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Fee-only, Fee-based and Commission-based. How Financial Professionals Get Paid, and How It Affects You.

BLOG, EDUCATION  |  26 Jan 2010

At the conclusion of my gripping piece on the differences between financial professionals of varying titles (Brokers, Advisors and Planners! Oh My!), I promised you a follow-up article of equal or greater value on the topic of compensation. Well, here it is. I have to warn you that you probably shouldn’t read this near your bed time, because it’s pretty exciting, and it may be hours before your heart rate returns to normal. And here’s a spoiler: We are fee-only financial advisors, and we think that’s the arrangement that benefits our clients the most.

Commission-based Compensation

First of all, just about everyone understands what it means to be compensated by commissions. In my last article I explained that this is the way brokers are paid. You buy a stock from them, and they charge you a commission on the sale. “Full-service” brokers charge a much higher commission than discount brokers because full-service brokers want to be compensated for the advice that gave you, even though in the eyes of the law that advice was “merely incidental” to the sale.

In addition to brokers, some registered investment advisors receive all of their compensation in the form of commissions. These commissions can either be paid by the client directly, like a brokerage commission, or they may be paid to the advisor by mutual fund companies, or insurance companies. When compensation is based on commissions, there is a great potential for conflicts of interest. Commission-based advisors are only paid if a client buys a product. There is an incentive to conduct transactions that may not necessarily be in the client’s best interest. Because all registered investment advisors act as fiduciaries, these potential conflicts of interest must be disclosed to clients.

Fee-based Compensation

There are also registered investment advisors whose compensation is “fee-based”. Many consumers confuse fee-based with fee-only compensation, and that is unfortunate because there are some critical differences. Fee-based advisors receive some of their compensation directly from their clients, but they are also free to accept commissions from the companies whose financial products they sell. Often, the details of these commissions are not readily apparent in the client’s statement. Like the pure commission-based model, fee-based compensation creates many potential conflicts of interest because the advisors income is affected by the number of transactions conducted and by which products are selected.

In the last several years, many brokers have also started offering “fee-based” accounts to their clients, presumably in response to the shift of assets away from brokers to registered investment advisors. Under this arrangement, the broker will normally charge a flat annual fee based upon the amount of assets the client holds at the broker, but the broker will also earn money on sales commissions for the products they sell. Those commissions are paid to the broker directly by the company providing the product, but it is usually the client who pays for this indirectly when the product provider charges a sales load. As you may recall, brokers owe their duty of loyalty to their employer, not to their clients. The fact that a brokerage account is fee-based does not change that fact.

Fee-only Compensation

Of the three compensation methods discussed in this article, fee-only is the only one that is not commission-driven. Fee-only advisors only accept compensation from their clients and will not accept commissions or other incentives from companies whose product they recommend. Whether they charge an hourly fee, a flat fee, or a percentage of assets under management, fee-only advisors have made a pledge to their clients not to accept compensation from outside sources. The fee-only model is designed to ensure impartiality, honesty and independence, and thus it enables fee-only planners to truly act in their clients’ best interest. Although all registered investment advisors are required to act as fiduciaries with respect to their clients, the fee-only model is the only method of the three that really encourages advisors to follow that standard by eliminating the conflicts of interest inherent to the other two methods.

As I stated at the beginning of this piece, we have chosen to work under the fee-only method of compensation. In our view, this way of doing business gives our clients confidence that everything we do on their behalves is done for their benefit, not ours. We recognize that there are honest, good-intentioned professionals who chose to work under different compensation structures, but too often their clients are unaware of the conflicts of interest that exist between themselves and the people they put their trust in. As long as full disclosure is made, and as long as that disclosure is plain and clear, there is room in the world for all types of financial professionals.