fee-only vs. fee-based- choosing a financial advisor

6-‐YEAR BREAKEVEN POINT: FEE-‐ONLY VS FEE-‐BASED 1

6-‐Year Breakeven Point: Fee-‐Only VS Fee-‐Based Executive Summary

Do you know how your financial advisor is compensated? Are you aware of

his or her conflicts of interest when advising you? Do these conflicts of interest

affect your advisor’s ability to act objectively in a fiduciary manner? When does it

make sense to use a Fee-‐Only versus a Fee-‐Based advisor? This article is designed to

help you learn more and start asking the tough questions.

Ultimately, you want you and your advisor’s interests to be aligned. You want

to know that a recommendation he or she makes

is always in your best interest and not born out

of a desire to increase the advisor’s

compensation. You want your advisor to remain

objective, to minimize conflicts of interest, and to

disclose remaining conflicts of interest.

Another aspect to consider is when does it make sense to engage a Fee-‐Only

planner who charges a flat fee versus a Fee-‐Based advisory who has the ability to

charge a commission based on the product being considered. Based on analytical

studies of fee structures, it takes roughly 6 years for an account hit with an upfront

5% fee to catch up to an account with a yearly 1% asset under management fee. If

another trade is made before the 6 year mark, the economics are in favor of the AUM

yearly fee. What is more is that this phenomenon exists regardless of the initial

invested amount and the expected rate of return on the investment account.

Read on to help you decide whether Fee-‐Only versus Fee-‐Based is right for

you. In the appendix, you will find a tool developed by The National Association for

Personal Financial Advisors to help you engage your current or future financial

advisor.


6-‐Year Breakeven Point:

Fee-‐Only VS Fee-‐Based

Do you know?

Do you know how your financial advisor is compensated? Are you aware of

his or her conflicts of interest when advising you? Do these conflicts of interest

affect your advisor’s ability to act objectively in a fiduciary manner? When does it

make sense to use a Fee-‐Only versus a Fee-‐Based advisor? This summary is

designed to help you learn more and start asking the tough questions.

Compensation

It is important to know how your financial advisor is getting paid. Are they

getting paid commissions for selling you products including investments, insurance,

and annuities? What are the resulting implications?

A Fee-‐Only financial advisor gets paid a flat fee which is calculated either

hourly, by the project, by a percentage of assets under management, or by a

percentage of the client’s net worth. Fee-‐Only advisors do not

receive any compensation from referrals or products they sell

you. Assets under management fees typically range from 1-‐2%

and may be tiered based on the level of wealth. Larger portfolios

tend to have a lower percentage fee. Many Fee-‐Only planners

have minimum account requirements or charge a minimum fee to

cover services offered including comprehensive planning, investment

recommendations, and implementation. In terms of insurance, Fee-‐Only advisers

typically assess your needs as part of the planning process and simply advise you on

how much and what to get. They do not receive portions of the premium or

commission on the policy sale (Bergen).


A Fee-‐Based advisor can charge either the previously mentioned advisory fee

or commissions on products or referrals they make to you. Fee-‐Based is a term the

brokerage community developed to counteract the success of the Fee-‐Only

classification (Wealth Engineering). One advisor interviewed said, “I think ‘fee

based’ is a euphemism invented to make it sound like ‘fee only’ which it is not. In

my opinion, a more honest label would be ‘commission and fee’.” A Fee-‐Based

advisor we interviewed said:

I can be compensated in numerous ways. How I am compensated from my

clients is really up to them. I can charge an annual fee based on assets under

management, or I can be paid based on the type of investment that fits my

client’s needs. I am always 100 percent transparent with clients on how I am

compensated, and always allow them to choose the manner in which they pay

for my services… We stress transparency and doing what is best for the client.

How much the advisor can make on commissioned products varies which

brings us to the next topic.

Conflicts of Interest and Objectivity

You want to know that an advisor’s recommendation is really what is best for

you, not just the advisor. For a Fee-‐Only planner, advice is totally independent of

the financial products recommended (Wealth Engineering). Fee-‐Only advising

eliminates many conflicts of interests, but there are

scenarios to consider. Let us say you wanted to take out

$250,000 of your investment portfolio to pay off a mortgage

or invest in rental properties. The payout to your advisor is

less because the assets under management would be less even though your net-‐

worth has not changed. Depending on your circumstances, paying off debt may be

more prudent for you, and you want to make sure your advisor truly recommends

what is your best interest, even if it is not in theirs (Wohlner). Some advisors avoid

this scenario by charging a percentage of your net worth regardless of where it is

invested.


Many Fee-‐Based advisors are registered reps for larger brokerages, which

means they are compensated by the brokerage firm based on the products they sell.

You can think of them as glorified sales people. Some advisors are limited in

products they can recommend based on the offering of the broker they work for.

This brings us to the point that they are working for the broker, not for you.

Brokers have monetary incentives to steer large investors away from share

classes with load-‐reducing breakpoints and to steer short-‐term investors to

high-‐load, low annual fee classes. This conflict of interest between fund

investors and brokers is most dangerous when brokers advise relatively

uninformed investors who likely make up a significant fraction of investors who

retain advisors on mutual fund investments (Dr. Edward S. O'Neal).

Another problem with transaction-‐based fees is the advisor’s temptation to over-‐

trade your account to generate fees, known as churning. Many regulations and

internal controls are in place to help mitigate this dilemma.

Fee-‐Only planners are legally obligated to work as a fiduciary on your behalf.

This basically means they must make recommendations that are in your best

interest at all times. Fee-‐Based planners are

only required to operate under the suitability

requirement. This means that investment

recommendations must generally meet the

objectives and means of you the investor

(Investopedia). Suitable recommendations do

not necessarily represent the best available recommendations. Therefore, a

commissioned advisor may choose the higher commissioned product as long as it

generally meets your investment objectives and budget. See a description of the

Fiduciary Oath attached in the Appendix (NAPFA).

The National Association of Personal Financial Advisors’ core position is that

Fee-‐Only engagement removes the potential conflicts of interest that are inherent in

a commission relationship. NAPFA is the largest professional organization of fee-‐

only financial advisers in the country.


Commission-‐based advisors may receive higher commissions on certain

products they sell than on others. This may

influence their decision to recommend

investment products that are not in your

best interest. Ideally, you want an advisor

who offers objective advice based solely on

your specific needs, not the difference in

advisor’s compensation.

Ultimately, you want an advisor who aligns the interests of the client and the

advisor, sitting on the same side of the table. A Fee-‐Only advisor is incentivized to

earn more money by growing your portfolio, generating a percentage of a larger

asset base. The more money you make, the more the advisor can make. You do not

have to worry if a trade recommendation is being made in order to profit you or

create a revenue opportunity to the advisor. Alternatively, if an advisor is

incentivized to sell a product which may or may not be in your best interest, a

conflict of interest arises.

The 6-‐year Breakeven Point

Let us do a cost comparison of fees under both the commission and the

advising fee structure. For this comparison, assume that the Fee-‐Only advisor will

charge 1% of assets under management, calculated and paid quarterly. Similarly,

assume the commission rate is an upfront 5% fee. Assume a fixed rate of return in

both scenarios of 7% annually on a portfolio with an initial investment of

$1,000,000. The results show that it takes 6 years of holding an investment

position before the value of the investment account that took the upfront hit

(Fee-‐Based commission) catches up to the Fee-‐Only account. Figure 1 below

shows the results of the data analysis. What is even more interesting is that when

the amount of the initial investment and/or the assumed rate of return are varied,

the results are the same: a 6-‐year breakeven point!


Figure 1 Investment Account Balance Comparison

What does this mean? It means that if you plan to hold your purchase of a stock,

bond, mutual fund, etc. for less than 6 years, it costs you more with the commission

model. Data and graphs for the following scenarios are located in the Appendix:

$50k initial investment with a 7% rate of return and a $50k initial investment with a

10% rate of return. Again, both will confirm the 6-‐year breakeven point

phenomenon.

Who is best served by the Fee-‐Only Planner?

If you have a larger portfolio that requires frequent trades and active asset

allocation to meet its objectives, Fee-‐Only planning is certainly the way to go. A Fee-‐

Only advisor interviewed recommends his model to “anyone who meets the

minimums. Most do, it just may be hourly planning rather than AUM.”

$950,000

$1,050,000

$1,150,000

$1,250,000

$1,350,000

$1,450,000

$1,550,000

1 2 3 4 5 6

Investment Account Balance

Years Invested

Investment Account Balance Comparison Initial Investment: $1M, Assumed 7% growth

1% Advisory Fee

5% Commission


With the previously mentioned topics and now including the actual cost comparison

of fees, a Fee-‐Only planner would better serve most clients. Conflicts of interests are

reduced greatly and they are required to operate under the fiduciary oath.

Who is best served by the Fee-‐Based planner?

The client who is best served by a Fee-‐Based planner is one whose objectives

require less active management. The “buy and hold method” works best with the

commission model rather than the ongoing assets under

management fee. Consider the situation where an individual

inherits company stock from his or her grandfather’s

passing. Based on personal reasons, this individual never

really intends to sell the stock. It does not make sense to

continue to charge an on-‐going management fee for

something that does not involve active management.

One advisor interviewed says Fee-‐Based planning is for “someone who can't

or won't do it themselves but can't meet the minimum for Fee-‐Only.” Similarly,

many smaller portfolio accounts would suffer from frequent trading due to

associated trading costs. A one-‐time commission fee would mathematically make

more sense. A Fee-‐Based planner interviewed said the following:

Whether the client wants to pay an up front fee for the service I provide, or pay

an annual fee, that is up to them. It is my job to ensure they know the

different options of payment available to them and that I build them a strong

portfolio designed to help them reach their goals.


Ask your advisor if you have not already done so.

Whether you are interviewing a

new advisor or have been with one for

many years, it is important to know how

they get paid and how are they

incentivized to make more money. Ask

to see the advisor’s form ADV and firm

brochure which outline all forms of

compensation, relationships with other financial institutions, and other potential

conflicts of interest. In the Appendix is NAPFA’s convenient form that guides you

through asking the tough questions. Remember the 6-‐year breakeven point fee

comparison. It is important for you to know this information to make sure the

advice you are getting is in your best interest at all times. Ultimately, you need

transparency and full disclosure of compensation to make the best decision for your

financial goals.

Daniel Hannoush, MS Founder | Financial Advisor [email protected] 404.374.5486


Works Cited Bergen, J. V. (n.d.). Paying Your Investment Advisor -‐ Fees or Commissions? Retrieved 4 21, 2015, from Investopedia: http://www.investopedia.com/articles/basics/04/022704.asp Dr. Edward S. O'Neal, P. (n.d.). Mutual Fund Share Classes and Conflicts of Interest between Brokers and Investors. Retrieved 4 20, 2015, from Securities Litigation & Consulting Group: http://www.slcg.com/pdf/workingpapers/ONealonShareClasses.pdf Investopedia. (n.d.). Suitable (Suitability). Retrieved April 20, 2015, from Investopedia: http://www.investopedia.com/terms/s/suitable.asp NAPFA. (n.d.). How to find Your financial advisor. Retrieved 4 21, 2015, from The National Association of Personal Financial Advisors: www.napfa.org/Howtofindanadvisor.asp Wealth Engineering. (n.d.). What is the Difference Between "Fee-‐Only" and "Fee-‐Based?". Retrieved April 21, 2015, from Wealth Engineering, We Build Financial Peace of Mind: �http://wealth-‐engineering.com/what-‐is-‐the-‐difference-‐between-‐fee-‐only-‐and-‐fee-‐based/ Wohlner, R. (n.d.). Fee-‐Only Financial Advisers: What You Need to Know. Retrieved 4 20, 2015, from Investopedia: http://www.investopedia.com/articles/investing/102014/feeonly-‐financial-‐advisers-‐what-‐you-‐need-‐know.asp *(3) Fee-Based and (1) Fee-Only Advisors were interviewed. Each requested their name and firm be left anonymous for compliance purposes.

APPENDICES


Fiduciary Oath

The advisor shall exercise his/her best efforts to act in good faith and in the best interests of the client. The advisor shall provide written disclosure to the client prior to the engagement of the advisor, and thereafter throughout the term of the engagement, of any conflicts of interest, which will or reasonably may compromise the impartiality or independence of the advisor.

The advisor, or any party in which the advisor has a financial interest, does not receive any compensation or other remuneration that is contingent on any client's purchase or sale of a financial product. The advisor does not receive a fee or other compensation from another party based on the referral of a client or the client's business.

Following the NAPFA Fiduciary Oath means I shall:

- Always act in good faith and with candor - Be proactive in disclosing any conflicts of interest that may impact a client - Not accept any referral fees or compensation contingent upon the purchase or sale of a financial product

APPENDICES


APPENDICES


$47,000

$52,000

$57,000

$62,000

$67,000

$72,000

1 2 3 4 5 6


Years Invested

Investment Account Balance Comparison Initial Investment: $50k, Assumed 7% growth

1% Advisory Fee

5% Commission

$48,000

$53,000

$58,000

$63,000

$68,000

$73,000

$78,000

$83,000

1 2 3 4 5 6


Years Invested

Investment Account Balance Comparison Initial Investment: $50k, Assumed 10% Growth

1% Advisory Fee

5% Commission

APPENDICES


NAPFA: CONSUMER TOOLSBeing armed with the right questions is vital in understanding an advisor’s motivations and whether or not they are going to work in your best interests.

Here are some questions to get you started!

Tough Questions To Ask Your AdvisorWhat is your educational background?

College Degree: Graduate Degree:

What are your financial planning credentials/designations and affiliations?

NAPFA-Registered Financial Advisor Certified Financial Planner (CFP) Chartered Financial Consultant (ChFC) Certified Public Accountant/Personal Financial Specialist (CPA/PFS) How long have you been offering financial planning services?

_____ years and _____ months

Do you have clients who might be willing to speak with me about your services?

Yes No

Will you provide me with references from other professionals?

Yes No

Have you ever been cited by a professional or regulatory governing body for disciplinary reasons?

Yes No

What more can you tell me about your experience in providing financial planning services?

How many clients do you work with?

Number of clients: _____

Are you currently engaged in any other business, either as a sole proprietor, partner, officer, employee, trustee, agent or otherwise?

Yes No

Will you or an associate of yours work with me?

You will Associate Team

Will you sign a Fiduciary Oath?

Yes No

How is your firm compensated and how is your compensation calculated?

Fee-Only Commissions Only Fee and Commissions (Fee-Based) Fee-Offset

Do you have an agreement describing your compensation and services that will be provided in advance of the engagement?

Yes No

APPENDICES


For additional tools to help you properly review the qualifications of a financial advisor, visit www.NAPFA.org and click on “Consumer Information”.

Tough Questions To Ask Your AdvisorDo you have a minimum fee?

Yes No

If you earn commissions, approximately what percentage of firm’s commissions comes from:

Insurance Products Annuities Mutual Funds Limited Partnerships Stock and Bonds Coins, Tangibles, Collectibles Other

Does any member of your firm act as a general partner, participate in, or receive compensation from investments you may recommend to me?

Yes No

Do you receive referral fees from attorney, accountants, insurance professionals, mortgage brokers, or others?

Yes No

Do you receive on-going income from any mutual funds that you recommend in the form of 12b(1) fees, trailing commissions, or other continuing payouts?

Yes No

Are there financial incentives for you to recommend certain financial products?

Yes No

Do you offer advice on:

Goal setting Cash management and budgeting Tax planning Investment review and planning Estate planning Insurance needs Education funding Retirement planning Other

Do you provide a comprehensive written analysis of my financial situation and recommendations?

Yes No

Does your financial planning service include recommendations for specific investments or investment products?

Yes No

Do you offer assistance with implementation of the recommendations?

Yes No

Do you offer continuous, on-going advice regarding my financial affairs, including advice on non-investment related financial issues?

Yes No

Do you take custody of, or have access to my assets?if you were to provide me on-going investment advisory services, do you require “discretionary” trading authority over my investment account?

Yes No

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