“Show me the incentive and I will show you the outcome.”
Charlie Munger
When seeking financial planning and investment advice it is important to understand how much you are paying for the advice. This is a key question I recommend asking your Advisor up front (before you start working together) and should include a breakdown of both the cost of the advice and the cost of the underlying investments that the advisor recommends.
Equally important to the question of how much you are paying is the question of how you are paying. Is your advisor receiving a commission each time you invest? Is there a difference in how much your advisor gets paid depending on which investments are recommended? Do you pay the advisor a percentage of the assets they are managing? Are there any separate fees for financial planning and other services? Do you pay for this advice a la carte or is it included in your ongoing fee? By understanding these questions you can then understand any incentives that may influence the advice you are receiving.
Before we dive into the details it is important to know that the cost model is not the end all be all of whether you should work with a particular Advisor or firm. During my time in the industry I have worked under most of these models at one time or another and always strived to give advice in the best interest of the client regardless of the monetary incentives. I know many excellent financial advisors working under these various models today. The goal of this article is to help reduce some of the confusion (from an investor’s point of view) of the various cost structures, and point out the incentives (both positive and negative) of each model.
What follows are my opinions based on my experience of 20+ years as a financial Advisor. I will attempt to do justice to the various models in a fair way that points out the most important incentives of each. I’m sure I will miss some and there are likely some cost structures I will not be able to cover. While I will give my opinions on the various models, I do not attempt to identify the “best” model as that is in the eyes of the client as they seek financial advice from their trusted advisor.
Let’s dive in. There are essentially three ways to charge for financial advice. Commissions, Fees, or a combination of the two. Today I will tackle the commission only model. In future posts I will discuss the fee-only (including assets-under-management, hourly, and project based) and hybrid models.
Commission Only
This is the model that reigned for most of the 20th century in financial services. For each security transaction or financial product sale there would be a built in commission. This commission could either be a fixed amount (say $400 for an individual stock purchase) or more often a percentage (for example 5% added to the net asset value of a mutual fund). More complex financial products such as variable universal life insurance or variable annuities will have commissions built into the amount you pay. The price is set by the broker and is (usually) not negotiable.
In many product areas these commissions have come down significantly in recent years due to competition and regulatory reform. While it may have cost several hundred dollars to purchase 100 shares of Exxon stock in 1980, today this stock can be purchased from several online brokers for no commission. Similarly, mutual fund commissions were around 8% in the 1980’s and dropped to 5.75% by the 2000’s, with significant additional discounts called “breakpoints” for larger investments. Generally, commissions for self-service (such as purchasing an individual stock or ETF on an online brokerage platform) have dropped to zero or near zero. Commissions for more complex financial products such as annuities and mutual funds sold through an Advisor have remained.
Pros
- Unlike other forms of compensation, working with a financial advisor on a commission-only basis does not cost the investor anything up front. Only once the investor has agreed to purchase a financial product do they pay. You could say this allows a “try before you buy” period. If you decide not to work with the advisor after the initial engagement you have lost nothing but your time.
- It is possible (with many caveats) that this form of payment could be less expensive over the long haul than fee based approaches. As a simple example, assume a $100,000 initial investment and no growth over a twenty year period. You could either purchase a mutual fund with a 5% up front commission or a 1% assets under management fee to a wealth management firm. The mutual fund would cost you $5,000 and the fee would be $1,000 in the first year. However, while you are done paying the broker for the mutual fund, the fee would continue to be paid over the 20 year period, for a total of $20,000, or 4 times the commission. Of course, there would likely be growth (which would further favor the up-front commission.) Also, in reality, the typical holding period for a mutual fund is around 3 years. This means that it is likely that most investors would end up purchasing a different mutual fund every few years and thus compounding the commission. Also, there are typically ongoing built in commissions (usually 0.25%) to commission based mutual funds. In my experience it is a rare investor who would buy and hold a commission based mutual fund for 20+ years. Although, if you do, this form of payment would be favorable.
Cons
- This form of payment creates an investor-unfriendly incentive. The goal of the investor is to maximize their return (which includes minimizing costs). The incentive for the commission based financial advisor is to sell new financial products or commission generating transactions. After all, that is the only way he gets paid! While this does not mean that an advisor would purposely give bad financial advice, the incentive structure is strong and shouldn’t be ignored by the investor.
- The available investment options may be limited by what the advisor is able to access. First of all, commission products by definition need to have a commission attached. This would exclude many actively managed mutual funds, index funds, and non-commission insurance products. Also, many commission only advisors may be tied to proprietary products produced by their broker dealer or insurance company. For example, it would not make sense to recommend a Vanguard Index fund to an investor due to a lack of commission and likely unavailability to even hold the fund on the commission advisor’s platform.
- It is increasingly difficult to find an advisor working on a commission-only basis. Due to market pressures reducing commissions, increasing regulations targeting the commission-only model, and the potential higher profitability of fee-based models many successful advisors have moved to a hybrid or fee only model in the past couple of decades.
The Evolution from Commissions to Fees
While the fee-only (no commission) model has existed ever since the Investment Adviser Act of 1940, in the 1990’s and 2000’s it became increasing popular for advisors to charge fees to clients either in liu of or in addition to commissions. Many Advisors began starting new Registered Investment Advisory firms and marketing themselves as fee-only in order to differentiate from a marketplace dominated by commissions. Even more advisors and broker-dealer firms began to take a hybrid approach (sometimes marketed as “fee-based”) to offer their clients a combination of fee and commission options. These new fee models have assisted in broadening the services of financial advisory firms to include comprehensive financial planning, proactive tax planning, and other services.
In future posts I will discuss the pros and cons of the Assets-Under-Management (AUM) model, charging by the hour, monthly subscription, and the hybrid of fees and commissions.
