As the fee versus commission debate continues to simmer, Ray Griffin examines this age-old debate and explains why remuneration is ultimately in the hands of financial planning clients.
It’s been such a long time coming that you could almost overlook that initial and trailing commissions will be largely defunct within a couple of years.
The push for the abolition of commissions has been multi-faceted — from financial planners to accountants, consumer groups to industry observers — many parties have contributed to this progress.
However, there is never an idle moment in financial planning and the debate has now moved on to critiquing what constitutes a ‘true’ fee, and it looks set to be a drawn out debate as some attempt to gain the higher ground on billing methods.
The so-called fee purists will always argue that the only true fee is an hourly rate and that asset based fees are but commissions under another name.
How is it, such protagonists argue, that the time involved in managing a $1 million portfolio could be 10 times that of managing a $100,000 portfolio — if we assume a 1 per cent per annum management fee, for example? With some validity, they would correctly point out that there isn’t 10 times the work involved.
However, they would be overlooking the fact that there will be more investments — granted not 10 times more — in the larger portfolio and a commensurately higher level of management liability if recommendations were found to be negligent.
There will also be more client review meetings for the client with the larger portfolio and ongoing advice documents will take somewhat longer to prepare for that client.
The hourly rate advocates proffer that a client is only charged a fee when the firm’s attention is turned directly to the client’s matters.
It is, they argue, more equitable to their clients, however, in considering such claims, it really is important to look at how the hourly rate environment functions in other professions such as law and accounting.
In what is perhaps a portent to the eventual direction of the hourly rate fee debate in financial planning, in May of this year, the Honourable Wayne Martin, Chief Justice of Western Australia, presented a Law Week address titled: “Billable hours — past their use by date.” Interestingly, in reflecting on billing regimes when he first practiced Law, he noted:
“The amount of the bill would be determined by a process which, usually involved picking up the file in one hand to assess its weight, conjuring to mind an image of the client and their capacity to pay, and then assessing the benefit which the client received from the work done on his or her behalf, to arrive at a figure.”
In his address, Chief Justice Martin cited the so-called father of the billable hour, American lawyer Reginald Herber Smith, who in 1940, promoted the introduction of ‘billable hours’ in a series of articles titled Law Office Reorganisation.
However, Chief Justice Martin also noted that Smith’s view on how such a regime could be applied in practice was somewhat less clinical than we know it to be today. He pointed out Smith’s application of the theory:
“That is the cost. Maybe the bill will be more than that, if so, there is a profit. Maybe it will have to be less; if so, there is a loss. In practicing a profession, knowledge of the cost is a helpful guide towards arriving at a fair bill but it's not a determinant.”
Interestingly, the failings of the standard six-minute billing units are seemingly becoming de rigueur in Internet blogs by lawyers. Consider this purging blog entry from a disgruntled Australian lawyer:
“Six minute units do not promote efficiency … It was very easy for me to read a reasonably long e-mail in 30 seconds and quickly type up a reply.
However, my performance would be judged on how many units I could bill to a client: the more units the better.
So the fact that I was efficient was not good for my career, because someone who took 15 minutes to read and reply to an email could bill more than me.
That person’s figures would look better at the end of the month, and they would be more likely to get promoted than me.”
Recently The Economist weighed into the debate with a probing article on hourly rates in the legal profession. The article opened with: “Lawyers hate keeping track of their billable hours.
Clients hate them even more; each month they receive bills showing that their legal representatives have worked improbably long hours at incredibly high rates. Billing by the hour often fails to align lawyers’ interests with their clients’.
The same drivers exist for accountants and the fundamental failing of hourly rates is that they promote inefficiency.
By stark contrast, an asset-based fee promotes efficiency by virtue of the fact that the firm gets paid at the same rate no matter how long the task takes.
Sensible business practice suggests that this actually leads to efficiency via achieving more output with relatively stable resources.
Yes, the asset-based fee firm shares in clients’ successes as portfolios rise in value over time but equally they share in clients’ misfortunes when markets are unkind.
On this point, it is worth noting that long term returns in a typical balanced portfolio have been reverting to the mean in aftermath of the global financial crisis (GFC).
Indeed, seven year average rates of growth would be doing well, in a typical balanced, portfolio to top 4 per cent per annum.
The aberration of five or six years of pre GFC high portfolio growth has been gravitating back to what experienced financial planners have known to be the norm for a very long time.
As such, claims that financial planners unduly benefit through portfolio growth fail on deeper analysis.
The very essence of financial planning is intermediation; matching investors with the users of their capital has been a function of commercial enterprise for several thousand years and this is what financial planners do when recommending, implementing and managing investment portfolios.
Granted that some functions of a financial planner’s role are not related to investments, for most their primary function is related to capital investment and protection.
Indeed, this is not unique to financial planning and it is salient to note that the margin between the interest rate paid to a term deposit investor (the lender) and that charged by the intermediary to the borrower is an asset-based fee.
Indeed, this method of remuneration — the notion of compensation to the lender (asset-based interest) and the intermediary (asset-based fee margin) — has been the foundation of many forms of investment intermediation for hundreds of years.
And yet in thinking about the tone of argument proffered by those who promote the hourly rate billing method over asset-based fees, you could be forgiven for concluding that it is financial planners who invented the asset-based fee.
Ironically, hourly rate financial planners, accountants and lawyers the world over, profitable enough to be able to make a term deposit with say a bank, willingly allow their bank (the intermediary) to charge them an asset-based fee for the investment.
There are times when a financial planning firm will need to charge an hourly rate or a flat rate for a specific job for clients; a task that is, for example, unrelated to investment capital.
However to suggest that an hourly rate is at all times superior to asset based fees, for some elevated professional reason, is to conveniently overlook the deleterious aspects of hourly rates.
It is easy to mount an argument that someone paying $1,000 a year for the management of $100,000 is not paying the true costs of that service when considering the amortisation of the associated business operating costs across a client base.
That client is in effect being subsidised by larger portfolio clients.
So too can it be argued that very small deposit holders in banks and other deposit taking institutions are being subsidised by the interest rate (fee) margins being made from the larger account holders.
Similarly, low volume Internet-based share trading accounts are being subsidised by the higher volume traders.
In financial planning terms, to charge smaller portfolio clients the true cost of providing a service for a full year would be to disenfranchise many hundreds of thousands of investors — most simply could not afford to pay the hourly rate required to make the service commercially viable.
This ‘socialisation’ of cost apportionment is the standard for all money management functions in all economies and has been so for many hundreds of years and — save for a carve out for Australian margin lending portfolios – it will forever remain so.
While there will always be those who seek to stake claims to the contrary, the only issue which, is really at stake in Australian financial planning remuneration is that clients must have a full understanding, based on a comprehensible disclosure regime, of what their costs are going to be and how those charges will be applied over time.
It really is disingenuous to attempt to mount an argument that hourly rate fees are somehow professionally superior to asset-based fees for all stakeholders.
Such a billing method is patently vulnerable to abuse and can unofficially promote an across-the-firm environment of inefficiency so that profits can be enhanced and careers advanced on the basis of billings.
Let those who chose to do so, operate on hourly rates and yet not condemn those who choose to levy their fees.
Both groups should note however, that the ultimate choice is that of the client who will be the final arbiter of value for money regardless of billing methods.
