A trailing commission is a fee you pay a financial advisor each year that you own an investment. The purpose of a trailing commission is to give an advisor an incentive to review a client's holdings and provide advice. It is essentially a reward for keeping you with a particular fund.

Understanding Trailing Commissions

Trailing commissions are essentially ongoing payments made to financial intermediaries. They're fees for the distribution and servicing of certain investment products. These commissions are paid periodically, typically as a percentage of the assets under management. Trailing commissions often continue for as long as the investor remains invested in the product. When an investor puts money into a particular investment product, such as a mutual fund or insurance policy, a portion of that investment may be allocated to pay for distribution and ongoing services. Trailing commissions compensate financial intermediaries for the ongoing services they provide to investors, such as portfolio monitoring, rebalancing, and providing investment advice

Asking your advisor is the most obvious way to find out whether you're paying a trailing commission. An ethical advisor will probably answer the question directly. If you would prefer to do your homework and find out on your own, consider reading the investment prospectus. Be sure to look carefully at the footnotes under any section that says "Management Fees." The highest fees are usually the best hidden.

How Much Do Trailing Commissions Cost Investors?

Fees vary depending upon the fund; however, it is not uncommon for a trailing commission to range between 0.25% to 1% of the total investment per year. That is a significant amount and builds up year after year as the value of the asset grows. As the asset grows in value over time, the advisor that initially sold you the investment makes more money off the trailing commission. That actually gives your advisor an excellent incentive to grow your investments.

Who Receives Trailing Commissions?

In short, trailing commissions are paid to financial intermediaries who sell products and provide ongoing services. More specifically, this includes:

• Financial Advisors: Financial advisors may work independently or as part of small advisory firms.
• Brokers: Brokers facilitate the buying and selling of securities such as stocks, bonds, and ETFs. They may receive trailing commissions for distributing certain types of investment products such as mutual funds. In addition, registered representatives that can buy or sell securities on behalf of their clients may also earn trailing commissions.
• Insurance Agents: Variable annuity sales agents may sell variable annuities, which are investment products with an insurance component. These products often earn trailing commissions. In addition, agents selling certain types of life insurance policies such as whole life or variable life insurance may also receive trailing commissions.
• Investment Managers: Portfolio managers or registered investment advisors (RIAs) overseeing mutual funds may receive trailing commissions.
• Financial Institutions: Staff at banks such as wealth advisors who work in a bank's wealth management or investment advisory divisions may receive trailing commissions; the same can be said for credit union representatives.

Justifications for Trailing Commissions

Trailing commissions appear unfair to many investors, but there are some justifications. A trailing commission is not supposed to give an advisor income in perpetuity in exchange for doing nothing. The advisor should be reviewing your investments and providing you with advice.

In theory, trailing commissions give the advisor an incentive to keep you in successful funds. It can be easy to become discouraged during bear markets, and trailing commissions give your advisor a reason to keep you fully invested. A trailing commission is usually much better than giving your advisor a share of a load fee. When the advisor gets a percentage of the load fee, the advisor has an incentive to move you in and out of mutual funds. That type of overtrading can reduce returns. Trailing commissions encourage your advisor to invest for long-term growth and avoid overtrading.

Avoiding Trailing Commissions

As markets continue to develop, trailing commissions are becoming less justified and easier to avoid. Many mutual funds do not have trailing commissions, and a large number of exchange traded funds (ETFs) with low fees are also available. There are even a few low-cost mutual funds with high returns.

Avoiding trailing commissions is just one way to stop paying high mutual fund fees. Reducing fees is the only sure way to improve returns, so mutual funds and hedge funds must do something special to justify extra fees.

Trailing Commissions and Liquidity

Trailing commissions can still make sense for funds focused on illiquid investments, such as direct real estate holdings, unlisted companies, and frontier markets. These investments are not available in the U.S. stock market and can have higher returns, but it costs more to buy and sell them.

Funds focused on illiquid investments have a good reason for using trailing commissions to keep advisors loyal and their clients invested.

Limitations of Trailing Commissions

We'll wrap up the article touching on several downsides to trailing commissions. One significant drawback is the potential conflict of interest they create. Since financial intermediaries receive ongoing payments based on the assets under management, they may be incentivized to prioritize investment products that offer higher trailing commissions rather than those that best suit their clients' needs.

Like any form of commission, trailing commissions can contribute to higher costs for investors. However, this specific type of fee may have a bit more lack of transparency. In many cases, investors may not be fully aware of the existence or extent of trailing commissions associated with their investments. As mentioned earlier, discuss trailing commissions directly with your advisor to learn more about your specific situation. Last, trailing commissions can potentially hinder competition and innovation within the financial industry. Since these commissions provide a steady stream of income for financial intermediaries, these intermediaries may be less motivated to explore alternative models or more innovative investment products. Aside from not having the best interest of the client in mind, this may also hold back the financial industry.

The Bottom Line

Trailing commissions can be a good way to keep an advisor incentivized to manage your money and earn strong returns, though it's important to analyze your cost-benefit ratio to determine if it's worth it to keep paying these costs. Today, there are many ways to invest your money and earn a strong return without having to pay high trailing commissions; low-cost mutual funds, robo-advisors, and ETFs are some good options.