Commission Compensation
Paladin recommends that you do not pay for financial advice with commissions for several reasons that are described below.
What is Financial Advice?
Financial advice occurs when advisors recommend investments for your assets. The investment could be a mutual fund, annuity, or a security. There is a very fine line between selling you a mutual fund and recommending a mutual fund because the end result is the same.
What are Commissions?
There are two primary types of commissions:
- Advisors are paid "product commissions" to sell you products, for example, mutual funds, annuities, and life insurance.
- Advisors are paid "transaction commissions" when you buy and sell securities through their broker/dealer
Who Pays Commissions?
Two types of organizations pay commissions to advisors:
- Companies that manufacture investment or insurance products. For example, a mutual fund or annuity company.
- Broker/dealers that process transactions for advisors.
- Commissions are a sales expense for these companies.
What are Commissions Paid For?
Commissions are the advisor's economic reward for selling you particular products. Commissions are not compensation to help you achieve your financial goals. In fact, most commissions are paid in advance and the amounts are not impacted by the achievement of your goals.
Different Types of Commissions
There are three primary types of commissions (loads):
- Front-end Load - Commissions are deducted when you make initial and subsequent investments
- Back-end Load - Commissions are not deducted from your assets. Product companies pay commissions at the time of sale and recover the commissions by charging you higher fees over time. You pay a penalty if you want to sell the product before the company has recovered the upfront commissions it paid advisors. Penalties are also called Surrender Charges and Contingent Deferred Sales Charges.
- Trails - Advisors are paid an annual commission for as long as you continue to hold the product.
Sales Person vs Advisor
You don't want to rely on a sales representative for the investment of assets that may determine your standard of living during retirement and your financial security late in life. You want an advisor who has the knowledge, services, and ethics to help you achieve your financial goals. Representatives are paid with commissions. Advisors are paid with fees.
Conflicts of Interest
Commissions have more potential conflicts of interest than fees for three reasons:
- Commissions are paid to advisors by product companies. Who does the advisor work for, you or the company? Most people work for the companies that pay them
- Some lower quality products pay higher commissions than higher quality products. How do you know the advisor didn't recommend the product that pays the highest commissions?
- Commission amounts are hidden from you by the product companies and advisors.
Pay in Advance
A 5% commission is the same as paying a 1% annual fee five years in advance. You might ask what the advisor did to earn such a substantial commission? The answer is he or she sold you a product. Since the advisor is paid in advance he or she has no economic incentive to help you achieve your financial goals.
Free Services
Advisors who work for commissions frequently refer to their services as "free" because they are paid by third parties. Their services are not free because the product companies raise the fees they charge you to offset the costs of the commissions that they pay advisors. Then they apply a surrender charge to withdrawals to protect their interests at your expense.
Small Investment Amounts
Investors with smaller amounts of assets or a limited capacity to pay fees may find their only alternative is to select advisors who charge commissions for their services. If that describes your situation be very careful when you select this type of advisor. You still want full disclosure in writing for credentials, ethics, business practices, compensation, and potential conflicts of interest.
