Commission Based Financial Advisors

On 12/20/2010, in Financial Advisors, by Jordan Wilson
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I mentioned in an earlier post that I would say a few words on financial advisors.

Mainly, my thoughts on commission versus fee based advisors.

I shall split this into two parts.

Today, the pros and cons of commission based financial advisors.

First, some disclosure. I run my business 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.

Commission Based Advisors

Commission based financial advisors do not directly charge clients for their services.

These advisors earn their income through salaries, commissions, or retrocessions paid by their employer and/or third parties.

There are potential advantages and disadvantages for investors.

Advantages

Nothing Out of Pocket

When getting investment or financial planning advice, the investor is not charged directly for the service. Instead, advisors are compensated by the companies who issue the financial products purchased 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, these 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?

An argument may be made that the advisor’s fees are spread out over all the commission product sold. Let’s say that you and your sister invest through a commission based advisor. You plan to invest $5000, your sister will invest $50,000. You meet separately with the advisor for 3 hours and arrive at an investment strategy. The strategy involves either purchasing mutual funds with 5% front-end loads or the no-load funds having an extra 0.25% annual operating cost (reflecting retrocession payments to the salesmen by the fund).

With the front-end load funds, you will pay $250 in a sales charge. Your sister will pay $2500.

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.

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.

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

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.

Improved Service Quality in Commission  Based Advisors

With so much competition in the financial planning industry, it aids 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 investment 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.

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 the 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.

Disadvantages

The Free Lunch

There is no such thing as a free lunch, or so the story goes.

Often you get what you pay for.

If you intend on obtaining financial planning or wealth management advise, make sure that the individual is competent. I am not saying that commission based advisors are incompetent. But their key function is that of product salesman, financial expertise may be second, third, or further down their list of strengths.

If you get poor advice and end up in an inefficient portfolio, there is a cost associated with that.

The Lunch May Be Free, But Watch the Charges for Plates, Cutlery, and Napkins

The advice may be free, but someone is paying the advisor.

Directly, it is the company behind the products being sold.

Indirectly, it is you. Whether you pay a sales charge or are assessed higher annual operating expenses, you are paying the advisor’s wages.

Small investors may pay less than large investors. But everyone pays to some extent.

Length of time holding an investment can also impact how much one pays. With load products, the shorter the holding period, the higher the relative cost. With no-load products, the longer the holding period, the greater the cost paid back to the advisor.

Is it in Your Best Interest?

When I sit down with a professional – doctor, lawyer, accountant, etc. – I expect that they are acting in my best interests. I pay a fee and get their unbiased expertise in return.

With commission based advisors, I am always extremely leery as to whether they are looking out for me or for their own family.

In my mind, I can hear them say:

“If he invests in this 5% front-load, 2.5% annual operating fee mutual fund, my son can get those braces. Try not mention the excellent no-load index fund and ETF that track the same market.”

I feel much more comfortable dealing with someone that will give me unbiased advice as to what is best for me.

That said, there are commissioned salesmen that act in the clients’ interests. There are also fee only advisors that act unethically. But, on average, I have more confidence with a fee only advisor than with someone whose own income is linked to what he sells to me.

To make your own comparison, we will look at fee only advisors next.

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