So your financial advisor’s website states that she is fee-only. What does that mean exactly? A one-time fee, perhaps a percentage, or is it simply another way of saying commission?
Part of why financial advisors make the fee-only distinction is to differentiate themselves from those earning income from commissions. This is a good distinction to know about, but it can be misleading.
First let’s look first at how advisors earn income.
This is where the financial industry has its roots. The financial advisor is paid a percentage of the revenues they generate by selling a particular product. This product could be a mutual fund, life insurance contract, or annuity. The problem with commissions is the conflict of interest it creates, which is that the advisor is paid to sell you something, whether that something is good for you or not. In fact, some of the worst products usually have the highest payouts, which incentivizes the advisor to do what is in their best interest, not yours. Additionally, the person paying for the commission is you, either the price of the product is increased to cover the commission, or the amount of money you have invested is reduced by the amount of the commission.
Now there are times when commissions are better for the client than paying fees would be. One example was a firm that I used to work for. We would take clients that only had a few thousand dollars to invest, buy a low-commission mutual fund that we had vetted, and not charge any other fees. These accounts would not be traded until the amount had built up to where it made sense to further diversify. In effect they were paying us about $80 - $120 a year for investment advice. They could have done this cheaper on their own, but that’s a great deal for a professional’s help.
Fee based is confusing because of the word “fee,” but what it means is that the advisor is paid by both fees and commissions. Often advisors that also have their insurance licenses are fee-based because very few insurance companies pay their “producers” with fees rather than commissions.
If someone claims to be fee-only, but sells insurance, dig into how they are paid when they sell an insurance product. A lot of advisors that are fee-based claim to be fee-only. Also watch out for the letters ChFC or CLU behind someone’s name; these are designations that focus on insurance. It doesn’t mean that they are paid by commissions, but it does mean you should ask some questions.
Fee only has become a popular model in the past few years. When it looked like the Department of Labor was going to require any financial advisor working with an IRA to be a fiduciary then several companies moved away from commissions and toward fee-only. The gold standard for the fee-only definition is that set by the National Association of Professional Financial Advisors (NAPFA).
“NAPFA defines a Fee-Only financial advisor as one who is compensated solely by the client with neither the advisor nor any related party receiving compensation that is contingent on the purchase or sale of a financial product. Neither Members nor Affiliates may receive commissions, rebates, awards, finder’s fees, bonuses or other forms of compensation from others as a result of a client’s implementation of the individual’s planning recommendations. "Fee-offset" arrangements, 12b-1 fees, insurance rebates or renewals and wrap fee arrangements that are transaction based are examples of compensation arrangements that do not meet the NAPFA definition of Fee-Only practice. If you have questions about specific compensation arrangements, please contact the NAPFA Membership Manager.”
The key here--which several financial advisors use to try to claim fee-only when they are truly fee-based--is the “nor any related party.” This means that the owner of the firm cannot have a separate company that receives commissions in any way shape or form.
Which method is best?
There is no “best” way for you to pay your financial advisor. Even within the fee-only realm, there are multiple ways for your advisor to be paid, all of which have their unique conflicts of interest.
The key for you to be a smart investor is to know how much you are paying your financial advisor and how they are being paid. If it feels like you're being nickel and dimed dig deeper and ask tough questions to find out if you are.