“Fee Based” vs “Fee Only” Financial Advisors
By CHM on Mar 11, 2008 in Advisor Compensation, Featured
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According to Wikipedia, the languages of India primarily fall into two major categories: Indo-European and Dravidian. According to the 2001 Census of India, individual mother tongues number in the several hundred.
You’re probably wondering what any of that has to do with ‘fee-only’ vs ‘fee based’ advisors? Well, that’s a good question, I bring it up to make a point.
Much like the languages of India, financial advisors (more and more these days) tend to fall into two major categories: Fee Based and Fee Only. And within these categories there are so many different ways to run an advisory business; the many different advisory factions kind of reminded me of the breakdown of different mother tongues found in India. (not too sure if this analogy worked… lol)
Keep it simple stupid
I want to try and simplify things here, so the average investor isn’t left with a headache when it comes to understanding the different terminology. But before I break down ‘fee based’ vs ‘fee only’ I want to refer you to an article I wrote last July that talks more to the differences in compensation, that I will lightly touch on here. Please read that post!
A fee based advisor
I am a fee based advisor. My clients are charged a flat percentage of the investment assets I manage for them, generally 1% (I break down the whole process in the article I referenced in the last paragraph.)
My clients assets are held at my broker/dealer, and based on the mutually agreed to cost (1%), a quarterly fee is taken out of the client account and paid to me. The CLIENT IS NOT RESPONSIBLE FOR PAYING ME DIRECTLY (i.e. cutting a check to (MWM) McKeever Wealth Management) but instead my broker/dealer automatically deducts the fees from the client account, takes a piece for themselves, and then pays MWM.
The important distinction to be aware of here, and a big part of why I’m classified as a fee based advisor, is how I’m paid. In my case, I’m paid by my broker/dealer, which is considered a third party.
A fee only advisor
According to the CFP Board, “a certificant may describe his or her practice as ‘fee only’ if, and only if, all compensation from all of his or her client work comes exclusively from the client in the form of fixed, flat, hourly, percentage or performance-based fees.”
From that definition, to the untrained eye, it’s really not that easy to distinguish between ‘fee only’ and ‘fee based.’ The key part of the definition is how a fee only advisor is compensated. Regardless of the form of engagement, a fee only advisor is paid DIRECTLY by the client. By receiving payment directly from the client (and not from a third party provider), an advisor can hold himself out as a fee only advisor.
What it really comes down to
In plain English, what differentiates the majority of ‘fee based’ advisors from ‘fee only’ advisors is somewhat technical in nature… it comes down to whether or not you are paid directly by the client or by a third party provider (i.e. broker dealer, annuity company, mutual fund company, separate accounts managers, alternative investments, etc.)
At the end of the day, there are plenty of fee based and fee only advisors that run very similar businesses. Where the differences between fee based and fee only businesses become more evident is when you start moving towards the poles of each group.
My advice to investors seeking financial advice
I think instead of focusing on one group or the other, what’s important to look for are tell tale signs of objectivity, and which individual advisory businesses (within the two categories) are most likely to provide impartial advice, transparency and full disclosure.
Tags: Advisor Compensation, fee based advisor, Fee only advisor
Dylan | Mar 12, 2008 | Reply
Great analogy about the languages! I’d like to add a point of clarification.
A fee-only adviser that manages assets can still deduct fees right out of the client’s account, and a broker-dealer can also send account owners a bill to pay with a check, neither of which changes whether an adviser is fee-only or fee-based. The direct payment has to do with who pays what and to whom, not the method of payment.
With fee-only, 100% of the fee is paid to the adviser directly for advice, which may include a limited power of attorney to place trades and collect fees directly out of the account.
With fee based, at least some of the fees are paid directly (could be by check or account debit) to a third party, out of which that third party pays an agreed upon amount (commission) to the adviser, representative or agent for facilitating the relationship between the client and the third party.
These two distinctions hold true in any fee-only or fee-based situation regardless of the actual mother tongue spoken within the broader categories of fee-only and fee-based.
CHM | Mar 12, 2008 | Reply
Hey Dylan… welcome back;) I think this topic is confusing for most investors and I tried to keep it as simple as possible. I admit that the ‘fee-only’ is confusing for me, even after doing quite a bit of reading on it.
A few points…
Now I know (as you stated) I can run my business many different ways. I can continue to do what I do (fee based), if I wanted I could charge clients commissions in a brokerage account (transaction based), or I have the option to bill by the hour for financial planning advice rendered (fee only)… which would be similar to what you do… and I would be paid by the client, although the check would be made out to my B/D.
And from what you wrote in your comment… a fee-only planner has the same capabilities, vice versa.
The only difference is… in order to hold yourself out (to the public) as a fee only planner you must always be paid directly by the client for advice received, correct?
For the sake of the readers, when you boil it down, you and I have many of the same capabilities and offer clients a similar planning experience, but it literally comes down to how we are paid for that advice, agreed?
CHM | Mar 12, 2008 | Reply
btw, glad you liked the India reference, I think I told you I was going to use it. Not sure if it worked but I hope it helps some to make a few distinctions between the two groups:)
Reinhold | Mar 12, 2008 | Reply
I’ve never understood the justification for fees based on %-assets-under-management. If 2 independent clients come to you with very similar needs and ask you to manage their accounts with the same objective (say, capital preservation), would you provide different advice or management oversight if Client A brought $50,000 than if Client B brought $500,000? If you perform exactly the same services to Client A and Client B, why does Client A owe you $500 while Client B owes you $5,000? (assumes 1% fee-based structure)
I cannot see how what you define as fee-based is in the client’s best interest. Seems that you would always steer clients to a fee-only structure if you have their best interests in mind. Care to justify the %-assets-under-management fee model?
Dylan | Mar 12, 2008 | Reply
There is more to it than whether you are allowed to call yourself “fee-only.” I agree that there are many similarities. The big difference is that fee-only only involves an arrangement between two parties; whereas, fee-based is involves three parties.
In the three party situations the advisor is serving two different parties with different interests. The advisor represents or is an agent for the party compensating him or her for that function. At the same time, he or she is advising the client (the one paying the other party that pays the advisor).
With fee-only, the adviser never represents or acts as an agent for a third party. The adviser is always paid to represent the client that is paying. No other compensation, ever, from anyone else.
Fee-based is, for the most part, unregulated in its use, and can be used to describe anything other than fee-only or purely transactional arrangements. There is no such thing as a fee-only option or fee-only for some clients. Fee-only must be the only method of compensation.
When we start talking about planning, we are now getting into “individual mother tongues.” It is possible that a fee-based adviser may have the similar planning capabilities and offer a similar planning experience as a fee-only planner, but that is not necessarily the case.
For example, a fee-based account at a broker/dealer may not be able to hold certain mutual funds because those funds do not have agreements with the broker/dealer. Or the advisor’s agreement with a broker/dealer or an insurance company may preclude the advisor from recommending products or services of a competitor, even if they are better suited for the client.
Lastly, in the case of fee based, what the client pays in fees does not necessarily equate to the advisors compensation. Because some products may pay the advisor more than others (I’m talking about the actual pay out, not what the client pays in fees) there is an incentive to recommend products that pay more to the advisor. Advisors can certainly make the claim that the compensation does not influence their advice, that may very well be the case, but there is no way to substantiate that claim one way or the other. At the same time, those offering the higher payouts are doing so for the purpose of swaying advisors toward recommending their products. They wouldn’t be doing that if it didn’t work for at least some advisors.
CHM | Mar 12, 2008 | Reply
Hey Rheinhold - I think someone with $50,000 in assets doesn’t necessarily need to pay a 1% fee. I think their needs may be better served by going it on a fee only basis. I think someone who has $500,000 will likely have more complex issues that will go beyond just building a capital preservation portfolio and justify the need for a more sustained engagement.
I charge 1% and for that fee I’m on permanent retainer for that client to provide the full gamet of financial planning services, everything from investment management, to what if - estate planning scenarios, LTC, education and insurance planning, etc.
I’ve made a decision to run my business a certain way and believe I’m fairly compensated for the services provided. I believe this is the best approach for everyone involved and IMO this compensation model fosters a deeper client/planner relationship as everyone’s interests are properly aligned. I think it’s important for a responsible financial planner to have a financial interest in the preceedings, I think it makes for a planner who is fully engaged and properly motivated to provide services to the best of his (or her) ability. I wouldn’t have it any other way.
CHM | Mar 12, 2008 | Reply
Hey Dylan - In my three party arrangement, the third party (my B/D) really just acts as an intermediary between the client and myself to facilitate payment.
I think after the last week or so I understand your point of view and the words you use bear that out. I’m sure you probably feel the same way about the views I’ve expressed. I think we agree there is merit to both approaches.
At the end of the day, both of us strive to do what is best for our respective clients, we just go about it in different ways.
misanthropope | Mar 12, 2008 | Reply
logically, it seems that anyone inclined to ask the question “does a non-fee-only financial adviser have conflict of interest”, has no business accepting the judgment of a non-fee-only financial adviser on the matter.
CHM | Mar 12, 2008 | Reply
@misanthropope - well it helps when other people show up, express their opinion, so it’s not just me, Dylan and Rheinhold expressing ours.
Reinhold | Mar 13, 2008 | Reply
CHM, the logic of your explanation says to me that there is a linear relationship between the size of the client portfolio and the level of services required on the part of the advisor to engage that portfolio. E.g. a $500,000 client portfolio fully engaged earns you $5,000 per year; another client’s portfolio that is 50% larger earns you a 50% larger fee of $7,500. Does a $750,000 client portfolio really entail an increase of 50% in the level of service you provide, above that of the $500,000 client portfolio? You put in 50% more hours on the portfolio? You achieve 50% better results?
CHM | Mar 13, 2008 | Reply
For the purposes of this discussion, there is a linear relationship between the size of the client portfolio and the fee they are charged. As you pointed out a $500,000 client portfolio would be charged $5,000 (which is not what I would earn, it’s what they are charged, you can read more on that here… http://chancefavors.com/2007/07/how-much-does-a-financial-advisor-make/)
There is not a linear relationship between the size of the client’s portfolio and the level of service provided. I give each client as much attention as is needed, each situation is unique.
Reinhold | Mar 13, 2008 | Reply
So you feel that if the situations were very similar in scope and scale (yet still unique) that — on average — you would be providing 50% higher level of service to $750,000 portfolios than you would to $500,000 portfolios? I’m really trying to fathom this, but haven’t been able to get it yet. What are the significant and higher requirements and considerations that apply to a $750,000 portfolio that would not also generally apply to a $500,000 portfolio?
Dylan | Mar 13, 2008 | Reply
Ciaran,
I think its fair to say that something, anything without merit wouldn’t survive for long. And I don’t fault anyone for doing something different just because its not what I prefer.
On the comment, that your B/D really just acts as an intermediary between you and the client, I don’t think that is accurate. And I don’t think that is how regulators view it either. It may appear that way; however, if the client’s agreement for services is actually with your B/D, you act as the intermediary.
When acting as a registered rep, you and the B/D are part of the same party, and the third parties are usually other companies the registered rep, through the B/D, represents like mutual fund companies.
The securities brokerage industry operates on a self-regulatory platform based on supervision. Registered reps work for and answer to a broker/dealer, even those paid by 1099 through their own business.
This is not a fee-based/fee-only thing; a registered rep or a B/D cannot be fee-only. Every single fee-only adviser is an RIA, but not all RIAs are fee-only.
CHM | Mar 13, 2008 | Reply
Hey Dylan - I was simply trying to illustrate the role my B/D plays ‘in MY business’ so one might might be able to conceptualize it a bit.
Here’s another comparison example I might use and why I could be considered, “a fee based advisor in fee only clothing.” (not to be taken too literally)
A ‘fee only’ planner might be paid by the client for providing fin. planning advice. He also might advise the client on setting up a portfolio of ETF’s at a discount broker. In both instances the client pays the planner directly. The only difference in my dealings (for the most part), instead of the client paying me directly, my B/D acts as the middleman when it comes to payment, since the investments are held here. I was merely trying to illustrate this concept.
If you want you could have a field day with me calling my B/D ‘middle man’, but if I was having a conversation with you that’s how I might put it. But if you take things quite literally like you did in my earlier remark, it would be easy to analyze each word, put it side by side with a verse of regulatory scripture and wax poetic about the inaccuracies of the statement.
Dylan | Mar 13, 2008 | Reply
Ciaran,
You are correct, I do go with the literal interpretations. That is partly because of my personality and partly because, and this is in no way aimed toward you or even implied to be, there are people in finance related professions that do mischaracterize, even unintentionally, what their roll is and how and what they are paid.
The two models do operate similarly; however, they are not the same. I do think some of those differences are important. That’s what I was trying to clarify, in my literal way
CHM | Mar 13, 2008 | Reply
@Rheinhold - each client situation is unique, you can’t accurately quantify the things you are trying to quantify.
I use 1% as a benchmark, I have the ability to charge more or less than that. If a client demanded a large amount of my time I could charge them more, this is up to my discretion. You can’t just look at the size of a capital preservation portfolio in a vacuum, like you’re doing.
But using 1% as a barometer, I think that’s a fair price and it comes down to whether or not the client thinks it’s worth it, and if the value I add is worth paying the 1% fee.
CHM | Mar 13, 2008 | Reply
Hey Dylan - I may have to adopt a different stance with the time I allot to commenting (here and away) going forward, it’s getting to be too much…
I understand and appreciate your point of view but sometimes IMO I think you have to be mindful of overshooting it. I think you would have a bright future as a regulator if you ever left the advisory business;)
Dylan | Mar 13, 2008 | Reply
I don’t want you to think that I’m arguing minor points just for the sake of arguing. I do believe that consumers of financial advice should understand the working relationships involved because they involve different rules, standards, and recourses, all of which impact the consumer. I don’t think this is overshooting. You know as well as I do that things are not always what they appear to be in the world of financial services.
I do think that because I tend to view laws, rules, and regulations in such a strait forward manor, I’d be incredibly board as a regulator.
Reinhold | Mar 14, 2008 | Reply
CHM, you don’t have to justify %-assets-under-management if you don’t want to. Glad to hear that you seem to have clients who accept that fee structure, but I remain unconvinced! I’m just looking for a square answer here! ;-\
CHM | Mar 14, 2008 | Reply
I’m not justifying anything, I’m not sure what has you so confused. I charge a flat fee, I think at 1% it’s a good deal for the client and me. If that doesn’t appeal to you (or any investor) then they are free to explore other options.
In this country when you provide a service, you are allowed to charge for it, it’s not a concept unique to the financial services business. If you’re a client and think value is being added then you’re happy, if not you can explore other options, much like a lot of decisions the average person makes.
I can tell you when the market is as volatile as its been lately, many investors are thankful to have an established relationship (which all of my fee based relationships are) with someone they trust and it’s tough to put a value on that.
Reinhold | Mar 14, 2008 | Reply
Like I said, glad to hear your business is good and clients pay what charge.
1% isn’t a flat fee. It’s a fee that scales with the client’s portfolio. What I am confused about is whether the fee also scales with the level of service you provide. What I’m getting at here is that you can do a good job for your client whether it’s with a $50k portfolio, a $500k portfolio, or a $5M portfolio. Why wouldn’t you assess the same fee if you are providing the same service? I could understand if you said “Well, the $500k portfolio would entail some complications with that amount of money, so my fee would be double that for the $50k portfolio.” But, 10x the fee of the $50k portfolio? I have a hard time swallowing that anything you do for the $500k portfolio would be worth 10x that you do for the $50k portfolio.
This also references the discussion here recently about fiduciary duty. I don’t get how it’s in the client’s best interest to be on a fee-based plan when a fee-only plan exists. If you offer a fee-only plan, regardless of the client’s portfolio amount, isn’t it your duty as prospective fiduciary to suggest to the client that s/he engage you on a fee-only plan? Should you not tell them they are not getting the best deal if they go fee-based with you?
Thanks for your patience with me. Why is it so hard for either me to understand or you to explain to to me? ;-\ Feel free to kick me off your site at any time.
CHM | Mar 14, 2008 | Reply
Sorry, a flat percentage.
IMO, it’s in a client’s best interest to work with a trusted financial planner over the long term, I believe it has a material impact on the probability of whether or not a client attains long term financial goals.
I think a fee based relationship aligns all parties and offers investors the best opportunity to develop a trusted client/advisor relationship. At the end of the day this is a relationship business, not just a fee ‘only’ business (for lack of a better way to put it).
If you’re not interested in building a relationship with a financial planner and (or) want to be charged the lowest fee then going elsewhere makes sense. But remember the lowest fee doesn’t equate to the best value and a large segment of the investing public believe that (you don’t happen to be one of them), if they didn’t I’d be out of a job.
Reinhold | Mar 14, 2008 | Reply
Well, you have lots of company. The mutual fund industry also operates on the %-assets-under-management model. I’m not a fund investor, but stumbled across several reports (Bogle, Morningstar, maybe others) examining historical returns (not to give history too much credit) shows that lower expense ratio funds outperform higher expense ratio funds. Would seem to suggest that for the %-assets-under-management model, a lower fee bears a relationship with a better value.
I doubt you’d be out of a job. You’re an enterprising fella and you’d adapt to the new conditions and thrive in a fee-only environment.
%-assets-under-management just doesn’t make sense to me under any circumstance (I have the same opinion of Realtwhore commissions). A mutual fund manager doesn’t do anything more or less for me regardless of how many shares you have, but the manager gets paid more the more money you have (not the more money the manager gains for you). I understand that the model exists because the clients are willing to bear the cost, but don’t understand why clients do so, or why you think it is their best interests to do so. However, I’ll keep and open mind and continue to read your posts and perhaps I’ll have an a-ha moment with a future post of yours. ;-\
CHM | Mar 20, 2008 | Reply
Rheinhold - fee based relationships can’t be looked at like a ’science experiment’ or ‘in a vacuum’, and that’s what you are doing.
How much value do you put in someone you trust? how much are you willing to pay someone to have peace of mind, when it comes to your investments? and your entire financial planning picture? These things mean a lot to many people and are powerful concepts.
Like I’ve said before, IMO, successful client/advisor relationships are a big part of long term client success. So what’s that worth? To many 1% is a bargain; for you it may not be, maybe you don’t need someone for this, maybe you can do it yourself; but your thoughts on the matter are not representative of most, certainly (and obviously) not my clients.
Do you think every baseball team should have a manager? Do you think the Yanks would have won 3 World Series’ w/o Joe Torre? Is Joe Torre worth 1%? Is Joe Torre worth anything? Did Joe Torre add value? There are differing opinions and degrees of seperation.
A good fee based advisor is Joe Torre. He manages all the different pieces (of the client team) and brings it all together. He hires the investment managers (pitchers) or builds the ETF based portfolios (pitching machines), he does the educational and estate planning and works with lawyers and accountants, etc.
I mean you could substitute ‘fee only’ every time I wrote ‘fee based’ (above) and maybe it works, but I think the way fee based advisors are compensated (a profit sharing model of sorts) tends to make the potential for deeper relationships more likely. And deeper relationships with people you trust tend to be more rewarding and ultimately successful.
I don’t look at it, like you do, from a pure ‘dollars and cents’ point of view, it’s relationship driven and what is fair compensation (or value added) for all the benefits a trustworthy advisor can bring to the table.
Reinhold | Mar 25, 2008 | Reply
CHM, I hear what you are saying, but have to admit I just plain don’t get it. I don’t get the client/advisor relationship concept. It makes it sounds like a client pays an advisor to hold client’s hand. Your comment about a profit sharing model would make some sense to me if there was a downside for the advisor (other than potential loss of the client/advisor relationship). Would the advisor in this kind of relationship pay a fee credit to the client’s account (or at least waive the fee?) if the return on the client’s account failed to achieve some pre-arranged performance metric (either absolute or relative)?
Maybe you could elucidate this in a future post; I’d be curious to understand it all better. My mind is open to it. I’d particularly like to understand the basis for your opinion that long-term client success hinges in large part on successful client/advisor relationships. Have studies or papers that back this up? Or your own data? Not asking for names and account amounts, of course, due to privacy, but are you allowed and willing to disclose what kind of success your clients have had in % terms, and over what period of time? (i.e. what is long term to you?) I’m not looking for an advertisement, so I hope you (and others) wouldn’t be uncomfortable with you holding forth in modest, simple matter-of-fact tone re: the specific nature of a run-of-the-mill client/advisor arrangement.
Thanks for your patience in explaining this to me. I hope I’m not the only one interested by this.
CHM | Mar 25, 2008 | Reply
@Rheinhold - sometimes a client does pay an advisor to hold their hand. It’s definitely part of the job description and responsibilities of a financial planner, emotional support and a professional’s perspective, especially during choppy times like these.
I’m sure 5-10 years from now there will be many clients that will be very thankful for their financial advisors helping them to weather these emotional times.
Profit sharing aspect of fee based is simple. For example, lets say client starts with you and is charged 1% on $300,000 or $3,000/year, 2 years later the portfolio is worth 400,000= $4,000/year), you are compensated more when client portfolio grows and goes up. After market falters, a year later the portfolio goes down to $350,000 (1% of 350,000= $3,500/year), you (as the advisor) take a pay cut when the client portfolio goes down in value.
This is what I mean when I write about making sure client/advisor relationship is properly aligned.
I have seen studies that show that having/or not having an advisor, materially impacts your results. Again this is all very subjective and is unique to each situation, each client and the different assumptions used in the study.
Most of my clients are not looking for absolute performance, performance is relative to their financial planning goals, I factor in the fee charged in plan assumptions.
Again, using a fee only planner is a great alternative for someone who is uninterested in this approach.
Dylan | Mar 25, 2008 | Reply
This is not a fee-only vs. fee-based thing as charging a percentage of assets under management can be done in either case.
Asset management and financial planning are two different disciplines. Regarding asset management, charging a percentage of the assets under management is very common. Even if you buy a low-cost index fund, you pay a percentage. If you invest enough, you may be eligable to use a lower cost share class.
It has also become quite common for financial planning to be offered as a value add on top of asset management services, sometimes at no additional cost. Clients need to look at their service agreements with their adviser to see what services they are entitled to for the fees they pay. In many cases, the agreement the client signs includes asset management but no mention of planning services, leaving the client with little recourse when planning expectations are not met.
I absolutely disagree that charging a percentage of assets under management aligns the adviser’s interests with the client’s interests in a financial planning relationship. Perhaps it does to sum extent purely in the context of asset management but not for planning.
A significant benefit of planning is to reduce unnecessary sacrifice; however, tying compensation to assets under management creates a financial incentive to encourage sacrifice. It is not necessarily in the client’s best interest to have the largest possible account balance. Yet, now the adviser has a financial incentive to encourage clients to save as much as possible, spend as little as possible, take as much risk as they can possibly tolerate, and not to use assets to meet other planning needs (unless there is equal or greater incentive to do so). This may promote advice that leads to unnecessary sacrifices for the client.
I’m not saying that every adviser succumbs to this influence, but it is still present any may influence objectivity. I do not believe that their financial interests are aligned unless the client’s financial interest is solely and perpetually to grow an account balance. Also, with assets under management pricing, the client keeps the money in the account, but when the adviser gets paid, they can spend the money, pay bills, go out to lunch, see a show, etc.
As far as the handholding, I haven’t seen that the amount of handholding increases with larger accounts. I have actually witnessed the inverse. Those with smaller balances typically have less experience with personal finance and require more direction and guidance.
Again, this is not a fee-only vs. fee-based thing; it’s an issue about paying for planning based on the size of the investment account.
Dylan | Mar 25, 2008 | Reply
One last point, the adviser does not cause the value of the account to go up or down; the markets do that. Too many advisers try to take credit for positive returns, but when that account value is down, those same advisers are quick to point out that everybody’s accounts are down because of the markets.
Reinhold | Mar 25, 2008 | Reply
Pure hand-holding seems more like a per-hour product than a %-of-assets product.
I realize it’s not pure-holding though, so then let’s talk about the non-hand-holding duties…
Thanks for your example — helps me to think on this. It seems to me that the fee structure you laid out there does not align the interests of client with those of the advisor. In the first two years, everybody “gets paid”: the client makes money, and the advisor makes money; but in the third year, the client does not “get paid” but the advisor still does, and it’s not that much less than the previous two years when the portfolio was up considerably!
You say the performance that clients look for is relative (to some goals), not absolute. That’s fine, so let’s roll with that to refine the example you gave. Let’s say that the market (some index that a client could use index funds with to make an apples-to-apples comparison against your performance as a picker of financial managers on your their, the client’s, behalf) did this over each of those three years:
17% (banner year, late 1990s notwithstanding)
6% (mediocre/average year)
-10% (a market “correction” that year)
Now, let’s imagine what value you provided:
25% (great outperformance!)
6.66% (just eeked out better than the index)
-12.5% (worse than the market)
Let’s figure out the 1% fee-based compensation for each of the above scenarios. In the first scenario, you (or the client in the case of tracking index mutual funds) would get paid something like this:
$300k grows 17% to $351k, you get paid ~$3,500.
$347.5k grows 6% to $368k, you get paid ~$3,700.
$364.5k shrinks 10% to $328k, you get paid ~$3,300.
Total compensation over 3 years is about $10,500 to you, and about $25,000 to the client. You take about 42% of the client’s gains for picking some ETFs. Of course, the client could have picked the same ETFs and paid in the ballpark of 20 to 30 basis points each year. (Let’s say 30 basis points, leaving the client with about a $32,000 gain after 3 years.)
Now the second scenario, where you may be picking some active fund managers:
$300k grows 25% to $375k, you get paid ~$3,700.
$371k grows 6.66% to $396k, you get paid ~$4,000.
$392k shrinks 12.5% to $343k, you get paid ~$3,400.
Total compensation for you over 3 years is about $11,000, and about $40,000 to the client. You take about 28% of the client’s gains for picking active managers for them.
So I don’t really see the alignment of client/advisor interests. In the first case, the client is out about $7,000 over 3 years, versus what they could have done with the ETFs going it alone. In the second case, the client is up about $8,000 due to your selection of active managers, beyond what they could have gotten with the ETFs going it alone. So in either case, you make money, in the ballpark of $10.5k to $11.0k (and the client does not make as much, relative to the go-it-alone index), so what incentive is there for you to pick better active managers when there’s only $500k on the line for you? Since you know there is not much on the line in terms of compensation, isn’t in your interest to not take chances, focus on client retention, and just stick to a strategy that you believe will stay close to the market indices, so that you can wave away any minor underperformances as “just the nature of fluctuations in the ever so slightly more volatile strategy we’ve adopted for your portfolio, but we believe that the strategy will outperform for you in the long run”?
In my view of client/advisor mutual interest, I don’t think handholding and fund manager picking for 3 years is worth $11k when the client only enjoyed a $8k outperformance above what could have been obtained via ETFs using the same asset allocation. But I also don’t hold that against other folks for willingness to pay that for the service. The marketplace for these services is what it is.
If I might elaborate on what I think is a % model that aligns client and advisor interests:
* year 1, you arranged a $24k nominal outperformance above the equivalent aggregate index performance — since it’s the client’s money, I think the client should enjoy the bulk of that gain, say 70-80%, leaving you with a fee of 20-30%, that’s $4.8k to $7.2k, let’s say a clean 25%, $6k to make it easy numbers
* year 2, $375k reduced by $6k for your fee, is $369k grows 6.66% to about $393.6k; that year the market index did 6%, from $369k that’s about $391k, for a nominal outperformance of about $2.5k, 25% of which is about $625k
* year 3, you don’t get paid because you didn’t outperform the nominal index; the client endures the full brunt of the loss, but you don’t take a hit other than the lack of a gain (compensation)
So how’s it look at the end of 3 years under my naive fee structure? You’ve earned about $6.6k in fees, and the client has gained about $9.0k net of fees (~$344k ending balance, versus a ~$335k ending balance for the ETF go-it-alone route). This seems “fair” to me, client is enjoying about 60% of the outperformance (it’s their money after all!) and you as advisor are enjoying about 40% of the value you’ve added. This scales up as the client’s portfolio grows (or scales down as it shrinks), so this seems to be an alignment of client/advisor interests, in the year-to-year short term as well as in the long term.
If the clients still want hand-holding, seems the best way to justify the value you add there is to charge them $500 a year for a personally-crafted newsletter you write to them, or $100/hr for a monthly 1-hr meeting where all hands are held and financial feelings assuaged.
Don’t you think it would be best to separate the pricing for these two important yet distinct services you provided?
Reinhold | Mar 25, 2008 | Reply
Correction: in my year 2, of course I meant a fee to you of $625, not $625k
Reinhold | Mar 25, 2008 | Reply
Dylan, your points take well with me, notably that I cannot imagine how planning costs track linearly with investment account size. e.g. I cannot imagine that planning for a $100M account in the main takes 10x more planning/effort/expense than does planning for a $10M account. Do you have a blog, too? I would like to follow this little gentlemen’s debate that is developing here between you and Ciaran.
The contest all in good fun of course. I know the two of you are professionals, so it won’t ever turn into a spectacle.
CHM | Mar 25, 2008 | Reply
@Dylan - I fall into the category of offering asset management services, with financial planning offered at no additional cost, as you know. As you mentioned this is common place.
I stand by my remarks that my fee based asset management business aligns the interests of client and advisor. To suggest that this pay model potentially corrupts all the financial planning based decisions is over the top and borders on conspiracy theory.
Flip the tables, a supposedly unbiased fee only advisor is constantly calling clients back for repeat appointments to fix this that came up, or that that came up (at up to $500/hr), drumming up hefty hourly billing (much like lawyers are often accused of doing). You don’t find me making those suggestions, but they certainly are possible, much like the conflicts you present on the fee based side.
Your arguments speaks to unscrupulous planners, regardless of what side of the fence they fall on, fee based or fee only… although I agree with you it seems to be a bigger problem for fee based advisors (esp. those compensated heavily by product companies), it’s still unfair to portray them to the degree you do.
And there’s a big difference between hand holding and providing direction for those starting out. I was using Rheinhold’s words, I think it’s important to re assure clients during times like these.
CHM | Mar 25, 2008 | Reply
Rheinhold I applaud the time you put into coming up with those examples. I don’t have much more to offer you, it’s clear where you stand on the issue and where I stand. I provide a service that many people value and they are comfortable with this structure.
As an aside, I would be willing to say my fee structure is more affordable than that of many a fee only planner, for the majority of clients. Simple example and then I have some big issues to take care of, earn my keep;)
A client of mine has $220,000 which I manage at 1% that’s $2200 annually. Let’s assume the average fee only planner charges ($250/hour) and provides full financial planning services, budget planning, etc. 9 hours is all it takes to eclipse the amount in fees I’d charge this client for an entire year. 9 hours is nothing when dealing with most clients. I’m sure it’s not uncommon for fee only planners to bill over 20 hours for certain clients. Take it a step further, a client has $100,000, I charge $1,000, no time constraints. A fee only planner charges the same $250 an hour and has to take the same planning based approach and potentially spend the same amount of time as with the $220,000 client, all of a sudden the fee only charges seem excessive in comparison to what this client would get in a fee based relationship.
Rheinhold - you seem pretty knowledgeable on a lot of this, maybe you only need a 0-5 hour tune up each year. You are the exception to the rule, and it’s obvious someone like you wouldn’t need someone with my fee based approach.
CHM | Mar 25, 2008 | Reply
@Rheinhold - Dylan is one of the moderators over on Get Rich Slowly. Just go back and re-read the interview I did with him right here on my blog. You should remember - you commented quite a bit on that thread:)
Reinhold | Mar 25, 2008 | Reply
CHM, the example I elaborated upon was yours! $300k to $400k in 2 yrs, then down to $350k in yr 3. (I just went back and broke out fees explicitly so that we could see what we were talking about.) Believe me, I admire you for filling a market niche and earning your keep. I just am still not able to grasp how it’s the best alignment of client/advisor interests. In your $220k example, don’t you feel underpaid for your planning time? Likewise, in the $100k example, isn’t there less incentive for you to spend hrs on that client than on a $220k client? Your fee structure may funnel your time in favor of the clients with higher account balances. Are you comfortable disclosing what kind of annual ROI you get for your $220k client, and what is the approximate asset allocation / financial goal set for that portfolio? (No hard feelings if you can’t / won’t give such numbers. I’m not a financial professional, so I don’t know what’s kosher. So I hope I haven’t gone too far by asking.)
I promise you my knowledge is limited and not so exceptional. I’m simply in (very) early retirement, and so can afford to spend several hrs per week on ways to reduce financial costs (fees, taxes, etc.) Hashing stuff out here with you is great and helps me think through some issues, and I hope I don’t drag you down about it. You have a fine objective for your blog, and I (morally) support it!
Thanks for the reminder on Dylan on GRS. I guess I blew through the various links too quickly.
CHM | Mar 25, 2008 | Reply
Many fee based advisors set minimums for starting relationships, typically $250,000 in investable assets… this is a business decision they make. They tend to aim for clients with high end assets because they typically have more complex planning issues across the board and can justify the costs associated with this fee structure.
The analogy I would use to the body of your latest post: I don’t discriminate because of account size. Because of the structure of my business I have ample time for them all (another reason I like long term prospects of fee based advisor/client relationships). I try and treat them the same way a responsible parent treats their children, fairly and equal, regardless of their age, size or maturity.
The whole purpose of my blog is to bring as much as I can here for free and create as much on topic information as I can for those that need it, for those that can’t afford to pay a fee only or fee based planner. If this blog would only grow a bit faster I’d have some more leverage to help people, oh well, working on it. If you read many of my early posts I talk a lot about all this.
Gotta run
Dylan | Mar 25, 2008 | Reply
It’s not just me suggesting that this pay model potentially corrupts financial planning decisions. This potential is a conflict of interest, and it is required to be disclosed as such by CFP professionals and Registered Investment Advisers.
There is a difference between the PRESENCE of a conflict of interest and ACTING in conflict of interest. I never accused anyone or any group of acting in conflict of interest. I also never claimed that other compensation models are conflict free or unbiased. Anytime, two parties interests are not 100% in alignment (pretty much every business interaction), there is potential for conflicting interests.
It wouldn’t matter if there were not a single unscrupulous planner on the planet; the conflicting interest is still there, whether acted upon or not. I’m not faulting you or anyone one else for the way you do business as long as you are not hiding the presence of conflicting interests.
One cannot “act in the best interest” of a client unless they are also faced with alternative courses of action that are not in the best interest of the client. Because “best” is a relative term, there must be a conflict in order to choose the “best” action in the first place.
It is one thing to defend one’s own actions in the face of a conflict of interest, which acknowledges the presence of the conflict. It is another thing to deny its existence or trivialize its relevance. I don’t think you are trying to sweep the conflict of interest under the rug, but I also don’t think it is clear when you refer to your relationship with the client as “properly aligned.”
@ Reinhold – I do not have a blog of my own, but I occasionally write guest posts for other blogs. My function as a moderator in the GRS forums really amounts to deleting spam when I see it; I do not contribute any more or less than non-moderator members of the GRS community.
Reinhold | Mar 25, 2008 | Reply
Dylan, could you give me a link to the list of guest posts you’ve done? I could only find 04-17-2007 and 02-06-2008 on GRS, and the 03-07-2008 one here.
CHM, I’ll be back reading your blog, too. I definitely think you are a straight shooter about your operation, but I might suggest that a %-based fee structure insidiously (i.e. subconsciously) has you being motivated toward the work that has the greatest incentive for you. And I want to be clear that I don’t think it’s a shortcoming unique to you; it’s simply human nature manifesting under the conditions that prevail in a fee-based arrangement.
CHM | Mar 25, 2008 | Reply
@Rheinhold - With all due respect, you just don’t get it.
I’m very comfortable with my business and wouldn’t run it any other way. You are the one stuck seeing things one way, not me.
Please do me a favor and don’t bother me about this anymore.
Dylan | Mar 25, 2008 | Reply
@Rheinhold - In the spirit of using StumbleUpon. I have tried to assemble my guest posts on my SU page under the tag “guest-blog-posts.”
dylanross dot stumbleupon dot com
If you cannot locate it, please email me from the contact page of my Web site, and I’ll reply with the links.
Reinhold | Mar 25, 2008 | Reply
CHM, will do. My apologies for pressing the thread (a bit) too far.
Reinhold | Mar 25, 2008 | Reply
Dylan, found your tag, thanks. For the record, it’s “blog-guest-posts” not “guest-blog-posts” (corrected here for anyone else who may run through this comment thread).
EMF | May 14, 2008 | Reply
WOW … I “stumbled” on this timely thread via a Google search for fee and related issues regarding Financial Advisors; I am considering making a change related to some of the issues raised here.
I know that the answers to some of my questions are buried in the give-and-take within this thread. I have read through (most of) it. But I can’t absorb it without pencil and paper - which I haven’t done yet. However, it looks like this might be the place to air some of my questions - if there is anyone still left standing
(1)Why did I not see the oft-abused word “fiduciary” mentioned in this thread? Maybe I missed it. Can anyone offer something approaching a definition in the financial / investment area? It seems to be related to the issue of “alignment” raised in the thread.
(2) I have recently been told that for some or all classes of Financial Advisor, there is some level of Government Regulation (as distinct from a Company Policy) which requires their clients to have $500K minimum available before an account can be established. Is this accurate? I can’t find a reference to such a thing on the Web.
(3)The cast of character types in this business is intriguing. I think the thread introduces at least 3 types:
(a) CFP (Certified Financial Planner?) Certified by whom?
(b) RIA (Registered Investment Advisor?) Registered with whom?
(c) B/D (Broker / Dealer?) Stuff-For-Sale?
Can someone clarify the differences and perhaps introduce the rest of the cast?
I have more questions, but will be encouraged if someone can answer these. Please don’t be put off by my e-mail security measures. I will accept your e-mail responses, even those that say - get lost!
Thanks, Ed
CHM | May 14, 2008 | Reply
Hey Ed,
My blog has been silent for a while and I’ve had to limit my commenting for various reasons. If you want more answers I would strongly recommend getting in touch with Dylan Ross, one of the main commenters on this thread.
He is extremely well informed on all the questions you raise. He may even see this thread and post some answers. I will defer to him and he will help clear the air for you.
If he doesn’t see this thread… you can always reach him directly at http://www.swanfinancialplanning.com
regards,
Ciaran
Natalie Straub | Mar 4, 2009 | Reply
Very helpful, thanks!