What’s a Fair Fee to Pay a Fiduciary

As part of Fiduciary September, we’re proud to present the sixth and final segment of our six part series exploring the six duties of all fiduciaries and what they mean for investors. “Essential to fiduciary conduct,” these core duties are defined by the Institute for the Fiduciary Standard and have been provided to FiduciaryNews.com by its President, Knut Rostad.

In the world of fiduciaries, there will always remain one enduring conflict of interest. No one can remove this conflict of interest. It represents the ultimate in the tug-of-war between always putting the interests of the beneficiary ahead of the fiduciary and placing the fiduciary’s desires above those of the beneficiary. It comes down to one word: Fees.

Think about it. It’s impossible to eradicate this conflict of interest. Imagine what would happen if you did. You’d have the fiduciary answering every beck and call of the beneficiary – or client – and receiving no compensation for the provision of those services. We have a word for that, too. It’s called “slavery.” Most folks nowadays pretty much agree slavery is a bad thing that we shouldn’t encourage.

That leaves the question, “how do we reconcile our need to always act in the best interests of the client with the need to avoid resorting to slavery?”

This question has two answers. This first focuses on the idea of what “best interests” means. Remember our earlier discussing on “The Whole Truth” where we described a situation where the client isn’t always right. This is along those same lines. Let’s say you have the opportunity to hire two workers. One, essentially a slave, will work for free. The other will receive compensation. Which will provide better service? A better way to ask this same question is to ask which employee has the most to lose as a result of providing poor service?

If you’re not getting paid, you have nothing to lose; ergo, you have no incentive to offer superior service. On the other hand, if you are getting paid, you better offer the best possible service lest you kiss that paycheck good-bye. So, as you can see, it’s actually in the client’s best interest to pay for services rendered.

Now for the second part of the answer. Once we’ve established it is actually in a client’s best interest to pay a fiduciary, the next question is, “How much should the client pay the fiduciary?”

Part of this answer lies in the nature of the fiduciary relationship. For example, if the fiduciary serves as an individual trustee, then, unfortunately, the scope of this article is too limited to provide a sufficient answer. Why? Because many states have legislated compensation levels for those providing individual (as opposed to corporate) trustee services. What’s the difference between an individual trustee and a corporate trustee? An individual trustee is a person. For example, Uncle Joe has been named trustee for Grandpa’s estate. Uncle Joe is an individual trustee. A corporate trustee is a company, most often a bank trust company but in some states it could be a law firm. For example, Big Trust Company, Inc. has been named trustee for Grandpa’s estate. Big Trust Company, Inc. is a corporate trustee. Even if Big Trust Company hired Uncle Joe to serve as trust officer for Grandpa’s estate, the relationship would still be considered a corporate trust relationship.

But we’re really not talking about that kind of fiduciary relationship. We’re talking about any one of a number of fiduciary relationships. Since we’re speaking of different types of services, we’re also speaking of different types of fees. For example, recordkeepers normally charged both fixed fees and per employee fees (also fixed). Investment advisers (RIAs) generally charge asset-based fees as a percentage of total assets. These fees can range from 30 basis points to more than one percent. Custodians also charge asset-based fees as a percentage of total assets. These fees can range from 3-25 basis points.

In both cases, actual asset-based fees will depend both on the nature of the service and the size of the plan. For example, RIAs managing portfolios of stocks and bonds will generally charge about 1%, whereas RIAs managing portfolios of mutual funds generally charge about 30 basis points. On the other hand, RIAs offering only index funds will generally charge only 5 basis points.

The reason for this broad disparity in fees doesn’t mean one kind of RIA is overcharging while the other isn’t. The fees are fair, based on the services offered. In the case of managing stock and bond portfolios, RIAs have to search through thousands of individual stocks and even more bonds. RIAs picking mutual funds, though, have the advantage of screens based on apples-to-apples collections of regulatory required data submissions. Analyzing mutual funds, with their similarity in reporting, is much easier and faster than analyzing individual stocks and bonds. In fact, that level of analysis is being done by the underlying mutual funds selected by the mutual fund picking RIA. Lastly, the ease of picking index funds is magnified by a similar magnitude as the adviser need only focus on identifying the relevant fund with the lowest expense ratio. (N.B.: If the RIA claims to be offering a market timing asset allocation service, then that is yet another different type of service.)

Let’s not leave the idea of low fees. A fiduciary’s responsibility to charge only a fair fee does not mean he should charge the lowest fee. In fact, regulators go out of their way to warn investors against looking only for the lowest fee. Perhaps they’re worried those investors might be getting what they pay for (see the first part of the “client’s best interest” above).

But don’t confuse this with avoiding all non-essential costs. For example, there’s almost never a case where a fiduciary should place a client into funds with commissions or 12(b)-1 fees, as these fees are meant for fund salesmen, like brokers, not investment advisers. Paying these fees comes directly out of the performance of the fund.

Lastly, when we talk about fees, it’s important to understand the difference between fees that matter and fees that don’t matter. For example, with the exception of index funds, rarely does looking at a mutual fund’s expense ratio tell you anything more than what you’ve already seen in the fund’s performance results. Why? With index funds, you have exactly the same portfolio from one fund to another based on the particular index those funds are attempting to track. It makes sense, then, to screen out high expense ratio index funds because those higher expense ratios detract from what would otherwise be the same performance among the similar portfolios. The same cannot be said of actively managed funds, which almost never have identical portfolios and therefore offer a wide range of investment returns. In other words, it would not be unusual to find a high expense ratio actively managed fund with better investment returns than a low expense ratio actively managed fund.

Fees may be a sexy subject for salesmen and the media to talk about, but, given the number of shades of grey involved, they’re actually difficult to analyze. It’s best just to remember these three rules of thumb: 1) Fees should be fair and reasonable based on the services provided; 2) Avoid looking only for the lowest cost provider; and, 3) Avoid non-essential fees.

And thus concludes our series on the six core duties of the fiduciary. We hope you’ve enjoyed it and found it most helpful.

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