The end of the 1% (and higher) advisory fee?

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     Many investors routinely pay a fee for ongoing investment management that has typically averaged between one and two percent of their "assets under management" (AUM).  But percentage-based billing often leads to extremely high dollar amounts that bear almost no relation to either the amount of work actually done on the client's behalf, nor to the likelihood of obtaining superior investment returns that might justify such high fees. 

     In its place, many investors could benefit from simply paying a flat annual dollar-based fee that bears a far more reasonable relationship to either the time involved in managing their accounts, or to the real value of the investment and financial planning services being provided.  In addition, a flat dollar-based flat annual fee would also greatly reduce - though not entirely eliminate - the conflicts of interest that are often inevitable with percentage-based billing.

       Most investment professionals know that the time and expertise required to manage a $500,000 portfolio is largely similar to that required to manage a $2M investment portfolio.  But under a system where fees are assessed at one percent of AUM, one portfolio results in annual fees of $5,000, while the other results in annual fees of $20,000. To bill a client $20,000 for managing a $2M portfolio cannot be justified from the point of view of the time spent managing the account, nor from the point of view of the expertise required to provide investment management and financial planning services.  It certainly does not take four times as much time and expertise to manage the $2M account as compared to the $500k account.  

     Yet that inequitable result prevails throughout the investment advisory industry.  Managing the larger account does reasonably require a larger fee - there is greater potential liability, as well as the likelihood of more complex planning issues.  But the larger fee should probably be on the order of several thousand dollars a year more, and not a multiple of three of four times higher.

       Which begs the following question: Why percentage-based billing at all, instead of an annual flat dollar-based fee, for what should be a professional service similar to that provided by other professionals?  The answer often put forth by the financial services industry is that the percentage-based fee serves to "align" investor interests with those of the adviser - the better the adviser does, the better the investor does.  But this line of reasoning only serves to highlight the fact that most of the financial services industry's interests are not inherently aligned with those of the investor, for if they were, this argument would be superfluous. It would be inconceivable for an accountant who is rendering tax advice, or preparing a tax return, to argue that he or she should take a  "percentage" of the client's after-tax income so that the accountant's interests can be "aligned" with the client's interests.

     It would be equally inconceivable for an estate planning attorney to quote a fee for delivering an estate plan based on a percentage of the value of the estate.  Professional investment and financial planning services should be priced this way as well, with a reasonable price adjustment made to take into account the added costs involved in providing ongoing management.

       And, far from aligning the client's interests with those of the adviser, the percentage-based fee often leads to inevitable conflicts of interest. For example, how is an investment adviser who bases fees on a percentage of assets under management to react when asked by an investor whether it would be wise to sell a sizable portion of his or her stocks and bonds and pay off a mortgage, or buy an annuity or a vacation home?, each of which will reduce the adviser's AUM and revenue?  Under the percentage-based system, the adviser has every incentive to fight tooth-and-nail to keep the investor in assets that will generate revenue for the adviser, and almost no incentive to recommend courses of action that may well be in the best interests of the investor.  

    Even if one is a fiduciary, and legally obligated to act in the client's best interest, if the fiduciary's entire revenue model is based on the size of the assets under management, the percentage-based billing method often poses a potential conflict of interest that could at least be significantly reduced with a flat annual fee in which the fee is not so strongly tied to the amount of the assets under management. 

       Of course, high percentage-based fees could - theoretically - be justified on the basis of the adviser obtaining consistently superior investment returns over the long run on both a risk-adjusted and after-tax basis- except that the odds of any adviser actually achieving this are very small, as decades-long studies have shown that the vast majority of financial professionals do not, and logically cannot, provide a higher investment return than what the market as a whole is returning.  And what the market is returning can be achieved for investors with an intelligently-designed portfolio of low-cost index funds that is held for the long-term.  This is especially true on an after-tax and risk-adjusted basis.

       Such a return - a risk-adjusted "market" return - can and should be obtainable at a much more reasonable cost for many investors than the cost of surrendering between one and two percent of their assets under management in the form of fees.  It defies logic for an adviser to assemble a suitable portfolio of index funds which might cost one-tenth of one percent, then charge the investor ten or fifteen times that amount, in the form of a 1-1.5% advisory fee, to provide investment and financial planning services.

     Indeed, if most investors really understood the long term risk of damage to their investment returns that the "active" approach entails - in fees, in taxes, and in the greater risks that are often taken - few would even want their financial adviser to take such an approach, and fewer yet would be willing to pay their adviser between one and two percent every year to simply achieve a return that can largely be obtained with a suitable basket of low-cost, diversified index funds.

       And what are the impacts to investor's returns when paying high percentage-based fees?  Studies generally indicate that each additional percent in investment fees can reduce long-term returns by twenty percent. Many investors have already begun to demand, and receive, lower fees, and the industry is starting to recognize that the percentage-based fee may soon be a thing of the past.  Much as full-commission brokerage fees were supplanted by companies such as Charles Schwab in the 1970's, paying one or two percent for investment management will likely fade away.

     With a flat dollar-based fee that is based on both the time, expertise, size of the account, and other business costs, the cost of expert investment management and financial planning services can and should be priced much lower, perhaps between one-third and one-half of the amount that many clients currently pay under the percentage-based system. A flat dollar fee in that range may well be reasonable if the client is also receiving expert financial planning services as well, for this is the area where real "adviser alpha" is far more likely to be achieved in terms of improving the client's long-term after-tax returns.  

       In reality, most investors could be well-served by ongoing investment management - as long as it is stripped of the illusion of investment out-performance, reasonably priced, and includes financial planning services.  Investment management is highly valuable to many investors - though far more valuable when accompanied by tax, retirement, Social Security, estate, and genera financial planning. The great majority of investors will, for a myriad of reasons, do much worse on their own than with professional assistance.  While it may seem like a simple task to just buy and hold a basket of suitable index funds, there are dozens, if not hundreds, of important financial decisions that need to be thought through over the course of many years - tax, retirement, estate,education, and other financial planning issues and decisions.

       Left to their own devises, most investors simply cannot handle market volatility on their own, as demonstrated by studies showing that the average investor will underperform the market by three or four percent a year as they get in and out of markets at the wrong times, nor can they see or anticipate the complexity of financial planning factors that go far beyond the investment itself.  For quality investment and financial planning advice,  I believe that the fees investors pay for such services - if reasonable - will pay for themselves many times over.