Traditionally, most financial advisers and brokerages operated on a commission-based model, which meant the advisers got paid more for selling certain investment products and making more trades. The fee-based investment model typically charges a flat fee no matter what you invest in or how much you trade. Though it offers several advantages, this system is not without flaws.
One of the biggest advantages of using a fee-based investment adviser over a traditional commission-based adviser is that your fee is set up-front regardless of how you ultimately invest the money. You don't need to worry that your investment guru is going to push certain mutual funds or other investments on you because he gets a bigger commission out of it. Plus, you don't need to worry about your adviser racking up commissions by constantly buying and selling in your account, a practice known as churning. Under the commission model, your adviser received a percentage of every trade made, so the more trades made with your money, the more you paid.
Potential Cost Savings
If you're an active trader, using a fee-based account rather than a commission-based account can save you a substantial amount of money each year. Many fee-based accounts allow you to do unlimited trading each year for a flat fee, usually a percentage of your assets in the account. For example, say you have $50,000 invested and you pay a 2 percent commission per trade. If you make 20 $5,000 trades per year, that's $2,000 in commissions. If you just paid a flat fee of 1.5 percent, you'd pay just $750 in fees during the same year.
Portfolio Composition Conflicts
Many financial planners charge a higher rate for equity investments, like stocks and mutual funds, than for fixed-income portfolios. This can tempt a manager to push more of your investments into equities than is right for your personal finances. However, when you're young, you're generally better off with a larger portion of your portfolio in equities anyway because if the market drops, you have decades to recover.
Asset Consolidation Conflicts
The Wall Street Journal cautions that under a fee-based investment adviser, there could be a potential conflict when it comes to the advice you receive on how to manage your retirement funds in employer plans like 401(k)s or 403(b)s. If you roll the funds into a qualified retirement plan managed by your adviser, that increases the fees that adviser receives from you, because you're now investing more money with her. While that might be the right decision sometimes, leaving your money in your employer-sponsored plan might be the better option if it charges lower management fees.
Mark Kennan is a writer based in the Kansas City area, specializing in personal finance and business topics. He has been writing since 2009 and has been published by "Quicken," "TurboTax," and "The Motley Fool."