One reason the fee can't be lower than 3 per cent is that it is difficult for an RIA to do a good job and remain viable even at 3 per cent.
Only around three dozen Securities and Exchange Board of India (Sebi)-registered investment advisors (RIAs) -- financial planners -- charge a fixed fee.
The rest charge a percentage of the assets under advice (AUA).
Depending on an RIA's experience, academic qualifications, and the number of hours of effort put in (by a fixed-fee RIA), the highest-fee RIA in India can charge 10 times the lowest-fee RIA.
An important decision a client must make is the appropriate level of fee they should pay an RIA.
In my view, the appropriate amount a client should spend on average annual fees over the first five years of engagement should be around 3 per cent of the client's annual household budget.
This rule of thumb refers only to the client's budget and not to the RIA's fee structure.
Let us see how this works using an illustration.
This rule of thumb applies to any age. But for simplicity, let's focus on a couple aged 60 years, who have just retired, do not have children, and have lived in a rented apartment their entire life. Let's call them X.
Let's also assume for simplicity that inflation and post-tax investment returns are both zero per cent.
Couple X has a net worth of Rs 8.4 crore. Dividing it by 30 years of retirement indicates they can afford an annual household expense budget of Rs 28 lakh.
Three per cent of their household budget is Rs 84,000. Over the first five years of engagement with an RIA, the total fee would be Rs 4.2 lakh.
RIAs have to put in significantly more effort in the first year of engagement to understand the nuances of a client's situation and educate the client, for example, on why they should use passive index funds.
Therefore, they typically charge half of the first-year fees from the second year onwards.
Accordingly, X can afford fees of around Rs 1.4 lakh in the first year and Rs 70,000 from the second year onwards (inclusive of GST).
The amount X spends should vary in a narrow range from this level, based on the nuances of their situation.
The same rule of thumb applies to couples with one-fourth or even four times the household budget of X.
This fee, totalled over the remaining 30 years of X's life, is equal to Rs 21.7 lakh, which is equal to 2.6 per cent of X's current net worth.
Thus, it is conceptually similar to X making a one-time payment of a total of 2.6 per cent of their retirement corpus, in return for 30 years of service from the RIA.
The fee cannot be much higher than this because then it will eat into important expenses such as health care.
This is completely different from a fee based on AUA. AUA is often in the ballpark of net worth, so for simplicity, let's treat them as the same.
A typical AUA-based fee is 1 per cent per annum of AUA, which, in this case, would be Rs 8.4 lakh per year. That is 10 times the fee I am recommending.
One reason the fee can't be lower than 3 per cent is that it is difficult for an RIA to do a good job and remain viable even at 3 per cent.
At this level of fee, clients must execute their own mutual fund investments.
This is easy to do using a portal like mfcentral.com. Such an arrangement also makes it easy for clients to redeem investments during an emergency and to change their RIA.
The ability to easily exit an engagement with an RIA will also ensure that the client continues to get good value for money.
Avinash Luthria is an hourly-fee financial planner and a Sebi RIA at Fiduciaries.in. He was a private-equity investor for 12 years.
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