Commission or fee based investment management – which compensation model is better for the client?
In my last post, I explained how commission-based investment advisors make their money since they don’t directly charge clients a fee. In this post, I’m going to explore if the difference in compensation models present any conflicts of interest between client and advisor and which is best for you.
Let’s look at an imaginary investment advisor named John. If John sells an A Share Class fund, he is compensated right away and not much afterward. He gets an initial compensation of 5.75% of the investment and then just a .25% in compensation on those funds in the years the follow.
Since John is compensated right away and then not much at all after, he doesn’t have much of an incentive (aside from integrity) to monitor that investment or continue to meet with those clients. Although John does receive 0.25% each year on the amount invested, that is not going to feed his family. On a $100,000 investment that would only amount to $250.
For John to make a living, he is going to have to find more clients that he can sell A Shares to, or he would need to purchase a new A Share fund with the current client. That doesn’t exactly encourage him to enforce the fiduciary standard of what’s in the client’s best interest. John is compensated based on making a change in the investment, but is that change in order to produce compensation, or is it because it is a good change for the clients? Under the A Share Class, it’s hard to know.
Either way, if an advisor is focused on finding new clients or on replacing funds to ring the cash register again, it’s not good for the client.
The B Share Class has a contingent deferred sales load so John is required to stay invested in that fund for a 7 year time period or the client will pay a fee. This is problematic in the opposite way because if over 7 year time period the fund isn’t doing well, it should be replaced, John is stuck between not replacing it to avoid that fee the client will pay and replacing it because that’s what is in the client’s best interest.
This becomes even more complicated when you consider that a B Share Class fund provides the highest amount of compensation over the 7 year time frame (compared to the A Share or C Share) so John has even more of an incentive to stay put for the full 7 years. This class carries a conflict of interest is due to lack of flexibility.
The C Share Class pays John a flat 1% per year and he only need to stay in fund for 12 months before he can change. This seems like it would be the fairest share class to the client, but it is the one that pays the advisor the least so they may be less likely to suggest this option even if it is a good option for you.
As you can see, all 3 of the commission-based share classes have inherent conflicts of interest. It’s very difficult within the commission-based structure to get client & advisor on the same side where both of their interests are mutual.
The other option is to work with a fee-based advisor and although there is less compensation for them in the early years, they have the flexibility to make changes because their compensation doesn’t come from the purchase or from the company. Instead, their compensation comes directly from the client via the regular investment management deductions. I work as a fee-based advisor because it incentivizes keeping the client happy and working for the client’s best interests.
If you’re looking for a financial advisor that is transparent and a fee-based fiduciary, click here to schedule a complimentary consultation to find out how I can help you.