The cost wedge just got fatter
Most personal finance sections have recently converged on the story that several large fund management houses are pushing up annual management charges again. This is an inevitable consequence of consumers using more agents, including the internet, to avoid or cut front-end loaded sales commissions. The effect is that more of the commission payments from providers to distributors must take the form of a share of the annual management charge, making distribution costs more equal across different types of fund and the ‘cost wedge’ harder to avoid. It is also an unintended (but predictable) consequence of the Treasury validating 1.5% as the cost ceiling for stakeholder products, as this encourages consumers to view a relatively high point in the cost wedge as its thin end.
The only way consumers can avoid the wedge, and the biases it creates in financial advice, is to pay for advice by fee, not commissions. If people understood what commissions cost them personally and what they do collectively to the product of the nations’ savings, this mad, mad world would be turned upside down. Read on and you will see how you can turn it around for yourself. If you are currently placed at the average level of the wedge, you can generate up to a third more money in 20 years by working your way back down it.
I have to declare an interest here. As well as writing for about five years on the damaging business model the funds industry and the advice industry have mutually adopted, I am a co-founder of a company, No Monkey Business Limited, that provides both financial planning and continuous portfolio management for fixed fees, independent of the values involved. Our business model is focused on individuals with millions, for whom cost savings typically pay our fees many times over, but the principles apply at every level of affluence.
Our model arose out of a much earlier business plan, conceived in the heady days of the internet boom, for the ‘democratisation’ of advice and portfolio management. Behind the webby sales pitch was a simple means of making mass customisation a reality by marrying technology-delivered, rules-based decision support systems and simple low-cost products like trackers. The principle of charging low fixed fees or subscriptions for planning financial goals, identifying resource requirements and risk preferences and then dynamically managing a goal-based journey remains a viable mass market possibility. It is being actively explored by firms with appropriate consumer brands as well as by firms who think the subversive model can spawn a new brand. But five years on, it remains a blue-print.
Much of the business risk in turning the blue-print into reality arises from the fact that consumers are not well-informed about the cost and impact of commissions, in terms both of biases in advice given and lower financial outcomes. If this were not so, fund managers would not be able to keep edging annual management charges higher to pay for the advice industry’s cost of doing business.
Breaking the link between advice and products, and so between advice costs and asset values, makes sense for all but the smallest investors. There is some level of savings at which a fixed charge would be more expensive but only because variable charges mean these savers are being subsidised by more affluent savers. Apart from the fact that those doing the subsidising may not want to be so generous, it is debatable whether those being subsidised are well-served using the same financial products. The kind of advice most valuable for families on low incomes is not being provided by banks and IFAs anyway.
A worked example
The impact of the cost wedge at modest levels of fund accumulation can be illustrated by projecting values for two different types of strategy:
Fees for advice coupled with simple low-cost products
Commissions for advice which require the selection of expensive actively managed products
A regular investment of £5,000 pa in real terms is a good benchmark for modest earners funding retirement income, so let’s take that, and 20 years as the term, as the basis of the illustration. For route 1, we’ll assume that the saver starts with a budget of £500 for advice which is enough to buy several hours of financial planning for this retirement goal, taking into account analysis of other needs and means. For good measure, we can assume that during the 20 year term a further £1,000 in today’s money is spent on advice bills.
Because the plan assumed here relies on a simple and mechanistic ‘lifestyle’ approach to asset allocation and uses index funds and government-guaranteed bonds to implement it, the need for further advice is limited. With proper communication of the progress of the journey and where a customer is in relation to his or her goal, there may be no further requirement to pay for advice. The choice of index-tracking funds over active funds makes a big difference because active management generates its own need for advice – whenever actively managed funds disappoint and investors cannot tell whether the fund they thought was a star is really a dog.
If we project this plan forward using a real (inflation-adjusted) return before charges over the entire 20-year period of 4.5% (weighted by the different asset class exposures), take off fund charges averaging 0.6% pa as well as the three advice bills, the fund will accumulate in 20 years to £151,602 (still expressed in today’s money, or ‘constant purchasing power’).
Let’s see now what happens when route 2 is chosen. The typical commission-based adviser or bank will recommend active funds. This is simply because their business model depends on commission flows. It depends on them even when they are offsetting the commissions against a scheduled fee for advice or portfolio management because they think the customer will not pay the level of fixed fee that would generate the same present value of income for them. Therefore fee-based advisers still need to recommend actively managed funds. We will assume that the charges associated with active funds are a sales charge of 5% and an all-in annual fund cost of 2% – made up of an annual management charge of 1.5%, other fund expenses of .10% and a modest level of transaction costs within the fund. If recent portfolio turnover levels within active funds were to be sustained over the next 20 years, we would need to assume total costs nearer 3% pa but turnover has reached such a barmy level it makes little sense to extrapolate it. Because the cost of advice is covered by some of these charges, we need to add no explicit cost of advice for route 2.
Assuming the same asset mix and market returns, the expected fund value in 20 years is £114,553. The difference between route 1 and route 2 is £37,049. Route 1 is worth a third more than route 2.
This is equivalent to a return difference of 1.5% pa. The commission-based adviser will tell you that the active managers’ potential to outperform is more important than this cost difference. What they will certainly not tell you is that the chance of the actively managed funds making up a cost difference of 1.5% pa for 20 years through superior stock selection, even if all the fund was in equities, is quite simply infinitessimal.
It is the fundamental dishonesty of the sales pitch that the business model relies on, for both advisers and fund managers, that led me to call the chapter on active management in No Monkey Business ‘the performance lie’.
Low risk investment and fund charges
In this example, part of the problem of irrecoverable additional costs arises from the fact that part of the investment is in assets that have a much lower real return expectation than equities. Fixed income investments may only carry a 2 or 3% real return hope, compared with say 6% in real terms form equities, yet get saddled with the same (or nearly the same) high costs as an equity fund.
This problem is being aggravated by the current round of cost increases, as they particularly apply to funds that hold a mix of assets and offer lower but safer expected returns. In many case, these mixed funds are also bought for income and fund costs directly impact the income stream. Even small increases in costs can make the choice of low-risk fund irrational.
This applies even more to pure fixed income funds. Take Legal & General’s Fixed Income fund, which is one of the largest and most straightforward bond products (suitable, for instance, as an alternative to equities in an ISA). The increase in the annual management charge made last year was from 0.5% to 0.75% pa. It still sounds low but when you consider that the risk-adjusted expected real return is possibly only about 2% pa, it means the cost of packaging bonds in a fund is irrational.
To overcome the bond cost wedge, fund managers are driven to own higher yielding paper – which is also what is happening in with-profits funds that are trapped in fixed income investments. But these higher yields cannot be both a risk premium for credit quality and a means of absorbing higher fund costs.
Most savers would be far better off holding their low-risk assets as cash, National Savings certificates or individual gilts and avoiding fund packaging costs entirely. Even inflation risk can be managed efficiently by direct investments, whether by buying instruments with a government inflation guarantee or rolling over cash deposits at market interest rates that over time will hopefully reflect inflation fairly accurately.
The traditional one-stop shop for low-risk savings and investments, the Post Office, now sells guaranteed equity bonds in direct competition with National Savings. These are a perfect example of a product devised by clever marketing people to look like something it isn’t. It is a fitting commentary on the way successive governments have failed to undertand the social benefits of encouraging basic low-cost savings products and easy access to them. If the Treasury had spent the time it devoted to market-based stakeholder rules on government-based solutions for mass-market savings, it could by now have something useful to show for it. Something for Labour backbenchers to add to their buy lists?