Pay by Commissions
For Financial Advisors
Financial advisor pay based on commissions is the traditional method within the financial services industry. This is shorthand for saying that clients are charged a fee, usually called a commission, for each security transaction made, whether to buy or to sell. The financial advisor, in turn, receives a portion of these commissions back as compensation, usually through an intermediate process that converts commissions into a metric called production credits.
A potential source of confusion comes from the fact that the title financial advisor can be applied to both investment brokers operating according to the suitability standard and registered investment advisors operating under the fiduciary standard. While commission based client relationships are the long established norm among the former, the latter traditionally work on a fee only basis.
Financial advisor pay may vary by type of security sold, and typically the percentage he or she retains increases as the total commissions (or production credits) earned during the year increase. This is often referred to as the financial advisor's payout rate. The firm's matrix of payout rates typically is called its payout grid.
Advantages to the Client:
Basing financial advisor pay on commissions generally is the most advantageous option for clients who are long term investors, following a buy and hold investment strategy rather than one which involves frequent trading and rapid portfolio turnover.
This is doubly true if the client is largely self-directed and financially savvy, not needing much ongoing attention and advice from the financial advisor.
Advantages to the Financial Advisor:
For financial advisors who are aggressive and skilled in sales, and whose clients are comfortable with investment strategies that involve high transaction volumes, a commission based payment plan can yield considerably higher compensation than alternative methods.
However, the more active a trader a client is, and the greater the financial assets on deposit in the client's account, the more likely the client is to demand (and receive) increasingly discounted commission rates versus the standard rates charged by the firm. Only the most confident and aggressive financial advisors typically succeed in holding the line against client demands for discounts in these scenarios.
Conflicts of Interest:
When financial advisor is on a commission basis, there is a clear conflict of interest, given that pay is linked directly to generating transactions, rather than to investment performance. The practice by which unscrupulous financial advisors seek to maximize their commission based compensation through excessive trading is referred to as churning.
Churning is a particular danger with so-called discretionary accounts, in which the financial advisor has been granted the ability to enter trades on his or her own discretion, without first obtaining explicit permission from the client. With a non-discretionary account, the financial advisor must obtain such permission from the client for every transaction that he or she proposes. A telephone conversation suffices as a means to obtain such approval.
Because of the potential legal exposures, the compliance departments in the most conservative securities brokerage firms tend to place severe restrictions on the ability of clients to open discretionary accounts.
Among registered investment advisors operating on a fiduciary basis who serve individual clients and have at least $25 million in client assets (these advisors also must be registered to act as broker/dealers), the percentage of those who earn commissions has been:
- 22% in 2010
- 23% in 2009
- 24% in 2008
Note that some of the investment advisors counted here accept multiple payment plans, which differ by client or client account. Thus the percentages in this study add to more than 100% across all payment types.
These figures come from a study by Dr. Lukas Dean, Assistant Professor and Financial Planning Program Director at the Cotsakos College of Business at William Paterson University in New Jersey.
Findings of this study were cited in "How to Pay Your Financial Adviser," The Wall Street Journal, December 12, 2011.