Question: How much more would a financial advisor earn over their career by dropping product costs for their clients?
Answer: Over $1 MILLION
Last week I showed how lifetime investing fees could easily top $100,000. That’s an inflation adjusted figure. Before inflation that’s more than $300,000. I also mentioned I was going to spend some time discussing some nuances of that conversation. I’ll start with the idea that advisors could earn more money by focusing on reducing costs.
The Two Main Cost Components
There are two main cost components for investors: the cost of advice, and the cost of the actual investment product. If an advisor was providing comprehensive financial advice (financial planning) and we held the price of advice constant at 1%, then by reducing costs of the investment products, not only will investors have paid lower fees which translates into higher growth, those bigger portfolios would generate more income for advisors using the predominant asset-based remuneration models that exist today.
Traditional commission based advisors may sell mutual funds with embedded commissions. Fee-based advisors may charge a transparent client advisory fee. (For the purpose of making this simple, let’s assume for now that in either case, this revenue is 1% of assets*.)
*The cost for advice is usually split between the advisor and the company he works for, known as the dealer. Let’s assume that this payout split is 70/30, meaning that for every dollar of cost for advice the investor pays, 70 cents goes to the advisor.
Advisors using either revenue model can reduce the cost of investment products. Practically speaking, it’s much easier using a fee-based model on an IIROC platform (Investment Industry Regulatory Organization of Canada – these advisors are licensed to sell individual securities like stocks, bonds, and ETFs, as well as mutual funds). The other main licensing platform (MFDA – Mutual Fund Dealers Association) precludes transactions on individual securities – advisors licensed through the MFDA use mutual funds almost exclusively. While there are index mutual funds available in Canada, costs are generally not as low as index ETFs, and yes, that includes F-class index mutual funds where all embedded compensation has been stripped out.
The Assumptions
Let’s start with the following assumptions: our investor starts by earning $25,000 per year, and his income grows by 4% per year until age 65. He saves 10% per year until he retires, after which time he withdraws from his portfolio until he has $0 at age 90. His risk profile stays constant throughout his life and so his weighted average benchmark is 6%. Inflation is 2% his entire life. Now the only thing left to do is model two different cost scenarios:
Scenario A: 2.25% in annual costs. This is made up of 1% for the cost of advice and 1.25% for the cost of the product (this might be an actively managed mutual fund portfolio).
Scenario B: 1.25% in annual costs. This made up of 1% for the cost of advice and the use of a couch potato portfolio at 0.25%.
Since I know salespeople and marketers use non-inflation adjusted numbers to shock and awe investors, I’ll do the same.
For the client’s perspective, they have reduced their lifetime investment costs from $293,000 to $199,000, increased their annual retirement income by 37%, and their cumulative retirement spending has increased by just over $256,000. From the advisor’s perspective, she has increased her income by over $20,000. Due to the lower drag on portfolio return, the portfolio balance at age 65 is $458,000 with annual costs of 2.25%, but $558,000 with annual costs of 1.25%. If the cost of advice is 1%, with 70% of that going to the advisor, the income to the advisor that year is either $3,200 or $3,900, a difference of $700 in that year alone. There is no year, from start to finish, in which the revenue to the couch potato advisor is lower than a high product cost model.
(You can download the original spreadsheet here to calculate lifetime investing fees. To calculate advisor compensation, you’ll need to add your own columns/formulas.)
Realistically, advisors aren’t going to be working from age 25 to age 90, a 65 year career. Many career advisors also do not take on clients with less than $50,000 in assets. If we assume and advisor has a 40 year career and only takes on clients with $50,000 to invest, then to make a long story short the income differential from using lower cost products would be closer to $14,000 per client.
Multiply this by 100 clients, and that works out to $1.4 million.
In a future post, I’ll explore the difference in revenue to the dealers, factoring in different payout rates between MFDA and IIROC shops. I’ll also provide a few different ways at looking at the increase in advisor income when holding the cost of advice constant, but reducing product cost. Essentially, it’s better for everyone except the higher cost product manufacturers.
Addendum
There are lots of variables at play here. I think I’ve used middle of the road assumptions so that for every person who can demonstrate a less dramatic difference, another can show a more dramatic difference with everyone having used assumptions that are plausible.
Yes, I’ve assumed that the passive portfolios underperform the benchmark by cost, and I’ve assumed the actively managed portfolios underperform the benchmarks by cost. I imagine someone will suggest that an actively managed portfolio might earn back their fees and even beat the benchmark. That’s fodder for an entirely different series of posts, in the meantime I suggest reading this to start.
Great article. Shared on my pages and groups.
It’s interesting this debate always centers on only two compensation methods: commissions/trailers and fees based on assets.
What would happen I wonder if advisors were only allowed to charge and hourly rate for the work they perform, and accept no other compensation? Can we begin to imagine how the industry would change?
http://www.facebook.com/groups/itstimecanada
http://www.moneysense.ca/invest/find-the-perfect-financial-planner
My apologies, I see you have discussed it. Thanks!
No apology necessary. I’ve been talking about it for years, but it’s tough to include every aspect of the overall discussion into each conversation, blog post, or column. Back when I was an advisor, I offered clients all three methods of compensation: commission, percentage of assets, and hourly/flat rate. I can tell you that back then (started offering all three in 2007), few people were willing to cut a cheque, percentage of assets were taking off, and commissions were still thriving. Little has changed, although fee-for-service is starting to gain more momentum.
Interesting change of perspective. The challenge for advisors will be to find clients willing to pay the 1% explicitly. Sadly, this is likely to be challenging even though the clients are better off in this model.
I’ve always thought that an opportunity for the old guard (fund companies) would be to offer couch potato funds with embedded compensation. While I would prefer explicit transparency, I think it’s a ways away from being the norm. In the meantime, this would allow the advisors who want to use a couch potato solution but aren’t set up for fee-based accounts to do so.
Indeed, BlackRock has launched embedded compensation couch potato funds. The costs are higher than the 1.25% with 1% for advice example I used (I think their offerings are around 1.5%).
See Dan’s comment below. The BlackRock funds are actively managed using passive components.
Good stuff Preet. It’s an interesting perspective – and one to which advisors should pay attention. It’s worth noting, however, that while more mutual funds have been launched that contain ETFs, the unfortunate reality is that few if any are really passive – or couch potato like.
I thought that the iShares funds would be run in this spirit, but as the uber-smart Norm Rothery pointed out a couple of months ago, even those funds have some very odd structuring features that amount to some big active bets.
http://www.theglobeandmail.com/globe-investor/funds-and-etfs/etfs/go-the-diy-route-instead-of-using-these-funds/article16906593/#dashboard/follows/
Well that’s disappointing. Tough for an incumbent to launch: leads to lower margins as higher margin products get cannibalized. Tough for a new entrant: low margins to start means critical mass could be years away.
Seems like a segment ripe for disruption though.
I am trying to understand the real value of this article. I don’t mean to be critical but it is has so many assumptions that it weakens the argument. Also the payout ratio of 70% to the advisor and 30% is overstated and unrealistic. At the Big Six brokerages, the dealer takes the lions share leaving the advisor with 30% to approximately 50%
It’s okay Fred, you can be critical. I don’t mind at all.
I can think of more assumptions that need to be addressed: everything so far has looked at straight line returns. With contributions and withdrawals, the sequence of returns will wildly change the results over time (sometimes better, sometimes worse). It’s far from perfect, but far better than keeping one’s head in the sand.
Given the variables used, I think the possible value is that advisors might see that both they and the client might be better off with lower costs. In this case we are just looking at lowering product cost. I think much push-back to date has been that it’s hard for advisors to lower cost because it means an income cut. But even a small reduction in product costs can go a long way, and it seems to me is worth considering.
And your use of the ratio 70% to advisor and 30% to dealer, where does this come from, as it does not reflect the payout ratios at any of the Big Six Brokerages in Canada ?
No, that is an MFDA number. Keep in mind, that while big six payouts are 30-50%, you wouldn’t be there long with a $25 million book. One of my next posts will look at an IIROC model and book expectations.
Preet, I think your use of the 70% to advisor, 30% to dealer might be flawed. With MFDA funds there is an MER . Part of this is known as a “management fee”. Of this management fee- part of it is paid out as a trailer fee to the dealer firm and a portion of this trailer fee is then paid out to the advisor. As an example, the RBC Canadian Equity Income Fund A series has an MER of 2.09%. Inside this MER there is an Investment Fee portion of 1.75% of which 1.15% is a trailer fee. If this trailer fee is paid out to the dealer firm and the advisor receives a top rate of 50% of commissions/revenues then the advisor has received .575% (50% of 1.15%) or 32.85% of the Management Fee or 27.5% of the MER- much less than the 70% used above.
Hi Fred. No, I’ve factored this all in.
“MFDA funds”: mutual funds can be sold through MFDA or IIROC channels. There is no such thing as an MFDA fund. MFDA = Mutual Fund Dealers Association and this refers to the SRO that manages the dealers that license advisors under the purview of the MFDA. For example, that fund you cite can be sold at a big bank brokerage, through an advisor licensed under IIROC.
Using your fund example with a trailing commission, 1.15% hits the grid and yes, a top rate bank brokerage rate of 50% nets 0.575% to the advisor. No disagreement there.
Quoting a ratio of the net trailer to the overall MER is moot.
As I said, I’ll put together another analysis that looks at an IIROC advisor – who has much higher quotas. I think you will find that a comparative advantage still exists for lowering product costs. The client wins, the advisor wins.
I am sorry but i still don’t understand how your use of 70% to advisor and 30 % to dealer is correct, whether MFDA or IIROC
You do know that 100% payouts are possible, right?
What do you mean specifically ?
There are many dealerships with many different payout grids. As an advisor, you could sign on with a dealership that offers a 70% payout, or more, or less. There are even models where you pay a flat fee per year, and take 100% (so from your example fund, the advisor would net 1.15% of the trailing commission).
(note this blog only allows 10 levels of comments – you’ll have to reply to an earlier comment above to continue the discussion)
The vast majority of mutual funds in Canada are sold through the larger financial institutions, in which case advisor payouts on trailer fees would fall more in line with the lower estimates.
Define “vast majority”.
I wouldn’t be surprised if the vast majority in this case means greater than 65% . The mutual fund industry in Canada is dominated by the following companies (in no particular order): RBC Wealth Management/RBC Global Asset Management, IGM, Mackenzie Financial, MD Management, Franklin Templeton, Invesco, AGF Management, Sentry Select, Fidelity, CIBC Wealth Management, TD Asset Management, ScotiaBank/Dynamic Funds, CI, BMO and National Bank of Canada
According to Investor Economics, in 2011, non-bank financial advisors managed $235 billion in mutual fund assets, while full service brokers managed $168 billion.
According to the MFDA, in January 2014, assets in mutual funds under purview of the MFDA was $389.2 billion.
And note that non-FSB advisors at banks are predominantly MFDA.
In any case, what you are really getting at is “what do the numbers look like” for the lower payout FSBs (full service brokers). I’ll detail that in an upcoming post. Remember, if an FSB had an average career book of $25 million, they would get turfed before they could really call it a career. With much larger book sizes, the comparative income increase from lowering costs will offset the lower payout and so I imagine the income opportunity cost is still big enough that it’s worth paying attention too.
Still the math isn’t right. February 19th, 2014 the Investment Funds Institute of Canada (IFIC) announced that as of Jan 31/14 the size of the mutual fund industry in Canada had topped 1 trillion. Looks like even over the last 12 months assets under management increased by 140 billion. I look forward to reading your post on the IIROC advisor model.
I see what you are assuming: that the two channels I cited represent the entirety of distribution of mutual fund assets. They do not.
I’ll post the hypothetical IIROC model example next week.
Still waiting for the promised IIROC advisor model.
Hi Fred, sorry for the delay. My other commitments have been keeping me busy. I hope to get to this soon.
True to your word, Preet, you wrote an excellent post on why everyone wins with lower fees. If only we could get all FAs to think altruistically like you. The market would benefit as a whole and everyone would win, advisors and clients. I can’t wait for your next post.
Preet,
Great article. Ignore Fred… he seems to like giving you a hard time. I am a financial planner within the big 5. I think lower fees are necessary in the industry. Fortunately at my bank, advisors are compensated regardless of where the client ends up. Whether it goes to a broker, stays within the branch in mutual funds, goes to our discount broker the advisor is compensated. This ensures that the client is in front of the right individual at all times.
Thanks James.
For clarity, do you mean you are a financial planner that handles planning for the different types of advisors within the bank at all levels? Or are you one of the retail client facing advisors the client ultimately deals with one-on-one?
In either case, getting the client in front of the right person is indeed the key.
I do however have an issue with your marketplace episode on financial planners. It seems like the lady met with the walk-in sales associate. This isn’t a fair comparison and I am sure you will agree with me. I have lots of issues with the industry but the fact that CBC video tapes a sales associate on her first month on the job is just not an accurate depiction of the advice most Canadians are getting.
Please note… the Dynamic funds advisor and Edward Jones Advisor should face a firing squad (From the marketplace documentary). They knowing deceived the clients. These are the advisors MFDA and IROC need to be dealing with.
As did I. I have to point out that I had no editorial control over the piece. What didn’t make it into the piece was that I saw a lot more footage than what was shown, and there were examples of great advisors giving great answers that didn’t get the coverage I would have preferred.
It was not a balanced piece, in my opinion. It painted with strokes that were much too broad. I’m actually a champion of financial advice and advisors for the vast majority of financial consumers. It’s worth taking the time to find the good ones, and there are plenty of them out there.