The financial industry has managed to get away with incredible price discrimination by charging clients based on their assets, rather than based on the services provided. This practice needs to stop.

Imagine you just found out your child needs surgery. You’re feeling worried and stressed. You just want to make sure everything is going to be okay. After you decide to move forward with the surgery, the office staff discusses the logistics and brings up the cost.

Then the staff member asks you a question you aren’t expecting: “How much do you have in investable assets?” They proceed to explain that the cost of the surgery is based on your ability to pay.

You and your spouse have worked hard for years, saved aggressively, and invested wisely. Your net worth is quite high, and as such, the cost of your child’s surgery will be much higher than it is for most others.

Despite the higher price, you are told the procedure will be no different for your child than any other – same doctor, same hospital, same recovery time, etc.

Of course, this scenario sounds absurd. In the medical field, as in other fields, we are used to paying fees based on the service provided. Of course, the best doctors charge higher fees, but they don’t discriminate based on a patient’s ability to pay. (Of course, there are charitable organizations who provide amazing support for families in need, but that’s a different discussion).

Ridiculous Pay Structure

Contrast that with the investment world. The most common fee arrangement is to charge a percentage of assets managed, typically around 1%. That means a client with $5,000,000 will pay 10x what a client with $500,000 pays and 100x what a client with $50,000 pays, even if the services offered are essentially the same. Some advisors offer a “tiered” fee schedule, where the more you invest the lower your % fee. But the relationship still holds true:

Clients with more money pay drastically more for essentially the same services.

Of course, there are situations where higher-net-worth individuals have need of additional services. But I can tell you based on my experience with hundreds of clients over the years, there is often very little correlation between the work done and the value of a client’s account. I have seen clients with millions who are happy with 1 or 2 meetings per year and who understand and trust the process and demand very little. I have also seen clients with less than $100,000 who call regularly, panic every time the market dips, and demand large amounts of their advisor’s time.

The result is that the client with $5,000,000 provides his advisor with an absurd profit margin.

Why would this client accept this arrangement?

Interests (mis)aligned

Many advisors claim that their interests are aligned with their clients’ when they charge a % of the assets they manage. They want the account to do well and to avoid losses, just like the client. This sounds good but is far from the truth.

First, most clients’ primary goal is not to increase the assets held by their financial advisor. Certainly, they want to see a positive return on their investments, but their actual goals have much more to do with things like enjoying retirement, feeling secure and leaving a legacy.

Why does this distinction matter? Think about the following scenarios and the conflicts that could arise due to your advisor’s sole incentive of increasing the assets he manages:

Your employer provides a pension plan with a nice monthly payout, but with an option to take a lump sum at retirement.
You have always had a goal to pay off your mortgage before you retire, so you’re considering withdrawing some of your investments to pay it off.
You have more assets than you’ll be able to spend in retirement and prefer to give your money away before you die, so you can see the difference it’s making in people’s lives.

In each of these scenarios, your advisor has an incentive to increase his assets under management by recommending you take the lump sum, not pay off your mortgage, and not give away your money.

How could someone possibly argue that your interests are aligned?

Panic Mode

Perhaps an even more important question is, should investors even want their fates aligned with their advisor in this way? Here’s a big reason why they shouldn’t:

Many investors still remember the devastating bear market that started in 2007 and didn’t end until early 2009. During that time, the S&P 500 lost more than half of its value. Sadly, many investors committed the cardinal sin in investing and sold out of the market after watching their nest eggs evaporate over the previous year and a half.

One of the most vital roles a good financial advisor plays for investors is to provide objective advice, free from the emotions of greed and fear. Unfortunately, because of their fee structure, many advisors saw their revenues plummeting during this time, right along with their clients’ portfolios. As a result, they were dealing with the same stress and fear that their clients were dealing with.

That’s a good thing, right?

No!

Advisors in this predicament lost all objectivity. They fell prey to the same reaction their clients had, “Better cut our losses now before we lose everything!” Advisors who recommended selling at the bottom cost their clients dearly, putting in jeopardy many retirement goals.

In short, you don’t want your advisor panicking at the same time you are!

A more sensible approach

At some point, I hope the investment industry will join other professionals and charge fees based on the level of service and the expertise of the advisor, not based on the client’s ability to pay.

For now, investors should insist on calculating fees paid to investment or financial planning professionals on an average hourly rate. If you are interviewing advisors or evaluating your current advisor, ask how many hours they plan to spend on your account on an annual basis.

If they are unwilling to have a discussion around the value they provide for the fee they charge, there’s a good chance you will end up paying for financial advice based on what you are worth, instead of on what your advisor is worth.

And that just doesn’t make sense.

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