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Fees Vs Commissions – What’s the Difference?

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Fees Vs Commissions – What’s the Difference?

‘Do the Math’ Philosophy

Financial advisors who rely on fees and fees only on transaction-based commission accounts have become increasingly popular. Advisory fee-based accounts bring diversity to the wealth management industry in the way investors pay for financial advice, and we all know that investors love to diversify. There are some major differences between fee-based consultants, fee-paying consultants only, and “traditional” brokers. I think it’s important for investors to be familiar with these differences before selecting investments and determining if recommendations are in their best interest.

A fee-based advisor works much like an attorney who charges an hourly rate or retainer for legal advice. They provide professional opinions regarding financial planning, portfolio management, and asset allocation; and are compensated according to a predetermined pricing method (i.e. a fee). These fees can take on a few distinct forms — commonly a small percentage (maybe 1%) of ‘Assets Under Management’ (AUM). When the account grows in value, the advisor makes more money, and vice-versa. Many investors view recommendations provided by fee-based advisors as being less biased and more reliable than what they would otherwise receive from brokers or dealers.

Brokers are paid commissions by selling products from multiple companies — typically products that their own firm doesn’t already own. Commissions can be spread out, paid up-front, or charged in combination. In some instances, fees can be charged on the back-end through a surrender charge. Brokers facilitate transactions by bringing buyers and sellers together. Commissions are a percentage of the total transaction and are often referred to as ‘transaction costs’. Recommending certain financial products over others may 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 rule BICE (Best Interest Contract Exemption), products sold through broker-dealer channels in qualified retirement accounts, like Traditional IRAs, must adhere to similar fiduciary levels and standards expected of fee-based advisors.)

Dealers (aka Principals) charge a ‘mark-up’. They have an inventory of financial products that they previously purchased using their own capital. The ‘mark-up’ is the amount paid to the firm in excess of the current ‘market value’. This amount must be disclosed by the dealer. Don’t confuse ‘market-value’ with the original cost of the security to the dealer (The firm took a risk by investing in securities held in inventory and thus gets to reap the financial gains of any appreciation in value). Dealers that operate in a securities exchange are known as ‘Market Makers’. The main question to ask is — ‘can I take advice from someone selling me something they already own?’. We tend to consider these types of arrangements full of 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 purchased in fee-only accounts, some in brokerage, and some can be purchased in both. So, if you wanted to buy something, and for argument sake, it was only offered in a transaction account, the fee-only advisor wouldn’t be able to execute the transaction. This is why we feel that in order to strive for best execution, firms need to do it all.

Step 2. Determine the associated fees of a commission-based account. Is it one-time or spread out over numerous years? Do I pay a fee if I want to get out? If I buy more of the investment can I get a reduced commission (i.e. Breakpoints)? Sometimes if you commit to purchasing more over time you can get the discounts in advance.

Step 3. Determine the associated fees of owning investments in a managed account. Do I pay a fee to the advisor if we decide to buy or sell the investment? If I want to get out of a position, how much do I pay and who would earn the fee? Is the investment liquid and can I sell it? Should I be buying something in a managed account that I can sell? Liquidity matters.

Now for the fun part — ‘Do The Math’. We perform a very simple ‘break-even calculation’ to determine (based upon on how long you plan on holding the investment) whether fees or commissions are more cost-efficient.

Step 4. Perform the ‘break-even calculation’… math goes here.

Step 5. Determine the confidence of conclusions based upon general bias. For instance, a ‘buy-and-hold’ investor may prefer commissions over fees due to their high level of market resiliency and bias to low trading activity. Conversely, investors who actively trade securities in their accounts may find fee-based payment methods more desirable. Read the fine print in your contract — you might be responsible for both the trade costs to buy and sell in a managed account (fees that would not be charged by the advisor but could be paid to the custodian). It is worth noting that just because an investor has a fee-based account doesn’t mean they can’t also be charged commissions for engaging in recommended transactions, however, fee-only accounts are just that – fee-only.

Step 6. Discuss your biases with your professional. Remember — volatility and liquidity can change. Get a full picture before choosing.

‘Full service’ wealth management firms are a great way for investors to customize the way they pay their advisors. The focus is to develop client-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’ by applying the most cost-efficient methods of compensation.

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