How financial planners can implement a fee-for-service model

Many financial planners today face having to adopt a fee-for-service model. Much more is being written on the need for this than on how to implement it in practice. Robert Keavney offers suggestions about managing this transition. 

Three things are necessary for planners to successfully begin the transition to fees:

1. You need to have stopped fighting the inevitable and begun to face the need for change;
2. You must actually provide a service worth paying for; and
3. Your explanation to clients of the change to your business must be based on the truth.

Step 1: Facing reality

The first element is obvious. Beyond 2012 commission will be banned. Commission planners have two years to fundamentally restructure their businesses, or get out of the industry.

Some are wasting this time protesting the decision of regulators and wishing that the problem would go away.

This is the 'I’ll hold my breath until I turn blue' school of strategic planning. The first step to ensuring your business survives is to face the reality of the new landscape and begin to plan for it.

Step 2: Providing a valuable service

I first argued the case for fees in Money Management in 1991, a year after introducing fees to the dealer I then ran.

After two decades of talking to planners on this topic, I am certain that the biggest resistance to fees is psychological. Some planners don’t really understand what clients value.

This is partly because working on commission inculcates two attitudes: advisers deserve to be paid more for recommending growth assets than cash; and they deserve to be paid when an investment transaction is implemented (ie, a commission paying product is bought).

These concepts reflect a misunderstanding of clients’ valuation of a quality planner.

Planners don’t just sell commission products for a living, they guide people through a complex and sometimes frightening financial and investment world.

This touches deep insecurities for many people — fears of being without financial security, fears of making a stupid mistake and regretting it all their lives, fears of being taken advantage of and feeling a fool, and so on.

If planners produce successful outcomes, their clients are indifferent to whether they were achieved using growth assets or income assets.

Nor do they care whether frequent or rare transactions were undertaken. As an example, in 2007 the best recommendation would have been to increase cash holdings.

Advisers who had done so would feel they had delivered real value to clients. Clients would feel well served. Yet commission advisers would have reduced their income by recommending cash rather than growth assets. This is inappropriate for both the client and the adviser.

The reason planners have been paid when they recommended growth assets is that this is of value to fund managers that pay commission. Consequently, it is of value to commission planners as their source of income. However, this does not mean that this is how clients value service.

A portion of advisers do not provide a valuable service. Some advice has been designed to maximise commission, including building a passive trail book for which no real service has been provided beyond intermittent churning.

It will not be possible to survive under the new rules with such an approach. The industry and its clients will be better for the disappearance of those who operate this way.

Service for a fee

Fee-for-service should really be thought of as service for a fee. Planners should begin by assessing what services they actually provide. Any planner who can’t give a robust answer to the question ‘what value do you provide for clients?’ will have a problem in asking clients for fees.

Under fees, your service offering should be set out in a contract, in plain English. Certainly services should include regularly scheduled portfolio review meetings, with systematic rebalancing taking into account the tax position of each individual/entity.

Certainly commission should be rebated under a fee system, at least while commission lasts.

Your obligations must be described in specific, measurable terms (eg, two reviews per year or a quarterly newsletter).

Avoid vague, nice sounding phrases like ‘we will monitor your investment and ensure your portfolio is appropriate for all market conditions'.

What is ‘appropriate’ is a matter of opinion and sometimes can only be known in hindsight, so how could you prove in court that you fulfilled this commitment?

Be explicit what assets, and what elements of your clients’ financial life, your responsibility is limited to. This clarity will help defend against any possible claims for, say, not having advised that the client’s health or car insurance were inappropriate; or that their holiday home was a poor investment, if this is outside your brief.

Be very careful about benchmarking or indicating future investment returns in the contract. An event out of your control like the global financial crisis, which generated negative returns for several years, could produce an outcome below even modest return expectations.

This brings us to the question of fees. The most important element is determining an appropriate level of ongoing fees. Of course, there will need to be initial fees for developing the strategy and implementing the portfolio.

Planners can determine what they wish to charge for each client. The level of initial fees can be refined with successive clients, based on experience.

However, ongoing fees are contractually established in advance and are not easy to subsequently adjust. If ongoing fees are set too low it will be a major problem. In my experience, most planners who provide quality ongoing service set their fees too low at the first attempt.

High quality ongoing service requires a sustainable business model. If service is loss-making, a constant flow of profitable new clients is required to subsidise existing clients.

However, as client bases grow, compounding servicing obligations take increasing time, leaving less for prospecting. More support staff won’t solve this if revenue does not fund salaries.

Therefore, if promises of high quality, tailored, ongoing service are to be kept, fees need to be adequate to sustain it. Of course, the lower the level of service, the lower the cost — allowing for market segmentation.

Portfolio reporting, billing and commission rebating systems are necessary. It is business suicide to promise a level of service that your administration cannot support. It is reasonable to expect dealers and/or platforms to provide this infrastructure.

If they don’t, you should review your current relationships from the point of view of supporting a fee based business.

Clearly no single fee methodology is best for all clients and all services. Asset based fees can be appropriate for the investment advice element of planners’ services, as there is a justice in advisers’ income fluctuating with their clients’ welfare.

Asset based fees must apply equally to all assets, including cash. If you don’t charge on cash you will have preserved some of the inappropriate elements of commission.

The regulators have been wise in banning asset based fees on gearing, though this doesn’t fully eliminate the conflict of interest around recommending gearing.

No matter how fees are charged, planners can be tempted towards recommending gearing in order to levy them.

There have been planners, including some on fees, who have been heavily flogging gearing in recent years, where a prospective client has no assets to invest.

What do you give to the prospect who has nothing? Debt apparently, according to the recommendations of certain planners.

Clearly asset-based fees are not appropriate where the adviser’s value add is in non-portfolio matters.

Flat fees or retainers will also prove appropriate for many clients or services.

However, it is important to make clear what the retainer is for. If a retainer is charged 'for the relationship', it is hard to see how the adviser can avoid a liability for anything financial that the client may do.

Some believe that the only ‘professional’ method of charging is for time, though I have never heard a good argument for it.

However, there are occasions where planners should charge by the hour. Time-based fees can only apply for reactive work (ie, instructed by the client). Yet much of the work of a good planner is proactive.

Whatever fee structure is adopted, the level of fees or the basis for calculating them must be known in advance so they can be deducted from client accounts when due.

Without this, planners will find themselves chasing payments receivable and writing off bad debts — problems from which planners have historically been largely free.

Communicating with clients

Commission planners face the need to explain a fundamental change in their relationship with their clients. As always, the most convincing message is the truth.

When we introduced fees in 1990, it was before the existence of trail commission. We acknowledged to clients that we had said we’d look after them ongoing, and had tried to do so, but we had come to realise that it was not sustainable.

As our client base had grown, an increasing amount of time was required to provide this service. Yet we needed to maintain a level of sales to generate revenue.

It had become clear that, over time, the level of service would have to decline in order for us to produce the revenue to survive.

We therefore needed to charge clients fees going forward if we were to service them.

We gave a fee holiday to clients who had just joined us, from whom we have recently received an upfront commission, and provided the service at no cost for two years before charging those clients.

It was possible to deliver this message with conviction because it was true. Because we were straight, and our clients valued our service, we had a tiny attrition rate.

Whatever has brought you to move to fees will be the best possible explanation for the change in your business. This will vary for each adviser.

Perhaps, the global financial crisis led you to realise that it was inappropriate to be paid more for growth assets than for cash investments, as it would damage your business revenue to recommend conservatism.

Or it could be that you have found it distasteful to have to reassure every client that commission differences did not override your desire to provide quality advice, so you have decided to move to fees to eliminate any possible grounds for suspicion about your motives.

Or it could be that you have felt quite comfortable working on commission, which was mainstream industry practice.

However, the regulators are requiring a change. While you don’t agree with it, of course you must comply with it.

Therefore, if you are to continue to look after your clients, you have no choice other than to charge them fees.

If you are presenting the genuine reasons for making a change, you will be able to speak with conviction.

The truth is that the worst outcome for clients is poor ongoing service (ie, being abandoned after their investments have been placed).

This fact can give you the confidence to look clients in the eye and explain it truly is in their best interests to pay for and receive quality ongoing service.

As noted above, you may wish to give some clients a fee holiday, during which you can demonstrate the value of your service.

However, beyond this time, you need to be firm with yourself and your clients. They cannot remain clients if they are unwilling to pay for your service.

This change should be undertaken as soon as possible. Until 2012, you will be able to rebate trail commission to offset your fees.

This gives you a couple of years to demonstrate the value of your service at little cost to clients.

You can explain to clients that this rebate applies until 2012.

Thereafter, investment products will become cheaper, as their management expense ratio will fall by the amount of trail commission they paid previously.

Alternately, you may be able to move clients into wholesale funds when you are no longer reliant on commission. This will save clients the best part of 1 per cent, which will surely cover the fees of most planners.

It is quite legitimate to compare the total costs the client paid under the old arrangement (ie, a retail management fee) versus their total cost under the new arrangements (ie, a wholesale management fee plus your fees). In many such cases, clients will pay no more under the fee structure.

A stronger business

Planners who successfully transition their business to a fee basis will find it substantially strengthened. Many advisers won’t make the change.

The industry will experience the most significant contraction of competition it is ever likely to undergo.

Those who survive have a strong possibility of growing their market share.

You will have also escaped from the fundamental business flaw that has made commission businesses so vulnerable to these regulatory changes: it is unsound to provide service to clients but be paid by a third party.

Both you and the client may be satisfied with the arrangement, but the third party, fund managers, can alter your income — and are now required by legislation to do just that.

Further, you will be less impacted by periods where fewer people are willing to invest, such as during market downturns, as you will have recurrent revenue from existing clients.

This will strengthen your ability to smooth out the impact of market cycles on your revenue, especially where fees are not solely asset based.

Fee based advisers are also freed from the internal conflicts that beset some commission based advisers. There are no grounds for biased product selection.

There is no need to pretend that wholesale versions of products don’t exist.

Problems with fees

There are some businesses that may not be able to move onto fees.

Businesses with income from the superannuation assets of lots of small portfolios — belonging to fund members who they have never met — will struggle to find any way to charge those members directly.

I have written before that the future for corporate superannuation advisers may be to charge employers for their service.

Certainly there are particular difficulties faced by superannuation advisers in going to fees.

There can also be problems with classifying clients into A, B, and C. If all are paying fees, but at differential levels, do C clients know that they will receive third-class service for their fees?

The reality is that lower category clients are more likely to be neglected and therefore may be more likely to make a claim.

There are potential problems in defending such a claim if the client was not aware that they were not paying for top-level service.

Just do it

If planners don’t transition their businesses to fees, they will have to leave the industry by 2012. This is a strong motivation to change.

The experience of many individuals who have gone down this route is very encouraging. Yet many planners are wasting the limited window for change.

If you wish to extend your career beyond 2012, you need to begin to chart your course to a new business model as soon as possible.

Robert Keavney became a financial planner in 1982, and has played many roles since then. He still believes financial planning can be called an honourable profession.