This is a topic that, as a financial planner, I feel we have beaten into the ground. If you Google the question in the title, you will find a plethora of articles that will give you the answer. Despite this being one of the most written about topics by financial planners, there is still a lot of confusion among consumers. This confusion leads to poor financial decisions and overall distrust for the financial services industry.

There are two primary ways that investment advisors get paid, and a third way that is simply a hybrid payment model.

1. Commission – Most investment advisors make money when they sell a product. An example commission rate for an investment product is 5 percent, however the rate varies depending on the type of product they are selling. For investment products such as mutual funds, the commission is also known as a load. This load can be paid when you purchase the product (known as Class-A or front-end load), when you sell (known as Class-B or back-end load), or can be paid each year (known as Class-C shares or level load). Either way, the commission is taken directly from the investment by the company and paid to the seller. Commission advisors are regulated by FINRA.

2. Fee-Only – These investment advisors are paid a fee directly by their clients and do not accept any commissions. This fee can be charged in different ways, such as a flat fee retainer or on an hourly basis, however the most popular fee model is assets under management, or AUM. With AUM the advisors charges a percentage, such as 1 percent, on the investments they manage. Fee-only advisors are regulated by the SEC.

3. Fee-Based –Fee-based refers to advisors that charge both commissions and fees. The advisors may charge a commission on the sale of financial and insurance products, while charging a fee for financial planning. There any many different ways a fee-based advisor may structure their compensation, but it very important to note that although many believe fee-based and fee-only are identical, they are not. Fee-based advisors are dually registered with FINRA and the SEC.

Potential clients will sometimes ask “Why should I pay you for the services my investment advisor does for free?” The confusion comes from the misconception that commission advisors are not being paid by the clients. The answer is that even though they are not writing a check to their investment advisor, or having their fees deducted directly from their account, they are most certainly paying their commission advisor. The advisor isn’t working for free. The payment is simply being deducted from the investments in the form of a sales load.

Do you know how your advisor is being paid? Have you ever asked? Ever get an interesting answer? Please feel free to share.