Being a true financial planner is a new and growing profession. Few people actually are experts in the industry and many call themselves financial planners but in reality, they only use it as a way to sell products rather than actually give advice.
Regardless of the area of focus in the financial planning field, planners typically fall into one of three categories; Fee-Only commissioned, and Fee-Based. Fee-Only advisors usually charge their clients a flat rate (or an “à la carte” rate), fee-based advisors charge a mixture of commissions and a flat rate while straight commission-based advisors are compensated by commissions earned from financial transactions, commissioned mutual funds, and the sale of insurance products.
Which sort of advisor is better really depends on what you’re looking to accomplish. If you want a one-time transaction and to never talk to the person again, a commissioned advisor might make sense because they won’t charge you an ongoing fee.
If you want an ongoing relationship with an advisor who can also sell you insurance and earns commissions on mutual fund sales, a fee-based advisor might make sense.
Alternatively, if you’d like to hire an advisor who doesn’t take any commission on the sale of anything but instead pay them to give you optimal, unbiased advice on their finances; a fee-only advisor might make the most sense. Fee-Only Advisors are required by law to be fiduciaries as well.
- A fee-only advisor collects a pre-stated fee for their services, which can include a flat retainer, a % of Assets Under Management, or an hourly rate for investment advice.
- A fee-based advisor collects a pre-stated fee for their services which can include a retainer, a % of Assets Under Management, or an hourly rate for investment advice in addition to commissions earned for insurance and mutual fund sales.
- A commission-based advisor’s income is earned entirely on the products they sell or the accounts that are opened.
- A hotly debated topic is whether commission-based advisors keep the investor’s best interests at heart when selling an investment or security because historically, as per a study by Vanguard, most high-fee products perform worse than their non-commissioned, low-fee alternatives after fees.
How Fee-Based Financial Advisors Are Compensated
A fee-compensated advisor collects a pre-stated fee for their services. That can be a flat retainer or an hourly rate for investment advice.1 If the advisor actively buys and sells investments for your account, the fee is likely to be a percentage of assets under management (AUM).
It’s important to note that the income earned by fee-based advisors is earned largely by fees paid by a client. However, a small percentage of the revenue can be earned through commissions from selling products of brokerage firms, mutual fund companies, or insurance companies. Be careful, commissioned mutual funds are well-known to underperform because of high fees.
How Fee-Only Advisors Are Compensated
Within the confusing differences in ways of charging between advisors, there can be an even further distinction. In addition to fee-based advisors, there are also fee-only advisors whose sole source of compensation is fees charged by the advisor to their clients.
For example, an advisor might charge $2,400 per year to review a client’s portfolio and financial situation. Other advisors might charge a monthly, quarterly, or annual fee for the same service. Additional services, such as tax and estate planning or portfolio checkups, would also have fees associated with them. In some cases, advisors might require that clients own a minimum amount of assets, such as $500,000 to $1 million, before considering taking them on as a client. Some fee-only advisors, like Progress Wealth Management, don’t have minimums.
What is a Fiduciary Duty
Fee-only advisors have a strict fiduciary duty to their clients over any duty to a broker, dealer, or other institution. In other words, they have a legal requirement to only give advice that’s in their client’s best interests at all times. They must conduct a thorough analysis of investments before making recommendations, disclose any conflict of interest, and utilize the best execution of trades when investing.
What is a commissioned financial advisor and why are they considered predatory?
By contrast, a commissioned-based advisor only earns money when they open accounts and sell products. Companies like Equitable, Prudential, Transamerica, Statefarm, and Edward Jones are all examples of commission-based advisors.
Products for commission-based advisors include insurance, annuities, and mutual funds. The more they sell, the more these advisors get paid.
Commission-based advisors can be fiduciaries, but they rarely are and even if they can call themselves fiduciaries, they typically try to create a philosophy that supports them by calling themselves this, extra conservative to justify arguably over-selling insurance. These advisors must follow rules referred to as the “suitability rule” which is in opposition to the “fiduciary standard”. The Suitability Standard requires advisors to take into consideration a client’s financial circumstances, goals, and risk tolerance. In other words, if you’re 31 and say you’re conservative and your goal is capital preservation because you’re concerned with markets dropping, the advisor can justify the sale of a fixed annuity for your like savings even though what you really need is financial education on how markets work and then potentially investing for growth, instead.
They do not have a legal duty to their clients; instead, they have a duty to their employing brokers or dealers. Furthermore, they do not have to disclose conflicts of interest, which can occur when the client’s interests are at odds with those who are compensating the advisor.
This is typically the group that people who are referred to as “Predatory Advisors” belong to.
How Commission-Based Advisors are Compensated
Most commissioned advisors are employed by major companies like Morgan Stanley, Merrill Lynch, Edward Jones, or Prudential. They’re only sort of employed by these companies, however, and typically resemble self-employed individuals with no base salary and are fully compensated based on the income they’re able to bring in by finding clients. In exchange for a % of the fees they’re able to generate, the firm they work for provides their operational support, compliance, and technology.
The problem with this method of compensation is that it rewards advisors for engaging their clients in much more expensive practices like using highly-commissioned, high fees, suboptimal products, excessive trading, or selling their clients less than competitive and oftentimes excessive amounts of insurance.
The $17 Billion Cost of Conflicted Investment Advice
And it costs investors. A 2015 report, “The Effects of Conflicted Investment Advice on Retirement Savings,” issued by the White House Council of Economic Advisors, stated that “Savers receiving conflicted advice earn returns roughly 1 percentage point lower each year than those who don’t…we estimate the aggregate annual cost of conflicted advice is about $17 billion each year.”
Costs of Fee-Only Advisors
Fee-only advisors have their drawbacks too. They are often seen as more expensive than their commission-compensated counterparts, and indeed, the annual 1%-2% they charge for managing assets will eat into returns. A small percentage charged each year can appear harmless at first glance, but it’s important to consider that the fee is often calculated based on total assets under management (AUM).
For example, a millennial who is 30 years old and has $50,000 invested with a fee-based advisor, who charges 1% of AUM, might pay $500 per year. However, when the portfolio is valued at $300,000, that 1% fee equates to $3,000 per year. And when the portfolio reaches $1 million, that seemingly harmless 1% fee jumps to $10,000 per year.
For this reason, not all fee-only advisors are worth their fee. They still need to earn their fee, every year. This might be through prudent tax planning, estate planning, retirement planning, prudent investment management, budgeting, coaching, counsel, etc.
The Bottom Line
There’s no simple answer to which option is better; it really depends on what you’re looking to accomplish by hiring the advisor to do for you. Paying the occasional commission in exchange for one-time advice isn’t likely a big mistake unless you can find comparable advice at little to no cost. However, for investors with large portfolios who need active asset allocation, a fee-only investment advisor might be the better option. The key to ensuring you hire the right advisor is to understand, upfront, the reasoning why the advisor recommends what they do and why they don’t recommend what they don’t. This is an incredibly important decision for most people because choosing the right advisor can be worth millions to you throughout your life.
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