The first post in this blog examined: services provided by FAs; types of clients who will benefit by hiring an FA; and criteria for selecting an FA. This second post discusses FA fees. It discusses in detail the nature and problems with current fee arrangements, and suggests how the retiree should deal with such fees.
Part 2: Financial Advisor Fees
By now you may be asking yourself why the entire second part of this blog is devoted to fees. The reason is that the most common fee structure used by fee-only advisors is percentage of assets under management (AUM), and the most typical annual percentage charged is 1%. This fee is often billed quarterly for each year of investment management. Neither the structure nor the rate is appropriate.
Why retirees like percentage of AUM fees
Although the percentage of AUM structure and rate are inappropriate, the billing procedure is often painless to the client. Some of the reasons why percentage of AUM fees have worked so well from the client's perspective include:
a) most clients have little understanding and appreciation of the services they receive in relation to the cost of those services (1% just seems small and reasonable);
b) many of those who do have an understanding of financial matters will not want the hassle of dealing with hourly-based fees, and vetting each item on a monthly bill;
c) clients will not have to decide whether or not to decline some needed services in order to save on fees (everything is taken care of); and
d) in some cases the fees are less visible because they are withdrawn quarterly from the assets being managed. When billed in this manner they can seem less onerous than the "out-of-pocket" monthly billed fees. However, fees are fees, so when considering or comparing advisor fees, the dollar amount rather than percentages should always be used, e.g., rather than simply thinking in terms of 1% per year, the $5m AUM client should consider he is paying $50,000 per year ($1million+ over 20 years).
Why percentage of AUM is inappropriate
The percentage of AUM structure would indicate that there is a reasonable relationship between the level and skill of the services provided and the amount of assets. However, the fee has practically no relation to the services rendered. There are three reasons for this:
First, despite arguments to the contrary by many advisors, the fee cannot be attributed to superior investment performance. The same basic planning and choices of investments exist regardless of the amount of AUM.
Second, the services performed in the first year when the plan is established, are substantially greater than in subsequent years, yet the same percentage of AUM is charged each year.
Third, the time and effort needed to perform the advisor's services are not directly proportional to the amount of AUM. Of course, it may take more effort to plan for a client with $10m of assets than a client with $1m, but it is unreasonable to expect that the fee differential should be $100,000 versus $10,000 per year. Often there is some scale back of the percentage at higher net worth levels, but the fees still remain significantly out of proportion in relation to services performed.
One additional negative aspect of percentage of AUM fees is that it may create a conflict of interest. A percentage-of-AUM fee structure can potentially cause the advisor to be reluctant to recommend actions that will benefit the client, but that will also reduce the AUM base. Such actions include paying off a mortgage, and using investment assets to purchase annuities, which may then fall outside of the AUM classification. In particular, annuities are an excellent alternative for some retirees, and should be fully considered as an option in most cases.
Why 1% of AUM is an excessive rate
Fifteen years ago, Rick Ferri of Portfolio Solutions began charging 0.25%, now 0.375% of AUM, nearly two-thirds less than the industry standard. He explains his rationale and approach on his website. Now Vanguard has a new advisory service that charges a 0.3% fee and invests in its own very low cost funds. The great majority of the FA industry has, however, held fast to the 1% (or greater) amount, which continues to demonstrate what the traffic will bear.
There are now also the so-called robo advisor firms that charge about 0.25%; Schwab now charges 0%. These firms invest in a variety of index funds and cash, and rebalance when necessary. Robo advisors provide none of the behavioral coaching and other personal services described above; their services are often more appropriate for younger clients and those with a smaller net worth.
CPAs and attorneys provide financial and other services, but charge on an hourly basis. They do not, for example, charge based upon a percentage of total income tax or estate tax savings. On the other hand, the FA might point to Vanguard's estimated value added savings of 3%, and claim that this entitles them to 1% or one-third of the total savings.
A Better Approach to Fees
The most logical fee structure is the hourly based fee that applies to most CPA and law firms. The fee is determined by the number of hours specifically devoted to serving the client, and billed at a rate that is based upon the expertise of the people performing that service. Fees performed by skilled partners are charged at a higher rate than assistants or clerical staff. Compare this to a percentage AUM fee that has no direct bearing on hours of services, or on the skill of the various advisors providing the service.
Even though the financial advisor's fees should be based on the same criteria used for hourly based fees, the client often likes the simplicity of fixed quarterly billings, as discussed above. In this event the client's interests may be better served by converting fees, computed by estimating hourly based fees, to a set fee that is billed quarterly or annually. The first year's services will involve several hours obtaining information from the client and developing an appropriate plan. After the initial meetings with the client, the advisor should estimate total first year hours that will be devoted specifically to the client, then the firm should assign an hourly fee, based upon the skill set of the individuals performing the services. This should be presented to the client as his total first year fees, billed quarterly or annually. Fees for succeeding years, where fewer and more routine services will be provided, should be similarly set and billed each year.
This fee structure would substantially benefit retirees. In many cases the total fees incurred by the client will decline significantly. The client can expect less reluctance by advisors to recommend desirable actions that reduce AUM, such as paying off a mortgage or acquiring an annuity. Price competition will increase because fees will be quoted in dollars rather than percentages, and retirees will not be required to disclose their own AUM when discussing or comparing financial advisor pricing with friends and family. Needless to say, such changes would result in lower fees for many advisors. However, these advisors would still be able to generate fees comparable to those earned by most CPAs and attorneys -- so how bad can that be?
But will the FA Agree to a Revised Fee Structure?
I don't know; the industry has been extremely resistant to any fee reductions. HNWIs, the higher the net worth the better, are the prize clients for the FA. Hopefully the HNWI will be successful if he requests a fee bid using the revised fee structure from three or four qualified competing firms. If the FA insists on a percentage of AUM fee, he should be willing to justify that fee by comparing it to a detailed summary of what the fee would be if computed on an hourly basis, in both the first and succeeding years.
The typical fee structure and fee of financial advisors is inappropriate and excessive. FAs perform a valuable and professional service, but, unlike the hourly-based fees of CPAs and attorneys, the typical 1% of AUM fee is not a representative return for services rendered. HNWIs should insist on a fee more comparable to that of attorneys and CPAs.