When you're just starting to accumulate an investment portfolio, let's face facts: You don't have a lot of options as to how you pay your financial adviser. As your assets grow, however, so does your choice of fees structures.
I'll put it out there right now: There is no clear winner when it comes to fee models. Some may appear better suited for certain investor profiles, but there are pros and cons within each.
Let's look at the three main options:
The Traditional Transactional Model
The incumbent. If you are buying and selling individual stocks, you pay a commission for every transaction. Mutual funds may be sold on a DSC basis (deferred sales charge) or front-end load basis. Many advisers choose to sell front-end load funds with a 0-per-cent commission these days (more on that below). With either the DSC or front-end load funds, there is an ongoing service fee (commonly known as a trailing commission), which is designed to compensate the adviser for ongoing advice or financial planning services provided to the client.
The Fee-Based Model
With this model, the fees for investment advice and execution start to get separated from the products. Your adviser may choose to charge a set percentage of assets under management as your fee. For example, if your portfolio is worth $250,000 and they charge 1.25 per cent as their "client advisory fee," your fees amount to $3,125 per year. If you made no changes to your portfolio, or if you made a few trades per month, the client advisory fee would be the same.
Some people like this model because it addresses the apparent conflict of interest of wanting to generate transactions. The adviser compensation is directly aligned with the value of your account. If they feel that no changes are the best strategy to grow the account, they still get paid. Others may argue that it can lead to complacency.
Further, even though there may be potential tax benefits of a client advisory fee (it is potentially a deductible expense for non-registered accounts), many investors do not like seeing the fees reported in a transparent manner. In fact, many advisers have shared experiences where they switched clients over to fee-based accounts and ended up saving clients money, only to have clients complain about actually seeing the fees being charged. So while transparency is seemingly in everyone's best interest, in practice, some investors prefer the head-in-the-sand approach. It's silly, but it is what it is. This is part of the reason front-end load funds with a 0-per-cent commission are so popular.
The Fee-Only Model
Note the difference between the fee-based option above and this model. Fee-only advisers would charge by the hour, or by flat project fees negotiated in advance. They wouldn't care if you took their recommendations or not, which is a positive from some perspectives and a negative from others. Since these advisers are paid solely for their expertise, the investor worries less about any vested interest in recommending one fund over another, or putting more emphasis on equities (which can pay more in each of the other two models) than fixed income. However, some people may feel there is less accountability for this type of adviser compared to an adviser who is attached to your hip for the long haul. We also have the same problem with being handed a bill. It's a psychological hurdle.
Further, recent regulatory changes have made the fee-only model less tenable than in the past if you are looking for planning advice as well as tailored investment recommendations. This is less so for DIY investors who may only be looking for ancillary financial planning advice while handling their own investment portfolios.
There really isn't a clear winning model that works for everyone. Each has its pros and cons. By far, the larger determinant of success is going to be a quality adviser who looks out for you first and foremost. These advisers exist within each of these fee models, and they would be happy to discuss these and other models in more detail with you.