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.
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.
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.