Reducing Attorney Fees (Investment Fees, that is)
While many clients gripe about attorney fees, attorneys should themselves be focused on reducing asset management fees. This blog post begins a series examining the negative effects of high fees and how fee reduction should be a cornerstone of financial planning.Most Ultra High Net Worth (“UHNW”) investors pay their advisor(s) an asset management fee between 75 and 100 basis points, in addition to the underlying expense ratios of the investment vehicles used, such as separate accounts, mutual funds, and exchange-traded products. For an investor with $10 million in assets under management (“AUM”), these fees typically total to 1.25 to 1.5 percent per year.Over time, such high fees amount to the confiscation of significant portions of potential asset growth.
Reducing Attorney Fees - Confiscation by Fee Compounding
“The most powerful force in the universe is compound interest.” – Albert Einstein
The payment of fees amount to a built-in compounding loss over time. The higher the fees, the greater the damage to the growth of the assets. Using simple math, for an investor with $10 million in AUM, a one percent incremental fee will cost them approximately the following amounts in lost growth:
- $600K over five years;
- $1.5M over 10 years;
- $4.6M over 20 years, and;
- $10.8M over 30 years.
Thus a typical 50 year-old client, living in Manhattan, with $10M in AUM today would see one-third of her terminal value confiscated by fees by the time she turns 80.Needless to say, this is incredibly damaging to clients, and largely avoidable.
Unpacking Negative Fee Compounding
Keeping with our $10 million in AUM example, in the first year the incremental one percent fee is $100,000. This one percent annual incremental fee will be debited from the account on a prorated monthly or quarterly basis. Importantly, it not only reduces the return, but also reduces the investable assets over the course of the year.If the client’s assets are thought of as an engine that produces returns, the steady reduction of assets from fees makes the engine slightly smaller. Over time, the smaller annual output from a smaller engine amounts to significant lost output, and a lot less distance covered (i.e. terminal portfolio value).In order for the investments to be profitable, they first have to overcome this asset reduction. If the account is profitable, the profit will be reduced by the fee amount and if the account is unprofitable, the loss will be increased by the fee amount.This is then repeated the next year and so on. In effect, there is the initial loss of the fee amount, the subsequent loss of growth on the fee amount, and then the loss of growth on the lost growth, etcetera, compounding in this way each year.
Let us assume our $10 million AUM client is invested in a 50/50 portfolio (stocks/bonds) and earns five percent per year. She pays an all-in 1.5 percent fee (management fee plus investment vehicle expenses) that decreases over time as she hits management fee breakpoints.Over 30 years, she will pay $6.3 million in fees and have a terminal value of $30.1 million.Table 1: Typical Fee Structure
If our client can reduce her fees to 50 basis points throughout the 30-year relationship, her total fees will be reduced to $3.1 million and her terminal value will increase to $37.5 million.Table 2: Alternative Fee Structure
Importantly, the fees would have been reduced by $3.3 million ($6.3 -$3.1), but the terminal value would have increased by $7.3 million ($37.5 - $30.1). The additional $4 million in terminal value is due to the reduced negative compounding effect.In my next post, I will examine the easiest way to reduce fees, which involves decomposing them into asset management and wealth management components.
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________Notes: Berkshire Hathaway 2017 Annual Report; Available at: http://www.berkshirehathaway.com/2017ar/2017ar.pdf; Accessed April 2, 2018; 12. Opinions vary about whether Einstein ever said this. However, the fact that the quote persists, even if an urban legend, speaks to its truth. For a discussion on the alleged quote, see: https://www.snopes.com/fact-check/compound-interest/. Accessed April 3, 2018. I am here assuming the difference between a net five and net four percent return. If the assumed rates are higher, the difference becomes larger.