I thought I would share the research I prepared to speak at the Inside ETF's conference this week on financial advisor fees and compensation.
To clients, the industry of financial advice has been and probably will always be confusing, especially when every firm seems to look the same. Is there really a difference between a financial advisor working at a bank, a brokerage firm or an independent practice? The answer is yes, but the details get cloudy to the consumer. Personal Capital conducted a trust report in 2017 and the report showed 46% of respondents believed that financial advisors were legally required to work in their best interest and 31% had no idea what they pay their advisor. The reality is that a very small percent of advisors are legally required to work in the best interest of their clients.
The Stockbroker Refined, Sort of
Hollywood portrays stockbrokers in the Wolf of Wall Street, Boiler Room and Wall Street as crude, cocky and greedy. This was not a dramatization of the days of old, it was reality. Sell or get fired was management’s mentality, thus high-pressure sales tactics were the norm. The full commission broker pushing individual stocks is almost a trade of the past, however; the one-sided nature of the business still remains. The stockbrokers of old have been refined into softer financial advisors that are actually referred to in the industry as Registered Representatives. These are the easiest advisors to find, as they are at Wells Fargo, Truist, Edward Jones, Morgan Stanley, Ameriprise, JP Morgan and many other lesser known brokerage houses.
These Registered Representatives will build a financial plan, show you how to diversify your portfolio, make insurance recommendations and even offer you a mortgage, but make no mistake, this is not financial advice as their primary objective is to sell product. With their only guideline being that you are suitable to be sold the product, you are not guaranteed that any product recommended is the best option for you. Edward Jones has the following in their fine print “When we do business with you, our financial advisors and the equity owners of our firm may benefit financially from fees, commissions and other payments from you and our investment providers. These financial incentives may create a conflict between Edward Jones’ interest, your financial advisor’s interest, and your own.” This is standard language for the companies named above. This disclosure reminds me when I was working briefly as a Registered Representative, my boss would often tell me, “There are three people in this relationship, two out of the three better be making money on this transaction.”
Compensation for Registered Representatives is tied to the product they sell, with each one having the potential of being higher than the other. Very often, prospective clients interviewing me will tell me that they don’t pay anything to their current financial advisor. The reality is that the mutual fund used in their portfolio could have had a 5.25% purchase commission and a trailing 12b-1 fee near 1%, a portion of which goes to the broker, advisor and the mutual fund company. All indirectly paid for by the client. There are options where clients can pay a percent asset management fee based on the portfolio value, but also expensive fund options are chosen in addition to the asset fee being charged. The funds used will also pay the advisor on top of the asset management fee, causing the client total expenses to top 2%+ annually, eroding portfolio values for future use.
Big box insurance and brokerages firms have the marketing dollars to sell themselves as moral leaders of the industry and making sense of investing, but the reality is that they don’t build the toolbox for their advisors to truly give unbiased advice. While there are thousands of Registered Representatives with great intentions, the reality is that they buy into the company marketing and just fall in line. Those that don’t, discover the better way.
There is a Better Way
In the early 1980’s in Atlanta, GA, a group of advisors began offering financial advice for a fee not related to any product commissions. It took a few more decades to fully catch on, but there is now a vast, yet still minority, group of financial firms offering fiduciary, fee-only financial advice. Fiduciary Duty is the obligation of the advisor/firm to act in the best interest of the client.
This is the very opposite of the Edward Jones disclosure included above.
Fee-only simply means that the advisor/firm are not being compensated by any product. This setup allows the clients and advisor to work in sync in the best interest of the client. The setup is very transparent and straight forward. The client pays the advisor an hourly, flat fee, subscription fee or most common, a percentage of assets under management. In return the advisor builds and monitors a financial plan and manages the client assets.
The most reputable firms will hold/manage the client assets at TD Ameritrade, Charles Schwab or Fidelity. Because the advisor is not getting paid by any product, the cost of the portfolios is generally much lower than what is seen with Registered Representatives. It is not uncommon for total fund fees to stay below 0.2% annually and no transactions fees are charged by the custodian. Because of their unbiased approach, fee-only firms are a great source for second opinions on your own self-management or your current advising relationship.
There have been attempts to mandate a fiduciary standard across all parts of the financial services industry in the US, however the lobbying efforts of big insurance and brokerage companies, who see their products not fitting the fiduciary standard, have stopped all efforts to protect clients from financial sales. In Australia and the UK, financial service professionals cannot receive compensation from the products that they sell.
Mud in the Water
To make matters even more confusing, in addition to Registered Representatives and Fee-Only, there is also Fee-Based. It sounds very similar to fee-only but there is a difference. Fee-based advisors are not required to be fiduciaries and will also sell products that pay them a commission such as mutual funds and most commonly, insurance. We find the fee-based model to be confusing to the consumer. How would a client know when the advisor is no longer working as a fiduciary and is instead selling a product that is suitable but maybe not the best for the client? For the advisory firm, it is a great way to supplement investment management fees with the higher commissions of annuities and life insurance. For the client, it is mixed signals. There are more fee-based firms than fee-only. In 2017, FINRA data shows there were 286,789 fee-based firms vs 56,472 fee-only and 343,333 brokerage firms.
Playing Dress Up
The most recognized financial industry certification is the Certified Financial Planner, CFP® designation. Once a candidate passes either online or a traditional study class, he or she can sit for the CFP exam. Once passed, the advisor must act as a fiduciary when doing financial planning for a client. What is interesting is that a Registered Representative can also hold the CFP certification. This means while the CFP board may hold the rep to a fiduciary standard, the company that he or she works for and the government do not. In comparison, you could work with a non-CFP at a fiduciary fee-only firm that is an actual fiduciary and held to that standard by government regulators. For those entering the business with a non-financial undergrad or master’s program, it is a good idea to have the CFP designation but clients should not assume that the CFP means that the advisor is not compensated through selling products or is required to work in his or her best interest.
The future of financial services appears to be in the fee-based model, with fee-only growing at a slower pace. A recent FA Insight study, made up of fee-based and fee-only firms, shows that 90.4% of these advisors are charging a fee-based on assets under management, 4.9% are charging a retainer fee and 4.9% are still taking a commission on transactions. There has been a lot of industry talk about how advisors should be compensated and perhaps the current prominent fee-based model on assets managed could be challenged. It is important to remember that there are two sides to the discussion, the client and the advisory firm. Even though the majority of the industry operates selling financial products as registered representatives, this group is not a part of the analysis below as they can never work in the best interest of the client.
Assets Under Management
This is the most common form of advisor compensation. On average, advisors will charge a tiered management fee based on a percentage of a client’s assets in which they manage. This fee can range from 1.5% to 0.5% annually depending on the amount of funds the client has with the firm. The average annual fee is 1%.
The benefit of this model is when the client’s assets increase, the firm revenue increases as well, or should the account value drop, so does the advisor’s compensation. This would seem to help align the advisor and client to have the same interest. However, if it benefits a client to pay down debt, delay social security or even if a client wants to be charitable, all these recommendations would reduce the advisor’s compensation. This should not be an issue under the Fiduciary standard, as what is best for the client should always be first, but there still creates a potential conflict on the advice to be given.
From the firm’s perspective, there could be a sudden market sell off, as in December 2018, that causes billings to be greatly reduced, only for the market to recover the next month. This can cause financial stress on the firm with radical cash flow drops. Many firms will have a fee minimum to protect the company’s margins. For example, a minimum fee of $5,000 and a 1% management fee annually helps to keep the firm operating at or above their operating costs in a major market sell off and signals to the firm prospects/clients what the minimum amount of assets the firm will manage. The S&P 500 historically is up over 70% of the time, so a company with proper reserves should be able to weather a market storm.
What services the clients get under the assets under management will vary. Some firms may charge the AUM fee only for management of the portfolio, while others will include comprehensive financial planning. Firms working with ultra-high net worth clients may also include estate planning and tax preparation services. It is important for the client to understand what they will be receiving as purely asset management is only a part of their financial goal strategy. This should all be laid out in the firm’s client brochure as required by regulators.
A fiduciary firm, focused on the overall client’s financial well-being through financial planning and monitoring, who is being compensated solely through the assets under management model, may not be the best alignment of work vs incentive. If 75% of the work for a client is focused on planning, why should 100% of the compensation be built on market performance. Many in the financial services are beginning to question if the assets under management model should still be relevant.
There are many households that do not fit into the assets under management model. Perhaps all their assets are in their 401k or they are just getting started in retirement savings. Financial planners can work on demand outside of the assets under management model by charging a flat fee or hourly rate to create a comprehensive plan or focus on areas like retirement, college planning, portfolio creation, tax planning, Medicare or insurance planning. Generally, the flat fee or hourly agreement is a one-time fee, with no commitment by the client to maintain the relationship.
Clients can benefit from this approach because they get the same quality advice given to assets under management clients without the need to transfer assets or meet the firm minimum. Some firms also will use this fee setup to charge for financial planning in addition to their assets under management fee. Alternatively, some firms do not manage assets and are only providing advice.
A much talked about and growing trend is a flat subscription fee for planning and asset management. Large brokerage houses like Charles Schwab are launching planning and asset management for a flat fee as little as $30 a month. The client transfers assets to Schwab, as little as $25,000, and has an 800 number to call for planning advice. Smaller firms with a more personalized approach are charging an initial planning fee then a monthly fee ongoing fee for maintenance. This approach to advice is allowing those not qualified or interested in moving assets to a firm an opportunity to access quality advice. This also allows advisors to create new revenue streams that have been virtually untapped by firms in the past, level out income fluctuations and align their pay structure with the planning vs market performance.
For clients with five million or more in investable assets, the subscription model seems to make more sense. If it could be in your best interest to buy a million-dollar beach property to add quality of life to your family, hold real estate and even generate income, you want your advisor to recommend or agree to it. In the assets under management fee model, the advisor would have a cut in revenue with this real estate recommendation. In a subscription model, there is not a conflict of interest.
Clients choose to work with advisors for several reasons, but it all comes down to the fact that they trust the advisor that they are talking to. Many don’t even know if an advisor is a fiduciary or not. In many ways this is the regulators fault in not having the same standards across all areas of financial services and allowing for there to be so many similarities in descriptions of today’s firm types. In the end, clients have to ask the hard questions, with the first one being are you a fiduciary and the second being how you get paid. The answers to those two questions should determine how long the meeting should last.
Posted January 27, 2020