The world of finance is known for its confusing terminology and baffling acronyms. As a result, clients often feel that they need to learn a foreign language to understand it all!
But if clients don’t understand the language of finance, they can end up making mistakes and incorrect assumptions, especially in the area of advisor compensation. “In The Black” blogs try to help explain terms and definitions so that they are more easily understood and relatable.
Two terms that are crucial for clients to understand are fee-based compensation and commission-based compensation. These two payment models can make a huge difference in the type of advice a client is paying for and the kind of relationship they are able to build with their advisor.
Differences Between Fee-Based And Commission-Based Advice
Fee-based advisors charge a flat fee directly to their clients for their services. This fee can be structured in multiple ways, such as an hourly rate, a monthly retainer, a flat annual fee, or a percentage of assets under management (AUM). Sometimes fee-based advisors receive commissions based on the products that they sell, but that is secondary and not the basis for their compensation structure.
On the other hand, commission-based advisors charge nothing to their clients and are compensated solely through commissions. These commissions come from accounts they open and financial products they sell. These products can be anything from insurance to mutual funds where the commissions are embedded into the actual products themselves.
There has been a lot of backlash against compensation-based advisors, as the assumption is that they will be biased towards selling their clients the most lucrative product. Lucrative for the advisor, that is. There is definitely merit to this argument, but it is important to recognize that not all advisors are the same. They don’t all have the same motivations or predilections. Regardless, we should understand the pros and cons of both systems and how the compensation method may affect an advisor’s brand and practice, which can also influence how well the advisor’s and clients’ goals align, the quality of their long-term relationship, and the legal standard to which the advisor is held.
Compensatory Independence
A commission-based advisor has to accept the commissions offered by financial product companies and has no say in what he earns. The profitability of the client-advisor relationship is dictated by a third party, and once the sale is made, neither the advisor nor the client exerts any influence over the matter. My hope is that a commission-based advisor will have the fortitude to always put the client’s interests first when fact finding or going through a needs analysis with their clients. They also need to make sure that the client understands fully the products or services that are being recommended and include an honest discussion about the commissions that result.
In contrast, a fee-based advisor has complete control over what he chooses to charge and the fees are always agreed upon by the client before the advisor begins his work. As an independent advisor, he alone decides what his time and knowledge are worth and who he wants to serve. He has the flexibility to set his fee schedule to correspond with his ideal client’s willingness to pay. Unfortunately, this doesn’t necessarily mean that fee-based advisors are more principled or that their advice is better. However, it does give clients the opportunity to approve the fees set by the advisor, which is not possible with commission-based advisors or products. As already mentioned, even fee-based advisors may end up selling commission-based products in which they are licensed, such as life insurance. However, there is usually the backing of a financial plan that has also prompted the recommendation.
Transparency and Goal Alignment
Fee-based compensation has the benefit of allowing an advisor to better align his clients’ goals with those of his own practice, offering clients the transparency needed when staying within a certain budget. With commission-based advisors, the rules and regulations have been changing rapidly to make these embedded fees transparent where they are literally brought to light and signed off on at the point of sale. Many financial products are not yet regulated in this way and we believe that it will not be long before the whole industry will be forced to be transparent. As already stated, commission-based compensation, which is generated by the sale of products, may not always be in the best interest of the client.
Fee-based advisors can be more objective because their pay is not dependent on selling specific products, therefore, it is less likely that they will be biased towards a particular product or company, and they can offer a more holistic approach to the value-added financial advice they stand by. For example, advisors who charge based on AUM are usually more motivated to multiply their clients’ assets because the more money they help their clients make, the more money they make. In the case of a fee-based financial planner, a fee charged for the preparation of a financial plan allows the client/advisor relationship to carry on without bias or conflict of interest, creating a win-win situation.
Relationship Longevity
Commissions are designed to be paid up front, either immediately or within the first few years after the initial sale. Unless a commission-based advisor has a strong service-oriented structure in his practice, he or she may decide that they have little reason to continue their relationship with the client, unless they anticipate future sales.
On the contrary, fee-based advisors are paid recurrently as they serve their clients, which can ensure, although not guaranteed, continued service from the advisor on a consistent and ongoing basis. Due to this factor, fee-based advisors are more likely to take a long-term approach with their clients, building trusted relationships and making recommendations that will work over an extended period of time.
Suitability vs. Fiduciary Duty
Finally, commission-based and fee-based advisors are held to different legal standards. Fee-based advisors have an inherent fiduciary duty to their clients, meaning that they have to put the clients’ best interests ahead of their own, or that of any broker, dealer or other institution.
Commission-based advisors do not have an inherent fiduciary duty to their clients as of yet. However, it is still implied given the position they hold in the advisor/client relationship, as the suitability rule is intrinsic. This means that they cannot sell their clients products that do not suit their needs and objectives. They may not have to do what is optimal for their clients, as long as what they provide them with is considered suitable.
We Are Fee-Based First To Keep You First
At Black Spruce Financial, our first priority as independent advisors is your overall financial success. Therefore, our compensation is mostly structured as fee-based unless dictated by the financial company’s products that we sell, such as most insurance products. We want the freedom to help you realize your dreams without any potential conflicts of interest. If you are looking for a long-term relationship with a fiduciary that will always put you first, call us today at 416-553-5004 or gino@blacksprucefinancial.com.
About Gino
Gino Scialdone is a financial advisor and the owner of Black Spruce Financial, an independent wealth management firm serving independent business owners. Having grown up in a family business and owning a business himself, Gino has a unique understanding of the challenges and needs business owners face. Offering a comprehensive array of wealth management and financial planning services, he strives to provide sound and creative strategies that meet a business owner’s short and long-term needs. Based in Toronto, Gino serves clients throughout the greater Toronto area and southern Ontario. To learn more, connect with him on LinkedIn or visit www.blacksprucefinancial.com.