Difference Between a Fee-Based and a Commission-Based Financial Advisor

When considering hiring a financial advisor, cost is one of the most obvious factors to consider. How much you pay and how you pay can impact not just your budget, but also your overall investment returns.

It is simple math.

If you earn $10 in profit but pay $15 for advice, it does not look too good. But if you pay $15 for advice and, as a result, earn $10 every single month going forward, the math starts to make a lot more sense.

The details of what you pay often depend on the compensation model your financial advisor uses. In other words, it is about how they choose to get paid. Broadly speaking, there are several models you may encounter. Each has its pros, cons, and implications for how your financial advisor works with you.

In this article, let’s compare two compensation models - fee-based vs commission-based.

What is a fee-based financial advisor?

A fee-based financial advisor charges you a set fee for their services, but with a twist. The central portion of their earnings comes directly from you, but they can also earn commissions from financial products that you may end up buying. So, while most of their income is fee-driven, a small portion can still come from outside sources, such as brokerage firms, mutual fund companies, or insurance providers.

The fee itself can take different shapes. It might be a flat annual retainer that covers a certain range of services. It could be an hourly rate, which works well if you only need advice occasionally. Alternatively, if the financial advisor is actively managing your investments, they may charge a percentage of your assets under management, commonly referred to as AUM. In the case of AUM, the more your portfolio grows, the more they get paid.

Now, because fee-based financial advisors can also earn commissions, there is a potential for a conflict of interest. Let’s say your financial advisor recommends an index fund. Now this should ideally be because it is the best fit for you.

However, in many cases, it is also possible that the basis of the recommendation is that they earn a commission from the sale of that product. While this does not discredit the financial advisor entirely or mean that they are dishonest, it can create doubt in your mind.

An important distinction to note about fee-based financial advisors is that they differ from fee-only advisors. A fee-only financial advisor is paid strictly and entirely by you. There are no commissions, and no third-party payments are involved. With fee-only advisors, there is generally a lower chance of product-based bias, as their sole source of income is your payment.

Fee-based financial advisors, on the other hand, live in a sort of middle ground. They get a stable income stream from your fees, but they can also supplement it with commissions from selling or recommending certain financial products.

Fee-based financial advisors are not usually fiduciaries. So, they are not necessarily legally liable to act in your best interest. They are held to the suitability standard when it comes to product recommendations. So, while the investment has to be suitable for you, it does not have to be the ideal choice available.

What is a commission-based financial advisor?

A commission-based financial advisor earns their income from the products they sell to you. Instead of charging you a set fee for their time or a percentage of your investment portfolio, they get paid when you buy a specific financial product. In most cases, these advisors work with companies that offer financial products, such as mutual funds, annuities, or insurance policies. If you purchase such a product on the recommendation of the financial advisor, they would earn a portion of that sale as a commission.

For example, a financial advisor may suggest a certain mutual fund scheme to you. Say, you decide to invest $5,000 in it. The financial advisor might earn a percentage of that amount. This commission would not be paid by you, but borne by the company offering the fund. However, the cost would be hidden in the product you are buying. So, it would essentially come out of your pocket.

Just like fee-based financial advisors, commission-based advisors are also typically held to a suitability standard. So, the products they recommend only need to be suitable for your situation at the time of sale. They do not have a legal obligation to choose the absolute best product for you.

Many people are deterred from working with a commission-based advisor for this reason.

However, it is essential to note that these financial advisors can be honest, experienced professionals. You should be aware of the potential conflict of interest, as their paycheck is derived from the sale. But you do not need to reject them outright. In fact, there are situations where working with a commission-based financial advisor can actually be cost-effective.

For instance, if you do not need ongoing financial management and only make occasional investments, they can be a good fit. Additionally, if you only need help with specific transactions, paying the commission may actually cost you less over time than a flat annual fee or a percentage of AUM.

Commission-based financial advisors may also have access to a wide variety of investment and insurance products. They can introduce you to unique options that can perfectly fit into your portfolio.

Fee-based vs commission-based - Pros and cons

Let’s evaluate the pros and cons of both categories:

Pros of fee-based financial advisors

Transparency is a significant advantage of working with a fee-based financial advisor. You know upfront exactly what you are paying and what you are paying for. The fees are usually laid out clearly. They may be a flat annual retainer, an hourly rate, or a percentage of the assets they manage for you. It is not uncommon for these fees to range from approximately $1,000 to $5,000 or more per year, depending on the level of work involved and the complexity of your financial situation. Because you know the cost ahead of time, it is easier to plan for it in your budget, too, rather than getting hit with unexpected charges at the end of the year.

Another benefit is that there is generally less conflict of interest compared to someone who is paid only through commissions. So, you do not have to worry as much about whether their recommendation is based on your needs or their bottom line.

Now, the potential for bias is not completely eliminated. After all, some fee-based advisors can still earn small commissions from certain products, but the risk is reduced.

Cons of fee-based financial advisors

Fee-based financial advisors may require a minimum account balance of $500,000 to $1 million, which can automatically exclude many potential clients. If you are just starting out, do not have highly valued assets, or belong to a relatively lower income group, you may miss out on the opportunity to work with them.

Moreover, these financial advisors are not always fiduciaries. So, they may not be legally obligated to act in your best interest. This is a drawback that these financial advisors share with commission-based advisors.

Another drawback is that their charges are typically based on a percentage of your AUM. For instance, if the financial advisor charges 1% annually and your investment portfolio is worth $1 million, you would pay $10,000 per year in fees. The higher your AUM, the more you pay. This can be quite expensive in the long run.

Pros of commission-based financial advisors

They can introduce you to a wide range of products they have access to. For instance, if you are looking for wide-ranging insurance and investment products, they can be a good fit. Let’s say you want to explore five different life insurance policies and three types of mutual funds. A commission-based financial advisor can quickly connect you with these options.

They are ideal if you simply want product recommendations rather than ongoing financial advice on a specific matter, as they typically focus on buy and sell transactions without complicating things with ongoing planning services.

Cons of commission-based financial advisors

The biggest drawback starts with the potential for biased product recommendations. Since commission-based financial advisors earn money from the products they sell, there is always a risk they may nudge you toward something that benefits them more than it benefits you. You might end up with an insurance policy or investment product that is not the best fit for your needs, simply because it pays them a higher commission.

However, as a client, you need to be vigilant. Instead of simply following the financial advisor’s recommendations, it may be helpful to research on your own, ask questions, and have detailed discussions about the products they offer. This ensures that you fully understand the products you ultimately invest in. And also, that they match your needs and do not create a conflict of interest.

Another issue is cost. Sometimes, you are paying for something you don't even need. Even if the financial advisor commission itself is not huge, it can feel like wasted money when the product is not delivering any real value.

And remember, these financial advisors typically are not fiduciaries. Therefore, they do not have a legal obligation to prioritize your best interests. That does not automatically make them a poor choice, but it does mean the responsibility is on you to double-check everything they recommend.

What should you keep in mind when selecting a financial advisor?

1. You need to research well and look around for choices

First, do your homework. Research as much as you can. Understand the difference between fee-based and commission-based advisors to make an informed choice. You can also meet with both these types of advisors and ask them more about their compensation model to understand how they work.

Additionally, ask friends and family, look for feedback from people you trust, read online reviews, and ask for referrals. Do not forget to evaluate the professional's personality and expertise as well. You should be comfortable with all of these things and be able to share your personal details, goals, and financial fears and anxieties with the professional.

2. Evaluate your needs

Next, think about your needs. It is essential to match the financial advisor’s services to your actual needs to save time and money in the long run.

Are you looking for product recommendations, such as an insurance policy or a specific investment fund?

If that is the case, a commission-based advisor might be a suitable option for you. However, if you require broader, ongoing guidance on matters such as retirement planning, estate planning, budgeting, tax strategies, and other financial concerns, a fee-based financial advisor may be a better fit.

3. Estimate your net worth and the value of your portfolio

You also need to consider your net worth as well as the size of your portfolio. For instance, many fee-based financial advisors have minimum asset requirements that range between $500,000 and $1 million. They do not take on clients whose assets are valued below this threshold. If you do not meet the criterion, you may need to look for commission-based financial advisors or fee-only advisors with lower minimums.

However, if you have a larger portfolio, you may prefer the more comprehensive services that a fee-based advisor offers. In this, these financial advisors can be a better match.

4. Check your personal preferences

Finally, think about what kind of payment model you are most comfortable with. Do you prefer a fee-based model, where the financial advisor charges a fixed fee plus a small percentage of assets under management, and may also earn commissions from time to time? Or would you rather work with someone who charges only for the products you buy through them? You will be the one paying the fees at the end of the day, and you must be comfortable with the model.

The Bottom Line: Making the Right Choice That Aligns with Your Needs

The financial advising industry is diverse, and there truly is something for everyone. The variety of compensation models is not meant to confuse you. It is designed to serve your needs. Once you understand the difference between fee-based and commission-based advisors and know what you want, you will be in a prime position to choose a professional who can guide you.

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