Would-be consumers of financial advice often hear they should inquire about the advisor's compensation structure. But even that's a mess. One key area of confusion? What it means to be a fee-based advisor, versus one who's fee-only or commission-only. Some investors incorrectly assume that the presence of the word "fee" means that fee-based advisors are free of the conflicts of interest that can affect commission-based brokers. In fact, of the three major compensation structures for financial advice, only fee-only advisors avoid commission-based products altogether, along with the potential conflicts of interest that business model presents.
Because understanding the different types of advisor compensation is central to finding the right advisor, here's a review of the three major categories. If you're interviewing advisors, it's reasonable to ask them to classify themselves into one of these groupings. And if an advisor refuses to detail compensation, or worse yet, says that their advice is free, that's a huge red flag and you should find someone else.
Fee-Only
Fee-only advisors do not receive commissions--upfront, ongoing, or otherwise--for selling specific products. Rather, they charge their clients fees for whatever services they personally provide. The big attraction of the fee-only model is that it removes potential conflicts of interest: Because the fee-only advisor has no vested interest in putting you in one product or another, you can feel confident that any recommendations are being made at arm's length. Fee-only advisors, as registered investment advisors, are also required to uphold the fiduciary standard, meaning they must put their clients' interests ahead of any other interest, including their own.
Even within the fee-only group, however, there are big variations in compensation setups. Some fee-only advisors might charge a flat fee for a certain type of engagement, much as an attorney might charge you a flat fee to execute estate-planning documents or a certified public accountant will charge you a fixed sum to prepare your tax return. Fee-only advisors who work for a flat fee won't typically require a specific investment minimum.
Other fee-only advisors work on an hourly basis. The complexity of your situation and what you're seeking from the advisor--a full-boat financial plan or help with a targeted issue--will determine your total bill. Hourly fees can run in the neighborhood of $150-$200 an hour or more, but the hourly model can be the most cost-effective way to pay for advice if you don't need a lot of hand-holding on an ongoing basis. And as with advisors who charge a flat fee for a specific set of services, planners who work on an hourly basis won't typically have any investment minimums.
Still other fee-only advisors charge clients a retainer--a fee on a monthly or quarterly basis--or ongoing fees as a percentage of their investment assets on an annual basis. For advisors who charge a percentage of assets per year, 1% is a common rate, though rates can swing higher or lower depending on the advisor and the client's asset level. Under this setup, the advisor will provide customized financial-planning guidance as well as specific recommendations about when to buy and sell securities.
Commission-Only
In contrast with fee-only advisors, commission-only brokers receive compensation when you purchase a product--a stock, fund, or insurance product. Such brokers often provide specialized research to augment their recommendations and, if they work for a large brokerage firm, might also have access to traders, analysts, and other professionals. However, it's worth noting that most such brokers aren't there to provide soup-to-nuts financial planning; rather, they're focused on a specific area of expertise--insurance planning or investments, for example.
Moreover, brokers who earn commissions might have more incentive to recommend certain products rather than others, or to trade more than what is ideal. That stands in contrast with the aforementioned registered investment advisors who work on a fee-only basis. In fact, commission-based brokers are held to a different standard when recommending products to their clients. Products that brokers recommend must fit with the so-called suitability standard, meaning that the products must be suitable for their clients, based on the information the client has provided. But they needn't necessarily be the best product for their client; there might be cheaper or better options out there.
Fee-Based
Fee-based advisors use a combination of the two previous models. Although they may charge fees for financial-planning services, much as fee-only advisors do, they may also recommend products on which they earn commissions, such as mutual funds or insurance products. Some fee-based advisors avoid double-dipping by charging either fees or commissions (not both), depending on the client. But some fee-based advisors do not, meaning that working with them has the potential to be more costly than either the fee-only or commission-only route. Thus, when interviewing a fee-based advisor, it's fair to ask how he or she handles this issue.
Because they might have incentives to sell you certain products, it's also worth noting that fee-based advisors aren't necessarily free of the conflicts of interest that can affect commission-only brokers. Moreover, some fee-based advisors are governed by the fiduciary standard while others operate under the suitability standard that commission-based brokers do. To further complicate matters, some fee-based advisors operate under the suitability standard for some parts of their business and the fiduciary standard in others. Thus, this is another area to home in on if you're conducting due diligence on fee-based financial advisors.
D2 Capital Management is a Fee-Only Registered Investment Advisor
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