Like any industry, the financial industry is full of technical terms and jargon that can easily get confusing to anyone who doesn’t work in it — including the distinction between fee-only and fee-based financial advisors. The way these terms are structured, you wouldn’t be wrong in assuming that they’re basically the same thing.
They aren’t though, which is why in this post, I help break down these terms and their key differences — when you’re choosing who to trust to help you build your financial future, you should understand how the financial advisor you’re working with makes their money.
What does fee-only mean?
A fee-only financial advisor is only compensated by the transparent and agreed-upon fees they charge their clients for advice. They are not compensated by nor can they accept commissions or any other compensation paid from the investment products themselves, such as mutual funds, insurance, structured products, annuities, etc. The best way to find out if an advisor is fee-only is to simply ask whether they are fee-only all of the time, and whether they are a fiduciary (more on that in a minute). A good indicator that a financial advisor is fee-only is if they are part of Registered Investment Advisory firm that has NO affiliation with a broker/dealer.
Fiduciary = Trust
If a financial or investment advisor calls themselves a fiduciary or mentions they follow the fiduciary standard, what that means is that they are legally bound to always act in their clients’ best interests.
The fiduciary standard was established as part of the Investment Advisors Act of 1940, and means that advisors can be regulated — by either the SEC or state securities regulators — to ensure they are prioritizing their own needs (generally, financial needs) below their clients’. Financial advisors held to the fiduciary standard must also operate within a “best execution” standard, which means they are held to trading securities with the best possible combination of efficient execution and low cost to the client.
The act specifically defines this standard, and calls out in particular for advisors to avoid — and disclose — any potential conflicts of interests that might arise when it comes to choosing clients’ investments.
What conflicts of interest are possible? How fee-based is different from fee-only
First of all, the majority of financial advisors these days describe themselves as fee-based advisors. Fee-based simply means that financial advisor charges their fee as a percentage of assets under management.
So, as an example, if an advisor is working with a client with $100,000 in managed assets and charges 1%, the advisor would charge that client $1,000 per year. In lieu of or in addition to this transparent fee, the advisor may be compensated in a non-transparent fashion from the investment products he or she recommends. So for that same client with $100,000, they may have multiple accounts with their fee-based financial advisor. The advisor may operate as essentially fee-only on a couple of those accounts, but they also have the ability to charge the client a non-transparent fee on their other accounts.
Fee-only advisors, on the other hand, can accept no such non-transparent compensation, no matter the account type.
Some of the confusion comes from the term financial advisor: there is no restriction on the use of the term “financial advisor,” and it can be used by stock brokers, insurance agents, investment advisors acting under the fiduciary standard, or a combination of these.
A financial advisor that is not also fee-only may be presented with a conflict of interest when it comes to recommending investment products — again, something not permitted by the fiduciary standard.
In some cases, the following types of products can include non-transparent, embedded advisor compensation of between 4% and 7% — sometimes even up to 10%:
- Load Mutual Funds
- Variable Annuities
- Permanent Life Insurance
- Structured Notes or Structured Products
- New Issue Closed End Funds
- Limited Partnerships
- Private Real Estate Investment Trusts
- Debt Securities — like Bonds and Brokerage CDs.
By embedded commissions, I mean that the compensation is ‘baked into’ the product. When you invest in these types of financial products through a financial advisor, you won’t see your account balance reduced by the commission. Rather, there are other provisions that allow the advisory firm to recoup those commissions. I won’t say that the aforementioned products are never appropriate, that determination can only be made on a one on one basis.
I also don’t mean to put too much of an emphasis on the advisor’s compensation — because after all, there are many other factors you should consider before making an investment. That being said, consider this: securities markets are highly efficient — if you take 7-10% off the top of any type of investment, where does that money comes from?
Transparent vs Not
Let’s look at a real dollar example: if you invest $250,000 in a product such as a Variable Annuity that has a 7% commission for the financial advisor, that advisor is pocketing $17,500 before the ink in your signature is dry. The creator of the investment product is certainly going to make sure they have a way to recoup that $17,500. They are also going to charge fees over and above that so they can make a profit. And then after all of that, they are going to seek to earn money for you, the investor, with products that in most cases you could have bought without paying the significant fees.
To sum it all up, a fee-only financial advisor is a fee-based advisor but a fee-only advisor restricts their compensation to the transparent, agreed-upon fee that appears as a line item on client statements. Whereas, other fee-based advisors who are not also fee-only can charge their asset-based fee , but they also often use products or platforms that provide them with additional non-transparent compensation. Confusing, right?
Oak Road Wealth Management is a Fee-Only Registered Investment Advisory firm. We do not accept any commissions from any investment product such as mutual funds, insurance, structured products, annuities etc. Our transparent fee is the only compensation we receive from our clients. We act as a fiduciary, which means we only make recommendations that are in the best interest of the client.
From my perspective, I see that many advisors use the term fee-based advisor to describe themselves, and the public perceives that description to mean that they are fee-only advisors. I feel strongly about the confusion created around these terms, as I feel that all compensation to the financial advisor should be transparent and easy to understand.
Do you have a question about the fees a financial advisor charges? Reach out to me and I can help with answers.