The Wrong Way to Pay for Financial Advice

"Your margin is my opportunity." -- Jeff Bezos

Imagine you're checking out at the grocery store. As the clerk scans your bananas, she asks you to step on the scale. "Two-hundred seventy-five pounds," she reads off. "Your bananas will cost $9.86."

You are confused. What does your weight have to do with the cost of bananas?

"You weigh more than average," the clerk explains. "So it costs us more to provide you with bananas."

But the skinny guy in line behind you just bought the same amount of bananas. He received the same product and the same service as you, but paid half as much.

This infuriates you. How much you weigh shouldn't alter how much you pay for bananas. It's the amount of bananas you actually buy, and the service the grocer offers, that should affect prices. Customers would never put up with grocery prices being based off your weight, which is why no one weighs you when go to the grocery store. 

But this is how most of the financial industry operates. The price of almost every service you buy takes your weight -- or your portfolio's weight -- into consideration.

Most financial advisors charge a fee based on a percentage of your investments, called an asset under management (AUM) fee. If you have $500,000, a 1% fee means you'll pay $5,000 a year. One million dollars with the same advisor costs $10,000 a year, and so on. This is standard across the industry. Tens of trillions of dollars are managed based on this arrangement.

But why? It's like charging fat people more for bananas. Clients often receive the same service, the same investments, the same performance, the same brokerage statement, and with the same amount of effort put in by the advisor, but at vastly different prices. Few other industries could get away with this.

AUM fees might make sense for advisors focusing on small-cap or private companies, where managing more money truly becomes a hindrance. But that's a small exception. It is not 10 times harder to buy 5,000 shares of Microsoft as it is 500 shares, nor is it 10 times as difficult to purchase $5,000,000 in Treasuries as it is $500,000. But advisors will receive 10 times as much in fees.

There are two reasons financial advisors charge AUM fees: It's how the industry has always operated, and you can make a lot of money doing it. Warren Buffett said a few years ago:

Wall Street markets are so big, there's so much money, that taking a small percentage [of assets] results in a huge amount of money per capita in terms of the people that work in it. And they're not inclined to give it up.

But some advisors have given it up. I'm hearing about a growing number of advisors charging a set, flat fee, regardless of the amount of client assets.

"Rather than arbitrarily deriving our compensation from the value of an investor's portfolio, we have built a retainer fee structure around the services that we provide," writes James Osborne of Bason Asset Management. This is the how most CPAs operate. His fee structure is simple: "$4,500 per year, per client relationship."

 "Our services do not vary appreciably between clients with larger or smaller portfolios, so our fee structure reflects this," he writes.

Unless your income depends on AUM fees, it is hard to argue with that logic.

Flat fees will likely lead to lower incomes for advisors -- especially large advisors -- while clients keep more of their money. Welcome to capitalism! The traditional advisory business has been a honeypot for decades, where advisors could earn more than brain surgeons while lagging their benchmark. Since stocks tend to grow above the rate of inflation, advisors' income balloons over time through no effort of their own. If an advisor put his clients in the S&P 500 and went to the beach, his annual income would have grown at six times the rate of inflation over the last 30 years, all without lifting a finger. Competition shouldn't allow that to occur. "The average AUM-based established advisory firm is running 50-70% gross margins," Osborne wrote last week. That's enormous. And as Jeff Bezos says, "Your margin is my opportunity." Flat-fee advisors are coming after that opportunity as fast as they can.

I think one of the biggest trends we'll see over the next decade are financial management fees falling like a rock. They've already dropped in recent years, but there's still enormous fat to cut. Not only will AUM fees be pressured to decline, but the way advisors charge may be upended. The winner is you, the investor. 

Check back every Tuesday and Friday for Morgan Housel's columns on finance and economics. 

 


Read/Post Comments (26) | Recommend This Article (41)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On April 07, 2014, at 11:30 PM, astuber9 wrote:

    I am skeptical that management fees will come down but I do have to admit my 401k got a whole lot leaner after (or really just before) the new 401k disclosure legislation that went into effect last year. Hooray for government. They got something right.

  • Report this Comment On April 08, 2014, at 10:22 AM, jpanspac wrote:

    A couple of years ago my wife put some of her 401k into one of her company's target date funds. Back then fees weren't disclosed for those funds. Now they are, and I recently found out her fund charges 1.6%! Needless to say we dumped that fund as fast as we could.

  • Report this Comment On April 08, 2014, at 1:11 PM, dreamimmigrant wrote:

    Because of scams like this, i'm managing my own portfolio and I'm doing pretty good (thanks to dividend growth investnig)... who needs these overrated money managers anyway. 401Ks that don't allow you to buy and sell individual stocks are a big scam and subsidy for wallstreet...they make money whether you make or loose money. I don't know why no one hasn't challenged 401Ks that restrict your investments to only mutual and index funds and not individual stocks

  • Report this Comment On April 08, 2014, at 2:27 PM, vjalukar wrote:

    The scams are on many levels.

    Many smaller companies don't make any effort to get good investment options...

    My wife's company has an S&P500 index fund with fees in excess of 1.0%. There's a Money Market fund (making less than 0.01%) which charges 1.2% in fees.

    When she asked about getting Vanguard funds, the 401K manager stated he could "do her a favor, and invest in those funds," but would charge a broker-assisted trade charge for each (weekly, since her company's payroll is every 7 days) purchase.

    As always, be vigilant.

    My company's 401K plan switched some funds that were offered. The letter announcing the changes boasted about the outstanding management team that would be overseeing our money. But when I looked at the fine print in the prospectuses, there were across-the-board increases in fees, even for the index funds.

    The difference was staggering... For every $100K of AUM, they were going to charge me $3.52 per day, to put my money in a 500 index fund.

    Loud complaints from all of us led to reduction of the fees to our pre-change levels.

    Now, I'm looking at doing my own direct investment of 401K dollars. But, for that privilege, they will charge me around $300/year. That's better than gouging I was about to get.

  • Report this Comment On April 08, 2014, at 6:25 PM, Daryl98229 wrote:

    I wish we could get a flat fee structure for selling real estate. How they "earn" 6 to 7% of the value of a home just for selling it is beyond me.

  • Report this Comment On April 08, 2014, at 6:58 PM, Lucaskasan wrote:

    IF you have $500,000, that flat fee is only a little less than the common 1% AUM. However, the flat fee prices out the little guy who really needs the best advice. Since most advisers also have a minimum AUM, the little guy cannot even qualify to pay any fee. In fact, that flat fee prices out medium-size guys. Think about how many years it would take to amass amounts between, say, the $100K to qualify for advice and the $500K cited by Morgan.

  • Report this Comment On April 08, 2014, at 8:03 PM, TMFHousel wrote:

    Lucaskasan,

    It's true for most products that some people with lower means won't be able to afford the services that richer people can. There's nothing odd about this. I'd love a Ferrari. I can't afford one. So I have a cheaper car I can afford. Likewise, there are lower-cost options than Bason Asset Management. Stock Advisor is less than $100 a year.

  • Report this Comment On April 08, 2014, at 11:38 PM, TomBooker wrote:

    "It's true for most products that some people with lower means won't be able to afford the services that richer people can. There's nothing odd about this. I'd love a Ferrari. I can't afford one. So I have a cheaper car I can afford."

    Buffett is right again. Count that as about 9 years of reputation down the hopper.

    Only Tom Friedman could come up with a metaphor as skewed as comparing a vanity depreciating asset to thoroughly informed self-investing.

    Please change the mission to "Help the world invest better, if you have $250,000 or more to invest in equities."

    Christopher Nolan is not a universally well-received screenwriter and Director. This is mainly because he writes scenarios which are complicated by the messiness of reality. Being a Hero is not all of the pristine easy colors of a graphic novel, when you have to be one for all and Everyman.

    Because I have been around and watched so many defeated by their success,.. and been there, too..I like the observation of a rather numb but fatalistic character of Nolan's..

    Either you die young as one of the Good Guys, Or you live long enough to become one of the Bad Guys you thought you were fighting.

    I look back to 16 years ago, and I don't remember the values as "let them eat cake."

  • Report this Comment On April 09, 2014, at 4:59 AM, nivekluap wrote:

    For all of you who wonder if you can manage your own money, yes you can! Is this "Fool" thing just for the rich?...No. Does it take time, effort, etc.?...Yes. I had 35k in a tradional IRA managed by others. I moved it to an online brokerage and changed it to a Roth. Eight years later it's around 175k (max. contributions every year). I don't buy every stock that's reccomended in SA, but I read about them. I get more information I need from the articles that tell me to be patient, and learn from the mistakes of others.

    Thanks for all the articles you write Mr. Housel, and everyone else as well...Keep 'em coming!

    Fool on!

    KD

  • Report this Comment On April 09, 2014, at 5:13 AM, Lucaskasan wrote:

    If " some people with lower means" refers to people with less than $500K available for advisement, that phrase describes nearly all Americans. And you are recommending a newsletter? Really?

  • Report this Comment On April 09, 2014, at 6:47 AM, TMFHousel wrote:

    Lucas,

    <<that phrase describes nearly all Americans.>>

    As of 2013 there were 14.8 million American households worth more than $500k.

    http://fm.cnbc.com/applications/cnbc.com/resources/files/201...

    <<And you are recommending a newsletter? Really?>>

    I'm recommending services people can afford. People shouldn't buy things they can't afford.

  • Report this Comment On April 09, 2014, at 6:52 AM, TMFHousel wrote:

    I'll add: If the argument for AUM fees is that they allow smaller investors high-level investing services, then you're implicitly saying that higher net-worth investors should pay more to subsidize small investors. If that's the case, AUM charges are less of a fee and more of a tax.

  • Report this Comment On April 09, 2014, at 9:32 AM, mikecart1 wrote:

    You come up with some clever metaphors to describe your main points. I like the banana and scale one!

  • Report this Comment On April 09, 2014, at 10:13 AM, daveandrae wrote:

    Here we go again...

    What Morgan refuses to tell you is that when one juxtaposes the investment performance of, say, the s&p 500, against that of Investor Return over the 2014-1994 period, the results are horrifying.

    Roughly 8% for the s&p vs 3% for individual investors. This literally means that in attempt to save 1% in fees, most people chose, instead, to pay 5% to their inflated egos.

    Thus, the term....better to be a pennywise than a pound foolish.

    Don't take my word for it. Look it up for yourselves. When measured over long periods of time, left unaided, not only do most people underperform their own investments, they cannot even beat the annualized rate of inflation.

    And no, I am not a financial advisor. But I do question the things I read. Especially when it is coming from someone with less than twenty years of market experience.

  • Report this Comment On April 09, 2014, at 10:29 AM, TMFHousel wrote:

    daveandrae,

    Recommending alternative fee structures is not the same as recommending people refuse to seek advice from an adviser. I think everyone should have an adviser of some sort, regardless of experience.

    Thanks,

    Morgan

  • Report this Comment On April 09, 2014, at 10:53 AM, TMFHousel wrote:

    I'd also like to add in response to previous comments, I don't think AUM fees are a scam. A scam implies the managers are crooks. The vast majority are not. I understand why AUM fees are standard. I just think, in many cases, alternatives might be better.

    -Morgan

  • Report this Comment On April 09, 2014, at 11:05 AM, gskinner75006 wrote:

    If you have a 401K and it has a self directed brokerage account and you are not in it, you are wasting your money on fees and commissions. If you talk with an adviser that is commissioned based, then the only advice given will be based on the highest commission and your needs and goals will not factored in.

  • Report this Comment On April 09, 2014, at 12:04 PM, jdp245 wrote:

    Many of the points the author makes are good ones in favor of flat fees. But if fees as a percentage of assets are not defensible, then why does the Motley Fool charge a management fee as a percentage of assets for its mutual funds?

    I think there is a different way of looking at it that could justify the use of fees as a percentage of assets. Asset-based fees can work where there is competition for assets. Some people actually have multiple money managers. For example, I currently have two. (I also manage on my own a substantial portion of my money.) The reason for this is simple: manager risk is a risk to be controlled just like any other. The more managers you have, the more you are diversified against that risk. (Just ask anyone who lost everything to Madoff about whether you should diversify your manager risk.)

    Having multiple managers also forces these managers to compete against one another for your assets. I make sure my managers know about each other and know that they are competing for my assets. The better their results, the more assets they get to manage. The more assets they manage, the more they earn. (And if I beat them both, then I am more likely to keep my money self-managed.)

    On the other hand, a flat fee encourages an investor to pool all of their money with one advisor. This is not necessarily a good idea. In most cases there won't be a problem. But if you are swindled or given bad advice and have not diversified your manager risk, you stand to lose everything.

  • Report this Comment On April 09, 2014, at 12:55 PM, XTMFCaptain wrote:

    I am a fee-only financial planner and use to work at the Fool. My firm does hourly, retainer, and AUM. I do keep my AUM much lower than the competitors at 0.5% annually.

    I agree with Morgan that advisor fees will see massive compression over the ensuing years and that the AUM model isn't the most effective.

    There are some reasons why bigger accounts get bigger fees. Liability insurance is one reason. A lawsuit from a client with $1 Million will cost more than one with $100,000. Second, the time spent with the client tends to be another factor. Advisors tend to put more time with the big clients in order to keep them.

    This doesn't justify an enormous difference in the fees charged, but a flat AUM fee isn't a reality. Also, with flat AUM fees, the advisors would tend to overcharge smaller clients with their fee minimum.

    Complexity is also an issue with both AUM (that includes planning) and retainer models. An advisor has to plan for this. A client who just has a 401(k) is much simpler than one who has stock options, a small business, or foundations/trusts/etc. So a flat planning fee or AUM doesn't work in those cases.

    However, I do agree with Morgan that financial services tend to charge too much and a move towards an hourly/retainer/flat fee is the trend of the future. Either that or cap the AUM at a maximum fee.

  • Report this Comment On April 09, 2014, at 6:41 PM, Lucaskasan wrote:

    Daveandrae, You are right of course that stock market returns far outpace the returns of individual investors. But it is more a lack of knowledge and access to competent advice more than a fee on outsized egos. If you cannot afford the fees, a newsletter subscription is a very poor substitute that virtually guarantees loss to most subscribers regardless of the newsletter's marketing claims. Furthermore, as studies have shown, most advisers cannot beat the SP 500 Index anyway. (We can save the debate on benchmarking for later). But they get their riskless return of 1% anyway.

    Morgan, As far as the 14.8 million households with assets over $500K, how much of that $500K is tied up in a house? How many households have $500K or more AVAILABLE for advisement? How many households are there in America? I think you will have trouble arguing against the statement that most Americans cannot benefit (fee-wise) from the flat fee you cited, much less even qualify for advise. Another tax season is winding down. Oh, the stories I could tell...

    On the other hand, at no point did I recommend the 1% fee structure. I am only pointing out that even if a client has the minimum $100K most advisers require the flat fee you cited will eat the client alive. Most people who need advise do not qualify, and are forced to rely on what they can get. You and I both know how poor most of the cheap or free advice is, and yet pundits will cluck at the foolishness of people who (for example) do not understand that an insurance agent posing as a financial adviser is not one. Honestly, what else do they have?

  • Report this Comment On April 10, 2014, at 9:18 AM, Libor8erBlake700 wrote:

    My broker super-charjed me not for advise but for exekution-only fees.

    Laing & Kruikkshank, founded in 1882, charjed only 2% kommission on share trades, 1% for bonds, plus Stamp Tax (0½% kreamed off by govt when we buy house & some other assets).

    Even foreign shares were held free, until 1989, when Laing & Kº° would no longer adsorb kost of konverting foreign dividends & started passing on their own ajents' fees as annual fee of £25 Ster£ing (about $40). Ok, I thought, that wipes out most my annual divvy, but i still get kapital growth.

    Laing & Kº° were bought by Crédit Lyonnais in the '80s then by Union Bank of Switzerland in 2004.

    In 2009 the minimum annual fee for all share-holding & dealing was raized from £0 (home) & £25 (foreign shares) to £500 (about $833), to be off-set vs any kommission in same period, but still a jump of +1900%! As my annual dealing kosts were about £500 anyway, i stukk with them, although my father moved to a new broker many years earlier.

    In 2012 Laing & Kº° said 2013 Exekution-only annual minimum fee would be £10 000 ($16 667) another hike of +1900% or +39999% (nearly forty thouzand persent) of the orijinal £25. Now I really was out of their league!! (Advizory, like in your artikle, would be £5 000 ($8 333)).

    Lukkily in 2011 i'd started an on-line broking akkount with far flatter fees. If i typikly spend £17.50 ($29) on £1000-worth ($1667) of shares, that's only 1¾%.

    Flat fees are fine, but not when they're minimum fees for mega-rich folks. Blake 700

  • Report this Comment On April 10, 2014, at 11:01 AM, daveandrae wrote:

    Lucas wrote-

    "Daveandrae, You are right of course that stock market returns far outpace the returns of individual investors. But it is more a lack of knowledge and access to competent advice more than a fee on outsized egos."

    ----------------------------

    True story-

    Just four days ago I was corresponding with a very successful Attorney via cnbc.com. He thought the market was "frothy" at the end of the 1st quarter, subsequently sold out seven figures of equity capital and was now sitting in cash, and proud of it, given last Friday and Monday's declines.

    I then explained to him that he now not only needed to market to decline more in percentage terms than the aggregate costs of his trades, capital gains tax and inflation, since cash yields NOTHING, (which, when added up, is a hell of a lot more than "1%," but I digress) but, and get this....he also now needs the virtue of Courage to get back in should the market fall as low as he hopes, which he (obviously) won't have.

    His retort?

    I made these trades in my 401k, which is fee and tax based free.

    My retort?

    All the more reason NOT to sell. For no one plants a tree and then pulls it up out of the ground just because its "snowing." Thus, you're playing a suckers game with that money.

    Sure enough, the market rebounded sharply yesterday, wiping out all of Monday's losses, thus erasing all the purchasing power he gained by selling out at the end of the "quarter," leaving him now exposed to brokerage fees and capital gains taxation. All the while sitting in cash, earning nothing against say, a 2% inflation rate, still waiting for the market to fall to the 1840 level.

    Moral of the story....Arrogance enshrined

    Good day.

  • Report this Comment On April 10, 2014, at 6:12 PM, Lucaskasan wrote:

    Someone once said that anecdote is not data. My tax clients lose because of lack of knowledge (and because the advice they do get is flawed. My anecdote: My client needed money to pay some huge unforeseen medical bills and asked his financial adviser what would happen if he used his IRA worth $90,000 after many, many years of conscientious contributions. The adviser said nothing would happen because his IRA is tax-free and withdrawals for medical expenses are penalty-free. Wrong, wrong wrong, but the client did not know that.

    I first met him when he came in to do his tax return. Since more than 60 days had passed, there was nothing I could do. His tax bill (differed taxes, cap[ital gain and penalty, fed and state) gobbled up half his next egg. A competent adviser should have told him how to manage this problem. Instead his adviser blew him off saying his firm does not give tax advice. That part alone tells you that most financial advice is half-baked because the tax consequences need to be an integral part of every financial decision, but for some silly reason nearly every adviser has a policy of not giving tax advice or taking responsibility for tax consequences. Meanwhile, his adviser took his 1% anyway.

    I stand by my original assertion because of data, not anecdotes, not even my anecdote.

  • Report this Comment On April 11, 2014, at 6:01 AM, Lucaskasan wrote:

    Someone once said that anecdote is not data. My tax clients lose because of lack of knowledge (and because the advice they do get is flawed. My anecdote: My client needed money to pay some huge unforeseen medical bills and asked his financial adviser what would happen if he used his IRA worth $90,000 after many, many years of conscientious contributions. The adviser said nothing would happen because his IRA is tax-free and withdrawals for medical expenses are penalty-free. Wrong, wrong wrong, but the client did not know that.

    I first met him when he came in to do his tax return. Since more than 60 days had passed, there was nothing I could do. His tax bill (differed taxes, cap[ital gain and penalty, fed and state) gobbled up half his next egg. A competent adviser should have told him how to manage this problem. Instead his adviser blew him off saying his firm does not give tax advice. That part alone tells you that most financial advice is half-baked because the tax consequences need to be an integral part of every financial decision, but for some silly reason nearly every adviser has a policy of not giving tax advice or taking responsibility for tax consequences. Meanwhile, his adviser took his 1% anyway.

    I stand by my original assertion because of data, not anecdotes, not even my anecdote.

  • Report this Comment On April 11, 2014, at 2:58 PM, daveandrae wrote:

    ^

    Please...

    Obtaining an excellent Investment/tax advice is no different than obtaining an excellent legal advice. If you don't know who the best in the business is, you're the one that's the sucker.

    Truth be told, His tax return gobbled up his half his next egg because he chose to pay his medical bills, not because he told you, he got "bad" advice. Had he gotten good advice he would have sold out anyway.

    Devil (IRS) or the deep blue sea(medical bills)? Sadly, sometimes life boils down to choosing the lesser of two evils.

  • Report this Comment On April 11, 2014, at 6:22 PM, Lucaskasan wrote:

    Please...

    The client gave me authority to speak to his financial adviser. I know what I am talking about. His adviser blew me off too. This client would never have destroyed his life savings, but with sudden, catastrophic, unforeseen medical bills, he had little choice. "He chose to pay his bills"? Oh, please. However, he could have been properly advised on how to take distributions to minimize the tax hit. He could have avoided the penalty altogether with decent advice.

    The main point is that regardless of our anecdotes, data shows that most people lose because of lack of knowledge and good advice. The people commenting on MF articles do not represent most people. However, I never lose sight of them.

    You are fortunate that you are wealthy enough to not only know who is the best is the business and but also be able to afford it. Studies also show that finding a competent and honest adviser is very difficult. As an earlier comment pointed out, adviser risk is real. But hey, good luck.

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