Prepare for an upheaval in how planners get their revenue.
If you’re paying a percentage fee for financial advice, you’re stuck in the 20th century. Time to cut a new deal with your advisor.
The percentage-of-assets fee is well entrenched in wealth management. But it’s doomed, says Wei Ke, a consultant at Simon-Kucher & Partners who helps investment firms price their services. Percentage deals can’t compete in a world of dirt-cheap index funds and price-cutting robots.
Ke isn’t saying that financial advisors charge too much. His point is that they have to come up with alternative fee structures that do a better job of matching price to value.
The size of your portfolio isn’t a good measure of value. What matters is the work done to plan your financial life and cut your tax bill. How to capture that value? An annual retainer, explicitly tied to the complexity of your finances, would do it. So would an hourly fee.
It’s easy to see why planners cling to assets-under-management pricing. Clients scarcely notice the small percentage taken out of their portfolios every quarter. The arrangement can be quite lucrative for advisors with mature practices that include wealthy clients.
But percentage fees are problematic. They don’t cover the cost of dealing with clients who have small assets and large financial complexities (like divorce, illness and business ownership). They overcharge clients with large assets and simple finances.
A typical assets fee, Ke says, is 1% of the first $1 million and a declining percentage of larger amounts. A client with $5 million of investable assets might pay $35,000 a year to get financial advice. Some of those $5 million clients do indeed require a lot of work, but many of them are just $500,000 clients with the decimal point moved over.
Investment advisors might leave pricing where it is if they weren’t being battered by index funds and robots. Index funds let you manage a $1 million portfolio at a cost of $570 a year (see table). My 4-3-2-1 model portfolio has you buying VTI, SCHZ, VXUS and VCIT. Robo-advisors like WealthFront and Betterment deliver more-customized solutions, but still charge only a fourth as much as a traditional planner.
And if you want something warmer than a robot guiding you through the next stock market crash? A discount model has emerged that is a hybrid of robo and human advice giving. Vanguard offers it, at an annual 0.3% on the first $5 million (plus underlying fund fees); for that you get a financial plan, advice by telephone and computer-optimized portfolio. Charles Schwab & Co. has a similar product with a fee of 0.28% that is capped at a bargain $900 per quarter.
The discount planners are gaining ground. Vanguard’s service had $51 billion at the end of 2016 and could attain double that by the end of this year.
There’s a torrent of fees up for grabs. Ke estimates that U.S. investors are paying $233 billion a year to have $15 trillion overseen, somewhat more than half of that outlay going to the financial consultants who talk to the clients and the remainder to vendors of products like mutual funds.
In olden times, a money manager could justify a 1% annual fee just for the work of assembling a portfolio. Why, with clever timing or security selection the manager could earn back the fee. So went the implicit sales pitch.
That sales pitch doesn’t work so well these days. Trillions of dollars have migrated into passive investing. John Bogle’s message is sinking in that stock pickers, as a group, can do no better than an index fund before fees, and are destined to do worse after.
Financial advisors have to earn their keep some other way. They can do that if they know a lot about refinancing mortgages, paying for college, timing Social Security, covering health costs and reducing tax bills.
Maybe it’s time for another seismic shift in how advisors get their revenue. Consider the history. A century ago the sales commission became the standard way to pay for financial advice. Half a century ago percentage-of-assets billing began to make inroads. Now what?
So far only a tiny fraction of the nation’s financial advisors have broken away from both commissions and percentages. A paper from Ke’s firm cites several iconoclasts using different value-based fee schedules.
The flat fee. Ke’s role model is Third Eye Associates in Red Hook, N.Y. You start out there paying a flat fee for a financial plan; the amount ($2,500 to $5,000) and the hours devoted to it (13 hours to 41 hours) are determined by the complexity of your financial life. You pay for portfolio management and annual checkups separately.
The annual fee. Life Planning Partners is a Jacksonville, Fla. firm with an annual retainer, keyed to complexity, that ranges from $5,000 to $30,000. What causes complexity? One of the many things is having assets in both taxable and tax-deferred accounts.
The hourly fee. No reason an advisor can’t bill the way a lawyer or accountant does. Timothy Financial Counsel, in Wheaton, Ill., charges $255 to $350 an hour. A comprehensive review of your finances will usually take between 10 and 40 hours. You can also get narrowly targeted consultations.
The firm boasts that its hourly-only approach “makes us truly unique among financial planners.” That’s an overstatement, but not much of one. I’ve been collecting names of planners who primarily bill by the hour, and they are a tiny subset of the country’s 310,000 personal financial advisors. Timothy is on the list, under the name of one of its planners, Michael Thrasher.
The income-sensitive fee. Ke notes that financial complexity is a function of income as well as of assets. A young person, for example, might have scant savings, a big income and tricky questions involving student loans and employee options. Upperline Financial Planning in New Orleans sets its annual planning fee at 1% of income plus 0.5% of assets. Consulting assignments run between $75 and $250 an hour.
My recommendation to clients: Figure out what you’re paying, including the cost of the funds you own. Subtract $570 (per $1 million) from that number. Compare the result to the value you assign to the financial counseling you’re getting.
Recommendation to advisors: Don’t wait too long to follow Ke’s advice.
Originally published at Forbes