Commission based

What Is Commission Based?

"Commission based" refers to a compensation model in the financial industry where a financial professional, such as a financial advisor or broker-dealer, earns money directly from the sale of specific financial products or investment transactions. This falls under the broader category of Investment Advisory Compensation. In a commission-based structure, the more products sold or the more transactions executed, the greater the compensation for the professional. This model is common in sales-driven environments where the primary service involves facilitating the purchase or sale of securities, mutual funds, or annuity products.

History and Origin

The commission-based model has a long history in financial services, predating many of the fee structures seen today. Before the 1980s, large commissions were a dominant form of compensation for brokers, who often profited significantly from each stock they sold. A pivotal shift occurred on May 1, 1975, known as "May Day," when the Securities and Exchange Commission (SEC) mandated the deregulation of brokerage commissions. Prior to this, brokers charged a fixed rate for all trades regardless of size, which limited access for small investors. The deregulation led to market competition setting trading fees, transforming how brokers operated and paving the way for the evolution of compensation models beyond solely commission-based structures. Despite these changes, the commission-based model continued to be popular for a significant period, particularly for the sale of specific products like insurance and annuities.¹¹,¹⁰

Key Takeaways

• Commission-based compensation means advisors earn a direct payment for selling financial products or executing trades.
• The more products sold or trades made, the higher the commission earned.
• This model can introduce conflicts of interest, as higher-commission products might be prioritized over those most suitable for a client.
• Regulatory efforts, such as the SEC's Regulation Best Interest, aim to enhance investor protection in commission-based scenarios.
• Many financial professionals have shifted away from a pure commission-based model towards fee-based or fee-only structures.

Interpreting the Commission Based Model

When engaging with a commission-based professional, it is crucial for a retail investor to understand that the professional's compensation is tied directly to the products they recommend and sell. This means that a specific financial product might be recommended because it generates a higher commission, rather than being the absolute best fit for the client's needs or objectives. Investors should inquire about all potential fees, including upfront sales charges, ongoing trail commissions, and other transaction costs, to fully comprehend the total cost of their investment.

Hypothetical Example

Consider an individual, Sarah, who is seeking guidance on retirement planning. She consults with a financial professional, Alex, who operates on a commission-based model. Alex recommends that Sarah invest a significant portion of her savings into a particular variable annuity, which carries a 5% upfront sales commission and annual trailing commissions.

If Sarah invests $100,000 into this annuity, Alex immediately earns a $5,000 commission from the sale. Additionally, Alex will continue to receive a percentage of Sarah's investment each year as a trailing commission, as long as Sarah holds the annuity. While the variable annuity might have some features that align with Sarah's goals, the commission structure provides a direct financial incentive for Alex to recommend this specific product over potentially lower-cost or more suitable alternatives that might not offer commissions, such as certain fee-only investment options or exchange-traded funds (ETFs). Sarah should ask detailed questions about all associated fees and explore other options, potentially seeking a second opinion, to ensure the recommendation truly serves her best interests.

Practical Applications

The commission-based model is predominantly found in settings where financial professionals act as agents or brokers facilitating transactions rather than providing ongoing holistic financial planning advice for a fixed fee. This includes:

• Brokerage Firms: Many traditional brokerage firms compensate their agents through commissions on stock trades, bond sales, or sales of proprietary products.
• Insurance Sales: Agents selling life insurance policies, annuities, or other insurance products typically earn commissions from the insurance companies.
• Mutual Fund Sales: Certain share classes of mutual funds (e.g., A-shares) include a "load" or sales charge, which is effectively a commission paid to the professional who sells the fund.
• Real Estate: Real estate agents earn a commission on the sale price of a property.

Regulators like the Financial Industry Regulatory Authority (FINRA) require clear disclosure of fees and commissions to investors, emphasizing the importance of understanding all associated costs before making an investment.⁹ The Consumer Financial Protection Bureau (CFPB) provides resources to help individuals understand different compensation models when choosing a financial advisor.⁸

Limitations and Criticisms

The commission-based compensation model faces several limitations and criticisms, primarily centered around the potential for conflict of interests. Since the professional's income is tied to sales, there can be an incentive to recommend products that generate higher commissions, even if they are not the most appropriate or cost-effective for the client.⁷,⁶ This can lead to issues such as:

• Product Bias: A professional might favor a proprietary product or a product with a higher payout over a more suitable, lower-commission alternative.
• Churning: Excessive trading in a client's account to generate more commissions, often without a justifiable investment purpose.
• Lack of Ongoing Advice: The transactional nature of commission-based compensation may lead to a focus on individual sales rather than comprehensive, long-term financial planning.

In response to these concerns, regulatory bodies have implemented rules to enhance investor protection. The U.S. Securities and Exchange Commission (SEC) adopted Regulation Best Interest (Reg BI) in 2020, which requires broker-dealers to act in the "best interest" of their retail investor clients when making recommendations. This standard goes beyond the previous "suitability" standard, which only required that a recommendation be generally appropriate for the client, without necessarily prioritizing the client's interests over the broker's.⁵,⁴, Despite these regulations, potential conflicts can still exist, and investors must remain vigilant.³

Commission Based vs. Fee-Only

The distinction between commission-based and fee-only compensation models for financial professionals is crucial for investors.

While commission-based professionals are compensated for specific transactions, fee-only advisors typically charge based on a percentage of assets under management, a flat fee for services, or an hourly rate. This fee-only structure is generally seen as reducing conflict of interests because the advisor's compensation grows when the client's assets grow, aligning their interests. Investors should inquire about how a professional is compensated to understand potential biases.

FAQs

What does "commission based" mean for me as an investor?

"Commission based" means the financial professional receives payment from the company whose products they sell to you or for the transactions they execute on your behalf. This compensation is typically a percentage of the amount you invest or the value of the trade.

Are commission-based financial advisors bad?

Not necessarily "bad," but the commission-based model inherently carries a greater potential for conflict of interests compared to other compensation structures. It's essential to understand how your advisor is paid and to ensure their recommendations align with your best interests, not just their potential earnings.

How can I tell if a financial professional is commission based?

You should directly ask any prospective financial professional about their compensation structure. They are required to disclose this information. Look for terms like "commission," "sales charges," "loads," or "12b-1 fees" in their disclosures, particularly on documents like Form CRS, which outlines the relationship summary between you and the firm.

Does "commission free" trading mean there are no costs?

"Commission free" often refers to the absence of a direct trading commission, particularly for common stock and ETF trades. However, this does not mean "zero fees." Firms may still generate revenue through other means, such as payment for order flow, spreads, or charges for other services. It's important to read the detailed fee schedule provided by your brokerage or advisor.

What regulations apply to commission-based professionals?

In the U.S., broker-dealers who operate on a commission-based model are subject to regulations from the Securities and Exchange Commission (SEC) and FINRA. Key among these is the SEC's Regulation Best Interest (Reg BI), which mandates that broker-dealers act in the best interest of their retail investor clients when making recommendations about securities transactions or investment strategies.²,¹