Investment Advisors: Commissions Or Client Interests?

Investment advisors can be compensated in one of two ways: through flat fees or commissions. Commission-based investment advisors are paid by the financial companies whose products they sell to their clients. This can be through upfront, backend, or trailing commissions. Commissions can create a conflict of interest, as advisors may be incentivised to recommend options that pay them the most, rather than those that are best for their clients. Fee-based investment advisors, on the other hand, charge clients an annual percentage of the value of the client's portfolio or an hourly fee for their services.

Fee-based vs. commission-based

Investment advisors can be compensated in a few different ways, and it's important to understand the differences between these methods before choosing an advisor to work with. The two main categories of investment advisor compensation are fee-based and commission-based, and there is a third, more specific type of advisor called a fee-only investment advisor.

Fee-Based Advisors

Fee-based investment advisors charge the client an annual percentage of the value of the client's portfolio or an hourly fee for their services. A fee-based advisor who actively manages a portfolio for a client would typically charge a percentage of the assets under management. Most of the income earned by fee-based advisors is paid by clients, but a small percentage can come from commissions paid by brokerage firms, mutual fund companies, or insurance companies when the advisor sells their products.

Fee-based advisors are often required to be registered with the Securities and Exchange Commission (SEC), a governmental agency responsible for protecting investors. They must also disclose upfront how they receive compensation. Fee-based advisors are also tied to a fiduciary standard, meaning they must act in the best interests of their clients at all times.

Commission-Based Advisors

Commission-based investment advisors are paid by the financial companies whose products they sell to their clients. Their income is earned mostly or entirely from the products they sell or the accounts that their clients open. The more transactions they complete or the more accounts they open, the more they get paid.

Commission-based advisors are not required to be fiduciaries, but they must follow the suitability rule for their clients, meaning they can only buy and sell products that they believe are suitable for their clients' objectives and situation. This yardstick is fairly subjective, and advisors are not legally obligated to disclose conflicts of interest to clients.

Fee-Only Advisors

A fee-only advisor, unlike a fee-based advisor, never receives a commission for selling a financial product. They are paid exclusively by their clients and do not sell products. They work for their clients and charge an hourly rate, a fixed annual retainer, or a percentage of the investment assets.

Advantages and Disadvantages

There is no simple answer to which type of advisor is better, as it depends on the client's needs and situation. Fee-based advisors offer fewer conflicts of interest and tend to offer a more holistic service, but they are generally more expensive, especially as clients' portfolios increase over time. Commission-based advisors can be suitable for investors with smaller portfolios that require less active management, as there is little gain for them in paying a percentage fee every year.

Industry Trends

The financial advisory industry is shifting away from commission-based models toward fee-based models. This is due to concerns about the conflict-of-interest commissions present, an increasing trend toward advisory services and support beyond financial products, and the prevalence of SaaS (software as a service) solutions that help facilitate asset transactions.

Fiduciary duty

A fiduciary is a person or organisation that has a legal and ethical duty to act in the best interests of their client or customer. In the financial world, a fiduciary typically manages a client's assets and must put their client's interests first when making investment decisions.

Fiduciary relationships exist across many industries, including law, medicine, and finance. In finance, only certain types of financial advisors, such as certified financial planners and registered investment advisors, are bound by fiduciary duties.

There are two standards of care that apply to financial planners: the fiduciary duty and the suitability standard. The fiduciary standard requires the professional to act in the best interests of the client, whereas the suitability standard requires only that a financial advisor makes recommendations that are suitable for the client's needs, even if they are not the best choice.

Fiduciary duties tend to fall under two main categories:

Duty of Loyalty

This requires fiduciaries to prioritise the interests of their clients before their own, avoiding potential conflicts of interest that may impact their ability to make good decisions.

Duty of Care

This holds fiduciaries to a high standard of care, requiring that they make decisions prudently and in good faith. This duty can either be implicitly stated or spelled out in a contract, but it essentially requires professionals to exercise good judgment and make informed decisions.

Breaches of fiduciary duty can result in legal consequences, including lawsuits, penalties, and the loss of the fiduciary's professional credentials.

It is important to note that not all financial advisors are fiduciaries, and it is generally up to the client to verify whether a financial professional carries fiduciary status.

Pros and cons of fee-only advisors

Investment advisors can be compensated in one of two basic ways: by earning flat fees or by earning commissions. Fee-only advisors are paid a set rate for the services they provide rather than getting paid by commission on the products they sell or trade.

Pros of Fee-Only Advisors

• Transparency: Fee-only advisors generally provide transparency and don't face conflicts of interest tied to product sales.
• No hidden charges: Fee-only advisors don't receive commissions or referral fees, so there are no hidden charges.
• No conflicts of interest: Fee-only advisors are less likely to be influenced by sales commissions. They are also bound by fiduciary standards to always put their client's interests first and disclose any potential conflicts of interest.
• Objective advice: Fee-only advisors can offer more objective advice as they are not incentivised by sales commissions.

Cons of Fee-Only Advisors

• More expensive: Fee-only advisors are often more expensive than commission-compensated advisors, as they charge a percentage of the total assets under management.
• Limited scope: Fee-only advisors may have a more limited scope of products and services offered.
• Not totally disinterested: If a client wants to withdraw funds, a fee-only advisor being compensated by a portion of the assets under management may be biased against this.
• Not always competent: Being fee-only does not ensure that the advisor is competent or appropriate for a client's needs and profile.

Pros and cons of commission-based advisors

Pros of Commission-Based Advisors

• Commission-based advisors may be more cost-effective for clients who engage in infrequent transactions or require limited ongoing financial advice. In such cases, paying a commission for individual transactions can be less expensive than paying a flat fee or a percentage of assets under management.
• Commission-based advisors often have access to a diverse selection of investment products and services, allowing clients to choose from a wide range of options to meet their financial goals.
• Since commission-based advisors earn compensation based on the products they sell, they may be more motivated to recommend investments that perform well and help clients achieve their financial objectives.

Cons of Commission-Based Advisors

• Commission-based advisors may face conflicts of interest when recommending financial products and services, as they may be incentivized to recommend options that generate higher commissions rather than those that are in the client's best interest.
• Commission-based advisors are typically held to a "suitability" standard, which means they must recommend investments that are suitable for the client's needs and objectives, rather than the best available options. This suitability standard is fairly subjective and does not require them to act in the client's best interests.
• Advisors are not legally obligated to disclose conflicts of interest to clients, so unsuitable financial decisions can be hard to identify.
• The commission-based model may incentivize advisors to engage their clients in active trading, even if that is not in the client's best interests. This can lead to the unethical practice of "churning", where brokers excessively buy and sell securities in a client's account to generate transaction fees.

How to find a fee-only advisor

Investment advisors can be compensated in a few different ways. They may be fee-based, commission-based, or fee-only. Fee-based advisors collect a pre-agreed fee for their services, which can be a flat retainer or an hourly rate for investment advice. If they are actively managing a client's portfolio, they would typically charge a percentage of the assets under management. Commission-based advisors, on the other hand, are paid by the financial companies whose products they sell to their clients. They are compensated mostly or entirely from the products they sell or the accounts their clients open.

Fee-only advisors, unlike fee-based advisors, never receive commissions for selling financial products. They are paid a set rate for the services they provide and are compensated solely by their clients. They work for their clients and charge an hourly rate, a fixed annual retainer, or a percentage of the investment assets.

• The National Association of Personal Financial Advisors (NAPFA) is one of the largest professional organizations of fee-only financial advisors. You can search for an advisor on their website by zip code and area of specialisation.
• The Garrett Planning Network is another organisation of fee-only financial planners who primarily provide hourly advice. They also have a "find an advisor" function on their website.
• The Certified Financial Planner Board has a directory of financial advisors who hold the CFP designation. Being a CFP does not mean the advisor is fee-only, so be sure to check.
• The Financial Planning Association (FPA) has a database of financial planners that can be searched by location. You can easily filter the list to highlight fee-only planners, as their compensation is indicated in their profiles.
• FeeOnlyNetwork.com has a database of over 3000 firms that provide local or virtual services.

While fee-only advisors offer transparency and no conflicts of interest, they may be more expensive and offer a more limited scope of products and services. It is important to weigh the pros and cons of each type of advisor to determine which is the best fit for your needs.

Frequently asked questions