Fee-based brokerage accounts (also known as wrap accounts) were originally developed to give investors the opportunity to consult with an investment professional, receive advice on security selection and portfolio construction, and then buy and sell securities for their portfolios without paying individual commissions for the trades.

They were such a breath of fresh air at a time when Wall Street had developed a reputation for unsavory sales practices that, in 1995, the Securities and Exchange Commission (SEC) released a statement to the effect that fee-based accounts serve to better align the interests of the financial advisor with the interests of investors. A decade later, regulators reversed course.

In April 2005, the NASD (now called the Financial Industry Regulatory Authority or FINRA) censured and fined financial services firm Raymond James for violations relating to the firm's fee-based brokerage business. In response, Raymond James closed all fee-based brokerage accounts. According to the regulators, investors in fee-based brokerage accounts were paying for trading, not comprehensive advice. The Raymond James action was a sign of things to come. Read on as we go over the 2007 changes to fee-based brokerage regulations and give you a sense of how this affects investors.

Background
Historically, commission-based brokerage accounts were (and continue to be) criticized because brokerage firms earn commissions whenever clients make trades. This no-trade-no-fee approach provided a powerful incentive for brokers to get investors to trade, which encourages boiler room tactics and churning. With the FINRA censure, the fee-based brokerage account (once hailed as the antidote to boiler room tactics) became a problem because some investors were not trading enough. Regulators pointed to the low level of account activity and noted that some investors were paying higher fees than they would have paid in traditional commission-based brokerage accounts.

From a regulatory standpoint, a complicated series of definitions, legalities and regulations can be summarized by sorting investments into two categories: advisory products and non-advisory products. With advisory products, the advice provided by financial services professionals is considered to be a material part of the process. Investors are essentially paying for advice and getting commission-free trades as part of the package. With non-advisory products, the regulators view the advice as incidental.

These fairly straightforward concepts become problematic when applied to the traditional fee-based brokerage (wrap) account because it was classified as a non-advisory product, even though many advisors included ongoing advice as part of the package of services they provided to their fee-based brokerage clients.

Genesis of the Non-Discretionary Advisory Account
After much public wrangling, regulators finalized the reinterpretation of the rules for fee-based brokerage accounts, banning them effective October 1, 2007. This decision impacted approximately $300 billion invested in around one million accounts, according to industry estimates. Losing this money would have been financially disastrous for some of the country's largest financial services firms, so they needed to come up with a solution that would enable them to continue to meet their clients' needs as well as continue to charge a fee based on assets under management (a more lucrative proposition that commission-based trading). To meet this need, the non-discretionary advisory account was developed.

From a practical, functional perspective, non-discretionary advisor accounts are no different than their predecessors. They are similar to full-service commission-based accounts in that investors can use them to purchase a variety of investments, including stocks, bonds, exchange-traded funds, and more. They include an advice component, just as their fee-based brokerage predecessors offered, but from a legal perspective, the investors are the ultimate decision makers. So, although the financial advisors provide advice, the investors are free to take or leave the advice with the understanding that they are paying a yearly fee for trading (not for advice) instead of a per-trade commission. Many investors prefer this arrangement because the financial services professional giving the advice has no incentive to sell them anything.

From a financial advisor's perspective, compensation is based on a percentage of the assets in a client's portfolio, so it is in the advisor's best interests to see those assets grow. A 1% fee on a $250,000 portfolio is $2,500 per year. If that portfolio grows to $500,000, the advisor's fee doubles. Under this compensation model, financial advisors have no financial incentive to recommend trades unless those trades will add value.

Which Brokerage Account Is Right for You?
Fee-based brokerage accounts are particularly well suited to investors who have concerns about objectivity, but still want professional advice. They allow investors to focus on results, not the commissions they have to pay with every investment decision. They also appeal to investors who anticipate a high level of trading activity.

Critics argue that after a portfolio has been created, some investors may not need to make many changes, and are therefore paying a yearly fee without getting any additional service. The counter argument is that sometimes the best advice one can get from an advisor is to simply construct a solid portfolio and take no action unless financial goals or circumstances change.

Of course, if advice is something that you do not need, a commission-based brokerage account might be right for you. Purchased through a discount broker, these accounts charge just a few dollars per trade and provide a convenient, inexpensive way to manage your own money.

Another option, especially for larger account sizes, is to employ a registered investment advisor (RIA) to manage the account. This type of professional money management is bound by the strict regulations of the Investment Advisors Act of 1940, and accounts are typically discretionary, meaning that money managers can make trades on their own accord. While this may not appeal to the do-it-yourself investor, it effectively aligns the goals of the RIA with those of the client, whether it be to grow or simply preserve assets.

Conclusion
As with any investment, you need to understand what you are buying before you buy it. Before selecting a brokerage account, think about how you intend to use the account, whether you anticipate a high-level of trading activity, and the value you place on professional advice. Compare the cost of commission-based trades against the cost of a yearly fee.

If you like to day trade or you are confident in your ability to construct a sound portfolio, there may be no reason to pay for advice, and a discount broker may offer everything that you need. If you are comfortable with a commission-based compensation structure and have confidence in your advisor, a traditional brokerage account may be the right choice. If you prefer the benefit of professional assistance, a fee-based brokerage account may meet your needs. If you gather all the facts first and then make an informed decision, you are more likely to be happy with your choice regardless of the type of account you pick. (To learn more about fee-based investing, read Wrap it Up: The Vocabulary And Benefits of Managed Money.)

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