Today, it is common for financial advisors to charge based on a percentage of assets under management. Numerous industry studies have shown that the typical median asset-based fee is about 1.00% annually for accounts under $1 million, and it doesn’t scale down too quickly with the median fee being around 0.90% annually for a $2 million client. Many firms have shifted to a model like this over the years to remove potential conflicts that can arise from being paid on commissions for portfolio transactions.
Years ago, the advisor (then referred to as broker) was only paid when there was trading activity in the account. There was a direct incentive to recommend more transactions, as it meant more revenue for the brokerage firm. This created a problem, as evidence showed over time that not only did more activity fail to lead to higher investment returns but it actually detracted from them.
This led to the popularity of the asset-based fee model, where the advisors were not paid for transactions but rather for the advice given. In theory, this model would help remove conflicts of interest from recommending unnecessary transactions, or choosing products solely because of the commission paid. The advisor would only recommend a transaction if they thought it was beneficial.
While the asset-based fee model may be an improvement over the commission-based one, there are still a few issues to point out as to why more improvement is needed. The fundamental disagreements I have with the asset-based fees are the inequitable nature of them, the nasty compounding effect they have, and the conflicts of interest that still exist under the model.
Generally speaking there is not more time, services, or overhead involved for a $1 million client versus one with say $500,000. But if both clients are charged 1% annually, one of them pays $10,000 while the other pays $5,000. Assuming they are both receiving the same service, why should one client be charged twice as much as the other? It may seem equitable as they are both charged the same percentage, but why should they be charged a percentage in the first place? A flat annual fee can make more sense given that the services rendered are substantially similar.
It’s hard to imagine many other services you pay for in the private sector where the sole determinant of your cost is based on how much money you have. Imagine shopping for a financial planner and one of the questions you ask is how much your advisory fee is annually in terms of dollars, and they respond with “how much money do you have?”.
This reminds me of a scene from National Lampoon’s vacation when the Griswold family is broken down at a remote tire repair shop:
Clark Griswold: “How much will it be?”
Mechanic: “How much ya got?”
How much you have shouldn’t be the sole determinant of what you pay for a service.
Conflicts Still Exist
Next, conflicts of interest still exist under an asset-based fee model. Say you’d like to take $100,000 out of your portfolio to invest into a rental property, and you ask the opinion of your financial advisor. There is now a conflict, as a withdrawal from your account will affect the advisory firm’s revenue if they work on an asset-based fee schedule.
Imagine you are 60 years old, preparing for retirement, and your employer has offered a lump sum distribution of your pension benefit. You can collect an annual pension of $35,000 annually or a $500,000 lump sum to rollover into an IRA. Getting objective advice on such a matter would be difficult, if the person giving you advice could get a significant raise by suggesting a rollover.
A Compounding Effect
What we want as investors is for our portfolios to benefit from the wonderful nature of compounding interest, but we’d probably be okay if our costs didn’t. Asset-based fees compound and can make a significant difference in the long run.
Allow me to demonstrate, this chart below displays the comparison over a 20 year period of two $1 million portfolios, where one pays 1% annually of assets under management and the other pays a flat annual fee of $5,700 (the current flat fee for new clients of Meredith Wealth Planning). Assuming both portfolios earn a gross annual return of 6% annually, the asset-based fee portfolio would pay about $216,000 more in expenses over those 20 years:
The common pushback in defense of asset-based advisory fees goes something like this: “I can charge 1% because I add 3% in value for my clients”. That could definitely be true, but it’s quite difficult to prove because we cannot study the alternative histories of the client’s life without the advisor. We do know the advisor’s probably aren’t beating the market over the prior decade, but the question is would the client’s have been even worse off without the advisor?
Vanguard has provided research claiming financial advisors do add significant value through prudent investment allocation, maximizing tax-efficiency of accounts, and helping clients stick with plans throughout difficult market conditions.
Charging a flat fee could add more net value to the client assuming everything else is equal. They’d keep the difference between the blue bars and the orange bars in the chart above.
“We Make More When You Make More”
Some firms that charge asset-based fees would like you to think your interests are more aligned because as you make more money, so will they, and as your accounts decline, their revenue declines. That all sounds great, but your advisor cannot control how markets behave and I will bet you my Swingline stapler that they do not possess a skill to consistently time market movements.
If they truly thought they were the sole determinant of your investment performance outcome, they should only charge a percentage of the profits, not the principal you invested.
Not Being the Cheap Guy
This may sound like I am attempting to be the low cost provider by undercutting the asset-based fee advisory firms, and that is not the case. The flat fee for new clients of Meredith Wealth Planning is $5,700 annually, which in my opinion is not a small amount to shell out. But yes if you compare that to the insanity of someone paying 1% annually on a portfolio in the millions, it does look like peanuts in comparison. A client paying a 1% fee on a $100,000 portfolio may be getting a great deal, but I believe there should be an upper limit to the total dollar amount being charged in most cases.
Choosing a financial planner on how they charge or how much they charge probably shouldn’t be your sole decision factor, as conventional wisdom is “you get what you pay for”. But finance and investing is a little different in that regard, as a 2016 study by Morningstar showed that the best predictor of future mutual fund returns was indeed the price you pay. The cheapest quintile of funds went on to have the best success rate going forward, and there was pretty much a linear relationship in the fact that the higher the fund fees you paid the lower your future returns were.
A financial planner should help in other areas besides portfolio management, which the value of is not always easy to quantify.
Why Doesn’t Every Firm Go Flat Fee?
The major wirehouses, broker-dealers, large independent firms, and banks in this country have built their wealth advisory empires on asset-based fees, as you can see from the prior chart that it is a lucrative business model. Their comp structures, earnings projections, and much of their overhead is built on the premise of asset-based fees continuing indefinitely. And as their client’s portfolios grow with the markets, they will receive automatic revenue increases.
They will not proactively adapt to a flat fee model, as it would drastically disrupt their business revenues and profitability. The current fee structures must be kept in place to pay for incredible overhead they’ve built up over the years. This is where the small firm has the advantage. Overhead expenditures are not wasted here on research analysts that pretend to know where the market is headed, fancy offices, or season tickets to take clients to Cardinals games. With what the clients will save in long-term costs, they can afford their own tickets.
At the end of the day, a client will only pay if they perceive it to be worth the cost. From my perspective, it is not well known to many what the true cost is of asset-based fees over many years, which is the reason for this 1,400+ word article.