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Financial Services Compensation 101

Mukesh Dedhia, CFP, IndiaBy Mukesh Dedhia, CFP

Have we ever given a second thought as to why we pay fees to our doctor? Not really. This is because our doctor is the one who gives us life saving advice and appropriate treatment. He deserves the fee he charges. Then, what about the professionals who give their clients, savings (investment) advice for life??? Don’t they deserve fees for the scientific way in which they plan their client’s finances?

Financial planning is an issue that should be given priority, but people tend to postpone it until an emergency, when it’s probably too late! They realise it’s worth it, only when some emergency comes up, or some unfortunate thing happens. That’s when it’s too late. A common misperception is that financial advisors provide their services for free. Clients should understand that “there are no free lunches”. A planner’s work should be remunerative because of all the hours they are going to have to spend using their skill set to improve the client’s situation.

The next and the most important question is, “What is the ideal compensation that the planner should receive for planning his client’s finances?” My answer to that question is, “There is no amount that is the right amount.” There are various compensation models that are evolving.

I think, first of all, the planner should decide if they are providing only financial planning services or catering to wealth management needs of their clients. Financial planning is the preliminary stage in handling client’s money and is more so for retail clients. Whereas wealth management is for those HNI type clients who have already accumulated a decent amount of wealth. The analysis and handling of finances, in both cases, is different. The investment advisor should categorize his client and the service he would be providing and charge accordingly.

Assets Under Management (AUM) Fees or One-Time Fees

The planner can charge a one-time plan construction fee or a fee as a % of AUM to be managed or a combination of both. He can also charge fees on the basis of the number of hours he spends for meeting the client and for preparing the plan.

The % of AUM fee is based on a percentage of the client’s account value. As the account value grows, the planner will make more money. If a client’s account value goes down, the planner will make less money. In this way, the planner has an incentive to grow the client’s money and to minimize losses.

If there is a combination of a one-time plan construction fee and AUM based fee, then the planner should be charging an upfront fee for the plan and give credit while charging a percentage-based AUM fee. Another option could be to just charge AUM fees. This is option is simple. The client can perceive the direct value when his portfolio rises and won’t mind paying a part of the profits as asset management fees.

Product Commissions Need to Be Considered

Well, if the plan is to be implemented by the planner, then the percentage of AUM fees to be charged should depend on the commissions received from manufacturers. Planners should give appropriate discount when charging AUM fees; this discount should be based on the average commissions to be received from all AMCs/product manufacturers across all the scheme/products.

The discount given should be disclosed to the client, so the client knows what the actual charge is and how much they are paying. This way, the planner is being transparent about his charges and commissions and this will also avoid confusion in the future, if any of the average commissions fall or are removed.

There are a few points to keep in mind while charging AUM percentage fees. The percentage should depend on asset allocation and expected returns. For example, it is only rational to charge percentage fees on the part of the client’s money that is invested in equities as the expected returns from this asset class are also high.

Also, this fee should be collected on a quarterly basis, so that the planner’s cash flows are taken care of. This gives regular income to the planner. There is one more risk in collecting a yearly fee; if the markets are down at the time of collecting a yearly fee, then it would be difficult for the planner to earn an appropriate amount for his efforts throughout the year. One thing to note in this case is, the planner should collect the fees at the end of the quarter and not upfront, so that he is motivated to perform better and does not become lethargic.

Client Referrals Should be Rewarded

Apart from that, a planner can also give credit to the client if any referrals are generated by him. This amount should just be an appropriate token; it should not be too much or too little. In this way, the planner can garner business growth and also keep his existing clients happy.

Fees for Ancillary Services

A planner can also charge separate fees for the ancillary services, if any provided. Such services would include making a will or tax filing. If the planner has expertise in these areas, then they can provide the service and charge accordingly or they can refer the client to respective professionals and work alongside them, for the client’s benefit. While working alongside other professionals, it is up to the planner to share the other professional’s fee or provide the additional assistance to the client for free, depending on his (planning) contribution.

Ultimately the value a planner is able to add to his client’s portfolio and to his financial life, is for the amount he should be compensated. The real task is how to make the client perceive that value, correctly.

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