Difference Between a Fee-Based and a Commission-Based Financial Advisor
Not everyone needs professional financial advice. However, several studies over the years have shown that people who actively get financial advice are more likely to grow their assets and reach their financial goals as compared to those who make their own financial decisions. As per a study conducted by Vanguard, expert advice can help boost returns by 3% per year. This has been further validated by another study conducted by Russell Investments, which says it is possible to improve returns by 3.75% through professional financial counseling.
A sound financial plan created by the right financial advisor can help you aptly define your goals, determine your risk appetite, and create a well-defined investment plan tailored to your needs. But when it comes to choosing a financial advisor, you have different choices. So, how would you know which one is right for your needs?
Typically, the type of financial advisor you choose depends on your wealth management requirements. Some financial advisors offer simple services, while others provide more complex financial services. Irrespective of whether you want simple advice or assistance with complex financial services, having a financial advisor is always a valuable asset.
When you hire a financial advisor, you are also required to pay them. The remuneration or compensation structure of your advisor significantly impacts their services. The objective is to find a person whose compensation model fits your personal needs. There are typically two types of financial advisors – fee-based or commission-based. Fee-based advisors usually charge their clients a fixed rate, while commission-based professionals earn their remuneration through financial transactions and products you buy through them.
Here is a look at the differences between a fee-based and a commission-based financial advisor:
Fee-based financial advisors
A fee-based advisor provides financial services as per your needs at a pre-defined fee. The fee can be a flat retainer rate or an hourly rate, depending on the length of your contract and type of engagement. Professionals who are actively involved in buying and selling investment assets on your behalf charge their fee as per a specific percentage (usually between 1% and 2% per year) of the assets they manage. This method of compensation is also known as Asset Under Management (AUM).
So, if your financial advisor is in charge of your assets worth $200,000, then you can expect to pay anywhere between $2,000 and $4,000 as compensation under the AUM model. The exact fee depends on the experience of the professional and the firm they work for. In the long run, this method can work to your advantage because the fee percentage often reduces as the AUM value increases. In some cases, advisors also set a benchmark from where the fee will be lowered.
Fee-based advisors receive their fees directly from you. Apart from this fee, these advisors do not receive any compensation. This characteristic of fee-based advisors makes them unbiased and transparent. Moreover, these professionals only charge for their services and management and do not sell any financial products or services to earn a commission.
A major advantage of working with a fee-based financial advisor is that these professionals are governed by fiduciary standards. They have a fiduciary responsibility towards you and are obligated by the law to do their best to help you achieve your financial goals. If your advisor receives remuneration as per the AUM model, the more money you make, the more money you will have to pay the advisor. This will help them stay invested towards increasing your wealth and not get swayed into selling you mediocre insurance products or securities only to earn a high commission. In all, fee-based advisors, especially the ones remunerated through the AUM model, are likely to dedicate more time and attention to you, which will suitably work in your favor.
Fiduciary financial standards
As specified, fee-based financial advisors, more specifically AUM-based professionals, are governed by a fiduciary duty. This implies that they follow an ethical code of conduct, thereby ensuring that your money is in the right hands. These advisors act in your favor and aim to improve your wealth in the long run. Hence, the support they provide is unbiased, in-depth, accurate, and ideal (not just suitable) as per your requirements. Moreover, a fiduciary financial advisor will make every effort and work towards minimizing any disputes or differences to ensure complete transparency. These professionals do not use your assets for their benefit. If a financial advisor violates their fiduciary duty, you have the right to sue them and take legal action (financial or civil). A fiduciary relationship is considered to be breached if the advisor does not honor his commitment, makes uncalled transactions, sells biased financial products, misrepresents information, etc.
How to hire a fiduciary advisor?
Foremost, you should know your requirements and assess if you want a flat-fee engagement, hourly-based relationship, or the AUM model. Once you know this, you can find a financial advisor using advanced online tools like WiserAdvisor’s advisor match tool and assess if they follow the fiduciary standard by checking their registrations. Typically, an advisor registered with the U.S. Securities and Exchange Commission (SEC) or state securities regulator is governed by a fiduciary standard. Moreover, a Certified Financial Planner (CFP), a Chartered Financial Consultant (CFC), an Accredited Investment Fiduciary (AIF), etc. are bonded by a fiduciary duty and follow ethical financial planning standards.
Overall, when you engage with a fee-based fiduciary financial advisor, you can expect the person to:
- Place your requirement and interest before their own.
- Act in good faith and with honesty and transparency in all your monetary transactions.
- Disclose and remove all possible disagreements.
- Put in earnest efforts to provide ideal and profitable financial advice.
- Not utilize your assets for their profit.
- Receive compensation directly from you and earn no commissions.
Commission-based financial advisors
A commission-based financial advisor is a professional who earns income from the financial products you buy through them or the accounts you open through these advisors. These advisors can also receive a specific amount of compensation from you. However, the figure is minimal. Typically, these advisors sell financial instruments, such as insurance packages, mutual funds, stocks, etc. So, the more accounts they open, the higher number of insurance packages they sell, or the greater number of mutual funds they sell, the more they get paid. But since there is no upfront fee, commission-based advisors are more cost efficient than fee-based financial advisors. They are not bonded by a specific contract and hence, you have the option to engage with more than one commission-based advisor at a time. Further, when you engage with a commission-based advisor, you do not have to actively manage your investments. These professionals control the process of purchasing and selling of different financial products for you.
These advisors may work for major firms but act as independent contractors. Another significant benefit of working with commission-based advisors is that they offer greater diversity in terms of financial product offerings. They can help you create more diversified risk management strategies and cover different heads, such as life insurance, health insurance, long-term care insurance, etc.
On the downside, while commission-based advisors can offer you a financial plan and help you build your portfolio, their product recommendations and security inclusions may be prejudiced. Commission-based advisors may or may not follow the fiduciary standard. In most cases, these professionals adhere to a suitability standard. This means that the recommendations they provide are only suitable and not ideal as per your financial needs, objectives, and life circumstances. A commission-based advisor might be incentivized to churn your account to generate a higher commission. This means that there are higher chances of conflict of interest and you can never be sure if their advice is directed for your interest or theirs. Further, these professionals are also not obligated to disclose their conflict of interest, which makes their services even more questionable.
Difference between fee-based and commission-based financial advisors
|Point of difference||Fee-based financial advisors||Commission-based financial advisors|
|Payment||Paid directly by the client for the services provided.||Paid by the client but receives a major share of their earnings (as commission) from the sale of financial products recommended to the client.|
|Predetermined payment||Payment is pre-defined as per a flat fee, hourly fee, or a percentage for AUM.||The exact payment is not predetermined and depends on the financial products purchased by the client.|
|Sources of income||Single source of income||Multiple and undefined sources of income, including the fee paid by the client as well as commissions from the sale of financial products purchased by the client.|
Fee-based advisors are governed by a fiduciary standard. They have a lawful duty to place the needs and interests of their clients on top.
Commission-based advisors (including insurance agents, brokers, dealers, etc.) do not necessarily conform to a fiduciary standard. Instead, they follow a suitability standard and hence, can sell products that might be suitable but not ideal as per the client’s needs and goals.
|Transparency||Higher transparency as the advisor is obligated to disclose and minimize all possible areas of conflict.||Lower transparency as the advisor is not obligated to disclose any conflict of interest.|
|Element of risk||Less risky as the interest of both parties is aligned and governed by fiduciary standards.||Higher risk as the interest of the client and the advisor may or may not be aligned. There is also no legal fiduciary guarantee.|
Which type of advisor is best for you?
Once you understand the major differences between commission-based and fee-based financial advisors, you can easily assess which type of advisor relationship is more suitable as per your goals and needs. For instance, if you are a small investor and only require basic investment advice, you can choose to opt for a commission-based remuneration model or choose a flat-fee model. However, if you are a high-net-worth investor and need comprehensive financial advice for account management as well as retirement planning, tax management, estate planning, or more, you should ideally consider engaging with an advisor who works as per the AUM model. In such a case, even if you end up paying a larger sum, you will have assured financial support, complete transparency, expert management, and unbiased financial advice. When you evaluate which type of advisor is best for you, take into consideration the pros and cons of each model and make an informed decision:
Pros of commission-based financial advisors
- No upfront fee
- More cost-efficient
- Option to engage with multiple advisors at one time
- Less work because these advisors manage your investments for you
Cons of commission-based financial advisors
- Higher chance and risk of bias
- No transparency
- Governed by suitability standards
- Conflict of interest
Pros of fee-based financial advisors
- Unbiased financial advice
- Complete transparency in the remuneration model
- No conflict of interest
- No disharmony
- Assurance of advice
- Governed by fiduciary standards
- Pre-determined fees
- Flexibility and a wider range of financial services
Cons of fee-based financial advisors
- More expensive than commission-based advisors
- Limited services available at low charges
- Deal with clients with a minimum level of assets to invest (or can charge a fee equivalent to that level of the assets)
- Requires active management on your part
It is advised to weigh the benefits and drawbacks of both types of advisors and conduct in-depth research and compare your options before you make the final choice. There are different types of advisors with varied competencies. Also, human advisors are not your only choice, you can also opt for Robo-advisors. However, Robo-advisors may offer limited services only. They also do not involve human interaction.
To sum it up
A good financial advisor can help you significantly improve your wealth over time and build for you a financially secure future. However, there is no definite answer to which advisory model will work best for you. Commission-based services might be helpful for you if you prefer less active management and do not have a high-value portfolio and hence, do not mind paying a commission. However, if you have a high-net-worth portfolio, a fee-based advisory model is a preferable choice. This is because in the fee model your advisor adopts a fair indication of their interest alignment, transparency, and loyalty. Typically, commission-based advisors rank low on these parameters, whereas fee-based advisors tick all the right boxes. Hence, when it comes to choosing your financial advisor, it is wiser to engage with a fee-based one. These professional financial advisors follow a fiduciary standard, pledging transparency, finest financial guidance, and utmost loyalty in service.