Fee based financial advice Vs commission: Which choice pays?

The debate over fees versus commissions, and ultimately which is best for clients, is an age-old debate. It is also true, that where the option remains to choose between fee based financial advice and payment by way of a commission by product providers, the debate will continue to rattle on.

In the UK, the debate has been closed, at least for now. Following the Retail Distribution Review (RDR) which came into force on 31st December 2012, Financial Advisers making a personal recommendation to a retail client are no longer permitted to be remunerated for the advice they give by payment of a commission by the product providers (with the exception of some insurance products).  Instead Advisers will agree an initial and ongoing charge directly with the clients. The amount charged varies depending on the firm and often the amount a client is investing but research has shown that this is typically between  1 – 5% as an upfront fee, with the average around 3%. The firm will then charge an annual management fee, with the majority of firms charging around 1% but with some firms charging as much as 1.5%.

In other parts of the world, commission payments are still permitted. These payments are facilitated by the products that a firm recommends paying an initial commission, which usually comes in the form of an upfront payment. The amount paid will vary depending on the product and the charging structure, but are often in the range of 4 – 7%.  The commission is paid out of the product providers own money, rather than as an initial charge from the investors money, and this is then recouped over the investment term through the annual management and/or administration fees that are taken.

Typically where an investment has been paid for by commission, rather than an upfront fee, there will be a higher exit penalty on any full withdrawal before the end of the investment term. Depending on the nature of the investment, and the requirement for ongoing advice, the firm may or may not charge on ongoing service fee, which will be in addition to the standard management fees payable on the policy. The service fee charged will vary, typically between 0.25% and 0.5% per annum but check the small print as some firms have been known to charge as much as 1% or even 1.5% – which in addition to the upfront commission has to be seen as extortionate.

In the short term at least, it is likely that a firm offering payment purely by commission only are likely to be able to offer a lower cost proposal than a firm that only have the option of charging an upfront fee. However, if there is a service charge attached as well, then this may well balance things out, and in some cases, result in a much more costly proposal than what you could receive by obtaining strictly fee based advice. To illustrate the comparison more clearly, we will use an example of two clients making identical investments of £250,000 into an investment bond:

Client A has chosen to pay by commission. As the firm providing the advice receive a commission from the investment provider at the outset, there is no need for them to charge an initial advice fee. As a result 100% of client A’s money is invested. The product fees (which are there to recoup the commission paid to the firm and also for the product provider to make a profit) are 1.25% per annum. The firm then charges an additional 0.25% service fee for the ongoing advice and regular reviews. The result is a total annual management fee of 1.5% per annum. The service fee charged by the firm in this case is lower [than when compared to a typical fee only model] at 0.25% per annum, as the firm received an upfront commission; for this example, let us assume this was 6.5%.

The term of the investment is 8 years, so this 6.5% commission payment that was received upfront averages out at 0.812% per annum over the term of the investment. If the firm add the service fee of 0.25% then this equates to around 1.06% per annum (or a total of 8.5% over 8 years). The amount of the service fee charged will be important here in determining the overall value; so in theory, over an 8 year period, the firm will have received between 0.81% per annum (with no service fee attached) to as much 2.31% per annum (where in extreme cases service fees as high as 1.5% per annum have been added). This would be classed as a commission only model if no service fee has been added, or a combination of commission plus fees if a service fee has been added.

Now let us compare client B, who has chosen to invest using a fee only model. The firm charges an upfront fee, which is taken directly out of the clients money. The amount of the fee will probably depend on a few factors; these are likely to include the amount invested, the nature of the investment – and complexity of the advice, and of course the firms own charging structure. For this example, we will assume that [the average of] 3% has been charged, in addition the ongoing service fee is [also using the average] 1% per annum.

As no commission has been payable, the product providers fees will be lower, so let us assume these are 0.5% per annum. This gives us a total of annual management fee of 1.5% per annum; this includes both the product providers fees and the financial intermediary’s fees. In keeping with our 8 year term, this would equate to 11% paid over 8 years (3% upfront and 1% per annum); this is equivalent to 1.375% per annum when averaged and spread over 8 years.

A point to note here is that if there has been a commission payment paid upfront by the product provider, there is also very likely the impact of any additional exit penalties to consider; the client will need to consider whether these are likely to impact on any requirement they may have for future flexibility. Where a commission is paid over an upfront (initial fee) it may result in anything from 3-7% added as a penalty if your plans change and you need to surrender all of your investment early.With a fee based model, if you need to surrender the investment early, as you have already paid an initial fee upfront (taken out of your capital on day one) you will pay either no exit penalties, or at least a reduced penalty, when this is compared to a commission model.

In summary you can expect to lose some of your capital through payment of an upfront fee when choosing fee based financial advice; whilst using a commission model will usually remove this upfront fee, you may still lose some of your capital by way of an early exit fee – if – you needed to withdraw all your capital before the end of the investment term. 

From a cost perspective the fee only model will usually mean lower upfront profits for the firm, but with this being compensated for with better long term profits. This approach would appear to reward firms for providing longevity in both the quality of their advice and their ability to sustain profitable and harmonious relationships with their clients.

Perhaps a fair comment that we can make in favour of fee based financial advice over upfront commission only financial advice is this: If you find yourself in the unfortunate situation that you are not happy with the service or the advice you have received, then with a fee based Financial Adviser, although you won’t be able to reclaim the initial fee you paid to them, you will be able to cancel the service fee and take your business elsewhere. With an upfront commission model, if you become dissatisfied, yes you can still move your investment elsewhere, but the product fees will remain as they are, as they are linked to the commission that was paid at the outset. This means that the new company that you transfer your investment over to will then need to charge separately; this will be in addition to the product charges you are already paying. You may still be able to cancel any additional service fee that was in place, although you will need to check the exact terms of this to be certain.

In concluding we might comment that whilst commission may be cheaper for clients over the long run (at least where the firm is acting ethically and not double charging clients with excessive service fees); if things don’t work out as planned, be this as a result of  changing circumstances forcing early closure, or you not being satisfied with the performance or service received, then having paid using a fee based Financial Adviser will be less complicated.

At First Equitable rather than attempt to take the moral high ground by declaring one superior than the other, we take the impartial view of letting our clients choose the most appropriate structure for their own individual set of circumstances. Where the option remains, we let our clients choose between strictly fee based financial advice, commission only, or a combination of both.

We would argue that the question of how you pay for advice is often not the the most important question. For instance, how you pay your Financial Adviser is much less important than:

How much do you trust your Financial Adviser?

How have your investments performed when compared to other investments in the same sector or risk category ?

Has the advice you have received been consistent with your investment outlook and your goals and objectives?

We would advise that clients ensure they look for a Financial Adviser that has the integrity, experience and knowledge of the area or areas in which you are planning to transact business. From a foundation of trust and openness, on both parts, you will then be in a good position to sit down together and agree how remuneration is to be resolved.

When it comes to seeking financial advice, it would serve you well not to lose sight of the motto caveat emptor – let the buyer beware.

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