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FEE-ONLY ADVISING - IS IT FEESIBLE? (Richer Life 31 May 2004)

Chris Preen is a Certified Financial Planner - a qualification administered by the Financial Planning Institute (FPI)

The dilemma I face as I set about establishing my new financial advisory practice in Cape Town is whether to become a fee-based practice or still rely on commissions.

Originally I started a practice in Durban in 1995. But in 2001, for various reasons, I decided to sell, relocate to Cape Town, and take two years ‘sabbatical’ leave. I am now setting up shop again, and considering the merits of different remuneration structures with a fresh eye.

The industry has undergone tremendous change during my absence, most notably the overdue advent of FAIS. A similar move to more onerous compliance requirements abroad, principally in the UK and Australia, has thrust the fee versus commission debate right to the forefront and it would be foolish for a new entrant not to take cognizance.

Internationally four principle models of advisor remuneration dominate - fee-only, retainer, assets under management and commission. Fee-only is charged either at an hourly rate or per planning task, the task often being chosen from an ‘a la carte’ menu, and the advisor does not receive any remuneration in the form of commissions.

Commission has always been the mainstay of the risk side of the industry and has comprised the traditional up-front commissions, which are paid when life or disability policies are sold to a client, as well as an initial commission of between 1 and 5% on lump sum investments. In the unit trust industry, in addition to the initial commission, an annual trail “fee” (usually 0,5% - 1%) is also paid to the advisor on the total value of client investments, ostensibly to cover the advisors costs of ongoing administration of the investment.

There has, however, been much international debate about how to define commissions, with some authors questioning whether the trail fees on assets under management can also be defined as commissions. Tom Collins has argued in the past that if an investment product pays an incentive, it should be described as a commission and on this basis assets-based fees fall into that category.

Most advisors opt for various combinations of the above remuneration structures, often choosing to be fee-based (where their remuneration is primarily, but not only, derived from fees), rather than fee-only.

From the client’s perspective, the payment of a pre-agreed set fee for professional personal financial advice, as opposed to ‘free advice’ that is actually paid by commissions incurred on products sold, is arguably a better option because it encourages the advisor to give independent financial planning advice that may not involve the sale of a product rather than giving advice on which product to buy. If after completing a comprehensive financial plan the advisor finds there is a need for a policy or investment , the fee-only practitioner would implement the policy, but at a zero-rated commission. This is how Gregg Sneddon, an independent financial advisor in Cape Town (and head of the Western Cape Chapter of the FPI), operates. He has converted his practice to a fee-only practice over the past 18 months.

Other planners, like Johannesburg-based Dolos, a small operation run by Ronel Pieterse, don’t even have contracts in place to sell financial products, preferring to trade under the slogan ‘Wealth advice is our only product’. Pieterse was motivated to launch her service after her frustrated attempts to glean personal financial advice for herself from commission-driven advisors.
“Only one of the 18 advisors I saw attempted to compile a personal balance sheet or income statement for me!” She asks: “ How else can my financial position be properly assessed?”

If a Dolos client wants to take out a policy or invest money, they are referred to a traditional advisor after having received pure, untainted advice in return for a set fee.

Unfortunately the commission-only route has cultivated an industry that promotes products rather than planning; sales talk rather than service. The advisor/client relationship is fraught with potential conflicts of interest from the outset because it is in their interest to sell as many products, on which they earn commission, rather than advising a route that would not earn them a commission, such as paying off their bond first.

Any advisor would be hard pressed to argue that the fee-only route does not facilitate more objective advice. Indeed, the closer you look at the commission-only structure, the more ethical dilemmas emerge. From the client’s point of view, the commission model is like receiving medical advice from a doctor who doesn’t charge you, but gets paid commissions from the drug companies. It is this conflict that prompted Australia's financial services watchdog to go as far as preventing advisors from calling themselves ‘independent’ if they receive any commission from third parties.

Besides ensuring objectivity, the fee model also offers the consumer several other potential advantages. Firstly, there’s a considerable cost-saving, with a R400 a month, full-term life assurance policy giving the advisor R 5 362 in commissions during the first two years. Compare this with a fee of R 2 500 (R 500 per hour) for what should not take more than three hours planning and two hours implementation.

A fee model also lends itself to a more ‘holistic’ planning approach because the ‘bigger picture’ of a client's life can be considered and the advice given would include planning options that have traditionally fallen outside the commission earning net.

In the US, where fee-only advisors make up steadily growing 23% of all advisors, ‘life-coaching’ is becoming the fastest growing service segment of financial planners. Life-coaching is loosely defined by Bob Veres, former editor of the respected Financial Planning magazine, as ‘helping clients achieve a better life’. He argues that the traditional professions such as accounting, law and medicine are not equipped to provide this personalised service and believes that financial planners are best positioned to fill the growing gap (but only if they’re charging an hourly rate)

SA has a long way to catch up with the US financial planning industry. It is estimated that only 2% of all advisers have adopted the fee-only model. Part of the reason for the slow take up is probably that many product providers are not geared to deliver zero-commission products and certainly do not actively promote it because they rely on the commission paying model to generate sales.

The fee model does have potential drawbacks, the most significant of which is that the level and quality of planning can only be truly established by the client after it has been produced and paid for. This problem could be circumvented to a degree if the advisor offers free first consultations during which both client and advisor could establish their relationship.

But many advisors charge from the first minute and in such situations that prevents the client shopping around and getting comparative plans and quotes.

Another criticism that has been levelled against fee advisors is that there is often a lack of follow through. Commission-based advisors, who only get remunerated once all policies and investments are securely in place, have a bigger incentive to take planning through to its conclusion. Admittedly some of the less scrupulous commission advisors often “drop” the client once the commission is paid, so clearly pitfalls exist both ways. In the investment arena, advisors remunerated by on-going trail fees/commissions have a built-in incentive to ensure good on-going performance, something they argue is lacking in the hourly-rate arrangement.

On balance though, I must say that I feel the client is better off with the fee model. But what about the advisor? It is easy to forget that the advisor is running a business, and needs to be profitable for the business to be sustainable.

Also, The pay-first-then-sample model doesn’t necessarily present a problem to existing clients of an established advisor, as they are presumably already satisfied with the advisor’s planning. But when building up a client base from scratch, as I am, this could present a huge obstacle to getting new clients.
There are clearly different considerations for planners converting an existing commission-based practice to a fee-based one compared with those starting out as a fee-based practice. Canvassing new clients with the proposal of spending a three hours with me at a cost of R1500, is no easy task, especially when your practice is an unknown entity to them. Even established advisors report some resistance from existing clients, and estimates that, when converting to fee-based, these advisors can expect to earn 30% less revenue in the 12 months following the change over.

But the fee-only model does offer advantages from a pure viability analysis. Most attractive to me, is that it provides the advisor with a more secure long-term future. For one thing, there is inevitably going to be disintermediation in the financial planning industry where, as in the short term insurance industry, product providers go direct to their client rather than relying on intermediaries to sell their products. This poses a much greater threat to the advisor earning commission from those products than the fee operator.
Disintermediation could even benefit the fee operator, creating a demand for pure planning advice, which clients then implement themselves through an on-line, ‘product only’ discount brokerage. The planner can also avoid being pushed around by the big financial institutions because independent financial planners are continually pressurised to meet minimum production quotas, a pressure that practices like Dolos’ avoid.

Fee structures also give the advisor some control over long-term revenues because when the planner has more clients than time available, he can simply increase his hourly fees until a new balance is attained, a strategy that is unavailable to the commission earner.

Perhaps even more fulfilling for the fee advisor is being able to ditch the ‘insurance-salesman’ image and become a legitimately independent operator. ‘Selling your first life policy with zero commission is incredibly liberating,’ says Sneddon.

A key decision in a fee-based practice is how much the advisor should charge for his services. Let’s start with the assumption that a professionally qualified and experienced Certified Financial Planner (an international professional designation awarded by the Financial Planning Institute) could reasonably expect to earn R 18 000 gross per month. Add to that the cost of an assistant, rent, IT costs, and telephone bills and with all the new regulation imposed on the financial planning industry, including FAIS and anti-money laundering legislation, there are also the added costs of compliance and licensing as a financial services provider. Ironically, building a fee-only practice adds a further layer of costs because the planner has to engage in the cumbersome process of billing clients, as well as having to allocate a provision for bad debts.

One of the attractions of getting paid commissions is that you’re only dealing with a handful of debtors (the product providers) and most of them have AAA credit ratings. Taking all of this into account, monthly overheads are unlikely to be less than R 32 000 for a one-man practice.

Assuming a planner charges out every hour of his time over a 160-hour working month (that’s assuming the planner works eight hours a day), he or she would have to charge R200 an hour to break-even. But any advisor will confirm that it is unrealistic to charge for eight hours every working day because time needs to be set aside for staff supervision, research, attending industry presentations, marketing and the like. You also need to subtract fifteen days annual leave, sick leave and public holidays, and you’re probably down to a maximum of about five chargeable hours a day.

An advisor starting a new practice, as I am, also needs to schedule in free initial consultations and, in that situation, you’ve probably realistically only got 80 chargeable hours every month. Suddenly the fee you need to charge is R400 an hour if you want to earn R18 000 a month. That means Sneddon’s R350 charge an hour (plus a small retainer of R 60 per month plus the on-going trail fees), and Dolos’ R400 an hour, is about as low as a planner can conceivably go.

Unfortunately, setting a recommended industry tariff is not easy, as the Competition Board recently came down on both the legal and medical professions for allegedly “price-fixing”. However, Nigel Scott of the FPI’s professional standards committee confirms that the FPI will be suggesting a rate of R 500 per hour for CFPs, obviously varying according to the geographic location within SA. This compares favourably with the fees paid in other professions, such as the tax and legal fraternity, where consultation fees with partners are anything between R600 and R1200 an hour.

But how many clients will be happy to pay R500 an hour or R1 500 for an initial financial plan that takes three hours on average to do? It’s not an easy question to answer and my initial forays into the field have met with mixed responses. While there are strong arguments in favour of fee-based financial planning for a client, many clients have been conditioned to believe that financial advice comes ‘free’ and thus they baulk at the idea of being charged a fee for advice. At the end of the day it is the advisor’s responsibility, and legal obligation, to be fully transparent about the fee structure under which they operate. Providing the advisor has done this, it is up to the client to make a fully informed choice. comment

Chris Preen is a Certified Financial Planner - a qualification administered by the Financial Planning Institute (FPI)

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