Is fixed fee model a better fee charge model for the client?

In Financial Services, the remuneration for advice rendered has traditionally been indirect, through product commissions, brokerage etc. The advice rendered is incidental and is not paid for. It is no wonder then that the advice tends to be self-serving. Financial intermediaries tailor the advice so that they can chaperone the customers to buy products.

The intermediary would want to sell the product s/he is dealing with and among them the one that offers the best remuneration. Hence, what the intermediary ends up selling may not be aligned with the needs of the customer at all. The way one is remunerated plays a major role in the outcome for the customers and even well-meaning regulations has not been able to change that.

Fee-only advisors – To remedy this, SEBI had brought in a class of fee-only advisors through the IA Regulation. They are legally bound to a Fiduciary Standard of care, where they need to put their client’s best interests ahead of even their own interests.

The product distributors are bound by a lower Suitability standard, which allow them to sell products that are broadly suited to the client situation.

However, the public at large does not know the distinction between fee-only advisors and product distributors, though regulations have come in. This ignorance is a big problem.

In case of fee-only advisors they get the remuneration in the form of fees only from their clients. This right alignment of interests ensures sharp focus on client’s best interests and results in good outcomes. This is hence a model that inspires trust.

But, even in this model, there can be conflicts of interests. Let me just give an instance. Should an advisor suggest a client to monetise their real estate and invest in financial assets, there could be a conflict of interest especially if they are charging on an Asset under Advice basis.

However, advisors state the conflicts of interests to their clients upfront, even though that will not make the conflict go away.

That is the reason why a fixed fee charge is seen as a panacea. But is it? Let us examine.

Fixed-fee model – In fixed-fee model, the advisor charges a lumpsum amount for an estimated amount of work, which is not connected with the quantum of assets. The problems start there itself.

Firstly, one cannot have a fixed fee for a service for every client. It must vary from client to client and the advisor needs to estimate and charge the fee correctly for every client, for each service.

In the fixed-fee model, the regulation limits it to Rs.1.25 Lakhs pa. This will pose problems if the client is a wealthy investor where the advisor needs to look at diverse range of products and the client may need sophisticated & nuanced advice in multiple areas. If they cannot charge more than the limit set by Regulations, the advice & services will not be of the requisite quality or depth. This fee limit can be a serious problem.

Secondly, in a fixed-fee model there is no incentive for the advisor to assist in growing the assets, unlike in the case of one who charges on Assets under Advice (AUA). Hence, in this model there is no alignment of interests between the client and the advisor.

An advisor charging on AUA basis, growing the wealth is in the interest of both. Hence, as the interests are aligned, they will work in harmony, ensuring good outcomes.

Thirdly, in specialized services, one charges for the expertise, not just for the time or underlying product. This happens in all fields.

For instance, an experienced and sought-after lawyer may charge several lakhs for an appearance in the court, while another lawyer may charge just thousands of rupees. Expertise, experience, and reputation are built over time. Monetisation will be possible only in the later stages of the career. A fixed-fee model with a limit of Rs.1.25 Lakhs pa would be a huge hindrance to that.

Fourthly, in a fixed-fee model one gets discreet services as one goes along. The prices for each service will be different and will need to be discussed and agreed upon with several back-and-forth discussions on this. This is cumbersome & takes time. Fixed-fee model is great for transactional relationships ( like a doctor consultation ).

In case of an advisor operating under an Asset Under Advice model the relationship is typically an ongoing relationship. Most services are offered to the client as a part of the engagement and a percentage of asset fee is charged. This makes it an easy way to charge one fee for all services that are defined as a percentage of assets. This is simple to understand and easy to implement.

Fifth, an advisor is taking responsibility for timely achievement of goals and desired outcomes in life. Also, the advisors help clients accumulate wealth and build it over time and achieve their potential.  That is an invaluable service and a huge responsibility that the advisors shoulder. Clients are engaged with advisors for decades. The advisor needs to be remunerated for the responsibility s/he shoulders.

A related example would be a CEO who runs a company and is responsible for achievement of the company objectives and profit targets. S/he gets paid a lot more than most others in the firm for shouldering this responsibility and not for putting in extra hours in a day.

Similarly, advisors need to be paid for the responsibility they are taking for their clients. The easiest way would be to align with their client’s wealth and charge a percentage of that, which the advisors have helped create.

It is wrongly believed that a fixed-fee will be cheaper and an Asset under Advice (AUA) fee will be costlier. The reality is that they will be quite near to each other. That is so because the clients will be aware of what the services would cost with other advisors in rupee terms, irrespective of the model.

Also, the advisors know the market rates, irrespective of the model. Advisors in either model would not engage with the client, if it is not remunerative enough. Hence, the fees charged in either model would converge in any case.

Currently, as per IA Regulations, an AUA fee of 2.5% pa can be charged. However, the AUA fees charged in reality is far, far less. That again is based on market dictates.

A fixed-fee may be good in some instances, for some clients and the same holds true for AUA fees. Taking sides in the charge model is hence unnecessary hair splitting and unproductive.

The focus of the Financial Advisor should be on ensuring great outcomes for the clients.