Commission Based Advisors, Part 1

In Finding a Financial Advisor, a key consideration is understanding how the advisor is compensated. As investment fees and expenses significantly impact portfolio returns, this is an area to monitor closely.

In general, there are three forms of advisor compensation: commission based; fee only; combination of commissions and hourly or flat rate fees.

Note that “commission based” is not the same thing as the “sales commission” you may pay when buying or selling an investment. Similar terms, just slightly different context. We will cover sales commissions later.

Commission Based Financial Advisors

Commission based financial advisors do not directly charge clients for their services. These advisors usually earn their income through salaries, commissions, or retrocessions paid by their employer and/or third parties. There may be some cost recovery or non-advisory fees charged to the client, but the actual advice and product placement tends to be free to the client.

Commission based advisors should disclose their compensation arrangements to potential clients prior to providing any services. In many jurisdictions, this is legally required.

Before beginning our look, a quick disclosure. I run my practice on a fee only basis, so there may be some unintentional bias in my analysis. I try to be fair, as there are undoubtably excellent commission only advisors, but please keep this in mind as you read the post. We will look at fee only advisors separately.

Advantages of Commission Based Advisors

Nothing Out of Pocket

When getting investment or financial planning advice, the investor is not charged directly for the service. Rather, advisors are compensated by the companies issuing the financial products bought by their clients.

Perhaps you have $5000 to invest. It may take a commission based advisor 1 hour to determine an investment strategy to pursue. Or it may take 5, 10, or 15 hours. Regardless, you do not directly pay a cent to the advisor.

With no money paid directly by the client to the advisor, this may seem a cost-effective solution for investors. And, in many instances, I am certain the client believes he does receive value for the service.

For small investors, this may be the key reason to choose a commission based advisor.

Possibly Useful for Small Investors

Why small investors?

The advisor’s fees are spread out over all commission products sold. Or paid by his employer. So no initial expense by the client. Small investors have limited capital. Not paying out costs up front is attractive.

For example, you and your sister invest through a commission based advisor. You will invest $5000, your sister $50,000. You meet separately with the advisor for 3 hours each and arrive at an investment strategy. The strategy involves purchasing ABC Equity mutual fund.  You can purchase the fund with a 5% front-end load. Or invest in the same fund with no-load, but charging an extra 0.25% annual operating cost (reflecting retrocession payments to the salesmen by the fund).

Note that I will write down the road about various fees and costs relating to mutual funds. So if loads, total expense ratios, and management fees are unfamiliar terms, we will cover them in due course.

With the front-end load funds, you will pay $250 in a sales charge. Your sister will pay $2500. Technically, you are paying a sales commission on buying the fund. The advice you received is free. The reality is that the advisor will receive a portion of that sales commission from the fund company.

With the no-load funds, you will “pay” (through higher total expense ratios) an extra $12.50 annually on your initial capital. Your sister will end up “paying” $125 annually.

I will further note that (hopefully) the extra amount that you spend annually increases over time under the no load approach. In the example, your $5000 in invested capital generated an extra $12.50 annually in expenses (above the annual fee for the front load option). Say in 5 years, the fund grows and your invested capital is now worth $10,000. Now you are paying an extra $25.00 per annum in fees.

It may not seem like much. But if you hold the same fund for 35 years and it grows to $160,000 (assuming roughly 10% growth per annum), you are now paying an additional $400 per year. It adds up over time.

One lesson from this is that the longer you hold a fund, the more attractive a front load commission may be versus no load and higher annual fees.

A second lesson is that with commissions and operating costs, the investor with greater capital invested always pays higher fees.

Even though you and your sister required the same amount of time from the advisor and are investing in identical products, she will end up paying more.

Note that often there is room for negotiation for those bringing in substantial assets. Not everyone pays retail for investing services. Be sure to ask about any discounts. Even if you are just starting out.

Often reduced fees/commissions are available to fund investors for subsequent purchases in the same fund (or fund family). Also, many funds offer rear loads and/or declining loads which reduce the sales commission based on the number of years you own the fund. Find the option that is best for you.

Improved Service Quality in Commission Based Advisors

With so much competition in the financial planning and investment industries, it assists in product sales to have knowledgeable salesmen.

Today, many commission based advisors possess the proper technical training and experience with which to advise investors. If you can find an advisor with top credentials and not pay a full price for financial planning assistance, then you may save money in the long run.

As to whether there is a potential saving, I think this differs from investor to investor and advisor to advisor. If you find an excellent advisor (or you force the advisor to follow a low-cost strategy), the money paid by you through higher product costs may be worth the quality of service you receive. But if you end up with someone pushing high margin products, well …

Best of Breed Products

Some investment firms and commission based advisors now offer “best of breed” product sales. They do not automatically push clients towards in-house solutions. Instead, the advisors attempt to find the best product in the market for the client’s needs.

This may result in less commissions for the advisor and less revenue for the investment firm. But better results and lower costs for clients.

No, these are not Mother Teresa firms. Rather, the belief is that a satisfied customer will generate more wealth over the long-run than unhappy clients.

Studies show that satisfied clients have much longer relationships with the investment firm, which results in longer revenue streams. The firms are trading short term profits from investors who leave after experiencing high costs and/or poor performance for lower margins on clients that stay for long periods.

Secondly, satisfied clients bring additional wealth to the firm. Most investors maintain multiple investment and banking relationships. Yes, the eggs in one basket concern. But, over time, if one firm or advisor achieves a high level of customer loyalty, assets are normally shifted in from other institutions.

Assets under management is a key driver for the value of investment firms and banks. In most cases, these companies reward employees based on generating net new money to the same degree as product sales figures. You may be able to negotiate lower product costs if the advisor believes you will invest higher amounts over time.

Third, word of mouth advertising is an excellent way to generate new customers. Do you like getting a cold call at home or work from someone trying to sell you something? Probably not. But what about if you are at a party with friends and you mention that you intend to buy a house and are looking for a realtor? A friend tells you that she just bought a home and her realtor did an excellent job. You likely want to know more and may end up calling the realtor yourself. That is the principle here. While a satisfied client may produce less short term revenue, they will assist in generating new customers over time.

Key Takeaways

We will cover the disadvantages of commission based advisors in Part 2.

I think the keys to remember from this post are:

If you intend to hold a mutual fund for a long time, a front load sales commission will likely end up less expensive than the same no-load fund that charges higher annual fees.

With commissions and operating costs, the investor with greater capital invested always pays higher fees.

As in any industry, the skill and experience of financial advisors vary from individual to individual. Also, advisors may be tied to a limited product offering. If choosing a commission based advisor, look for one who is highly competent, meets your specific needs, and offers products from as wide a range as possible.

Sales commissions and fees may be negotiable. Advisors are looking for satisfied clients who maintain long term relationships and assets under management. Advisors may be able to reduce some costs in exchange for a longer (more lucrative) revenue stream. Do not be afraid to negotiate.