Generally speaking there is not more time, service, or overhead involved for a $1 million client versus one with $500,000. However, if both clients are charged the common industry fee of 1% annually, one of them pays $10,000 while the other pays $5,000.
Assuming they are both receiving similar services, one client should not pay twice as much as the other. A flat annual fee can make more sense given that the services rendered are substantially similar.
We don’t believe in charging someone more just because they can afford to pay it. How much money one has should not be the sole determinant of their cost.
It's a bit like the scene below from National Lampoon's Vacation, when the Griswold family is broken down by a remote repair shop.
A 1% annual fee may not sound like a lot.
Stating your annual fee is only 1% a year has a different ring to it for a client with a $1 million portfolio, than stating “Your fee is $10,000…and will compound as your portfolio grows”.
As investors we want our portfolios to benefit from compounding interest, not our advisory expenses. Asset-based fees compound with portfolio growth and can make a significant difference in the long run. The compounding effect of a 1% fee can be quite ugly.
This chart below displays the cumulative fee comparison over a 20-year period of two $1 million portfolios, where one pays 1% annually of assets under management and the other pays a flat annual fee of $6,000 (the current flat fee for new clients of Meredith Wealth Planning) which increases 1% annually.
Assuming both portfolios earn a gross annual return of 6% annually, the asset-based fee portfolio would pay about $163,636 more in expenses over those 20 years:
However, the difference in fees is not all that matters.
The asset-based fee investor’s portfolio would actually be worth $219,738 less than the flat fee investor’s after 20 years, despite the difference in fees being ONLY $163,636.
The more you take out in expenses, the less money you have left to compound. While this investor paid an advisory fee $163,636 greater than the flat-fee investor, they cost themselves an additional $56,102 in missed compounding.
Why Do Asset-Based Fees Persist?
The short answer is “because it’s always been done this way”.
Also, it’s quite lucrative.
With equity markets expected to outperform inflation over time, asset-based fee advisory firms receive automatic raises.
Shifting to flat fees would massively disrupt many major investment firms, as they use higher net worth clients to subsidize lower net worth clients currently.
As stated above, “it’s just 1%” doesn’t sound too terribly bad until you look at the math and the inequitable nature of the fee.
Asset-based fees will be around for a very long time, but now clients can choose which fee model works best for them.