[Editor's Note: This is a guest post from John D. Craig, JD, CPA. He has two blogs, here and here. We have no financial relationship.]
Most financial advisor fees are excessive and should be reduced. This article will focus on retirees with a net worth of $1 million or more. It has been estimated that there are about 10 million households in the US with a net worth of $1million or more, excluding primary residence. A large percentage of these engage the services of financial advisors.
The client, Bob, graduated from a good university and has had a successful career. Bob worked his way to upper management, and was somewhat knowledgeable with respect to personal and company finances. Bob contributed the maximum to his 401(k), and invested separately in a taxable account; his investments are now worth $2 million. He has had a mixed history of self investing and use of investment advisors; some good results and some horror stories. Bob is now retiring and he realizes he needs to get serious about his future financial planning.
Bob reads a couple of books and some articles on financial planning. After some soul-searching he realizes that he might have enough financial savvy to do his own financial planning; however, a) that would take a lot of time and effort doing what he feels is a disagreeable task, and b) he is not sure he trusts himself to make the best decisions, particularly in difficult times. He decides to hire a financial advisor.
After much thought he reaches the following conclusions regarding the choice of financial advisor:
- He has learned that investment advice is not about stock picking, but about selecting the right mix of funds or ETFs for his specific situation. He is not sure if any value can be attributed to picking among diversified funds.
- He does believe that he needs the other services provided by financial advisors including: asset allocations, risk management, tax planning, behavioral coaching, withdrawal strategies, etc.
- He is willing to pay the going rate.
- He wants to hire an advisor that he likes and trusts. He is willing to hire the best. He does not want to hire a robo advisor or a discount firm where services may be limited.
- He wants a fee only advisor who does not get commissions or kickbacks. He understands that even the large national firms will work on a fee only basis.
- He wants to be sure that all necessary services are taken care of, and he will give advance approval to do whatever is necessary.
- He is aware that some advisors charge on an hourly basis or fixed fee, but that the majority of advisors, particularly the largest and most reputable, base their fee on a percentage of assets under management.
- He does not want the hassle of vetting hourly fees, and is willing to go with the typical top advisors who will charge a percentage of AUM, provided the fees are reasonable and do not exceed the industry standard.
The advisor, Ted, works for a large reputable financial planning firm. He has a CFP and 15 years of experience. Bob was a perfect prospect and he assured Bob that: he was not a stock picker, but does add value through picking the appropriate funds; he and his firm have the necessary expertise for providing all necessary services; he is subject to a fiduciary standard and can produce recommendations from satisfied clients; his firm's standard fee is 1% of AUM, which is on the low/average end of the industry standard, and .25% will be deducted quarterly from AUM.
Bob and Ted are a perfect fit. Bob signs on and he is very pleased with Ted and the services he receives.
So Where's the Problem?
Bob is getting excellent service and he is happy; everything is taken care of, and this is a no-hassle arrangement. Ted enjoys working with Bob. Bob clearly made the right choices in both deciding to hire a financial advisor and in choosing Ted. The only problem here is that Bob is paying an exorbitant fee for the services he is receiving. It is true that Bob is simply paying the industry standard fee, and Ted is only charging the 1% of AUM fee, which the industry has approved for many years. Perhaps neither Ted nor Bob understand how excessive the fee is.
The financial planning industry is enormous — trillions of assets being managed and billions of fees earned. The industry has changed a lot over the years. Its beginnings were with the large commission-based stock-picking firms. At that time it may have been logical to tie fees to the assets under management. Today most agree that there is little or no value generated by stock picking (and likely additional cost), so the industry has moved to providing services such as those listed above. All of these services are somewhat generic in nature. Learning the skills of a financial advisor takes much less time and effort than, for example, learning the skills of an attorney or CPA. Here we have assumed that Ted performs these skills very well and does an excellent job in relation to his peers.
So let's take a look at how Ted's fees compare to those he would charge if based on an hourly rate as charged by attorneys and CPAs. Let's assume that his hourly rate is $250, which is generous in comparison. Bob's 1% fee is $20,000 per year and this would convert to 80 hours of Ted's time. How much actual time do Ted and others in his firm spend on providing services to Bob each year? First, all of the time spent obtaining Bob as a client and later entertaining Bob doesn't count. Second, much of the report preparation and analysis is done by lower level staff and clerical personnel. In the first year it is possible that 20 hours of staff time was spent at, say, $100/hr. Maybe in the first year Ted spent another 20 hours on meetings with Bob and technical analysis. On an hourly basis, that totals to $7000. It is hard to imagine how the total fee could ever reach close to $20,000. In the second and subsequent years the hours spent could easily be less than half of the hours spent in the first year, yet the annual fee remains the same (or increases if the portfolio value increases).
Of course, Ted could disprove these assertions by providing a detailed schedule of hours spent, as is often provided by attorneys. This won't happen. Instead the focus is inevitably on the spurious justification of value provided. For example, the advice: “Defer taking your Social Security benefits until age 70”, might result in gaining Bob $100,000 during his lifetime. Bob was not aware of this benefit, but Ted and most of the 200,000+ financial advisors in the US can give this advice off the top of their heads. The value may be $100,000, but what justification would there be for charging more than $100-$200 for that advice?
In this example, Bob did the right thing by hiring Ted as his financial advisor. Bad apples exist in all service industries, but we have assumed Ted provided excellent service and did so with integrity. Bob likely received value, both financial and psychological, in excess of the fee that he paid. Despite this, there is simply no justification for the exorbitant fee. The work is skilled but it is highly generic. The only logical fee structure is hourly based, or possibly a fixed annual fee tied to estimated hours. Since Bob dislikes the idea of vetting monthly hourly fee bills, he would probably prefer the fixed annual fee. Such fees would be tied to estimated hourly fees and revised annually, but with periodic justification of the fees based upon hours actually expended.
Hiring a financial advisor by a retiree is often the best choice. In most cases a qualified FA will provide value in excess of the fees paid. Today there is no logical justification for basing the fee on percentage of assets under management. The typical 1% of AUM fee is exorbitant. The only logical fee arrangement is one based upon hourly fees similar to the arrangement used by attorneys and CPAs.
[Editor's Note: The information in this post won't be new to long term readers of this site. I have long maintained that if you're going to hire an advisor, that advisor should be fee-only and preferably paid on a flat-fee or hourly basis. That is tricky, since most advisors, even most good advisors, charge on an AUM basis. Part of that is because that is the way it has always been, and partly because “AUM fees are the best kind of passive income there is.” One workaround is simply to calculate out the AUM fee each year, and compare it to a flat annual retainer or hourly rate. If it is still reasonable, then you need do nothing. If it is not, then it is time to either negotiate or move on to another advisor who not only gives good advice, but also does it at a fair price.]
What do you think? Do you think the AUM model is a good one? How do you pay your advisor? Do you like that method or would you prefer something else? What is a fair price for a year of financial advice and/or investment management? Comment below!