Are You Working as Your Clients' Investment Cost Manager?
To many financial advisors whom I meet these days, I pose two questions:
- Do you help your clients set total investment cost targets?
- In helping clients select mutual funds, do you screen for costs, among other criteria?
Surprisingly, many advisors respond with vexed expressions or questions of their own.
In this article, I'd like to explain why it is in your best interests, as well as your clients', to become their investment cost manager.
Two mighty trends are occurring in your business. First, the world of professional financial advice is gradually shifting from a transaction/commission model to a fee-based model. Secondly, as a result of a deep bear market, a dramatic compression has affected investors' return expectations and risk appetites.
Four years ago, large numbers of investors believed it was possible to earn 15-20% annually on their portfolios, and risk was a minor concern. Today, many of these same people are humbly aiming at perhaps 8% (pre-tax) annually, and they are deeply interested in protecting against further losses.
Pure Gross Returns and Total Costs
Let's begin by imagining a hypothetical concept-namely, that of a "pure (cost-free) investment return." This idea is hypothetical because it is not attainable for most investors, due to myriad cost components-some visible and quantified, others hidden and murky. The closest proxy to pure return may be the earnings produced by an individual security bought and held long-term in a super-discount brokerage account.
Suppose you have an affluent client who wants moderately low risk exposure while aiming at a pure return of 8% over time. Four years ago, when this investor was aiming for the moon, costs didn't matter. But now, you are sitting down with the client in a different environment. The question is: What portion of that 8% should the client be willing to give up in total investment costs, assuming the client values your continuing services as a financial professional and believes you should be compensated? Surprisingly, few financial companies address this question in light of their own products and services, perhaps because it is threatening to many.
I believe that question should not be a threat to you and your clients. Instead, it can be an integral part of your relationship-building process.
I don't think the answer is a mystery, either. Industry trends support the following model:
- The low end of total costs for the "economy shopper" needing professional advice and service is trending toward about 1.25%, assuming the 8% risk/return goal described above. As risk/return goals increase, the low end can rise proportionately, so that total costs absorb about one of every five or six dollars of pure cost-free return.
- The high end for the "premium shopper" who wants professional advice and service is trending toward about 2.25%, assuming the same risk/return goals, and proportionately higher for those with higher risk/return appetites. At the premium end, total costs can absorb about one of every three or four dollars of pure return.
- Some premium clients will pay total costs above 2.25% for professional services that enhance their lives, apart from helping them achieve pure returns. Examples of such services might be financial planning, estate planning, tax planning, and insurance services embedded in investment products.
Opening your mind to this model can help you plan strategically, set your fees, and select investments in product areas such as those discussed below.
Mutual Fund Wrap Accounts
These accounts boomed during the bull market of the 90s, when costs were not a great concern. Now, they are maturing in a cost-conscious environment, while giving advisors more choices and flexibility. For example, some wrap programs allow advisors to select among several hundred approved mutual funds and negotiate program fees with the client. The wrap fee covers the advisor's compensation and the program's costs and profits. But there are two other components of costs in wrap programs that should fit inside a client's "total cost" target:
- The operating expenses of underlying mutual funds, including management fees.
- The portfolio transaction (trading) costs of underlying mutual funds. This is one of the most nebulous niches of investment costs, where details are hidden and highly debatable, and where Congress is breathing down the fund industry's neck to provide more disclosure. (To help you understand current analysis of this subject, I will devote this column to it next month.)
As a rough estimate, you might assume that total costs in underlying mutual funds, including transactions, are about 120% to 140% of a fund's published operating expense ratio.
Currently, investment advisors typically net about 45%-65% of the wrap fee paid by the client, after charge-backs and broker-dealer haircuts. Here's how the wrap account math might work in today's industry, for that 8% risk-return client:
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Client Pays
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Advisor Nets
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Wrap fee Underlying fund operating expenses Fund-level transaction costs Total costs
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1.20% 1.50% .30% 3.00%
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50% of wrap fee = .60%
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What's wrong with this picture? The client's total costs exceed one of every three "pure return" dollars. Meanwhile, the advisor may earn too little. For providing high-level professional service over 50 wrap accounts with $200,000 in assets each ($10 million total), this advisor nets just $60,000 a year. That's enough to pay office overhead and an administrative assistant's salary and benefits. But not much more.
Recently, we've seen communications from some leading wrap programs to advisors, indicating the programs are aware of clients' cost sensitivity. Their proposed solution: In some cases, they urge advisors to be flexible and negotiate wrap fees down. But for every dollar of fee negotiated down, the advisor must sacrifice personal earnings of 45-65 cents annually, perhaps for a long time.
There's another solution that often makes more long-term sense, in my opinion. Strike a better balance between the value added by the advisor and wrap program disciplines, compared to underlying mutual fund investments. In many wrap programs, the advisor's counseling and asset allocation models provide by far the greatest part of value. So, why not implement those models by screening for low-cost funds, in addition to screening for manager experience, past performance and other criteria? In the example above, if the underlying fund operating expenses are reduced to about .60%, the program moves closer to a reasonable total cost, and the advisor can avoid pressures to negotiate program fees and personal earnings down. Within the allocation disciplines of wrap programs, most clients don't need high-cost or high-turnover mutual funds to reach conservative return goals. So, why not screen among all the wrap fund choices available, to help your clients meet their total cost targets?
Separate Accounts
Separate accounts are cleaner than wraps because they avoid double-layered management fees, while absorbing part of trading costs in program fees. The problem with separate accounts is that they may not give advisors enough fee flexibility to meet total cost targets of clients below the "premium" end of the spectrum. For example, a typical separate account program allows advisors to negotiate program fees between 2.5% and 3.0%, while netting the advisor 45% of the program fee. This can meet needs of aggressive investors and also those who want premium services, while compensating the advisor well. But it may not be a good fit for economy-minded clients with modest risk/return goals. I believe the solution for these investors will be a new breed of separate accounts implemented with economical tools such as folios (see my February column) and low-turnover managers who post trading recommendations on Internet sites, and grant password access for a modest subscription fee. Don't reject innovations in this area, unless you aren't interested in offering the many benefits of separate accounts to frugal millionaires.
Hedge Funds
The old equation in hedge funds was the opportunity to earn a 20%+ annualized return and pay total annual costs of about 5-8%. In today's world of lower expectations, the new equation in some funds is an opportunity to earn 8-12% while paying a variety of costs that might average 4-6%, if they could ever be sorted out. Hedge funds are by far the most difficult investment for purposes of helping clients set and meet cost targets, especially in new funds, small funds, highly leveraged funds and heavy-trading strategies. Hedge funds make the most economical sense for clients who want premium services and are aiming for high returns. Even so, many hedge funds haven't figured out how to include in their high-cost structures a meaningful, compensated role for financial advisors.
Variable Annuities
Some advisors say VAs are a great value proposition for today's economy-minded, risk-sensitive clients. These clients can pursue a professionally-guided discipline that mixes assets between a guaranteed fixed account and variable separate accounts, while often hitting a total cost target of about 1.5% or less, and having their advisor well compensated. The greater the portion of assets allocated to the fixed account, the lower the cost target can be, because in this choice neither portfolio operating expenses nor mortality and expense risk charges apply. Since taxes can be considered an investment-related expense, tax-saving features of VAs are a bonus.
Just keep two points in mind when recommending VA's to cost-conscious investors: 1) As in wrap accounts, you can screen for low-cost portfolios among the 40-70 separate account choices offered by many contracts; and 2) It's important to educate clients on the fact that part of VA costs, the part that pays for the guaranteed death benefit, is not a true investment cost. Instead, it is insurance protection embedded in an investment account. As such, its "premium" should not be included in the total cost target.
Individual Securities
One of the most cost-effective solutions for building your practice is a group of professionally selected individual securities bought and held long-term, but periodically reviewed and adjusted, in a non-discretionary fee-based brokerage account. As I suggested in last month's column, you can help clients pursue a strategic sector rotation strategy, with tax advantages, by weighting portfolios among sector SPDRs (exchange-traded funds) that have operating expenses of just .28%. That means the fee-based brokerage rate could be set at perhaps 1.20% to earn attractive compensation, while meeting the needs of economy-minded clients at a total cost target of about 1.50% (on this part of their assets). With some success in strategically adjusting sector weightings over time, this program might perform as well as a growth mutual fund held in the same fee-based brokerage account, at an implementation cost about 1.0% lower.
Mutual Funds Costs-More Complex Than You Think
In this analysis, I am not ignoring mutual fund families and individual mutual funds.
In next month's column, I'll discuss how you can help your clients understand mutual funds' true total cost, including the costs investors unwittingly pay for transactions, liquidity and rebalancing. For all the benefits that mutual funds offer, you may be surprised at the many different ways their costs can drag down "pure return." Understanding these issues will help you become your clients' cost communicator and manager. In today's climate, that's a valuable role for demonstrating sensitivity and objectivity, while building stronger client relationships.
freeERISA.com FOCUS:
Using FreeERISA.com to Identify Plan Decision-Makers
In my book 12 Steps to Your Personal Success in the 401(k) and Small Plan Market, I observe that one of your major prospecting challenges is to identify plan decision-makers. In fact, among six basic rules for success in this market, the first two are to:
- Identify and meet the decision-makers.
- Identify and document needs.
FreeERISA.com can help you identify key decision-makers for purposes of your initial prospecting calls. It also can indicate other decision-makers whom you may meet "down the road," such as when you gather data for a Request for Proposal (RFP) or present your proposal and recommendations.
It would be helpful if you could go to one screen in the FreeERISA data base and find all of a plan's key decision-makers neatly arrayed. Unfortunately, the Department of Labor did not consider your needs in designing the public disclosure forms that feed data to FreeERISA. So, you will need to scavenge among several forms to find names and titles. In this article, we'll highlight where to go and what you may find.
Form 5500
Line 2a contains the plan sponsor's name and address. For many small businesses, this will be the name of the business owner. In the space below this line you will find the name of the individual signing as plan administrator and the individual signing as employer or plan sponsor. In many companies, these names will be for the same person. In some larger companies, the plan administrator may be a senior manager in the Employee Benefits or Human Resources department. In some filings, the plan administrator's telephone number can be found on Line 3a.
Line 5 contains the name of a tax preparer, if one is used. Not all tax preparers are CPAs who provide high-level advice on plans and their features. But since some are, you should note the preparer's name in your notes, and ask during fact-finding if the preparer provides plan-related advice or services.
Schedule A
This schedule is filed by plans funded by insurance contracts. Line 2 of Part I often identifies an insurance agent or broker to whom commissions or fees have been paid. This may be a potential competitor, but don't assume that's the case without probing. It could also be an advice-giver whose buy-in you will need.
Schedule B
This Actuarial Schedule is required of defined benefit plans and other plans that accrue future liabilities or cross-test for future benefits. The statement is signed by an enrolled actuary, a professional enrolled with the IRS to perform these calculations. Note whether the actuary's address is local (in the same area) or not. A local actuary is more likely to provide other types of technical advice than one working more distant. Whether or not the actuary is a decision-maker, this can be a valuable person to know for purposes of obtaining information (with the sponsor's permission) and assistance in plan conversions.
Schedule C
This schedule lists Service Provider Information, including fees and commissions paid and the nature of services rendered. It is only available for a small percentage of plans in the FreeERISA data base.
Schedule H
This schedule, containing detailed financial information about the plan's assets and liabilities, is not required of most filers in the data base. In some cases, it discloses the name of the plan's CPA under Part III, Accountant's Opinion.
Schedule P
This schedule is the Annual Return of the Fiduciary of the Employee Benefit Trust, which holds plan assets. It technically is not filed by the plan sponsor or administrator but rather by the trustee or custodian of the trust. The name of that individual can be found on line 1a, and that person's address is on lines 1b and 1c. If you find that the administrator and trustee/custodian are different people, consider both as possible decision-makers. The administrator may hold sway over the plan's design, recordkeeping system, compliance, and cost issues. The trustee/custodian may have responsibility for investment-related matters and also is technically responsible for making distributions.
Moving Forward
Once you know a decision-maker's identity, you can pick up the phone and call that person directly. Or, you can investigate among your clients and contacts to find an individual who knows the decision-maker and is willing to provide an introduction. A third approach is to contact lower-level employees at the company and ask them how the decision-maker works and thinks. In your first call to any decision-maker, introduce yourself and your firm briefly but avoid proposing, recommending or selling. The goal of that call is always to ask questions, listen and identify decision-makers' needs-on both business and personal levels.
Once you have identified key decision-makers and then identified and documented their needs, you have taken two important steps toward a potential sale.
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