The answer to this question is not as simple as you might expect. Depending on the circumstances, the answer could be yes or no. I’ll help you understand those circumstances!

What is the Difference Between Fee-Based, Commission-Based or Fee-Only?

Critical to answering the question is an understanding of the difference between a fee-based advisor and a fee-only advisor. For the purposes of this topic only, fee-based and commission-based are essentially the same. I’ll treat them as one. Fee-only is different.

Fee-based advisors are salespeople. The overwhelming majority of advisors fit this category —almost 94% according to a Cerulli & Associates (Forbes 2010). They get paid to offer you products. Some products pay more than others. You may pay these advisors a fee, but they can also put you into products that pay them and their firms a fee as well. They’re paid by both you and products, which creates conflicts of interest.

Fee-only advisors can only accept fees direct from the client. You are their only source of revenue.

To the untrained eye, a fee-based advisor’s fee may look just like a fee-only advisor’s fee. People often think an advisor is fee-only because he charges them a percentage of the assets under management. This is a big mistake. Both types can charge you that way — but the fee-based advisory firm is also receiving money from third parties for making the recommendations it makes.

Transactions vs. Decisions

The best way to understand this is by asking what exactly you are paying your advisor for? You are paying fee-based advisors to sell your investments, which they “manage.” You only pay them for what they invest, never for what they don’t invest.  You continue to pay them as long as you stay invested.

Fee-based advisors should not charge you on cash. They aren’t paid to make decisions. Instead, they are paid to convert your cash into investments. The only way they get paid by you or by the products they sell is if they invest your money. They have to sell you an investment. For this reason, you’ll rarely find a fee-based advisor who will have any strategies that aren’t fully invested at all times. They need you invested to get paid, yet you don’t want advisors’ decisions to buy now to be based on them getting paid.

Fee-only advisors are philosophically different. They don’t get paid on transactions, commissions, products, etc. They can only get paid by you. You are paying them to make decisions on your behalf that will benefit you. Sometimes that decision is to buy an investment, sometimes it is to hold cash.

This is where you have to stop and ask yourself why you chose to work with a fee-only advisor. Was it because you didn’t want them working for anyone but you? Was it because you wanted to pay them to make decisions that were in your best interest? Because you didn’t want them to make decisions to get themselves paid?  Does that sound about right?

If so, you are going to want to pay your fee-only advisor on uninvested cash in your account. Why? Easy: because of incentives.

If you tell a fee-only advisor you only want to pay him on invested money, you have completely changed his incentives. When he got paid on managing the entire account value, his incentive was to make whatever decision was best for you at the time — even if that meant keeping a higher percentage of your account in cash for a while. If you tell him you don’t want to pay him on the cash part, his incentive is no longer to do what’s best for you. His incentive has changed to getting you fully invested as soon as possible so he can get paid. You’ve essentially turned him into a commission-based advisor. Wasn’t that what you were trying to avoid?

But how long should I pay on cash?

I recently got this follow-up question from a prospective client who was referred to me.  Her current advisor has spent a great deal of the last couple of years with her almost completely in cash. He has charged his full fee.

I told her there is no perfect rule on this. He’s not doing anything wrong. If his strategy called for him to be in a lot of cash, he’s not necessarily “wrong,” but his strategy may not be best for her. I told her she definitely shouldn’t go tell him she didn’t want to pay unless he invested her money. Then she’d just be incentivizing him to do something he wasn’t comfortable doing! You can change strategies or advisors. What you should never do is mess with your advisor’s incentives.

Would you do anything different?

I’d be uncomfortable charging a client to just be cash for long periods of time it I wasn’t adding any other value. Advisors who sit in cash for long periods of time may only have one strategy. If they aren’t confident it will work right now, it may be best that they stay in cash. This is a better option than forcing a strategy on a market! As for me, I’d rather not sit in cash for long periods of time. I’d rather rotate to a strategy that has potential right now.

Why? It’s common sense to me. I keep almonds in car and in my briefcase just in case I get so busy that I can’t eat a real meal. Almonds aren’t my long-term plan! But they do get me through and add nutritional value to keep me going until I can have a real meal.

Financial strategies matter, and they aren’t all the same.

It is important to understand that there are many ways to manage money. Some work well in the long term, but may actually perform rather poorly in the short term. Other strategies may work particularly well under certain market conditions, but not so much under others. What makes sense for a client depends on his or her goals, time-frame, risk tolerance and investment knowledge.

Some strategies need to stay fully invested at all times to work out in the long run. For strategies like that, this really isn’t an issue. This comes up when we are talking about strategies that need to have the ability to shift partially or completely to cash. I refer to strategies like this as being “tactical” or “active.” You should expect to pay a management fee on the uninvested part of a tactical strategy. I would not just settle for that if I am working with a client who has the ability to understand other ways we can add value.

How Financial Advisors Add Value

When I run a tactical strategy for a client, I prefer to have the ability to run multiple strategies in the account at one time. The most natural selection for an alternative strategy for uninvested cash is an options strategy. An advisor can conservatively trade options to generate income for the account when it is in cash. Cash is put to work with short-term income generating trades while the advisor waits for the right setup for a tactical investment. Clients may like this because it allows the advisor to stay busy adding value on cash. The client gets to keep the peace of mind of knowing he didn’t turn a fee-only advisor into a broker by only paying him to buy things. Yet the client still gets extra value during the waiting period.

In Summary: Financial Advisor Fee Structures

Fee-based advisors should never charge you on uninvested cash. They get a fee to sell you a product as well as an ongoing fee for keeping you in that product or collection of products (“portfolio”).

Fee-only advisors should charge you on the uninvested cash in your portfolio because they are paid to make decisions. One such decision may be to be in cash for a period of time. Decisions, not commissions.

I believe fee-only advisors can do things to add value to the account even when it is in cash. Options trading is one way an advisor might add value on cash. Just remember, it may not be appropriate for everyone. Do not take this as an individual recommendation.

I believe clients are best served if they work with an advisory team that has a diversity of expertise and experience. Don’t get so hung up on working with a Certified Financial Planner™ that you forget other things. It matters whether your CFP® professional is a fee-based advisor or a fee-only advisor who abides by a fiduciary standard at all times.