What Everyone Should Know About How Commission-Based Investment Advisors Work
Recently I had a conversation with a client where we reviewed their investment accounts and the topic of investment management fees came up. This client had previously worked with an investment advisor who worked on a commission basis so they weren’t used to seeing these fees on a statement. Of course I’m very transparent about the way I am compensated as an investment advisor, but when you come from working with a commission-based advisor it’s understandable that there will be some questions.
Many people don’t understand the different ways investment advisors are compensated when it comes to investments. It is more important than you might think because it can create conflicts of interest.
As an advisor who charges a fee for investment management, my clients see a transparent fee on their statements. Not all investment advisors charge a fee though. There are commission-based investment advisors that don’t earn their money directly from the client, instead they are paid a commission from the product company.
In this client’s previous relationships when their mutual funds were purchased, there was a commission paid to the advisor and so when the client viewed their statement, they only saw an increase or decrease in their account value, no investment fees were listed. That’s the case for anyone viewing their statement from a commission-based investment advisor.
There is more than one way that an advisor can purchase different kinds of investments and be compensated. What’s unknown to most clients I talk to is how that works behind the scenes and it’s important to be aware of.
It should be noted that some commission-based investment advisors are more transparent than others. Most of the clients I work with that have previously worked with commission-based investment advisors have not had a high level of transparency and clarity about how their advisor was being paid.
When a commission based investment advisor purchases mutual funds, they can purchase different kinds of share classes of mutual funds. The underlying investment is the same, but the share classes impact the way the advisor is compensated and what the ongoing expense to the clients will be.
A Share Class
The A Share Class is a front-loaded commission based product. That means the advisor gets 5.75% of the initial investment as a commission. It is deducted from the client’s investment so only 94.25% of the money is actually invested. For instance, if you invested $10,000 in an A Share Class mutual fund with a commission-based advisor, your actual amount invested would be $9,425 because the advisor would receive $575. In the following years, that investment advisor only receives 0.25% in compensation on those funds (one quarter of 1%). It should be noted that the 5.75% the investment advisor gets may be less depending on the amount invested due to what are called “breakpoints”.
B Share Class
Funds in a B Share Class don’t have a front-end sales load like the A Share Class so there is no reduction from the client’s initial investment to compensate the investment advisor. The initial advisor compensation comes 100% from the product company instead.
4% is paid to advisor in the first year and 1% is paid every year after that for the first 7 years. After the initial 7 year time period, the B Share Class funds convert automatically to the A Share Class with the lower ongoing expenses/compensation.
C Share Class
The C Share Class is very straightforward. It provides a 1% ongoing compensation to the advisor which comes out of the internal expenses of the mutual fund. That means it is not deducted from client’s investment, instead it comes from internal costs of the fund much like B Share Class funds.
A client won’t see this compensation on their statement because it’s part of the internal expenses of the mutual fund. The only time the client ever sees a deduction from their investment on their statement with a commission-only advisor is with the initial purchase of the A Share Class product.
There are many different ways for a commission-based advisor can get paid and knowing how that works can help you make the best decisions for your investments and understand where your advisor’s financial interests may lie.
Now that you know how commission-based investment management works, you may be wondering if it’s better to go with a commission or a fee based advisor. I’ll be tackling that question in my next post.
If you’re looking for a financial advisor that is transparent and fee-based, click here to schedule a complimentary consultation to find out how I can help you.