Why Should You Avoid Commission-Based Financial Planners?

Financial planning involves making informed decisions about managing money and investments to achieve life goals. Professionals who offer financial guidance can be compensated in several ways, and understanding these structures is important for anyone seeking assistance. Compensation models for financial advisors generally include salaries, fees paid directly by clients, or commissions earned from product sales. The method by which a financial planner earns income can influence their recommendations and the overall client experience. Therefore, considering how a planner is compensated is important when selecting an advisor.

Understanding Commission Structures

Commission-based financial planners generate their income through commissions. These payments are received when a client purchases financial products or services the planner recommends. This means the planner’s earnings are directly tied to sales, rather than an hourly rate or a percentage of assets managed.

Common sources of commissions include the sale of investment products like mutual funds, annuities, and insurance policies. Mutual funds may carry front-end loads (sales charges paid when shares are purchased) or ongoing trailing commissions (percentages of fund assets). Annuities pay commissions ranging from 1% to 10% of the contract value. Life insurance policies can offer significant first-year commissions, with smaller renewal commissions in subsequent years. These commissions are paid by the product provider, not directly by the client.

Potential for Misaligned Recommendations

A commission-based compensation model can create a conflict of interest, as the financial planner’s financial incentive may not always align with the client’s best financial interests. The planner earns more by selling certain products, which can subtly influence their recommendations. This structure might lead to advice that prioritizes the planner’s income over the client’s optimal financial outcome.

One manifestation of this misalignment is the recommendation of products that pay higher commissions, even if more suitable or lower-cost alternatives exist. For example, a planner might suggest a mutual fund with a higher sales charge or an annuity that yields a larger commission, rather than a more suitable or lower-cost product. “Churning” is another concern, involving excessive buying and selling of securities in a client’s account to generate additional commissions. This practice can significantly erode the client’s portfolio value through increased transaction costs and fees. Planners compensated this way may also limit product recommendations to a narrow range of options from which they receive compensation, restricting access to a broader market of suitable investments.

Varying Standards of Client Care

Financial professionals operate under different legal and ethical standards when providing advice to clients. Understanding these standards is important for discerning the level of obligation a planner has to their clients. The two standards are the “suitability standard” and the “fiduciary standard.”

Commission-based planners operate under a suitability standard. This standard requires that any recommended product or transaction be suitable for the client’s financial situation, objectives, and risk tolerance. However, it does not require the recommendation to be the best or lowest-cost option. In contrast, a fiduciary standard requires the financial professional to act in the client’s sole best interest, prioritizing the client’s needs above their own compensation or firm’s interests. This includes a duty of loyalty and care, meaning they must disclose and avoid conflicts of interest. Regulations like the SEC’s Regulation Best Interest (Reg BI) aim to enhance the suitability standard for broker-dealers, requiring them to act in the customer’s best interest without placing their own financial interests ahead of the customer’s. However, Reg BI does not impose the full fiduciary standard across all recommendations, maintaining distinctions between broker-dealers and registered investment advisors.

Less Obvious Fee Structures

Commissions associated with financial products are frequently embedded within the product’s cost or transaction fees, making them less transparent to the client compared to direct, itemized fees. This structure can obscure the true cost of the advice and products received. Clients may not see a separate line item for the commission, as it is often built into the overall price of the investment or insurance policy.

For example, mutual funds may have sales charges or ongoing 12b-1 fees. Annuity commissions are factored into the contract price and deducted from the premium paid. This lack of direct visibility can make it challenging for individuals to understand the total compensation a planner receives and how it impacts their investment returns. The absence of clear, upfront disclosure of these embedded costs can hinder a client’s ability to compare different financial products and services.