Why performance based fees for advice won’t work

“About 19 per cent of investors say their preferred model for paying an adviser is performance-based fee,” according to Mark Johnston, principal of research firm Investment Trends. (Reported here today).

Performance based fees will not work for most types of financial advice.

Performance based fees for finance advice may only be appropriate when:

  • The advice service has a narrow focus solely on investment selection; and
  • The value proposition of the adviser is based on beating the investment performance of valid alternatives such as the broader market or what the investor could achieve on their own.

But that scenario is a very small portion of advice. It perhaps only really applies to stockbrokers and some other investment advisers.

Most financial advice provides a far broader service including providing intangible value such as clarity, direction, confidence and peace of mind. Other benefits include saving you time by handling a lot of research and paperwork on your behalf.

The advice fee is therefore relative to the value of such benefits to you. And it is separate from the investment performance.

Certainly performance based fees couldn’t apply to true financial planning.

The value of planning anything in your life is that it gives you greater confidence that you will get the future outcome or experience that you desire, how and when you want it. You get that confidence because planning and purposeful action actually increases the likelihood the desired outcome will occur.

If the financial adviser controlled every element of you achieving that life goal then maybe you could argue for a performance fee based on you getting the desired outcome. But they don’t control most of it – you do!

Traditional percentage based commissions on product sales are absolutely not the way to remunerate an adviser for strategic advice and guidance. But neither are performance fees.

The solution is a move to transparent fees agreed up front for a defined scope of advice. The level of that fee will be based on mutual agreement between you and your adviser to provide mutual reward:

  • The fee needs to be high enough to cover the adviser’s costs plus a reasonable profit margin;
  • Whilst also being low enough to represent value for the tangible and intangible benefits received by you