What Is a Fee-Based Investment?
A fee-based investment is a product that is recommended by a financial planner whose compensation includes a sales commission paid by the investment provider in addition to the fees paid by the client. Fee-based investments may be offered by investment companies, banks, or other financial institutions.
A fee-only investment is recommended by a financial planner who is solely compensated in fees paid by the client.
Confusingly, a "fee-based advisor" may charge clients an annual flat percentage for all financial services. This advisor may or may not receive commissions for recommending fee-based investments.
- A financial planner who recommends a fee-based investment is receiving a sales commission from the investment provider as well as fees from the investor.
- A financial planner does not receive a commission for recommending a fee-only investment.
- In either case, the client will be charged a fee, which might be an hourly rate or a flat annual percentage of the account assets.
- An investor should ask how the financial planner will be compensated.
The terminology of the profession can be confusing. A "fee-based advisor" may charge clients a fee but also receive commissions from sponsoring companies for recommending specific investments. That's why the client needs to ask exactly how the advisor will be compensated.
How Fee-Based Investments Work
There is a wide range of fee-based investments from annuities to mutual funds, stocks, bonds, and other securities. In any case, the advisor whose client buys the asset is paid a commission from the sponsoring company for selling it.
The term fee-based is also used to describe a hybrid advisor, who charges fees to certain clients and earns commissions by selling products to others.
About Investment Fees
An investment advisor may charge a fee for each service or a fixed annual percentage of the assets under management (AUM). Annual fees average 1% to 3% and cover most or all of the services a client receives from the advisor.
The commissions paid to an advisor are often folded into the cost to the investor. For example, the expense ratio of a mutual fund includes commissions paid to the advisors who recommend it to their clients.
The commission is an annual one and will be paid to the advisor for as long as the client owns the investment. It is a source of recurring revenue for the advisor.
Fee-based investments can represent a conflict of interest. Advisors have a financial incentive to sell the product that offers them the best commission rather than what is best for the client.
Fee-based advisors, as well as fee-only advisors, are constrained by professional regulations. Financial advisors may follow one of two standards, fiduciary or suitability.
- Advisors who follow the fiduciary standard are required to put the interests of their clients before their own when they recommend investments.
- Advisors who follow the suitability standard are required to recommend investments that meet the needs of the client in terms of the client's age, income, retirement goals, and other individual characteristics.
In either case, advisors are required by Securities and Exchange Commission (SEC) rules to disclose their compensation to the client.
Advisors who follow fiduciary standards often describe themselves as "fiduciary financial advisors." They may also be members of the National Association of Personal Financial Advisors (NAPFA), an association of fee-only advisors.
In any case, there are a number of questions that a prospective client can ask an advisor before committing to a financial product.
Questions to Ask Your Advisor
Not all advisors volunteer information about the fees or commissions they receive. Investors can ask the following questions:
- What are your professional qualifications and educational background as it relates to financial advice?
- What is your particular area of expertise?
- Are you paid client fees, commissions, or a combination of both?
- Do you adhere to a fiduciary standard?
- Why are you recommending this product to me? Why is it suitable for me?
This doesn't mean investors should avoid fee-based advisors. They may be better for clients who want to avoid at least some of the fees for the services they receive.
Fee-Based Investments vs. Fee-Only Investments
A fee-based advisor may collect a fee from the client and a commission from the investment sponsor for some products, or just a fee or just a commission for others. Some clients may pay lower or no fees for recommendations that earn the advisor a commission.
For this reason, some investors may prefer a fee-based investment advisor. The overall fees paid for the investment advisor's services may be lower.
Fee-only advisors do not accept sales commissions from investment product companies. They are seen as being free of potential conflicts of interest. To use the industry terminology, they follow a fiduciary standard rather than a suitability standard.
Example of a Fee-Based Investment
Here's a hypothetical example to show how fee-based investments work. Let's say Mr. Sharma wants to set up a retirement account and meets Ms. Jones, a fee-based financial advisor. She suggests that he set up an investment account.
Ms. Jones makes an assessment of Mr. Sharma's current financial situation as well as his goals for the future. After drawing up a plan, Ms. Jones suggests that Mr. Sharma put his money in a series of stocks, bonds, mutual funds, exchange-traded funds (ETFs), and other investment vehicles. As part of her compensation, Mr. Sharma pays her a 1% fee for her advisory services. She may also receive a commission from some of the investments she sells.
What Is the Difference Between Fee-Based and Fee-Only?
A fee-based investment product is recommended by a financial advisor who will receive a commission for its sale. The commission may be included in the annual fees charged by the company that sponsors it and be paid annually to the advisor as long as the investor holds it.
A fee-only investment does not come with a commission paid to the advisor. The advisor is reimbursed only through fees the client pays.
What Is the Difference Between Fee-Based and Commission-Based?
There is little or no difference between a fee-based investment product and a commission-based product.
In both cases, the company that sponsors the product is paying a commission to the advisor who successfully recommends it to a client.
In both cases, the client may or may not pay additional fees for the services of the advisor.
What Are Fee-Based Services?
The term fee-based services is a source of confusion.
Usually, a fee-based service is offered by a financial advisor who charges an annual percentage of the client's assets as a flat fee for all or most professional services. The average fee is 1% to 3% of the assets.
This is not the same as a fee-based investment, which is a product that pays a commission to the advisor for selling it to clients.