Fee based advice

What Is Fee Based Advice?

Fee based advice refers to a compensation model in financial services where a financial professional receives fees for their guidance and services, but may also earn commissions from selling specific financial products. This positions fee based advice as a hybrid compensation structure within the broader field of financial planning. Unlike fee-only models, where the advisor is compensated solely by the client, a fee based advisor can derive income from both direct client payments and third-party commissions. This dual compensation model means that while a client pays for the advice directly, the advisor might also receive payments when certain investments, insurance policies, or other financial products are recommended and purchased.

History and Origin

The landscape of financial advisory compensation has evolved significantly over time. Historically, financial advisors, often referred to as stockbrokers, primarily earned income through commissions on trades and sales of financial products. This system, prevalent before the 1970s, often incentivized frequent trading or the sale of higher-commission products, regardless of optimal client benefit. A significant shift occurred on May 1, 1975, when the Securities and Exchange Commission (SEC) mandated the deregulation of commissions, leading to a dramatic drop in trading fees and spurring the growth of discount brokerages.¹³

In the early 1980s, an alternative compensation method emerged with the introduction of asset-based fees and "wrap fees," notably by E.F. Hutton.¹² These early models charged a percentage of assets under management (AUM) annually, shifting compensation away from individual transactions. This innovation paved the way for the "fee based advice" model, allowing advisors to collect direct fees while still potentially earning commissions from product sales or other third-party arrangements. The National Association of Personal Financial Advisors (NAPFA), founded in 1983, specifically promoted a "fee-only" standard, distinguishing it from fee based advice and further driving industry dialogue around transparency and potential conflict of interest.¹¹

Key Takeaways

Fee based advice involves a hybrid compensation model, combining direct client fees with potential commissions from product sales.
This structure can introduce potential conflicts of interest, as the advisor may have an incentive to recommend products that pay commissions.
Clients should fully understand the compensation structure and any potential conflicts before engaging a fee based advisor.
The fees charged can be based on a percentage of assets under management, an hourly fee, or a flat fee for services, in addition to commissions.
Disclosure of all forms of compensation is a critical aspect of regulatory oversight for financial professionals offering fee based advice.

Formula and Calculation

When dealing with fee based advice, especially where an assets under management (AUM) component is involved, the calculation typically follows a percentage of the assets being managed. While commissions are variable and product-specific, the AUM portion is straightforward.

The annual advisory fee based on AUM can be calculated as:

\text{Annual Advisory Fee} = \text{AUM} \times \text{Advisory Fee Percentage}

Where:

(\text{AUM}) = Total value of client's assets managed by the advisor.
(\text{Advisory Fee Percentage}) = The annual percentage rate charged by the advisor (e.g., 1%).

For example, if a client has $500,000 in assets under management and the advisor charges a 1% AUM fee, the annual advisory fee would be:
($500,000 \times 0.01 = $5,000)

This fee might be billed quarterly (e.g., $1,250 every three months). Separately, the client might also pay commissions on specific product recommendations made by the fee based advisor. Understanding this fee structure is crucial for accurate financial planning.

Interpreting Fee Based Advice

Interpreting fee based advice requires clients to understand the nuances of the advisor's compensation structure. Unlike a fee-only model, where the advisor is solely paid by the client, a fee based advisor has multiple revenue streams. This can include charges based on assets under management (AUM), hourly rates, or flat fees for services, combined with commissions or other forms of compensation from third parties for selling financial products.

Clients should evaluate whether the advisor's dual compensation model creates a conflict of interest. While a fee based advisor can still provide valuable guidance, their incentive to earn commissions on certain products might subtly influence recommendations. Transparent disclosure of all fees and potential conflicts is paramount. A client should explicitly ask for a full breakdown of how the advisor is compensated, including any commissions or referral fees received from product providers. This allows the client to make informed decisions about the advice received and assess whether it truly aligns with their best interests.

Hypothetical Example

Consider Sarah, who is seeking a financial planner to help with her retirement planning. She interviews two advisors.

Advisor A operates on a fee-only model, charging a 1% annual fee on assets under management (AUM). If Sarah has $750,000 in her investment portfolio, Advisor A would charge $7,500 per year, regardless of the specific investments chosen, as long as they are managed by the advisor.

Advisor B operates on a fee based advice model. They charge 0.75% annually on AUM. For Sarah's $750,000 portfolio, this would initially be $5,625 per year. However, Advisor B is also licensed to sell various investment products, such as annuities or certain mutual funds, which pay them a commission upon sale. If Advisor B recommends a specific annuity product that pays a 2% commission on the invested amount, and Sarah invests $100,000 into it, Advisor B would receive an additional $2,000 from the annuity provider. This commission is separate from the AUM fee Sarah pays directly.

In this scenario, while Advisor B's AUM fee is lower, the potential for additional commission earnings introduces a factor Sarah must consider. She needs to understand if the annuity recommendation is solely in her best interest or if the commission plays a role in the suggestion.

Practical Applications

Fee based advice is a common compensation structure in various aspects of financial services. A financial planner might utilize this model for providing comprehensive wealth management services, including investment management, retirement planning, and estate planning. In such arrangements, clients pay a direct fee, often based on a percentage of assets under management, while the advisor may also receive commissions from the sale of specific products like insurance policies, mutual funds with loads, or certain structured products.

This model is frequently seen among advisors who are dually registered as both registered investment advisors (RIAs) and broker-dealers. As an RIA, they are typically held to a fiduciary duty for advisory services, meaning they must act in their clients' best interests. However, when operating as a broker-dealer and selling products, they may be subject to a suitability standard, which is less stringent. The Securities and Exchange Commission (SEC) frequently provides guidance and FAQs regarding disclosure obligations for investment advisers concerning financial conflicts related to compensation, emphasizing transparency about any direct or indirect payments advisors receive.¹⁰ This dual capacity means fee based advisors can offer a broader range of services and products, but clients must carefully review disclosures to understand all potential sources of advisor compensation.

Limitations and Criticisms

A primary limitation and criticism of fee based advice stems from the inherent conflict of interest that can arise from its hybrid compensation structure. When an advisor receives both direct fees from clients and commissions from product providers, there is a potential for recommendations to be influenced by the commission rather than solely by the client's best interest. For example, an advisor might be incentivized to recommend a product that offers a higher commission, even if a lower-cost or more suitable alternative exists.

Research indicates that financial advisors can be influenced by their compensation schemes, potentially impacting retail investors' financial well-being.⁹ This raises concerns about whether the advice is truly objective. While regulatory oversight bodies like the SEC require disclosure of such conflicts, understanding and interpreting these disclosures can be challenging for the average investor. Critics argue that even with disclosure, the potential for subtle biases remains. This lack of complete alignment with the client's interests is why many advocates for transparent financial advice often prefer advisors who adhere strictly to a fee-only model, eliminating third-party commissions entirely to reduce perceived conflicts.⁸

Fee Based Advice vs. Commission-Based Advice

The distinction between fee based advice and commission-based advice lies in their fundamental compensation structure and the potential for conflict of interest.

Fee Based Advice: In this model, advisors receive direct fees from clients for services rendered, such as investment management or financial planning. These fees can be a percentage of assets under management (AUM), an hourly fee, or a flat fee. Crucially, fee based advisors may also receive commissions from third parties for selling specific financial products (e.g., mutual funds, annuities, insurance policies). This hybrid approach means while clients pay directly, the advisor has additional income streams tied to product sales.
Commission-Based Advice: Here, the advisor's entire compensation is derived from commissions earned on the sale of financial products. Clients do not pay a direct advisory fee. The advisor earns money when a client buys or sells a security, an insurance policy, or other investment products through them. This model can create a strong incentive for the advisor to recommend products that generate the highest commission, potentially leading to excessive trading ("churning") or the sale of unsuitable products.

The key point of confusion often arises because both models can involve product sales. However, fee based advice includes a direct client fee component, whereas pure commission-based advice relies solely on sales commissions. Clients generally perceive fee based advice as more aligned with their interests than purely commission-based models, though the hybrid nature means potential conflicts still exist, which is not the case for a pure fee-only advisor.

FAQs

What types of fees do fee based advisors charge?

Fee based advisors typically charge a direct fee to the client, which can be a percentage of assets under management (AUM), a flat fee for specific services, or an hourly fee. In addition to these direct fees, they may also receive commissions from third parties (e.g., mutual fund companies, insurance providers) for selling certain financial products.

Is fee based advice the same as fee-only advice?

No, fee based advice is not the same as fee-only advice. A fee-only advisor is compensated solely by the client, meaning they do not receive any commissions or other third-party payments. A fee based advisor, while charging direct fees to the client, can also receive commissions, making it a hybrid model.

Why might there be a conflict of interest with fee based advice?

A potential conflict of interest arises because fee based advisors can earn commissions from selling specific financial products. This creates an incentive for the advisor to recommend products that pay them a commission, even if other, potentially more suitable or lower-cost options that don't pay a commission, are available. This contrasts with a fiduciary duty, which requires advisors to always act in their clients' best interest.

How can I find out how my financial advisor is compensated?

You should directly ask your financial advisor for a clear explanation of their compensation structure, including all sources of income they receive. Investment advisors registered with the SEC are also required to provide clients with a Form ADV Part 2A (Brochure) and Part 2B (Brochure Supplement), which detail their services, fees, and any conflicts of interest. Checking the advisor's background through FINRA BrokerCheck is also a good practice.

Is fee based advice always a bad thing?

Not necessarily. While the potential for conflict of interest exists, many reputable fee based advisors provide valuable service and prioritize their client's interests. The key is transparency and diligent disclosure. Clients need to be fully aware of all compensation streams and assess whether the advice they receive genuinely aligns with their financial goals and risk tolerance.¹ ² ³ ⁴ ⁵ ⁶ ⁷