Within the financial advisory industry, there’s plenty of debate about whether the fee-only model is always best for clients.
That’s a separate question from adhering to the fiduciary standard, which is required of all advisors who hold the certified financial planner, or CFP, credential.
[Sign up for stock news with our Invested newsletter.]
Michael Donnelly, a CFP who’s interim managing director of corporate relations at the Washington, D.C.-based CFP Board, says the organization requires all CFP professionals to act as fiduciaries at all times. That means acting in the client’s best interest.
“Many different business models exist in today’s evolving financial services ecosystem,” he says. “This affords individuals the opportunity to work with a CFP professional in a business model that meets their personal needs.”
CFPs, as well as other advisors who are licensed but don’t carry that credential, are compensated in various ways. Some receive fees from clients and others a combination of fees and commissions. The full-commission model still exists, mainly in the insurance industry, but it’s not as common among financial advisors these days.
Whether or not your advisor holds the CFP credential, it’s important to understand how they and their firm are compensated. Fee-only advisors, for example, won’t be swayed by commissions from insurance or annuity sales.
“Fee-only advisors are typically not subject to the same conflict-of-interest concerns as traditional brokers and their commissions and transaction-driven client relationships,” says Andy Kilbarger, vice president and chief compliance officer at Sigma Planning Corp. in Ann Arbor, Michigan.
If you’re considering a fee-only advisor, here are some pros and cons to understand:
Fee-Only Advantages
Many clients like the relative ease of understanding a fee-only advisor’s business model and compensation structure. While even a fee-only advisor may work with outside asset managers who charge a fee, it’s still easier for clients to grasp how the planner’s firm is paid.
With the fee-only model, there’s an alignment of incentive between the client and advisor, says Phillip Hamman, president and CEO of Linscomb Wealth in Houston. “Fee-only firms typically follow the fiduciary model, which holds them to a legal standard of placing clients’ best interests first,” he says. Because the client is paying for advice, rather than a commissioned product, there’s no question about direct or hidden incentives, Hamman adds.
“The model is transparent and relatively easy to understand, in my opinion, and fee-only advisors oftentimes offer breakpoints in their fee schedules,” he says. “As the portfolio grows and reaches breakpoints, the average fee rate declines.”
[How to Invest During Rate Cuts]
Compensation Transparency
“Fee-only advisors provide transparent fees for service, which can drive lasting long-term relationships with their clients,” Kilbarger says.
There’s no compensation method that’s completely free of conflicts of interest, says Ken Robinson, CFP, who is the founder of fee-only Practical Financial Planning in Cleveland, Ohio.
“Certainly, there are many commission-paid advisors who give excellent client-focused advice,” he adds.
Robinson points out that clients seeking advice on more than just investments and insurance may find the fee-only model to be a good fit. “It’s well suited to a comprehensive, unbiased plan, since it’s human nature to focus on what we get paid for. You might not want to limit that to investments and insurance,” he says.
Not Influenced by Sales Commissions
Frequently, insurance-licensed advisors, who receive a commission for those sales, will only use insurance products when a client’s plan calls for it. They don’t market insurance sales and annuities separately from planning and asset management.
However, other advisors base a large portion of their revenue on annuity sales. It’s important for clients to understand an advisor’s position on these commission-based products.
Still other advisors at large national firms can receive commissions for selling mutual funds to clients. This can potentially be a problem if there’s a less expensive mutual fund or exchange-traded fund, or ETF, that is equally suitable for the client.
Robinson adds that there’s a great deal of confusion when it comes to fee-only versus fee-based advisors. “Consumers need to be very wary of advisors who call themselves ‘fee-based,’ since those planners also take commissions,” he adds. “Just ask how much of the firm’s compensation comes from commissions. If the fee-only approach is important to you, commissions should be zero.”
Long-Term Focus
The absence of sales commissions generally means a fee-only advisor can establish relationships with clients that last years and encompass many stages of life. In contrast, an advisor who sells products has a more transactional approach, which can mean only a short-term working relationship.
That long-term focus is advantageous because it aligns the advisor’s interests with the client’s successful financial outcome. By building lasting client relationships, compensated with recurring fees, advisors can develop a more thorough understanding of each client’s goals and evolving needs. This allows for a more personalized approach than you’ll generally find with an advisor who receives a significant chunk of compensation through commissions.
A long-term focus also promotes more strategic investment strategies, rather than a portfolio constructed around commissioned products.
Potential Fee-Only Disadvantages
There are situations where the fee-only model isn’t the best fit, says Hamman.
“I observe two primary goals when clients seek out fee-only firm,” he says. “They want trust, and they want to feel confident when delegating day-to-day responsibility. Their goals are reducing stress and freeing up their time for other pursuits.”
However, Hamman says, some investors want a more active role in their portfolio management. These do-it-yourselfers don’t want to delegate the management to an advisor.
“They like ideas and a sounding board, but they want to drive the process,” he says. “In those situations, the fee-only model may not be the best fit. It’s good to have options for different preferences.”
No Access to Insurance Products
The comprehensive financial planning process includes an insurance review. Sometimes the planner finds that clients are over-insured, such as when they are retired with no dependents, but continue paying premiums for life insurance intended to replace income from their working years.
In other cases, clients are underinsured or might even benefit from an annuity. That’s where a fee-only planner has to send the client elsewhere to buy those products.
The planner can certainly review options with the client when agents prepare policy illustrations, but some clients prefer one-stop shopping. For example, they may not want to take the extra time and effort to seek out other professionals. In addition, this can lead to fragmented financial planning and a lack of coordination, making the process less streamlined and convenient.
Difficulty Working with Smaller Accounts
Many fee-only advisors are paid through the assets under management model. There are various ways that can be structured, but the most common is to charge a percentage of client assets the planner manages.
For example, say an advisor charges a fee of 1% for an account of $1 million. That fee typically includes regular plan updates and other on-demand services. That fee amounts to $10,000 a year for the advisor.
It’s usually impractical to base a practice around clients with fewer assets to manage. Those engagements can also entail planning and ongoing services, but for a much smaller fee. For example, a client with $100,000 in assets under management would result in a yearly fee of only $1,000. Even at a fee of 1.75% of assets under management, that’s still just $1,750 a year.
That’s why it’s often difficult for clients with small accounts to find a fee-only advisor. To make it work, advisors must charge a higher fee or limit the scope of work.
“One challenge of the fee-only model is that the management fees necessary to service small accounts may be too high to make sense to the client,” says Ed Mahaffy, a CFP who’s president and portfolio manager at ClientFirst Wealth Management in Little Rock, Arkansas.
“For smaller accounts, paying a one-time commission can make sense,” he says.
Mahaffy cautions, however, that this approach may result in costs that exceed what a fee-only advisor would be paid over the course of several years.
“One alternative is to retain a fee-only advisor for a project fee or one-time charge. This can be achieved by paying a flat fee for a financial plan and a lesser fee for periodic updates as needed,” Mahaffy says.
“Implementation of the prescribed asset allocation can be executed through a discount firm, such as Schwab, utilizing their robo-index ETF services for nearly free,” he says.
Yet another alternative is to avail yourself of the plethora of services offered by Schwab or Vanguard, including a financial plan delivered by a CFP professional. However, the quality of service may suffer considerably. You may not have immediate access to a CFP nor the same advisor whenever you need advice, but this approach can certainly be more cost-effective.
Incentive to Keep the Assets Under Management
An advisor who is compensated for a percentage of client assets may cringe at the idea of a client cashing out a significant portion of the investment portfolio for a large item.
That’s an area where a fee-only advisor must take a hard look at whether a recommendation constitutes a conflict of interest.
“An advisor incentivized by the assets under management may not want to recommend a strategy where the funds need to leave the accounts to use to pay off a loan or mortgage or to start a new business,” says Jennifer Kim, a CFP who’s managing senior partner at Signature Estate & Investment Advisors in Los Angeles.
That can also be a problem for clients of a fee-based advisor who charges a percentage of assets under management. As always, clients should mull over their own financial decisions, review all possible options with an advisor and be sure to understand how a particular decision affects the advisor’s compensation.
More from U.S. News
10 Best Financial Certifications
Revocable vs. Irrevocable Trust: What’s the Difference?
Fidelity vs. Charles Schwab: Which Is the Right Choice for You?
Pros and Cons of Using a Fee-Only Financial Planner originally appeared on usnews.com
Update 10/07/24: This story was previously published at an earlier date and has been updated with new information.
