The SEC tells investors, “before you hire any financial professional—whether it’s a stockbroker, a financial planner, or an investment advisor—you should always find out and make sure you understand how that person gets paid.”

In this two-part post, we’ll look at how clients pay advisors, AND how advisors get paid. It’s important to understand both if you’re going to protect yourself from being overcharged, or, worse, guided into decisions about your portfolio that benefit the advisor and not you.

Just as it’s smart to question the doctor suggesting test after test for you at a facility he or she owns, it’s important to know how your advisor’s pay structure creates incentives that may harm or help your portfolio in the long run.

In part one of the post, we’ll look at how clients pay advisors. In part two, running Wednesday, we’ll take a look at an even more complicated topic: How advisors get paid. (See: 3 Conflicts of Interest That Can Slice Into Your Portfolio). In addition to the money you pay your advisor, he may receive other kinds of compensation. It’s crucial to follow that money, too, because that’s how you can figure out if the money you’re paying the advisor is dwarfed by the amount a mutual fund company or a bank is paying him to sell you their products.

“It’s more than just a question of how you pay, it’s also a question of how your advisor gets paid,” says Barbara Roper, director of investment protection at the Consumer Federation of America.

How you pay your advisor

The Internet contains practically an entire library expanding on the subject of how you pay your advisor. The key questions you should ask your advisor about how you pay her:

How much will you charge me, and what are your fees based on?

Is that compensation structure best for my particular situation?

Why?

There are three different compensation models in the business. Each creates its own incentives.

1. Fee on assets under management

When an investor pays his advisor on a percentage of assets under management, the fee is typically deducted from the assets, often on a quarterly basis. The typical fee is 1% of assets under management, but I have known it to range from .75% for large portfolios, up to 2% for small ones.

If you’re paying a fairly typical 1% fee on $100,000 under management, and your assets remain at $100,000 at the end of the quarter, you’ll pay a fee of $250, or one-fourth the annual charge of $1,000.

A fee on the assets under management gives your advisor an incentive to grow your assets because his or her fee will grow at the same time. Some have argued that the fee model may create an incentive for advisors to grow your assets fast, and take too much risk. See this Bloomberg piece on what happened to clients of an advisor who took too much risk.

An advisor who seeks to create a long-term relationship with you, however, is less likely to do that. Over time, the fees on a well-managed account add up to more than the quick-hit fees on a fast-growing one if the bottom then falls out of the market.

2. Commission

Some advisors, especially those that are licensed as brokers, are paid by commission on the securities they buy and sell for you. Commission-based pay creates an incentive for advisors to buy and sell securities. Excessive buying and selling, studies have shown, is the biggest drag on investor portfolios. (See Investing Mistakes According To The Library of Congress.) However, if you have a large portfolio, and you trade infrequently, you may well end up paying less in commissions than you would to a fee-based advisor. A key thing to watch out for with an advisor paid on commission is very frequent rebalancing of your portfolio. If you’re rebalancing four times a year or more, and your advisor can’t give you a good rationale for it, look deeper.

3. Hourly fee

Some advisors charge an hourly fee, often to help you organize your entire financial life. An hourly fee is much like the lawyer model: The investor is billed for the time that his advisor is working for, talking to, or thinking about him. Some people have argued that the hourly billing model should be adopted in a more widespread fashion by the investment advisory business because it steers clear of all the issues raised by the two models above. But hourly billing creates its own perverse incentives, as lawyer-turned-author Scott Turow argues in this piece.

“Who ever says to a client that my billing system on its face rewards me at your expense for slow problem-solving, duplication of effort, featherbedding the workforce and compulsiveness—not to mention fuzzy math,” he writes. His answer, basically, is that nobody does.

These days, many advisors use a combination of the models above to charge you for their services. A fee-only advisor may charge clients an hourly or fixed fee for the creation of a financial plan, plus a percentage of assets under management, just as an advisor who is also a broker-dealer may charge a percentage of assets in addition to commissions on transactions.

So it’s important to ask a fourth question of your advisor after she explains how she’s getting paid. If she tells you that she charges a fee on assets under management, specifically ask if she also is paid via commission or if there are services for which you’ll be charged an hourly fee. If her response to your question about payment revolves around commissions or an hourly fee, ask about the other two categories of pay, as well.

Bottom Line

The bottom line is that nobody has devised a perfect way of paying a professional like a doctor, lawyer or investment advisor. The best a patient, client or investor can do is to be aware of the incentives built in to the system and be educated about how they are affecting your own advisor.

As investor advocate and University of Mississippi law professor Mercer Bullard points out, every pay structure creates its own peculiar incentives.

“The fundamental tension has always been that if you have a commission-driven compensation structure, you might encourage high turnover,” he says. “If you have an asset-based fee structure you might encourage a do-nothing approach.”