Why do flat fees matter
Imagine shopping for a financial planner and one of the questions you ask is how much is your fee is annually in terms of dollars, and they respond with “how much money do you have?”
You – “I pay you 1% on the $200,000 you manage for me, right?”
Advisor – “Correct. That 1% is $2,000 annually.”
You – "I am getting ready to retire and you want to manage my $800,000 401k balance at the same 1% fee. This would increase the fee I pay you 5 times from $2,000 to $10,000 annually. Explain to me in detail how you will increase your services 5-fold."
Advisor -” …….”
Retirement Portfolio Partners firmly believes that despite the growing popularity of the “Assets Under Management” (or “AUM”) model and its important advantages over commissions, it is still riddled with conflicts of interest while also preventing clients from receiving the enormous benefits of economies of scale that now exist. Moreover, it does not make sense that the value of a client’s portfolio should determine the fees paid for financial planning services.
AUM fees do not really incentivize financial advisors to grow accounts; they incentivize them to gather more assets. It does not cost a firm twice as much to manage a $2 million portfolio as it does to manage a $1 million dollar portfolio, and the service provided does not change much, so why should the client pay twice as much? If the market goes up 10% and you are invested in index funds that also go up 10%, do you think it is fair to pay your advisor 10% more even though he didn’t do any additional work?
“understanding the power of incentives, and all my life I’ve underestimated it. Sometimes the solution to a behavior problem is simply to revisit incentives and make sure they align with the desired goal”
A COMPOUNDING EFFECT
Your portfolios should benefit from the wonderful nature of compound interest, but you would probably be okay if your costs didn’t. Asset-based fees (AUM) compound and can make a significant difference in the long run.
The chart below displays the comparison over a 20 year period of two $1 million portfolios, where one pays 1% annually of assets under management and the other pays a flat annual fee of $5,100. Assuming both portfolios earn a gross annual return of 7% annually, the 1% fee portfolio can cost an investor over $500,000 in lost returns compared to a flat fee.
An investor starting with a $1,000,000 account investing over 20 years will pay 1% advisory fees to the tune of $400,000 in this scenario. This compares with the $102,000 this investor could have paid under a flat fee structure. The $400,000 figure equates to roughly 14% of the investor’s long-term returns.
You should be the one who benefits from the economies of scale your large account balance provides, not your advisor.
CONFLICTS OF INTEREST
Conflicts of interest still exist under an asset-based fee model:
Rental Income
Imagine you’d like to take $100,000 out of your portfolio to invest into a rental property, and you ask the opinion of your financial advisor. There is now a conflict, as a withdrawal from your account will affect the advisory firm’s revenue if they work on an 1% fee schedule.
Pension Choices
A common scenario is if your employer has offered a lump sum distribution for your pension benefit. Imagine you have the choice of receiving a $35,000 annual pension, or a lump sum benefit of $500,000. Getting objective advice on such a matter would be difficult, if the person giving you advice could get a significant raise by suggesting the lump sum without doing any analysis what so ever.
Spending
Many of my newly retired clients are healthy and anxious to travel and enjoy their new-found freedom. Many advisors use client’s fear of running out of money to get them to live on unreasonably low budgets. An advisor who charges on your assets would love for you to have millions left in your portfolio when you pass away. For most of my clients, they’d much rather enjoy that money in retirement.
Gifting
Many clients have gifting goals, and would like to see their money at work, rather than wait to gift when they pass away. That gifting may bring a client great satisfaction, but will bring an AUM based advisor a hit to his bottom line.
Annuities
Riddle me this: Most advisors will tell you that compensation structure is irrelevant, you just do what’s right for the client. Perhaps those advisors can explain to me why commissioned-based advisors recommend annuities to everyone, but AUM based advisors never recommend them. To me the answer is obvious, commissioned based advisors make huge commissions by selling annuities, while AUM based advisors give up their client’s assets (and therefore their ability to charge AUM fees) when they recommend annuities.
Smarter Planning. Smarter Portfolios. Smarter Fees.