When I’m talking to family and friends about the investment industry, I’m often surprised at how much confusion there is around the topic of how financial advisors (or financial planners, or stock brokers, or portfolio managers, or investment analysts, or wealth advisors…you get the point) get paid. I have to remind myself that if I wasn’t a financial planner myself, I’d probably be confused, too. Far too often, the discussion between advisors and clients about how the advisor gets paid is either hurried, doesn’t happen at all because it’s disclosed in some fine print, or it happens, but the client doesn’t understand it and feels embarrassed to ask for clarification. Hopefully I can bring a bit of clarity to that topic.

In short, a financial advisor typically gets paid one of three ways: fees, commissions, or both. Commissions are a sales charge for a product, so the amount of the commission depends on the product(s) being sold. Fees, on the other hand, pay for advice instead of a product, and the amount of the fee isn’t necessarily tied to the product. Instead, it can be an asset-based fee calculated on the size of the account being managed, an hourly fee based on how long the advisor spends helping the client, or a monthly retainer that allows the client to have access to the advisor’s recommendations without having the advisor manage their investments.

So, why does it matter how your advisor gets paid? In my humble (and admittedly biased) opinion, I believe the fee-only compensation structure is best for investors, and here are my top five reasons why.

1: Commissions can create conflicts of interest.

Put yourself in the shoes of a financial advisor. Your client comes to you asking which mutual fund they should buy. You take a look at a few funds that fit their objectives. One of the funds will pay you 5% of whatever your client puts in that fund on day one, and the others only pay you 4%. If they both fit the client’s objectives (broadly speaking), which would you recommend? You can see that there is a monetary incentive for the advisor to offer the fund with a higher commission. It gets more complicated than that, but the core issue is that when compensation is tied to a specific product, the advisor has to wrestle with more issues than simply what is best for the client. It’s true that conflicts of interest can happen even in fee-only compensation structures, but it does minimize the possibility when compared to a commission fee structure, or a fee plus commission structure.

2: The absence of commissions enables better advice.

When commissions don’t exist and conflicts are minimized, the advisor is free to focus on advice related to things that matter more than a sales charge. Let’s take insurance, for example. A fee-only advisor doesn’t have an incentive to recommend $1 million of life insurance to a client if $500,000 would have been sufficient, because the advisor doesn’t get paid more depending on what the client buys. An advisor who also sells insurance, however, does have an incentive to offer more insurance than may be necessary, because insurance products typically involve commissions, and the higher the death benefit, the higher the commission.

This same concept can be taken a step further. If an advisor is getting paid to offer advice rather than acting as a broker or salesperson, there becomes a sense of satisfaction and duty to offer quality, client-focused advice. It’s what the advisor does – they offer advice, they don’t offer a product. Advisors who are primarily product salespeople may possibly view themselves as order takers, and they may not invest as much time and energy in offering the best possible advice. That’s not to say that all advisors who receive commissions are order takers, because that simply isn’t true. It is true that many advisors who receive commissions take a lot of time and effort to offer the best possible advice. However, their compensation structure isn’t necessarily aligned with that level of service.

3: Fees for advice help the investor focus on what matters.

One of the biggest failures of the investment industry is that so much focus is placed on performance of mutual funds or individual stocks. When selecting mutual funds, investors spend a lot of time analyzing performance of funds, and it’s no wonder. Fund performance is front and center of so many different analysis tools, publications, and even regulatory requirements. Commissions keep the focus on the product – the mutual fund. When paying a commission or sales charge, the investor can view the advisor as simply the intermediary between a mutual fund company and themselves. The conversation with the advisor is all about the fund companies, their offerings, their performance, etc.

When clients are paying for advice, however, the conversation can look a lot different. To get the most bang for their buck, investors may be interested not only in which mutual funds they have, but also how much should they be saving, when they should take social security, when they can retire, whether they should take advantage of their employer’s various benefit offerings, etc. There are exceptions, but I truly believe there is a mindset shift when an investor knows they’re paying for advice instead of for a product.

4: Commissions incentivize an unethical practice called churning.

Churning is not only unethical, it’s illegal. The technical definition goes something like this: churning is when an advisor places trades in a client’s accounts more frequently than is appropriate for their objectives, resources, or account characteristics. Let me translate: churching is when an advisor buys and sells securities – or recommends to the investor that they buy or sell securities – with the intent of generating commissions, and ignores the effects on the investor. Compliance departments monitor this by making sure excessive trades aren’t placed on a regular basis every, say, 12 months. If an advisor knows this, they might just wait 12 months, then take a look at the client’s account, find a few “poorly performing” stocks or mutual funds, and then call the investor to recommend selling those and buying something else. The advisor might have skirted the churning rule, but did that benefit the client? For reasons beyond the scope of this article, no. Even if you don’t know much about investing, it just doesn’t sound right.

5: Fees enable a better advisor-investor relationship.

Commissions are tough to keep track of. Sometimes they are buried in disclosures, and they usually don’t show up on a statement; they simply reduce the return to the account. One of the ickiest feelings an investor can experience is not knowing how much he or she is truly paying his or her advisor.

When advisors are fee-only, it removes that feeling. Fees based on the size of an account are not only disclosed up-front, but they’re also apparent on statements. Hourly fees or monthly retainers are even easier to spot. There isn’t a feeling of “I don’t know if I should trust him, because maybe he is getting something else out of this that I’m just not seeing.” By definition, a fee-only advisor isn’t getting other forms of compensation. In my opinion, that enables a new level of trust between the advisor and the investor.

In conclusion

I’m a fee-only advisor, so again, I’m biased. However, there are plenty of consumer advocates like Clark Howard, Consumer Reports and Suze Orman who recommend working with fee-only advisors. While I do believe a fee-only compensation structure is best for the investor, there are plenty of great advisors who care about their clients, but still accept commissions. I have family and friends in those positions. At the end of the day, you should at least know how your advisor is getting compensated, and then ask yourself whether you are comfortable with that arrangement.