One of the most confusing things in the financial services industry is trying to understand how financial advisors and financial planners charge for their services. Many people we talk to who have investment accounts at other institutions don’t understand how they’re paying their advisor, or how much they’re paying. Some don’t even realize they’re paying their advisor at all! It doesn’t help that the lingo we use can be confusing. Case in point: fee-based versus fee-only. There’s a subtle but important difference between those two fee structures.
Commissions and Fees
To understand the difference between fee-based and fee-only compensation structures, it’s important for you to understand the two primary sources of compensation for financial advisors: commissions and fees. Commissions are typically earned as a result of selling a product. For example, if an advisor sells a mutual fund to you, the mutual fund company might pay a commission to the financial advisor. While the advisor receives the payment from the mutual fund company, ultimately you end up paying that commission, and it reduces the returns in your mutual fund.
Commissions can also be earned by selling insurance policies, individual stocks, individual bonds, and other products. Unfortunately, commissions are difficult to calculate because they don’t show up on your statement. But that’s a topic for another day.
In addition to (or instead of) commissions, advisors can earn compensation in the form of fees paid by you, their client. The primary example of this type of fee is an assets-under-management (AUM) fee that is based on the value of an investment account. This fee pays for investment advice as opposed to paying for a product. Other fees from clients can include monthly financial planning fees, hourly fees, or project-based fees. Fees are typically pretty easy to calculate because you see those fees on your investment account statement or you pay for financial planning directly from your bank account.
Conflicts of Interest and Fiduciary Standard of Care
Some advisors only accept commissions, while other advisors only accept fees. Many advisors accept both. At Flagstone, we believe commissions present conflicts of interest that can influence advice, and sometimes they can benefit the advisor more than the client. We also believe that the compensation types speak for themselves in terms of what an investor gets. Commissions are paid for getting access to a product, whereas fees are paid for investment advice.
So investors who simply want access to a product might be fine with paying a commission to an advisor, broker, or insurance agent. But clients who want advice in their best interest might prefer to pay a fee instead of commissions. For more details on why we believe a fee-only structure is best, check out my other blog post. But the bottom line is that fee-only advisors are legally bound to give advice that is in your best interest, which is called a fiduciary standard of care. It’s the same standard of care that attorneys or doctors have to follow. Advisors who accept commissions are not held to that same standard of care.
Fee-Only Versus Fee-Based
As I mentioned, advisors who only accept fees are called fee-only advisors. This gets confusing with the term fee-based. A fee-based account is just that: an account. It is descriptive of how an account is set up. The account might have an AUM fee, as I described above. If you have a fee-based investment account, you’ll probably see an asset management fee listed on your statement.
While the term fee-based can describe an account, the term is not descriptive of the advisor’s compensation structure on the whole. An advisor who earns fees from a fee-based account isn’t necessarily fee-only. In fact, if they’re using the term “fee-based” instead of the term “fee-only,” chances are they DO accept commissions. Otherwise, they’d probably use the term “fee-only” instead. In addition to the fees they earn on that fee-based account, they might also earn commissions when they place trades, when they purchase an individual bond or CD, or sell an insurance product.
Understand What You’re Paying
One unique way of learning about your advisor’s compensation structure is to ask your advisor if he or she belongs to any financial advisor or financial planner networks. For example, we at Flagstone are members of NAPFA, which is a network of fee-only financial planners. We are also members of the XY Planning Network, which is a network of fee-only financial planners who offer advice to people seeking holistic financial planning advice without investment minimums.
It’s worth mentioning that while Mike and I both hold the CFP® designation, someone who is a CERTIFIED FINANCIAL PLANNER™ professional doesn’t mean they’re fee-only. They can still accept commissions. We don’t, but others do. The same is true for advisors who are part of FPA, or the Financial Planning Association. While the CFP® designation and FPA membership are both positive, they do not imply any particular fee structure. With that said, the CFP Board website explicitly lists compensation structure for all CFP® professionals, so you can just look it up.
If you are unsure of how you are paying your advisor, have a discussion with him or her. Ultimately, the decision of how you want to pay your advisor is up to you. But you need to know the trade-offs. When you chat with your current or prospective financial advisor, it’s important that you understand their compensation structure. Ask them how they get paid – commissions, fees, or both. If you hear the term “fee-based,” ask for further clarification about whether, under any circumstances, they get paid a commission.