Lesson type: Understanding investment philosophy
How much should you pay for financial advice?
When you walk into an electronics retailer – let’s say it’s JB Hi-Fi (where I spend far too much time) – and notice a fantastic new 4K TV on display, you can see the price right away. You might negotiate a bit, but you can decide if you think it’s a good price and whether or not to buy it. It’s a straightforward transaction, in which both sides perceive and understand the value they get.
Imagine for another moment you go to a car dealer to buy a new car, and the salesperson offers you a fixed-price deal on servicing for the next five years that is going to cost you $280 a year. You can consider whether that’s a good price and whether to take up the offer. Again, you can decide if there’s value in both the price and in the certainty of knowing what it will cost each year.
Now imagine you go to a financial planner and they offer an ongoing service. We know from reams of research and surveys that there is great value in getting good advice. The adviser tells you what services you will get, and you ask them how much it will cost. They tell you it’s a flat fee of 1 per cent of the value of your investments. Sounds like it might be a good deal – but how can you tell? How do you know how much you’ll actually be paying, in dollar terms? The short answer is, you don’t.
How do you know how much you’ll actually be paying, in dollar terms? The short answer is, you don’t.
There are a few things that arise from this kind of pricing structure. The first is an assumption that you will invest money. If you don’t invest, the adviser will not get paid. You can draw your own conclusions as to whether you think that might influence the advice you receive, and how likely it is that the advice includes a recommendation that you invest money.
The second, and assuming investing is legitimate advice in your circumstances, is knowing how much you will actually pay – how much it will cost, in dollars. The adviser cannot tell you what that will be from year to year.
In fact, if they do their job well, you will pay more each year, but they can’t tell you now how much. And if the value of your investments falls, you will pay less, in dollar terms. So there’s nothing flat about a percentage-based fee at all because the amount you pay changes every year. Let’s look at why.
Let’s say you put a total of $100,000 into a range of different investments. A 1 per cent fee on that amount is $1000. And let’s say that over the course of a year the investments increase in total value by a remarkably convenient 10 per cent, to $110,000. A 1 per cent fee on the larger portfolio is $1100. Ten per cent growth the following year lifts the adviser’s fee to $1210. And the year after that it somewhat unbelievably increases in value by 10 per cent yet again, so the adviser’s fee rises to $1331.
Of course if the value of your investments falls, the adviser receives a smaller fee, which they say ensures they “feel the pain” as much as you do. That’s a superficially attractive proposition.
This is the way many players in the financial services game charge for their services. Fund managers have done it since the year dot. But that doesn’t mean it’s the best way to do it, nor that it should necessarily continue that way.
It’s far better if a financial planner quotes you a dollar figure, in advance, for the cost of their services you’re going to receive. You know right upfront what a TV costs, you know upfront what an ongoing car servicing deal will cost, and there’s no particular reason financial advice should be any different.
A good financial planner should be able to quantify what they’ll charge. It doesn’t really matter what calculations they use to come up with the figure – it could be a notional hourly rate, multiplied by an estimate of how many hours they’ll spend on you, with a bit thrown to cover unforeseen issues that may arise. The point is, they can tell you it will cost $X, and you can decide if that’s good value for what you’ll get in return. If they tell you X per cent, you have far less certainty.
An adviser will tell you than a fee based on the value of your investments – which they might call an “asset-based fee” – is the best way to go, because it aligns their interests with your own, as if providing you with a valuable professional service is not a sufficient incentive to act in your best interest.
A good financial planner should be able to quantify what they’ll charge.
It has been something of a mystery as to why so many advisers continue to charge asset-based fees. But the Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry shed some light on why it might be. An asset-based advice fee is often collected via an investment platform, which means a simple percentage-based fee, applied across all of an adviser’s clients’ accounts, is simpler to administer than a different fee charged to each client.
The royal commission also highlighted problems with this fee-collection mechanism that can lead to fees being deducted from clients’ accounts without the adviser providing ongoing service, and often without the client knowing the fee is still being deducted.
At least if an adviser charges you directly for their services you can quickly work out not only how much you’re paying but the fact that you’re paying at all – and whether you’re getting a level of service in return that you think is worth the fee.
None of this is to say that an adviser should not be well paid for giving you good advice. An adviser needs to make a living, pay staff, undergo professional development and training, and so on, so you should not expect to pay peanuts for good advice. In fact, if you are, then have a good close look at the quality and frequency of the service you’ve been getting.
The point is you have the right to know how much you’re paying (as well as the fact that you are actually paying), and what level of service you should be getting in return. As your circumstances change, and the complexity of the issues you face changes, the fee may also change. That’s a matter for the adviser to work out and communicate to you.
But somewhere in all of this complexity is a fee-calculation approach that reflects the professionalism, qualifications and experience of your adviser, represents good value for the services you receive, and doesn’t potentially distort the advice you get by requiring you to invest money so the adviser gets paid.
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