Fee-Based vs Commission-Based: Which Type of Advisor Is Better?

The investment advisor field encompasses a variety of professionals. Some, such as money managers and stockbrokers, analyze and manage portfolios; others, such as financial planners, are often involved in other aspects of a client's financial life, such as real estate, college financial aid, retirement and tax planning. But to some folks, the investment advisor field is essentially divided into two types: the fee-based (or fee-only) and the commission-based. The former charges a flat rate (or "à la carte" rate) for their services; the latter is compensated by commissions on financial transactions or products.

Which sort of advisor is better is a question almost as old as the profession itself. But the debate heated up again in 2016, with the advent of the Department of Labor's (DOL) Fiduciary Rule. The ruling mandated that all those managing or advising retirement accounts (IRAs, 401(k)s, etc.) comply with a fiduciary standard. This conduct of impartiality involves charging reasonable rates, being honest about compensation and recommendations, and most of all, always putting the client's best interests first, never running contrary to his objectives and risk tolerance. Advisors can be held criminally liable if they violate these rules.

Fee-based advisors (like money managers) already tended to be fiduciaries; in fact, if they were registered investment advisors, they were required to be. Commission-based advisors (like brokers) weren't.

Never fully implemented, the DOL's Fiduciary Rule was rescinded in 2018. But it did spark fresh conversations about advisors' conflicts of interest and transparency about their compensation. Many Americans can be ignorant on both scores. A 2017 survey conducted by Personal Capital, an advisory firm and supplier of financial software, found that 46% of respondents believed advisors were legally required to act in their best interests, and 31% either don't know if they pay investment account fees or are unsure of what they pay.

Let's look more closely at the two types of advisors.

A fee-compensated advisor collects a pre-stated fee for his services. That can be a flat retainer or an hourly rate for investment advice. If he actively buys and sells investments for your account, his fee is likely to be a percentage for assets under management.

Within the compensated-by-fee realm of advisors, there can be a further, subtle distinction between fee-only and fee-based. The sole source of compensation for fee-only advisors is fees paid from the client to the advisor. In contrast, income for fee-based advisors is earned largely by fees paid by a client, although a small percentage of it can be earned through commissions earned by selling the products of brokerage firms, mutual fund companies or insurance companies.

Fee-only advisors have a fiduciary duty to their clients over any duty to a broker, dealer or other institution. This means, upon pain of legal liability, they must always put the client's best interests first, and cannot sell their client an investment product that runs contrary to his needs, objectives and risk tolerance. They must conduct a thorough analysis of investments before making recommendations, disclose any conflict of interest and utilize the best execution of trades when investing.

In contrast, a commission-based advisor's income is earned entirely on the products she sells or the accounts she opens. Products for commission-based advisors include financial instruments such as insurance packages and mutual funds. The more transactions they complete or the more accounts they open, the more they get paid.

Commission-based advisors can be fiduciaries. But they don't have to be. The laws state they must follow the suitability rule for their clients, which means they can sell any products they believe suit their clients’ objectives and situation—though the yardstick for suitability is a pretty subjective one. They do not have a legal duty to their clients; instead, they have a duty to their employing brokers or dealers. Further, they do not have to disclose conflicts of interest.

Many commissioned-based investment advisors (including full-service brokers) work for major firms, the Edward Joneses and Merrill Lynches of the world. But these advisors are employed by their firms only nominally. More often than not, they resemble self-employed, independent contractors, whose income derives from the clients they can bring in. They receive little or no base salary from the brokerage or financial services company, though the firm may provide research, facilities, and other forms of operational support.

To receive this support from the investment firm, advisors are held to some important obligations. The most important of these provides the firm with its revenues: Advisors must transfer a certain portion of their earnings to the firm, earned through commission-based sales.

The problem with this method of compensation is that it rewards advisors for engaging their client in active trading, even if this investing style isn't suitable for that client. Furthermore, to increase their commissions, some brokers practice churning, the unethical practice of excessively buying and selling securities in a client's account. Churning keeps a portfolio constantly in flux, with the primary purpose of lining the advisor's pockets.

And it costs investors. A 2015 report, "The Effects of Conflicted Investment Advice on Retirement Savings," issued by the White House Council of Economic Advisors, stated that "Savers receiving conflicted advice earn returns roughly 1 percentage point lower each year…we estimate the aggregate annual cost of conflicted advice is about $17 billion each year."

Fee-only advisors have their drawbacks too. They are often seen as more expensive than their commission-compensated counterparts, and indeed, the annual 1%-2% they charge for managing assets will eat into returns.

And although fee-only professionals help investors avoid the problems of churning, there should be no misunderstanding that brokerage commissions are eliminated entirely. Investors still need to pay a brokerage to actually make trades. The brokerage may charge custodial fees for accounts as well.

As with so many things, there's no one simple answer to which is better—a fee-or a commissioned-based advisor.

Commissioned services may very well be the most suitable for some investors, particularly in the case of a smaller portfolio where less active management is required; paying the occasional commission is probably not going to be the downfall of the portfolio's returns over the long-term. The key is to understand up front why the advisor is recommending a certain vehicle or product and to ensure you are being offered a choice among products—not just the best ones for your advisor's bank account.

Yet for anybody who has a very large portfolio to manage, whose investment objectives necessitate frequent trades and active asset allocation, a fee-only investment advisor might well be the better option. This compensation structure allows investment professionals to do well for themselves while taking their clients' best interests to heart, which is an emotional component that is high on many investors' list of absolutes.