Why Flat Fee or Service Led Advice Fees Represent Greater Value, More Money in Your Pocket and Better Long-Term Investment Outcomes
The current wealth management and advisory space is dominated by the assets under management ‘fee’ model. In many cases this doesn’t represent value in terms of outcomes achieved and services delivered. It inevitably means you have a cross-subsidisation effect where often the wealthy pay too much in ‘fees’ and those that don’t have a large enough investable asset base either receive no or poor advice – and/or are led into financial and investment products with high ‘fees’ and commissions. Reimagining the advice proposition that charges fees tied to the actual quality of advice and level of ongoing service provided is the only fair and transparent outcome not littered with conflicts of interest.
The Existing Landscape
The current advice-led business model that is predominant in the financial advisory and wealth management industry today is the ‘assets under management’ model. As an investor that means you pay a percentage of the sum you have invested with an advisor or firm on an ongoing basis.
That typically ranges between 0.50% p.a. – 1.00% p.a. (excl. VAT). So, for example if you have a R1 million invested with a firm and they are charging you an advice ‘fee’ of 1% p.a. – they are earning R10,000 p.a. and that is paid from the underlying investment provider to your advisor or firm providing the advice, typically on a monthly basis and dependant on the actual value of your portfolio at that point in time. If markets go up and the value of your investment is up, they receive proportionately more. On the other hand, if markets are down, they receive proportionately less.
Some firms will also charge an initial fee to cover the cost of the time spent to provide the initial advice that led to a particular transaction taking place. This is typically between 1% – 3% (excl. VAT) and is a once-off fee levied for the time and expertise provided that led to the purchase of that particular financial product.
So, on that same R1 million investment example, if you were charged 1% as an initial fee to cover the cost of the advice provided you would pay R10,000 (typically deducted from the amount invested so R990,000 is invested) – and the ongoing ‘fee’ would be the 1% p.a. levied to continue looking after you as client, i.e. making sure the investment performs as expected, continues to reflect you risk tolerance, goals etc.
A Question of Fairness and Transparency
So, what’s the problem?
In fairness as regulations have evolved around many parts of the world this is a huge improvement on where we have come from not that long ago where products had high upfront commissions built into them with various early termination penalties – and only led to the enrichment of the advisor and company that created the financial product (typically life assurance companies) – because the hurdles for achieving good investment returns were next to impossible to overcome with all the commissions that first had to be recouped.
We digress. Coming back to the example of the R1 million client being charged 1% p.a. or R10,000 p.a. What ongoing advice or work is a client receiving for that ongoing ‘fee.’ An annual review? Quarterly reviews? What other work might the advisor be doing for a client that is being indirectly paid for out of that R10,000 p.a.?
There is often no service agreement that explicitly details the ongoing services you will receive for the ongoing advisor fee that is paid, other than an implied understanding that the advisor (or firm) is supposed to be looking after your investment (s).
Unless of course you have a need for another financial product – in this case it might be some risk cover because you need life cover for estate planning purposes for example, in which case a new set of commissions will be generated as a result of that.
The result is that this entire system is dependent on the sale of financial products to keep the wheels turning and any advice provided is often simply a mechanism to point out that some kind of financial product needs to be purchased.
If that’s the model on which the system is built, how can advise ever be regarded as truly impartial and not have any conflicts of interest? Surely, the purchase of any financial product should be the consequence of a comprehensive and impartial advice process, where the right advice and the best advice could simply be to do nothing, repay debt or invest in something else (e.g., property) – none of which generate revenue for the advisor and could mean a reluctance to discuss, let alone recommend any such course of action.
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Now consider, another client. She has saved diligently her entire life and is about to retire with a retirement pot of R10 million. Because her investable assets might be regarded as more than most, she has more negotiating power and will probably find an advisor or firm willing to charge her a lower ongoing fee than the average, say 0.50% p.a. – and who will probably forego an initial fee too, considering the size of the amount to be invested.
That means the advisor/firm earns R50,000 p.a. from this client (assuming no change in the investment value). Again, the question becomes, what ongoing service and advice will she receive that warrants the R50,000 p.a. in ongoing fees?
There might actually be a lot of ongoing work she needs that justifies paying that as an ongoing fee. Provided that there is a clear correlation between serviced rendered and what is paid, the actual quantum of the fee paid is irrelevant.
But if all she is getting is a review or two a year with a portfolio statement that is sent to her quarterly or bi-annually … it probably doesn’t pass the ‘sniff’ test.
A client should intuitively be able to ascertain how much time they roughly have spent on them in term of actual face time and other ongoing services (investment review meetings, estate planning etc.), perhaps a bit of admin that needs to be done on their behalf, compliance, and a reasonable profit margin that a firm can add on top to account for operational costs etc.
So, if she works out that by her estimation, she is lucky if she gets 5 hours of time and resources allocated to her on an annual basis – she is effectively paying R10,000 per hour.
That’s quite the rate and explains why asset management and business models that depend on the AUM approach to generating revenue are so profitable once economies of scale have been reached and why the wheels that oil the financial services industry at large can be so profitable for so many different stakeholders in the value chain.
The question then becomes on the assets under management model – what is the appropriate fee to pay and how exactly does that correlate to the level of ongoing services provided?
And what about someone else – perhaps someone younger without a large amount of investment capital to invest, who then gets ‘guided’ towards the purchase of financial products that have higher built-in commissions that offer very little flexibility (and often lead to terrible outcomes), for a firm to feel they are being compensated for the time they spend with that person.
Cross-Subsidisation and its Effects
There is often very little difference in terms of an advice process followed and ongoing service provided for wealthier clients (or those at least that have larger capital sums to invest), compared to those that are perhaps a little younger and haven’t yet accumulated a sizeable investable asset base.
Yet the fee each client is paying varies significantly and is purely a function of the amount of money they have available to invest.
Younger investors that seek quality and specialised advice might therefore struggle to obtain it, because they don’t have big lump sums to invest yet. Or the advice they receive is purely transactional and can lead to products with higher commissions being sold to them that might not be in their best interests and lead to poor outcomes.
At the other end of the scale, those with large investment amounts, can end up paying too much for the actual advice and ongoing service provided if it’s clear that the ongoing services provided don’t correlate to the quantum of fee paid.
That is why there is such a clamour by firms targeting ‘high net worth’ individuals as clients because it is such a lucrative and profitable segment.
Definitions of high net worth vary but in many cases it’s an investable asset base of over USD 1 million. For most international private banks today, you need to have above USD 5 million in investable assets to qualify for an account and their wealth management and related services.
So, imagine you’re a high-net-worth investor with R20 million invested with a private bank or similar institution (this is just an arbitrary number). With the bigger, global institutions you’re probably paying closer to 1% p.a. than 0.5% p.a. for the privilege of having that account and someone looking after you and your investment portfolio. Is paying R200,000 p.a. really justified for the level of the ongoing advice you are being provided with?
Separating investment performance from advice
When markets are going up and you see the value of your investments increasing, you probably don’t pay too much attention to the different fees you are paying and how those are levied. It’s very different in bear markets and when portfolio values are falling, and you begin to question what all those fees are for and to what end?
That’s why it’s also important to distinguish who does what in the value chain and where accountability actually lies.
A wealth manager or advisor is responsible for understanding you, your needs, your risk tolerance, and appropriate asset allocation etc. They will then recommend a suitable investment portfolio for you which can be constructed in various ways, e.g. using actively managed funds, ETFs, direct shares or securities, discretionary managers etc.
But they are not actually responsible for how those investments perform. That is a function of markets more broadly (are we in a bear market or bull market) and the skill of the chosen portfolio managers actually making the day-day investment decisions.
Which begs the question – why do individuals and firms whose value is derived from the advice they provide (and not the performance or lack thereof of the investments they happen to recommend) generate a large proportion of their income from a function they have no control over?
It’s a great business model once a certain level of scale is reached – recurring ‘fees’ linked to investment values, which over time as a function of markets more broadly tend to deliver positive returns anyway – and with very little skill needed to participate in those returns if a simple ETF or index fund were chosen.
It All Adds Up
Investors have become more educated and aware of the impact fees have on their ultimate investment performance over the long term, especially as ETFs and low-cost index funds have begun to enter the mainstream over the last decade.
Once you add it all up, for every Rand invested in a typical scenario
- 1.5% goes to the fund manager (in an actively managed fund)
- 0.4% goes the platform or LISP for administration fees
- 0.5% – 1% goes to the advisor for the ongoing advice
That doesn’t even include fees when using DFMs and trading costs.
A 2.5% all incl. fee is probably not far off the average you’re paying for every Rand invested to satisfy all the stakeholders in the value chain. Do the maths on that and see over a 30–40-year period how much less of your hard-earned invested capital you end up with.
As it happens, we’ve done it for you. On a R1 million investment, over 30 years that means R3.5 million less in your pocket by paying 1% p.a. less in investment related charges (assuming a 10% p.a. investment return).
We’re certainly not advocating for no fees. That puts us out of a job. And isn’t realistic. There is no such thing as a free lunch. And the adage ‘you get what you pay for’ is certainly also true. It’s simply a question of what is fair and proportionate. (This isn’t a debate on whether active vs. passive is better either. We’ll save that for a separate article. But FYI we believe both have their place).
Understanding the different layers of charges across the value chain also allow you to make more informed decisions and ensure you are able to get your money working harder for you and achieve your lifestyle and financial goals far quicker than you would otherwise.
Imagine you’re a professional millennial. You work in job that is demanding and keeps you busy. You earn well and know that getting on top of your finances and having a clear strategy towards achieving financial freedom is important – but you just haven’t gotten around to it yet.
You may belong to a company pension fund or be making some sort of or investment towards retirement. You don’t know however what this will get you, whether its enough and ultimately if your dreams of achieving financial independence are realistic.
Moreover, you may have a mortgage you’re paying off which accounts for a lot of your disposable income, or you’re wanting to get onto the property ladder.
If you have children, you also have to think about providing for them, ensuring they have the best possible education and making sure if anything happens to you, they will be okay.
You may also not yet have a particularly large investable asset base, but you have disposable income you want to be able to put to work towards achieving your lifestyle and financial goals.
As a millennial, you don’t want to deal with your parent’s financial advisor because they probably don’t get you or understand what you need. And because you’re still building your investable asset base, you may find advisors you have engaged with are more concerned about the financial products they can sell you in order to maximise the commission they can earn – which may or may not be in your best interests or what you actually want or need.
Instead imagine paying a monthly service fee (much like an ongoing subscription) where you pay for an ongoing set of services that are customised to helping you achieve your financial and lifestyle goals. Where you know someone is always acting in your best interests and not always trying to sell you a new or different product so that they can earn a commission.
And if you find you no longer need the service, you can simply cancel at any time and at no cost or penalty. Wouldn’t that be a fairer and more transparent model which delivers demonstrable value?
Fundamentally, everyone wants to achieve financial security and freedom at some point. But the journey towards achieving that is different for everyone.
Avoiding costly mistakes and having someone to help us navigate that journey and that we know is acting in our best interests can go a long way to getting us there.
And understanding what we are paying, why we are paying for it, and what we get in return for services across the value chain when it comes to spending and investing our hard-earned cash, mean we load the probabilities of success in our favour.
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