Financial service providers should work in the best interest of their clients, but a small misunderstanding of your provider's language can lead to a profound legal difference. The difference can have a major consequence in how the financial planner works for you.Commission-Based
When you work with a commission-based service provider of any kind, it's in their best interest to make money. Financial advisors may charge a commission, and when they do, they will make more money based on the amount of money that you make.
But there is a conflict of interest here.
Commission-based may sound like a good thing. A planner may work harder for you to make money, but then this might mean:
- Taking larger risks
- Working against your best interests
The commission-based individual isn't held to a fiduciary standard. That is, they don't have to disclose how they earn their commission. If there is a conflict of interest, they don't have a standard to follow to divulge this information to you.
Commission-based may seem like a more logical approach since the provider only makes money when you make money, but the fees are tied into the commission.
What does the U.S. Securities and Exchange Commission think?
A report was released by the SEC recommending that investment advisers and brokers be held to a common fiduciary standard.Fee-Based vs Fee-Only
Fee-based may not be the ideal option when working with a financial planner. You see, there are some planners that state that they're "fee-based," yet they also charge a commission. It's in the best interest of anyone planning for retirement or investing to work with a professional that is truly "fee-only."
"Fee Only method of being compensated. The only money that we receive is directly from our client. (No commissions, no kickbacks. We believe that this insures complete objectivity)," states Financial Freedom.
Fee-only is best from a legal standpoint.
Investopedia states that any financial advisor who joins NAPFA must be free-only. There are a few reasons why this is important.
- There's no conflict of interest
- Fiduciary standard
If a financial advisor is part of NAPFA, they are committed to a fiduciary standard. This standard means that the financial advisor must disclose:
- Any potential conflicts of interest
- How the advisor is compensated
This is the safest way to work with a financial advisor. You'll know, based on fiduciary standards, how and where your money will be used.
Fee-based, on the other hand, may also charge:
- Fees for advice
Many clients don't realize that advice isn't free when working with a financial planner who uses a fee-based model. You may be charged for advice given on the phone, and the fees can add up quickly.
Fee-only allows you to have some form of confidence in knowing that you'll only be charged for the service provided. You won't be charged a commission, and there are no administration fees involved. Commission, often 1%, can be a significant amount of a person's assets over time.
Fee-only investments aren't tied to the frequency of trades. These planners have a high level of standards they must uphold, and they're more likely to encourage you to invest properly rather than try and make trades to earn a commission.
Large investors are at greater risk when using a commission-based advisor. These professionals need to make trades frequently, and in this case, they'll pay a much higher commission. Smaller investors that don't need their assets to be reallocated frequently won't lose much money in terms of commission because there is less management involved.
Legally, financial advisors that follow a fiduciary standard are the best suited for investment purposes from a legal standpoint.