A significant amount of attention has been generated by a recent announcement that financial advisors in the United Kingdom and Australia will be legally required to stop charging commissions and adopt a fee-for service model. This transition has even been referred to as “the most significant change taking place in the global financial services industry…"
With two developed, sophisticated nations adopting such a firm anti-commission stance, questions have arisen over whether or not the United States should follow suit and enact similar legislation. What many news stories don't mention is that that United States did explore fee-based compensation and, for some accounts, regulators actually chose to ban that method of compensation in favor of commissions. Of course, that decision did not affect all fee-based relationships, and punditry aside, the truth is that investors in the United States have had the option to enter into fee-only relationships for decades. Still, today, neither investors nor regulators seem inclined to do away with commission-based relationships.
Different Service Models for Different Needs
The popular mass-media argument of fees versus commission is an overly simplified evaluation of a complex topic. Financial professionals provide a service to their clients; in exchange, they are paid for that service. There are a variety of potential payment arrangements: a sales commission may be charged on each product sold, or an hourly fee may be charged for each hour of service. Sometimes compensation is calculated via a flat fee based on a percentage of the assets under management; a combination of fees and commissions is yet another option.
Commissions: The Bad Reputation Is Unfair
The popular press often presents commission-based compensation as an unethical practice that rewards advisors for engaging their clients in active trading, even if this investing style isn't suitable for those clients. The argument is based on the idea that investment brokers increase their commissions by encouraging investors to make unnecessary and excessive trades. This practice, known as churning, is unethical because the excessive buying and selling keeps a portfolio constantly in flux, with the primary purpose of lining the advisor's pockets. Fee-based compensation is touted as a better solution because the broker earns a fee for providing investment advice and is, therefore, not motivated by the frequency of a client's trades.
On the surface, the argument sounds noble; however, if you look beyond the surface, the argument loses its strength. First and foremost, the argument assumes that investors are completely clueless. These investors are supposedly willing to blindly trust a broker as the broker churns their account, earning commissions without generating any profits for the investor. In reality, even the least intelligent investors are likely to notice an ever-changing portfolio that never makes any money.
Interestingly, fee-based brokerage accounts were sold in the Unites States prior to October of 2010. They were designed as the antidote for churning, because investors could make as many trades as they wanted without paying commissions. The Unites States banned these accounts, forcing the financial services industry to close them. The ruling was based on technical definitions of "advice" and a variety of similar factors that many argue had little to do with the practical realities of investing.
Still, picture yourself at age 80, having $4 million in dividend-paying stocks and interest-bearing bonds that you have held for the past 20 years in a fee-based brokerage account. They have generated a nice income for you; they have also paid your financial advisor $40,000 per year, each and every year, if you have been paying a 1% fee. That's $800,000 in fees over the course of two decades. A commission-based relationship would have generated the exact same investment results at a fraction of the first-year's cost. You would likely have kept the overwhelming majority of that fee had you paid commissions or an hourly fee, even if it took dozens of trades to build your portfolio.
The argument against commissions discounts all of the potential value that comes with the advice to make a trade. At large brokerage firms, there are teams of analysts that research securities. The investment advisors themselves spend time and effort to learn about these securities and have the skills and experience to match investors with appropriate investments. At some firms, the investment advisors themselves research securities and make recommendations.
Before you dismiss this as the infamous “lipstick on a pig," spend some time seeking income-producing investments for your portfolio in a low-yielding interest rate environment. Solutions such as preferred securities, unsecured bonds, annuities and limited partnerships are not likely to come to mind as you scramble to find ways to turn your nest egg into an income stream. These sophisticated investments are not often found by investors, they are researched by professionals and generally sold by them. Talk to a good commission-based broker, and for a modest one-time commission, your nest egg could be delivering the payment steam you are seeking.
It's also worth thinking about the 1% yearly fee you would be paying a fee-based broker every year for the rest of your life to get the exact same advice. The first year's fee alone could be many times more expensive that the one-time commission that you paid. Over 20 years, the $250 commission you paid could look like the deal of a lifetime.
Fees Have Their Place
All of that noted, fee-based relationships are the right choice for some investors. Investors that need a lot of assistance on an ongoing basis may be perfectly comfortable paying for that advice via ongoing fees. After all, they want advice and their advisor has an incentive to grow their clients' assets because the advisor's fee will increase as the value of the portfolio rises.
Just keep in mind that the end result could be a payment of 1% a year for 20 years, despite making zero trades. Such an arrangement might be a complete rip off if you never speak to your advisor during that time. Or it might be a real bargain if your advisor's recommendations are what keep you from buying high and selling low while you generate a nest egg large enough to provide for your retirement needs.
An Educated Investor Makes Better Decisions
Arguments in favor of fee-based accounts sound fantastic to the uninformed, but there are two sides to every story, and investing is a complex endeavor with a wide range of investors, each with unique needs. A compensation system that would be a big mistake for one investor might be perfect for another.
As an investor, you have the freedom to decide which type of compensation relationship is right for you. Before agreeing to any payment arrangement, take the time to carefully consider your situation. Think about your personality. Are you a "set it and forget it" type of person, or do you want to have ongoing discussions about your financial needs and various ways to address those needs? Match your needs to the type of advice you are getting. Make your decision based on your personal needs, not rhetoric, and you likely be far more satisfied with the resulting arrangement and cost schedule. In turn, you are more likely to stick with the resulting investment plan, therefore increasing the odds of achieving your financial goals.
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