Many new investment firms have popped up in the last few years offering better service, more transparency and lower fees. Some of them are Betterment, Wealthfront, Personal Capital, just a few to mention. Yes, this is better for the investing public as competition and transparency bring about better service, higher quality and lower fees. Yet there’s still one thing that not many have dared to touch nor change and today I’d like to give a version of why we need to educate the public to pay investment fees OUTSIDE of their investment accounts.
A bit of background first, many ‘advisors’ are paid via commissions from their firms but many firms get paid fees to manage clients’ accounts, those fees are typically paid as a percentage of the assets that the advisor supervises. The advisor gets authorization at the beginning of the relationship to withdraw the fees from the client’s account, usually quarterly, based on an agreed percentage, typically at 1%/year fee. Betterment and Wealthfront are at much lower fees starting at 0.25% up to 0.89% for Personal Capital.
Now, I’m not debating the value of service that a client gets, in my opinion, there are many good firms that provide significant value to the client, education, proper asset allocation, risk management, technology and also behavioral assistance during tough market times. What I’m debating is the account that those fees usually come from. They almost all the time are deducted from the investment account that the advisor oversees.
The conveniences and behavioral benefits are really large to mention here, but mainly the advisor has a recurring stream of revenue to plan on, the client doesn’t have to look where to get the money from and also everything is on auto-pilot; no one has to do anything, it just happens. So why change it?
If we were trying to help the client and the ultimate goal is to maximize client’s assets, taking fees from a growth account (typically a long-term investment/retirement account) is the equivalent of taking food from your best horse to feed the trainer. If the goal is to use that horse to win the race, you wouldn’t want to do that.
Let’s see an example:
You start with an investment of $100K observed over 30 years where we charge 1% fee annually. If we don’t take the fee out of that account, the balance will be about $1 Million after 30 years (assuming an 8% average annual performance and no other cash added during the time.) In the same scenario where we take the 1% fee out of the account, the balance will be $740K, for a difference of $260K or about 35% less than if we paid fees from outside the investment account. Now, to compare apples to apples we have to account for the fee paid outside the investment account over time of about $120K during the 30 years, which still yields $140K more to the client after the fee.
You will have almost $140K (19% more, even after fees paid) in the scenario where you pay the fee outside the investment account due to the compounding of the money that would have gone to fees. Even the advisor will make more under the ‘outside fee’ scenario, $120K vs. $100K from inside the portfolio, due to a larger size portfolio. If the fee was 0.25% the gap is smaller but is still there and the account would be about 8% more in value ($1M vs. $930K) if fees were paid outside. So, a win-win scenario for both advisor and client, but it’s not being executed and rarely seen. Why?
First: many clients cannot afford to pay for the advisory fee from the everyday cash flow. They mainly think that the investments should pay for themselves and not require extra money. Makes sense, but also they’re not told the benefit if they pay the fee otherwise.
Second: The advisor has a secure way of getting the fee (without chasing the client) and simply deducting it from the account. It’s easy, convenient, and not invasive to the client.
Third: Not much analysis has been done (that I know of) that compared the two and clearly shows the benefit of paying the fees outside the investment account from regular cash flow.
Fourth: Most importantly, many advisors are still afraid to show how much they make. While few clients check their statements, research shows that many don’t know what they exactly pay their advisor every quarter. If you send a bill to be paid, the fee becomes material and a conversation happens to justify it (or not.) Most advisors don’t want to be weighed every quarter, neither told if their value is worth the money or not.
Basically, many clients don’t know and many advisors don’t make it well known, but there is clearly an advantage if you paid advisor fees out of everyday spending vs. client’s investment accounts. Investment accounts are typically for the long-term, earning much more than typical savings or checking accounts so taking money from them which could compound at much higher rates than your saving accounts doesn’t make any sense. Having $1M or $740K at the beginning of your retirement makes a big difference, the 35% difference could mean at least an extra decade that the money can last at the recommended withdrawal rates. And if we can add 10 more years of income by a simple shift in the way we charge for our value, that to me is looking in the best interest of the client.
We, as advisors, can do better if we’re open to pure transparency and not afraid to help our clients even if some of them will punish us for it. And if affordability (paying the fee from cash flow) is the concern, at least we should inform the client of the benefit and give the choice of such. Will the client go for it? Will advisors go for it? I don’t know the answer but to me seems like a win-win scenario. As companies get more transparent, clients more educated and costs more reasonable, this just seems like the next step in maximizing value. Our firm strongly believes in this, not charging any fees from the investment accounts and solely being compensated by clients’ cash flow.
Thoughts? Would you do it if you were a client? An advisor? Let us know your opinion in the comments sections below.