An Outsider’s Perspective Financial services professionals enjoy debating all sorts of technical questions in the course of their business. Can active management add alpha? Which custodian offers the best service? Which target market offers the best long-term business opportunity? For the most part, these are friendly debates, like what you’d hear at your college roommate’s fantasy football draft. There’s one question, though, that inspires more heated debate, both inside the industry and among regulators. That’s the “Berlin Wall” separating the grubby commission sinners from the sanctimonious fee-only saints.
Decades ago, financial salespeople (and I use that term deliberately) dismissed the notion of “fiduciary” entirely. They just wanted to sell. Those were the good old days when a naïve customer could ask his stockbroker, “where are the customers’ yachts?” That model lasted for decades and fixed a vaguely shady image in the public’s mind. (Can you imagine Gordon Gekko calling himself a “wealth manager”? Or even worse, counseling young Bud Fox to keep the client’s interest first and foremost?)
As stockbrokers recovered from the collapse of tax shelters, and insurance agents started competing for assets to manage, the more ambitious ones realized that polishing their act might help them stand out from the crowd. They reinvented themselves as advisors and consultants. Out went the cold calls, the canned pitches, and the glossy prospectuses. In came the financial plans, the fee-based accounts, and the new notion, borrowed from accountants and attorneys, of “fiduciary.” This involved rejecting the old standard of mere “suitability.” They needed to make recommendations based on their knowledge, experience, and wisdom applied to their client’s specific situation. Gone were the halcyon days of selling stuff they would never own and would never recommend to anyone they knew.
I run a nationwide group of tax professionals called the Tax Master Network®. Our members, along with their clients, have watched this evolving definition of fiduciary. Most have done so from the sidelines, but about half have jumped in to offer insurance and investments. My experience with this group convinces me that the debate over fees versus commissions misses the boat. The real question shouldn’t be how the advisor is compensated. It should be how well the advisor serves the clients’ needs. So let’s look at how advisors and CPAs handle “fiduciary” in the real world, and how the conflicts between those approaches (and those groups!) lead to a more appropriate model.
The American Institute of Certified Public Accountants’ Professional Code of Conduct “embodies standards of conduct which are closely analogous to a fiduciary relationship—objectivity, integrity, free of conflicts of interest and truthfulness.” Call it “fiduciary-adjacent” if you will. Back in 1988, the AICPA’s governing council voted to let CPAs accept commissions, with appropriate disclosures, except for clients engaging those CPAs for “attest services”—audits, financial statements, and the like. Some CPAs objected that accepting commissions would seem crass and commercial. But the majority agreed that members could use the additional income to help offset client fees and reduce the cost of going to outside investment and insurance advisors to implement their advice.
Thirty years of experience suggest that CPAs have taken their obligation under this model seriously. Banks, brokers, and insurance companies have all found themselves in the spotlight for cheating retail consumers. Hedge funds stand accused of ripping off clients and “the system” in general. Yet accountants have quietly persevered, enjoying the highest level of trust in the financial landscape.
At the same time, CPAs who don’t bother to acquaint themselves with the financial products landscape do their clients a real disservice. There are four primary opportunities to save taxes for their clients. Timing-, shifting-, code-, and product-based strategies. Most CPAs are at least familiar with timing, shifting, and code-based moves, even if they’re not as proactive about recommending them as they could be. But few CPAs are truly versed in helping clients choose the right financial products to achieve their financial goals with a reduction in tax friction.
Today’s fee-only advisors position themselves under the CPA’s fiduciary-adjacent umbrella. But their model still leaves plenty of conflicts of interest.
First, most fee-only advisors confine their efforts (and advice) to a standard range of paper assets: stocks, bonds, and cash, in various individual and managed forms. Few of them have access to alternative products in real estate, commodities, or oil & gas, that can add layers of diversification or accomplish specific objectives like a pinch-hitter in baseball or a seven wood on the golf course. When those solutions are available, recommending them can mean reducing their own fees. In other words, recommending some products creates a pay cut. Even worse, many fee-only advisors don’t recommend paying off debt, like a house, using shoddy math, but still consider themselves fiduciaries.
And second, those “conflict-free fees” add up over time! Charging clients 1% of AUM means charging them over and over and over, for the assets themselves, the growth on those assets, and the growth on that growth. If a client places a million dollars with the typical 1%-per-year manager, then earns just 6% net of fees for the next 10 years, he’ll generate $100,000 in fees on that initial deposit – plus nearly $40,000 more on the growth and the growth on the growth. Those same fee-only advisors would surely call shenanigans on an investment paying a 14% up-front commission.
Now, let’s walk through some scenarios illustrating some of the potential conflicts and opportunities. We’ll assume that in each case, I’m a CPA and my client has a business to sell. It’s worth $5 million; there’s no basis to offset tax, and he lives in Texas where there’s no state tax to complicate the discussion.
Scenario One: I file the client’s tax return for the year of sale, calculate his tax bill, and hold his hand while he strokes a check for close to 20% of the proceeds.
This is perfectly unobjectionable, meat-and-potatoes accounting. It also does the client an awful disservice by exposing him to a whopping tax bill I could have (and arguably should have) helped him avoid.
Scenario Two: I file the client’s return for the year of sale, calculate his total tax bill, and have him stroke a check for that amount. Then I take the remaining $4 million balance and invest it in a fee-based account where I generate $40,000 per year in management fees. (Realistically, of course, the client will qualify for fee breakpoints, but we’ll assume a flat 1% to make the numbers easier.)
Lots of CPAs are already extending their services that way. No one would object if an unrelated financial advisor took over that account on the same terms, so why object if the CPA takes it?
Scenario Three: Same as in Scenario Two, except I also take $250,000 of the proceeds and invest them in an oil & gas partnership offering a 90% upfront deduction for ID&D expenses. The strategy knocks $45,000 off my client’s tax bill and pays me a seven percent commission equal to $17,500.
Now we’re complicating things. Commissions! But let’s take a closer look at the context. Now I’m going beyond just recording the history the client gives me. Now I’m introducing proactive planning to pay less tax. I’m taking a portion of the assets the client would have generated for me (or anyone else) to manage and positioning them in a vehicle that cuts their tax bill, diversifies their assets, and reduces their overall portfolio volatility. For that service, I accept a one-time commission from a third-party product vendor. That commission isn’t “free” to the client – he pays it in the form of lower portfolio performance over time. But the haircut he takes is less than the tax he saves, so he still comes out ahead in the long run.
Scenario Four: Instead of just waiting for my client to sell his business and recognize the taxable gain, I charge a $5,000 fee to help him set up a charitable remainder trust (CRT), convey the business assets to the trust before selling, and eliminate the tax bill entirely. Then I take the $5 million proceeds and invest them in a fee-based account where I generate $10,000 more in annual fees than if the client had just sold the business and paid the tax. (I also insulate those assets from potential creditors and shelter it from Elizabeth Warren’s proposed wealth tax.)
No one would object to charging a $5,000 fee to avoid a million-dollar tax bill. (Now that I think about it, I really should have charged more.) That move also gives more AUM, which pays me enough to lease a new Jaguar. But I’m worth it, right, because I saved the tax and created the extra assets to manage? Or am I double-dipping because I already charged a planning fee? Or should I have waived the fee in exchange for accepting the extra million in AUM? This fiduciary stuff sure gets complicated.
Scenario Five: Same as Scenario Four, except my client doesn’t want to disinherit his children. So, I set up another trust to replace the equity for his heirs, and use some of the additional income I gained for him to finance a $2 million life insurance policy paying a $40,000 commission.
Now we’re in real trouble. We aren’t just accepting commissions, we’re accepting commissions on life insurance! 80-100% of target premium is highway robbery, or so the writers at Money magazine tell us. Of course, charging the same client “fiduciary” 1% of AUM every year can add up to far more than a one-time commission, as we saw above.
What does our survey tell us? The first scenario, where I charge my client a fee to prepare a return documenting a sale, is the easiest. But that scenario, which leaves him exposed to the full tax bill on his sale, is also the least advantageous to that client! Succeeding scenarios get more and more complex, both in terms of the work I do and the compensation I accept. But they also get better for the client.
The conclusion is clear. There’s no correlation between the way I get paid (and really, not much correlation between the amount I get paid) and the quality of outcome for my client. Charging an asset-based fee to manage his assets, accepting a commission to put part of those assets in a tax-advantaged oil & gas program, charging a professional fee to establish a CRT, charging a higher asset-based fee to manage more assets, and accepting a commission to finance a wealth replacement trust all put him closer towards his goals of financial security, retirement income, and family legacy. Shouldn’t that be the real test, not how I get paid?
And here’s the irony of the whole fees-versus-commissions debate. It focuses on compensation instead of results. It focuses on effort instead of value. And it focuses on the advisor instead of the client.
Here’s how I see it from my fiduciary-adjacent sideline. Am I doing what’s right for the client? Am I making all appropriate solutions available to the client, or am I limiting myself to the solutions within easiest reach? Finally, am I letting the client’s 1040 drive the decisions? Or am I just looking for the product/manager/fad du jour?
There’s room under that umbrella for all sorts of compensation arrangements. Sometimes a straightforward professional fee is the answer. Sometimes an asset-based fee makes the most sense. And sometimes a one-time commission really is in the client’s best interest. So why limit the client’s options to do what’s right for them, because of what appears to be an arbitrary standard that is not driven by client-centric approach or math?