The Best Way Plan Sponsors Should Pay Fees for 401k Fiduciary Advice
The rise of the machines may sound like another Arnold Schwarzenegger sci-fi action movie, but it may also be a harbinger of things to things to come for employees whose company’s offer 401k plans. The “Robo-Advisor” represents can automated delivery vehicle for investment advice. It has been touted as the answer to cheap, efficient, participant advice.
“In the pure robo-advisor solution, this essentially gets you an asset allocated portfolio that will be continuously monitored and rebalanced,” says Michael E. Kitces, Partner and Director of Research for Pinnacle Advisory Group in Columbia, Maryland, and publisher of the financial planning industry blog Nerd’s Eye View. Kitces is one of the featured speakers at fi360’s Annual Conference from March 18th through the 20th in Orlando, Florida. He’ll be speaking on the topic “Understanding the Robo-Advisor Landscape And Ways To Leverage Them.”
The low cost of robo-advice certainly offers an attractive the small end of the retail investor market. “Although there is some variability from one provider to the next,” says Kitces, “the true robo-advisor platforms are generally charging in the range of 15bps-50bps for the services, with a median price point of 25bps that seems to be popularized as the ‘going rate’ for robo-advisor services. Notably, this does not include the underlying fees of the funds being used (though those are typically very-low-cost ETFs), and it does generally include transaction costs (which the robo-advisors absorb as a part of their assets under management fee).”
Can this pricing model also attract 401k investors? Investment advice business models are generally built around three different types of pricing models. Historically, registered investment advisers have charged asset-based fees. A growing number of advisors are turning towards the hourly or project-based pricing model. Still others have found the ongoing retainer-rate model most appealing.
Hourly Fee Rate/One-time Fees/Project-Oriented Fees
Much attention has been paid to the hourly rate model, with some suggesting it represents “the fee a fiduciary” charges, mostly because it’s often the least expensive alternative for clients. But does that mean hourly fees are always in the client’s “best interests” (the minimum threshold of anything claiming to be of a fiduciary nature)? “The good news about hourly fees is that the cost to deliver advice can be effectively matched to the time it takes for the expert to deliver advice,” says Kitces. “The bad news is that clients often try to minimize the transaction (feeling like they’re ‘on the clock’), and may be less inclined to ask questions and seek out advice because every question costs them more money to get answered. Hourly fees can also be challenging because the nature of the ‘limited scope advice transaction’ is that you need a very high volume of clients to generate sufficient revenue, which is a marketing challenge in practice for many advisors.”
Hourly fees do have their place. In fact, to better see this, think of them not in the “on the clock” sense Kitces refers (and which inspires fear in the heart of anyone who has ever hired a lawyer). Rather, think of them as a project-based fee more akin to that charged by a home repair contractor. Sheryl Garrett, founder of The Garrett Planning Network, Inc. in Eureka Springs, Arkansas, says, “In many cases the hourly fee is most appropriate for financial planning, where there is no continuous investment advice and no investment discretion. Imagine it like working on a project. A project generally has a limited scope and a defined end point. In fact, although fees can be based on an hourly rate, we find clients prefer to know the entire cost of a specific project, so that’s what we quote them.”
Consider what typically occurs during a one-on-one session with a 401k participant who seeks broad advice. The professional sits down with that person, maybe once a year, and spends an hour going over the employee’s general financial situation and perhaps offers a few specific suggestions. This is a perfect application for a one-time fee. The meeting has “a limited scope and a defined end point,” to use Garrett’s phrase. She says, “Clearly, since the generally accepted model is to provide a (typically) one-hour sit down with a 401k plan participant to address financial planning needs, the hourly-rate fee model seems best.”
In the long-term, though seemingly small, those asset based fees of robo-advisers add up over the course of a career. Additionally, their functionality is limited as they are simple asset allocation machines, not sophisticated artificial intelligence engines capable of anticipating the question you should have asked, not merely answering the one you did ask. Says Paul Ruedi of Ruedi Wealth Management in Champaign, Illinois, “The one potentially huge problem with the robo platform is they likely will not be able to talk a panicked investor off the ledge when they need it most.”
Does this then imply asset-based fees are inherently bad? “Simply put, the asset-based fee structure fits best for the subset of clients who have assets to actually be managed in the first place,” says Kitces. “There is a strong alignment of (investment) interests between the advisor and client.” On the other hand, he acknowledged the potential problem with asset-based fees. “[Asset-based fees] can create challenges for more comprehensive financial planning arrangements that are paid for by asset-based fees, though, because the advisor has a conflict of interest that emerges – spending more time giving more advice doesn’t necessarily result in more compensation (except indirectly through client retention), and as a result the advice quality isn’t always as consistent from one firm to the next.”
More broadly, and this is especially true outside the world of institutional investing where financial planning service often become commingled with pure investment advisory services. “Inherently, asset management done on a ‘fee’ basis is superior to the commission based model,” says Ed Vargo, Founder and Private Wealth Manager at Burning River Advisory Group in Cleveland, Ohio. “The advisor and the client reside on the ‘same side of the table’ with their respective interests aligned. This is the good part of working on a fee basis. However, there are flaws, particularly for ‘fee only’ financial planners – meaning, those who advise on more than just investment management.”
Garrett offers this illustration: “The asset-based fee model can have conflicts of interest. For example, a client may have the opportunity to pay down a mortgage, but that could reduce the assets under management (hence, the fees) and advising on that represents a conflict of interest for an adviser charging AUM fees.”
In its purest form, the asset-based fee model offers many advantages to clients. “Advisors using this model tend to be more talented advisors than the average,” says Bruce Wing, President at Strategic Wealth, LLC in Alpharetta, Georgia. “Fees to clients are small on an annual basis vs. with the traditional commission based model. Clients can change the portfolio structure without surrender charge….and can change advisors without a problem, too.”
It’s true fee may be higher in the asset-based fee model, but so is the value, an important – and what the DOL might label, “critical” factor when determining the appropriateness of the fees being paid by the plan sponsor. “The long-term fee to the client is greater in this arrangement,” says Wing. “That cost is there, but it needs to be placed in context. By way of analogy, think about this: Individuals that go to their doctors every year for their annual physicals pay more to their primary care physicians than individuals that don’t get annual physicals every year. Which group do you think has better health outcomes? Me too.”
The greater question of asset-based versus one-time fees involved the nature of the service. “Although I moved from the asset based model to the hourly rate model,” says Garrett, “I have no problems with investment advisers who use the asset-based model, especially when they offer customized portfolios of individual stocks and bonds. This type of service requires continuous advice and often full investment discretion. This is the traditional Registered Investment Adviser model. On the other hand, I’m not so sure about asset-based fees for portfolios built with mutual funds. In my mind, that’s a limited scope project that, while it may be periodically revisited, appears better suited for an hourly rate rather than an asset-based rate.”
Flat Fees/Retainer Fees/Ongoing Fees
Some advisors are already charging a flat fee for their services 401k plan sponsors. “Our fees include enrolling the employees individually, providing ongoing guidance and financial and retirement planning assistance to the employees, and fiduciary support for the organization” says Mark Zoril, founder of PlanVision in Plymouth, Minnesota. “We generally work with employers that have less than 200 employees. (Some real small ones under 20 and 10 employees). Also, we agree by contract with each employer that will not generate any additional revenue by selling other products and services to the employees.”
“My gut tells me, because we’re talking mutual fund recommendations and not individual stock and bond security selection, it’s a challenge to justify the asset-based fee model for 401k plan sponsors,” says Garrett. “even in the case where the adviser offers 3(38) fiduciary services (i.e., discretionary management with continuous advice). On the other hand, this is a question best left to an ERISA attorney because, unlike individual investors, 401k plan sponsors have a fiduciary liability that might have needs beyond what I’m considering here.”
In response, Stephen Rosenberg of The Wagner Law Group in Boston, Massachusetts, says, “I have not seen this precise point come up in litigation or as a point of contention in a dispute outside of court. I can certainly see how the hourly fee model could raise issues for dispute over who is really in control and exercising authority at any given time.”
To reduce the potential for liability issues rising due to discontinuous service while at the same time addressing the potentially extraordinary numbers in the case of asset-based fees, very large retirement pay a retainer or ongoing fee. This both provides continuous service while it effective caps the potential fees.
“In practice,” says Kitces, “most advisors have asset-based fee structures that have ‘breakpoints’ already, (i.e., the fee rate declines as the asset base increases). At some point, it simply becomes more practical to charge a single flat fee – and the client pays enough fees to have some bargaining/negotiating power to do so. The upside of this for the client is that it allows them some control over the cost and limits its increases over time, though conversely that puts more pricing pressure on the advisor to manage the business effectively and the rising cost of doing business over time. Though the consulting fee approach can also disconnect some of the alignment of interests and the advisor’s incentive, since the advisor is no longer rewarded for growing the portfolio but simply for maintaining the advisory relationship.”
The Best Fee Model
As we’ve seen, there is no single “best” fee model. Two many factors can influence the decision as to which is the optimal fee model given a single set of circumstances. There does appear, however, to be a growing consensus around several key points. First, project-based fees seem more appropriate for smaller clients seeking limited scope services such as creating or updating a financial plan, a situation which applies to many employees in 401k plans. The asset-based fee, and perhaps this is the reason why it’s considered the “standard fee,” is generally in the best interests of clients in need of continuous discretionary management of customized stock and bond portfolios. It’s less clear how useful this method is for mutual fund advisors, although 401k plan sponsors may have ERISA fiduciary liability that make an asset-based or other ongoing fee more appropriate. We most often see that final fee model, the ongoing retainer fee, in the arena of very large retirement plans. In those rare cases, the asset-based fee generates fees too high to justify, yet the need for continuous discretionary management requires some form of ongoing fee arrangement. An ongoing fee satisfies this need while effectively capping the total fees.
This article has covered how an adviser gets paid. For those interested in learning how much an adviser gets paid, see “What is an Appropriate Fee that a 401k Plan Should Pay?” FiduciaryNews.com, August 6, 2013.
Interested in learning more about this and other important topics confronting 401k fiduciaries? Explore Mr. Carosa’s book 401(k) Fiduciary Solutions and discover how to solve those hidden traps that often pop up in 401k plans.
Mr. Carosa is available for keynote speaking engagements, especially in venues located in the Northeast, MidAtantic and Midwestern regions of the United States and in the Toronto region of Canada. His new book Hey! What’s My Number? – How to Increase the Odds You Will Retire in Comfort is available from your favorite bookstore.