Fee-based advisors vs. commission-based advisors: what’s the difference? As the financial industry has evolved, so too has the manner in which consumers pay for financial advice. The difference between “fee” and “commission” sounds somewhat innocuous at first blush – you know you have to pay for the advice one way or another, so what difference does it make? Dig a little deeper, and you may realize the difference between a fee advisor and a commission advisor is a bigger deal than you think.
What is a commission-based advisor?
Commission-based advisors can mostly be found at large Wall Street firms, banks, and insurance agencies. As the name implies, they are compensated for initiating transactions with consumers.
Many commission-based advisors are licensed to sell a cornucopia of products such as stocks, bonds, mutual funds, life insurance, and annuities. However, they often stand to make a higher commission if they sell one product over another. Life insurance and annuities are typically the most lucrative – on average, according to thebalance.com, commissions on variable and fixed index annuities can range from 4%-8% (of the total amount invested). It is probably not a coincidence that these types of products also tend to be the most complex and confusing.
FINRA is the regulatory body that oversees commission-based advisors. At present, FINRA holds its advisors to a “suitability” standard, meaning their recommendations only need to be suitable given what the advisor knows about their client (i.e. general risk tolerance, needs, etc.). So out of the thousands of investment choices on the market, this advisor just needs to believe the one they recommend fits your general profile – which may or may not include cost considerations.
While commission-based advisors often help clients with comprehensive financial plans, some trend more towards building your investment portfolio because that is how they are paid. This can create a conflict of interest. Consumers should therefore be vigilant as to whether such an advisor’s recommendation is truly in their best interest, or whether the advisor is attempting to fit a square peg into a round hole – or in other words, justifying a high-commission product as the right course of action even if more practical (or cheaper) alternatives are available.
Of course, this is an extreme example and usually not the case in real life; advisors under a commission model are capable of providing honest, transparent advice. The point is that these are important questions to keep in mind.
What is a fee-based advisor?
Nowadays many fee-based advisors can be found at small, independent companies known as Registered Investment Advisory firms (RIAs), though many can still be found at large Wall Street firms and banks.
The term “fee-based advisor” can mean many different things: some charge flat hourly fees (similar to a lawyer), while others charge flat retainer fees (usually a few thousand dollars per year), or – most commonly – a flat or tiered annual fee based on a percentage of the money they manage for you (typically 1.00% – 1.50% or less depending on the size of the account). Some may even charge a combination of the above, plus a separate fee to produce a written financial plan.
Fee advisors are regulated by the Securities and Exchange Commission (‘SEC’), which holds its registrants to a “fiduciary” standard, meaning they operate under a legal obligation to work in their clients’ best interests at all times. While both commission- and fee-based advisors give clients investment recommendations, it is the one held to a fiduciary standard who must consider whether those recommendations are truly in the client’s best interest (not just whether it checks a few boxes). Perhaps unsurprisingly, the high-cost product usually does not make the cut when put under this level of scrutiny.
As opposed to the commission world, where monetary incentives are oftentimes hidden (at worst) or just downright confusing (at best), fee-based structures tend to be more transparent. This is because the fee is typically agreed upon at the start of the client-advisor relationship, not charged on an ad-hoc, per-transaction basis as is the case for commissions. Moreover, a fee-based structure tends to put clients and advisors on the same side of the table, mainly because the advisor has a legal obligation to put the clients’ interest first. In theory a fee-based advisor should be motivated to make prudent investment recommendations because if the client’s account goes down, so too does the advisor’s fee; this unfortunately is not always the case in a commission setting, where commissions are oftentimes paid upfront.
There are plenty of good (and bad) advisors on both sides of the spectrum. The takeaway is that no two advisors are the same – neither in how they are compensated, the services they provide, or their general approach to financial management. Choosing the right investment advisor is not a decision to be made lightly. Just as important is choosing how to pay for that advice, especially considering consumers now have plenty of options. Do your research and ask plenty of questions!
Taylor Hoffman is a proud member of the fee-based advisory community. To learn more about our fiduciary financial planning services and our investment management approach, contact us today!
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