What is a 'Commission'
A commission is a service charge assessed by a broker or investment advisor in return for providing investment advice and/or handling the purchase or sale of a security. Most major, full-service brokerages derive most of their profits from charging commissions on client transactions. Commissions vary widely from brokerage to brokerage.
BREAKING DOWN 'Commission'The brokerage with the lowest commissions is not necessarily the best one. Discount brokerages and robo-advisors are gaining popularity in the 21st century. These services provide access to broad index funds and exchange-traded funds (ETFs) on a user-friendly platform that does not require meeting face to face with a broker or advisor. Clients pay very little in commissions or fees to use such services. The downside, however, is discount brokerages and robo-advisors typically offer no advice, which can prove troublesome for many rookie investors. On the other hand, full-service brokerages offer a more personalized service, but commissions are much higher.
Commissions vs. Fees
Often, brokers and financial advisors advertise themselves as being fee-based rather than commission-based. While the distinction may seem nebulous, it is actually a very important one for clients to understand. A fee-based advisor charges a flat rate for managing a client's money, regardless of the type of investment products the client ends up purchasing. This flat rate is either a set dollar amount or a set percentage of assets under management (AUM).
A commission-based advisor derives his income from selling investment products, such as mutual funds and annuities, and conducting transactions with the client's money. An advisor who is compensated in this manner can increase his income by selling higher commission products, such as annuities which are known for paying substantial commissions, and moving the client's money around more frequently.
When commission is charged, there is the potential for a conflict of interest to develop between brokerages and their clients. Because commission-compensated brokers do not get paid very much if their clients do not conduct many transactions, unethical brokers may encourage clients to conduct more trades than necessary.
Likewise, the worry exists that a commission-based advisor may try to steer his clients toward certain investment products, such as annuities or universal life insurance, that pay large commissions yet often do not serve the client's best interest. Advisors, whether compensated by fees or commissions, have a fiduciary responsibility to offer the most suitable investments to clients. However, the line is often hazy as to when an advisor is abdicating this responsibility for higher commissions.