It’s Time To End Financial Advisers’ 1% Fees
Will the other shoe drop?
For the past decade, fund investors have eschewed actively managed funds, those that aim to beat the market. Instead, they have poured money into passively managed index funds, which seek to replicate the performance of a market average.
That shift has driven down investment costs. But even as fund expenses have fallen, one cost has held remarkably steady: the price paid for financial advice.
Will we see an end to the standard 1% of assets charged each year by many financial advisers? My hunch: Traditional advisers won’t cut their fees—but they’ll need to beef up their offerings or risk losing clients to low-cost online advisers.
During the 10 years through year-end 2014, index funds have grown to 35% of stock-fund assets from 18%, according to Chicago investment researchers Morningstar. The figures include index-mutual funds, which are bought directly from the fund companies involved, and exchange-traded index funds, which are listed on the stock market and trade like individual company shares.
That shift has sharply lowered fund costs. Morningstar calculates that stock investors now pay 0.64% of assets in annual fund expenses, versus 0.92% a decade ago.
It isn’t just do-it-yourself investors who have made the move to index funds. Many financial advisers have also switched—and, in the process, saved clients a bundle in fees.
Before, clients might have paid 1% a year to their adviser and 1% for the actively managed funds that the adviser recommended, for a total of 2%. Today, these same clients might still pay 1% to their adviser, but now they own index funds that charge 0.2%, so their total cost has dropped from 2% to 1.2%, a 40% decline.
To be sure, in lowering clients’ costs, advisers have also taken away the chance to beat the market. But the odds of that happening were, in any case, extremely slim—and getting slimmer, argue Larry Swedroe and Andrew Berkin in their book, “The Incredible Shrinking Alpha,” published this month.
The two authors write that, “as the ‘less skilled’ investors abandon active strategies, the remaining competition, on average, is likely to get tougher and tougher. As the trend to passive investing marches on there will be fewer and fewer victims to exploit, leaving the remaining active managers to trade against themselves. And that is a game that in aggregate they cannot win.”
So far, advisers have managed to cut their clients’ costs, without cutting their own fee. But the standard 1% fee is now under pressure, thanks to online financial advisers.
For instance, Betterment.com, SigFig.com and Wealthfront.com typically charge 0.25% a year, though it can be less, depending on an account’s size. Charles Schwab won’t charge anything for its new online advisory service, slated to launch during 2015’s first three months. It will provide investors with customized index-fund portfolios.
How much of a threat is all this to traditional advisers? Major brokerage firms and fee-only financial planners are heavily focused on clients with investable assets above $500,000 or $1 million, so they likely won’t be bothered if they lose smaller customers to the online advisers.
But there’s a risk they could also lose larger clients—depending on what these larger clients need and what these traditional advisers offer. Thanks to online advisers, helping investors build globally diversified portfolios has become a low-cost, commodity service. But many clients need more than just a portfolio design: They might require handholding when the market declines and they could need help with other financial issues.
“If someone is in their 20s, what’s the advice? ‘Save as much as you can and put it in stocks,’ ” notes Mitch Tuchman, managing director at Rebalance-IRA.com. “Once you get to middle age, things become much more complicated.”
Rebalance-IRA.com aims to distinguish itself from other online advisers by giving clients their own dedicated financial adviser. For 0.5% a year, that adviser helps clients design a portfolio, juggle goals, coordinate different accounts, and figure out how to make their money grow and then draw it down in retirement.
For traditional advisers to continue charging 1%, they’ll likely need to offer even more, including detailed advice on estate planning and tax issues, as well as full-blown financial plans.
What if traditional advisers continue to offer portfolio building, the occasional in-person meeting and a client dinner once a year? They shouldn’t be surprised if clients head elsewhere.