Welcome to Part 2 of a paper by AdviserVoice’s Ray Griffin in which he argues that all forms of adviser fees are imperfect. In Part 1 he discussed hourly rates and fixed fees and in this edition asset based fees are the focus.
Asset Based Fees
As the Canberra architects of FoFA went about putting initial and trail commissions to the sword, asset fees became the primary point of contention in financial services. Indeed, they seem to have become the latest demon to infest the financial services discourse; but are asset based fees really as toxic as many commentators argue quite strongly?
Before responding, consider two term deposit account customers with a bank or credit union. One has a deposit of $1 million and the other customer’s deposit is $100,000 and both are invested (loaned to the bank) for 12 months. During the period of the deposits, both customers will likely receive exactly the same number of statements and it’s highly likely they’re sent to the customer electronically. They will both receive a similar letter as maturity of the deposit approaches. Granted that the $1 million account holder might – might – receive a courtesy phone call to advise of prevailing interest rates as maturity approaches, both customers will likely absorb a similar amount of time from the bank/credit union term deposit officer with either rollover or withdrawal instructions. However, they divergence when we consider how much the bank is charging each term deposit investor (the lenders) to find a borrower(s).
Notwithstanding the complexity of bank capital management and Capital Adequacy Ratios, KPMG (2013) reported that the Net Interest Margins of the four major Australian banks were all above 200 basis points or 2% p.a.
So our $1 million term deposit holder is effectively paying say $20,000 per year for a very similar level of service that the $100,000 term deposit customer pays just $2,000 for. That phone call from the bank as maturity approaches has in effect cost that investor another $18,000 a year. One argument to support such a disparity might be that the bank is making more on the $1 million account because, in part, it is removing the risk which would fall to the deposit account holder if she tried to lend directly to a borrower. More to lend equals more to lose if things went wrong.
Assuming the term deposit holder does not withdraw all or part of their holding, the bank will earn the same each year on the deposit – the same 2% or better Net Interest Margin.
Looking now to asset based fees for portfolio management services, I’ve seen such fees range from 0.50% p.a. to an eye-bulging 2.50% p.a. The number is not the primary issue because, ultimately, the market as a whole will eventually pass judgement on whether or not a fee is too high; witness the pressure on managed funds’ MERs over the last twenty years. The issue is the whether or not asset based fees – as a method of charging – are exceptional in the context of the modern commercial and economic environment?
They are not exceptional. Banks and other deposit holders all charge their own form of asset based fees via their Net Interest Margin – the difference between what they (the banks) borrow at from the depositor and what they can earn when they (the banks) lend the money out. The larger deposit customers of such institutions are unquestioningly subsidising the cost of services to smaller account holders from which the banks et al earn very little because there is less to earn a margin from. Quite simply, the larger account holders give the banks greater leverage to make more revenue.
It’s worth noting that the fee – the Net Interest Margin – is never and never will be – disclosed to depositors. Contrast that to requirements under the Financial Services Reform Act (2002) to disclose all fees and charges in writing to clients of financial advisers.
Similar to the subsidisation of service costs which exists in bank deposits, in asset based portfolio management fees, the larger portfolio owners are to some extent subsidising the cost of services provided to smaller portfolio holders. The numbers will vary from firm to firm and portfolio to portfolio but there will always be some measure of cross-subsidy happening in every financial services business.
Under asset based fees, when portfolio values rise through market lift or additional capital from clients, the fee income to the firm rises. Conversely, when portfolio values decline through market falls or client withdrawals, revenue for the firm falls.
The long stated claim of asset based fee chargers is that they share with their client in the outcomes of their advice – their intellectual (portfolio management) property skills. Some will argue that market lift is not IP but, really, it is. If the advice was to have a component of portfolios in the share market in order to attain an increase in capital over time and portfolios do increase as a result, then that is IP. Similarly, if portfolios decline at a point in time, it too is as a result of IP and for the period of portfolio declines the fees paid by clients will reflect the fact that it was the IP which saw the values fall.
Conflicted
One glaring conflict of interest for asset based fees exists when advisers, rather than recommend for example, reducing a home loan or other non-deductible debts, recommend the client invest through the firm which then charges asset based fees accordingly. In this example, keeping the client in debt results in higher fees to the licensee/adviser. Until the passing of Future of Financial Advice (FoFA) legislation, a similar conflict existed when advisers recommended clients borrow to invest and therefore earned a higher fee due to the higher portfolio value through leveraging. That conflict has now been removed by FoFA.
Interestingly, anecdotally at least, we’re seeing some asset based fee charging firms place caps on the maximum fee they will charge higher portfolio value clients. This could be the beginning of a quasi asset/fixed fee model.
In the final of this 3 part series, I’ll discuss how asset based fees are ever-present in other parts of the economy and ask: Could the economy function without them? How could financial services function if asset based fees were banned? And passing I’ll look at how governments help themselves to asset based fees and commissions in order to provide services to tax (fee) payers.