Let me dispel a misconception: financial advice is not free. Just because you don’t hand over a cheque, does not mean you are not paying. This post is designed to ensure you are better informed of the issues next time you decided to take advice. It will also help you determine the best payment method for you.
Neither commission nor fee based advice is inherently bad but like many industries, financial services has added a twist: commission isn’t paid directly by the person who seeks the advice. It is paid by the company whose product is sold. The commission paid is then recouped by the company via product charges deducted from the policy purchased.
This makes the system less than transparent and understandably, those seeking advice are concerned about the motives of the adviser/salesman. This is because the person seeking advice does not know how much they are paying for the service they receive and whether the adviser is bias toward a particular company because it pays higher than average commission or for a more valid reason.
On a related issue, about 30 years ago, the financial services industry faced a problem: commissions being paid were low and without massive volume it was difficult to run a successful business. Life assurance companies did not want to increase premiums as this would lose market share. Instead they allowed advisers to be paid a lump sum of commission on credit representing most of the commission due on the contract over its lifetime once the first premium was paid. This is called indemnified or indemnity commission. In U.A.E. virtually all regular premium insurance policies are sold using indemnified commission.
Indemnity commission is repaid to the life insurance company by the adviser if the customer stops contributing to the policy within a pre-agreed time frame, usually the first few years of the plan. This is a powerful incentive to make sure the adviser provides a good service, at least for the first year or two. Unfortunately, advice and administration services are required for the full term of the product and this is where I often hear of complaints from policyholders who are no longer receiving any service from their original adviser.
Paying a fee is certainly more transparent from a customer perspective and avoids the indemnity liability for the adviser. Once the work to be done has been assessed, an estimate of the cost can be given and once completed the fee is paid. In addition to transparency, there are other advantages such as control; only paying for the service you use and avoiding the ‘orphaned’ client status described above. If an investor wishes to change adviser all they need to do is change the broker of record with the investment or life assurance company, which is free, and appoint a new adviser under a new fee agreement. There will be no incentive for the new adviser to recommend cancelling the old plan and starting another just to make some money to cover the cost of advice, known in the industry as ‘churning’.
Fees have another advantage, commission based financial planning often focuses on those products and services which generate payment. Full service financial planning should encompass all aspects of personal finance, such as: budgeting, bank accounts, credit cards, debt management, estate and succession planning, government savings products, mortgages, will writing etc.
Given the apparent advantages of a fee based approach, why don’t more investors use this method? The simple answer is that the international financial services market is not structured for it. It is possible for advisers to waive commissions on most products and be paid a fee but few will or are permitted to by their employers.
There are disadvantages to a fee based approach, particularly where policies are paid for monthly. Here the cost of advice may be the equivalent of several months’ contribution, building the commission into the product charges is a convenient way of making payment for advice.
Another difference between fees and commission is under commission based advice only those who buy a product pay for the service, under the fee option all who receive advice pay whether they decide to proceed with the advice or not. Where the advice is not taken the cost may be discounted as only advice charges are usually made and administrative costs will be lower as there may be little use of an adviser’s administration team.
As an adviser who has worked in commission, hybrid and fee based markets, I can see advantages for clients and advisers in both options and I do not have a preference. The important point for a client is to know: how much they are paying for the advice; how that payment is structured (upfront lump sum or over the term of the contract) and the service they can expect in exchange for the payment. Based on this information they should then be able to make an informed decision.
Please let me know if you have any questions or comments.