Fee for no service

While up-front commissions are facing virtual extinction, trail commissions continue to form the backbone of the revenue streams of most financial planners. Some in the industry believe this model is unsustainable. Rob Keavney presents his case for direct billing of clients.

A large number of clients of the financial planning industry are paying every year for service they are not receiving. They will continue to do so indefinitely - unless they become educated.

One of the challenges for financial planners is whether we are prepared to provide this education. This will depend on the extent to which we are willing to align our interests with our clients'.

There have been two dominant trends in managed funds' fees over the past two decades. Consumers and the media have focused on entry fees and initial commissions and driven them down while financial planners and fund managers have focused on trail commissions and driven them up.

While entry fees have declined from around 8 per cent in the mid 1980s to zero in many cases today, MERs have not declined to anything like the same extent. In fact, the table below shows that the average MER of a number of leading Australian equity trusts (Advance Imputation Fund, Rothschild Australian Equity Trust, BT Imputation Fund and the Colonial First State Imputation Fund) has only declined by 20.4 per cent (from 2.37 per cent to 1.89 per cent) over the past nine years.

However, this disguises the reality that the MER of a typical managed fund contains two elements: the cost of running the investment plus a margin added in order to pay ongoing revenue to advisers. The average rate of trail commission of the equity funds in the table is 0.43 per cent. Without this, their MERs would average 1.46 per cent, that is their costs are 29.5 per cent higher than is required to manage the funds in order to pay advisers. With a typical master trust the margin can be even higher.

Without question, there is nothing more important for the financial planning industry than building an ongoing revenue stream. If we are providing ongoing service to clients, and many of us most certainly are, we must be paid for this. If we are to build businesses of real value then we must have recurrent earnings.

While not accepting the view that the act of receiving an ongoing commission makes advisers unethical, it is regrettable that a large proportion of our industry has felt it necessary to secure ongoing payment whether it provides service or not - which is the key difference between trail commission and directly billing clients for ongoing service.

Is trail commission a payment for service to clients or is it remuneration from product providers for procuring and maintaining their funds under advice?

The revenue is paid by institutions. Thus, if it is payment for ongoing service to clients, we must recognise that we are in a unique and barely credible position. We are professionals paid by one party for providing service to another.

Why would a third party pay for this?

Trail commission clearly is not payment for service to clients because its payment is not conditional upon the client being satisfied with the service. Indeed, the fund manager who pays it has no idea what quality of service is being provided to the client or, indeed, if any is provided at all. In fact, they pay it to discount houses who specifically exclude ongoing service!

Failing a specific written instruction from a client to cease to pay it, trail commission continues in perpetuity, so long as the real so-called "service" for which it is paid continues to be provided - the retention of funds under advice in the hands of the institution.

As the bulk of investments placed by planners today is through master trusts. These institutions may be providers of administrative services rather than funds management services, but that doesn't change the fundamentals.

The ongoing revenue of most financial planners is paid for the procurement and maintenance of funds under administration (master trusts) or funds under management (retail managed funds), rather than the provision of service to clients.

Yet very many advisers truly feel that their first responsibility is to clients rather than to administration services or to fund managers. Those in this group, in my opinion, ought to adopt a business model consistent with this view, that is we should bill our clients directly.

I believe that the primary reason that trail commission has become the dominant form of recurrent earnings, rather than direct and transparent fees from clients, is its lower level of visibility. It is subject to a much reduced level of disclosure.

As evidence of this, consider whether most advisers would resist a move by fund managers to disclose the impact of trail payments in every income distribution. It would not be difficult to create statements to accompany income distributions in the following format:

Your income entitlement $X

Minus your adviser's or discount

broker's payment-$Y

Your net income$Z

This would be an accurate reflection of reality and is certainly information a client is entitled to have disclosed. This is the form of disclosure that direct billing bears.

If we believe we provide value for money for this income, and that our clients recognise this, we would have no reservations about statements taking this form. If we don't believe this, are we entitled to receive the income? This is especially true given the growing number of fund managers with the capacity to rebate it to clients as extra units. Is the old position that the client won't benefit if it is relinquished, becoming outdated?

Advisers who feel uncomfortable with the above form of trail disclosure may be tacitly acknowledging that their clients are incurring an unnecessarily high MER on their funds in order that the adviser can earn an income which the client might actually prefer not to pay for.

The parties who would be most pressured by this disclosure would be the discount houses and many of the Internet-based securities transaction services who deal in managed funds. The business model these follow is to build up large trail income streams for no initial advice and zero ongoing work or liability.

Advisers often express frustration that these entities receive the same recurrent income as advisers. Yet, if planners billed directly and trail was disclosed as suggested above, advisers who provided service could maintain their businesses but discount houses could not.

Today, the pure income yield on diversified portfolios is probably around 5 per cent. In aggregate, the intermediaries (advisers, administrators and fund managers) are generally costing more than half of this.

This means that a client with a million dollars is earning income of around $50,000, of which the majority is going to someone else. This net income is unacceptably low. This has not been an issue to date because portfolios have produced such strong capital gains distributed as income by managed funds that the unsustainable reality of our industry's economics has not hit home.

Over the ten years to 30 September 2000, the average return from the All Ordinaries Accumulation Index, the MSCI World Index, the ASX Property Trust Index, the Commonwealth Ten Year Government Bond Index, and the Salomon Bros World Government Bond Index was 13.9 per cent. Over this time, inflation was 2.4 per cent.

Thus, any randomly diversified portfolio could have produced a real return of around 11.5 per cent over the decade. We might wish for this to continue in perpetuity as a child approaching adolescence might wish that there really was a Santa Claus.

However, it would be risky for us to base our businesses on this impossible hope. The next period of flat market growth will certainly cause a scrutiny on costs.

Too many clients are in administration or funds management products with chronically high cost structures because advisers have not been able to come to grips with the need to provide efficient low cost reporting, efficient low cost asset management, and to bill directly for services (in order to avoid uncertainty, I do not suggest this billing should be for time rather than as an ongoing percentage of funds).

Yet it is ironic that many planners have wedded their businesses to revenue from funds management or administration institutions as this entrenches an industry structure which allocates planners an inadequate slice of the pie.

Advisers who provide high quality service should earn more than either a fund manager or an administrator. Yet they have widely recommended either:

? High MER Retail managed funds which pay only 0.25 to 0.5 per cent trail revenue, an amount which is inadequate to allow the profitable provision of high quality, personalised service; or

? High cost Master Trusts, which have been able to retain as much as 1% merely for administration.

The fear that clients will not pay fees is contradicted by the experience of those advisers who have tried it, assuming they are providing ongoing service.

Some dealers resist direct billing on the grounds that it is more efficient to collect ongoing revenue as trail rather than billing clients. Speaking as a dealer who has done both, it is far simpler to collect a quarterly or six monthly fee from a client than to gather the same income from the monthly commission statements of a dozen fund managers. Ironically, they also claim that rebating of trail is too administratively difficult.

If dealers are able to collect trail and allocate it to the relevant advisers, the same mechanism can be used to rebate it to clients. One has to know which client it relates to in order to know which adviser to pay. Without doubt, this takes some investment in systems, but it is disingenuous to pretend that this is the dominant reason for not adopting a direct billing approach.

I have seen the average entry fee on a managed fund evaporate from 8 per cent in the mid 1980s to far less today, and perhaps nothing on most funds in the future.

The consumer focus is now turning to ongoing costs, the biggest expense over the investment lifetime of a client. This will be a powerful force. According to Salomon Smith Barney, US retail MERs usually are between 0.9 per cent and 1.2 per cent. In Australia, they are double this.

Businesses which align with, rather than resist, strong market forces usually find themselves with a competitive edge in the long term. Moving to direct billing, and consequently being able to select low cost product, is as much about building a sound business as it is about offering greater transparency of payments to clients.

<B>Table 1: MERs

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