To fee or not to fee

By Kraig Strom

Over the 12 plus years that I have built my financial practice, I have lost track of how many times I’ve heard differing opinions on what kind of financial professional I should be. Should I be a commission based advisor or a fee based advisor? Although I have long since addressed this question in my own practice, it is still a topic of contention in the highly competitive financial services industry. The subject is further complicated by financial entertainers who dole out alleged financial wisdom without so much as a 10 minute consultation.

So what’s the difference between a fee based advisor and a commission based advisor and why would you want to work with one or the other? The most common answers invariably include the word bias, objectivity, and impartial. I hear people say things like “a fee only planner can be impartial” or a “commission based advisor is biased in favor of products that offer the biggest payday”. So which point of view is right? As with most things in the financial world, the complete answer cannot be delivered in a 30 second sound bite. Personal biases should not be overlooked so, with that in mind, let’s examine the biases which exist in both practice profiles.

Before I get too far along, it’s important to understand that we all have a bias of some kind or another and financial professionals are no different. An associate of mine once shared a story that illustrated this point perfectly. During an interview with a prospective client, the client asked “How can I be sure that your advice is unbiased”. The advisor responded by saying that there was no way to avoid getting biased advice from anyone. He illustrated his point like this:

When I was a kid, my father was a real estate agent. Trouble is that he was not a very good real estate agent. In fact, he was never very good at it. We lived a very basic life and never had much money. Our vacations consisted of long road trips in the family station wagon because we could never afford to fly anywhere. Being the second youngest in the family, my clothes were third and fourth generation hand me downs. Don’t get me wrong, we had a great childhood and enjoyed life but do you think that I have a bias against real estate? Of course. Well what if I told you that my dad was a real estate investor and he was actually extremely good at it. He made a fantastic living. We lived in the biggest house, had the best toys, and went on the grandest vacations. Instead of hand me downs, each of us got to go shopping for new clothes before school started each year. We lived an angelic life. Do you think I have a bias in favor of real estate? Of course I do.

If we agree that everyone has a bias of one sort or another, how does one choose whether to work with a commission based versus a fee based advisor? To answer this question, we must first understand the inherent biases of each. Fee based sounds self explanatory; however, it’s not that simple. There are four different compensation models under the “Fee Based” title.

Fee Based

Fee based professionals can receive remuneration in one of four ways.

Flat fee – The advisor charges one price for a comprehensive plan. They are paid by their customer and do not receive compensation from the sale of investment or insurance products. Flat fee professionals often refer business to other advisors who receive commissions or fees from the sale of insurance or investment products.

Bias? The monetary bias for a flat fee advisor is an incentive to possibly rush through a plan so that they can sell more plans. After all, they get paid based on the number of plans they produce.

Hourly – These advisors get paid by the hour. Advisors charge for time spent meeting with the client as well as time spent drafting the plan. Creation of a comprehensive financial plan can take many hours depending on the complexity of each clients situation. Ongoing service and review of the plan is also billed on an hourly basis. Hourly advisors also refer clients to other professionals when insurance or investment products are needed to meet plan requirements.

Bias? The hourly consultant has an economic incentive to lengthen the process. The more time spent making the plan, the more they get paid.

Retainer – The advisor collects a set amount at the beginning of the year. During the initial engagement with a client, the first twelve month retainer usually includes several initial discovery meetings, the creation of the financial plan and ongoing review. Advisors who work on retainer often set restrictions on the unfettered access they give to clients. Those with a retainer based arrangement should not expect to meet with their advisor every week.

Bias? In addition to an economic incentive to “load up” on retainer agreements, an advisor who collects a fee in advance may not have an incentive to monitor investment performance. They keep their retainer even if investment returns waiver.

Assets Under Management (AUM) – The AUM advisor gets paid based on the value of investments in their client’s account. An average AUM advisor will charge between 1 to as high as 2.5% of the total assets in their client accounts. If you had 500,000 in an IRA, you could pay as much as $7500 per year in asset management fees. For accounts above one million, the fee can drop below 1%. The usual argument in favor of the AUM model is that the advisor’s paycheck goes down if the client’s account value drops.

Bias? An AUM professional has a monetary incentive to move more assets into the AUM portfolio. The more investments under management, the higher the potential payday.

Commission Based

Professionals who work on a commission basis receive compensation from the sale of a product or service. Examples of a commission based professionals include pharmaceutical and software reps, car dealers, realtors, insurance agents, investment advisors and dentists. That’s right, dentists are often paid commissions based on a percentage of revenue.

Consider the pay structure of a property & casualty (P&C) insurance agent. They sell home, car, and liability insurance. A car insurance agent is paid by the company providing the insurance, not by the customer. A Farmers Insurance agent is paid a commission based on the amount and type of insurance someone buys. The same applies when you buy life insurance over the phone or from an advisor at your kitchen table. The advisor is paid a commission by the company that produces the product or service. In the case of car insurance or life insurance, the commissions paid to advisors usually comes from investment gains on the general assets of the insurance company and not from the initial monies paid by the consumer. So where is the bias?

Bias – A commission based advisor can be biased in favor of selling a product or service based solely on which company offers the highest compensation. An advisor who lives by the “what’s in it for me” motto will seek out companies that offer higher commissions rather than finding the product or service that fits the customer’s needs most appropriately.

Everyone has a bias of one kind or another. Financial professionals, whether commission or fee based, are no different. That begs the question, how do you know which is the right one to work with? When searching for a financial professional to work with, I suggest that you look for one bias in particular. Find the advisor who is biased in favor of you, their customer. Make sure that your financial advisor’s core objectives put your needs first.