Background

Today, I had lunch with an old friend. Our conversation quickly centered around some of the things we are dealing with within our respective families, conversations that many of our contemporaries can probably identify with when it comes to aging parents.

We both acknowledged that we have arrived in that time of our life, and I mentioned that I see it within my client base as well. Things are changing, and people our age are finding themselves becoming more involved in the care of their parents, or even siblings, and it’s happening as Hemmingway put it, “Gradually and then suddenly.” ***

We moved on to other topics, but unprompted, my friend found himself asking about how financial advice works. I’m paraphrasing here, but the initial question was somewhere along the lines of, “Isn’t it bad to pay a percentage?” Suddenly, I found myself in the position of trying to explain the nuances of fee structures for financial advice for my friend who has been stressing out over his parents’ health, and now I’ve come to realize he’s stressed about their finances too and is just trying to get a simple answer to a simple question.

It really angered me that my industry causes this problem for virtually everybody that tries to seek financial help. I’d been thinking about writing a blog or making a video to explain the different fee structures and why anybody would ever be better off paying for “expensive” financial advice rather than finding the “cheapest” option, but I hadn’t gotten around to it. Until now. I know I’m probably banging my head against a wall and/or screaming into the void, but for anybody that reads this, here’s what’s up:

Key Takeaways

There isn’t one “right” answer to the best way to pay for financial advice. Seriously.
The classic tactic that critics use to illustrate the loss of wealth over time due to advisors’ fees is at once mathematically correct, and very misleading. Some might call it “lying with statistics”.
There are some excellent investment advisors that I admire and respect who will disagree with me on certain points in this blog. Experts can disagree, but this is my well-informed opinion.

A short history of advisor compensation models

I’m not going to spend a ton of time here providing a history of stockbrokers and the minutia of how they were compensated back in the 20th century. Instead, here is a short summary of the 3 broad types of compensation, as I see them.

Commissions - The commission sales model is where a salesman sells you a product and is paid by the product manufacturer for making the sale. Insurance is a good example of this model. Commissioned salespeople are not bad people, you just need to have a lot of faith that what they’re selling you is actually in your best interest; it doesn’t have to be.
Fee-Based - This is gibberish to most people. It means that the person is paid both commissions for the sale of products (like insurance), and then also paid an advisory fee by their clients for their advice.

This is a step in the right direction and can be a good choice for clients that want a one-stop shop for many things (get your insurance and investments from the same person or firm). Once again, you just have to trust that when the person is selling you a product, that the product is actually in your best interest. It doesn’t have to be.
Fee-Only - This is the most “modern” model, the least common, and the one that applies to advisors that must always act as a fiduciary by law.

In this model, the advisor is truly an “advisor”, being paid strictly for the advice they provide. Advisor = Advice. They are paid the same whether you take their advice or you don’t. When it comes to commissionable products that you may need, they will help you find the product that is right for you and sit on your side of the table, guiding you through the purchasing process.

But you will be purchasing and paying commissions to a third party that is not your advisor, and your advisor will not receive any extra compensation if and when you make a purchase. This is the model that doesn’t make me want to put the word “advisor” into air quotes. A fee-only advisor is actually an advisor, in my opinion.

Within the realm of fee-only advice, there are a variety of ways advisors calculate their fee. I’m going to spend some time on those now:

Fee-only advice

Fee-only advice comes in many flavors and packages. The most well-known and sometimes controversial version is the one in which the client pays the advisor a percentage of the assets that the advisor manages, AKA the % of AUM model (Assets Under Management). I’ll get to that one last because I want to give a brief run-down of some of the other varieties first:

Flat Fee - The advisor quotes a flat rate in dollars and that’s the fee. An example is $10,000 per year, regardless of the size of your investment account. Our firm’s flat fees range from $4,000 per year to $12,000 per year, depending on your career advancement and household size.
Hourly - The advisor quotes a flat rate per hour in dollars and the fee is that rate multiplied by the number of hours the advisor works. My BigLaw and Private Practice Attorney clients are familiar with this model. So are most everybody else. An example is our Hourly Services fee at $500 per hour.
Percentage of Net Worth - The advisor charges a percentage fee based on the client’s net worth. This sounds great because it takes the focus off of the investment account and shifts to a more holistic look at the overall financial well-being of the client, which is what we advisors want you to do in the first place.

Unfortunately, it’s logistically more difficult to implement: How do we value illiquid assets like your home, collectibles, etc.? Who pays for those appraisals? How often? Do we include assets on which we are not advising? What degree of discussion constitutes advising?

What you find is that as you try to eliminate the ancillary items from Net Worth calculations, or things that are hard to appraise, you get closer and closer to just valuing the investment portfolio. An example of a Net Worth-based fee might be 0.50% of your net worth, as calculated.

There are probably half a dozen more flavors (% of Assets Under Advisement, Complexity-Based, Income-Based) but the common link between all of these is that they have nothing to do with whether you purchase a product or even take our advice. The idea is that we are removing many (but not all) conflicts of interest when we are:

Only paid by our clients and not by product manufacturers, and
Paid the same whether you take our advice or not.

Suddenly, our income depends solely on the quality of the advice we give and the value the client perceives from working with us.

Now I will spend time focusing on the question my friend asked: “Isn’t it bad to pay a percentage?”

“1%”

So, if you’ve been wondering when I’m going to start respectfully disagreeing with people I admire, here we are. “1%” in this context refers to the model in which an advisor charges a client 1% of the value of their investment account each year as compensation for their advice. I believe this is the best model for many clients, though certainly not perfect.

First, the way critics present the problems:

Charging the client 1% of their investment portfolio reduces returns over time, in a compounding manner (the client’s returns get further and further away from what they’d be if they weren’t paying 1%). TRUE.
A client with $5mm paying 1% in fees to their advisor will pay their advisor $50k per year, assuming their account value doesn’t move. That’s so much money! TRUE.
The advisor gets a raise just by virtue of the stock market going up in value. They had nothing to do with that! TRUE.
Charging the client a fee based solely on the investments they have with the advisor makes it seem as if the investments are the only thing that matters. TRUE.
Charging the client a fee based on the size of their investment account diminishes the respect of our industry from the general public. MAYBE?
An advisor isn’t doing anything different for a client with $5mm versus a client with $500k. They shouldn’t be charging more just because one is wealthier than the other. MAYBE?
Charging a 1% fee means that the advisor is just focused on gathering as much AUM (assets to manage) as possible. They are in the business of getting new clients. TRUE.

That list probably isn’t comprehensive, but I think you can tell that I’m making an honest attempt at capturing the gist of the issues. Now, my rebuttals, organized by the same numbers as above:

There is a difference between the investment return and the investor return, and it is often enormous. The math assumes that the client would earn the same return as the investment that the critic is referencing, which is often a steady rate of, say, 6% per year.
The reality is that there is a significant amount of the population which will not have the “diamond hands” required to just buy and hold a single investment for 30 years and earn the actual investment return. If you can do that, then by all means that is what you should be doing! But I have had enough real-life experience to tell you that many people will sell low, buy high, follow fads, and just generally make poor investment decisions that will cause them to not actually get the investment return.
Additionally, this argument ignores the very real positive financial impact an advisor can make for a client based on financial planning techniques and advice. And this is not to say that the advisor will be able to convince the client to do the right thing all the time, or that the advisor him/herself will give the right advice all the time! But I view the comparison of a fixed rate of return with an advisor’s fee and the same exact rate of return without an advisor’s fee and financial planning advice as lying with statistics.
First of all, a client with $5mm is probably not paying a 1% fee to an advisor. Those of us that offer a fee option based on the assets we manage usually reduce the % as the client’s investment account grows. If you’re reading this and paying 1% on $5mm, call me.

Secondly, when dealing with a $5mm portfolio, the nominal numbers in dollar terms are going to be big, and the impact an advisor’s advice can make may be big as well.

For example, imagine a hypothetical scenario in which the $5mm portfolio is earning 2% in annual interest, or $100k per year. If the client is earning all of that interest in a taxable account, they may be paying 37% or more of that interest in marginal taxes each year if they’re in the highest marginal tax bracket (maybe more with other taxes included). That’s $37k for the economics majors out there (no disrespect, I’m an Econ major too).

If the advisor simply helps the client implement a strategy of asset location to efficiently allocate investments among different types of investment accounts (taxable, tax-deferred, tax-free), the advisor’s advice may start to reduce that $37k tax hit. Frankly, it’s not that big of a leap to imagine that a competent advisor’s advice for systematic portfolio management (rebalancing, asset location, tax-loss harvesting, etc.) may help chip away at the percentage-based fee they’re charging.

Of course, it can and does go the other way where bad advice and mismanagement makes things worse. But the point is that when dealing with large investment accounts, quoting fees in dollar terms and not considering the potential positive impact of competent financial advice in those same dollar terms is only telling half the story and is misleading.
The advisor also takes a pay cut when the market falls. Advisors are saving money for retirement and other goals just like their clients. When there is a reduction in value of their clients’ investment accounts, that represents real-time income that the advisor is losing that may otherwise be going to their retirement and goal savings.

For younger clients, the losses they experience should be temporary (paper losses) whereas the income foregone to the advisor is truly lost. It doesn’t mean the client should be happy and I am not trying to cue the world’s tiniest violin, but it is true that the advisor’s income is at the mercy of the markets when they are charging clients based on the value of their investment accounts. When there is a bad period for the stock market, that may represent a bad period for the advisor’s income that directly impacts their family. It works both ways.
This is just straight up true and one of the major drawbacks of charging clients based on the value of their investment account. We advisors have to spend a lot of time trying to overcome the dissonance that this setup creates.
I am not a client looking in from the outside, so I don’t know for sure. But I kind of doubt it. I think we are an industry instead of a profession not because of the compensation model but because of the extraordinarily low barriers to entry relative to the incomes that can be generated. I would equate the licensing exams to become a financial advisor as similar in difficulty to the exams to get a driver’s license.

Having the licenses to work in this industry does not demonstrate a high level of competency at all. I am very confident in my hunch that the barriers to entry to become a financial advisor are not in the same universe as those of other professions, such as law, medicine, architecture, engineering, and others.

I think many wealthy and/or high earning clients know that they are academically smarter than the people they remember from high school who have gone on to be financial advisors. I think that if people knew that to become an advisor a person would have to go through the rigors of law or medical school first, they wouldn’t care so much about the compensation model. That’s why our industry isn’t a profession yet, not because of the math equation we use to determine the fees.
This one is a little bizarre to me. Really? If somebody comes to an advisor with $500k to invest, they have the same level of complexity to deal with as somebody with $5mm? I just don’t see it. The best analogue I can think of relates to health. It’s like saying that since “eat right and exercise” is the basic advice that should be given to any patient, then that’s the only advice that should be given to both the 35-year-old and the 65-year-old patient.

In my opinion, it is just reality that the person with more wealth is akin to the person with more age in a health context. Their needs are going to be more complex, more unforgiving, more immediate, and more diverse. They shouldn’t pay 10x more for having 10x more money, but per point 2 above, they most likely aren’t paying 10x more because the percentage fee rate typically gets reduced as the assets grow.

Again, if a 35-year-old comes to me with $500k in cash (no prior investment baggage), no insurance baggage (ill-advised life insurance or annuities, for example), high income, plenty of years ahead to accumulate wealth, no tax issues, etc.….This is wildly different from a 65-year-old with $5mm of investment baggage, insurance baggage, estate planning issues, no more income from employment, the need to plan for 30 to 40 years of investment decumulation, potential tax issues, long-term-care issues…the list goes on.

The point is, I think it’s entirely reasonable to assume that an advisor is going to be doing a lot more work for a client with $5mm than they are for a client with $500k, because the investment account size is often a very good barometer for complexity, just like age is a very good barometer for health. Of course, just like health, this does not always hold true. But in cases where it is not true, the advisor should be willing to negotiate a lower fee rate.
This is also just straight up true. But it’s true for virtually every fee model. If you charge an hourly rate, a flat rate, even commissions - you’re in the business of gathering more clients. If anything, charging based on a % of assets allows you to “scale” your business faster so that you can hire help and spend more of your own time advising a smaller number of clients.

Not to mention being able to afford the employees, the technology, and the services that help you deliver a world-class experience for your clients. While your company will always be bringing in new clients to remain an ongoing concern, the advisors within the firm may have more room to focus on serving their own clients as compared to a situation in which their fee structure means that they must spend more of their time on a volume-based business.

What do I do?

The “I” here is me, Matt. For all the defense of the percentage fee model outlined above, you would assume that it’s the model I offer. The truth is that I offer a hybrid model that starts with a flat fee in which the calculation is tailored to my niche clientele, BigLaw Attorneys. Specifically, the flat fee is based on the career level and household size of the client.

Eventually, if a household’s investment accounts grow to over $750,000 that I directly manage, I will increase the flat fee to compensate for the added liability I am taking on as well as the increasing value that the client is getting from the service. The increase to the fee is designed such that the annual fee does not amount to more than 0.80% of the assets we manage.

So far, many of my clients have not yet built up the $750k in savings, and so they fall under the flat-fee models where there is a set dollar fee per year that is not based on the size of their investment account.

In fact, my clients don’t have to have me manage any of their money at all! I recognize that some people that are just starting out with their savings are wary of paying an advisor to manage their money, often based on some of the critiques mentioned above, but also because they feel like investment management isn’t worth it, or that they can get it cheaper elsewhere (they can).

And that’s fine. I charge fair prices for the services that clients select, and if they don’t want me to manage their money, I’ve got a program for that! I’m not here to offer average services at a lower price than the next average firm. I’m here to offer excellent services at a fair price for the customized, niche services that we deliver.

the risk of cutting Costs

I do think that over time and through research, clients may discover that there are hidden costs of cheap services, and that there are benefits of having a consistent, trusted advisor design a portfolio that is specific to the client, beyond just using an age-based or risk-based metric to assign the client to a model.

Going back to the medical analogy, I believe that low-cost providers may be thought of as akin to a pharmacy providing over-the-counter drugs, whereas an investment advisor may create a portfolio that is akin to a prescription from a doctor. The over-the-counter option is designed to do the most good for the most people and is probably adequate for many people. They are also created by very smart people doing wonderful things for humanity. I have no problem with low-cost brokerages and have a number of clients that keep their investment accounts with such firms.

However, the over-the-counter drug is not designed to treat you, specifically, based on a detailed understanding of what ails you. It’s based on broad, common symptoms, and is dosed based on broad, common swaths of the population. Similarly, the “set it and forget it” funds and/or “financial advice” offered by low-cost brokerages may be based on very broad strokes, or even just one metric such as your age or “risk tolerance”. As a person’s financial situation grows in complexity, the “prescription” route may become more and more relevant.

As I work with clients who keep their investment money at third-party “low-cost” firms, I am able to witness some of the more hidden costs that may be associated with the apparently cheap offering.

In one example, a well-known low-cost provider faced a class-action lawsuit and paid a fine to the SEC as a result of their practice of keeping large portion of customer investment accounts in cash, and paying the customer low interest relative to the interest that the low-cost provider collected on that same cash.

That’s their money that is not being invested, losing purchasing power to inflation, and is effectively a hidden fee to the customer. In my opinion, that’s an insidious cost to the client. Cash is not bad in and of itself, but it does not make sense to keep too much cash on hand. Instead, it’s a hidden cost to the client and source of revenue for the low-cost brokerage.

Summary

I know that this blog takes some positions that are not going to win me any awards. Defending fees in the financial advisory world is not a popular thing to do. But I was jarred by the conversation I had over lunch with an old friend who is dealing with serious life issues involving aging parents, health, and finances.

Obviously, I didn’t want to answer his simple question with the treatise I have written here, but I was also reminded of what can happen when confusion leads to paralysis in terms of addressing serious needs. My answer was and is, “It depends.”

We continued our conversation focusing on some specific issues that I could be helpful with over lunch, but of course could not solve with the limited information available to me, and the limited information available to my friend.

And so, it seems that we are in a common yet very difficult situation, where a family has financial issues coming to the forefront at the same time as health issues. And this family does have an “advisor”. But whoever that advisor is, he or she is apparently not aware of major financial issues that have been in place for 15 years, nor did the family even think to ask the advisor for help with those issues because they appear outside of the scope of his or her services.

And so, my friend’s sweet mid-70’s mom is sitting at the kitchen table with a binder full of research notes on a financial topic that is very confusing, trying to figure out the best course of action, and hopefully not making a life-changing mistake. If you’re wondering, of course I’m trying to help and trying to find help for the family by connecting them with a fiduciary, fee-only advisor that specializes in situations like theirs.

This is the exact thing I am inspired to help people avoid by getting started with all this stuff earlier in life than is typically seen. It has also inspired me to finally put my thoughts down on the subject of fees so that interested parties can get my perspective on when and why they are worth it. Last, if you see this blog published, know that I have received the permission of my friend to do so.

***About an hour after I wrote that quote, my friend notified me that he was at the emergency room with his family member we had been discussing…Gradually, and then suddenly.

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