Fee and commission compensation

What Is Fee-and-Commission Compensation?

Fee-and-commission compensation is a hybrid payment structure within the financial services industry where financial professionals receive a combination of ongoing fees and transaction-based commissions for the services and products they provide to clients. This model falls under the broader category of Financial Advisory Compensation Models. In this arrangement, advisors may charge an advisory fee, often based on a percentage of assets under management (AUM), while also earning commissions from the sale of specific investment products like mutual funds, annuities, or other securities. This differs from a commission-only model, where compensation is solely transaction-based, or a fee-only model, where advisors are paid directly by clients and receive no product commissions. The fee-and-commission compensation model means that an advisor's total earnings can fluctuate based on both the value of assets managed and the volume or type of products transacted.

History and Origin

Historically, financial advice was almost exclusively commission-based, with brokers earning a fixed percentage on every trade executed. This structure dominated the industry for decades. A significant shift occurred on May 1, 1975, famously known as "May Day," when the U.S. Securities and Exchange Commission (SEC) mandated the deregulation of brokerage commissions. Prior to this, brokers charged fixed-rate fees for all trades, which often made investing prohibitively expensive for small investors. The deregulation introduced market competition into trading fees, leading to a substantial decrease in these costs over time and fostering the evolution of compensation models beyond just commissions⁴.

As the financial landscape grew more complex and investor needs expanded beyond simple transactions, the pure commission model faced increasing scrutiny due to inherent conflict of interest concerns. This paved the way for the emergence of fee-based and fee-only structures. The fee-and-commission compensation model developed as a middle ground, allowing advisors to provide ongoing financial planning and portfolio management services for a recurring fee, while still retaining the ability to earn commissions on certain product sales, particularly where such products carried embedded sales charges.

Key Takeaways

• Fee-and-commission compensation is a hybrid model where financial professionals earn both ongoing fees (e.g., AUM-based) and transaction-based commissions.
• It allows advisors to be compensated for both advice and product sales.
• This model can introduce potential conflicts of interest, as advisors might have an incentive to recommend products that pay higher commissions.
• Regulatory bodies require disclosure of such compensation structures and associated conflicts to clients.
• Understanding this model is crucial for investors to assess the alignment of their advisor's interests with their own financial goals.

Interpreting the Fee-and-Commission Compensation Model

Understanding how fee-and-commission compensation works is essential for investors. When a financial professional operates under this model, their income is derived from two primary sources: direct fees charged to the client and commissions received from third-party product providers. The "fee" portion typically covers advisory services like asset management, while the "commission" portion arises from buying or selling specific investment products.

For clients, interpreting this model means recognizing that an advisor's recommendations might be influenced by the commission potential of certain products. Therefore, it is important for investors to thoroughly review all disclosed fees and compensation details and to ask questions about how the advisor is compensated for different investment recommendations. Transparency in this area allows clients to make informed decisions about their client accounts and ensures they understand the potential implications of the advisor's compensation structure.

Hypothetical Example

Consider an investor, Sarah, who seeks wealth management services. She engages a financial advisor who operates on a fee-and-commission compensation model.

Scenario: Sarah has $500,000 in investable assets. Her advisor charges an annual advisory fee of 1% on assets under management (AUM). In addition, the advisor recommends that Sarah allocate a portion of her portfolio to a specific actively managed mutual fund that carries a 2% upfront sales charge (a "load").

Calculation Breakdown:

1. Annual Advisory Fee:

   • On $500,000 AUM, the annual fee is 1% of $500,000 = $5,000. This fee is typically billed quarterly or monthly.

2. Commission from Mutual Fund Sale:

   • Suppose Sarah invests $50,000 into the recommended mutual fund. The 2% sales charge means the advisor (or their brokerage firms) receives a commission of 2% of $50,000 = $1,000 at the time of purchase.

In this example, the advisor earns $5,000 annually for managing Sarah's assets and an additional $1,000 upfront commission from the sale of the mutual fund. This illustrates how fee-and-commission compensation combines ongoing charges with transactional earnings, impacting the total cost to the investor and potentially influencing product recommendations.

Practical Applications

Fee-and-commission compensation models are prevalent in various segments of the financial industry, particularly where advisors act as both advisors and product sellers. This model is commonly found among dually registered financial professionals who are licensed as both investment adviser representatives (IARs) and registered representatives of broker-dealers. This structure allows them to offer advisory services (fee-based) and execute transactions or sell packaged investment products (commission-based).

For instance, an advisor might charge an annual fee for providing comprehensive financial planning services but also earn commissions when clients purchase life insurance policies or certain types of structured products through them. Regulatory bodies like the SEC require strict disclosure regarding how financial advisors are compensated to ensure transparency. Specifically, the SEC mandates that investment advisors disclose any compensation based on the sale of securities or other investment products, including commissions, bonuses, or distribution fees from mutual funds, in their Form ADV brochure supplement³. This ensures that clients are aware of the advisor's compensation structure and any potential conflicts.

Limitations and Criticisms

A primary criticism of fee-and-commission compensation is the potential for conflict of interest. Since an advisor earns commissions from product sales, there is an inherent incentive to recommend products that generate higher commissions, even if those products may not be the most suitable or cost-effective for the client's specific needs². This can lead to issues such as "churning," where excessive trades are made solely to generate commissions, or the recommendation of higher-cost products over lower-cost, equally effective alternatives.

Another limitation is that this model can obscure the true cost of advice for clients, as fees are often paid directly by the client, while commissions are embedded within product costs or paid by product providers. While regulatory bodies such as the Financial Industry Regulatory Authority (FINRA) have established rules like the suitability rule (FINRA Rule 2111) to mitigate these conflicts—requiring that recommendations be suitable for the customer's investment profile—the potential for misaligned interests remains a concern. Cr¹itics argue that the fee-and-commission structure can make it challenging for advisors to uphold a strict fiduciary duty, which requires them to act solely in the client's best interest.

Fee-and-Commission Compensation vs. Fee-Only Compensation

The distinction between fee-and-commission compensation and fee-only compensation lies in the sources of an advisor's earnings and the associated potential for conflicts of interest.

Confusion often arises because both models may involve "fees." However, the key differentiator is whether the advisor receives any compensation from third parties (fee-and-commission) or only from the client (fee-only). The fee-only model is often seen as more aligned with the client's interests due to the absence of product-based sales incentives.

FAQs

Q1: What is the main difference between fee-and-commission and commission-only compensation?

A1: Fee-and-commission compensation means the advisor earns both ongoing fees (often a percentage of assets) and commissions from selling specific investment products. Commission-only compensation means the advisor earns solely from sales commissions, with no recurring fees for advice or asset management.

Q2: How can I tell if my financial advisor uses a fee-and-commission model?

A2: Financial advisors are legally required to disclose their compensation structure. You can typically find this information in their Form ADV Part 2A brochure or Form CRS (Customer Relationship Summary), which they must provide to clients. It should clearly state how they are compensated, including any commissions received.

Q3: Does fee-and-commission compensation automatically mean there's a conflict of interest?

A3: While not every transaction under a fee-and-commission model indicates a negative outcome, the structure inherently presents a conflict of interest. The advisor has a financial incentive to recommend products that pay them commissions, which might not always be the most cost-effective or suitable choice for the client. Regulatory bodies require these conflicts to be disclosed.