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Fee-Only vs. Fee-Based Financial Advisor Compensation .@NAPFA #fiduciary

By August 21, 2014October 10th, 2016Financial Advisors

Sorry. After not publishing a post in ages from my website for financial advisors, this one is pretty long.

There is a lot of confusion over the difference between fee-only and fee-based compensation for financial advisors, even among many advisors.

Fee-only means that the only compensation paid to the advisor are fees paid by the clients to the advisor or the advisor’s firm. Those fees might take several different forms, but essentially it means that the money goes from the client to the advisor with no 3rd party intermediary, such as a bank, brokerage firm, or mutual fund company paying it out. It also means that the advisor doesn’t receive any compensation in the form of commissions earned for selling any financial services products or any other compensation of any kind. (Of course, there is a current debate about whether there should be de minimis rules for accepting commissions. You have just read how I come down on the debate.)

The most common form of fees, by far, are investment advisory fees debited directly from clients’ accounts for the management of those accounts. Clients often also pay fees by writing checks out for investment advisory or financial planning services. Some clients write checks (or have fees debited from their accounts) for monthly or quarterly financial planning retainer fees. There are also other less common ways for clients to pay their advisors.

Fee-based compensation generally means that the advisor charges fees for managing investment accounts, but still receives commissions for selling financial services products, typically annuities and life insurance. On the surface that doesn’t sound so bad, but there are more conflicts of interest in this type of arrangement and it is harder for fee-based advisors to move from a product-centric orientation to a client-centric one. It just is.

I have spoken with a lot of fee-based advisors and am friends with many of them and when we speak about work they always talk about the platforms they are on or the investment management products they use or the broker-dealers they clear through or how good the guarantees are in the annuities they sell. I’m not sold on any of it because it is always the means of distribution they speak of. Always. As if they are selling products instead of advice.

As an aside, let me be clear that I don’t think that fee-only means “holier than thou” and offering your services to the public using one type of compensation arrangement over others does not put you on the side of angels. There have been a couple of pretty high profile fee-only advisors who have been charged with crimes in the last few years and more that have also been sued successfully. It doesn’t make you a better person because you decide to be fee-only. I do think it makes most people better advisors though.

(There have been many, many, many more fee-based advisors charged criminally and successfully sued. In no way am I saying they are equal or equivalent, I am just saying people do bad things even if they start with the right compensation model.)

Fee-based is a misnomer. It should be called “commission-based” or “commission and fee-based” as fee-based advisors as a whole derive about 70% of their compensation from commissions. If fees account for less than a third of your income, how can you call yourself fee-based?

When an advisor says he is fee-based it doesn’t really say much about how he runs his practice. For most advisors what it means is that they sell a lot of commissioned products and when they manage stock, bond or fund accounts, they generally charge fees to do so, instead of charging commissions. Well, what financial advisor sells stocks on commissions these days? I haven’t spoken to an advisor who primarily worked like that since I left Merrill in 2001.

My guess is that the brokers (notice the term change) that work like that have been in business a very long time and are working with customers that are used to working with that type of arrangement or they have positions they want to keep and occasionally make purchases and sales through a human broker.

When you sell commissioned products, you are legally an agent of the company whose product you are selling and you have a legal duty to act on its behalf and protect its interests. If you are protecting the interests of the company, how can you be protecting the interests of your client? You can’t have it both ways. One has to be subservient to the other and if you are selling products, you are necessarily not putting your clients’ interests first. If you aren’t putting your clients interests first, how can you be acting as an advisor? Well, legally you aren’t.

For those fee-based advisors who manage investment accounts as an advisor and sell products as a broker, you go through the silly charade of changing hats when discussing different things.

When the client comes in for a meeting and you are talking about the fee-based investment accounts, you are acting as an advisor and have to put your clients’ interests first as a legal fiduciary to them. When you switch gears and talk about life insurance or annuities, you take your fiduciary hat off and become a representative or agent of the insurance company and don’t have to put your clients’ interests first. You just have to know your customer and suggest suitable investments.

Do you think your clients really know this? Do you tell them “by the way, I no longer have to work in your best interests, I am a salesman now, not an advisor?” If you did say that, how would they react? Think about it. It is a very different orientation for the customer when they know that they are visiting with a life insurance salesman versus sitting with their financial advisor. Their guard will definitely be up more with the former. It’s ok to be an insurance agent! My dad is a retired one. Just don’t call yourself a financial advisor.

We all like to think that we are always putting our clients’ interests first, and we all start out with those intentions, but when you sell an annuity for the standard 5.75% commission instead of managing accounts for your clients at 1 or 1.25% per year, how do you really know that it’s in the clients’ best interests and not because you are earning as much in a day as it would otherwise take you five full years to earn? You don’t. You rationalize the high expenses charged in the annuity and you never actually have the client take the benefits they are paying so much for and think, by the way, I just did the right thing for the client and made a lot of money today, win-win!

I have heard that you can be a fiduciary and sell commission-based products. I don’t know how that works but would be interested in hearing it because I have a hard time wrapping my head around it. How can you put two different parties’ interests first? You really can’t, you can just rationalize that you are.

Instead, I would recommend that anyone pursuing an advisory career or trying to take their career to the next level ought to seriously consider switching to a fee-only model, give up their commissions, and act at all times like a fiduciary to their clients.

There might be short-term pain in giving up those commissions, but you get to actually be an advisor all of the time.

You spend less time thinking about platforms and clearing and more time looking after your clients or looking for new ones.

Your whole focus changes. It did for me and it can for you. Of course when I worked at Merrill I always thought I was doing what was right for my clients, but now that the whole compensation hurdle has been removed and everybody pays a fee the same way, I don’t have to worry about that, I just worry about the client. Maybe I don’t always make the right decisions for my clients, but I never have to worry that my compensation is clouding my judgment.

From a business perspective, there are plenty of fee-only advisors who make as much money as the highest-paid fee-based advisors, and their businesses are worth a much higher multiple of recurring revenues.

You also get the benefit of people looking for a fee-only advisor, even if they are confused when they call and say “fee-based.” As I have written before, I don’t do seminars or cold calling or networking events or anything besides providing a website and content, but every month I get contacted by on average 3 to 5 prospective clients, almost all of whom are looking for a fee-only advisor, someone who specifically can’t sell them any products. They are literally calling because I can’t sell them any products. Think about that.

Sorry again for the length of this post. Next time I will discuss the fact that if you are going to be someone’s financial advisor, you’d better be an expert.

Michael Garry

Author Michael Garry

Michael Garry is a CERTIFIED FINANCIAL PLANNER™ practitioner and a NAPFA-registered Financial Advisor. He is a member of the National Association of Personal Financial Advisors (NAPFA) and the Financial Planning Association (FPA).

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