Commission based accounts

What Is Commission-Based Accounts?

A commission-based account is a type of investment account where a financial professional, typically a broker-dealer, earns compensation in the form of a commission for each transaction executed on behalf of a client. These transactions can involve the purchase or sale of stocks, bonds, mutual funds, exchange-traded funds, or other investment vehicles. This compensation model falls under the broader category of Investment Accounts within financial services. In a commission-based account, the client pays a fee for each specific trade, rather than an ongoing fee based on the value of their holdings.⁵⁸

History and Origin

The practice of charging commissions on securities transactions dates back to the earliest days of stock exchanges. For centuries, fixed commission rates were the norm, meaning all brokerage firms charged the same predetermined fee for executing trades, regardless of the trade size or value. This system ensured a consistent income for brokers but made stock trading prohibitively expensive for many individual investors.⁵⁷,⁵⁶,⁵⁵,⁵⁴

A pivotal moment in the history of commission-based accounts occurred on May 1, 1975, a date widely known as "May Day." On this day, the U.S. Securities and Exchange Commission (SEC) eliminated fixed commission rates in the brokerage industry, ushering in an era of negotiated commissions.⁵³,⁵²,⁵¹ This deregulation sparked fierce competition among brokers, leading to significantly reduced trading costs and the emergence of discount brokers like Charles Schwab, who offered lower fees and expanded access to investing for individuals.⁵⁰,⁴⁹,⁴⁸,⁴⁷ This shift fundamentally reshaped the financial services landscape, moving towards more competitive pricing models.

Key Takeaways

• Commission-based accounts involve clients paying a fee for each transaction (e.g., buying or selling a stock).⁴⁶
• Compensation is directly tied to trading activity, not the total value of assets in the account.
• Historically, fixed commissions were abolished on "May Day" in 1975, leading to greater competition and lower trading costs.⁴⁵
• Broker-dealers operating commission-based accounts must adhere to the suitability standard, ensuring recommendations are appropriate for the client.
• Potential conflicts of interest exist, as advisors may be incentivized to recommend transactions that generate commissions.⁴⁴

Formula and Calculation

The calculation for a commission in a commission-based account is typically straightforward, often expressed as a percentage of the transaction value, a flat fee per trade, or a per-share charge.

For a percentage-based commission:

$\text{Commission} = \text{Transaction Value} \times \text{Commission Rate}$

Where:

• Transaction Value = The total monetary value of the securities bought or sold.
• Commission Rate = The percentage charged by the broker for the transaction.

For a flat-fee commission:

$\text{Commission} = \text{Flat Fee per Trade}$

Where:

• Flat Fee per Trade = A fixed amount charged for each transaction, regardless of size.

For a per-share commission:

$\text{Commission} = \text{Number of Shares} \times \text{Commission per Share}$

Where:

• Number of Shares = The quantity of shares traded.
• Commission per Share = The fixed amount charged for each share.

These calculations determine the direct cost incurred by the client for executing a specific trade within their brokerage accounts.

Interpreting the Commission-Based Account

In a commission-based account, the primary interpretation revolves around the cost per transaction. A higher commission rate or flat fee directly translates to higher trading costs for the investor, impacting net returns, especially for frequent traders. Investors in these accounts should closely monitor how often trades are executed and the associated costs, as excessive trading can erode returns over time. The fundamental principle is that the financial professional is compensated only when a transaction occurs.⁴³ This model can be more cost-effective for investors who employ a "buy and hold" strategy, meaning they make infrequent trades and do not require ongoing portfolio management or frequent asset allocation adjustments.⁴²

Hypothetical Example

Consider an investor, Sarah, who opens a commission-based account with a brokerage firm. The firm charges a commission of 1% of the transaction value for stock trades.

1. Scenario 1: Buying Stocks
   Sarah decides to buy 100 shares of Company X, which is trading at $50 per share.

   • Transaction Value = 100 shares * $50/share = $5,000
   • Commission = $5,000 * 1% = $50
     Sarah pays a total of $5,050 ($5,000 for the shares + $50 commission).

2. Scenario 2: Selling Stocks
   Later, Sarah sells her 100 shares of Company X when they reach $60 per share.

   • Transaction Value = 100 shares * $60/share = $6,000
   • Commission = $6,000 * 1% = $60
     Sarah receives $5,940 ($6,000 from the sale - $60 commission).

In this example, the commission-based account charges a fee for each buy and sell transaction, directly impacting the investor's total cost and net proceeds.

Practical Applications

Commission-based accounts are prevalent in various segments of the financial industry, primarily for executing specific securities trades.

• Brokerage Services: These accounts are the traditional model for brokerage accounts, where investors place orders to buy or sell securities. They are often suitable for self-directed investors or those who require transactional services without ongoing advisory relationships.⁴¹
• Real Estate: Real estate agents typically earn a commission, which is a percentage of the property's sale price, upon the successful completion of a transaction. This is a classic example of a commission-based compensation structure outside of securities.⁴⁰,³⁹,³⁸
• Insurance: Insurance agents frequently earn commissions from the sale of insurance policies. Their compensation is tied directly to the products they sell.³⁷
• Investment Product Sales: Certain investment products, like some mutual funds with sales loads or annuities, may involve commissions paid to the selling financial advisor or broker.³⁶,³⁵

These accounts generally focus on facilitating transactions rather than providing comprehensive, ongoing financial planning or portfolio management.³⁴ Broker-dealers offering commission-based services are subject to regulatory standards, such as FINRA Rule 2111, which requires them to have a reasonable basis to believe a recommended transaction or investment strategy is suitable for the customer.³³ Furthermore, the SEC's Regulation Best Interest (Reg BI) imposes a "best interest" standard on broker-dealers when making recommendations to retail customers, requiring disclosure of material facts about fees and conflicts of interest.³²,³¹,³⁰

Limitations and Criticisms

Despite their widespread use, commission-based accounts face several limitations and criticisms, primarily concerning potential conflicts of interest.

• Incentive for Over-trading: Since compensation is earned per transaction, there can be an incentive for financial professionals to recommend more frequent trades than might be necessary or beneficial for the client's investment objectives. This practice, known as churning, can lead to higher trading costs that erode client returns.²⁹,,²⁸
• Product Bias: Advisors in commission-based models might be incentivized to recommend products that offer higher commissions, even if less costly or more suitable alternatives exist.²⁷,²⁶, This can lead to clients being placed into investments that are not optimally aligned with their needs.
• Suitability vs. Fiduciary Standard: Commission-based advisors are generally held to a "suitability" standard, which means they must recommend investments that are appropriate for the client's needs and objectives.²⁵ This differs from a fiduciary duty, where an advisor is legally obligated to act in the client's absolute best interest, putting the client's interests ahead of their own.²⁴,²³ This distinction can create a perception of misaligned interests.
• Lack of Ongoing Advice: Commission-based models typically do not inherently include ongoing portfolio management or comprehensive financial planning. Clients seeking continuous advice or active management may find this model less comprehensive than fee-based alternatives.²²,²¹

Regulatory bodies like FINRA and the SEC have implemented rules, such as FINRA Rule 2111 (Suitability) and Reg BI, to address these concerns by requiring disclosures and establishing standards of conduct for broker-dealers.²⁰,¹⁹

Commission-Based Accounts vs. Fee-Based Accounts

The distinction between commission-based accounts and fee-based accounts lies primarily in their compensation structure.

Confusion often arises because some financial professionals are "dually registered," meaning they can act as both broker-dealers (earning commissions) and investment advisors (earning fees). In such cases, it is crucial for investors to understand the capacity in which the professional is acting for a particular service or recommendation, and how they are being compensated.¹¹,¹⁰

FAQs

What is a commission in finance?

A commission in finance is a fee charged by a broker or agent for facilitating a transaction, such as buying or selling stocks, bonds, or other investment vehicles. It is typically a one-time charge per trade.⁹

Are commission-based accounts always more expensive than fee-based accounts?

Not necessarily. For investors who trade very infrequently or employ a long-term "buy and hold" strategy, commission-based accounts can sometimes be less expensive overall because fees are only incurred when a transaction occurs.⁸ In contrast, fee-based accounts often charge an ongoing percentage of assets under management, which can accumulate to a higher total cost over time, especially for larger portfolios.⁷

Do commission-based advisors act as fiduciaries?

Commission-based advisors are generally held to a "suitability" standard, which requires them to recommend investments suitable for a client's profile.⁶ While some commission-based advisors may also operate under a fiduciary duty for certain services, it is not a universal requirement for all commission-based activities. Investors should always ask their financial advisor about their standard of care.⁵,⁴

What kind of disclosures should I expect with a commission-based account?

Broker-dealers offering commission-based accounts are required to provide disclosures about their services, fees, and potential conflicts of interest. The SEC's Regulation Best Interest (Reg BI) mandates that broker-dealers disclose material facts about the relationship and recommendations, including fees and conflicts, to retail customers.³,² Additionally, firms must provide a brief relationship summary (Form CRS) to retail investors.¹