There are many types of ways advisors are compensated and knowing what you are paying for can sometimes be difficult to understand. This article is designed to help you know the difference and ultimately to understand why a fee-only advisor is usually your best bet when it comes to finding the best financial advisor in retirement planning, tax planning, and investment management.
Fee-Based Financial Advisor
A fee-Based advisor collects a pre-stated fee for their services plus they can receive commissions from investments. That can be a flat retainer or an hourly rate for investment advice. If the advisor actively buys and sells investments for your account, the fee is likely to be a percentage of assets under management (AUM). This fee is pulled directly from your brokerage account, IRA, ROTH, or 401k.
It’s important to note that the income earned by fee-based advisors is largely paid by clients. However, fee-based advisors can still earn revenue from commissions paid to the advisor by brokerage firms, mutual fund companies, or insurance companies when the advisor sells their products. That is why it is important to make sure you understand all the fees. But if you want to make it simple on yourself just choose a fee-only advisor.
Within the compensated-by-fee realm of advisors, there can be a further, subtle distinction. In addition to fee-based advisors, there are also fee-only advisers whose sole source of compensation is fees paid by the client to the adviser.
For example, a fee-only adviser might charge $1,500 per year to review a client’s portfolio and financial situation. Others might charge a monthly, quarterly, or annual fee for their services.
Additional services, such as tax and estate planning or portfolio checkups, may also have fees associated with them. In some cases, advisers might require that clients have a minimum amount of assets, such as $500,000 to $1 million, before taking them on as a client.
Fee-only advisers have a fiduciary duty to their clients over any duty to a broker, dealer, or other institution. In other words, upon pain of legal liability, they must always put the client’s best interests first, and cannot sell their client an investment product that runs contrary to their needs, objectives, and risk tolerance.
They must conduct a thorough analysis of investments before making recommendations, disclose any conflict of interest, and utilize the best execution of trades when investing.
Commission-Based Financial Advisor
In contrast, a commission-based advisor’s income is earned entirely on the products they sell or the accounts that are opened.1 Products sold by commission-based advisors include such financial instruments 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 fiduciaries, but they don’t have to be. The laws state they must follow the suitability rule for their clients. That means that they can sell any products that they believe suit their clients’ objectives and situation.
The yardstick for suitability is a subjective one. They do not have a legal duty to their clients. Instead, they have a duty to their employers (e.g., brokers or dealers). Further, they do not have to disclose the conflicts of interest that can occur when a client’s interests clash with those who are compensating the advisor.
Criticisms of Commission-Based Advisors
Each investor can have their own investment goals, financial objectives, and risk tolerance level. One of the core criticisms of commission-based advisors is whether they keep the investor’s best interests at heart when offering a particular investment, fund, or security.
If the advisor is earning a commission from selling a product, how can an investor know, with certainty, that the investment being recommended is the best option for them? Perhaps it’s a product that primarily benefits the advisor. To better understand how commission-based advisors work, it’s important to know how they’re employed and compensated within the financial community. By far the biggest complaint with commissioned advisors is how their fees are hidden inside the products they sell.
How Commission-Based Advisors are Compensated
Many commissioned-based investment advisors (including full-service brokers) work for major firms, such as Edward Jones or Merrill Lynch. However, these advisors are employed by their firms only nominally.
Often, they resemble self-employed, independent contractors, whose income derives from the clients they can bring in. They receive little or no base salary from the brokerage or financial services company, though the firm may provide research, facilities, and other forms of operational support.
To receive this support from the investment firm, advisors have some important obligations. The most important of these provides the firm with its revenues. Advisors must transfer a certain portion of their income to the firm. This income is earned through commission-based sales.
The problem with this method of compensation is that it rewards advisors for engaging their clients in active trading, even if this investing style isn’t suitable for that client. It also may involve selling products that don’t benefit the client.
Furthermore, to increase their commissions, some brokers practice churning, the unethical activity of excessively buying and selling securities in a client’s account. Churning keeps a portfolio in flux, with the primary purpose of lining the advisor’s pockets with commissions from transaction fees.
The Huge Cost of Conflicted Investment Advice
A 2015 report, “The Effects of Conflicted Investment Advice on Retirement Savings,” issued by the White House Council of Economic Advisors, stated that “Savers receiving conflicted advice earn returns roughly 1 percentage point lower each year . . . we estimate the aggregate annual cost of conflicted advice is about $17 billion each year in 401k’s and IRA’s.”
Costs of Fee-Only Advisers
Fee-only advisers have their drawbacks too. They are often seen as more expensive than their commission-compensated counterparts. Indeed, the annual 1% they charge for managing assets seems steep. But this perception is usually brought on by the fact that commission-based investment products hide their fees and fee only advisor are completely transparent.
A small percentage charged each year can appear harmless at first glance, but it’s important to consider that the fee is often calculated based on total assets under management (AUM). It is also important to understand what services are included. Are you just getting investment management or are you also getting tax planning and estate planning as well. In some situations a good fee only advisor can more than cover their fee if they are provided true wealth management services.
Investors need to weigh the benefits received from the adviser’s services against the amount of fees that they pay as their portfolios grow over the years.
What’s more, although fee-only professionals help investors avoid the problems of churning, there should be no misunderstanding that brokerage commissions are not eliminated entirely. Investors still need to pay a brokerage firm to make trades. The brokerage may charge custodial fees for accounts as well. You can avoid these issues by choosing a fee only advisor that custodians with a low-cost provider such as Fidelity or Charles Schwab.
The Fiduciary Rule
The debate over fee-based versus commission-based compensation for advisors heated up in 2016, with the advent of the Department of Labor’s (DOL) Fiduciary Rule.
The ruling mandated that all those managing or advising retirement accounts, such as IRAs and 401(k)s, comply with a fiduciary standard. This conduct of impartiality involved charging reasonable rates as well as being honest about compensation and recommendations.
Most of all, it required that such professionals always put a client’s best interests first, and never operate contrary to their objectives and risk tolerance. Advisers could be held criminally liable if they violated these rules. Never fully implemented, the DOL’s Fiduciary Rule was rescinded in 2018.
Some fee-based advisers (such as money managers) already tended to be fiduciaries. In fact, if they were registered investment advisers, they were required to be. Commission-based advisors (such as brokers) weren’t required to be fiduciaries. Though never fully implemented, the Fiduciary Rule sparked fresh conversations about advisors’ conflicts of interest and transparency about their compensation. Many investors were unaware of both issues.
A report conducted by Personal Capital in 2017 found that 46% of respondents believed advisors were legally required to act in their best interests, and 31% either didn’t know if they paid investment account fees or were unsure of what they paid.
Here are 4 reasons to Go with a Fee-Only Advisor
Reason One: Fee-only financial planners do not make money on commissions.
When a financial advisor gets paid by commissions on products sold, their incentives may become skewed. Many “financial advisors” are incentivized to sell you insurance, annuities, or investment products that you may not really need or are not good for you.
Expensive life insurance products are being sold to young marine service members and others who don’t need them and can’t really afford them. My business partner used to work for a large financial services company in his 20s. They were pushing him to sell disability insurance since that’s where they can rake in higher commissions. Never mind that some of these clients already have disability insurance coverage through work and may not need an extra policy at all.
Fee-only financial planners do not get paid extra to recommend a product to you. There are no commissions, referral fees, etc. on advice or product recommendations given to you by a fee-only financial planner. The advice is for you and only you.
Reason Two: Fee-only financial planners are transparent with their fees.
With fee-only financial planners, you know exactly what you’re paying. No hidden fees or commissions.
Traditional fee-only financial advisors charge based on a percentage of assets that they manage. The typical fee is 1% of assets.
The more modern fee-based financial planners will charge a flat fee: either upfront (e.g. $1,500 to $4,000) or hourly (e.g. $200 to $400 an hour), or a flat retainer fee paid monthly or annually (e.g. $2,000 to $8,000). This fee schedule has been gaining popularity with Generation X and Millennials because a) it’s transparent; b) it allows them to hire a financial planner even with minimal assets; and c) they won’t get charged an arm and a leg once they have built a substantial amount of wealth.
Reason Three: Fee-only financial planners are not tied to a specific company, so they are free to provide a wide array of solutions.
If you work with a big box financial services firm, most likely the financial advisor will be encouraged to recommend mutual funds tied to that firm. And often, they won’t be the best option out there.
A fee-only financial planner can look at all available solutions in the marketplace and can recommend the best one for you.
For example, through intense competition of mutual funds to bring down their fees, there are now zero-fee mutual funds available. Z-E-R-O fees. Only fee-only financial planners can give you this kind of unbiased and money-saving advice.
Reason four: Fee-only financial planners act as a fiduciary, prioritizing your interests above their own.
The whole point of hiring a financial advisor is so that you can maximize your money and have it aligned with your goals and dreams.
It’s easier to trust someone if they have sworn a fiduciary oath to act in your best interest. You trust that your doctor is primarily concerned about your health because your doctor has a fiduciary responsibility.
It’s all about putting you, the client, first.
The Bottom Line
While you are dealing with your finances and investment portfolio, you must understand that hiring a fee-only advisor and fee-based advisor can make a huge difference. A fee-based advisor can steer you towards mutual funds which might not be suitable for you. Hence you need to be 100% sure if the advisor is working in your best interests or of the fund house or fund providing company. We at Davis Capital Management are one of the few companies in the country who has taken the fiduciary responsibility to act in customers’ interest.
Hence, it is advisable that you go for a fee-only advisor and who works in your favor and for the overall benefit of your investment portfolio so that it grows along with the growth of the advisor due to your portfolio’s success. Also, a fee-only investor would be a fiduciary and follow such standards to earn benefits over the success of your portfolio and not on the sale of a product. You can look out for investors registered with designated bodies.
Of all the available options whichever you choose, make sure your advisor works in the best interest of your portfolio and does not focus on self-interest only.