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Should I choose a commission-based advisor or a fee-only RIA?

Ramalingam Kalirajan |8314 Answers |Ask -Follow

Mutual Funds, Financial Planning Expert - Answered on Oct 21, 2024

Ramalingam Kalirajan has over 23 years of experience in mutual funds and financial planning.
He has an MBA in finance from the University of Madras and is a certified financial planner.
He is the director and chief financial planner at Holistic Investment, a Chennai-based firm that offers financial planning and wealth management advice.... more

Asked by Anonymous - Oct 05, 2024Hindi

Where should I go ?? Understanding the Incentives: Commission-Based Advisors: How they make money: They earn a percentage of the investment products they sell to you (mutual funds, insurance, etc.). Their revenue comes from the commissions paid by the companies whose products they sell. Incentive Structure: Since they get paid based on the products you buy, there’s a natural incentive for them to push products that give higher commissions, even if those products don’t always offer the best long-term growth for you. For example, they may suggest mutual funds with high expense ratios or ULIPs (which have higher fees) over low-cost direct equity mutual funds because they earn more on those products. Conflict of Interest: While they may seem to be working for your financial growth, their focus is often influenced by the product manufacturers (fund houses, insurance companies) rather than by your specific goals. Their goal can become selling more or higher-fee products rather than optimizing your portfolio's performance. Fee-Only RIA (Certified Financial Planners): How they make money: They charge you a fee, either a flat fee or a percentage of the assets under management (AUM), directly from you. They don’t earn commissions from fund houses or insurance companies. Incentive Structure: Because they’re not paid based on the products you buy, their primary focus is on providing unbiased advice that is solely in your best interest. They are motivated to keep you satisfied with the overall performance of your portfolio, your financial growth, and your long-term financial health so that you continue using their services. Fiduciary Duty: Fee-only RIAs are often legally bound by a fiduciary duty, meaning they are required by law to act in your best financial interest at all times. This is one of the biggest advantages, as their job is to ensure your financial goals are met with appropriate risk management, efficient tax planning, and optimized returns. Why Fee-Only RIAs Can Still Care About Your Growth: Your Growth = Their Reputation: Even though they charge fees directly from you, their reputation and continued engagement rely on how well they manage your portfolio and ensure it aligns with your goals. If your portfolio doesn’t grow and they don’t meet your expectations, you are less likely to continue working with them. Good RIAs build their business on client referrals and long-term trust, and they rely on providing excellent service and delivering results. Their reputation is their skin in the game. More Transparency: Fee-only advisors provide transparent pricing. You know upfront what you’re paying, and you won’t be hit with hidden fees or commissions that you might not notice in commission-based setups. Since they aren’t selling specific products, they focus more on low-cost index funds, ETFs, and direct mutual funds, which have lower fees and can potentially result in better long-term returns. Custom Portfolio Tailored to Your Needs: Since fee-only advisors aren’t restricted to selling certain products, they can craft a more diverse and well-balanced portfolio. They can focus more on your risk profile, your long-term goals, and tax efficiency, without the pressure of pushing high-commission products. Why Commission-Based Advisors Might Not Always Maximize Your Returns: Potential Conflict of Interest: Commission-based advisors often have a built-in conflict of interest. The products that provide them with higher commissions may not always be the best for you in terms of long-term returns. For instance, they may push you toward endowment plans, ULIPs, or actively managed funds that have high fees but don’t always generate the best long-term returns compared to low-cost index funds or direct equity mutual funds. High Expense Ratio Impact on Returns: The mutual funds or insurance products they sell typically have higher expense ratios or ongoing fees. Over the long term (10+ years), these fees can eat into your returns. For example, if a mutual fund charges a 2% annual fee versus a direct plan charging 0.5%, this difference can significantly reduce your returns over time. They may be incentivized to churn your portfolio (buy/sell frequently) to earn commissions, which can also reduce your overall returns due to transaction costs.

Ans: Understanding the incentives is key.

In a ULIP, the commission is fixed on your investment, regardless of how it performs. So, whether your money grows or not, the advisor earns the same.

Similarly, a fee-only RIA is charging a flat fee or a percentage of amount invested. Their fee doesn’t change, even if your portfolio underperforms.

However, a Mutual Fund Distributor (MFD) earns a commission based on your portfolio value. If your portfolio grows, they get a higher commission. If it underperforms, their earnings drop.

This creates a direct incentive for MFDs to help your portfolio grow.

Now, you decide where to go.

Best Regards,

K. Ramalingam, MBA, CFP,
Chief Financial Planner,
www.holisticinvestment.in
https://www.youtube.com/@HolisticInvestment

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