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Fees Vs Commissions – What’s the Difference?

‘Do the Math’ Philosophy

Fee-based and fee-only financial advisors have increased in popularity over transaction-based fee accounts. Advisory fee-based accounts provide the wealth management industry with diversity in how investors pay for financial advice, and we all know that investors like to diversify. There are some key differences between commission-based advisors, commission-only advisors, and “classic” stockbrokers. I believe it is important for investors to be familiar with these differences before selecting investments and determining whether the recommendations are in their best interest.

A fee-based advisor works much like an attorney who charges an hourly fee or retainer for legal advice. They provide professional opinions on financial planning, portfolio management and asset allocation; and are compensated according to a predetermined pricing method (ie, a fee). These fees can take a few different forms, typically a small percentage (perhaps 1%) of “Assets Under Management” (AUM). When the account increases in value, the advisor makes more money, and vice versa. Many investors find recommendations from commission-based advisors to be less biased and more reliable than those they would otherwise receive from brokers or dealers.

Brokers receive commissions by selling products from various companies, usually products that their own company does not already have. Commissions can be split, paid in advance or collected in combination. In some cases, fees may be charged to the fund through a delivery charge. Brokers facilitate transactions by bringing buyers and sellers together. Fees are a percentage of the total transaction and are often called “transaction costs.” Recommending certain financial products over others can provide brokers with special benefits, such as higher commissions, corporate incentives and paid vacations, which can sometimes create the possibility of a perceived reduction in fiduciary responsibility. (Under the new DOL BICE (Best Interest Contract Exemption) rule, products sold through broker channels instead of qualified retirement accounts, such as traditional IRAs, must meet similar levels and fiduciary standards expected of commission-based advisors.)

Distributors (also known as Principals) charge a mark-up. They have an inventory of financial products that they had previously purchased with their own capital. The “mark-up” is the amount paid to the company above the current “market value”. This amount must be communicated by the distributor. Don’t confuse “market value” with the original cost of the security to the dealer (the company assumed a risk by investing in securities held in inventory and thus gets to reap the financial gains from any appreciation in value). Dealers who operate on a stock exchange are known as “market makers”. The main question to ask is, “Can I get advice from someone selling me something they already own?”. We tend to consider these types of arrangements fraught with risks that can lead to self-dealing and inherent conflicts of interest.

So how do you decide which payment method is ideal?

Step 1. Determine what type of options are available when purchasing the investment. Some investments can be bought in commission-only accounts, some in brokerage, and some can be bought in both. So if you wanted to buy something and it was, for argument’s sake, only offered on a trading account, the commission-only advisor would not be able to execute the trade. That’s why we believe that in order to strive for the best execution, companies must go all out.

Step 2. Determine the fees associated with a commission-based account. Is it one-off or spread over many years? Do I pay a fee if I want to go out? If I buy more of the investment, can I get a reduced commission (ie break points)? Sometimes, if you commit to buying more over time, you can get the discounts upfront.

Step 3. Determine the fees associated with holding investments in a managed account. Do I pay a commission to the advisor if we decide to buy or sell the investment? If I want to exit a position, how much do I pay and who would collect the fee? Is the investment liquid and can I sell it? Should I buy something in a managed account that I can sell? Liquidity matters.

Now for the fun part: “Do the math.” We perform a very simple “breakeven calculation” to determine (depending on how long you plan to hold the investment) whether fees or commissions are more profitable.

Step 4. Do the ‘breakeven calculation’… here’s the math.

Step 5. Determine the confidence of the conclusions based on the overall bias. For example, a “buy and hold” investor may prefer fees to commissions because of their high level of market resistance and their bias toward low trading activity. Conversely, investors who actively trade securities in their accounts may find commission-based payment methods more desirable. Read the fine print in your contract: You may be responsible for trading costs for buying and selling in a managed account (fees that would not be charged by the adviser, but could be paid to the custodian). It’s worth noting that just because an investor has a commission-based account doesn’t mean they can’t also be charged commissions for participating in recommended trades, however, commission-only accounts are just that: commissions only.

Step 6. Discuss your biases with your professional. Remember that volatility and liquidity can change. Get the full picture before you choose.

“Full service” wealth management firms are a great way for investors to customize how they pay their advisors. The goal is to develop customer-centric models that allow us the ability to tailor recommendations to the most appropriate product, investment and strategy while minimizing “operating expenses” and “transaction costs” through application of the most cost-effective compensation methods.

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