Post RDR charging: the case for flat fees
The Retail Distribution Review (RDR) is a good opportunity to review the way wealth managers and advisers charge for investment services. The typical charging basis is the value of a transaction (sales commission or brokerage) or the value of an identified portfolio of assets.
If there were no practical constraints on the decision about how to charge, we should expect firm economics to drive the choice. Prior to RDR, constraints have had a major effect on the choices. The practice of providers paying a trail commission out of a product’s annual charges has made it very easy for advisers using packaged investment products to get paid regular fees painlessly and with negligible collection costs. The effect was to tie revenues to market values. Platforms have tended to reinforce this dependency.
You might imagine that this was optimal in economic terms, because regular fees in the presence of persistent relationships tends to increase the net present value of expected fee streams compared with transactional fees. Both stockbrokers and IFAs have typically made the change as long as they could finance the revenue hiatus. However, it may still be suboptimal in two other respects. Much of the work is (or should be) front-loaded and portfolio-based fees import capital-market volatility into the P&L account of the firm.
My view is that firm utility in planning-based wealth management is maximised by flat (as in level) fees that are broadly matched to each of the front-loaded and regular costs of providing the service.
The question then arises whether flat fees should relate to the resource cost of providing the service, which might lead to a narrow distribution of fees per client (which I presume is the case in pure financial planning businesses), or differentiate by wealth levels. In economic terms, the first assumes that the value of the service to clients is independent of their wealth levels and the second that the client perceives value as being related to wealth.
When I started my firm five years ago, I backed a long-held view that the industry had conspired to make perceived value, quite falsely, a function of wealth levels, hence the prevalence of ad valorem charges, whether transactional or recurring. I started out charging similar fees to all. But I quickly discovered that both prospects and actual clients did not value this ground-breaking innovation of supreme economic integrity. Ad valorem fees have survived because people really do think value is a function of the base wealth not the resource cost and even if it is ‘wrong’ it is not a tide I can control.
Wanting to retain the advantages of flat fees, we therefore changed to an approach that linked each client’s annual fee loosely to the level of the total wealth. I have no illusions that it is easier to carry this off when all portfolio services are conspicuously based on thorough financial planning and the investment solutions are obviously customised to an extent that makes the overall context of clients’ financial position significant in explaining portfolio actions.
What are the advantages of flat fees? For clients, they make budgeting easier and clearer. They remove anxiety that their adviser will be biased to taking more risk to maximise their own income. They no longer need to game the fee schedule by holding assets back from their manager or not telling the adviser about them, both of which cut across the benefits of a holistic approach.
For the adviser, flat fees reduce their exposure to market volatility and long down cycles, which is much more consistent with their true utility. Commission-based businesses were quite effective at making salaries variable with revenues but this has been much harder in portfolio management. Portfolio managers have always been greedy. They have been keener on harnessing the long-term upward trend of returns from ‘real assets’ than on controlling the variance in their revenues, which is why they have lurched from all shedding or all hiring staff at the same time as each other, usually too late. For smaller firms operating only with core staff, this is not even be an option. If flat fees are indexed to inflation, the real return trend given up is a small number and is worth far less to most owners than the gain in more predictable and smoother profits. I find it intriguing that advisers preach these economic truths to their clients, as in the discipline of measuring risk-adjusted returns and avoiding equities for short horizons, yet fail to observe them in their own firms.
Setting fees on the basis of value to clients rather than the value of portfolios can also deal with the different effects of having clients in accumulation or in drawdown (whether drawing down means taking income or living off capital). For young accumulators, the value of the service clearly does not increase proportionately with the stock of assets. For older clients the value lies above all in the successful management of the balancing of growth and consumption of capital and this risk-management dependency does not decline as the stock of wealth is run down.
Some professionals in wealth management may wonder whether they have what it takes to sell a value proposition on these terms. Our experience is that when we talk about fees the conversation naturally supports our claims to insights about household economics and ties in with how we want clients to envisage maximising the benefits of their wealth, including ‘soft’ benefits like clarity and confidence. Wealth managers who are already goal-based and planning-focused should find it a natural extension of what they do already.
Establishing with clients the principle of linking fees to the value of the service rather than the value of the assets has also made it easier to recover the front-loaded costs of taking on new clients as flat fees, either for planning or deployment activities, rather than amortising them as part of our regular fee stream.
Unbundling gives wealth managers using packaged products every incentive to drive down the annual charges of actively-managed funds (if they fail, so does RDR). Reducing the implementation costs of their service should make it easier to justify a higher fee for the added value sources of their own role. In this respect, I find it odd that many advisers choose to promote their selection skills above their higher-order planning and risk management skills.