What do we pay for the privilege of asking someone else to manage our investments? This post lists many forms of payment.
Advice or any form of assistance with your post-work financial planning is useful. And so you should expect to pay for it.
A problem is that sometimes it may appear to be free because you are not billed explicitly for it. (And many buyers of services – that is, people like you – prefer it that way; they prefer not to think about it or to have to write a check for it.) Clearly, when you seek advice or assistance the main thing you’re looking for is the competence of the person or firm you hire. But among your search criteria should be that you get a clear understanding of how your professional (or, more generally, your professional’s firm) will be paid. And since there are multiple ways of remuneration, and payments for multiple services may be bundled into a single amount or formula, you should be aware of the unbundled (that is, separate) amounts of remuneration for the difference services. That’s the only way you can compare the charges for the services you’ll receive.
Payments to your professional’s firm tend to be of two main types. One is an explicit fee that you pay directly, of a size independent of the amount of assets under consideration. The other is a commission (or equivalent) paid by an investment manager to your professional’s firm, for directing your assets to that investment manager, typically explicitly tied to the amount of assets under consideration. (Sometimes your professional’s firm is itself the investment manager.) Confusingly, sometimes remuneration is called fee-based, giving the impression that it’s independent of asset size, when in fact it is based on asset size after all. And some forms of remuneration are a combination of fees and commission equivalents. So: buyer beware, and be aware.
The main forms of fee-only asset-independent remuneration that you might pay to your professional’s firm are as follows:
- A one-time fee for a one-time service.
- A flat retainer fee (for example, so much a quarter or a year) for services that will be ongoing.
- An hourly fee for services that will be ongoing.
The main forms of asset-based (which I also refer to as commission-equivalent) remuneration paid by an investment institution or indirectly by you to your professional’s firm are as follows:
- A front-end load. This is an amount paid at the start. Typically it means that the amount that will be invested for you is reduced by an amount related to the front-end load.
- A back-end load. This is an alternative to the front-end load. Under this arrangement the payment is made to the professional’s firm at the start, and the full amount of your assets will be invested. But if you withdraw the investment before some specified period of time, there will be a form of surrender charge applied, to offset the up-front payment.
- A trailer. Under this arrangement the professional’s firm is paid a (smaller) amount periodically (such as every month or quarter or year) as long as your investment stays in the fund into which it is initially placed.
As you will have guessed by now, some commission-type arrangements involve both a front-end or back-end load as well as a trailer.
Asset-based commission-type arrangements have been very popular with advisory firms. They’re virtually out of sight, if they’re taken directly out of the fund. Obviously they have an impact by reducing what would otherwise be the value of your assets, but if all you see is an end-of-year value of assets, you won’t see explicitly how much the value has been reduced because of the professional firm’s compensation. And many buyers of services – that is, people like you – are perverse, in the sense that they will live happily with a concealed asset-based commission but be appalled by a much smaller explicit fee. This makes it much more convenient for a professional firm for remuneration to come from a commission; and since commissions vary from one kind of investment product to another, it is tempting to place your assets in a high-commission arrangement rather than a low-commission arrangement.
In some countries legislation has therefore been passed (for example, in the UK in 2013, in Australia in 2015) banning commission-type remuneration. And there may also be legislation that binds the professional to give advice that is solely based on what’s appropriate for you, unconflicted by remuneration arrangements. In the US, for example, the intention of the outgoing Obama administration was for a new fiduciary standard to come into force in 2017, requiring that the professional’s actions would be guided solely by what’s in your best interest. (But my current understanding is that this intention has not yet taken effect.)
I don’t profess to be knowledgeable or up to date on legislation (in any post on this website); my sole purpose is to educate you so that you know how to think about these issues. And a good way to think about the issue of payment to professional firms is simply to be aware of how they are paid in dealing with you.
What has all of this to do with active and passive investing? The connection is that active investing is a much more expensive service to offer than passive investing, for the investment management company offering it in a mutual fund or unit trust or ETF. It is also typically more profitable, so the company pays higher commissions for active than for passive. The higher cost of active management may be in addition to the remuneration of your professional’s firm. If so, by the time your professional firm’s own fees are added, the total charge to you may be noticeably high. With legislation requiring a fiduciary standard of conduct and explicit fees, commentators predict that buyers of services (that is, people like you) will be more inclined to ask for passive management in order to reduce aggregate fees, or that professionals will be more inclined to place you in passive investment products for the same reason.
And so a natural question now is: how can you compare active and passive products? That’s the subject of the next post, to look at one angle on that issue.
It is reasonable to be charged for financial advice and assistance. You pay for these services in many possible ways, some direct and some indirect. Only if you are aware of exactly what you are being charged can you compare the charges with what others might charge.
I have written about retirement planning before and some of that material also relates to topics or issues that are being discussed here. Where relevant I draw on material from three sources: The Retirement Plan Solution (co-authored with Bob Collie and Matt Smith, published by John Wiley & Sons, Inc., 2009), my foreword to Someday Rich (by Timothy Noonan and Matt Smith, also published by Wiley, 2012), and my occasional column The Art of Investment in the FT Money supplement of The Financial Times, published in the UK. I am grateful to the other authors and to The Financial Times for permission to use the material here.