Fee-based Advisors vs. Commission-based Advisors

by Bill Sweet

I met with a client yesterday to see if it made sense to leave her 401(k) account at her old company or roll it over to another type of account. I have about 10-20 of these types of conversations per week.

One of her very wise questions was that she wanted to know what potential fees she would be facing with each choice, and if it made sense to leave her 401(k) account open at her company because "it isn't costing me anything."

Unfortunately, she was wrong about her 401(k) plan being free. Nobody manages your money for free, and it's rather difficult in some cases to figure out what exactly you're paying to who. Federal laws supposedly went into place to make 401(k) and other ERISA plans more transparent as far as the fees that plan participants are paying, but I haven't seen this in action with a single 401(k) statement yet here in the real world.

There are several different ways to compensate your financial advisor. Personally, I think that this advisor should be independent (not captive) and act & make recommendations in your best interest. Even among advisors who can say this, there are still many different types of financial advisors and planners, and how they are compensated varies pretty wildly.

In the old days, just about every advisor was basically a commission-based broker. You picked up the phone, called your broker to buy or sell this or that, they placed the order, and got a cut of the action up front. This type of broker does still exist out there, but they are tough to find. Mutual funds came along and in addition to front- or back-end fees, there were (and are) also distribution (12b-1) fees that the advisor could receive.

A commission-based advisor typically receives payment upon opening an account for a client, usually a percentage (4-8%) of the initial investment. A-share mutual funds operate in this manner. In the event of an investment decline, the commission-based advisor isn't theoretically affected, since they have already collected their fee. In my mind, two of the most valid criticisms of the commission-based model is that advisors must constantly seek new investment in order to maintain their compensation, which can lead to less focus on existing clients, as well as the fact that any fees paid at the beginning of an investment aren't in the account to compound in time. However, in contrast to the fee-based model, once the initial transaction is complete, the on-going investment management fees are lower.

Recently, fee-based advisors, those who collect either a flat fee for investment advice, or based on percentage of assets under management, have become very popular. Growth in this area is not just at large investment banks, but also smaller Registered Investment Advisory firms.

Fee-based advisors tend to claim that their advice is conflict-free to the client since they collect a fee regardless of investment performance or recommendation (hence, they claim to be agnostic). In fact, fee-based advisors receive additional compensation if their client's portfolios gain in value, since as portfolio values grow, so does the advisor fees (the opposite is also true). These fees are collected through time, meaning that there is usually no up-front cost, but rather an ongoing relationship that continues until the client moves the money or spends down their assets. These fees can and do act as a drag on investment performance over time.

A solution to the drag of fees might be to negotiate a flat fee on an annual or quarterly basis for financial planning and advice. This is probably the least conflicted solution, since an investment advisor probably doesn't work 10 times harder managing a $10 million portfolio instead of a $1 million portfolio. However, this model would require an annual fee of several thousands of dollars, meaning it would probably only sense if you have a high amount of wealth to manage.

There is a lot of angst going on in the financial community over which of these compensation models is the best. Here is a fantastic article by Chris Latham discussing some of the issues at stake. I think he does a great job at capturing some of the nuance.

I don't personally believe that any one compensation arrangement is necessarily superior to another - there are pros and cons to each option. Just like I believe that there are no one-size-fits-all investments, I also don't believe there is a one-size-fits-all compensation arrangement with your financial professional. Some things simply work better or worse for different people, and the world is more complicated than black and white.

I strongly believe in putting my client's interests first and recommending the compensation arrangement that makes the most sense for what they are seeking as far as relationship & services. I'm definitely talking my own book, but I think that is the type of financial planner that you should look for too.