| The advantages of fee for service advice from a client's point of view |
Fee for service financial advice is a method of financial planner compensation that provides a very strong incentive for the adviser to give good advice and good service. Strict fee for service advisers do not receive trail commissions or have any automatic ongoing payment from clients, aside from what clients choose to pay them.
If you aren't happy with a commission based financial adviser you probably won't deal with him again, but that won't stop him getting his trail commission for as long as you hold your investment.
Advisers in favour of commissions usually argue that there is nothing wrong with commissions as long as they are disclosed properly in accordance with the law. The trouble with disclosure in accordance with the law is that knowing what the adviser is being paid does not tell you anything about the true extent of conflicts of interest.
Disclosure of commissions is only useful when a client is fully informed of what "normal" rates of commissions are. It is unreasonable to expect all clients to understand the range of benefits that are available from a wide variety of products and thus clients really have nothing to compare a disclosed commission with. Unless a client knows what advisers are "supposed" to make, they'll just have to take the adviser's word for it that the commissions being paid are reasonable. There are only really two ways for a client to be fully informed of the true extent of conflicts of interest:
Only one of those systems is even remotely practical!
Knowing the commission paid on an investment doesn't tell you:
For example, thanks to intensive lobbying by the Association of Financial Advisers (an adviser's association similar to the FPA), financial services reform legislation was watered down to remove the requirement that advisers disclose commissions on insurance products. The legislation, originally intended to bring about full disclosure of all commissions, also does not require disclosure of commissions earnt from debt products (mortgages, leases, margin loans etc). Advisers can earn a handy commission on these products, but do not need to disclose them. A third major hole in the disclosure rules is with real estate, advisers are not legally obliged to disclose commissions in real property and may well be earning substantial sums for recommending expensive properties on behalf of an associated developer. This is a major reason why you see so many wealth building seminars spruiking negatively geared real estate investing, as opposed to investments in shares.
These gaps in disclosure rules make a mockery of the original intent of the Financial Services Reform Act which was supposed to unite all the different types of advisers, planners, agents and brokers under a single regime with a single type of license where all commissions without exception needed to be disclosed and similar standards of training were required in each.
Even when a client does know what the commission is, the client doesn't know what the commission is on other products. The adviser may well fully disclose that the product pays a 1% trail commission, however is under no obligation to reveal that an alternative product with significantly lower fees to the client only pays a 0.25% trail commission. Commissions on insurance products vary enormously, and if the adviser were rebating these commissions the premiums on some products would fall greatly. It would be difficult for an adviser to provide full and frank disclosure of all commissions available on all products including products not recommended, so it is inherently difficult for clients to ever really find out the true extent of conflicts of interest.
A third problem with commissions is that usually they are proportional to the size of funds placed under management. Advisers can double their income by recommending that clients take out loans to build portfolios on borrowed funds. Not only do they get a trail commission (and often an up-front commission) that doesn't need to be disclosed on the margin loan or home equity loan, but they also get to take twice as much money in the form of entry fees and trail commissions on a portfolio twice the size. Gearing is a popular strategy with advisers, but it can be difficult for a client to really judge whether the gearing was recommended because it was a suitable strategy for them, or for the adviser. In nearly zero instances will a commission based adviser tell a client to pay off a mortgage or keep their existing investments where they are.
There is only one way to absolutely guarantee that the adviser is absolutely impartial, and that is to charge a fee that was fixed in advance before any products were discussed, and for the adviser to fully rebate 100% of commissions received and avoid soft dollar benefits and cumulative bonuses unless they can be clearly demonstrated to not affect the advice given. Fee for service eliminates the moral dilemma faced by advisers who would really truly like to do what is best for the client, but at the same time have a family to feed and clothe. That is the remuneration model I have chosen.
Fee for service is a pay-as-you-go system. Fee for service advisers charge separately for providing initial advice and ongoing advice. If you are not happy with the advice and the service you have been getting then you won't agree to see him next time you are due for a review appointment, and he won't make any more money.
Fee for service is regarded as risky by many financial planners because there is no "passive income" from trail commissions, and even worse there is no "goodwill" value in the business if the adviser wants to sell out.
A 100% fee for service adviser must hold a client for many years to get the same benefit as a commission based adviser after his first sale. This requirement, in turn, means that 100% fee for service advisers must only promise what they can deliver, rather than promise whatever is required to make the sale.
Advisers that do favour a remuneration system based on commissions frequently argue that most investors would refuse to pay if they were charged a fee for service. The reality, which clients need to understand, is that financial planning is a far more time consuming and expensive process than might be supposed. Although we'd love to, we can't just give a quick oral recommendation and fill in a few papers. Advisers used to be able to do that, but the system was abused and as a result the regulators stepped in and prescribed a long list of disclosure requirements and a broad format of how advice needs to be given. These documents take many hours to prepare, much of which is done behind the scenes and is thus unappreciated by consumers.
It is impossible for financial planners to do this job "cheaply" without cutting corners in quality, ethics and legality, so a properly disclosed fee for service will appear to an uninformed consumer to be a lot of money, the value of which may not be appreciated at first.
So advocates of the commission paying model prefer a kind of sleight of hand. They take a trail commission that may add up to a very significant amount of money in the end, instead of a realistic up-front fee. The logic of this is that consumers are less likely to balk at a smallish up-front cost and a large ongoing one, compared to a large up-front one.
From my point of view, this is dishonest. Many commission paying clients end up paying far larger amounts over many years than they would have otherwise if they had paid a fee for service adviser a realistic amount of money up front. The onus is on the adviser to explain the true cost of advice and to provide a service that delivers to the client at least as much value as is paid for. When advisers justify outrageously high ongoing commissions with the excuse that unsophisticated clients prefer to pay them because they can't add up, I think this is a rather cynical attitude to take.
| The advantages of fee for service advice from an adviser's point of view |
I have chosen to forgo the substantial financial advantages of being a non-independent financial planner. I have no passive income, if my clients walk away from me there will be nothing left of my business, I will be unemployed. On top of that, people who don't know the true cost of advice and the amounts that commission based advisers take tend to look at fixed fees for service and think they are expensive!!
There are great advantages for me though, advantages that I consider greatly outweigh the security of a commission based financial advice business. For a start, I am free to go about doing the right thing for clients without the pressure of having to sell anything. If the best strategy for a client is to simply pay off debts, sort out their estate planning and apply for social security, I can recommend that instead of having to sell them something. Fee for service is a system that allows financial advisers to make the same amount of money no matter what advice they give. This gives the adviser tremendous flexibility. I can be impartial because I earn my fee researching and preparing financial reports, not by selling products.
I want to move away from the idea that I am only here to recommend funds for people with money to invest. I am a financial planner, I didn't spend all that time studying taxation and structures, budgeting, estate planning, the superannuation system, portfolio theory, retirement planning, social security and other matters to end up as a salesman of managed funds. I would consider that a terrible waste of my time and effort. Financial planning is not the same as investment advising, because the latter is only a small portion of what we do.
One of my big motivations for wanting to offer a 100% fee based service is that I am an investment purist. There is overwhelming academic evidence that index funds are a better bet than active funds in general, and I want to be able to recommend them. If I was a commission based adviser I couldn't do that, instead I'd have to ignore all the research and only recommend higher priced active funds that I wouldn't want to invest in myself. So fee for service is a better solution for me, it enables me to sleep well at night knowing that I am doing the right thing for my clients.
Being 100% fee for service, and working with a small independently licensed financial planning practice means I can choose any strategy or product I feel suits the client. Even when I recommend active funds I still find fee for service liberating. Not all the active funds I like even pay commissions in the first place, in fact most don't. If I want to recommend a fund that pays a commission I can simply rebate it to clients, so I can offer the best of both worlds.
A further advantage is that my administrational burden is greatly reduced. Most financial planners spend an enormous amount of time going through their commission statements to make sure the various fund managers they have used have paid what is due. It is infinitely more simple just to present a bill to clients rather than have to deal with the commission department of some financial services conglomerate. This frees up time for me to pursue more important matters, like managing client's money and carrying out research.
With conflicts of interest virtually eliminated, fee for service advisers and clients find themselves in a win-win relationship, a true partnership of shared interests.