Below we examine the four predominate fee models in financial services and determine the financial adviser fee model that would be most appropriate for you.
Financial planning is a relatively new discipline which only really developed in Australia in the 1980’s. Prior to the 1980’s the average Australian had little spare money to invest and if they did, the options for investment were fairly limited – they could either buy an investment property, or call a stockbroker and buy some shares.
Over time, with innovations in technology, finance and banking, product providers, namely fund managers, insurance providers and banks, saw an opportunity to start selling their products directly to consumers.
The product providers faced a dilemma, they could either build an internal sales force and attempt to sell their wares directly to consumers, or they could piggyback on the existing industry model of independent insurance advisers who got paid on commission. The product providers chose the latter option and the financial planning industry was born.
At one stage everything a financial adviser offered to a client involved some form of commission. After all what client would pay for advice, especially considering most of the early advisers had no technical skills and their only value add was being able to sell you a financial product that you otherwise couldn’t buy for yourself?
There were upfront commissions on managed funds and insurance policies, as well as trail commissions as long as the client remained invested in the fund, or continued paying the premium on their insurance policy. Worse of all there was little requirement for disclosure, clients were in the dark as to how the adviser was being paid and by whom. The financial planning model back then is not unlike the mortgage broking industry of today.
Eventually the prevailing commission model resulted in unintended consequences for clients. Put simply clients were sold products which were unsuitable and they lost a lot of money during share market corrections.
- The client has no out of pocket expense for the advice.
- The expenses are usually built into the product (i.e. it costs you more in the long run)
- Encourages a sales driven mentality – the more products sold + the higher the dollar value = more commission for the adviser
- Sales and good financial advice don’t mix
Where there are commissions, you can never be sure who is working for who.
Is the financial adviser working for the product provider who pays the commission, or the client?
Put simply, commissions encourage advisers, whether consciously or sub-consciously, to hold their own self-interest over and above that of their clients.
”In the race of life, always back self-interest – at least you know it’s trying”
Former Australian Prime Minister Paul Keating quoting his early mentor, Jack Lang
Commission lead to a poor alignment of interests between the client and the adviser.
If you want to be sure your adviser is working for you, you need to pay your adviser out of your own pocket.
Beware The Industries That Still Charge Commission
Beware some of the industries where commissions are still the norm:
- Stockbroking – they charge a percentage of the trade and this can lead to overtrading. Brokers also get paid a commission for new offerings of shares, whether that be an IPO or a capital raising.
- Mortgage broking – they get paid an upfront commission by the bank and an ongoing monthly commission based on the size of the loan
- Real estate – real estate agents still charge a percentage of the value of the property sold
- Property (new developments) – the going commission on the sale of a new property development is usually around 20%, in fact developers factor this commission in as a cost of selling their product.
2.Percentage of Assets Fee
In time, the needs of the average financial planning client matured from simply requiring a one off financial product, to requiring ongoing assistance with the management of their growing investment portfolios. Financial planners now viewed themselves more as investment advisers than product salesmen and decided to adopt a pricing model to match.
The prevailing model in the funds management industry is to charge a percentage of assets under management (AUM). It makes sense that the more you have invested with a fund manager, the more effort the funds are to manage, the higher fee you should be charged. Financial planners adopted this model, even though they didn’t actually make investment decisions, rather they recommended their clients invest in a range of managed funds.
In order to provide some value for the fees they were charging the financial planning industry developed adviser only wrap or investment platforms that enabled clients to easily invest in a range of managed funds and more importantly streamlined their administration and tax reporting requirements. This model remains the predominate fee model for financial advisers in Australia.
- The client pays the adviser via the investment platform
- The fees are automatically collected via the investment platform, meaning clients need to keep track of the total fee they are paying
- Difficult to measure the value your adviser is adding
- Clients with higher portfolio balances subsidize the fees of clients with smaller portfolio balances (all clients require some work by the adviser, but does a client with $1,000,000 equate to ten times more work for the adviser than a client with $100,000?)
- Encourages average outcomes – there is no incentive for the adviser to work harder for you
If we consider the alignment of interests, you are rewarding your adviser for doing a minimum amount of work and achieving an average result. There is no incentive for your adviser to go above and beyond because the fee you pay is relatively constant.
Consider that an adviser has far more to lose in trying to get you better performance, as opposed to simply following the status quo.
“Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.”
John Maynard Keynes
It is also very difficult to measure the added value that your adviser is providing you. In my experience most wrap / investment platforms have very basic investment performance reports, which means it is very difficult to track whether your adviser is actually adding value to your investments, or just charging a fee for the sake of it.
3. Fee for Service
Looking to the examples of the accounting and legal professions, financial advisers slowly moved into the realm of the fee for service pricing model.
Financial advisers now possess that professional and technical skills that they can actually add significant value to a client’s financial position through advice alone.
High level strategic financial advice is particularly valuable during the period when a client transitions from their working life, to their retirement life.
- The client pays the adviser directly for a set item of work
- The other pricing models available in the industry lead new clients to discount the value of fee for service advice
- New clients require the most work and hence a charged a large fee for the service, while the ongoing value of that service is hard to quantify
- Clients who need advice the most are often the ones who cannot afford it
- Encourages one off services, as opposed to ongoing services
- Upfront advice is generally not tax deductible, while ongoing advice generally is.
Fee for service sounds like the best model, but for many people it is not appropriate.
In an attempt to provide value for their service, advisers are aligned towards providing overly technical advice which is rarely implemented by the client.
It is very rare to find a client who is willing to pay $5,000 or more for a financial plan, when the outcome of the advice is different to quantify from the outset.
4. Performance Fees
The performance fee pricing model was initially offered by fund managers as a way of better aligning their interests with the interests of their clients. If a money manager was able to beat a pre-agreed performance hurdle, then they could charge an additional fee on this ‘outperformance’.
To protect clients from suffering if their manager underperformed for a period, a high-water mark was introduced which meant that a fund manager would have to first recoup any previous underperformance before a new performance fee could charged.
- A strong alignment of interests for clients interested investment performance
- What benchmark do you use to measure outperformance?
- Do you measure the value added before or after taxation?
- Difficult to levy performance fees on non-financial value added services
I like performance fees because it provides the best alignment of interest between a client looking for investment performance and an adviser who believes they can deliver it.
Unfortunately, this model will not be widely adopted because most financial advisers do not actually add much value to investment returns.
Most financial advisers add value to their client’s financial positions by encouraging good financial habits and this alone can add performance in the long term, however it is very difficult to quantify.
What Fee Is Best for Me?
The way your financial adviser charges fees is important because it determines how you will reward your adviser for the services they are offering you.
If you desire a specific outcome, make sure your adviser knows what that outcome is and ensure you align your adviser’s interests with your own using the pricing model that is most appropriate.
Here is a quick guide:
- I want to buy many different financial products, such as insurance and mortgages – consider a commission fee model
- I want to maintain my level of wealth and receive some strategic advice along the way – consider a percentage of funds under advice fee model
- I need strategic advice for a certain requirement such as my impending retirement – consider a fee for service model
- My goal is to achieve the best investment returns – consider a performance fee model
I believe the best financial adviser fee model is a combination of the abovementioned approaches, determined by taking into account the client’s individual situation and what they are looking to achieve from their financial adviser.
A good financial adviser will be open to having a robust discussion around their fees and should have the flexibility to develop a fee offering that provides the greatest alignment of interests between the client and the adviser.
If a financial adviser isn’t flexible when it comes to fees, walk out immediately as more often than not it means they are pretending to offer you individually tailored advice, when in fact their business is simply a one size fits all client model.
Remember the worst advice you will ever get is free advice. The best advice will be the advice you pay for directly, aligned to the outcome you desire as a client.
The Wealth Guy
M.TaxFP, LLB(Hons), B.Bus(Acc), FTI, Adv.DipFP, Dip.FP, SMSF Specialist
The information on this blog and website is of a general nature only. It does not take into account your individual financial situation, objectives or needs. You should consider your own financial position and requirements before making a decision. We recommend you consult a licensed financial adviser in order to assist you.