Why Are Advisory Fees Lower Than They Have To Be?

Now here’s by far the most interesting part: Investment advisors and financial planners appear to have responded to this almost total pricing freedom by (get ready for a shock) discounting their fees.  That’s right; under these extraordinarily favorable circumstances, a large number of practitioners have chosen, completely of their own volition, to charge less than what the market will bear.  I dare anyone reading this to find an economic theory that would explain why they would do this, or how the rest of the profession should appropriately respond.

Is there a way to estimate the kind of fees the market would actually bear?  Can we figure out how much consumers would be paying for your services if normal supply and demand conditions prevailed?  As it happens, there are three ways to get broad estimates.

Let’s start with the simplest: comparing the supply (the number of full-service planners) with demand (the number of potential customers in the marketplace).  There are (this may be a generous estimate) roughly 100,000 advisors practicing in the U.S.  These people are offering their services to a total market of roughly 90 million U.S. households, and I am going to make a questionable-but-defensible economic assumption here: that everybody would like to have the help of a full-service advisor if the price were right. 

Punch those numbers into a calculator, and you find at least 900 potential clients per planner.  If you count only the wealthiest third of all Americans, that still leaves you with about 300 per practitioner.

If we assume that planners can only work with 100 clients each, then there are between 3 and 9 prospective clients who would have to compete for each place in your client files.  Under the normal laws of supply and demand, there ought to be at least a little bit of pricing leverage somewhere in that equation.  Any economics professor will tell you that, if the Invisible Hand were allowed to work freely then all those profitability surveys that show planning firms to be marginally profitable would, instead, turn up operating margins ranging from very healthy all the way to obscene and perhaps scandalous.  By this broad-strokes calculation method, I think it’s fair to surmise that most advisors are probably charging half to three quarters of what clients would pay them for their services.

A second method is to compare the fees that independent practitioners charge for planning work with the compensation that is paid to advisors who earn commissions.  Advisors who sell investments and life insurance for a living have consistently, according to the surveys I’ve seen, earned at least twice as much as planners with comparable practices – often more. 

Let’s assume that a client has a choice between working with an independent advisor and a wirehouse broker who will do very basic planning work and recommend in-house mutual funds.  The cost of working with the wirehouse broker, then, can be broken down as follows:

$1,000,000 invested in the wirehouse’s mutual funds at a 1.0% wrap fee, plus a 1.46% aggregate fund expense ratio (this is the actual average expense ratio of all the fund offerings at a name-brand wirehouse brokerage firm), is $25,000.

Of course, the clients would be paying a fund expense ratio anyway. To get an apples-to-apples comparison, we have to subtract the expense ratio of the funds that the independent advisor recommends from the expense ratio at the wirehouse funds.  If we assume an expense ratio of 45 basis points, or $4,500, you get a brokerage firm cost of $22,750. 

This is still not apples-to-apples, since an independent full-service planner will deliver a variety of intangibles that might call for a slightly higher fee: recommendations from a fiduciary versus an agency relationship, plus such value-added services as insurance advice, detailed estate and tax planning, charitable planning and any life planning services the advisor cares to offer.

Notice that this analysis is for a client with $1 million to invest.  To calculate the costs for a client with $3.4 million you would probably double the fee that would be charged by a brokerage firm.  If that’s accurate, then we could add an 11th firm to the comparison-shopping results above – the broker down the street – whose compensation would be surprisingly similar to the most expensive advisory firm in our earlier table.

I suspect that this represents a fairly accurate barometer of what the market will actually bear – and that accuracy shouldn’t come as much of a surprise.  Part of the reason that agents and brokers earn more than their independent counterparts is that, instead of having to set their own compensation, they have it set for them by well-staffed departments of large financial services corporations, armed with ample market research resources, whose sole function is to figure out how to price their products and services most profitably without losing a sliver of market share.  In terms of sophistication, their data and evaluations will be light years ahead of anything the solo practitioner is likely to stumble across.

It is interesting that both of the first two methods provide approximately the same answer:  that planners may be undercharging by as much as 50%, or, to put it another way, could probably, on average, raise their annual fees by half again and not suffer any diminution of clientele. 

That’s the high-end estimate.  But what about the low end?  What is the absolute floor to the pricing that financial planners should set on their services, when compared with other professions or industries?

To get this figure, we can start by assuming that a solo practitioner running her own shop actually has, at all times, an alternative: to close down her company and take a job with another, larger planning firm.  So you start by calculating what that other firm would pay her, in the current business environment, and then work the numbers backward.

The number will be different for different markets, but let's suppose it ranges between $100,000 and $200,000 compensation, depending on experience, plus $50,000 since she also functions as the paraplanner/casewriter in her own office.  The administrative chores she handles could be purchased for an additional $30,000 in salary. Add another 7% or a bit more for Social Security/Medicare and benefits, and you come up with a range of $170,000 to $300,000 in net revenue that a hypothetical advisor like her would probably cost to hire in the open market.  Add in another $30,000 in miscellaneous overhead that has to be paid by the sole practitioner’s existing company, perhaps $100,000 a year for support staff (salary and benefits), and this small shop would need to take in a minimum of $300,000 to $430,000, just to reach the point where she (or somebody like her) is compensated as well in her own practice as she would be if she were working for a larger planning firm up the road.

This figure leaves out an important additional factor, which a surprising number of solo practitioners seem to be ignoring: the return on investment for her ownership interest.  Based on the volatility of the value of an advisory firm, we can crudely estimate that this should return a minimum of 25% a year.  If we assume that the startup costs were, let’s say, $200,000 all-in, that adds $50,000 a year to the advisory firm’s total required compensation – for a grand total of $350,000 to nearly $500,000 a year. That’s just for our advisor to effectively break even – to make it exactly as attractive, financially, for the advisor to work in her own office as to work at the larger planning firm up the road. 

Assuming that this solo practice can handle 100 clients, the minimum base fee, on average, that she would need to charge to make her better off financially in her independent office than working for somebody else would come to between $3,500 and $5,000 – for an average of between 35 and 50 basis points a year on a $1 million portfolio.  Scale that down proportionately for the $3.4 million client, and you get something surprisingly close to the .21% of investable assets that Advisory Firm 2 was charging in the above comparison. 

But none of these analyses answer the most important question. Why??? Why are so many planners consciously charging less than the market will bear, in defiance of every established economic principle?  What has disconnected pricing for planning services from the normal laws of supply and demand?

The traditional answer has been that thousands of brokers and agents were giving away investment plans to anybody who opened an investment account, kind of like toasters to new banking customers.  How, an advisor might ask, can I charge an appropriate fee for a service that offices all over town are giving away for free?  Yes, those investment plans are canned and not always useful.  But how does the general public know that? 

In years past, this may have been a great explanation.  But lately we haven’t heard much about these companies offering free investment planning services; planning is, after all, the essential ingredient of their advertising campaigns, and so these firms would be fools to pretend that it has no value in today’s market.  It is at least possible that this particular restraint on the invisible hand is no longer operating.

If we’re no longer being handcuffed by free services handed out like toasters, then what is holding us back?  Interestingly, many planners already know what’s obstructing their ability to charge what the market will bear.  Out of hundreds of responses I received when I posed the question to my Inside Information audience of advisors, by far the most common response suggested (get ready for a not-totally-logical perspective) that many advisors enjoy their work too much to charge appropriately for it. 

Some said that they get so much personal satisfaction out of what they do that, if they had to, they would do it for free.  Others said that they’re afraid that people will see how much fun they’re having and demand a discount on their prices.  One told me: “It is hard to charge full bore for work you love.”

In other words, advisory firms all around the country appear to be offering their clients a “psychic gratification” discount.  They are consciously, deliberately pricing their services lower than they have to, simply because they really enjoy providing them.

Now, I know that, as I put those words on paper, Adam Smith and a whole cadre of economists began spinning fast enough in their graves to topple their headstones.  Why in the world would the fees you charge be in any way dependent on how much you enjoy your job?  In fact, if you enjoy providing financial planning services and helping clients live more prosperous and fulfilling lives, wouldn’t that tend to make your services more valuable, not less?

And that’s not all.  One advisor told me:  “Unlike our brokerage counterparts, we won't take on clients unless they’re right for our practice.” In other words, you will intentionally not allow at least some of those 9 hypothetical prospects a chance to bid for a place in your client files. We might call this “The Choosiness Discount.”

Others?  A full-fledged financial planner told me: “We get price resistance when a planning client sees our fee for comprehensive financial planning and then decides he/she doesn't need this or that part of it.”  (The Chinese Menu Discount?)

Any more?  “There is no doubt that we always put in more hours with a client than we can bill for, just because the borders of this work can be so fuzzy.”

And I think there is one more, part of which is NOT the fault of the planning profession.  Financial advice is a service that is paid for in advance, and its benefits are not clearly visible until some time in the future.  Paying an advisor those first year fees is a leap of faith, since the consumer doesn’t get to experience the value of your advice right there at the time of purchase, the way he would in the checkout line at Wal-Mart.  It may take years, perhaps more than a decade, before your clients realize the full value of advice you give today, in the form of terminal wealth and greatly increased quality of life. 

When you list all of these reasons in one place, it almost takes you from one conclusion to the opposite.  At the beginning, we wondered why advisors are not charging what the market will bear.  But with all of these tributaries feeding the psychological flood that’s washing away the effects of the invisible hand, you begin to feel like it’s a wonder that planners charge anything at all.

And that’s the point.  The point is that these impediments to market pricing are more prevalent than perhaps any of us have realized. It is going to be hard to overcome, and the job will have to be done advisory shop by advisory shop, one by one, all over the country. 

I'm not suggesting that you gouge the customer or charge fees in excess of what anybody is worth.  I am recommending that you simply loosen the cuffs a bit on the Invisible Hand, and let the normal laws of supply and demand operate in your practice to a greater extent.  If you can do that, I guarantee that you will be more profitable, you will be able to provide more services to fewer clients, and your clients will likely appreciate the work you do for them even more than they already do.

Bob Veres's Inside Information service is the best practice management, marketing, client service resource for financial services professionals. To invest in your practice and professional career, the annual cost is $299 a year with discount code 55DF: www.bobveres.com.

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