President Perceptive Business Solutions Inc.
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The Difference Between Fee-Only & Fee-Based Advice

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Although they sound similar, the terms "fee only" and "fee based"  have very different meanings when they pertain to giving financial advice. Here, expert Bryce Sanders offers some relevant history as well as a detailed explanation of why the answer to this simple question is anything but.

Sep 7th 2021
President Perceptive Business Solutions Inc.
Columnist
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The title poses a simple question. Unfortunately, the answer is less simple. In short: It depends on who is paying you. Before explaining more, it’s helpful to know some financial planning history.

May 1st is known as May Day. In 1975, it also went into the history books as the day fixed commissions were abolished in the US stock brokerage world, opening the door to discount brokerage firms and other forms of price competition. Forty-six years later, commissions to buy and sell stocks at major firms have largely disappeared, replaced by a fee structure instead. What does this mean?

To understand how two similar terms, fee-only and fee-based, can have significantly different meanings, we need to fill in some of those 46 years first.  Prior to May 1st, 1975, stock brokerage commissions were fixed, similar to US airline ticket fares at the time. There were lots of small brokerage firms, many with in-house research departments funded by the profit margins fixed commissions delivered.  

As price competition brought commissions down, major brokerage firms moved to a fee-based pricing system. Clients were charged a percentage of their assets under management instead of a commission whenever they bought or sold securities. This is how the financial planning profession had been operating for years, within their fiduciary capacity. Fee-based pricing also removed the perceived conflict of interest when the financial advisor recommending each trade is also earning their living by the amount of trading revenue they generate. 

Around this time, large brokerage firms started offering financial planning services. It benefitted the client, as the financial planning profession had been doing for years, yet it also opened up many other business opportunities for financial advisors. Insurance is one example. It also made a compelling case for a client to consolidate multiple investment accounts at one firm.

That’s enough history. We now get to the distinction between fee-only and fee-based financial advice.

Fee-only financial advice is primarily distinguished by the fiduciary nature of the relationship between the planner (or advisor) and the client. The client and the planner work together to develop a financial plan. This is paid for separately. The plan is fully portable. This is the ending point of the process for some accountants. If the client chooses, they can implement the entire plan by opening accounts and making investments online. They might return to the planner periodically to review their holdings and will pay for their time. They could approach a financial advisor at a major firm and ask them to build the portfolio.  

There’s a third option. The financial planner could build the portfolio for them and advise them on managing their investments. The financial planner is now stepping beyond planning into the role as a licensed financial advisor. The pricing is often done as a percentage of assets under management. Acting as a fiduciary, the advisor seeks out the best investments with the lowest expense ratios. Consider stock index tracker funds as an example. You know the ones traditionally offering wafer-thin cost structures.

The bottom line is, the financial planner/advisor is only receiving compensation from the client. They are acting in a fiduciary capacity, just as you as an accountant act in your client’s best interests. Put another way, they work for and are paid by their client only.

Fee-based financial advice sounds similar, but there are differences. For many years, the brokerage industry has operated under the suitability standard, not the fiduciary standard. They seek to act in the best interests of their client but are not required to provide the product with the lowest cost. They are required to provide a product that is suitable to meet the client’s needs; however, cost is not a primary consideration. Take the category of large capitalization growth mutual funds as an example. Morningstar lists 330+ funds in this category, with differing expense ratios. All might be suitable, but some performed better than others, and the expense ratios vary.

A fee-based financial advisor is also charging the client a percentage based on assets under management. Yet, they may also be receiving compensation from the product provider. Most financial services products that are not traded as listed securities (like stocks or individual bonds) have fees built into the fund structure. The client might be paying a flat fee based on assets to the brokerage firm. But is the advisor getting better compensation by choosing the more expensive mutual fund?

Major brokerage firms have taken steps to eliminate potential conflicts of interest by standardizing fee based pricing. A client paying a 1% annual fee on an account with $ 100,000 in mutual funds pays the same regardless of which mutual funds are in the account. The financial advisor is paid the same regardless of the funds they have recommended.

The bottom line is, the fee-based financial advisor is receiving their paycheck from the brokerage firm with their name over the door. The client is paying a fee based on a percentage of assets under management, yet there might be higher fees built into certain products that benefit the firm and the advisor.

There still are commission-based financial advisors. This can make sense for “buy and hold” clients who traditionally took delivery of their stocks in certificate form and stashed them in a safe deposit box. Since physical share certificates have been almost abolished, the client’s shares will need to be held at a firm somewhere. Firms charge account fees. That’s not relevant in this discussion.

Much has been written about the pros and cons of the fiduciary and suitability standards. The key takeaway is the quality of advice, service and investment performance. Investment pricing from years ago often included up-front fees or surrender charges on mutual funds. Trading stocks involved paying a commission on each side of the transaction. Fee-based pricing is the ultimate in “pay as you go” pricing. The client is only paying fees for the time their assets are in the program.

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