Adopting Fee-Based and Fee-Only Models

Advisors are heeding the unequivocal demand for in-depth and unbiased advice

by Laurence Greenberg

Mr. Greenberg is President of Jefferson National, innovator of the industry’s first flat-insurance fee variable annuity with the largest selection of underlying tax-deferred funds. Connect with him by e-mail: [email protected]. For more information, please visit www.jeffnat.com.

The fee-based and fee-only advisory model has now become the dominant form of client-advisory relationships. This trend has steadily transformed client-advisor relations over the past decade and will no doubt reshape the future of advisor practices. For advisors considering the move to a fee-based or fee-only practice, it is critical they understand how this model will change the way they do business, how they will interact with clients and the products they will use.

Driving the Trends

In the first half of the 1990s, the fee-based and fee-only model emerged to challenge the traditional commission-based approach, fueled in part by the growth of online trading offered by discount brokerages. The technology-bubble of 2000-2002 convinced many advisors to move from commissions to a fee-for service model. Following the crash of 2008, an increasing number of advisors began breaking away from brokerages to join the ranks of independent advisors – and an increasing number of clients have been seeking their holistic approach to financial planning.

By 2013 roughly 60 percent of all advisors practiced the fee-based and fee-only approach. According to Cerulli Associates, a Boston-based research and consulting firm, 21 percent of all financial advisors were fee-only, and an additional 38 percent were fee based advisors who earned 50 percent or more of their revenue from fees.

More importantly, over the past decade both the fee-only Registered Investment Advisor (RIA) channel and the fee-based Dually-Registered channel have been increasing, while other intermediary channels have declined. From 2004 to 2013, RIA headcount has increased 37 percent and Dually-Registered headcount has grown nearly 350 percent. At the same time, Independent Broker Dealer headcount has declined by nearly 30 percent and Wirehouse headcount has declined roughly 20 percent. These trends are forecast to continue, with both headcount and AUM of the fee-for service model increasing steadily as other channels decline or remain flat.

The Demographic Factor

An important factor driving the growth of the fee-based and fee-only model is the surging wave of Boomers entering retirement. According to Pew Research Center, in the United States, roughly 10,000 Boomers turn 65 every day – and another 10,000 more will continue crossing this threshold every day for the next two decades. This massive cohort is estimated to control $12 trillion in wealth as they move from accumulation to generating retirement income. In the face of tremendous challenges – increasing longevity, ongoing volatility, rising taxes and a low yield environment – their need for guided advice has become more urgent.

Likewise, the emergence of Gen Y and Millenials, born between 1980 and 1999, is poised to have a dramatic impact on the creation and transfer of an estimated $30 trillion in wealth. With their numbers reaching well beyond 80 million according to U.S. Census Bureau statistics, this is the largest cohort in history. Recognized as the most technically savvy, self-directed, well-educated and wired generation, their influence is already leading to new advising and planning techniques.

Thirty years ago, consumers had almost no access to real-time market indicators. Daily stock prices were available only on a Quotron machine in a broker’s office or listed in the Wall Street Journal the next day. Information was a precious commodity – and investors paid a high price. Now information is virtually free and unlimited. Tools for investing, trading and basic planning have become every day commodities. So while Gen Y and Millenials have enthusiastically adopted technology solutions as an entry point to investing, this generation also has a need for comprehensive holistic planning to navigate and manage the market’s increasingly complex dynamics.

Client Value Advocates

Registered Investment Advisors are barred from accepting commissions or other payments from the companies whose products they recommend. They have the legal duty to follow a fiduciary standard and put clients’ interests first. Most RIAs charge a fixed annual percentage of clients’ assets under management, typically one percent. Their incomes rise and fall with the fortunes of their customers, as they “sit on the same side of the table” as their clients. In comparison, Dually-Registered advisors collect fees for assets under management on a portion of their business, while also collecting commissions for selling products that adhere to “suitability standards.”

While all advisors are expected to act in a client’s best interests, regardless of how they are compensated, the shift from commissions to fees can help. The fee-for-service approach can eliminate potential conflicts of interest, moving away from financial incentives to push certain products or the appearance of churning an investor’s portfolio to collect a commission. This in turn can lead to far more transparency around the advisor’s fees and investment expenses. And both advisor and client can benefit from the greater access to a wider variety of funds and financial instruments.

The Transition to Fee-Based and Fee-Only

Independence requires an entrepreneurial mindset. Owning and operating your own business will entail start-up costs, ongoing expenses and added responsibilities. But for the right type of advisors, it can be highly rewarding. The opportunity for greater long term financial success is a primary motivation for making the move. Independent advisors can keep more of the revenue they generate. There is no splitting fees and commissions with the home office, which ranges from 25 percent to more than 50 percent for the typical Wirehouse advisor. There is also the opportunity to build equity – and to monetize it in the future. Industry rules of thumb indicate that advisory firms are often valued at 6 to 10 times cash flow or 1.5 to 3.5 times revenue.

Given the forecasts of strong growth in the coming years, the fee-based and fee-only model clearly will remain a dominant force. As you join the growing number of advisors making the move away from the traditional commission-driven model and towards the independent fee-for-service model, what are the factors you need to consider as you rethink you approach to planning, managing your practice and choosing products?

A New Approach to Your Practice

the emergence of Gen Y and Millenials, born between 1980 and 1999, is poised to have a dramatic impact on the creation and transfer of an estimated $30 trillion in wealth

The move to independence has separated many advisors from the home office structure. Under the traditional arrangement, investing decisions are made at the home office level, and advisors deliver the products to their clients. Many other core functions of practice management, such as marketing, technology, legal and compliance are also provided. But the fee-based or fee-only advisor operates independently and requires a series of specialized tools for three core functions – holistic planning, investing and managing their practice.

There has been a very significant move to open architecture platforms that can provide seamless integration of best-of-breed solutions. Oversight of the client’s full financial assets creates more opportunities to optimize their portfolio, by integrating brokerage assets with other held-away assets – to manage risk, maximize tax-efficiency, and enhance outcomes. Likewise, oversight of every aspect of your practice creates the opportunity for you to achieve greater profits.

The role of the custodian can be very important. First, as an independent fee-based or fee-only advisor, you are a client of the custodian – not an employee or supervised agent. You have the freedom to work with multiple custodians, or to change custodians at any time – giving you more flexibility and considerable leverage.

It’s important to choose custodians wisely. In addition to providing custody, clearing and a broader range of products, they can also provide integrated workstations, portfolio management systems, performance reporting, billing and other technology solutions. Many also provide institutional quality research, as well as training, support and resources for such areas as legal, compliance, marketing and other aspects of practice management.

A New Approach to Planning: The shift to a more holistic goals-based approach to financial planning

The traditional approach for the industry has been more product-centric, with individual products often used in isolation and investment decisions often driven by short term transactions. Now there is a new approach that goes beyond just selling individual products – with a focus on understanding the client’s overall financial goals and taking a more holisitic approach to achieving them. This includes not only investing for long term goals, but also planning for retirement, generating reliable retirement income, legacy planning, estate planning and other customized services. By deepening the relationship in this way, you can earn greater trust, increase in importance to your clients – and increase the value of your services.

Holisitic planning has proven popular. Over the past five years, from 2008 to 2013, when Cerulli asked all advisors to define their practice type, between 60 percent to 70 percent consistently identified themselves as a Financial Planner. Providing holistic advice, these Financial Planners, as defined by Cerulli, develop comprehensive financial plans for clients based on an extensive analysis, while also providing personalized and specialized services, including income planning, college planning and estate planning.

During this same time frame, roughly 25 percent of all advisors identified themselves as Investment Planners, emphasizing asset management as their primary service. Roughly 10 percent identified themselves as Wealth Managers, offering comprehensive planning for the higher net worth including executive compensation, complex trust and estate planning. Approximately 5 percent identified as Investment Managers, focused exclusively on asset management.

A New Approach to Product: The movement from commission to fee-for-service requires specialized best-of-breed products

The fee-based and fee-only advisor has an incentive to keep overall costs low and that makes certain products much more competitive. While Wirehouse advisors tend to use more individual equities, individual fixed income securities and separate accounts, RIAs and Dually-Registered advisors tend to use more no-load mutual funds. And as more advisors have adopted the fee-for-service approach over the past two decades, more fund managers responded by creating share classes without additional fees and offering “institutional” shares that often have the lowest recurring expenses.

The growth of fee-based advice has been the single biggest driver in helping to propel the ETF into the fastest-growing investment product, because they tend to be low-priced, tax-efficient and easily traded. RIAs allocate an average of 14 percent of their clients’ assets to ETFs, more than double the proportion among other traditional channels, according to Cerulli.

As advisers have moved to focus more on investors’ overall portfolios and less on making the next transaction, a more recent product innovation is the emerging category of low-cost Investment-Only Variable Annuities (IOVAs) built expressly for fee-based and fee-only advisors to deliver low-cost tax-deferral. While essentially unheard of less than a decade ago, IOVAs eliminate commissions and costly insurance guarantees—while offering more investment options—evolving to become an integral part of the fee-based and fee-only practice. By helping advisors to minimize cost, tax-optimize portfolios and mitigate risk, they can help maximize long term portfolio performance.

Fee-Based and Fee-Only: Good Business Sense

Making the move from a commission driven model to the fee-based and fee only model has many benefits. By adopting a holistic approach and a long terms planning outlook, by gaining the independence to choose from a wider range of best- of-breed products, you can create more value for clients, increase the value of your services—and generate consistent revenue over the long term that is aligned with your clients’ goals.

This is why, in today’s entrepreneurial culture, many advisers have come to believe that the old sales and product-driven model is not the best solution to meet their client’s needs—and not the best approach to building their business. Most important they recognized that “customer first” aren’t just good buzz words—they make good business sense. By adopting the fee-based or fee-only approach, the advisor is better positioned to create better outcomes for their clients—and better outcomes for their business.