Fee-Based vs. Commission-Based: An Overview
The investment advisor field encompasses a variety of professionals. Some advisors are money managers and stockbrokers who analyze and manage portfolios. Other financial advisors focus on financial planning and are often involved in other aspects of a client's financial life, such as real estate, college financial aid, retirement, and tax planning.
However, regardless of the area of focus of the investment advisor, advisors typically fall into one of two categories; Fee-based (or fee-only) and commission-based. Fee-based advisors usually charge their clients a flat rate (or an "à la carte" rate), while commission-based advisors are compensated by commissions earned from financial transactions and products.
Which sort of advisor is better is a question that's almost as old as the profession itself. However, it's important for investors to understand the differences between the two and ultimately, the cost of a fee-based versus a commission-based investment manager or financial advisor.
- A fee-compensated advisor collects a pre-stated fee for their services, which can include a flat retainer or an hourly rate for investment advice.
- A fee-based advisor charged with actively-managing a portfolio would likely charge a percentage of the assets under management.
- 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.
Fee-Based Financial Advisor
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. If the advisor actively buys and sells investments for your account, the fee is likely to be a percentage for 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.
Within the compensated-by-fee realm of advisors, there can be a further, subtle distinction between the advisors. In addition to fee-based advisors, there are also fee-only advisors in which their sole source of compensation is fees paid from the client to the advisor.
For example, an advisor might charge $1,500 per year to review a client's portfolio and financial situation. Other advisors might charge a monthly, quarterly, or annual fee for their services. 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.
Fee-only advisors have a fiduciary duty to their clients over any duty to a broker, dealer, or other institution. In other words, upon pain of legal liability, they must always put the client's best interests first, and cannot sell their client an investment product that runs contrary to their needs, objectives, and risk tolerance. 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.
Commission-Based Financial Advisor
In contrast, a commission-based advisor's income is earned entirely on the products they sell or the accounts that are opened. Products for commission-based advisors include financial instruments, such as insurance packages and mutual funds. The more transactions they complete, or the more accounts they open, the more they get paid.
Commission-based advisors can be fiduciaries, but they don't have to be. The laws state they must follow the suitability rule for their clients, which means they can sell any products they believe suit their clients’ objectives and situation—although the yardstick for suitability is a fairly subjective one. They do not have a legal duty to their clients; instead, they have a duty to their employing brokers or dealers. Further, they do not have to disclose conflicts of interest, which can occur when the client's interests clash with those who are compensating the advisor.
Criticisms of Commission-Based Advisors
Each investor can have their own investment goals, financial objectives, and risk tolerance level. One of the criticisms that lies at the core of commission-based advisors is whether they keep the investor's best interests at heart when offering a particular investment, fund, or security. If the advisor is earning a commission from selling a product, how can an investor know, with certainty, that the investment being recommended is the best option for them or merely the most profitable product offering that benefits the advisor? To better understand how commission-based advisors work, it's important to see how they're employed and compensated within the financial community.
How Commission-Based Advisors are Compensated
Many commissioned-based investment advisors (including full-service brokers) work for major firms, such as Edward Jones or Merrill Lynch. But these advisors are employed by their firms only nominally. More often than not, they resemble self-employed, independent contractors, whose income derives from the clients they can bring in. They receive little or no base salary from the brokerage or financial services company, though the firm may provide research, facilities, and other forms of operational support.
To receive this support from the investment firm, advisors are held to some important obligations. The most important of these provides the firm with its revenues: Advisors must transfer a certain portion of their earnings to the firm, earned through commission-based sales.
The problem with this method of compensation is that it rewards advisors for engaging their clients in active trading, even if this investing style isn't suitable for that client. Furthermore, to increase their commissions, some brokers practice churning, the unethical practice of excessively buying and selling securities in a client's account. Churning keeps a portfolio constantly in flux, with the primary purpose of lining the advisor's pockets.
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…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.
Investors need to weigh the benefits received from the advisor's services with the ever-increasing amount of fees that'll be paid by the investor as the portfolio grows over the years. And although fee-only professionals help investors avoid the problems of churning, there should be no misunderstanding that brokerage commissions are not eliminated entirely. Investors still need to pay a brokerage firm to actually make trades. The brokerage may charge custodial fees for accounts as well.
The Fiduciary Rule
The debate over fee-based versus commission-based compensation for advisors heated up in 2016, with the advent of the Department of Labor's (DOL) Fiduciary Rule. The ruling mandated that all those managing or advising retirement accounts, such as IRAs and 401(k)s, comply with a fiduciary standard. This conduct of impartiality involves charging reasonable rates, being honest about compensation and recommendations, and most of all, always putting the client's best interests first, never running contrary to their objectives and risk tolerance. Advisors can be held criminally liable if they violate these rules.
Fee-based advisors (like money managers) already tended to be fiduciaries; in fact, if they were registered investment advisors, they were required to be. Commission-based advisors (like brokers) weren't required to be fiduciaries. Never fully implemented, the DOL's Fiduciary Rule was rescinded in 2018. However, it did spark fresh conversations about advisors' conflicts of interest and transparency about their compensation, which many investors were unaware of both issues.
In a report conducted by Personal Capital in 2017, they found that 46% of respondents believed advisors were legally required to act in their best interests, and 31% either don't know if they pay investment account fees or are unsure of what they pay.
The Bottom Line
There's no one simple answer to which is better—a fee-or a commissioned-based advisor. Commissioned services might be suitable for investors with a smaller portfolio where less active management is required. Paying the occasional commission is not likely to erode all of the portfolio's returns over the long-term. However, investors with large portfolios who need active asset allocation, a fee-only investment advisor might be the better option. The key is to understand upfront, why an advisor is recommending a certain investment to ensure that you're best interests are being represented.