Over the winter break, I took the time to peruse Bob Veres’ new book, “A Behind-The-Scenes History of the Financial Planning Profession.” This won’t be a book review, though one will likely be forthcoming (early thoughts: It’s quite good, if quite long.) The relevance of this particular 736 page read is not to begin an exhortation of the short but storied history of financial planning, but to talk about how your experience as a consumer of financial products and services over the past 4-5 decades really has or would have changed quite a bit (your age depending).
While not intended as a treatise on the evolution of professional financial services, the book shone quite a light on how quickly we forget how new some of the things we today question as relevant and value-adding really are. So today, we’re talking about just how financial planning and the relevant financial products and services really have evolved over the past century.
An Era in Which Losing Money Was the Point
In the 1970s and the 1980s, losing money was the point. That’s not a joke, I really mean it. Coming out of the era of stagflation, where simultaneously inflation had spiked, and the markets had failed to perform meaningfully, the name of the investment game was the sale of limited partnerships, whose primary pitch was to lose money… for tax reasons.
During this time, the United States simultaneously still had rather high income tax rates. For example, a married couple could find themselves paying as little as 14% and as much as 70% between the varied marginal tax brackets; the 70% rate kicked in at $215,400 annually of income (this is the modern equivalent of making $845,700 today), but taxes were still an absolute killer. And if you were of the investing type (or of the relevant income or wealth to be doing so), you could meaningfully find yourself making money by not paying taxes. You see, prior to 1986, ordinary income and investment income were not meaningfully separated. Today, you’re allowed to write off up to $3,000 in short and long-term capital losses ($3,000 total, not $6,000) against your ordinary income, but that’s it. However, in the 60s, 70s, and into the 80s, you not only had to pay taxes on 50% of your capital gains (instead of 100%), but you could also claim 100% of capital losses.
In the late 60s, this was enhanced to a 50% limit, but even then, many investors found themselves effectively buying investments that could, through creative accounting (and often just outright mismanagement), find themselves simultaneously turning a profit but also having losses to both wipe out that profit not just in the present year, but to be carried forward for many years to come. Effectively, you had a choice between “risky” market investments that had just gone through a terrible decade, or you could take the “sure thing” of investing in companies that generated enormous tax write-offs and might turn a profit someday. Never mind future tax recapture issues, but we’re really getting too far into the tax weeds.
So if losing money was the point, how or why would anyone engage in this exercise? Well, financial services at the time were largely the stuff of brokers being paid enormous commissions (e.g., 8.5% of your investment up front) or insurance agents trying to protect you from taxes using the chassis of life insurance products to do it. Both were primarily aimed not at maximizing your lifetime wealth or producing strong taxable returns, but at reducing or sheltering your income from taxes, with returns mattering only slightly on the other side. Quite problematically, of course, this closely resembled the Wolf of Wall Street line: “The name of the game, moving the money from the client’s pocket to your pocket.”
Post 1986
The passage of the Tax Reform Act of 1986 effectively spelled the end of these tax strategies. Suddenly, capital gains were tracked and treated much more closely as they are today (plus or minus a few changes that have occurred since then). Simply put, you net out your short and long-term portfolio gains or losses against each other year over year, and even if you lose your shirt, you can only deduct a nominal amount against your ordinary earned income. So was the gig up? Not really.
While a little-known collective of Fee-Only Financial Planners would found the National Association of Personal Financial Advisors (NAPFA) in the early 80s, this wasn’t quite yet their time to shine. Instead, the industry began to evolve the share classes they used to sell investments. While previously less-regulated private investment offerings in limited partnerships and the like had paid enormous commissions, there was a fairly competitive “standardization” to the commissions in many investment products of the time. While levelized commissions had officially been done away with in 1975, paving the way for discount brokers with familiar names like Charles Schwab, the introduction of the 12b-1 presented another bite at the apple.
The popularized investment product of the time, mutual funds, generally paid out a 5%-9% commission up front. This created a conflict of interest issue for many of the brokers selling them, however, in that they only got paid on the sale. Consequently, the now-prohibited activity of “churning” was popular among brokers, going to their clients and bringing them a new exciting fund to invest in every year or two; ostensibly to provide their clients with new investment opportunities, but practically speaking, just to generate another large slice off the top for the brokers.
The introduction of the 12b-1 fee tried to hedge this issue by introducing the notion that while brokers could still take a large commission up front for selling a fund to their customers, they could be discouraged from churning their accounts by being paid not to. Or rather, by accepting a “marketing and distribution fee” from the fund companies in the form of an ongoing trailing commission. Thus, their greed better satiated, they might refrain from scalping their client every year or two for a larger commission in favor of building up a base of income from smaller trailing commissions.
Meanwhile, the nascent fee-only movement was starting to pick up steam. Not only because they had made it their business to get paid like every other professional out there, specifically for their services and expertise rather than based on sales transactions, but they had also deigned to be registered as Registered Investment Advisers, obliging them to serve as Fiduciaries rather than salesmen to their clients. It wasn’t long because their predominant business model, the “percentage of assets under management fee” would become the envy of the brokerage world.
AUM: The Best Idea To Date (at the time)
That Header 2 tag isn’t so much to make an argument for the assets under management (“AUM”) fee, so much as it is to highlight the value of the idea at the time. While charging a percentage of assets under management is the way almost the entire investment and financial advice industry works today, the AUM fee originally was akin to swearing a vow of poverty. The early fee-only financial planning practitioners didn’t rake in a windfall of recurring fee revenue from their clients, and for many painful reasons.
First, while the automated billing of fees from accounts today is well-established technology, during the 80s and 90s, the technology didn’t exist. The advisers would have to have clients provide copies of their statements to them or otherwise request that they be copied on clients’ statements, then hand-calculate rates of return for their clients, propose adjustments or changes to portfolios as necessary, and then request the client pay them directly based on the fee calculation. And of course, trading or rebalancing wouldn’t be technologically viable for another decade or two.
While today many financial influencers and non-professional pundits like to lambast the AUM fee as being something no one would ever pay if they had to write a check personally, it turns out that’s exactly how it started, and it was with good reason. Compared to paying 8.5% off the top every time your broker came to you with a new investment idea, paying a quarter of 1% every quarter of the year was a complete steal. Better yet, it was not only cheaper but also better in that the advice-givers being paid through the AUM fee were serving their clients as fiduciaries. Not just selling products and giving advice “solely incidental” to the sale of a product, but giving advice encompassing insurance, taxes, estate planning, and a variety of other matters that didn’t fit under the umbrella of advising someone to buy limited partnerships investing in cattle herds.
As the popularity of the model began to increase, the brokerage world began to take notice. Not of the fiduciary duty, increased scope of services, or extra work being a fee-only financial planner required. But instead, of the slowly shifting direction of market share and consumers’ preferences for more transparent costs and more comprehensive advice.
Having your Fee Cake and Eating it Too
As the industry got into the 2000s, the brokerage world had taken more than one step in the direction of trying to turn what was otherwise a transactional sales business into a recurring revenue stream. While the majority of consumers still paid a per-trade commission on investments to their discount broker or still ate the 5%+ commissions off the top from buying Class A mutual funds from their brokers, the industry had gotten more clever about hiding recurring revenue and profit-sharing arrangements inside of their “transactional products.”
Fund companies began to charge higher expense ratios and then remit a profit-sharing revenue stream to the brokerage companies selling their products, who in turn would juice the commissions and payout grids for their salespeople. Other funds began to offer Class B shares or Class C shares, ostensibly charging the Class A commission over time or annualizing it, and ensuring they’d get paid with contingent deferred sales charges that would trigger if someone tried to sell out of their expensive investment product too quickly.
The insurance world took note as well, introducing variable annuities and universal life insurance; products that still paid enormous commissions to the brokers selling them at the time, but burying the commissions in the fine print and obfuscating the investor’s real cost of investing within labyrinthine prospectuses and several-hundred-pages of disclosures.
They would finally grow too bold, trying to simultaneously charge AUM fees and claim commissions while simultaneously claiming that managing money on an ongoing basis was just a sales activity. The Financial Planning Association would sue, and win, forcing those brokerages looking to charge ongoing AUM fees on the products they sold to register their brokers as investment advisers and subject them to a fiduciary conduct standard, or to otherwise forgo fees. It’s taken almost 20 years for that to really shake out in practice, but the result on the business model of financial advice has been substantial.
The General State of the Advice Business
Whether someone is a “financial planner” or a “Certified Financial Planner® Professional” or just a broker or “financial advisor” is outside the scope of this blog and discussion. Rather, we’re here to remark on the state of the services world today.
Today, most consumers of financial services do so on a fee-for-service basis. This can be the original AUM fee, or one of the newer fee models such as hourly, retainer/subscription, net worth, projects, or complexity-driven calculation. We’re not here to debate which is better, and have vehemently stated before that such arguments are meaningless. However, consumers choose to pay their planner, today the majority are working not with fee-only planners but with fee-based planners. These hybrid bastardizations have been called “the worst of both worlds” in the academic literature; and I’m sympathetic to that conclusion because I started my career within one of those types of firms.
That said, the average consumer of financial services finds themselves paying for financial advice, ostensibly to a fiduciary financial professional of some sort. The majority then find that their planner has morphed into a salesperson without announcing it, and proceeds to use the fiduciary fee-based engagement that they started with to sell additional products and services. These might be fiduciary services such as investment management, or the sale of funds or insurance policies on commission. And we today are now seeing the creep of the limited partnership-esque products start to enter into the fold through “private equity funds” that proclaim to offer the impossible: higher returns with less risk.
For the part of the original fee-only world? Well, several thousand fee-only firms have been minted over the past decade, in no small part due to the hard work of organizations like the XY Planning Network and the advocacy of strong industry voices. The product selection has improved, but the consumer still lives very much in a caveat emptor world. While we’ve gotten away from 8.5% commissions on the sale of Venezuelan kite factory partnerships, consumers are still regularly presented with things that are too good to be true, masquerading as financial opportunities that are simultaneously “in their best interest” but also generating enormous fees and commissions to the brokers and firms manufacturing and selling the products.
But we’re not here to discuss that necessarily. This started as a conversation about the evolution of the products, specifically in the financial services world, and how your experience as a consumer might have changed over the years. In the 80s, you’d likely be buying borderline scams masquerading as tax savings. In the 90s, you’d be buying funds or trading stocks on commission to someone who wore a nice suit most of the time but also didn’t know the difference between the highest commission-paying product and what was good for you. In the aughts, you’d be able to get your money managed for a fee, but whether it was being done by a fiduciary or a salesman had to be decided in the courts. And even as we’ve gotten past the teens and into the 20s, the world of products pretending to be solutions has never been so vibrant.
The Irony of History
There’s an old adage about history, and one you’ve certainly heard before: Those who do not learn from history are doomed to repeat it. Yet, not a day goes by that I don’t see someone mocking up a lame comparison of the one-time-purchase of an insurance policy against the “crazy cost of fees.” Never mind that the commission is earned by signing a piece of paper one time, and the fees are earned over years or decades of ongoing services. Not a month goes by that someone doesn’t talk about how you just need to buy product XYZ, and that’s good enough for you. And somehow, the finfluencer class of non-professionals never fails to tell you in the same sentence that, “if you just put your house in a Wyoming LLC, you won’t ever have to pay taxes again, but also this isn’t tax advice and you should talk to a tax professional before doing this… *wink*.”
The truth of the matter is, the consumer experience for financial planning, investment, and risk management has come a long way. Today, you can trade investments essentially for free. You can use ample resources to research and understand your financial options. You can use find an advisor tools like NAPFA’s, XY Planning Network’s, Fee Only Network, or Wealthtender, to find fee-only fiduciary financial planners rather than brokers or salespeople who wear a fiduciary mask up front and a sales license in the back. There are endless websites, tools, apps, and AI boondoggles out there to help you do something with your money.
So whether you pay an AUM fee, or just do it yourself, or believe that money isn’t real, the good news is this: There’s never been a better time to try to build wealth for yourself. It isn’t a perfect world today, but it’s certainly better than it used to be.
Dr. Daniel M. Yerger is the President of MY Wealth Planners®, a fee-only financial planning firm serving Longmont, CO’s accomplished professionals.