The difference between fee-based and commission-based financial advice
An overview of the main differences between fee-based financial advice and commission-based financial advice, including the pros and cons of each approach.
Written by E4E Editor on 16 August 2018
Not all of us need to receive financial advice. However, studies over the years have shown that people who actively seek financial advice are far more likely to grow their financial assets and reach their financial goals over those who tend to leave it to fate or make financial decisions themselves.
Like any professional industry, financial advisers can train for years and accrue many years of experience which enables them to make better decisions for their clients. After all, if you can afford the best legal advice you will probably opt for that rather than relying on your best friend who used to watch Suits.
Fee-based financial advice vs commission-based financial advice
Internationally, financial advice is typically offered on two fee-paying structures, fee based and commission. For people familiar with the UK system and the recent rules imposed by the FCA, fee based financial advice is now required if an organisation is offering financial advice in the UK. However, internationally the same rules do not apply, even if you are British and seeking advice from a British financial adviser based overseas.
Financial advice for expats has traditionally been offered on a commission-based system due to the lucrative nature for financial advisers, however as the industry seeks to improve its image the number of fee based financial advisory firms is increasing.
However, what is the difference between the two systems and how does each system affect you as a user of financial advice?
Commission-based financial advice
Ultimately, if a financial adviser is paid on a commission basis it means they are compensated by the company offering the financial product, much like in traditional sales. Typically, the harder the product is to sell, the higher the commissions on offer for the adviser. The products are also highly likely to be tied to their employer, and the organisation sets the objectives for the adviser as being revenues and profits, rather than customer service or customer retention.
Quite often the primary responsibility for the “adviser” will be to make cold calls to anybody they can find that might meet the necessary criteria. When targeting expats, they will often hang out in expat friendly locations (pubs, bars and clubs) and become friends first.
This brings about one key problem for a consumer seeking independent advice: how can you guarantee that the advice you are receiving is in your best interest and not purely because the adviser wants to maximise his or her income?
On this basis, an adviser is going to ignore financial opportunities purely because they are not as lucrative individually, irrespective of whether the financial product is best suited to the client or not.
Additionally, what you are unlikely to find out is that a large chunk of the commission that the adviser gets paid is actually a percentage of your investment funds, meaning that your investments will immediately be in negative equity and therefore take longer to actually earn any income.
Unfortunately, the most lucrative financial products for commission-based advisers also have the longest tie in periods. For example, and adviser might receive 7-10% of the investment amount for being able to sell a bond with a 10-year lock in period. For too many expats, this has not only meant a huge financial loss, but also the prospect of reversing the decision is so financially prohibitive that it is a decision which cannot be reversed.
While it might not be immediately obvious why some people will choose commission-based financial advice, the appeal stems from when and where payments are made. Clients are typically drawn to not paying anything upfront and the commission route can therefore be attractive but knowing exactly what you are paying and what the adviser is receiving is key.
For example, using the 10-year life bond scenario, clients are driven to a decision of paying nothing upfront, however the annual costs will be higher as the providers need to factor in the commission they are paying the adviser in advance of the fees the client will be paying. The difference per annum could be as much as 0.8% difference which would equate to a 7% commission to the adviser.
Overview of fee based financial advice
Fee based financial advice is as it sounds: an adviser or firm will charge for their services. This is usually a percentage of the amount of funds that will be under management, normally ranging from 0.5% to 1.5% depending on the complexity of the situation.
Fee based financial advisers are ultimately more interested in keeping your long-term business because the long-term relationship provides greater opportunities to understand and adapt investment plans for their client and also there is a financial incentive to keep you, the client, happy.
The benefit of this approach over commission based financial advice should be clear: by wanting to keep their client happy, the financial adviser must work harder at matching the right investment products with the individual and their goals. This means that they will not be tied to products and are normally able to be independent and offer whole of market advice.
It is also possible for fee-based financial advisers to receive commission payments from the advising of some products, mainly insurance related. The main difference with this and commission-based advice is that you know exactly what the advice costs you .
Similarities between fee based and commission based financial advice
One of the biggest similarities between the two systems of financial advice is that there is normally a minimum financial entry point. With regards to fee-based advisers this is primarily because an individual with smaller financial assets or lump sums, fee based financial advice tends to be more expensive. Often, especially for expats, the minimum entry point for fee-based financial advice is around £50,000 which is where the cost/benefit starts to tip in favour of the client.
It is similar with commission based financial advice in that many lucrative financial products will only be available for potential clients with larger funds.
However, this is pretty much all the two systems genuinely have in common.
What about people with smaller investment pots?
In the commission-based world there is no real alternative, however for fee-based financial advice there are alternative digital solutions called Robo Advisers. Although not yet generally available for expats, Robo advisers charge much smaller fees and are available for people with much smaller investment pots.
The benefit of Robo advice is that it makes investment possible for people of differing experiences levels as well as wealth levels. However, the very nature of Robo advice is that it removes the major factor of financial advice – the personal element.
The typical profile of someone considering Robo advice is a young person interested in getting involved with investments.
The way that Robo advice works is that an investor opens a digital account and is asked a number of questions. These questions will create a profile which incorporates risk propensity, financial objectives and life goals. These questions will be very similar to the questions a financial adviser will ask to be able to understand more about the individual.
Robo advice can take the form of either fee-based financial advice or commission based. However, the charges will typically be a lot smaller and the option of choosing fee-based or commission-based will be based on who is behind the platform.
Issues unique to expats seeking financial advice
For expats, financial advice is a much murkier world, however it is often a necessity for people looking to minimise their tax liability or take advantage of the wider range of financial products available.
The problem for expats is that financial advisers that assist expats have minimal regulations to adhere too, therefore individuals are exposed to a greater risk of speaking to a rogue adviser.
One of the best measures of whether an adviser is likely to be rogue is through his charging structure. Traditionally “financial advisers” for expats have been far more akin to salespeople pushing a very limited range of products for huge personal financial gain.
Traditionally, one of the key areas of exploitation has been through pension transfers to QROPS where British expats were cold called by salespeople offering all manner of benefits, but the truth was that they were being sold very expensive financial products that would see pension funds diminish an exchange for salespeople and the unscrupulous firms behind them becoming very wealthy.
While this presented opportunities for fee-based advisers to enter the market, reputationally it is still taking time to change the perception of expat financial advisers. However, there is an increasingly large number of genuinely independent financial advisers offering fee-based services, and while they still have no regulatory body overseeing them, they will adopt the compliance approaches of highly regulated jurisdictions such as the US or the UK.
How to choose between fee-based and commission-based financial advice
While it should be relatively straight forward to understand which type of financial advice is best for investors, you should still be asking the right questions. For unregulated firms, it is relatively easy to disguise commission based financial advice as fee-based.
For example, even if you undertake a risk profile at the start of a relationship with a financial adviser, you should ask to see any report and how any recommendations align with the report.
Ultimately, if you ask the right questions (e.g. how are you paid? Do you receive any commission? Where do your payments come from? How long am I tied into the decision? What if I change my mind?) and only make a decision when you feel that you are being told everything about how the adviser is being paid should you even consider proceeding with anything.
As ever with financial advice, if you are ever in any doubt, you should always seek a second (or third) opinion before making any decision.
Similarly, if you receive a phone call out of the blue from a financial adviser, be aware that this is the standard trait of salespeople and they will be driven primarily by the commission in their pocket, rather than the long-term objective of assisting you.
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