The next evolution in how planners get paid

The last 15 years has seen a craze by the financial services industry: using fee-based accounts as a way to smooth out income fluctuations and insulate against fluctuating commission income. Additionally, fee-based compensation supposedly enhances trust as it positions the advisor as the investor’s advocate. However, the fee-based account is a false industry panacea for several reasons.

Most investors don’t care how they are charged. If they trust their advisor, they don’t worry about their advisor acting against their interest. They are interested in doing business with a trusted human being and are not focused on the mechanics of how they pay. To use a fee structure as a way of communicating concern with the client’s best interest is weak ethical footing at best. As an example, the medical industry charges on a “commission basis” (your doctor gets paid more when he sells you an operation), yet the medical profession does not suffer from a lack of public trust as does the securities industry.

Fee accounts may not even provide insulation from income fluctuation. I hear from advisors that their clients are leaving after years of zero return yet being charged a fee year after year. Clients are tired of the system “one for the advisor, none for me.” (The evidence of tired clients is anecdotal, as the industry does not break out separate account fee revenue from mutual fund asset fees).

The industry assumed that fee accounts had lower liability than commission-based trading accounts. While that might be so regarding client liability, the regulators have now fined at least one broker/dealer for inappropriately placing clients in wrap accounts when the client’s overall costs would have been less in a commission-based account. Although any financial planner knows that more money is made for clients by not trading and value is often created by telling clients to “sit tight,” the regulators seem to believe that value is created only when a trade occurs and that’s when the client should be charged. In other words, the regulators seem to favor turnover and justify its value even when the evidence shows that turnover reduces investment returns.

It takes years for industries to evolve but eventually, the underlying economics of the industry will form the industry’s most efficient revenue model. The underlying economics call for us to charge the client for value created. Currently, there is no correlation between client fees/commissions we receive and value we add. Enter the hedge fund. Here, the fee paid by the client can largely be based on gains (hedge fund charges are typically 1% of assets plus 20% of gains). So why isn’t this the dominant model in the industry?

As I understand it, the SEC’s rationale is that the investment manager who is motivated by a percentage of gains will take large risks. Therefore, the only people who may participate in incentive-based fee arrangements are rich folks, i.e., accredited investors ($1 million+ of investment assets or $200,000+ annual income). However, the problem of too much risk for the little guy is easily solved and thus we can forecast the next stage of evolution in the investment industry toward its underlying economics.

Specifically, the SEC could set prospectus guidelines for activities and ratios of any fund thereby limiting the potential risk. For example, if a fund states that it only buys or shorts stocks from the S&P 500 index and that not more than 5% of the fund may be invested in any one security, then the SEC and the investor now has assurance that the manager cannot take too much risk. These funds could be made available to the little guy who would pay incentive-based management fees. Of course, evolution is always slowed by those who like the status quo—investment firms, brokers and mutual funds that deliver no value, yet charge for it anyway. Eventually, the public demands a fair shake and the wall to a market-based system, like the wall in Berlin, comes tumbling down.