An Unjustifiable Cost of Financial Advice

An Unjustifiable Cost of Financial Advice

Earlier this week, Advisory HQ released a study detailing the average fees financial advisors charge across the country (How Much Does a Financial Advisor Cost?).  I get a bit preachy when it comes to fees but today I’ll keep my soap box time to a minimum.  Instead, I’ll focus on some simple facts that I think are worth considering for anybody who currently has a financial advisor or is looking for one.

Quick AUM fee refresher from Advisory HQ:

Charging each client a percentage of the asset being managed, also known as assets under management (AUM), was the original compensation plan for financial advisors, RIAs, and wealth managers, and it’s still the most commonly used investment fee structure today.

This structure is very simple: a client gives a particular amount/asset (for example $500,000) to an independent investment manager to invest on his or her behalf. In return, the investment manager charges an annual percentage (for example, 1%) of the assets entrusted to the firm.

Although the opinion is unpopular inside many industry circles, I have no issue saying charging AUM fees for financial advice is ridiculous.  It’s an outright abuse of economies of scale that robs investors of returns.  I won’t rehash what I’ve written in the past (Rethinking Advisory Fees), but the Advisory HQ study presents an opportunity to have some fun with numbers.  Let’s dive right in…

Breaking Down the Numbers

Here’s a table lifted from the report:

Fee table

When you view costs on a relative percentage basis, they seem small.  1% seems reasonable, so few people question it.  But when we examine the annual fee cost on a dollar basis, things look a bit different.

For these examples I will make the following assumptions:

  • 7% annual investment returns
  • No annual contributions
  • Fees are withdrawn from account at the end of each year

The calculations do not account for adjusting fees lower as portfolios grow.  As a result, the Year 20 Fee and Cumulative Fees are a little on the high side, but still illustrative of the point I’m making.

image

If you initially invest $1 million and pay your advisor 1.02%, after 20 years your portfolio would be worth ~$3.2 million.  In that same time, you would have paid your advisor $393,500 or an average of $19,600 per year. 1.02% doesn’t sound like a lot, especially when you never really see the money (fees are typically  withdrawn automatically by the advisor from investment accounts).  However, I have a feeling most people would feel differently if they had to write a check to their advisor each year for $20,000.

“But Tim, that advisor made $2.2 million!!  $20k per year is fine for those kinds of results!”

The market made $2.2 million.  The investor risked their capital and their advisor advised on a proper asset allocation.  The advisor doesn’t control the market.  His advice is valuable, but the investment outcome is entirely out of his control.

Impact on Net Returns

The annual and cumulative fees don’t tell the whole story, though. Remember, each time fees come out of your account, it eats away at your ability to compound returns.  In this next table you can see that when the dollar amount deducted from the account each year rises with the size of the portfolio, the net impact on investment returns is staggering.

screenshot-2017-03-03-15-41-59

Yikes! Those “small” AUM fees end up costing investors a huge amount of their total investment returns.  An investor with a $1 million portfolio will lose 25% of their total investment returns due to advisor fees!!  In dollar terms that is $717,000, a much larger amount than the already outrageous cumulative fees highlighted above.  Imagine if instead of describing their fees as 1.02% of AUM, advisors published a rate of “25% of 20-year investment returns.” Would as many people consider that reasonable?

Hourly Rates

Let’s take this one step further.  Can we break down these fees into an hourly rate?  After all, shouldn’t what you pay be somewhat related to the amount of work required by an advisor to manage your situation?  Lucky for us, the Advisory HQ piece also lists the average rates for advisors and planners who charge clients by the hour.  These fees ranged from $120 to $300 an hour.  We’ll test the high side and use an hourly billing rate of $250 for our calculations.

screenshot-2017-03-03-15-47-22

A couple questions arise out of this silliness:

1) Does it take an advisor twice as much time to service a client with $2 million as it does for a client with $1 million?

No!  Could it?  Sure.  Somebody’s financial situation might be very complex and may take a lot more time to service.  That has little to do with the actual size of their portfolio, though.

2) If you have a $2 million portfolio, do you think your advisor spends 81 hours per year servicing you?  

Highly, highly, highly unlikely.  Do you think they spend 187 hours on the client with $5 million?  That’s over a month, full-time.  What could they possibly be doing?

3) Is the person with a $10 million portfolio getting an advisor who is working for them full-time? 

No, but if I was paying $78,000 per year I’d certainly demand that.

I think we can reasonably assume these hourly estimates are slightly inaccurate.  I don’t know how much time other advisors spend specifically on each client.  Speaking for myself, I plan on spending between 10 and 20 hours per client each year.  Some situations require more time, some less, but 20 is a decent estimate.  What would hourly rates look like if we assumed 20 hours spend on each client annually?

image

As you can see, once you cross the $500k threshold the hourly rates start getting out of control.  Have a $1 million portfolio?  You’re being charged $540 an hour.  $2 million portfolio?  Surprise, you’re going to get charged $1,017 an hour.  Don’t worry, though, your advisor is charging you 0.96% AUM instead of the 1.02% AUM the $1 million portfolio is paying.  Sweet deal.

The Law of Value

“Your true worth is determined by how much more you give in value than you take in payment.” – Bob Burg, The Go-Giver

Good financial advice is incredibly valuable and I think those providing it should be well compensated.  With that said, the AUM fee model is far from ideal.  It has little to do with the true value of financial advice and everything to do with gathering assets.  It’s an easy way for advisors to make more money for less work, but a horrible injustice to investors who pay for a service.

Unfortunately, the finance advice industry is slow to evolve.  With few alternatives for investors who seek financial advice, there is little incentive for entrenched advisors to disturb the status quo.  It’s comfortable and they are making tons of money (cynical, but true).  Beyond that, most of the industry won’t change because it can’t.  The business models would completely break.

I am not all doom and gloom, though.  Albeit slowly, change is underway.  As the onion gets peeled back people are starting to understand what value really is.  To believe that value will always be tied to the performance of the stock market or the size of somebody’s portfolio is nothing more than a fantasy.  There are plenty of reasonable ways for an advisor to charge clients for financial advice; an AUM fee isn’t one of them. 

James Osborne over at Bason Asset Management deserves a lot of credit for opening my eyes to the AUM fee problem.  I’ll leave you with the optimistic conclusion from a great piece he wrote last night on the same topic:

But slowly, some young advisors out there are going to see this as a real chance, and move on it. Jeff Bezos said it best:

“Your margin is my opportunity.”

 

Further Reading…

Rethinking Advisory Fees

Asset-Based Colonoscopy Pricing


Tim Brennan

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