The cost of advice

I guess most financial advisers share the same objectives: Helping clients make the most of their money, generating a decent income and maybe some capital for themselves, doing a worthwhile, albeit sometimes frustrating job and, hopefully, enjoying it. What never ceases to amaze me is how different their businesses can be.

Firms can comprise one adviser or 3,500. They can be absolutely committed to the independent brand, restricted or currently deciding which model will work best for them. They can be passionately in favour of passive funds, firmly committed to active or somewhere in the middle. And when it comes to technology there are clear divisions between leaders and followers. By the way; as far as the restricted label is concerned the recent FCA RMAR Data Bulletin reported that only 14% of firms are restricted but they produce 62% of the revenue.

Fee models are another area where opinions are quite divided. The Data Bulletin also reported that about 48% of firms are in the “ad valorem” camp. We understand this is because clients seem to like the concept and advisers take some comfort from the fact that the size of the initial fee is aligned to the risk attached to the advice provided. Interestingly, about 22% of firms are now charging fixed fees based on the work required, 20% are offering hourly rates and 10% a combination of the above. Unsurprisingly, 81% of initial fees and 74% of on-going fees are facilitated through providers and platforms.

As far as annual “productivity” is concerned, the Data Bulletin reports an average of about £92K for firms with just one RI ranging to about £124K for firms with over 50 RIs. Maybe one should increase these numbers by about 50% to reflect the on-going fees that would be coming in. This would imply a total of, say, £140K ranging to £180K. That seems reasonable. But how much does it cost to generate this revenue? And are the fee rates adequate? The Bulletin identifies that the most common hourly rate nationally is £150.

In theory, when calculating any forms of fee structures and rates, firms need to understand how much it costs to deliver their service but many don’t have a strong grasp and no documented data. The Bulletin numbers gave me pause for thought on this topic. Some years ago, we carried out a several projects in this space in order to build some economic models for banks looking to understand the impact of RDR on their business models. The key question was: “Can we cover the costs of providing advice and create value over time without subsidising our advice business with product margins?” The answer was: “with great difficulty”

To obtain an indicative cost for the advice we needed to do some sums. Please forgive the (inevitable) over-simplification as I try and replicate the approach.  The assumption underlying the calculation is that the fee earners in the business have to generate sufficient revenues to at least cover all the costs of the business and some profit margin. Interestingly, on most of the banking projects, when all the direct and indirect costs were loaded on to the shoulders of the advisers, the number was just about three times the employed adviser remuneration

Let us take a hypothetical a firm with ten advisers, total costs of £1.5M and a profit target of £300K. This firm would need average initial and on-going fees totalling £180K per adviser to meet its objectives

There are 52 weeks in a year. If we assume public holidays and vacations reduce this to 48 and assume that the equivalent of three days a week are available for direct fee earning activity and that the adviser is working eight hours a day. (Yes I know that this must underestimate the hours that advisers work and the time spent on administration!) This gives the adviser a potential 1152 direct revenue generating hours. So, the amount necessary to achieve the revenue requirement is £180K divided by 1152; about £150 per hour; the most common hourly rate nationally reported in the Data Bulletin.

Let’s put this cost into the perspective of offering on-going advice. If the commitment is to provide two face to face meetings each year plus other services I would suggest we are looking at a minimum of four hours per annum per client. So, the cost of that service is £600. At 50bps this implies that the minimum client portfolio for an efficient firm is about £120K. Unless of course it decides a higher charge for smaller investors. For the initial advice on a £120K investment the fee is likely to be up to £3,600. So, there is plenty of margin available provided the entire process takes less than 24 hours. All good – unless advisers are seeking to serve less wealthy clients.

From my perspective, the only cloud on the horizon is that the fees for an on-going service based on a percentage of the investment can look heavy when the client is drawing income; particularly when, as often is the case nowadays, the investment management is out sourced. So, we have the adviser, the DFM, the asset manager and maybe a platform all taking a slice; which could add up to 2% pa

However, advisers tell me that the annual fee is not just about investment management. Indeed; an increasing number of firms’ focus on financial planning. Some charge flat fees or hourly rates and many provide a report which demonstrates the value they have added in terms of tax saved etc. And, of course, the regular meetings that clients have with advisers are not just about money.

Personally, I think that if the investment management is delegated to a third party, ad valorem fees are probably not ideal. Not least because they imply that the client financial planning requirements remain constant; which of course isn’t the case. And I also think there is a potential conflict of interest here. Many transaction valuations in the financial adviser market are based on what used to be called “trail commissions” and are now referred to as “on-going advice fees”. Replacing these with something different could have unintended consequences.

Perhaps it is worth considering a fee structure that could be better aligned with the interests of all parties. First. a smaller percentage adviser charge to reflect the on-going risk inherent in the relationship, with a minimum underpin. Second, an hourly or fixed fee which would be applied to time intensive work outside of the standard on-going service agreement.

Clearly, this is a more complicated approach but advisers need to not only ensure that clients understand what they are paying for in terms of an on-going service, and what they can expect to receive but also to ensure the service remains suitable for their clients’ needs. And, of course, they also need to evidence that what has been promised is actually being delivered. I would not underestimate this last point.

Even if it is a little complicated, one benefit for firms who choose to move away from a purely percentage based approach for on-going service fees is that it mitigates the reduction in adviser income when markets fall. And I imagine that when markets do fall, this can drive a need to communicate with clients and incur more costs at a time when revenue is reduced. Perhaps even more important, if clients are in drawdown and the plan is to reduce capital over time, the ad valorem fee income will reduce whereas fixed fees can stay level or even increase with RPI.

It seems to me that the FCA Data Bulletin has a pretty positive message. It describes a profession with a wide range of propositions that will accommodate diverse client requirements and preferences. In other words, a healthy market which seems to be working very well. And, given that the demand for professional and objective financial advice looks set to increase for the foreseeable future; I think the best is yet to come.