Fee-based vs. commission-based: an overview
The field of investment advisory includes various professionals. Some advisers are money managers and stockbrokers who analyze and manage investment portfolios. Other financial advisors focus on financial planning and often participate in other aspects of the client’s financial life, such as real estate, university financial assistance, retirement and tax planning.
However, regardless of the field of investment advisors, advisors usually fall into one of two categories: fees (or only fees) and commissions. Fee-based consultants usually charge their clients a flat rate (or “a la carte” rate), while commission-based consultants compensate with commissions earned on financial transactions and products.
Which consultant is better is a question almost as old as the industry itself. However, investors must understand the differences between the two and ultimately understand the fees and commissions of investment managers or financial advisors.
- Paid consultants charge pre-defined fees for their services, which may include fixed fees or hourly rates for investment advice.
- A fee-based consultant responsible for actively managing the investment portfolio may charge a certain percentage of the assets under management.
- The income of commission-based consultants comes entirely from the products they sell or the accounts they open.
- A hotly debated topic is whether commission-based advisors take the best interests of investors in mind when selling investments or securities.
Fee-based financial advisor
Paid consultants will charge a predetermined fee for their services. This can be a fixed fixed fee or an hourly rate for investment recommendations. If the advisor proactively buys and sells investments for your account, the fee may be a percentage of the assets under management (AUM).
It is important to note that the income earned through fees-based on The consultant’s income mainly comes from the fees paid by the client. However, a small portion of the income can be obtained through commissions for the sale of products from brokerage companies, mutual fund companies, or insurance companies.
In the field of consultant fees, there may be further subtle differences between consultants. In addition to fee-based consultants, there are fee-based consultants. The only source of remuneration is the fees paid by the client to the consultant.
For example, an advisor may charge $1,500 per year to review the client’s investment portfolio and financial situation. Other consultants may charge monthly, quarterly or annual fees for their services. Other services, such as tax and estate planning or investment portfolio inspections, will also charge related fees. In some cases, consultants may require clients to have a minimum amount of assets, such as US$500,000 to US$1 million, before considering them as clients.
Compared with any liability to brokers, dealers or other institutions, fee-based consultants have fiduciary responsibilities for their clients. In other words, in the pain of assuming legal responsibility, they must always put the best interests of their customers first and cannot sell investment products that violate their needs, goals, and risk tolerance to customers. They must conduct a thorough analysis of the investment before making recommendations, disclose any conflicts of interest, and use the best deal execution when investing.
Commission-based financial advisor
In contrast, commission-based consultants’ income comes entirely from the products they sell or the accounts they open. Commission-based advisory products include financial instruments such as insurance packages and mutual funds. The more transactions they complete or the more accounts they open, the more they get paid.
Commission-based advisors can be trustees, but they don’t have to. The law requires them to abide by the customer’s suitability rules, which means they can sell any product they think suits the customer’s goals and circumstances—although the suitability measure is a rather subjective standard. They have no legal obligation to customers; instead, they have an obligation to hire a broker or dealer. In addition, they do not have to disclose conflicts of interest, which can occur when the interests of the client conflict with the person who compensates the consultant.
Criticism of commission-based consultants
Every investor can have his own investment goals, financial goals and risk tolerance. One of the core criticisms of commission-based consultants is whether they put the best interests of investors in mind when offering specific investments, funds, or securities. If consultants earn commissions from selling products, how can investors know with certainty that the recommended investment is their best choice, or just the most profitable product that benefits the consultant? In order to better understand how commission-based consultants work, it is important to understand their employment and salary in the financial industry.
How commission-based consultants get paid
Many commissioned investment advisors (including full-service brokers) work for large companies such as Edward Jones or Merrill Lynch. But these consultants are only nominally employed by their company. Usually, they are similar to self-employed independent contractors, whose income comes from the customers they can bring. They receive little or no basic salary from a brokerage or financial services company, although the company may provide research, facilities, and other forms of operational support.
In order to obtain this support from the investment company, the consultant must assume some important obligations. One of the most important is to provide income to the company: the consultant must transfer part of his income to the company, which is obtained through commission-based sales.
The problem with this compensation method is that even if this investment style is not suitable for the client, it will reward the adviser who engages the client in active transactions. In addition, in order to increase their commissions, some brokers will stir up, which is an unethical practice of excessive buying and selling of securities in client accounts. Churning keeps the investment portfolio constantly changing, the main purpose of which is to add fuel to the consultant’s pocket.
$17 billion in investment proposal conflict costs
This will cost investors. The 2015 report “Impact of Conflicting Investment Recommendations on Retirement Savings” issued by the White House Council of Economic Advisers stated that “the annual return for savers who received conflicting recommendations was about 1% lower…We estimate that the total annual cost is a conflicting recommendation. Approximately 17 billion U.S. dollars each year.”
Fees for fee-based consultants
Fee-based consultants also have their disadvantages. They are generally regarded as more expensive than their commissioned counterparts. In fact, their annual asset management fees of 1%-2% will erode returns. The small amount of fees charged each year may seem harmless at first glance, but it is important to consider that fees are usually calculated based on the total assets under management (AUM).
For example, a 30-year-old millennial invests US$50,000 in a fee-based consultant and charges 1% of the AUM, and may pay US$500 per year. However, when the value of the portfolio is US$300,000, the 1% fee is equivalent to US$3,000 per year. When the portfolio reaches $1 million, the seemingly innocuous 1% fee will jump to $10,000 per year.
Investors need to weigh the benefits from advisory services and the ever-increasing fees paid by investors as the investment portfolio grows year by year. Moreover, although professionals who only charge fees help investors avoid the problem of churn, it should not be misunderstood that brokerage commissions have not been completely eliminated. Investors still need to pay a fee to the brokerage company to conduct the actual transaction. Brokers may also charge account custody fees.
In 2016, with the introduction of the Department of Labor (DOL) trust rules, the debate about consultants’ compensation and commissions intensified. The ruling requires everyone who manages or recommends retirement accounts, such as IRA and 401(k), to comply with fiduciary standards. This kind of fair behavior includes charging reasonable rates, treating rewards and suggestions honestly, and most importantly, always putting the best interests of customers in the first place, and never going against their goals and risk tolerance. If consultants violate these rules, they may be held criminally responsible.
Fee advisers (such as money managers) have tended to become trustees; in fact, if they are registered investment advisers, they must be. Commission-based advisors (such as brokers) do not need to be trustees. DOL’s trust rules were never fully implemented and were abolished in 2018. However, it did spark a new conversation about consultants’ conflicts of interest and salary transparency. Many investors are unaware of these two issues.
In a report conducted by Personal Capital in 2017, they found that 46% of respondents believe that the law requires consultants to act in their best interests, and 31% either don’t know if they pay for investment accounts or are unsure of what they pay. .
There is no simple answer to which one is better-a fee-based consultant or a commissioned consultant. Entrusted services may be suitable for investors with smaller portfolios that require less active management. In the long run, occasional commission payments are unlikely to erode all the returns of the portfolio. However, for investors with large portfolios that require active asset allocation, a fee-only investment advisor may be a better choice. The key is to understand in advance why a consultant would recommend an investment to ensure that it represents your best interests.