Are you getting the advice you're paying for?

Matt Pitcher
13 February 2008

From a simple economic point of view, fees would seem like the better option to commission. This is partly because different companies offer different rates of commission to advisers. Let’s imagine for a minute that advisers are not motivated by purely selfless goals and like most of us have mortgages to pay and mouths to feed. Does anyone still believe that an independent adviser would see twice as many clients and recommend that better investment that pays 2% commission or see half as many clients and recommend the investment that pays 4% commission? The truth is that whilst an advisory firm accepts commission it can never completely avoid the charge that recommendations are biased due to commission. In contrast fees can be a lump sum agreed in advance or based on hourly rates. So why is it that most adviser income is from commission rather than fees?

Commission is also inherently unfair in that it works on a percentage basis. So clients with larger portfolios pay more even though the adviser may not put in much more work on their behalf. Fees are transparent and fairer in that you pay for the time you need. If the work is complex or simple the cost reflects the effort of the adviser not the size of the client. There is also therefore an incentive for the adviser to recommend as high a lump sum as possible is invested to maximise the commission. How often do investments get made that are a convenient round figure? Is this after careful cash-flow analysis to determine how much needs to be invested or an amount the adviser thinks they can get away with recommending?

So if commission is bad for clients, is it necessarily good for advisers? Well in a lot of ways, no. Firstly the business model of a high initial commission payment of 5-7% doesn’t leave room for much if any recurring income or what is called trail commission. Recurring income from a client is what motivates an adviser to go back to that client each year and review their circumstances and plans. Many commission based businesses are trapped in a constant loop of having to search out new clients every year just to keep income flowing into the business. This will always be at the expense of delivering a good service to clients. By contrast it is much less expensive to look after existing clients and get paid for doing so as the business avoids upfront costs acquiring clients in marketing and initial meetings to gather information.

No system is perfect however and a fee has its drawbacks. The main practical obstacle to fee based advice is its transparency. Oddly the fee’s Achilles’ heel is actually also its largest strength. Fees are transparent which is excellent for combating concerns about bias and understanding what a service is costing you. At the same time this is psychologically difficult each time you have to write out a cheque. One of the benefits of commission is that it is unseen and even if it offers poor value to a client, that same client may prefer not to know the cost and receive the service from the adviser in ignorance. As soon as fees are involved the temptation for a client is to refuse valuable ongoing servicing from the adviser knowing all too clearly what the cost will be.

So what constitutes a perfect world scenario? Well for a start all clients would pay a fee on an hourly rate according to the work they required. They would receive regular contact and servicing from their adviser and again would be happy to pay for this time.

Is commission bad for clients, or does it help keep fees low? Have your say in the Moneywise Forums.