are paid and shed light on the compensation structures commonly used in the industry.

Commission-Based Compensation

Traditionally, some 401(k) advisors received compensation through commissions. This means they earn a percentage of the investments they sell to clients. For instance, if an advisor sells a mutual fund to a client, they may receive a commission based on a percentage invested. This setup can be upfront commissions, ongoing commissions, or a combination of the two.  

For example, we recently came across a plan where the advisor charged 2% on all new funds entering the 401(k) plan and an additional 0.50% on all assets on an ongoing basis. The plan sponsor was unaware of these fees. While situations like this are not as common as they used to be, it is still essential to review expenses. This compensation structure has become less common due to potential conflicts of interest and is now subject to stricter regulations.    

Since these asset-based commissions automatically come from participant accounts, the costs can sometimes go under the radar. Commission-based compensation generally comes through revenue-sharing mutual fund share classes. Mutual funds can have different fund share classes. Though the investments in these funds are the same, the fee structures differ. 

In a revenue-sharing fund, the mutual fund company allocates a portion of the fund's fees to reimburse the service providers for the services rendered. This reimbursement typically covers administrative, marketing, distribution, or record-keeping fees. The specific arrangement and percentage of revenue sharing can vary depending on the agreement between the fund company and the service providers.

Here is a tool to compare share classes (FINRA Fee Analyzer). 

Fee-Based Compensation

Fee-based compensation has gained popularity recently due to its transparency and alignment of interests between clients and advisors. Under this structure, advisors charge a fee based on a percentage of the assets under management (AUM) or a flat fee for their services. The fee can vary depending on the advisor's expertise, the complexity of the portfolio, and the level of service provided. Fee-based advisors have a fiduciary duty to act in the best interest of their clients, which helps mitigate potential conflicts of interest.

Fee-based compensation is adjustable to stay competitive as the plan assets grow. Completing an annual benchmark of fees and services lets you understand if costs are competitive. By signing a new fee agreement, you can have the advisor fees reduced if necessary. 

If the advisor's compensation is asset-based, there is some skin in the game for the advisor. If plan assets increase, the advisor's compensation is better, and vice versa. This setup can provide additional motivation to review investments, provide good investment options, and encourage employee participation.

Example

If the advisor charges 0.50% of assets and the plan has $500,000, the advisor will make $2,500 over the year ($500,000 x 0.005). 

Plan Assets Increase

If the plan performs well and assets increase from $500,000 to $600,000, the advisor's compensation will now be $3,000 ($600,000 x 0.005).

Plan Assets Decrease

If the plan assets go down from $500,000 to $400,000, the advisor's compensation will now be $200,000 ($400,000 x 0.005).

It is essential to ensure fees from a fee-based setup are the only fees paid for service. Some advisors will receive a commission and charge a fee.

Salary-Based Compensation

Some 401(k) advisors are salaried employees of financial institutions or consulting firms. In this arrangement, advisors receive a fixed salary for their services, regardless of the clients they serve or the investments they recommend. While a salary-based compensation structure provides stability for the advisor, evaluating whether their incentives align with the client's best interests is crucial.

An advisor may be salary-based but work for a company that sells specific investment products. Even if there is no compensation incentive for recommending a particular investment, that does not ensure a good fit. If the company creates specific financial products, there may be limits to what products are offered, or education may be skewed towards proprietary products.

Fee-Only Compensation

Fee-only advisors have become increasingly sought after to limit biases and help provide more objective advice. These advisors solely earn income from the fees they charge clients, without any commissions or incentives from third parties. Fee-only advisors typically charge a percentage of AUM or an hourly or project-based fee. Their compensation structure should help limit potential conflicts of interest in their recommendations, as they are not incentivized to sell specific investment products.

Hybrid Models

Advisors may use a combination of compensation models. For example, they may charge a fee for some services and earn commissions on other products they recommend. Hybrid models can be complex, and clients must clearly understand how their advisor is compensated to ensure transparency.

A great way to gain insight into the fees an advisor charges you is by completing a request for proposal (RFP) or getting a second opinion. Costs are often missed due to a lack of disclosure or needing to know where to look. When you have another party reviewing costs, they may be able to help you with any blind spots.

Conclusion 

When choosing a 401(k) advisor, understanding how they are compensated is essential. If you manage the company 401(k), your decisions will affect all the participants in the plan. By being aware of the various compensation structures employed in the industry, you can make an informed decision about the advisor who will best serve your retirement needs. Whether commission-based, fee-based, fee-only, salaried, or following a hybrid model, selecting an advisor who aligns with your goals is crucial. Remember, transparency and trust are critical to establishing a successful relationship with a 401(k) advisor. 

While reviewing fees and fee structures is essential, ensuring the costs reflect the given value is also crucial. CUI Wealth Management can help you review your 401(k) expenses, fee structure, and services. We can benchmark your plan and give you perspective on how your plan fees compare to your competitors.