Should you move your practice to a fee-based business? Here are answers to some of the key questions you should be asking.
Question: Is a fee-based practice for me, and if so, should I be fee-based only?
Answer: A “fee practice” is not necessarily a “fee-only practice”; in fact, it usually is not. Instead, it is a practice in which fees constitute a significant percentage of revenues but commissions are often still important.
Benefits for advisors who switch to a fee-based practice from a commission-based practice include more consistent revenues, fewer conflict-of-interest issues with clients, a more favorable regulatory environment and a better media image. On the other hand, you will need to consider the loss of front-end compensation as well as the need to offer stronger ongoing servicing, money-management and reporting systems, and greater fiduciary responsibility.
I believe that for most advisors, some combination of fee and commission business is ideal. For example, you could use fee accounts for large clients who are expecting more advice and money management and use commissions for smaller, less complex cases. Or, you could sell variable annuities, variable universal life insurance or 529 plans on a commission basis while offering stocks, bonds, exchange-traded funds and mutual funds on a fee basis.
Question: How do I convert to fees without incurring problems with clients, regulators or cash flow?
Answer: Find a broker-dealer that excels at fees, a partner who is a fee expert or an outside consultant. You may be able to convert tens of millions of commission-based assets to fee assets without triggering surrender charges. If so, what value-added services, such as money management and financial planning, will you offer? For some advisors, this is a no-brainer; for others, it is a major change.
Question: How do I convince clients to pay fees?
Answer: If an advisor doubts that his clients will pay fees, it usually means he is not convinced that fees are justified. The first step in convincing your clients is convincing yourself. Do you have a basket of services that you offer or can start offering that are worth 1 percent of your clients’ assets per year? If so, lay it out for them and most will be fine with it.
Question: How do I choose the right fee custodian and broker-dealer?
Answer: Selecting the right fee custodian and broker-dealer is crucial to building a successful fee-based practice. With most broker-dealers, if you plan to manage money yourself, the only option for a custodian will be the broker-dealer’s clearing firm. If this option is too limiting or expensive, an alternative is a broker-dealer with an “open architecture” that offers a dozen or more fee platforms and dozens or hundreds of third-party managers.
Another issue is price. For advisor-managed accounts, the payout on fees is normally about 90 percent, but there is an administrative fee of around 15 basis points to 25 basis points. If you charge 1 percent per year and pay the broker-dealer 20 basis points while getting a 90 percent payout, you will net only 72 percent of your fees and still have ticket charges. This is fairly normal, but in my opinion it is too expensive. Look for administrative fees in the 0-10 basis-point range, and 90 percent to 95 percent payouts.
A third consideration is expertise. Fees are estimated to account for 16 percent to 18 percent of the average independent broker-dealer’s business. There are a number of broker-dealers in the 20 percent to 35 percent range, which may still indicate good expertise. Below that percentage, the expertise may be suspect.
Other questions to ask: Does the broker-dealer add value on the fee side? Does it consult with you on registered investment account compliance issues if you have your own RIA? How about expertise in transitioning from commissions to fees? Does it have low-cost performance-reporting technology for all your accounts? How about document management, imaging, auto-population of all client documents, and auto-creation of compliance blotters?
Question: Should I form my own RIA or use the broker-dealer’s corporate RIA?
Answer: The regulatory burden, and thus the cost in time and money of having your own RIA, has jumped about 200 percent in the past five years and is likely to double or triple again soon. Therefore, most advisors who are starting to charge fees initially use the broker-dealer’s corporate RIA. You can always convert to your own RIA later if it makes sense.
Question: Should I manage money myself or use third-party managers?
Answer: Do you love analyzing stocks and mutual funds, or do you prefer meeting with prospects and clients? If you have no idea where to begin managing money, don’t try; use third-party managers instead. Your broker-dealer should be able to give you many to choose from. If you already manage money in commission-based accounts, love it and are good at it, keep doing it. Also, some advisors choose to manage money themselves for large accounts that need customization, but use turnkey, third-party managers for smaller accounts.
Question: What is a reasonable fee?
Answer: The average fee at Cambridge is about 1 percent of client accounts per year. Larger accounts, typically those that are over $1 million, will average around 80 basis points, and smaller accounts, typically those under $250,000, will average about 1.4 percent. Accounts managed by quality, third-party managers are generally more expensive than advisor-managed accounts. If the only service you offer is allocating money among four mutual funds and rebalancing once a year, the fee probably should be lower. If you manage individual stocks, use an active management style or include other services such as financial planning, then the fee probably should be higher.
Eric Schwartz is the founder and president of Cambridge Investment Research, a broker-dealer specializing in fee business. He is a founding board member of the Financial Service Institute. You may reach him at 800-777-6080.