We have been having this "fees versus commissions" debate for years and, in my opinion, it misses the point. We hear commission representatives argue that clients prefer paying for their services with "soft dollars," and may even pay less over the long run than they would if charged asset management fees or annual retainers. They may even claim that fee-compensated advisors, particularly those who charge hourly fees, may have no incentive to implement recommendations.
Many who do not earn any of their compensation from commissions claim that it avoids most conflicts of interest. Some go as far as to maintain that fee-only planners are more honest. But wasn't Bernie Madoff a "fee only" advisor?
Both sides exaggerate, even if they are right about a small number of people in our business. And yet both arguments are misplaced, in my opinion. The reality is, the model you choose depends on your service proposition. Just as attorneys who offer different services to their clients charge fees differently (by the hour, through annual retainers, through contingency fees), people who provide financial services and advice need to tailor their compensation to what they do. Commissions, in my opinion, are completely appropriate for representatives whose primary responsibility is to recommend and implement investments and/or insurance to clients. Many of these people may also produce a financial plan and charge a fee for that. But since our firm provides ongoing comprehensive financial life planning services to all of its clients, it is our belief that the only compensation program that works is to charge clients fees and not commissions.
In my last column, I outlined the financial life planning process as practiced by our firm. It is very labor-intensive, and I have been asked by several planners how we can maintain our profitability and continue to service clients as we do. Before I address that issue, it may be helpful to review my background in the financial services industry and the financial planning profession. My career started with a major life insurance company and 100% of my compensation was from commissions. And it was appropriate since my primary responsibility was to sell life insurance to people who needed it.
Ongoing service, while helpful, was not necessary to maintain clients or profitability. Renewal commissions and service fees adequately compensated us for any services that were necessary. And of course, we always strived for repeat business from clients whose circumstances changed. When I began providing financial planning to clients, I became a fee and commission planner. What that really meant at the time was that I produced a financial plan, charged for that plan and earned commissions from implementing the recommendations approved by each client.
That system worked for a period of time, but as we provided increasing services to existing clients, we realized that something needed to change. Most of our revenue came from new clients, since that's when commissions are generally higher. In effect, these new clients were subsidizing existing clients, particularly those who were retired and had no new money to invest (more about this later). So in 1990 we decided to eliminate commissions from investments and charge asset management fees. For a brief time, we charged hourly fees. In 2002, we felt that annual retainers were more appropriate for financial life planning clients.
So over the years we have transitioned from all commissions, to both fee and commissions, to fee-only. We've charged our fees based on assets under management, we've charged by the hour, and we've used flat retainers. You can say that we have used just about every method of compensation, and we find that flat retainers work best for us and our clients. We choose to stress the planning, whereas asset management fees imply that investing is the driving force for everything we do. As Deep Throat famously said, "Follow the money."
To demonstrate why an ongoing stream of income is necessary to provide the comprehensive services I discussed in my last column, I offer a dilemma that we faced at our firm and that others will most likely encounter if they decide to implement full financial life planning services for all of their clients. To make this point, I will need to make certain assumptions that I recognize are unique to each firm. So while the dollar amounts may not necessarily reflect each firm's financial situation, they still illustrate why a predictable stream of income is critical to providing holistic, ongoing financial life planning to clients.
As we've mentioned previously, to do this properly is very labor-intensive. And it requires revenue to support the services. So our illustration assumes that a firm needs a minimum of $10,000 per year from each client to implement these services. What if this firm relies on commissions for most of its income? Let's take a hypothetical client who is about to retire and has approximately $1 million to roll over from a 401(k) plan. Let's also assume that the commission planner earns $20,000 the first year and will receive $2,500 a year in trails. Since this client has no new money to invest, this planner is not likely to earn many more up-front commissions. Now we know that we need $10,000 to break even on this client. So the first year earnings and trails will provide the revenue for almost three years ($27,500). What are our choices after that time? As I see it, we have three:
The first would be to attempt to find new revenue by selling additional products. Since there is no new money to invest, this would have to come from investing money for which commissions have already been earned. We found that choice to be totally unacceptable at our firm, and we suspect most readers would agree with us. (Of course, if your relationship is only to help a person with her investments, then the level of service required is significantly less, and because the investments are truly necessary, the compensation would probably be adequate to implement those investments.)