The financial services industry is famous for terminology that is not readily understood beyond Wall Street. One of those terms, used to describe certain financial advisers, is “fee-only.” What does that mean?
Generally, “fee-only” financial advisers do not work on a commission basis but charge a fee for their services. The structure of those fees and the manner in which they are paid, however, can have a significant impact on the advice clients receive and on their pocketbooks. (See Are Your Assets Costing You Money? for a related article on the financial impact.)
There are two basic fee structures used by most “fee-only” financial advisers:
- Percentage of Assets Fee – charging a percentage of the assets under management
- Hourly Rate or Flat Fee – charging per hour of work or a flat fee for services rendered
It is estimated that 90% of all “fee-only” financial advisers use the percentage of assets fee structure for compensation and here’s why.
Percentage of Assets Fee — How It Works
Typically, your financial adviser will manage your investment assets (i.e., IRAs, brokerage accounts, money market funds, etc.) through a single custodian firm (i.e., Fidelity, Charles Schwab, etc.) that he or she works with on an exclusive basis. Your financial adviser is listed as your “agent” on the account.
As your agent, your financial adviser may have discretionary power to invest assets on your behalf or non-discretionary power, in which case only you have access to your funds. In either case, the custodian firm pays your financial adviser the contractually agreed management fee on a quarterly basis directly from your account. The withdrawal of these fees from your account is shown on your account statement sent by the custodian.
Percentage of Assets Fee — The Intent
The percentage of assets fee sounds great in principle. Your financial adviser is paid according to the dollar value of your assets under his or her management. The theory is that the more money you have, the more complicated your finances must be, and therefore the more money it costs to “manage” those assets. Your adviser has an incentive to grow your assets which in turn makes you wealthier. Of course, the more assets under management, the more money your adviser makes. Everybody makes more money. It’s a win-win arrangement. Or is it?
Percentage of Assets Fee — The Reality
The reality of percentage of assets fees is not nearly as pretty as the theory. Conflicts of interest abound for financial advisers whose compensation is tied to assets under management.
Conflict #1 – The mutual funds most financial advisers recommend in managed asset accounts typically have higher expense ratios. That could cost you an additional 1% per year on average and it has a significant impact on your long-term wealth. For example, if you contribute $5,000 per year to a Roth IRA and receive an average annual rate of return (after expenses) of 9% for 30 years instead of 10%, then that additional 1% expense ratio will cost you $161,841 over that time.
Conflict #2 – 401k/403b/457 retirement plans and 529 college savings plans are not an adviser’s best friends because they normally cannot collect asset management fees on such accounts. Instead, advisers aggressively push for rollovers to IRAs so they can collect their fees, offer general suggestions, or simply ignore these retirement assets altogether. Likewise, advisers may avoid 529 college savings plans in lieu of other opportunities. There are many good reasons for rollovers from 401k/403b/457 plans to IRAs or to choose other college savings plans than a 529 account, but one of them should NOT be your adviser’s paycheck.
Conflict #3 – Using an exclusive custodian for client accounts means that the financial adviser is limited to only those investment options available through that custodian. You may not be offered the best selection of investments to meet your needs.
Conflict #4 – Financial advisers have an incentive to keep as much of your assets under their management as possible, even if paying down debt, when to claim Social Security benefits, whether or not to take a pension buyout, making a large purchase with cash, or gifting for estate planning purposes is more prudent. Such decisions are rarely straight by the numbers and it’s easy to argue them either way. You may not get an unbiased perspective.
Conflict #5 – Financial advisers get paid whether or not your assets grow. If you had $500,000 managed by your adviser last year, then you paid $5,000 at a 1% annual fee. If you lose 20% in the market (now you have $400,000), you will still pay your adviser $4,000 this year. Sure, it’s a cut in his or her pay, but it hardly breaks the bank. Advisers also collect their fees to “manage” your money, even if you are engaging in a “buy and hold” strategy. the point is, having your assets managed on a percentage basis does not necessarily guarantee your adviser is “on the same page” with your or even working all that hard on your behalf.
Conflict #6 – You are not an attractive client if you haven’t already accumulated sizable assets. Most financial advisers require minimum asset levels, typically $250,000 or more. So, the very people who need help the most (the middle-class, young couples starting out in life, or those who have had financial difficulty) are left out in the cold.
Conflict #7 – You become a less attractive client as your financial planning needs increase beyond investments. For example, most clients face major financial decisions in the years leading up to retirement and early in retirement. An asset managing adviser doesn’t have time to do analysis of your retirement prospects, how best to claim your Social Security benefits, how to structure asset withdrawals to meet your retirement needs, etc. Yet these are huge issues for you with irrevocable consequences. Furthermore, from his or her perspective, you are only paying for “asset management” and these other pesky service requests amount to free work on their part. Therefore, you are not likely to get the careful attention these issues deserve and/or be asked to pay additional fees!
How Can You Avoid These Conflicts?
At Liberty Financial Planning, we believe that compensation based on an hourly rate or flat fee for services rendered is more sensible and economical for clients because it eliminates conflicts of interest. We work hard to provide you with objective advice that’s best for you.
Give Liberty a call today for a free initial consultation to see how we can serve you.
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