The argument that flat fee charging eliminates cross subsidy does not stand up and is not always fairer, argues Richard Ross of Chadwick's.

Last month Alan Smith, director of Capital Asset Management, set out to debunk what he believes are the most common myths about flat-fee charging (see New Model Adviser®, 22 June 2015).

While there are advantages and disadvantages to any charging model, a fundamental plank of his argument – that 100% flat-fee charging is fairer because it eliminates cross subsidy – does not stand up.

I would argue that a flat-fee model shifts the subsidy so less wealthy clients are subsidising more wealthy clients, which is fundamentally unfair.

Inherent cross subsidy

My first argument with Smith’s view is that all advice relies on a cross subsidy of time, and therefore cost, between clients.

Each piece of advice is not a discrete event. The advice I give to any individual client is based in part on knowledge I have acquired working on other cases.

I am fairly well qualified, but there are times when I need to perform further research to understand a new issue, such as flexi-access drawdown under the new pension freedoms rules. In other cases I can advise clients without doing any further research.

How does the firm charge for that knowledge? Does it charge the first client who wants to take advantage of flexi-access drawdown for the time it has taken for me to familiarise myself with the new regulations? Does it charge the second nothing for that aspect because the costs have already been covered? Of course not.

There is a cross subsidy of the time I spend on clients’ cases that would exist regardless of whether we charged by percentage or a flat fee.

Should we therefore charge a flat fee?

Being fair to clients

My second argument against flat fees is that wealthy clients benefit disproportionately from them.

Charging a flat fee would mean someone with a fund of £200,000 would pay the same as someone with £2 million.

However, the person with the larger fund would gain far more value from the advice, in pounds and pence. Is that any fairer?

Someone with a smaller fund could derive, to use an economists' term, greater utility than a percentage-based charge: relatively speaking, it would improve their life more than the millionaire’s. However, in this example do they gain 10 times as much utility? That is extremely unlikely.

A flat fee does not reflect the difference in the value and utility gained by each client. While not perfect, a percentage of assets under advice, at least to a degree, captures the notion of value.

If it proves expensive over time (and I am not convinced it does), then it is not the method of charging that is at fault but the level of charge.

Marginal costs

My third beef with flat fees is that the issue of high fixed costs and low marginal costs of advice makes either an explicit hourly fee or pure flat fee inappropriate for our profession.

As most of my business expenses are fixed, the marginal cost of advising an additional client is close to zero. It makes no material difference to the salaries, rent or regulatory fees my firm pays.

The only direct costs are fuel if I go to see them and paper and postage if I write to them. Unless I am 100% efficient, all my other costs remain unchanged. At some point I will reach capacity and the marginal cost of an additional client will be large, reflecting the costs of a further adviser.

We can use this notion of marginal cost to create a fairer charging model that reflects the lifetime value both of and to a client.

Staying flexible

We do not charge an initial fee. We are no worse off, and if we take the view that we learn something from every advice event, then we are better off.

Instead we charge a percentage-based ongoing advice fee that clients can cancel with one month’s notice. This addresses several issues:

  • It softens the tendency for buyer’s regret.
  • It aligns our interests more closely with our clients – we both need the relationship to work in order to profit.
  • It changes our focus from client acquisition to client retention.
  • It demonstrates confidence in our proposition.

It has a behavioural downside that could lead to client detriment: clients given advice at no charge may feel compelled to enter a long-term relationship.

We address this by having a commitment point post-advice that includes an option for a fixed fee for implementation of the advice.

So we also use fixed fees occasionally and I think that is the point: there are myriad charging models. To suggest any is intrinsically fairer than another is wrong. It depends on how they are applied.

Richard Ross is director of Chadwick’s