Wednesday, August 29, 2012

Fee-Based or Fee-Only? Does it Matter?


The Dodd-Frank Wall Street Reform and Consumer Protection Act passed without requiring a universal fiduciary-duty rule. Such a rule would have required broker-dealers (Merrill Lynch, Morgan Stanley, UBS, Wells Fargo Advisors, etc.) to be held to the same standards as investment advisers. Now the SEC must interpret the law’s meaning.

The heart of the debate is the question of sales commissions. Broker-dealers argue it is possible to collect sales commissions and also give trustworthy advice. Other advisors and regulators in the industry believe an advisor’s vision is clouded once the investment choices include products paying large sales commissions, and that clients pay a heavy cost when dealing with a broker-dealer. Sales commissions are attached to most products utilized by broker-dealers, including load mutual funds, unit investment trusts, and most insurance products.

When determining the impact of sales commissions on investment advice, consider these questions:
  • Can a financial advisor recommend that a client invest in a mutual fund that pays a 5.75% commission to the advisor and still say that he/she is looking out for the client’s best interest?
  • What if the financial advisor knows the client can purchase the same mutual fund without a 5.75% sales commission? Can the advisor still sell the product, collect the commission, and say he/she is looking out for the client’s best interest?
  • Does not the charging of even a disclosed sales commission disqualify an advisor from acting in the client’s best interest if the sales commission alters the advice of the advisor?
The holy grail of sales commissions for many broker-dealers is the variable annuity. A commission of 5% or more is regularly paid to advisors selling these products. Even though these expensive products don’t make sense for most people (as this article in the August 1, 2010 issue of SmartMoney points out), they are more aggressively sold “than fake merchandise on the streets of New York City”.

The fashionable trend for advisors working at a broker-dealer is to distance themselves from the entire sales commission debate by stating they are “fee-based” advisors. The connotation is that they don’t charge sales commissions much, but rather focus on fee-related compensation, which is deemed by investors as a more equitable source of compensation than large sales commissions.

Similarly, smaller broker-dealers are increasingly attempting to separate themselves from larger broker-dealers such as Merrill Lynch and Morgan Stanley by utilizing the word “independent” in their marketing campaigns. With the increase in momentum of the anti-Wall Street movement, the investing public equates the words “independent” and “fee-based” as good, “Wall Street” and “commissions” as bad.

So do “independent, fee-based” advisors really avoid sales commission products?

Unfortunately, the reality is quite different from the public marketing campaign of these broker-dealers. The fact is that even the independent broker-dealers rely on sales commissions for a large part of their revenue. In fact, in the June 2011 Financial Planning magazine cover article highlighting the top 50 independent firms, 48 of the 50 generate the majority of their revenue from commissions! It appears someone is still selling the front-load investment products and variable annuities after all.

The Fee-Only Advisor

There is a major distinction between a “fee-based” and “fee-only” financial advisor. By hiring a fee-only advisor, an investor can ensure that their advisor will never give advice that is tainted by the possibility of collecting a commission. A fee-only advisor has a fiduciary responsibility to choose investments that are in your best interest, are legally liable for the advice they give, and cannot receive compensation from outside sources such as brokerage firms, mutual fund companies, or insurance companies. A fee-only advisor is paid directly by the client and only by the client; thus, their loyalty is 100% to the client.

3 comments:

money said...

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Frank Smith said...

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