When it comes to fees, how advisers charge is as important to clients as how much

Looking across the vast wealth management landscape, investors have generally benefited from the multiyear trend toward fee compression that has resulted from technological innovation and increased competition.

Long gone are the days of 6% brokerage commissions to gain access to stocks and mutual funds, because investors can now buy a broad market index ETF, commission-free, that charges just a few basis points.

But while transaction costs are mostly gone from noninsurance products and fund fees continue to drop, the financial intermediary has somehow managed to hold firm on fees at right around the 1% mark for assets under management.

This is a topic that always elicits an enthusiastic debate, with some advisers insisting their clients don’t mind paying 1% or more, and a minority on the other side saying 1% is a rip-off.

Beyond just repeating those arguments, it's worth examining the actual drag asset-based fees have on portfolio performance and how that reverse compounding effect could be minimized.

Let’s start by looking at the impact of asset-based fees, as calculated by Darrell Armuth, owner of Sensible Portfolios, a firm that charges clients 35 basis points.

Armuth’s hypothetical client portfolio, starting at $1 million and riding through a 6% average annual return over 20 years, would grow to just over $3.2 million, net of advisory fees.

However, once you factor in the impact of a 1% advisory fee on that growing portfolio over two decades, the total gain of $2.2 million drops by $553,000 to $1.6 million, which drops the total portfolio balance after 20 years to about $2.6 million.

On a percentage basis, the total gain is cut by more than 25% due to the diminished compound loss, meaning not just the dollar amount of the fee but also the performance cost of taking that fee out of the portfolio.

It would be difficult to imagine an adviser who doesn’t understand the effect of pulling fees from an investment portfolio, but it's easy to understand why it is such a common practice.

A big part of the reason advisory fees have been so buffered from the fee compression sweeping across the broader financial services industry is that the fees charged to clients are often automatically deducted and are sometimes difficult to detect on client statements.

Armuth said he gives clients the option of paying his advisory fee outright or having it deducted from the portfolio. But he also explains to clients the impact of reverse compounding when fees are taken out of the portfolio.

“I tell my clients they can either pay me directly or pay me from the account,” he said. “But because the size of my fee reduces portfolio growth over 20 years by 10% or less, most clients just have me deduct the fee.”

[More: Asset-based advisory fees stuck between inflation and a hard place]

None of this is to suggest any adviser shouldn’t be compensated for their work, although Armuth and others say advisers calling themselves fiduciaries are walking a fine line with 1% advisory fees.

And it’s perfectly understandable why an adviser wouldn’t lower fees in the absence of any pressure from clients and prospects to do so.

Rick Ferri, owner of Ferri Investment Solutions, is a proponent of hourly fees and has become a vocal critic of advisers charging 1% asset-based fees.

In addition to being too high at 1% on average, Ferri views the popular asset-based fee model as lazy and inefficient.

The next stage of advisory fee evolution, he said, needs to separate portfolio management fees from financial planning fees.

“The overall asset-based fee is not fair to the client and sometimes it’s not fair to the adviser,” he said. “Because there’s a certain cost to carry a client, and you have to get paid, there’s a certain amount you have to make per client just to break even.”

For example, Ferri said, the work involved in serving a client with $250,000 might not be worth the 1% fee, but that work is currently subsidized by the 1% fee charged to clients with $2 million portfolios.

“It’s a welfare system,” Ferri said. “It’s a good deal for smaller clients, but it’s not a good deal for the $2 million clients.”

And it’s a worse deal for everyone when the fees are coming out of the portfolio, as Armuth insists.

“I don’t have a problem with high fees,” he said. “I have a problem with high fees deducted from the portfolio.”