Illustrations By Christoph Hitz
Looks like the revolution is pretty much complete, huh? Wirehouses are tumbling over themselves to offer fee-based financial services. Personal finance books routinely arch a warning eyebrow at commission-based advisors; stern warnings to consumers are a matter of course. Consumers themselves appear to be firmly on the fee bandwagon. A recent study by DALBAR, Inc. reported that nearly two-thirds of consumers say they'd prefer to compensate their advisors through fees rather than commissions. Aspects of the debate are so well known that a planner like Chris Brown of Gaithersburg, Maryland, wraps up the "same-side-of-the-table-as-the-client" objectivity speech with a wry "Okay, commercial over."
"There are three steps in the revelation of any truth: in the first, it is ridiculed; in the second, resisted; in the third, it is considered self-evident," wrote the German philosopher Schopenhauer. Hallelujah! Welcome to the third step in the fee/commission debate, the feeling seems to run. The tide is rising, the Great Darkness receding, even the creepiest of the creepy tossing aside their commission schedules, handing in their horns and pitchforks, and lining up in droves to don the glowing mantle of fee compensation! Everybody wants fees, everybody's dashing to provide them - looks like it's time to prop one's feet on the desk, sip some iced tea, and wait. It's only a matter of time.
Um, well ... no.
According to the CFP Board's 1999 CFP Practitioner Survey, the method of compensation for two-thirds of CFP practitioners still involves commission. Twenty-five percent of CFPs are still paid through commissions alone. The droves are not lining up. Not everyone, apparently, holds these truths to be so self-evident.
"I don't know too many people around here who are solely compensated with fees," says Elaine Kronberg, a fee-and-commission planner from Milwaukee, Wisconsin, who is affiliated with Waddell and Reed. "I am a CFP, and I do go to conferences. And I find that commissions are still very definitely out there."
Attendance at the Transitioning to a Fee-Only Practice seminar at NAPFA's annual conference has decreased, says Diane MacPhee, an advisor from Glen Rock, New Jersey, who teaches the seminar. "I'd say two or three years ago, there were more people transitioning over than there are now," she says.
And are those full-service brokerages really planning an all-fee transformation for the majority of clients? "No," says John Beuerlein, a general partner at Edward Jones in St. Louis, very firmly. "We really do not." Less than 5% of the firm's clients are in the company's fee-based money management program now. Does he expect that to grow? Again, very firmly: "No."
Wait a minute. What happened to the rising tide, the revolution, that same-side-of-the-table stuff? And could there be wrinkles in the shining mantle of fee compensation?
According to MacPhee, one of the greatest obstacles cited by advisors at the NAPFA transition seminar is the fear of a shrinking paycheck. "Planners' biggest fear is a major drop in income," she says. Particularly fearful are advisors for whom a substantial amount of income comes from recurring commissions. "I talked to some brokers when I was formulating my practice, and they all said, 'Wow, you're looking at fee-only? I'd love to do that, but it takes five years to break even,'" says Karin McKerahan, an advisor in Temecula, California (who, incidentally, took the fee-based route nonetheless). Nearly everyone seems to worry about clients bailing out if they rock the boat at all. "They fear that people who were commission investors with them before will say, 'Look, I didn't pay you before. Why should I pay you now?'" says MacPhee. The possibility of losing clients is enough to keep some planners from even broaching the subject.
A second obstacle is the fear of having to know everything. In a sales environment, consumers view the investment product as the purchase and advice as frosting, so expectations about the caliber of the advice aren't always as high. In a fee-based environment, however, the advice is the purchase, so it better be pretty darn good. "The thinking is, I'm paying for advice, so therefore you'd better know all the answers," says NAPFA Chair Gary Schatsky. And in order to do that, the advisor has to stay current on a wide range of topics.
Obstacle number three is rather ironic, given that advisors talk to their clients about money all day long. But for some planners, having to spell out a specific fee places an emphasis on payment that makes them uncomfortable. "It's difficult for somebody who's used to commissions, because they might disclose that there's a commission, but they might never have actually gone into dollars and pennies," says MacPhee. Fee-only advisors would undoubtedly respond vehemently that the dollars and pennies should have been spelled out, and they would be right. But even if commissions were explained, consider, from the consumer's standpoint, which hurts more: a little one-time collateral damage sprinkled in among some new purchases, or a big check to write every quarter and/or a big minus sign on every quarterly statement.
Perhaps the greatest complaint lodged against fee-based compensation is the cost. "My clients can't afford it," commission-based advisors say. That's not precisely the issue. Most people, even of modest means, could afford to pay 1% of their assets for financial advice. The problem is a Catch-22: If the advisor charges 1% of the modest amounts given to him to manage by clients of moderate means, he'll drive his practice into the ground; if he charges a higher percentage in order to keep his practice viable, he'll drive his clients away because they won't be able to afford his services. Either the clients can't afford it, or the advisor can't. "The commission relationship is a far more economical way to have a relationship," says Edward Jones' Beuerlein.
The majority of the fee-based world has not figured out how to solve this dilemma. The most common response is simply to set client minimums, thereby ensuring that the 1% or so can support a viable practice. If the client doesn't have enough money, they are sent elsewhere. Not surprisingly, the part of the fee world experiencing the greatest growth is the wealthier end of the client spectrum. Which brings us to the final major point: Once a planner decides to join the fee-based camp, there's no consensus on how best to actually charge the fees.
Cambridge Advisors, a network of about 45 fee-only advisors, charges clients a set retainer fee each year. "It's a range of $1,500 to $15,000, and reflects the complexity of their situation," says Karin McKerahan, an advisor in the network. "It's based on the extent of your assets, your income, whether or not you're self-employed, the relationship of your investable assets to your total net worth."
Retainers can put financial advice within the reach of people of modest means. But they're not perfect, either. DALBAR, Inc.'s 1999 Preferences in Payment Practices study found that while 46% of consumers said they'd prefer to pay a flat fee upfront, virtually everyone scurried back to the asset-based fee when they found how much the flat fee actually cost. "People want to know beforehand what it's going to cost them, and they don't want to leave it up to basis points, which they don't understand, or percentages," explains Louis Harvey, president of DALBAR. "But they also want to pay after they feel they have received something, not before. With the asset-based fee, it's split up over time, and they feel they've received something: investment management for a certain period of time."
The appealing "I-win-if-you-win" factor of asset-based fees is also lacking in the flat-fee scheme. And critics charge that flat fees are no better for middle-income clients than asset-based fees.
Though hourly fees are not terribly common in the financial advisory industry, advocates say that it is the only way to truly be fair to the client: the client pays when you are working for him, no more and no less. Hourly fee rates are fairly standard throughout the industry, usually falling in the $120-per-hour range, according to the CFP Board's CFP Practitioner Survey. But some advisors feel that it undercuts the idea of a long-term relationship with the client, and risks forcing them to make uninformed recommendations. "I don't like charging hourly," says MacPhee. "I would never have someone come in for an hour, say, 'Here, do this, this, and this,' have them leave, and never see or hear from them again. People can work hourly on 'Should I buy a house or rent? Should I lease a car or buy?' But when it comes to investments, I don't think it should be done."
Many planners with other payment structures will charge hourly on occasion, to help a non-client handle a specific financial issue or to tie up the loose ends of a financial plan paid for with a flat fee. Such meetings can be surprisingly effective, says McKerahan: "Let's say the client is a young teacher who doesn't understand all the options for his retirement plan, and among them are some insurance companies, and some load funds, and other things. Just explaining all that, you can help them make the best choices for themselves for the next 40 years."
Charging clients based on a percentage of assets managed by the advisor is certainly the most common method, says Dennis Gallant of Cerulli Associates, a Boston-based research firm. When the client's account grows, the advisor's income grows in proportion. Larger accounts are usually more complicated, which explains the higher cost. Charging a percentage of the money under management works a little like a tax bracket, requiring greater payments from those more able to afford it.
But, here, too, there are wrinkles. Larger accounts are not necessarily more complicated; wealthier clients can end up paying more for the same service.
The most striking problems, however, are the mixed messages. Assuring clients that investment performance is but a small part of their total financial health, then making the amount they have to pay hinge on that very thing, sends a conflicting message - first, about the importance of investment performance over all, and second, about the advisor's ability to control it. And since the advisor gets paid more in a bull market and less in a bear, the client is forced to conclude that the advisor must be doing better work when he receives more and not performing when he's paid less - when in fact, the opposite may be true.
For advisors venturing into the relatively new "life planning," charging a percentage of assets under management makes even less sense. "In life planning, the amount of assets has nothing to do with it," says John Cammack, a vice president at T. Rowe Price. "If people want to smugly say that it's worth 1% of assets, I would challenge that they're mixing apples and oranges. When you go to a shrink, they don't charge you 1% of assets, they charge you $120 an hour."
So, what to do? Unfortunately, there is no one magical ideal form of compensation - or at least no one has found it yet. A few things, however, are clear.
On the fee vs. commission front: Commissions are not going to go away. "If the whole world was going to go fee-based, it would have happened years ago," says Gallant, of Cerulli Associates. There is still money to be made in commission-based sales, many consumers are still willing to pay commissions, and numerous obstacles still stand in the way of the transition.
On the fee vs. fee front: Every fee style has both its perks and limitations, and different methods lend themselves to specific types of clients. Many advisors are experimenting with mixing and matching compensation structures. "I separate planning and investment management," says Chris Brown, the planner from Gaithersburg, Maryland. "First, a flat rate for a plan based on how much work I think the plan will be, and second, an asset management fee which includes the implementation of the plan, the asset management, and the ongoing relationship, including yearly updates." Strategies like these aren't perfect, but they seem most likely to increase in popularity, because they help the clients understand exactly what their payment is buying, plus it enables them to pick and choose what services they want. Such combinations will also help planners weather a rocky market.
"Before long, there will be a downward pressure on fees, driven partly by the financial press, which is touting asset management services through funds of funds. In an extended market downturn, many practitioners will lose asset-management-only clients," says Cerulli Associates' 1999 study, The State of the Fee-Based Financial Advisor Market. "The financial advisories who integrate asset allocation strategies with traditional labor-intensive financial planning services will be in a position to continue to guide their clients."
For advisors whose practices are drifting away from comprehensive financial planning and - as advisor Robert Moody of Atlanta puts it - "succumbing to to the siren song of asset management," the consensus is: Hang onto your hat. "Focusing entirely on asset management is short-sighted, because it's becoming so commoditized," says McKerahan. Says Brown, "It's easier to manage money than it is to deliver a plan to a client. But it is in the planning that the real value is delivered to the client."