What is the Difference Between "Fee-Based" and "Fee-Only"?
It can be difficult to know what you’re getting yourself into when you decide to work with a financial advisor. To make matters worse, commissioned salespeople get to use the title “financial advisor” along with those acting as fiduciaries.
The purpose of this article is to provide some clarity on the two terms “fee-based” and “fee-only.” While the difference in terms seems minor, in reality it can make a significant difference in the type of relationship you have with your financial advisor.
What does “fee-based” mean?
To understand the term “fee-based,” it’s helpful to understand how a commissioned salesperson/financial advisor gets paid. “Financial advisors” who are paid on commission sell a product in order to earn a living. Because they only get paid if you purchase a product, their advice, out of necessity, leads to a product sale. This is not an insignificant conflict of interest. Other factors, such as company quotas, may induce commission-paid financial advisors to give advice that leads to their company’s product, even though a different company’s product may serve you better. It’s even possible that if they don’t sell enough of their company’s stuff, they could get fined.
Because commissioned advisors need to sell you a product to make a living, their incentives aren’t aligned with doing what is in your best interest.
But what does this have to do with an advisor being “fee-based”? Well, a fee-based financial advisor offers investment management for a fee, or perhaps provides hourly or project advice for a fee. But they still sell products and earn commissions from the sales thereof.
In other words, fee-based financial advisors continue to experience all the conflicts associated with commission-paid financial salespeople, all while extracting fees from investments that you permit them to manage.
What does “fee-only” mean?
A fee-only financial advisor is one who is not paid on commissions. This advisor offers you advice in exchange for a fee. There are no product sales, but you can still permit them to manage your investments by giving them discretionary authority to trade on your behalf.
So how do fee-only advisors charge for their service? There are a lot of ways. Most will charge you some percentage of your assets under management (often somewhere around 1% when your investments with their firm reach the $1 million threshold), but you can find advisors who work for hourly, project, or flat retainer rates that don’t increase or decrease with the size of your portfolio.
The main benefit in working with a fee-only financial advisor is removing a layer of conflicts of interest brought about when advisors sell and get paid for financial insurance and/or investment products.
So if I work with a fee-only financial advisor, I’m good to go, right?
Well, not quite. You see, fee-only financial advisors still have their conflicts. This is especially apparent with financial advisors who are paid from extracting fees from your investment accounts.
For example, in his new book The White Coat Investor’s Financial Boot Camp, Dr. James Dahle writes:
Also be aware that even fee-only advisors can have biases and conflicts of interest. For example, if the advisor is only paid a percentage of assets under management, they may recommend an IRA rollover that is ill-advised (which would increase assets under management), recommend against paying off student loans or mortgages (which would decrease assets under management), or recommend against investments that they would not manage such as real estate. (116)
Understanding how your advisor gets paid, and then spending some time thinking about how that influences their behavior, is important as you consider the advice that they are giving you.
Some final thoughts.
Most of the financial advisors I’ve met are genuinely good people. Even that being the case, compensation is a significant incentive, and incentives drive behavior.
In The White Coat Investor’s Financial Boot Camp, Dr. Dahle points out that if you don’t know how you’re paying your financial advisor, or think you’re getting advice for free, that’s a bad sign (115). There’s a good chance that you’re working with a financial salesperson who is going to be earning money off of you buying a product from them. Hopefully it ends up being in your best interest.
If you’re paying a fee for investment management, and your advisor is also selling you other insurance or investment products, you’re working with a fee-based advisor and they still bear the conflicts associated with commissioned financial salespeople.
If you’re paying a flat retainer fee, hourly fees, project-based fees, or fees as a percentage from investments under the advisor’s management, and not compensating your advisor in any other way, you’re working with a fee-only financial advisor.
All financial advisors should disclose their compensation and conflicts of interest with you up front. If they don’t, you should ask them to explain those things to you. I think that working with a financial advisor can be a great thing, so long as you clearly understand what you’re paying for and how you’re paying for it.
I hope that this brief article helps equip you with the knowledge you need to find an advisor best suited to your needs.
These are my opinions, unless I’ve specifically cited other material. The information and ideas I’ve presented are for informational purposes only. Before you implement anything, make sure you have a thorough discussion with a qualified professional who understands your situation.