Q: What is the difference between a fee-based advisor and one who is commission-based? What are the advantages and disadvantages of each?
A: Both commission and fee-based methods come with great advisors on either side. However, the way advisors are paid can lead to some big differences between the two and the service you receive from them.
Advisors that are paid by commission receive their compensation from purchasing and selling securities like stocks, bonds and ETFs. In other words, their compensation is derived from executing transactions on their clients' portfolios. Investment firms generally require a minimum charge per trade, which is usually around $125 to $150 a trade. However, advisors charge varying amounts depending on their business model as well as client and trade size.
Although this is not the case universally, advisors that charge a commission tend to focus almost exclusively on managing their clients’ portfolios. This portfolio-based focus often means they don’t consider other important areas such as financial, tax, estate, or retirement planning.
On the other hand, fee-based advisors are paid a fee based on a percentage of assets they manage for their clients. This fee is understood to be for the aggregate advice and time the advisor spends helping the client, whether it is on their portfolios, or various types of planning that they could benefit from. Given this, the trades made on fee-based accounts are free. That being said, most firms usually set an annual limit of trades allowed so that clients don’t get too trade happy and take advantage of the low fee. It’s also important to remember that fees paid on non-registered accounts are tax deductible, which is always a nice benefit.
The way advisors are paid directly affects their incentives. Although most advisors are ethical, when they are remunerated by commission, advisors are in essence paid to trade securities and have an incentive to increase the number of transactions they execute. Fee-based advisors on the other hand have an incentive to grow their client’s portfolio in size, as they would get paid more as a result. Personally, I believe the fee-based approach to be more of a win/win structure for the client.
As the fee paid is often understood to be for an advisor’s advice, the scope of that advice tends to be much broader. Again, this is not a universal truth, but fee-based advisors tend to offer a more holistic range of services that can include retirement projections, strategies to save taxes, estate planning and insurance solutions to protect against unforeseen events.
For example, say a client is given a recommendation of 12 trades to rebalance their portfolio, as recent market volatility has created the need for adjustment.
In the commission option, each trade comes with a charge (most firms charge a minimum of $125 - $150 a trade) so it’s conceivable the total could be several thousand dollars. In a fee-based scenario, the same 12 trades are needed, but there is no added cost. Which scenario would you likely be more comfortable with?
This is not to say that there are no drawbacks to working with a fee-based advisor. As the fees will be charged on the account regardless of whether advice is given, it’s possible that a client pays a fee regardless of whether they receive any value. It’s a rare scenario, but definitely something to consider when making your decision.
Ask An Advisor is a regular feature based on commonly asked questions I’ve received from clients. If you have a question, shoot me an email. I will write back and post your question in this series for the benefit of other readers. If you don’t want your question posted online, or wish to remain anonymous, let me know.