How are you compensated?  That is one of the first questions you should ask when you are interviewing a financial advisor.  You may initially be confused by the answer because there are two very different ways that advisors can be compensated.  They can charge you a fee for service or they can be paid commission from the products they sell you.  Let’s take a deeper look at each method and how they can work in or out of your favor. 

Commission Based Compensation

Commission business applies to many industries, but the financial services industry was built on commission.  If you haven’t seen Wolf of Wall Street, take some time during quarantine to watch it and it will leave you with a very bad portrayal of commission business.  Regulations have changed over the years and commissions have come down due to the actions people like Leonardo DiCaprio’s character, Jordan Belfort. 

Simply put, an advisor is paid a commission to buy or sell a security.  You may have heard the terms “load” or “no load” when buying a mutual fund.  The “load” is just a different name for a commission.  The fund charges you a percentage upfront to purchase it and most of that upfront fee goes to the advisor.  The advisor is then paid a small fee annually from the fund for service, but earns the bulk of his or her compensation on the initial transaction. 

You may be best suited to use a commission-based advisor if you are looking to buy some products and not really talk to the person again.  Maybe you are young and just want to buy a mutual fund to forget about for the next 30 years.  Maybe you want to purchase an annuity or life insurance. Those can generally be commission-based purchases where you may not really need ongoing advice and service.  The main thing you have to think of with commission is whether or not the product being recommended is in your best interest or the advisor’s. 

Fee Based Compensation

Over the last 20 years, the financial services industry has made a monumental shift towards fee-based business.  It is beneficial to clients in that they know what they are paying and it is transparent.  When an advisor is paid commission, the client doesn’t see what he or she is paying.  Furthermore, the advisor is paid the bulk of his or her compensation upfront.  When an advisor is working for a fee, he or she does not receive any compensation upfront and gets paid a fee periodically. 

Full disclosure: I’m a fee-based advisor so my opinion may be biased, but I’ll explain objectively and let you decide. 

My opinion is that working with an advisor for a fee rather than a commission is more advantageous to clients in the long run.  Think about it for a second.  Do you really want to pay someone the bulk of his or her compensation upfront to help you navigate your financial future? 

In a fee-based arrangement, the advisor has to earn his or her compensation over time.  If the advisor is not following through on the initial promises that were made to you when you signed on, you can fire the advisor and you only lose the fees you paid over the time period you were working with that advisor.  In a commission arrangement, you have to think about the upfront fee you paid to purchase the product  or surrender penalties to sell the product and determine if it is worth it to pay another commission to move to another one.    

To take it a step further, forget about cost for a minute.  In most fee-based arrangements, the advisor does not get paid a commission for the products he or she recommends.  One of the biggest black marks on the financial services industry is advisors selling products that are not in the best interest of clients to earn high commissions.  If you are in a fee-based arrangement where the advisor doesn’t accept commissions, you can trust that the advisor is making recommendations that are in your best interest because there is no incentive to recommend one product over another.  Furthermore, when the advisor calls to recommend a change to the portfolio, you don’t have to step back and think about whether or not the advisor is recommending it to generate a commission. 

As I mentioned at the beginning, it is more complicated than you would think.  Like many financial decisions, it depends on your situation.  If you are looking for a true financial advisor who is acting as a fiduciary to you and is making honest, objective recommendations with your interest at heart, then you have a much higher likelihood of achieving that from a fee-based advisor.  Finally, it is always important to remember that no matter how the advisor is compensated, if it sounds too good to be true, it probably is.

Disclosures