How you pay for private-client investment services matters, but not as much as what you pay for and how much you pay. How you pay is typically now between flat fees, independent of the value of a transaction or portfolio, and asset-based fees, where a percentage rate is applied to a value. In this article we help you to think about the choice in a practical way.
In financial services, looking after your own best interest always means trying to identify agents who are out to exploit their information advantage over you. Unfortunately, charging methods are not a reliable proxy for differentiating between collaborative and exploitative businesses. Nor does the way they charge necessarily tell you what you need to know about actual service scope and the likely sources of value. That simply means you can’t avoid the careful work of identifying, by other means, how a firm’s interests will in fact be aligned with yours and whether the service meets your real needs.
How we charge
Before debating charging methods in an objective way, I should declare our firm’s position. We make a distinction between the optimal way to pay for financial planning and ad hoc transactional advice, on the one hand, and the most realistic approach to charging for continuous portfolio management:
- Flat fees for advice
- Asset-based fees for portfolio management.
That difference in wording here, ‘optimal’ and ‘realistic’, is deliberate. How to pay for advice is subject to objective tests. How to pay for portfolio management is nuanced, even with objective tests.
In our case, the two service elements are integrated. We use the same quantitative modelling engines to drive the goal planning and the management of goal-based portfolios. Besides, we only offer financial planning and ad hoc advice as part of a continuous wealth management agreement. In spite of that integration, there is no reason not to differentiate between charging methods, based on the service element, where these arise as different stages.
For instance, all new Fowler Drew clients go through an initial planning stage to identify objectives, needs and preferences by individual financial goal, such as retirement spending or gifting. Flat fees for this can easily be separated from the resulting portfolio management charges, by both amount and the basis of calculation. On the other hand, regular replanning of a goal (in the light of achieved investment returns or minor changes in personal circumstances or preferences) is hard to separate from portfolio management, so we cover it in the regular asset-based fee. Only a major restructuring, such as on divorce, would attract a new flat-rate planning fee.
How did we arrive at this charging approach? This involves explaining the theoretical or economic arguments for one or other charging method but also our practical experience, having tried various methods. What really singles us out is that we are one of the UK’s only wealth managers to have experimented with entirely flat fees for everything we do. You can read about our charging experimentation in our fees pages, here.
What choices do you have?
How much charging diversity is there for you to choose from? More in advice than management – but partly because the definitions are becoming more blurred. That means you have to be sure that you are comparing like with like.
For financial planning and transactional advice, there is no shortage of firms offering flat fees for their service, even though this competition by fee basis is relatively recent. I don’t know what the split is across the market but the direction of travel is definitely towards flat fees. The basis of the flat fee may vary, such as a fixed rate for a type of transaction or a time-based rate, but what it is not a function of is the value of the transaction.
The difference in fee basis for transactional advice and financial planning is not necessarily explained by differences in service scope. Both activities have common service formats shaped both by shared interpretation of FCA ‘conduct of business’ rules and by the homogenising effect of training for professional qualifications. Low diversity in service format is not a good thing but that’s a whole other story.
In ‘true’ portfolio management, on the other hand, there is effectively a hegemony of asset-based charging.
It is possible to find flat-fee advisers in the IFA community who offer continuous stewardship of a portfolio of products or funds which appears, on the surface, to be directly competitive with wealth management using similar products. Management of a portfolio of securities by discretionary managers, such as private banks, is universally asset-based and even where securities have been replaced by funds, including index trackers, the fee basis has not changed. Where advisory portfolio management used to be dominant, amongst private-client stock brokers, they have mostly adopted portfolio fees, usually on a discretionary basis, and have replaced transactional commissions with portfolio fees.
The differences between service scope and sources of value are in our view more important than the differences in charging model. A flat-fee IFA regularly reviewing and rebalancing a portfolio of funds may be doing more, and more of value, than a private bank or stockbroker with a large number of small accounts that get overlooked. But a flat-fee and low-cost service could be so standardised and commoditised as to be of little value. In effect, then, the competition is not defined by the charging method as much as by the activities in the scope of the service. Actual scope differences can be hard for investors to discern. Even we struggle with the descriptions on other firms’ websites.
Purely digital businesses, often referred to as robo-advice, have always looked the most likely source of disturbance to the dominance of asset-based fees. Yet these have mostly chosen not to disrupt the fee approach. Those that did were not successful in making a market impact, though perhaps for other reasons. What is clear is that it will take very deep pockets to challenge the hegemony of asset-based fees, whether using a trusted brand or establishing a new brand.
Flat fees for advice
The drive to flat fees has mainly been explained by minimising conflicts of interest. It stems from both regulatory impetus and developing professional standards but it has drawn oxygen from the competitive edge that comes from arguing for better alignment of interests.
IFAs were exposed to an external change in charging approach in the form of the Retail Distribution Review (RDR). IFAs were previously paid for their services in the form of commissions set and paid by fund management houses and insurance companies. This fee was contingent on there being transactions to broker. RDR replaced commissions with ‘customer-agreed remuneration’ whereby an IFA’s client signed a mandate instructing the provider to pay a fee to the IFA on the basis agreed between the client and the IFA. New FCA conduct rules also required there to be a genuine service matching every fee instance, which was not the case for commissions paid out over many years.
‘Adviser remuneration’, as it came to be known, had the notable effect of lowering the annual management charge of collective investment funds where managers previously bundled the broker’s commission into the rate even if there was no broker. But it did not make much of a difference, or not immediately, to the rates agreed by IFAs with their clients. The old commission rates were not particularly competitive and the old 3% ‘initial commission’ or ‘front-end load’ morphed almost seamlessly into a new 3% initial financial planning charge and the ‘trail commission’ of 0.5% pa became a new ‘ongoing advice’ charge for monitoring and reviewing the investments.
The most effective influence on IFA charging methods has arguably not come from regulatory change but internally, in a good way: diversity of service format. The most important influence came (like much in financial services) from the US: the development of financial planning, as distinct from transactional advice. As in the US, this emerging group of IFAs sought to occupy the moral high ground by arguing (successfully) that value-based fees contingent on a transaction necessarily bias advice. Behavioural finance ideas, also originating in the US, probably paid a part in this diversity of service. Financial planners demonstrated their value as ‘life coaches’, nudging, motivating and leaning against wealth-destructive behaviours – including those that professional investors were prone to.
Financial planners also recognised early that you won’t persuade clients you are offering something of high value if you also tell them they do not have to pay for it directly, or (worse) that the advice will be ‘free’, even when the commission is paid from their own money. The result is that when we started our firm in 2004 we were already far from alone in offering genuine, holistic financial planning and charging a flat fee for it that we successfully argued paid for itself in value received.
The FCA would doubtless claim credit for encouraging advisers to communicate more clearly the basis for their fees for service but competition had changed the advice landscape well before RDR. In only one circumstance, advice on Defined Benefit pension transfers, has the FCA actually banned a contingent fee. It admitted that other transaction-based fees could bias advice. It simply saw the quantum of the detriment being greater because of the large size of many transfers.
Asset-based fees for portfolio management
The fee rationale in portfolio management is more nuanced. The theoretical arguments favour an asset-based fee and these appear to be validated by how clients actually value this service, yet they run counter to arguments based on the best alignment of economic interests.
The rare businesses promoting flat fees for continuous portfolio advice or management tend to major on the conflicts of interest as much as they do on cost savings. This is not surprising. Flat fees for the same service equate to a very different cost when related back to asset values. So, assuming investment returns are equal, the value proposition with flat fees is highly dependent on the target market by wealth levels. The value is most compelling if the service is aimed at the low end with a low fee (perhaps most plausible with a purely digital solution) or at the high end with an effective fixed cost well below private banks and stockbrokers. This is very limiting. So whereas particular businesses might promote a flat-fee service because they are content with a narrow market segment, it will never scale up across the industry.
It is limiting for a firm but also for a client who may well expect to be in different cohorts at different stages of their saving career. This raises an important point about asset-based fees: they necessarily introduce cross subsidies between clients with different levels of wealth. This follows from the fact that the direct costs of providing the service are only loosely associated with wealth levels and may even be independent. Some of the costs are clearly directly dependent on values: regulatory fees, professional indemnity insurance and the accrual of capital reserves to meet regulatory capital requirements. Whether covered by insurance or own funds, errors tend to have an impact associated with transaction size which itself usually tracks portfolio size. Other costs follow asset values only if wealth levels are associated with complexity, which is generally but not always true.
The effect of asset-based fees in most firms is that the largest clients, even if they apply a ‘regressive’ scale with declining marginal fee rates, contribute most of the firm’s profit and allow it to lower its entry point for small clients. This is why it has scaled up and remained dominant. Cross subsidies excite some people. But when we have discussed this with our clients, they are not particularly fussed. Many realise they were small once and enjoyed subsidy and so are relatively happy now to subsidise other perhaps younger clients. Most are perfectly comfortable and some enthusiastic, even, with a progressive socio-economic business model where the wealthy subsidise the less wealthy. Older clients may also focus on how they plan to run down their capital through both spending and lifetime gifting. That could be penalised by a flat fee in the same way that minimum fees dictate the effective entry level for early-stage savers.
The fact that no serious competition to asset-based fees has found traction is important circumstantial evidence that investors really do associate the value they receive from wealth management with the base wealth to which that service applies. In other words, they think of it as being more like a utility where the benefit attaches to the amount of something consumed (like gas, data or borrowed money) rather than the benefit being independent of the amount of the capital to which it applies and a function only of the provider’s costs (like a solicitor’s time).
That does not mean they do not try to game the system. They do so by withholding information about their wealth and by trying to reduce the base capital the fee is attached to. But that can have a different explanation consistent still with maximising value, such as resisting pressure to invest where they prefer to hold cash or because they see declining marginal value in the service that is not fully recognised in the declining marginal fee. The best way to deter clients from gaming asset-based fees is to keep the fee low enough and the benefits of comprehensiveness obvious enough that marginal value remains high.
Theoretically, a hybrid of flat and variable portfolio-management fees can provide a better match of economic interests between agent and client. We experimented with a hybrid fee, on the basis we thought it was fairer, even if clients were not that fussed about cross subsidies. Because we operate goal-based investing and because the goal-specific portfolio solutions were in our case quantitative, we believed we could differentiate fee levels by how complex and how mission critical the problem and therefore how valuable the solution. For example, having a solution for drawdown is more valuable than one for early-stage saving. Though the principle was straightforward and credible, putting numbers on the flat fee and therefore the mix was less persuasive. Non-clients looking at our unfamiliar approach were even suspicious, if they did not know us, that it was designed for our benefit, not theirs.
Managing conflicts of interest
The disadvantage of asset-based fees from the client’s point of view is that they introduce potential conflicts of interest. Smart clients know this and that’s partly why they game the system. But if they’re smart they also know that an adviser will be pushing to take more risk if that has the effect of increasing the sums in the portfolio. This would not necessarily arise if all the capital was in the fee base but the fee was set at a low level. But some of the agenda differences around risk are too subtle even for smart clients.
It becomes clearer with an insight into the economics of asset-based fees from the perspective of a manager. Linking the income of the firm to portfolio values does two things. First, it means over very long periods (decades, say) revenues will tend to rise faster than ‘true’ costs (notably costs before profit share) because equity returns tend to exceed inflation. Second, over shorter periods it imports the volatility of capital markets into the firm’s profit and loss account. This means the firm has a set of time-related preferences or trade-offs to make in the area of volatility of profits that are closely equivalent to the trade-offs its clients want to make in the area of the volatility of their portfolio. They share the exposure to different short- and long-term effects but they do not share the same utility or optimality.
I’m not sure many of our clients appreciated it, but when we started the firm we had a definite preference for flat fees, to minimise variance in our income stream. We were more volatility-averse than our clients. Now the firm is established and well-capitalised, we are more comfortable with a more variable income stream, though the effect of our minimum fees and absolute caps is still to constrain that variance. But clearly it is only by chance that our utility and that of any one client were the same, at either stage.
This does not mean wealth managers necessarily make portfolio decisions or advise clients in a way that favours their own utility. But it does mean the client should be alert to the possibility and look for evidence it is not in fact happening.
The way we demonstrate that agenda differences do not in practice have any impact is by making the decision making method systematic, or quantitative, rather than subject to the judgement of any one portfolio manager. This objectivity also serves a purpose to demonstrate that behavioural differences have no impact.
It’s also important it is collaborative and transparent. Where a choice has to be made that does not involve our discretion (such as a change in target outcomes for unchanged risk, a change in risk approach, or a decision whether the resources available permit gifting or more spending), we get there not be recommendation but by interacting together with the model that generates the numbers for resources, time, targets and risk. Using our interface, clients reveal their preferences and tolerances directly by responding to the numbers. This means any trade-offs are those of the client. We explain this here with an example.
The digital future
If we are right, this combination, digital methods that put client’s more obviously in control and asset-based fees with caps or steeply regressive scales, means it will not be necessary for firms to move away from asset-based fees for portfolio management.
- Costs will be lower
- The value of comprehensive scope across all financial goals can be made plain
- Any conflicts of interest arising from the fee basis will be conspicuously resolved in favour of the client.