Avoid percentage of AUA fees for a financial plan
4 min read 24 Aug 2021, 12:54 AM ISTHourly-fee RIAs explicitly disclose their total fixed fee and also their hourly fee
PremiumI have previously written that there is no predictable way to become rich, but a predictable way to avoid becoming poor. Any financial planner and Sebi-registered investment adviser (Sebi-RIA) can only prevent a client from becoming poor. RIAs can do this by ensuring that clients save enough, don’t take too much of risk and avoid high-fee products. Further, I have previously explained how one should go about selecting an advice-only (i.e. hourly-fee or fixed-fee) RIA. Here, I explain why you should select an hourly-fee RIA than a fixed-fee RIA. Clients should select a more transparent fee structure as it minimizes conflict of interest between the client and the RIA. All RIA fee structures are usually more transparent than the high and hidden annual commissions of Amfi-registered mutual fund distributors that are difficult to exit from. Let’s look at the three possible RIA fee structures.
Percentage of AUA: The majority of RIAs charge a percentage of the client’s assets under advice (AUA). This is often 1% per annum (p.a.) of the AUA. And the AUA typically includes investments in mutual funds, ETFs, direct equity, PMS and AIFs. The percentage of AUA fee structure harms clients in four ways. First, 1% p.a. is equal to the client paying 26% of the investment to the RIA over 30 years. Such an RIA is directly making the client poor rather than preventing the client from becoming poor. Second, such RIAs often push clients to move money from outside the scope of the AUA to within the scope of the AUA even if it harms the client. For example, they push clients to not purchase a primary residence; or to sell all real estate; or to stop pre-paying a home loan; or to stop using fixed deposits and voluntary provident fund. Third, to hold on to clients who are willing to pay such absurdly high fees, such RIAs build a very complex portfolio that the client cannot manage by themselves. Such complex products (e.g. active mutual funds, sector funds, factor funds) also have higher expense ratios which waste the client’s money. Fourth, such RIAs cannot primarily recommend passive index funds that have expense ratios of 0.2% p.a. because it will make it obvious that the RIAs fees are absurdly high. Hence clients should avoid the percentage of AUA fee structure.
Fixed fee: Fixed-fee RIAs explicitly disclose their total fixed-fee on their website. For example, ₹64,000 during the first year of the engagement and typically one-third of that fee from the second year of the engagement since the RIA’s effort is lesser from the second year. This fee structure is a revolutionary improvement over the percentage of AUA fee structure. However, even this fee structure is not perfect. For example, RIAs W and X have total fees of ₹32,000 and ₹64,000 respectively. And RIAs W and X put in one and four hours of effort respectively into explaining the calculation which shows that a client should cut their lifestyle and save more for retirement. Since clients can only see the total fee, all of them will select RIA W and none will select RIA X. RIA X will then be forced to either drastically cut down the number of hours of effort or to exit the profession. So, the fixed-fee structure forces most such RIAs to minimize the depth in the engagement.
Hourly fee: Hourly-fee RIAs explicitly disclose their total fixed fee and also their hourly fee and number of hours of effort on their website. Further, such RIAs provide clients with a timesheet which tracks the number of hours of effort that the RIA puts in. For example, RIA Y discloses an hourly fee of ₹8,000 multiplied by four hours of effort equals to total fees of ₹32,000. And RIA Z discloses an hourly fee of ₹4,000 multiplied by 16 hours of effort equals to total fees of ₹64,000.
A client can easily figure out (a) that Z’s total fee is higher only because of four times more depth in the engagement and (b) whether or not Y has significantly higher credentials to justify double the hourly fee of Z. Some clients will select Y and others will select Z. Hourly fee is the most-transparent fee structure and hence is the gold standard in the US. However, currently hourly fee is almost non-existent in India and hence clients are forced to select fixed fee. But clients can use this insight to ask fixed-fee RIAs to verbally disclose the budgeted number of hours of effort. This will allow clients to distinguish between fixed-fee RIAs W versus X.
In summary, avoid percentage of AUA fees. Ask fixed-fee RIAs to verbally disclose their number of hours of effort. And in case you can find a suitable hourly-fee RIA with equal competence, then prefer hourly fee over fixed fee.
Avinash Luthria is a Sebi-registered investment adviser and advice-only financial planner at Fiduciaries.in .
