Wellll….
Sometimes the most interesting results from my polls of the Inside Information audience is not a definitive conclusion, but instead a lot of really interesting, intelligent, sometimes conflicting responses that take us a lot close to understanding and defining the issues.
That’s what I got from my survey about whether we should rethink how custodians get paid for their custody services. You probably remember the premise, offered by Michael Kitces in Nerd’s Eye View (and a shorter version in Financial Planning magazine): that advisors could potentially push aside the hidden fees on custodial money market sweep accounts, eliminate the Sub-TA fees that some funds and ETFs (though not Vanguard, DFA or BlackRock) pay to the custodians, and nuke away other undisclosed sources of revenue like allowing short sellers to borrow client securities or (something I didn’t include in my original list of custodial revenues) collecting payments for order flow on trades.
And also, perhaps, eliminate trading costs—the most visible fees that custodians collect from clients.
Kitces proposed that the custodians would give up all of these sources of revenues, collected in various ways from client accounts, in return for the advisor paying a fee based on total client assets. He proposed 10 basis points for smaller firms that have lower AUMs, dropping to 7, 5 and 3 bp at various AUM breakpoints.
Of course, those were just guesses; the real numbers would need to come from a detailed analysis of what, currently, the custodians are collecting—and we don’t have that level of transparency at the moment.
I was interested because, in various conversations with custodial executives, I’ve been told that the custodians themselves are looking at charging directly for their services.
Why? Because it troubles them that their favorite customers—the most fiduciary advisors—are also their least profitable relationships. The more their thriftiest RIAs get quicker at lifting assets out of the money market accounts, the more they avoid trading, the more they invest in the funds and ETFs that pay the least (or no) Sub-TA fees, the less revenues a custodian can make off of them.
And meanwhile, I was told, the costs to maintain the custodial platform technology are rising all the time.
Ergo: we may see some kind of direct fee arrangement being offered sooner than you might expect. Instead of clients paying for your custodial platform, in various ways, you would pay for it directly. Some custodial executives believe that this is Inevitable—although, of course, I was not given a timetable.
So what did the Inside Information readers propose?
The most common response was: a cautious maybe. The majority of advisors were totally in favor of aligning their interests more closely with the custodians, and they liked the idea of transparency in their custodial relationships. Sign them up!
“We are one of the fiduciary firms that have spent the better part of a decade trying to make our custodial relationship less and less profitable for them for the benefit of our clients,” says Casey Bear, of Cranbrook Asset Management in Troy, MI, speaking for many of the advisors I heard from. “This has been exhausting, puts us at odds with our custodian and is not something I’m excited about continuing to pursue for the next 10-20 years. In theory, the proposal makes perfect sense.”
But… advisors also wanted to know more about what (and how much, and how) their clients are currently paying before they rush into some kind of agreement on a basis point fee. “We think the [custodial] industry needs to come clean and be totally transparent,” says Jim Eastman of PFO Wealth Advisors in Naples, FL. “Everyone understands that people need to be compensated for services provided, but when those fees are hidden from the client, everyone suffers.”
“I resent the fact that I must disclose all fees and be transparent with my clients, when I don’t even know what I’m paying or paying for [to the custodian],” adds Kay Dee Cole, of Clarity Wealth Development in Corvallis, OR.
Some have tried to break it down. The trading costs are visible, and several advisors are calculating them down to the penny. For example, Joseph Kilner, who practices in Gaithersburg, MD, makes few trades through Schwab, and has calculated his total ticket fees would come to between 2.2 and 2.7 basis points a year.
These, of course, are negotiable, with larger firms paying less than smaller ones—and there are strict contractual restrictions on advisory firms making the details public. (One wonders if that would also be the case if we go to an omnibus asset-based fee: a world where nobody knows what anybody else is paying.)
Others also are able to make a rough estimate of how much of their clients’ money, over time, was parking in the money market fund, and therefore could estimate how much their clients were giving the custodian from that vector. One advisor noted that Discover pays 1.75% on money market assets, while his custodian is paying .01%. You could use that multiplier as a rough calculation of this second source of custodial expenses.
After that, the custodial costs are a very black box. Sub-TA fees? Nobody in the survey had calculated those, although many are consciously using funds that don’t pay them—and, of course, paying higher trading costs instead. Lending out client assets to short sellers? Is that really a thing? And payment for order flows is totally opaque at the moment.
I have heard of custodian representatives showing advisors a spreadsheet that lists how much the custodian is making on the individual advisory firm relationship, as part of the negotiations over potentially lower trading costs. Before we wade too deeply into these waters, it might help if you ask your customer service rep to show you what your own firm is paying. And ask about any fees that are listed here, that may not be listed on that statement.
There is reason to believe this all-in cost might be higher than Kitces’ proposed 10 basis points. One advisory firm reported that, after negotiations and some back-and-forth bidding between platforms, it is now paying more than 15 basis points just for unlimited trading.
Advisors working with TCA by E*Trade and Securities America told me that they’re paying a flat 10 basis points just to eliminate trading costs, and that also seems to be what advisors trading on the Folio platform through First Affirmative are paying as a wrap fee for all trades. Even there, TCA and Securities American impose limits on the number of trades, and ticket charges are assessed on certain funds (Vanguard was mentioned)—and on all three platforms the money market funds pay very little interest.
Therefore, it’s possible what the custodians have in mind is a flat fee simply for trading activities—and leave the other revenue sources alone. That seems to be the model that some of the alternative (non-Big Four) platforms are experimenting with currently.
Others are opposed because, when they run the numbers, the amount they would have to pay out of pocket would significantly cut into profits—while the benefits would accrue invisibly to the client. One advisor laid it out in very simple terms. At 10 basis points, for every million dollars under management, you’re paying $1,000 out of pocket. Let’s say that’s the cost up to $100 million under management—the new SEC-registered advisory firm is now having to pay $100,000 out of its current profit margin.
At $1 billion under management, if we assume (with no guarantee) a 5 basis point custodial fee, that comes to $500,000 a year of new expenses on the balance sheet. That might make a deep divot in the partnership profit distribution.
“The average AUM charge in my firm to a client is 52 basis points,” says Bear. “I am supposed to potentially give 15-20% of my gross revenue to my custodian? That’s crazy,” he says; “when they add very little value. Am I willing to sacrifice $50,000 or $100,000 out of my own personal income to better align with our custodian and clients? Absolutely,” he adds. “$700,000? No way.”
Therefore (said a few advisors) the money would have to come out of the clients’ pockets if we’re going to make the shift. “Maybe some advisors would absorb the custodial fee,” says Spencer Hall, of Retirement Planning Services in Knoxville, TN. “But our clients already pay the trading costs, and I would expect we’d find a way to have the custodial fee debited quarterly at the same time as our fee.”
Another objection: Bear noted that we are asking this question at a time when revenues are high. “This question is likely to come to a head as we experience the next, inevitable market downturn,” he says. “This poll is interesting, but it is being conducted towards the end of a 9-10 year bull market. Send this same email out after the next 20% market correction and compare the responses.”
Beyond that, smaller advisory firms believe that charging them three times what the largest firms would have to pay is unfair and uncompetitive—especially when they’re working just as hard to minimize client costs. “If [a larger firm] is paying 3 bps, you better not be charging me more than 5 or 6 bps, especially because I’m not trading much at all,” says Hall.
Ed Kohlhepp, of Kohlhepp Investment Advisors in Doylestown, PA, was very clear. “I don’t like the idea that larger RIAs can get considerably less fees.” Another advisor, who preferred I not use her name, said of Kitces’ proposed breakpoint arrangement: “It makes me want to ask what Michael Kitces has against small firms!”
Dwight Mikulis, of Pinnacle Advisory Group in Columbia, MD (which I would characterize as a larger firm), voted “no” out of concern for his smaller brethren. “It probably hurts the little RIA and those who have already reduced fees in favor of clients,” he says.
Some proposed that the fee equation be made more accommodative. “Maybe at the early end of one’s career there could be a lower fee until a certain size is reached,” says Anne Gibson, of Gibson Financial Solutions in Ellsworth, ME. “Because in the early days, trying to make a living plus pay for business costs can be tough. So discounts on the small end and then discounts on the big end might make sense.”
This led to a potentially fatal issue: that the flat fee based on client assets, which seems so simple, might actually make things much more complicated for the custodian. “We would want confirmation and affirmation that the custodian is collecting no other forms of revenue from third-party vendors on our client assets,” says Randy Brunson, of Centurian Advisory Group in Duluth, GA.
But, he wonders, what do you do with the money currently being collected? would the Sub-TA fees be foregone, rebated back to the clients, used to reduce fund expense ratios for all fund shareholders, or rebated back to advisors to offset some of the other custodian expenses?
Same, Brunson says, with the money market accounts. Would some advisors have access to the higher-interest-bearing sweep account, while for those not paying flat asset based fees, money would go into a more expensive money market account.
And if you pay a flat fee to the custodian, that might also invite some regulatory problems. Matt Goff, of the Goff Financial Group in Houston, TX, offered a strong “no” vote because he is concerned that a basis point charge in lieu of commissions would automatically put advisors under a wrap fee structure, which attracts SEC attention. And if the advisor is paying those fees out-of-pocket, suddenly the regulators might want to know how the firm is acting on incentives to choose the lowest-cost provider, rather than the custodian that offers the best executions and account protections.
Perhaps the largest group of respondents to my survey were opposed to the idea of switching to an asset-based fee for the simplest reason of all: they believe that, by carefully choosing low-cost (non-Sub-TA) funds and ETFs, and by trading only occasionally, and sometimes using NTF funds when clients are contributing to their accounts on a monthly basis) they believe that they’re getting a better deal for their clients than less careful or thrifty advisors.
In other words, the less cost-conscious advisory firms are, currently, subsidizing the operations of the thrifty ones. The thrifty ones envision being forced to pay more under a flat fee arrangement.
Along the same lines, Norm Boone at Mosaic Financial Partners in San Francisco, CA points out that under a flat fee arrangement, some advisory firms might abuse the flat trading fee, and make more trades, and generally be more expensive to service. Why shouldn’t firms pay proportionately to the actual services they use? (Like, for instance, the way they do now.)
Adds Michael Taxman, who practices in South Hanover, NH: “A custodial fee based solely on assets would leave low demand firms like mine subsidizing high demand firms. The number of trades,” he points out, “is actually a decent proxy for the demands a firm places on the custodian. The system isn’t broken; in fact, it works superbly,” he concludes. “Custodian and advisory firms’ interests SHOULD be misaligned, in that advisory firms should be reviewing custodial offerings and looking out for the best interests of clients.”
Which brings me to the two most creative responses I received on this topic. David Jacobs, of Pathfinder Financial Services in Kailua, HI, doubts that custodians are ever going to work up the courage to propose flat fees. “Most businesses prefer value-based pricing, since the margins are better,” he says. “Most consumers like to buy things which use a cost-based pricing model since it [inevitably] gives them a better deal.”
So? “True cost-based brokerage service would have a base charge per account, ticket fees for transactions and additional fees for additional features (e.g. checking, ATM, paper statements, etc.),” says Jacobs. “Putting all those fees up-front like this would make their fees very salient, squeezing custodian margins. Hiding fees in lower money market rates and fee sharing kickbacks allows custodians to make the fees less salient. Custodians,” Jacobs adds, “will not voluntarily move to a model that is going to squeeze their profits.”
Bill Ramsay, of Financial Symmetry in Raleigh, NC, proposes that, if custodians are forced to mitigate the squeeze, they could set a minimum custodial revenue target on a case-by-case basis for each advisory firm, with transparency on the actual revenues from each RIA’s clients. If the fees fall below that target, then the advisor would pay the (usually nominal) difference out of pocket. (Would fees above the target be accrued? Or kept by the custodian?)
And that, in turn, leads to some interesting questions that only two advisors posed. I’ll leave their names out for the moment, but the first wonders whether advisors aren’t actually providing at least as much value as they’re getting from custodians.
“For the custodians, we are effectively their asset gatherers,” he says. “They get the assets of our clients without paying for the brick and mortar of having a branch—and the end client gets access to most of the same funds and services as a retail customer.”
His custodian happens to have a large retail presence, and the tech expenditures that advisors take advantage of would, he points out, have to be made on that side of the business anyway.
Ergo, maybe the custodians should be paying the advisors for bringing them additional assets and piggybacking on the same tech that the direct retail customers get.
The other advisor directly questions the actual value that custodians are providing on their tech platforms. “The custodians are not providing valuable technology and services to the extent they think they are; not even close,” he says. “The technology is actually pretty awful compared to the higher end CRM systems (Redtail, Junxure, etc.), portfolio accounting systems (Orion, Tamarac, etc.) and pretty much else. The online presence at the custodians is a horrific user experience compared to a client portal you can create through your portfolio accounting system or your CRM provider. And the “practice management” services are simply laughable,” the advisor concludes. “I get 10 times more value out of your Inside Information, client articles and media summaries, along with Michael Kitces, than I do all of my interactions with our custodian.”
In other words, if custodians are going to come to advisors asking for more revenue, they can expect advisors to push back on the services they’re receiving. “Once we start paying custodians directly, the custodian-advisor relationship is going to get ugly,” this advisor commented. “We are going to expect much, much more.”