One of the things that irritates me about financial advisors using the typical 1%-of-assets fee structure is when they argue that their high fees are justified because their fees are based on the “value” they provide to their clients. The argument goes like this:
Wealthier clients get more value from our services, so they should pay a higher fee.
However, in many ways, the value argument is a red herring. By talking about value, the 1%-of-assets financial advisor can divert focus away from the possibility that their fees are simply too high.
As an illustration, let’s think about the value argument from the standpoint of the medical profession.
Imagine one day you find yourself in the emergency room with no pulse and unable to breathe. The emergency room doctor rushes to your side and provides life-saving aid in the form of CPR, intubation, a ventilator, or what-have-you. Fortunately, you make a full recovery.
In this case, the value provided by the doctor is VERY significant. Since you most likely would have perished without the doctor’s services, I could argue that the value you received is equivalent to every last dollar you earn for the rest of your life (or what economists call your remaining human capital).
We can compute this amount by finding the present value of your future lifetime earnings. Let’s assume the following variables:
- You are 40 years old the day you went to the hospital
- You plan to retire when you attain your 65th birthday
- You earn $50,000 per year for the rest of your career
- Inflation will be 3% per year for the rest of your career
Based on these variables, your human capital = $870,657.
And so your doctor provided you with $870,657 of “value.” Is your doctor then justified charging that much? Probably not. What about half of that amount? Nope. In reality, the fee you pay is based on the price negotiated between the hospital and your insurance company. The amount of the fee would have almost nothing to do with how much wealth you have or how much value you received.
We can apply similar logic to other professions like lawyers, accountants, architects, or engineers. Let’s say you hire an architect to design your house. You move in and create many happy memories while living there. Does the architect deserve a higher fee because they provided so much “value?”
In nearly all cases, the fees charged by a professional are not justified by perceived value that the customer received. Rather professional fees are more closely tied to variables such as the time, expertise, or difficulty required to complete the work. Why is financial advice any different?
Don’t get me wrong, financial advisors do provide real value to their clients. But that doesn’t justify charging insanely high fees based on that value. It’s also difficult to pin down what that value amount ends up being. Vanguard has tried, but with a slew of inherent flaws.
A more honest argument in favor of 1%-of-assets fees would be, “I charge a fee that the market will bear,” and leave it at that. There’s no shame in relying on capitalism and market forces to justify your fee amounts.
My main point here is to avoid getting into a discussion about “value” with your financial advisor. A better path is to focus on the fee you pay. Determine for yourself if it is fair and reasonable. It also helps to calculate just how expensive the typical 1%-of-assets fees can be over a long period.
