The debate has to do with fees. Fees that financial planners, financial advisers, and wealth/investment managers charge for their professional services.
While it’s critical to understand the fees you’re paying for a professional service and be able to compare them to the value you’re receiving, the debate can no longer be considered healthy discourse. It’s toxic and it’s starting to push young people away from the industry.
How Financial Advisors Are Paid
Financial professionals call themselves all sorts of things: financial advisers, financial planners, wealth managers, investment advisers, and a whole bunch of others. While they all might do slightly different things, their general intention is the same: to help their clients reach a better financial destination. Investment managers might do that through discretionary management of your investment accounts. Financial planners might do that through retirement modeling, tax planning & other means. Or perhaps a combination of all. The idea is consistent: they exist to help you get to a better place financially, solve problems, educate you, and maybe even hold you accountable.
The three classic compensation mechanisms for financial professionals are commissions, assets under management, and flat or hourly fees. The industry was born out of the insurance industry around 75 years ago, making commissions the only possible model. (Insurance policies are by statute attached to commissions paid to selling agents, as I understand it).
Insurance agents used life insurance, annuities, and other products to help their clients solve problems, collecting a commission on each sale. Mutual funds later became popular, and to enhance distribution investment companies would pay brokers a commission for selling their funds to investors. Financial professionals at this point had a variety of products available to help their client base.
Alas, commissions created a pretty large conflict of interest for financial professionals: not all commission rates were the same. If you have a client asking you for help solving a problem, one solution might generate a $500 commission while another might generate a $5000 commission. Even the most ethical and scrupulous people would have a challenging time ignoring these differences when generating recommendations.
Then came fees. Rather than draw revenue solely from commissions on sellable products, financial professionals began charging ongoing asset management fees based on the amount of money you have in an investment account.
Which made a lot of sense for both parties. Consumers could hire professionals for their objective advice, since the professional’s fee would remain the same regardless of client’s decision to take route A or route B. Sure, there are still situations where isn’t true (I just inherited some money, should I invest it with you or pay off my mortgage?), but on the whole there are dramatically fewer conflicts of interest than in a practice built on commissions. Plus, most people prefer an ongoing relationship with a professional who knows them, their situation, and their values.
For financial companies & their professionals assets under management created a recurring revenue stream. Rather than starting January 1st from zero each year, financial professionals could build a business based on recurring revenue that persisted indefinitely. While not perfect, this arrangement is mutually beneficial for consumers and professionals on a number of levels.
Flat & Hourly Fees
As much of an improvement as AUM model was – for both consumers and professionals – it’s not without faults. One of the biggest being that it excludes the vast majority of the people in the U.S., as only a small portion of the U.S. population has enough saved up to meet the minimums imposed by most professionals.
For example, the median net worth of U.S. households is $121,700. That’s not investable assets that a professional might bill you on – that’s total net worth. Which includes home equity, bank savings, and other assets that would not be considered investable or contribute toward a financial professional’s fee. Even if we took the median net worth and assumed every penny could be invested, a 1.5% annual fee (slightly below market rate for this amount of money) would total about $1,825 per year in fees.
Remember too that advisors have overhead costs like office space, staffing, and systems, which aren’t free. Since there is a limited number of people a professional can work with, we’re forced to maintain minimum annual fees to keep the lights on. Most professionals have minimums of at least $5,000 per year, which is more than twice what the fee would be on $121,700 in assets – the median household net worth in the U.S. Which means that there’s a huge portion of the population that simply can’t be served by financial professionals operating on an AUM basis.
More recently – in the last 5-8 years really – a different model has emerged: flat fees. Rather than basing fees on the amount of money in an investment account, some professionals are starting to impose flat fees on a monthly or quarterly basis. Which also makes a lot of sense. With so many households excluded from an advisory relationship simply because they haven’t yet built up $500,000 or $1,000,000 in investments, flat fees open to the door to true advice and guidance from a professional, without the influence of commission dollars.
These arrangements don’t necessarily need to be flat in nature, either. Some are derived based on a combination of net worth and investable assets. Other professionals use an hourly fee structure like attorneys do. The evolution has been wonderful and refreshing, since it enables households who couldn’t previously speak with a professional the opportunity to seek guidance.
So Which Is the Best?
Fee models themselves aren’t inherently good or bad. After 15 years in the industry I’ve met a ton wonderful advisers operating under all three models. I’ve also unfortunately run into some pretty lousy ones operating under all three. The key is choosing the best model for you and your needs given the situation. There is no one size fits all here.
If you’re 30, newly married with a baby on the way there’s a good chance you have a need for life insurance. If you’re feeling confident with your finances in general, you probably don’t need an ongoing relationship with an adviser, which excludes AUM or ongoing flat fees. You could hire a planner for some limited scope help obtaining the right insurance policy, or perhaps work directly with a commissioned agent. If you’re a little older, about to retire, or have other complex planning or tax needs, there’s a good chance you’d benefit from an ongoing relationship.
So why the debate? There’s a growing number of people in the industry who disagree with any fee arrangement that’s not a flat or hourly fee. The argument is that it’s impossible to receive truly objective advice from a professional when they’re paid via commissions. And they don’t believe that the amount of a fee should have anything to do with the value of your investments, which is the case with assets under management.
After having done this for a while, I can confidently say that a professional’s input and service very often has a dramatic impact on how your investments perform over the long run. Even if their strategy is simply to buy low cost index funds and hold onto them forever (which is a pretty good strategy) execution is not easy. A good adviser will be able to talk you through difficult periods in the market, and hopefully avoid major mistakes. Vanguard’s even done studies on it. Which to makes it logical that their fee would be tied to the value of your investment accounts.
**Caveat: Notice I wrote “very often” above. Most people would benefit from working with a professional, but not all. If you have the time, interest and capacity I have no doubt that you can do it on your own. Just be prepared to devote substantial time & energy to it all. Doing the process justice requires creating, monitoring and updating your financial plan, coordinating with your spouse, and staying abreast of the financial markets, retirement account rules and the tax code among other things.
How Much Financial Advisors Are Paid
The crux of the debate really comes down to the amount of the fee – not the model. While there are indeed some ardent naysayers of the AUM model out there, most of the animosity you’ll find emanates from the total fee – regardless of how it’s tabulated.
A few of the most outspoken claim that there is no circumstance where a financial advisor should ever assess an annual fee greater than $10,000. I’ve seen people claim that doing so is despicable & should be considered usury. And that any professional with an annual fee over $10,000 is taking advantage of their clients.
This is precisely where my problem lies. Every single industry in this country has a spectrum of cost and value. Which need to be aligned for any company to have long term success. Take hotels for example. If you’re going on vacation to visit family on the east coast, you’ll have a variety of hotels to pick from. Some hotels have nice pools, room service, workout facilities, and on-demand concierge services to make your stay more pleasurable. Think Ritz Carlton. On the other end of the spectrum you have Motel 6. They’ll rent you a room, it’ll be a lot less expensive, but it’s not coming with any frills.
Is one “better” than the other? Is the Ritz Carlton despicable for charging so much for a three night stay? Absolutely not – they’re just two different kinds of hotels catering to two different kinds of people.
How to Evaluate Value
The problem here really comes down to transparency and value. When you engage a financial professional you need to feel like you’re getting more in value from the engagement than the fees you’re paying for it. If that winds up being true it’s logical to continue the engagement. If it doesn’t then you should discontinue immediately. This is true of all products and services. When you hire an accountant. A lawyer. A personal trainer.
At my financial planning firm we try to be like Marriott. We try exceptionally hard to deliver a huge amount of value, and set fees that are about middle of the pack industry wide. We’re not the most expensive. We’re not the least. We use a blend of the AUM and flat fee models described above, because it’s a good fit for the needs of our clientele. We make a concerted effort to be transparent about fees in relation to that value.
The issue at hand is that most consumers have a hard time with this evaluation – for good reason. It’s frequently impossible to understand the fee you’re paying an advisor. And it can be even tougher to evaluate the value they’re getting in return.
My take here is that everyone really needs to compare the value vs. the cost of using a financial professional for themselves. A financial planner you’re considering should be able to communicate their fees and value in a clear and simple way. They should also continue to demonstrate that value consistently over the course of your engagement. The best can, but unfortunately many don’t. This is the real problem. It’s not the level of the fee. It’s that many people can’t tell what they’re paying for. There’s nothing wrong with staying at the Ritz instead of the Motel 6. The problem is when you drive off the lot with a Ford Contour after paying for a Tesla.
Stop With the Animosity
The unfortunate byproduct of the great fee debate is that it’s deterring newcomers to the industry. Who’d want to jump into a new career with so much vitriol being slung back and forth? Even though your actual day to day work life won’t involve sparring on social media, it’s a terribly bad look for the entire community.
Beyond that, it’s a deterrent to mentorship for young professionals. I’ve heard at least half a dozen stories from young professionals who want to find a mentor, but are unwilling to ask for fear that they’ll fall on the wrong side of the debate.
At the end of the day change is hard. You have to break a few eggs to make an omelette, yada yada yada. But enough with the altruistic crusading to end Ritz Carlton financial advisers. It’s a horrible look and has longer term repercussions. Financial planning is a wonderful profession. One where you have the opportunity to dramatically help other people. The advisory community should be focusing on welcoming newcomers and younger generations. Not bickering about where the shop down the street prices its services.