The investment advisor field encompasses a variety of professionals. Some advisors are money managers and stockbrokers who analyze and manage portfolios. Other financial advisors focus on financial planning and often help with other aspects of a client's financial life, such as real estate, college financial aid, retirement planning, and tax planning.
However, regardless of the area of focus of the investment advisor, they typically fall into one of two categories: fee-based (or fee-only) and commission-based.
Investopedia refers to investment professionals with a strict fiduciary responsibility who advise clients or manage their financial assets as "advisprs." We refer to investment professionals who follow the suitability standard as "advisors."
Fee-based advisors usually charge their clients a flat rate (or an "à la carte" rate), while commission-based advisors are generally compensated by commissions earned from financial transactions and product sales. Before choosing what type of money manager to work with, it's key to understand the differences between fee-based advisors and commission-based advisors and, ultimately, the costs of each.
Key Takeaways
- A fee-based advisor collects a pre-stated fee for their services, which can include a flat retainer or an hourly rate for investment advice.
- A fee-based advisor actively managing a portfolio would likely charge a percentage of the assets under management.
- A commission-based advisor's income is earned entirely from the products they sell or the accounts that are opened.
- A hotly debated topic is whether commission-based advisors keep the investor's best interests at heart when selling an investment or security.
- Some fee-only advisors may require a minimum account balance of $500,000 to $1 million.
Fee-Based Financial Advisors
A fee-based advisor collects a pre-stated fee for their services. 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).
It's important to note that the majority of income earned by fee-based advisors is paid by clients. However, a small percentage of their revenue can be earned from commissions paid to the advisor by brokerage firms, mutual fund companies, or insurance companies when the advisor sells their products.
Fee-Only Advisors
Within the compensated-by-fee realm of advisors, there is a further, subtle distinction. Fee-only advisors are professionals whose compensation is solely composed of fees paid by the client to the advisor.
For example, a fee-only advisor might charge $1,500 per year to review a client's portfolio and financial situation. Other fee-only advisors might charge a monthly, quarterly, or annual fee for their services.
Additional services, such as tax and estate planning or portfolio checkups, would also have fees associated with them. In some cases, advisors might require that clients have a minimum amount of assets, such as $500,000 to $1 million, before taking them on as a client.
Fiduciary Duty
Fee-only advisors have a fiduciary duty to their clients over any duties to other brokers, dealers, or institutions. 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 Advisors
In contrast to a fee-based financial advisor, a commission-based advisor's income is earned entirely on the products they sell or the accounts that are opened. Products sold by commission-based advisors 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 fiduciaries, but they don't have to be. US laws state these advisors must follow the suitability rule for their clients. That means that these advisors can only buy and sell products that they believe to suit their clients’ objectives and situation.
The yardstick for suitability is a fairly 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
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 since each investor has their own unique investment goals, financial objectives, and risk tolerance level.
If the advisor earns 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 actually 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.
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.
More often than not, 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 support from investment firms, advisors have some important obligations. The most important of which provides firms with 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 system 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 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."
Costs of Fee-Only Advisors
Fee-only advisors have their drawbacks too. They are often seen as more expensive than their commission-compensated counterparts. Indeed, the annual 1%-2% they charge for managing assets will eat into returns.
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).
For example, a millennial who is 30 years old and has $50,000 invested with a fee-only advisor who charges 1% of AUM might pay $500 per year. However, when the portfolio is valued at $300,000, that 1% fee equates to $3,000 per year. And when the portfolio reaches $1 million, that seemingly harmless 1% fee jumps to $10,000 per year. Compounded over many years, these costs add up and can make a dent in what your portfolio might have returned.
Investors need to weigh the benefits received from the advisor's services against the ever-increasing 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 actually make trades. The brokerage may charge custodial fees for accounts as well.
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. Advisors 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 advisors (such as money managers) already tended to be fiduciaries. In fact, if they were registered investment advisors, 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.
Frequently Asked Questions (FAQs)
Is it better to have a fee-based or commission-based financial advisor?
There's no simple answer to which is better—a fee- or a commissioned-based advisor. Commissioned services might be suitable for investors with smaller portfolios which require less active management. Paying the occasional commission is not likely to erode all of the portfolio's returns over the long-term. However, for investors with large portfolios who need active asset allocation, a fee-based investment advisor might be the more sustainable option. The key for investors is to understand upfront why an advisor recommends a certain investment to ensure that it's in their best interests.
What does fee-based mean?
The term 'fee-based' describes a kind of financial advisor who receives some or all of their income from fees paid to the advisor by the client. Many fee-based advisors not only receive pay from clients but also earn commission from brokerage firms, mutual fund companies, or insurance companies when they sell products. Fee-only advisors are a subsect of fee-based advisors who do not earn commission, so they are exclusively paid by clients.
What is the disadvantage of a commission-based advisor?
Since commission-based advisors earn income through sales commissions, they have incentive to engage their clients in active trading, even if that investing style does not act in favor of clients' best interest. The unethical practice of excessively buying and selling clients' securities is called churning. The suitability rule in U.S. law is meant to stifle unethical trading, by mandating Commission-based advisors to only act in accordance with clients' situations, but this rule is highly subjective. Plus, advisors are not legally obligated to disclose conflicts of interest to clients, so unsuitable financial decisions can be hard to identify,
The Bottom Line
While fee-based advisors are paid at predetermined rates, either exclusively or in addition to smaller commissions from sales, commission-based advisors are compensated based on the products they sell and accounts they open for clients. Commission-based advisors have external incentives to keep clients' portfolios in flux to maximize their incomes, even if these decisions are not in clients' best interests, but fee-based advisors are generally more expensive, especially as clients' portfolios increase over time. Knowing the benefits and drawbacks of each kind of advisor can help you determine what kind of services would best fit your needs.
