Fee-only, fee-based, and commissions: what Form ADV Item 5.E tells you

If you've started talking to advisors, you've probably heard "fee-only" and "fee-based" used as if they meant the same thing. They don't, and the difference is one of the more useful things to understand before you sign anything. The good news is that you don't have to take anyone's word for it. Every registered advisory firm tells its regulator exactly how it gets paid, and that answer is public.

Where the answer lives

Form ADV, the registration form every advisory firm files, has a question in Part 1, Item 5.E: "You are compensated for your investment advisory services by (check all that apply)." There are seven boxes:

• A percentage of assets under your management. The most common arrangement. You pay a yearly percentage of what the firm manages for you, usually billed quarterly.
• Hourly charges. You pay for time, often for planning without ongoing investment management.
• Subscription fees. On the form, fees for a newsletter or periodical. Some firms that charge a flat monthly or annual retainer for advice check this box anyway, though the form's wording points them to the fixed-fee box.
• Fixed fees. A set price for a defined project, like a financial plan.
• Commissions. Pay tied to a sale or a trade, such as a commission from the company behind a mutual fund, annuity, or insurance policy the firm sells you.
• Performance-based fees. A share of investment gains, generally limited to wealthier clients.
• Other. Anything else, which the firm describes in a few words in Item 5.E itself.

So what do the labels mean?

None of these terms are defined by regulators, and firms use them loosely. Read against Item 5.E, they sort out like this:

Fee-only means the firm, and the people and companies connected to it, are paid only by you. On the form, that starts with Item 5.E: some mix of percentage, hourly, subscription, or fixed fees, with commissions left unchecked. AdvisorCensus's test also leaves out firms that check performance-based fees or "other", to stay conservative, although a performance fee is paid by the client. But Item 5.E covers only pay for advice, so the rest of the filing matters too. A firm whose employees are also registered with a broker-dealer or licensed to sell insurance (Item 5.B), or that has a related broker-dealer or insurance agency (Item 7.A), can still earn commissions outside the advisory relationship.

Fee-based means the firm charges fees and can earn commissions, usually through a sister broker-dealer or insurance agency. Both kinds of box are checked. The name sounds close to fee-only, which is exactly why people mix them up.

Commission-based on its own usually describes a broker or insurance agent rather than an advisory firm. An advisory firm that checks only the commissions box is rare.

Why it's worth a minute of your time

How someone is paid shapes what's easy for them to recommend. A firm paid on assets does well when you keep more money with it, which can come up when you're deciding whether to pay off a mortgage or roll over a 401(k). A firm paid on commission does well when you buy a product. A flat or hourly fee ties the firm's pay to the work itself.

None of this is improper, and every registered adviser owes you a fiduciary duty however it's paid. But knowing the arrangement tells you which questions to ask, and a good advisor will be glad you asked.

Going deeper

Item 5.E is the checklist. The firm's Part 2A brochure explains the details in plain English: Item 5 covers fees and fee schedules, Item 10 covers affiliations like a related broker or insurance agency, and Item 14 covers referral arrangements. The brochure is linked from the firm's record on the SEC's IAPD site.

Checking a firm on AdvisorCensus

Every firm page lists the Item 5.E answers exactly as filed, under "How the firm is compensated." On any metro page, the "How paid" filter lists each Item 5.E answer, and its fee-only option narrows the list to firms that pass AdvisorCensus's fee-only test: Item 5.E limited to a percentage of assets, hourly charges, fixed fees, or subscription fees (so no commissions, performance-based fees, or "other"), and no sales-related compensation ties in the same filing: no employee registered with a broker-dealer or licensed as an insurance agent (Item 5.B), no brokerage, futures, real estate, insurance, or other product sales business of its own (Item 6.A), no related broker-dealer, futures commission merchant, insurance company or agency, or real estate broker or dealer (Item 7.A), no other sales interest (Item 8.B(3)), and no compensation from others for client referrals (Item 8.I). For example, see fee-only financial advisors in Nashville, TN. AdvisorCensus doesn't label any single firm fee-only; it shows what the firm filed and leaves the label to the firm.