Personal Investment & Financial Planning Q`s/CFP Fees
QUESTION: Mr. Smith, as far as I know. CFPs are either fee-only or commission for their fee structure. (Maybe some use either, for different clients?) What I have long wondered is why not use success as a measure of calculating the fees, given the tough market conditions we find out there these days? Paying, say, 1% of all assets under management could be excessive currently for fixed income items. And commissions on the other hand may well exceed the return on certain investments in many load funds. Are there any CFPs who charge according to how well they perform? Have you ever heard of anyone even trying this approach? What are the negatives? It surely would be an incentive for an investor to give such a CFP a try.
ANSWER: Hi Frank. Your question is a good one and revolves around the concept of performance based fees. There are varying reasons why this may or may not make sense from a practitioners standpoint, so I will share with you 2 reasons why I would never consider this type of arrangement; 1) if you offer comprehensive advise to clients that provides value to them beyond portfolio management, then fees that are paid should not be based solely on account performance. A fee-based assets under management approach allows for unbiased decision making (i.e. not getting paid for buying and selling products) and also involves the advisor having skin in the game as he/she earns more as the accounts go up in value and earns less as the accounts go down in value. 2) If an advisor's form of compensation is performance based, there is the possibility that the advisor may recommend the client taking on more risk in the portfolio than necessary in order to try and increase their potential pay. This same rationale applies to charging a different fee on stocks than bonds; if you as an investor have an arrangement where the advisor is charging you 1% on stocks and .50% on bonds, would you fear that the advisor may want to you to invest more in stocks than appropriate in order to increase their compensation?
My point of all of this is that I feel compensation structures should be designed in a way that results in the client feeling they are getting a tremendous amount of value for the price they are paying and at the same time removing factors that could potentially skew the advisor towards giving advice that is not based solely on the clients best interest.
I hope this is helpful.
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QUESTION: Not a follow-up question, but I wanted to reach you with my thanks for enlightening me, and very promptly, too. One issue that never occurred to me. but which you pointed out, was that annual growth would indeed add to the CFP's compensation, assuming it is based on a fixed percentage, e.g., 1% of assets under management. I assume this would work both ways, i.e. if the value of the assets under management declined, the 1% fee would then decline. If what I surmise is true, then I can see that there exists already a kind of performance-based fee structure. If what I've said is accurate, there is no need to respond. If I am off-base, please correct me. Thanks again for your complete and prompt to me original question.
Hi Frank. You're welcome and I am glad my comments were helpful. Yes, I would say your interpretation is correct in that there is a built in incentive under the fee only arrangement since an advisors overall compensation does in fact fluctuate with the value of a clients portfolio. However, I will add that once the assets under management reach a certain level of magnitude, the sways in the market are viewed as something that is outside of the direct control of the advisor and therefore they need to build a firm in a way that can withstand these fluctuations from a business standpoint. The key thing for fee based advisors is to make sure they retain a high percentage of thier clients as it is much "cheaper" to keep a client than it is to find a new one. In other words, a good advisor in my opinion will not manage portfolios with the focus being on how to protect or increase their compensation; they should instead focus on how to make and keep the client happy. I hope this has been helpful.