The Messenger: Are you charging what you’re worth?

All fee methods have strengths and weaknesses. However, let me begin (briefly) with fees versus commissions, particularly the claim that a percentage of an asset’s fee is the same as a commission.

If planners charge, say, a one per cent entry fee to join their service, which is not charged again no matter how often the portfolio is changed, it eliminates both bias and the temptation to churn, in fact and in a client’s perception. Ongoing fees again eliminate bias. Trail commissions can vary from nothing to one per cent.

Charging fees on a sliding scale, which discount with larger assets, avoids the anomaly of trail with the client, with $2 million paying 10 times as much as one with $200,000.

More fundamentally, fees are paid for service, and only for as long as clients are willing. If they terminate the relationship, it terminates the adviser’s income. Trail commission is paid whether service is provided or not, a reason why some low-service advisers may prefer commission.

Commission is unfair to both clients and advisers. A planner who recognised the height of the market, and recommended cash over equities in 2000, would have earned no initial commission and minimal trail subsequently. What rationale can there be for this superior advice receiving a lower reward?

There is also a substantial difference in disclosure. Ongoing fees are repeatedly and visibly disclosed every time the client receives a statement. There are many dissatisfied clients whose terminated adviser still receives trail only because the client is not reminded of it.

I openly acknowledge that some commission-based advisers strive to provide superior service, and some fee-based advisers do not. My point is that those advisers who do aspire to this should have their revenue clearly aligned with clients’ interests.

Consumer, media and regulatory scrutiny of the commission system will grow inexorably. It is poor strategy to position oneself to bear the brunt of this.

There are many possible bases for charging ongoing fees, none of which is perfect.

An asset-based fee system is transparent and easy to explain. It aligns client portfolio values with adviser income. This does result in revenue inevitably declining during a significant market downturn. However, this gives advisers a strong incentive to create portfolios that don’t experience major capital declines. In my view, this is no bad thing.

Asset-based fees do not remove all conflicts of interest — for example, they reward gearing recommendations and punish debt reduction. They are not appropriate where the adviser’s value add is in non-portfolio matters.

Performance fees can further align advisers’ revenue with portfolio results.

However, these also have drawbacks. When the entire fee system is performance-based it may encourage excessive investment conservatism. Should portfolios do badly for 12 months, resulting in zero business revenue, most planners would go out of business — a risk that could not be tolerated.

Conversely, if the performance element is a small component of the fee structure it could encourage advisers to take substantial investment risks. It is virtually a free option to be able to take a share of the profits from someone else’s investing, if you don’t have to fund any of the losses.

Both funds under advice (FUA) and performance-based fees clearly limit the assets planners are liable for — that is, those subject to the fee calculation. By contrast, if a retainer of a fixed amount is charged ‘for the relationship’ it’s hard to see how the adviser can avoid a liability for everything that the client may do financially.

However, retainer arrangements overcome some of the weaknesses of asset-based systems by breaking the nexus between assets and planner income.

This is important both with smaller clients and at the high-net-worth end of the market. We recently advised a client with a $40 million net worth, where most assets were tied up in shares in a listed company of which he is an executive. The advice required was complex, and added material value, independent of whether we invested any funds.

Fixed retainers, at first glance, appear professional and objective. However, they can be subject to abuses. What is the basis for selecting the level of retainer? It is surely inappropriate to simply charge an arbitrary amount, being the largest that it is believed each client would pay. How do you explain your fees to a prospect?

Some believe that the only ‘professional’ method of charging is for time, based on the illusion that accountants and lawyers operate this way. Those professions do keep time sheets, however, their revenue often varies from this. Many have profitable retainer-based relationships with large corporate clients. Most frequently write off hours because the fee is recognised as excessive. The act of keeping the time sheet itself is costly.

While a time base is reasonable for certain services, it is inappropriate as the foundation for a planner’s business. Time is not the only measure that is relevant to our work. Is an hour filling in a government pension form as valuable for the client as an hour of reasonable benefits limit (RBL) advice that cuts tax liabilities by $20,000?

Time-based fees reward most those who take longest to do a job. Further, the primary means to increase income is to work longer hours. This phenomenon drives the excessive burnout rate among young lawyers.

The main philosophical problem with time-based fees is that they can only be charged for reactive work. Accountants and lawyers generally are reactive to client initiation, for example, a property settlement, a divorce, and so on. Clients would be concerned if lawyers, unilaterally, decided to look at some issue and ran up a fee without forewarning.

By contrast, much adviser work should be proactive.

Finally, time-based fees can only be billed in arrears, and therefore are subject to bad debts. Both retainer and FUA-based fees can be collected periodically in advance and consequently are free of bad debt problems.

Clearly, no single fee methodology is best for all clients and all services. Any fee schedule should be assessed taking into account a number of factors, including: elimination of bias; transparency; ease of explanation; ease of calculation and collection; value add; workload; potential liabilities and bad debts; avoiding arbitrariness; and predictability for budgeting.

The classic mistake made by most advisers who move to fees is to set pricing too low to profitably provide high quality service. (Incidentally, standard rates of trail commission are insufficient for this.) Equally, we need to be aware of growing market pressure. With typical portfolio income yields of less than five per cent, the days of fat margins for advisers are numbered.

Most planners who have moved to fees believe it creates a significant change in culture. Why is the industry so slow to abandon commission? It is administratively simple to have funds regularly transferred from a client’s cash account on a pre-agreed basis, despite some claims to the contrary.

The key determinant of the willingness to charge fees is planners’ confidence that they provide value for money.

First-rate advisers provide a service of immense value. The majority of individuals who have acquired a substantial lump sum are mature enough to know there is no free lunch in this world. We therefore need not adopt a business model that pretends there is.

Our long experience confirms that transparency and objectivity are very strong sales propositions. When we discover we are competing with a commission-based adviser, our confidence soars. We ask prospective clients whether or not they prefer to see clearly what they pay us ongoing and whether they would like to stop paying us if they ever fire us.

Guess which they prefer? Which would you, if you were a client?