Fees or Commissions: Which is better and why?
A Fee-Only financial advisor is an investment professional that charges a fee for their services. This fee can take the form of either a flat annual fee, an hourly rate, or a percentage of the assets they are managing for you. This is different from the “traditional” way that financial planning and investments have been sold which is through commission on product sales and investment transactions. All advisors need to get paid for their services, that’s a given, but how they are paid is extremely important and I’ll explain why in this article.
The First Difference is in the Services Provided
The fee-only advisor is not paid for selling specific investment products instead their fee is based on the advice they provide. This leads to a more comprehensive style of planning. While all advisors are different most fee-only advisors will be able to analyze your investment portfolio as a whole, provide detailed retirement projections, college planning, insurance analysis, help with real estate transactions, tax planning/preparation, and other financial goal based analysis. Broker/Dealers, who are paid through commissions, are more product oriented because they are paid for selling you a specific financial products. A broker may focus solely on a specific type of mutual fund (usually sold by the company he works for) because he can’t get paid for selling other investments. An insurance broker will only focus on selling you insurance and even though insurance is a tool for controlling risk, will sell you an insurance policy as an investment (like a whole life policy) because he gets a larger commission by doing so.
The Myth of the Free Financial Advisor
It’s a common misconception that some financial advisors will provide their services for free. This is blatantly false. No one works for free and if they did they would certainly go out of business very quickly. This myth arises because commissioned based brokers do not charge fees directly to the client and instead rely on hidden costs that the client pays when they purchase the aforementioned financial products. For example, if you invest $100,000 in a mutual fund from a broker you will most likely not pay anything directly to the broker but instead you will pay a 5% commission when you buy the fund (called a load). As well, you are charged ongoing expenses by the mutual fund oftentimes in excess of 1%. Just on this one investment you would have paid $5,000 up front and pay another $1,000 ongoing every year. Guess who gets some of this cash. That’s right, you “free” financial advisor.
For comparison, I am a fee-only advisor and I charge my clients 1.5% all the way down to 0.25% depending on the amount of assets I am managing. The average is somewhere around 1%. There are never any upfront loads, and because I am not incentivised to sell expensive mutual funds the ongoing expense rates of the funds I recommend average around 0.20%. A relative bargain compared to the above example and the service/advice is arguable much better.
Compensation is Closely Tied to Objectivity
Because of the way Fee-Only Financial Advisors are compensated they can be expected to have a greater degree of objectivity. Fee-Only advisors are able to look at the entire universe of investments (stocks, bonds, and mutual funds) and find the ones that are best suited for a client’s personal financial situation. This is in contrast to a broker who is limited to selling the investments of the company they work for or at the very least the ones that charge large commissions. Because their compensation is so closely tied to the investments it has a bearing on which ones they actually recommend. See the below graphic for how a commission based (broker/dealer) is compensated.
Wall Street Banks, Brokers, Commission, and Conflicts of Interest
Most brokers are employed by large “wire-houses” or brokerages. Some of the most notable are Goldman Sachs, Morgan Stanley, JP Morgan, Merrill Lynch, etc. The advisors that work for them are like self-employed independent contractors that have access to tools, facilities, back-office support, marketing materials, and many other benefits. While they use the firm's name to market their practice they still have their own book of business, their own expenses, and create their own income.
In order to work for these advisors to receive the support and benefits they are held to some important obligations. One of the biggest is that they provide the bank with a portion of the revenue they bring in from clients (many new advisors actually get fired for not bringing in enough revenue which is why it’s such a high turnover industry). As we know this revenue comes from commissions and the sale of financial products. So, the natural incentive for both the advisor and the investment bank is to sell more products and generate more revenue. The reward is now tied to actively trading (sometimes called churning) clients’ accounts in order to generate more and more commissions. This might be done under the guise of “changing market conditions” or “sector rotation” or many other reasons when in reality it is just increasing the payouts for advisor and bank alike.
Fee-Only investment advice by contrast is not rewarded or motivated by the frequency of trades in an account and therefore is more likely to only trade when necessary. In addition, when a trade is placed it is done with the total cost in mind as well as the suitability of the investment for the client.
Why not just skip the Fees altogether? The Do-it-yourself Investor.
In the last ten or twenty years there has been a rise in the do-it-yourself investors. The technology advancements has allowed discount brokerages to flourish and investment advice can be found literally for free on the internet. It might surprise you that I am actually big proponent of do-it-yourself investing. Hey, that’s how I started out. And since basic financial education is not taught in schools the more people get involved in their own finances the better. The risk I have seen is that while there is a lot of good information on the internet, there is also a lot of questionable advice as well. This is why investment professionals and financial advisors are still very much in demand. Unless you have the time, desire, and ability to learn, analyze, and monitor your portfolio (let alone your financial plan) you shouldn’t be doing it. You can cause a lot of damage to your financial situation if you do not understand the risks. As well, even if you are smart enough to determine how to design a beautifully diversified portfolio and accurately project retirement cash flows, do you want to spend the time doing it or do you want to pursue your other interests like career and family. It’s like changing the oil in your car, just because you can find out how to do it doesn’t mean you want to do it every few months. So if you decide to do-it-yourself then good for you. You will save some money and hopefully have fun doing it. If not, I highly suggest finding a fee-only financial advisor who can take care of it for you.
The fee-only financial advisor model allows investment professionals to take care of their clients’ best interests as well as make a rewarding career for themselves. While all advisors need to be paid for their services, the commission based model is wrought with conflicts of interest that at best costs you a lot of extra money and at worst could cause serious damage to your long-term financial goals. Be sure you know who you are hiring when speaking with a potential financial advisor. If you want to learn more about the fee-only model or experience it for yourself, please reach out. I’m here to help you reach your financial goals.
For more info check out our Financial Advisor Checklist for free. Use it when evaluating a potential financial advisor or making sure your current advisor is right for you.
Or read about the Fiduciary Standard and why it's so important.