The last several years have seen many financial service providers gradually moving away from commission-based business, particularly among smaller retail firms with only a few employees. These planners have opted for another form of compensation, known as asset-based management, where the planner charges the client a small percentage of assets under management, such as 1%, annually. Securities America's Vice President Dennis King states in the article, "Top 12 Practice Management Trends", that he's seen a tremendous shift that's led 80% of Securities America's representatives to register to do fee-based business. In fact, Securities America's fee-based revenue rose from 15% in 2000 to 26% in 2006 (Morningstar.com, September 21, 2006).
Read on to learn more about this movement from commission to fees and what's causing it.
The Knock Against Commissions
Financial planners that are compensated by commission have often been villainized by the media, such as when CNBC aired a television commercial several years ago that showed an insurance agent with the head of a snake talking to a client about a policy. "Commission" has become an increasingly bad word in the financial industry, bearing connotations of dishonesty, manipulation and the churning of client accounts. All in all, there is a growing wave of sentiment that sales-based financial planning will increase the assets of the planner more than those of the client. (Keep reading about this topic in Understanding Dishonest Broker Tactics and Paying Your Investment Advisor - Fees Or Commissions?)
One alternative to this dilemma for planners is to charge an hourly fee for their services. This arrangement allows planners to be compensated regardless of whether their clients decide to follow their recommendations. However, this solution can be a very difficult adjustment for successful planners who earn high incomes from their commission-based practices. It is hard for a planner to justify receiving perhaps a $500 fee for advising a client if effecting the necessary transactions could generate $10,000 of gross commission instead. For this reason, financial planners who charge by the hour tend to deal more with low-to-middle income clients that have fewer assets to invest. There is little incentive for planners that deal with high-net-worth clients to focus on this segment of the market.
Securities Licensing: A Growing Complication
Negative publicity isn't the only reason that planners are relinquishing their securities licenses. The liability inherent in recommending individual securities has become more of an issue than many licensees are willing to deal with. This is largely because any kind of arbitration or legal action brought on by a disgruntled client will result in a blight on the licensee's disciplinary history - regardless of whether the licensee is in the right or not. And any kind of mark at all on the licensee's disciplinary history form, known as the FINRA U-5 form, will automatically disqualify the licensee from many employment opportunities - permanently. This kind of possible consequence for any recommendation made has effectively rendered individual securities recommendations impractical for many planners.
The bureaucratic burden that securities licensees must shoulder is becoming increasingly heavy as well, with many new rules and provisions coming into effect after the terrorist attacks that took place on September 11, 2001. The registration of any new securities associate with a firm entails a large amount of paperwork, both for the licensee, the back office and compliance departments. A complete background check is mandatory for every licensee, which includes not only a criminal background check (be it securities-related or otherwise), but also of the licensee's credit report and employment history, which must be disclosed for the past 10 years. This is in addition to the initial application, non-compete agreement and other paperwork that the majority of employees in other professions must complete as well. And, of course, there are the securities exams themselves, which can take months to study for and pass. (For more information, read Bad Credit Puts The Brakes On Broker Career and Putting Licenses To The Test.)
Finally, the possibility of a conflict of interest with a client can be a real issue for planners in some situations. This can happen when one possible recommendation will result in the generation of a huge commission, while another option that may be just slightly better suited to meet the client's objective will pay very little. As stated previously, this can be a very difficult issue for planners to resolve, particularly when their employees require a certain amount of monthly commission production from them. (To find out more about arbitration, see Deal Effectively With Difficult Clients, Don't Blame Your Broker and Tips For Resolving Disputes With Your Financial Advisor.)
Asset-Based Compensation: A Fair Solution
Financial planners that charge a percentage of assets under management as compensation are formally known as Registered Investment Advisers (RIAs). Planners that use this business model are only required to pass the Series 65 exam for RIAs. This license does not allow planners to recommend specific investments directly to clients, but only to construct and manage investment portfolios for clients in return for a percentage of assets (although planners who charge an hourly fee for advice must have this license as well). (To learn more, read What Is A Registered Investment Advisor.)
Asset-based compensation can fairly resolve virtually all of the aforementioned issues for both planners and clients. Because RIAs do not need a broker-dealer to sponsor them, they can escape the bureaucracy and paperwork required by FINRA. These reasons alone are enough for some planners to make the switch. Furthermore, not having a compliance department to deal with allows RIAs to focus on managing their clients' assets instead of filling out reports and other legal forms.
Most importantly, asset-based management resolves the conflict of interest between planners and their clients, because the compensation of the planner is contingent upon the value of his or her client's assets. For example, if a client has $100,000 in assets under management and the planner charges 1% of assets per year as compensation, the planner will earn $1,000 from that client for the year. Therefore, if the planner is able to double the client's assets, then the planner's compensation is doubled as well. If the planner loses money for the client, then the planner loses too. This is in contrast to a commission-based broker that is paid by the transaction, and will be compensated for placing a trade, regardless of whether that trade is beneficial for the client or not. Ultimately, this arrangement motivates RIA planners to increase their clients' assets sensibly, by taking as little risk within their clients' desired investment strategies as possible. Clients can be assured that their planners' compensation will not increase unless their asset base does.
Finally, the continuing education requirements (CE) for RIAs are less than those for securities licensees. RIA must only satisfy individual state CE requirements, while FINRA has both regulatory and firm elements to its CE requirements. Consequently, the number of hours of CE required for RIAs is much lower than for stockbrokers and mutual fund salespersons. (Need to upgrade? Check out Beware Of CFP Designation Maintenance.)
Financial planners who do business as RIAs enjoy greater freedom and simplicity than their commission-based counterparts. Planners who are seeking a way to reduce the stress and bureaucracy found in their practices will do well to seriously consider this approach.
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