“Fee-Based or Fee-Only” They Are Not the Same

By Mark Folgmann

The underlying difference between fee-based advising and fee-only advising is often disguised through many shades of grey. Advisors today use all kinds of smoke and mirrors to confuse investors and blur the lines between services offered in each form. Fee-based advisors would like clients to believe they are the same as fee-only advisors when in reality these are two completely different practices of investing which may result in substantially different financial futures for the client. It is the commissioned salespeople that find it to be a much better business model if they can produce predictable ongoing revenue from their clients when they can. When I see fee-based accounts created by broker-dealers and distributed by their sales force, they typically contain expensive, actively managed retail mutual funds that would have been offered in the past with sales loads. The fee-based account typically waives the loads (front end or back end) and allows the advisor to tack on a 1-2% fee each year to generate ongoing revenue. The average actively managed mutual fund charges about 1.25% in expense ratio and has about the same in trading cost (brokerage commissions, bid/ask spreads, market impact and cancelled trades) for a total cost of approximately 2.50% per year. Of course trading cost will vary depending on the percent of portfolio turnover and the asset class of the fund. After the advisor adds on their fee-based amount of 1-2%, the total cost amounts to 3.5-4.5% of the account balance each and every year. If you do the math and use the rule of 72 which states money doubles every ten years at 7.2%; it doesn’t take long to figure out why they would rather take their commissions each and every year on a growing pot of money. Keep in mind that a well diversified portfolio may return 8-9% each year before cost and if you lose 3.5 - 4.5% in fees, your ending value will be 40-60% less due to fees alone.
The National Association of Personal Financial Advisors (www.napfa.org) is a great place to find a fee-only advisor. To comply with full disclosure I should mention that I am a full member of NAPFA and we have a great group of NAPFA members in Traverse City. There are many advantages to using a fee-only advisor but in context of this article the difference is substantial. When a fee-only advisor creates your portfolio they will not use high priced retail funds with high annual turnover when they create your portfolio. They will either use low cost institutional funds, index/passive funds or individual securities. All of these options will significantly reduce fees and friction on your portfolio which in turn should increase your net return. Most of the fee-only advisors I know will create portfolios that have an all in cost of 1.25% or less which includes the advisor fees. Obviously it's impossible to completely eliminate all fees but it is important to understand the difference in pricing models. A long term annual fee of only 1.25% compared to 3.5% or 4.5% with the same expected returns on your portfolio will increase your monthly retirement income by a substantial amount over the long haul making this a notable difference.