All forms of adviser remuneration are imperfect! (Part 1)
In this, the first article in our special three part series, AdviserVoice Director and financial planning veteran Ray Griffin explores the often contentious issue of how advisers charge for their services. With upfront and trail commissions now banned by law, the discourse has moved on to what form of fee charging is the most appropriate and, in part 1, after taking a quick look at commissions, Ray moves on to discuss hourly rates and fixed fees.
All forms of adviser remuneration are imperfect! Part 1
All of them. None are perfect. Somewhere, somehow, each of them is flawed and some clients pay more than they might otherwise under an alternate method. Under all models, a portion of clientele is subsidising another type of client in very much the same way as bank customers with large balances subsidise small deposit holders. Indeed, this is exactly the same outcome as the Australian taxation system which, arguably, is where the government of the day takes a commission on every tax payer’s earnings, every year.
But back to adviser remuneration – let’s tick them off from the top.
Commission
Commission is gone. Well – not quite. Trailing commissions are still rolling in to the bank accounts of advisers who choose not to rebate it to clients on ‘business written’ before 1 July 2013 but the point is that its imperfections were there for all to see, especially law makers when they eventually got around to looking at them. There were major flaws – read: major conflicts of interests – in the so-called up front commissions system and despite the fact that legislation in the Financial Services Reform Act (2001) required full disclosure of all commissions, including trail commissions, I very much doubt there was ever 100% compliance across the sector. Grandfathered trail commission notwithstanding, commissions are dead and long may they remain so.
Hourly rates – the Holy Grail?
Some of the loudest voices in the anti-commission/anti-asset based fees discourse seem to be those who espouse hourly rates as the morally superior model of adviser remuneration. But is that really the case? The time based fee charging methods are extraordinarily vulnerable to abuse – to overcharging. Quite simply, hourly rate fees lead to inefficiencies which result in overcharging.
Over the years I’ve witnessed some accounting firms charge much higher fees for their work on Self-Managed Superannuation Funds which have higher asset levels. How can it be that a SMSF with $2 million of assets results in accounting fees of circa $5,000 per year when a fund with the same number of members and the same number of investments but with just under $1 million results in fees of $2,000 or so? Where are all the extra hours? More to the point, what were all the extra hours required for?
You might also wonder why, for example, a law firm charges $240 for an emailed three sentence response to a single emailed question. At least my plumber jumps in his truck, drives to my home, looks at the job and drives to his next job before charging me a $240 call-out fee even if he can’t fix it on the spot. You might wonder why both accounting and law firms seem prone to providing estimates of fees for work to be done but that the final cost tends to be in excess of the estimate.
In exactly the same vein as the conflicts of interest embedded in commission based remuneration, hourly rate chargers are conflicted – fundamentally conflicted. The client of an hourly rate charging firm is largely uninterested in how long a job takes. Rather, it’s the outcomes they primarily focus on – the end results of the work they are paying for and the cost of having the work done. On the latter, the more efficiently the service provider can deliver the service the happier the client will be in terms of the fee charged. Yet, it is in the financial interests of the hourly rate charger to prolong – to draw out – the time taken to complete the work. What’s in the client’s interest – an efficient conduct of the work required at a price they believe is reasonable – might not be in the interests of the firm if it means lower fees.
If we start from a presumption that in addition to trust, successful, enduring, commercial relationships should be founded on a ‘win win’ basis, then hourly rates fail – hourly rates are a ‘win lose’ with the client not even on the podium. Right about now the backs of every accountant, lawyer and every hourly rate financial adviser are starting to hunch up as they take exception to a suggestion that they would consciously extend a job timeline in order to raise a higher cost invoice to the client. Years of education and experience in learning their profession suggests to them that they can get client work done at a much higher standard than the next person without that education and experience. But taking offence doesn’t change the fact that the conflicts of interest exist under hourly rates as they do under the commission based model of remuneration.
As a junior lawyer in Melbourne said in her blog several years ago: “My career prospects are threatened because I’m more efficient than most of my colleagues . . . If I can respond to an email in six minutes but the next lawyer takes twenty five minutes, it’s not difficult to work out who will be billing the higher fees for the firm and there goes my upward career trajectory.”
Of hourly rate method of charging by legal firms, in a 2010 Law Week address, West Australian Chief Justice Wayne Martin said: “. . . there are serious problems with time billing in that it rewards inefficiency, encourages lawyers to spend more time, limits customer satisfaction and does not focus on outcomes.”
In 2007, the American Bar Association (ABA) Journal published a paper titled The billable hour must die by Chicago lawyer, Scott Turow. In closing, Turow said: “If I had only one wish for our profession from the proverbial genie, I would want us to move toward something better than dollars times hours.” Trurow’s paper also addressed the failings in hourly rates in terms of the pressure it forces onto practitioners to meet billable hours targets.
It is instructive that as long ago as 1989 the ABA was investigating alternate fee methods and established a task force which released a paper: Beyond the Billable Hour: An Anthology of Alternative Billing Methods.
Applied in an entirely ethical, win win, methodology, subject to what the hourly rate actually is, there is an argument for hourly rates having an application in financial services however it will never be the silver bullet – the solution which reigns supreme over all others.
By any measure, proponents of the hourly rate method for financial services are very late to the game; so late that they have failed to recognise that many in the accounting and the legal professions have acknowledged the flaws in hourly rate billing (both for the client and the practitioner) and are trying to adopt methods which can result in ‘win win’ fee method outcomes.
And it would be naïve in the extreme to believe that in hourly based fee charging licensees, we would not witness a similar deleterious outcome as that experienced by the law and accounting; mounting pressure on advisers to bill more and more hours to boost revenue and profitability.
Fixed Fees
I have been observing and participating in the adviser remuneration discourse for more than twenty five years and the latest method to gain prominence is the ‘fixed fee’ approach. In essence, clients are charged an agreed fee per year under an agreement which makes provision for indexation to, say, CPI. The agreement might also see the planning firm make provision for the right to charge higher fees if the anticipated level of work increases.
One fixed fee system I am aware of sees all clients pay a flat $3,500 plus GST per year. This entitles the client to portfolio management and advice or advice only services. It also sees the firm provide Centrelink application and reporting services under the same fee. It’s not a perfect system. Someone with $100,000 of investment capital (either under advice or not) is arguably paying much more than they might otherwise pay if, for example, they were paying by an asset based fee arrangement. The client with $1 million of capital under management by the firm (or not under management) is clearly ‘free-riding’ on the $3,500 coat-tails of the lower level FUM clients who are paying the same fee.
The first obvious point to suggest is that the $1 million FUM client should pay more. If so, how much more? Twice the $3,500 fee or more again? But then, is the $1 million FUM client really taking up that much more time and resources of the firm than the $100,000 FUM client? Alternatively, is the $100,000 FUM paying too much? If yes, and if the firm were to lower those fees then it’s going to need more clients to maintain earnings. Alternatively, it could lower the fees for the $100,000 FUM clients and increase the fees for clients with larger balance portfolios.
While the above is but one example of fixed fee charging, it nevertheless underscores the imperfections which exist in that method.
