Until the last 25 years or so, the overwhelming majority of financial advisors were registered representatives, more commonly called brokers (or, in your parent’s day, stockbrokers). They were paid commissions for trading stocks and for selling mutual funds that often carried a variety of sales charges.
But today, brokers are falling increasingly out of favor with investors because their primary motivation is their own compensation. Investors want objective professionals who put their interests above all other considerations. That’s why they’re increasingly turning to financial professionals who are paid directly by clients. But even among these advisors, there is a distinction between those who are only fee-only advisors and those who are fee-based. While both kinds of advisors are committed to acting in your best interests, it’s important to understand the nuances.
The fee-only advisor
Fee-only advisors, such as those you can search for here, are paid directly by clients. If they manage your investments, they may charge an annual percentage of your assets, generally starting anywhere between 1% to 2%. Some fee-only advisors are starting to charge annual retainers that encompass all the services they provide.
Fee-only investment advisors do not earn commissions for placing trades of selling investment products or insurance. If they’re managing your portfolio, they’re required by law to serve in a fiduciary capacity. This means they must always act in your best interests. If a situation arises that may present a conflict of interest, they’re required to disclose this conflict to you.
Fee-only financial planners may charge a fixed fee or an hourly fee for creating a personalized financial plan for you; however, if they’re not managing investments they’re not legally required to act in a fiduciary capacity. That’s why you may want to limit your search to financial planners who have been certified as CFP® professionals by the Certified Financial Planner Board of Standards (CFP Board). These financial planners earn their certifications by being experienced financial professionals who have passed a rigorous financial planning examination and agree to uphold the highest standards of integrity, accountability, and client service.
The fee-based financial advisor
There’s a great deal of confusion among investors about the differences between fee-only and fee-based advisors, much of it unfortunately sewed by the industry itself, which tries to downplay the distinctions.
Here’s a basic explanation. Fee-only financial advisors (and financial planners who manage investments) are usually only registered as investment advisers with the SEC and/or their state, They are paid only by their clients, and are required to act as fiduciaries.
Fee-based financial advisors and fee-based financial planners, on the other hand, are usually registered as investment advisers and registered as brokers by the Financial Industry Regulatory Authority (FINRA).
It is perfectly legal for fee-based advisors to be dually registered, and these days most advisors hold both registrations. This gives them the flexibility to manage some clients’ portfolios in a fiduciary capacity (receiving fees but no commissions) while also allowing them to act as brokers for other clients (for example, for clients who only want a broker to help them buy shares of stocks or mutual funds, but not want the advisor to manage their entire portfolio).
Fee-based advisors cannot be paid fees and earn commissions from the same pool of investments they manage for a particular client. However, they can earn commissions for selling them other kinds of products.
Here’s an example. A fee-based financial advisor charges her client 0.75% ($7,500) a year to manage his $1,000,000 portfolio. At some point, the client decides he needs term life insurance and asks the advisor for recommendations. The advisor recommends several different options offered through her broker-dealer. When the client purchases the policy the advisor receives a commission on the sale, which is paid from a source other than the client’s portfolio.
Fee-based advisors must tread very carefully in these situations. As a fiduciary, they’re required to act in their client’s best interests, and not be motivated by commission considerations. Yet, if the advisor is also earning both fees and commissions from the same clients, there’s a clear conflict of interest. The advisor must inform her client that this conflict of interest exists and explain how she’s making sure that the insurance products she’s recommending are appropriate and affordable choices. She should also clearly explain how much commission she herself will earn for selling each policy.
Should you avoid fee-based advisors entirely?
Not necessarily. If you only want your advisor to manage your investments, both fee-based and fee-only advisors can do so in a fiduciary capacity. But fee-based advisors must be vigilant in making sure that they’re managing the conflicts of interest that are always inherent in the dual registration model. If these potential conflicts worry you, a qualified fee-only advisor might be a more appropriate choice.