In 2014, and in the healthy spirit of challenging some of our own long-held beliefs, the leadership team at Capital Asset Management examined the way we charged clients for our services and how our competitors operated.
Like many firms, our compensation model was largely based on an ad valorem, or a percentage of assets model that varied in line with the amount of assets our client entrusted the firm to advise upon.
Upon deeper examination, we concluded the percentage model was past its sell-by date and there was a better alternative.
We summarised the key problems we had identified as the ‘four Cs’: cross-subsidy, conflict of interest, contingent charging and cost.
What are clients looking for when they engage with a financial adviser or wealth manager? For most people it can be summed up as ‘good, honest, impartial advice to help me and my family achieve our goals’.
However, many objectives can be achieved without the need to invest capital with an adviser. From paying off a mortgage, to helping their children onto the property ladder, several common lifestyle focused objectives mean there is no need to invest money and therefore no fee payable under the percentage model.
Hopefully most professional advisers will provide good quality advice untainted by any possible financial reward they may receive but there are a couple of challenges;
- Clients may have concerns that the advice offered is affected by personal incentives.
- The adviser may provide high quality detailed advice (for which he/she is accountable) without receiving any form of compensation.
At a recent conference, one of the speakers confirmed that advisers who maintain a percentage charging model will be forced to disclose this as a conflict of interest under the new Markets in Financial Instruments Directive (Mifid) rules due to be introduced next year.
The percentage of assets model in its most basic form means clients with larger portfolios or pension funds pay proportionality larger amounts each year in annual fees. For example, a client with £1 million invested with an adviser or wealth manager operating on the typical 1% model pays £10,000 each year in fees. A similar client with £100,000 invested pays only £1,000 a year.
One client pays 10 times the amount each year in fees than another with a similar service experience and adviser. That seems fundamentally wrong and does not happen in other areas of professional services such as medicine, accountancy or law.
‘Never ask a barber if you need a haircut,’ said Warren Buffett, chief executive of Berkshire Hathaway and the world’s most successful investor.
A couple of years ago, the then Financial Conduct Authority (FCA) chief executive Martin Wheatley expressed concerns about what he referred to as ‘dealing bias‘ in relation to percentage charging adviser fee models. In other words, to be compensated, the adviser must recommend products or services upon which a percentage charge can be applied.
This would mean advisers may be reluctant to recommend national savings products, investing in a business, or buying a holiday home: none of which can produce a percentage-based adviser fee, but all of which (and many more) can be legitimate decisions within a comprehensive family financial and investing plan.
Furthermore, ex-FCA technical specialist Rory Percival has recently expressed concerns over defined benefit pension transfers that are being offered on a contingent charging basis and the regulator is likely to revisit this area soon.
‘The miracle of compounding returns is overwhelmed by the tyranny of compounding costs,’ said John Bogle, the American businessman, investor and former Vanguard
Albert Einstein famously referred to compound interest as the eighth wonder of the world. However, the effects of compounding annual fees based on a percentage of investments linked to the underlying value can work against the client in a significant way.
Take the example of a £100,000 portfolio invested over 30 years and growing at 7.6% a year on average. The investor is charged a standard 1% a year fee for investment and planning advice. The alternative flat-fee model starts with the same monetary fee in Year 1 of £1,000 but is increased in line with inflation (assumed to be 2% a year, the target set by the Bank of England).
Over the full term of investment, the difference in the final portfolio value equates to the total of the initial investment, which is £100,000. The same applies regardless of the starting figure, so a £500,000 investment means overpaying by around £500,000 over 30 years and a £1 million portfolio at the beginning overpays by £1 million over the same term (see charts below).
These are meaningful sums and many client-focused advice firms will wish to consider alternative models that allow them to remain profitable and financially secure but do not overcharge clients they work with over long periods of time.
Many of the overheads in an advice business relate to staff and premises, neither of which rise in line with long-term capital markets but more likely in line with inflation and average earnings. It may therefore be more equitable to link fee increases to those, rather than increases in the FTSE for example.
Service versus costs
What is the client actually paying for, and what do they value most?
The feedback we receive from clients is that the value is in thoughtful advice, wise counsel, empathy, and detailed discussions enabled by cashflow forecasting and solid financial planning.
A client’s desire for advice does not rise and fall in line with the investment markets, and therefore the revenue they generate for the adviser. They are inversely correlated, as a client may need more advice in times of market stress, during which the adviser may be experiencing a 20% or 30% reduction in income on a percentage-based model.
There is also the vast and growing new market brought about by the pension freedom rules. Most advisers have experienced a significant increase in enquiries from clients keen to take advantage and access their pension funds. This means withdrawing funds from the pension account and ensuring ongoing advice fees fall in line with the reduced fund value.
Publicly available data suggests many IFA firms operate on fairly low profit margins once all costs and overheads have been accounted for. Therefore, linking ongoing fee revenue to the investment markets, which can and do fall, is likely to mean many firms making a loss, with owners being forced to take large pay cuts and let go key staff members.
The fact we are nine years into a bull run in equity and bond markets suggests some savage reductions to ongoing percentage-based fee revenue may not be too far away.
As the new year gets under way, this may be the right time to begin to ‘skate where the puck is going’ and give some considered thought to the future direction of the advice market to ensure the long-term success of both your firm and the clients it serves.