Pros & Cons of Fee-Based Investment

Few investors have the specialized knowledge necessary to create detailed, sophisticated investment or estate plans for themselves. Instead they rely on the work of financial advisors, who offer their expertise for hire. Advisors in turn expect to be compensated for their time and expertise, and that creates questions about motivation. Investors who are wary of commission-based advisors might opt instead for a fee-based planner, as a source of disinterested advice. In truth, all compensation models have pros and cons.

Commission vs. Fee-Based

Financial planners and advisors are expected to act in their clients' interest as a matter of professional ethics. It's also a pragmatic choice, since most planners rely heavily on referrals from existing clients. However, commission-based compensation creates at least the potential for conflicts of interest. Products with high commissions benefit the seller, but might not be the best fit for the client's needs. To avoid that tension, investors often prefer advisors who derive their income from fees rather than commissions. It's important to understand that the term "fee-based" doesn't mean the planner earns no commissions or other incentives.

Fee-Based Compensation

Financial planners can charge several types of fees for their work. Most will offer a set fee for a specific task, such as creating a detailed estate plan. Other alternatives include hourly fees, an annual retainer or a percentage of assets under management. Ideally, this means that the planner's advice is completely disinterested. However, there's a difference between "fee-based" and "fee-only" financial advice. A fee-only planner accepts no commissions, and often is not licensed to sell financial products at all. A fee-based planner accepts fees, but still earns commissions as well on the sale of products.

Pros and Cons

This doesn't mean a fee-based advisor is a bad choice. Fees provide a stable base income, reducing the temptation to promote products with high compensation. In turn commission income allows the advisor to keep fees lower, enabling smaller investors to benefit from professional assistance. Still, self-interest can influence a planner's advice regardless of the compensation model. For example, advisors paid by the hour might inflate their billable time, while advisors paid by assets under management might opt for high-yield investments that pad the portfolio regardless of whether that's in the client's best interest.

Choosing Your Advisor

Since each model has its own potential downside, it's important to understand exactly how a planner is compensated. Good planners will be open about this, and any reluctance to discuss compensation is potentially a danger sign. Seek out advisors with widely-recognized credentials, including Certified Public Accountants and Certified Financial Planners. They've been through rigorous training and testing, and they're subject to professional discipline if they don't measure up to your trust.