Robert Reid: The problems with percentage-based charging

ReidRob

The architects of the RDR made it clear one of its key objectives was to move the power in the market from the manufacturer to the distributor. Given the bulk of the market is still charging on a contingent basis on assets under their advice is it unreasonable to suggest this be revisited by the FCA?

The ongoing focus on the fairness of percentage charges is underlined by comments from regulators that this method of charging is likely to come under scrutiny in the near future. However, as long as the FCA charges on a percentage basis its case is somewhat weakened.

The great benefit of the current and undoubtedly dominant system is that it saves the advice firm the complicated work of setting appropriate fees for each individual client. Just how would you explain the new fee structure to existing and potential clients?

Some will point to the fact the assets under management charge for advice contains a built-in escalator clause, which grows your remuneration as clients add more assets to their portfolios and/or the markets rise. However, the greater workload emanates from a falling market just as the revenue follows suit, so it is easy to argue the AUM method is anything but intuitive.

As we strive to communicate the value we add, being paid on assets alone can lead to a misunderstanding as to where that value really lies. When clients agree to an adviser managing their assets, they will discover that for no extra cost they get a full financial planning service with recommendations they can claim on should they turn out to be unsuitable in hindsight. So zero charge for that element but maximum risk for the adviser.

The problem with this arrangement is best illustrated where an adviser explains his AUM fee structure to a high net worth prospect. The prospective client listens carefully and then says: “So, if I let you manage my £500,000 portfolio, you’ll charge a percentage of the assets and provide financial planning services at no extra charge?”

So far so good. But when the prospective client then asks: “What if I give you just £100,000? Would you still give me financial planning advice at no extra charge?” As the adviser says yes with a grimace he then finds the prospect asking: “Suppose I give you just £50,000?” That is the risk of bundled contingency charging, as providing extras for free leaves you vulnerable.

There are also some glaringly apparent inequalities built into the AUM model. Unless the fees reduce with larger portfolios the clients with the most assets are effectively subsidising everyone else. Is that fair? The trend to a flat 1 per cent will prove to be a major error for many firms and one that is hard to disconnect from.

Charging solely based on assets also has the potential to introduce conflicts of interest where liquidating investments could be the right call but it is at the expense of revenue.

The AUM model creates a dangerous countercyclical mismatch between remuneration and workload. When the markets drop, your phone rings. The harder and faster the plunge, the more your clients need reassurance. At the same time, your remuneration falls. Revenues going down while internal costs head upwards is never a good combination.

Robert Reid is managing director of Syndaxi Chartered Financial Planners