Cost Structures Needed for Advisors

In every other profession that serves the public the cost of delivering services is the gold standard for doing business. Health care costs are so compartmentalized that there are full time jobs to apply cost codes to every procedure. Attorneys, architects, educators and engineers all have cost structures for professional activities. These cost structures are by no means uniform but vary widely so clients can compare quality, convenience and cost.

Financial advisors do not need thousands of cost codes to manage their business but knowing what various professional services cost changes a primitive “pot luck” approach into a sustainable one. The knowledge of the cost of services enables the business owner to tailor services to a client’s budget and ensure ongoing profitability of the business. Cost structures also avoid the danger of unknowingly charging excessive fees and concerns of compensation disclosure. A cost structure provides a rational basis for selecting share classes that aligned with the services provided. (Fees can now be properly explained.)

Cost structures begin with an inventory of activities. The typical cost of performing each activity is then calculated, resulting in a menu of services that the advisor offers.

The inventory of activities contains all tasks that are performed in the business. Many of these are services to clients but many are not. Client services are those activities, where the value is immediately visible to clients. For example, client services may include activities such as:

  • Assess needs
  • Assess risk tolerances
  • Develop solutions
  • Create strategic asset allocation
  • Select investments
  • Make recommendations
  • Provide education
  • Monitor portfolio
  • Answer questions and concerns

Non-service activities include activities such as:

  • Client acquisition
  • Research
  • Compliance
  • Continuing education
  • Staff and management activities

Determining the cost of activities is the second step. This includes variable costs and allocation of fixed costs. Variable costs are determined by the resources expended on the activity. Resources include direct expenditures as well as the typical amount of time spent.

Variable costs can be shared by two or more activities. In this case, the variable cost is divided among the applicable activities. Typical variable costs are:

  • The value of time spent on the activity
  • Third parties paid to support a specific activity such as an estate planner or tax expert
  • Tools, subscriptions and services applicable to the activity(ies)

Fixed costs are those which apply to every activity. The business owner must decide on how the fixed costs are allocated to each activity. Typical fixed costs include:

  • Sales and marketing expenses
  • Office space, facilities and utilities
  • Equipment and communication
  • IT Services
  • Travel & Entertainment
  • Indirect employment expenses
  • Taxes
  • Profit

The result after creating a cost structure as described here is a menu of services that can be paid for in a number of ways… commissions, assets under management, flat fees, hourly rates, etc. The critical factor is knowing how much compensation is needed. The method of payment is secondary.

An advisor can use this information to prepare a cost statement that may be private or disclosed as the advisor sees fit. Such a cost statement would incorporate all the costs described here and might look like this:

The Service Cost Summary described here can also be used to create a blend of mutual fund share classes that properly pays the advisors cost of doing business. Take a situation where the foregoing example was the advisor’s cost and the advisor can use a blend of A, T and clean shares for a client’s portfolio. The objective is to use a blend that produces the compensation that covers the cost of servicing, including a desired margin of profit.

For our example, the client has a total of $500,000 to invest in mutual funds and requires only the following services:


Assess needs
                          $500
Assess risk tolerances
                          $300
Develop equity portfolio
                          $700
Develop fixed income portfolio
                          $500
Create strategic asset allocation
                      $1,200
Select investments
                          $450
Make recommendations
                          $750
                Total Payout Required
                      $4,400


A share class breakdown by assets produces this payout:



Load

12b-1

Assets

Compensation

Payout @ 80%

A Shares (at breakpoint)
                       2.00%
                       0.25%

$185,000

$4,163

$3,330

T Shares
                       2.50%
                       0.25%

$50,000

$1,375

$1,100

Clean Shares
                       0.00%
                       0.00%

$265,000

$0

$0

                Total 


$500,000 

$5,538 

$4,430 


The total payout of $4,430 is within $100 of covering the advisor’s cost and profit. More assets would be allocated to A and T shares is more services were required.

 As this example shows, advisors can control payout to ensure that costs are covered without a compliance risk or threat of excessive fee litigation.


About Lou Harvey

Louis S. Harvey
President & CEO

Founder and leader of DALBAR, Lou Harvey is relentless in the search for the forces that are shaping the world of financial services today, tomorrow and for years hence. Using Dalbar’s research capabilities, Lou Harvey seeks insights from inside and outside the industry to understand and anticipate changes in customers’ needs and the ways products are distributed.