This year will be a watershed moment for the issue of financial advisors’ compensation and the type of fee model that advisors and financial planners will be able to use to charge their clients. In fact, the list of threats to the traditional model of charging fees both for mutual funds and securities have never been more direct.
These main threats are:
- Canadian securities regulators are exploring banning embedded mutual fund fees, which have been used to pay for advice.
- The second phase of the client relationship model (CRM2) will require transparent reporting of fees later this year.
- The Ontario’s government study and potential legislative measures for more tailored regulation of financial planners and advisors may also put the spotlight on the way consumers are charged fees.
What does this all mean for advisors? They may be required to charge clients direct fees vs using hidden fees. The question is what direct charge fee method will prevail and which method is in the best interests of your clients: a fee-based account based on assets under management or a flat-fee annual retainer?
The fee-based account method is more prevalent in the brokerage business, but has been adopted by the mutual fund industry for Series F units in which the client pays an advisor directly through a fee-based account in which the fees are based on a percentage of the total assets an advisor manages. Under this model, the mutual fund manufacturer pays no commissions to the advisor and the management fees and operating expenses are lower than the traditional commissions-based Series A. In contrast, the flat-fee annual retainer is based on a payment for services given to the client regardless of the size of his or her investible assets. Nevertheless, some advisors may have a hybrid of fee-based charges and a flat-flee annual retainer.
Depending on how fee regulations are restructured, you, as an advisor, will need to decide your fee model for the future. At a minimum, the CRM2 transparency rules will put some pressure on you to do something. The first strategy you may consider is to go to a fee-based account model as you may think it has no client conflicts and is an accepted industry practice.
Before you adopt the fee-based account model, you should consider the arguments against this system and the new, albeit early, trends in which advisors are moving away from it. The biggest argument against this model is whether the relative value of an investor’s portfolio ought to determine the fees and charges that the client is subject to for the delivery of financial advice.
James Osborne, founder of Bason Asset Management, a flat-fee only asset management firm based in Lakewood, Colo., has argued that a flat-fee retainer model is a more appropriate compensation for advisors as it does not cost more to manage, for example, a portfolio of $1 million vs a portfolio of $500,000. So, why should clients with the higher portfolio pay more for the same services? Furthermore, the firm further highlights the difference on the client’s return on a portfolio if a 1% advisory fee is charged vs a flat annual retainer. Assuming a 7% return on a portfolio, a 1 % advisory fee can cost an investor with a $1 million portfolio more than $500,000 in lost returns during a 20-year period when compared with charging a flat-fee annual retainer.
In addition, trends in the U.S. show some advisors abandoning the fee-based account model. John Anderson, a consultant with SEI Advisor Network in Oaks, Penn., notes that with the rise in passive investing through index funds and exchange-traded funds, it’s difficult to argue for a 1% fee for a portfolio that’s invested mainly in inexpensive funds that take only a only a small amount of time to select.
It’s not yet certain if these trends will take hold, in Canada but advisors and financial planners need to consider them when choosing a new fee model if embedded commissions are eliminated. If the flat fee-annual retainer becomes the dominant model, then advisors performing basic transactions and services will receive lower compensation compared with full-service financial planners providing retirement planning, estate planning, tax planning and integrated wealth-management services.
All this may be another compelling reason for you to embrace financial planning. The integrated financial planning model using a flat-fee annual retainer will allow you to customize services to each client and to be the most transparent. Also, unlike the fee-based account model, your revenue will not be tied to short-term market performance. Finally, your clients will enjoy all the upside from your expert advice as their investments grow and you will not be in conflict by charging some clients different amounts for the same service.