by Jack Waymire
If you are an investor working with a financial advisor, it is only reasonable to expect that your advisor will provide you with advice that is suited to your specific circumstances. This is important because while investors with similar objectives and circumstances (age, investment objective, risk tolerance, etc.) may pursue similar investment approaches, small differences between such approaches can lead to big differences in investment results.
For instance, if one investor’s portfolio is 40 percent in bonds and 60 percent in stocks, while another’s is 50/50, this may not seem like a big deal. However, over 20 or 30 years, this seemingly small allocation difference could add up to significant differences in investment performance.
The point here is that when you choose an investment advisor or broker to help you make investment decisions, it is crucial that you fully understand your financial professional’s approach to offering advice, both in terms of investing strategy and method of charging fees or commissions. For example, if one advisor charges much higher fees than another without achieving better investment results, you will end up with significantly less money in your account over time if you work with that advisor. In addition, if your financial professional’s method of charging fees is not aligned with your investment objectives or style, it could lead to investment decisions that are not in your best interests.
In this article, we look at the difference between fee-based and commission-based financial advisors and how to determine which method best fits your investment needs.
The Problem with Commissions and the Rise of Fee-Based Compensation Models
Historically, most stockbrokers worked on a commission basis. Whether they sold mutual funds, stocks or bonds, they charged clients a fee each time an investment transaction took place, both when an investment was originally purchased and when it was subsequently sold. Over time, the negative aspects of this business model, such as its tendency to encourage brokers to, in some cases, “churn” accounts by engaging in excessive trading in a client’s account to increase their compensation, led to the development of fee-based business models.
For investors seeking active long-term investment advice from an advisor, the fee-based approach to compensation has clear advantages to the commission model. Delinking advisor compensation from the number of trades made in a client’s account helps ensure that the advisor’s focus is where it should be: On providing you with the best financial advice possible.
There are two main models for offering fee-based advice:
1. Charging fees based on the amount of assets held with the advisor.
This business model aligns an advisor’s interests more closely with their clients than the commission model by rewarding the advisor for increasing the value of a client’s assets. For example, if your advisor helped your portfolio grow from $50,000 to $100,000, and the advisor charged 1 percent a year in portfolio management fees, the advisor’s compensation would rise with the assets in the portfolio.
2. Charging fees on an hourly basis.
This approach, often described as fee-only, also avoids the conflict of interests associated with the commission-based approach. Because an advisor charging by the hour is not motivated to recommend transactions to increase compensation, their advice can focus on optimizing your investment strategy.
Of these two fee-based models, the asset-based approach is currently more common among financial advisors. Advisors who use this approach are typically Investment Advisor Representatives (IARs) of Registered Investment Advisor (RIA) firms, whereas advisors charging for investment advice on an hourly basis are often Certified Financial Planners (CFPs).
Sometimes, IARs are also CFPs and offer both asset-based and hourly-based financial advice. IARs are generally considered to be fiduciaries who must act in your best interests when offering investment advice. Registered representatives, or stockbrokers, who are compensated via commissions are held to a lesser standard whereby they are expected to only sell you investments that are considered “suitable” given your financial circumstances.
The Hybrid Model
To make things more complicated, some IARs use what is known as a hybrid model, meaning they are licensed as both registered representatives and Investment Advisor Representatives. One reason for this is that certain financial products, such as variable annuities or public, nontraded REITs, have traditionally been sold by commission rather than as fee-based assets. However, this has changed in recent years and now, most of these assets can be purchased in fee-based advisory accounts.
Another reason for pursuing a hybrid model is to avoid what the SEC refers to as “reverse churning.” This occurs when an advisor sells you a long-term investment, such as a mutual fund or stock, and then charges you regular asset management fees even though he or she doesn’t advise you to do anything other than to hold the investments. If you plan to hold such investments for many years, in many cases, you would be better off paying an upfront commission to compensate the advisor rather than paying a yearly fee in perpetuity.
What Type of Approach to Financial Professional Compensation is Right for You?
The method of advisor compensation that is best for you will vary depending on your financial circumstances and approach to investing. However, here are some general guidelines to take into consideration:
- Fees based on the amount of assets being managed.
This has become a popular method of hiring an advisor for long-term, ongoing investment advice. By basing an advisor’s compensation on Assets Under Management (AUM), the conflicts of interest associated with commission-based compensation are avoided and your advisor is incentivized to help grow your assets. The method is typically best for investors who want their advisors to take charge of selecting investments for their portfolios, based on their investment objectives and risk profile. If you prefer to take a simple buy-and-hold approach to investing, or if you prefer to select some investments yourself, the models listed below may be preferable.
- Fees charged by the hour.
This method is similar to the AUM-based method of charging fees in that it removes the temptation for a financial professional to advise you to make transactions for the purpose of boosting their compensation. This approach can work well for investors who desire professional investment advice but prefer to take charge of the process of buying and selling securities, such as stocks, bonds and mutual funds, themselves.
This method is generally not well-suited for investors looking to build long-term wealth in conjunction with active advice from their investment advisor, given the conflict of interest associated with an approach where the stockbroker is incentivized to trade an account as often as possible. However, there are still some cases where it offers advantages over fee-based approaches. For instance, investors who make all of their own investment decisions often turn to discount commission-based brokers to conduct transactions.
Sophisticated investors who want a stockbroker’s advice, or the advice of the broker’s firm from time to time, may prefer paying commissions rather than paying a fee based on the value of their entire portfolio. In addition, investors who want professional advice in selecting their investments (but not necessarily in managing them) and intend to buy and hold investments for long periods of time may find it more economical to pay commissions rather than an ongoing advisory fee.
- Hybrid model.
This method typically uses both AUM fee-based and commission-based compensation and sometimes hourly-based fees as well. It enables an advisor to charge fees or commissions depending on which approach is more suited to an investor’s circumstances.
The proliferation of different methods for compensating financial professionals for their services can make it difficult to determine which method is best for you. However, as mentioned above, the method by which your advisor is compensated, as well as the amount of such compensation, can have a large impact on the performance of your investments. The above descriptions of these methods are designed to make it easier for you to understand the rationale behind each method and to pick the approach best suited to your individual circumstances.
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