Do you know how your financial advisor is compensated? Two common forms of financial advisor compensation are called ”fee-only” and “fee-based.” They sound very similar, but they have vastly different meanings. Whether your advisor is “Fee-Only” or “Fee-Based” can have a huge impact on the type of advice you are provided and the types of investment products which are recommended to you.
Let me provide a made up example related to the medical industry to help differentiate the two fee compensation terms. Not everyone has worked with a financial advisor, but we all have visited a doctor.
Let’s assume you decide to visit your doctor because you have a health issue. Upon the visit, your doctor analyzes your health problem, provides you with a recommendation, possibly sends you to a specialist for further diagnoses, or gives you a prescription to take to your local pharmacy. In return for the doctor’s time and expertise, you likely paid him/her an out of pocket co-pay and/or your health insurance pays them a fee for your visit and any particular procedures or testing done. This scenario would be considered fee-only. You received a recommendation and the doctor received a fee.
Now let’s assume you visit your same doctor for the same health issue. But we further assume that the doctor’s compensation comes from two sources: 1) a fee for an initial assessment of your health issue and 2) the doctor also receives a commission for any particular health recommendation, procedure, referral to a specialist or pharmaceutical prescription sold. What if we take this one step further and also assume that not only does your doctor receive a commission for his/her recommendations, but that their commission based revenue can only come from a select group of products or procedures chosen by the health organization they are affiliated with? Do you see any potential conflicts of interest in this scenario? Would this cause you to question if you were receiving the best medical recommendation, or, if what your doctor recommended was potentially based on what paid your doctor the highest commission? This would be considered a “fee-based” compensation arrangement. The doctor receives a fee for the initial visit but also receives commissions for specific recommendations, procedures, referrals or prescriptions sold.
Consumers are fortunate the fee-based arrangement does not actually exist in the medical industry. However, it is common in financial services.
The two examples above can be directly substituted into the financial advice industry. Fee-Only means the only source of compensation your financial advisor receives is from fees paid directly to the advisor from clients. This could be in the form of an hourly fee, a retainer fee or a fee based on a percentage of the assets under investment management. Regardless of the type of fee, the point is that the client pays only a fee and no other type of compensation is charged. No commissions are received. No financial products are sold such as load mutual funds, commissioned based fixed and variable annuities, equity indexed annuities, whole life insurance or universal life insurance. The advice and compensation is totally independent of the financial products recommended.
Fee-Based is a term the brokerage and insurance community developed to counteract the success of the Fee-Only classification. The terms certainly sound similar and consumers are confused, so their strategy seems to be working. I can’t tell you how many times I have received a phone call from a consumer looking for a new financial advisor and one of the first things they say is that they are looking for a fee-based advisor. I always enjoy having that conversation and explaining the terminology differences as most consumers are greatly surprised.
Where Fee-Based can be confusing and potentially misleading is that not only does an advisor receive fees, but they can also accept commissions from financial products recommended such as load based mutual funds, or annuities and insurance. This system creates the potential for a huge conflict of interest. If an advisor, like the doctor above, has the opportunity to recommend a particular financial product that pays him/her a commission versus a financial product that does not pay a commission, do you think they could be incentivized and influenced to recommend the commissioned based product? Or, what if their product inventory only allows the choice between a select group of commissioned products based on the affiliation of their broker dealer? Would this raise a question – are the financial products offered to me what is best for my financial situation, and, do they make use of the best potential options considering the whole universe of financial products available?
No compensation system is perfect and free from all conflicts of interest. And certainly there are some great fee-based advisors doing amazing work for their clients. But we strongly believe the fee-only compensation method most closely aligns the interest of consumers with their financial advisor. We are proud and fortunate to belong to a great organization called www.NAPFA.org (National Association of Personal Financial Advisors), which represents a like-minded group of fee-only, fiduciary based financial advisors throughout the United States.
So when deciding which advisor you would like to hire, we would suggest that you ask how the advisor is compensated, request that they disclose their compensation in writing and look for someone who is paid as a “Fee-Only” advisor to eliminate as many conflicts of interest as possible.
Or, if you decide to work with a fee-based, commissioned advisor, at least look for one that is licensed under a fiduciary regulation. The fiduciary law requires that all compensation is disclosed in writing. Thus if you are going to pay commissions for advice and financial products, you will at least know what you are paying for. You can learn more about being a fiduciary by reading my article titled “What is a fiduciary and why does it matter?”