It’s Time for a Cus­tody Fee

The change is needed to bet­ter align the in­ter­ests of RIAS and the cus­to­di­ans that serve them.

Financial Planning - - CONTENTS - BY MICHAEL KITCES

The change is needed to bet­ter align the in­ter­ests of RIAS and the cus­to­di­ans that serve them.

A cus­to­dian is one of the most cru­cial ven­dors for RIAS. From the core ser­vices of trad­ing, hold­ing and main­tain­ing records of elec­tron­i­cally owned se­cu­ri­ties, to the an­cil­lary tech­nol­ogy that cus­to­di­ans pro­vide to help ad­vi­sors run their busi­nesses, a good RIA cus­to­dial re­la­tion­ship can help firms at­tract and re­tain clients.

How­ever, as the ad­vi­sory in­dus­try has shifted from a fo­cus on sales to advice, cus­to­di­ans and the RIAS they serve are in­creas­ingly in con­flict with one an­other. In­deed, many of the ways in which RIAS help their clients re­duce costs and fur­ther grow their wealth are ac­tu­ally detri­men­tal to the bot­tom lines of RIA cus­to­di­ans.

To bet­ter align the in­ter­ests of RIAS and the cus­to­di­ans that serve them, it’s time that the plat­forms start charg­ing the RIAS they serve a cus­tody fee. A ba­sis-point cus­tody fee would ul­ti­mately al­low cus­to­di­ans to fo­cus on pro­vid­ing the best ser­vices and so­lu­tions to RIAS, in­stead of just seek­ing new ways to make money off of an RIA’S clients.

The idea of pay­ing a ba­sis point fee for a cus­to­dial plat­form that, for the bet­ter part of the past 20 years we’ve got­ten for free, may sound hor­ri­ble. But the re­al­ity is that RIA cus­to­dial plat­forms aren’t free in the most lit­eral sense. As the say­ing goes, “If you’re not pay­ing for it, you’re the prod­uct.” Our clients are the prod­uct, and we are ef­fec­tively bring­ing them to the RIA cus­to­dian.

To un­der­stand why, we have to look at how RIA cus­to­dial plat­forms ac­tu­ally make their money:

1. On cash:

The few per­cent­age points of cash that are held in a client’s port­fo­lio may seem in­signif­i­cant, but when that money sits the RIA cus­to­dian makes money on the money.

With the cash held in a pro­pri­etary money mar­ket fund the cus­to­dian might earn a 50-ba­sis point ex­pense ra­tio. With the cash in a re­lated bank sub­sidiary, the cus­to­dian earns a net in­ter­est mar­gin of maybe 1% or 2%.

This may sound triv­ial, but bear in mind that com­pa­nies like Charles Sch­wab have al­most $1.5 tril­lion on their RIA plat­form, which means even if the av­er­age client has just a cou­ple per­cent in cash, that could be $50 bil­lion in cash as­sets earn­ing 50 ba­sis points on money mar­ket funds, or 1% more in net in­ter­est mar­gin.

In fact, if you look at

A ba­sis-point cus­tody fee would ul­ti­mately al­low cus­to­di­ans to ac­tu­ally fo­cus on pro­vid­ing the best ser­vices to RIAS.

Sch­wab’s an­nual re­port, you’ll see that over 50% of Sch­wab’s en­tire rev­enue for the whole com­pany was in­ter­est rev­enue. Which is tech­ni­cally not just things like net in­ter­est mar­gin from Sch­wab Bank but also a lit­tle bit of in­ter­est on mar­gin loans and se­cu­ri­ties based lend­ing, etc. But as Sch­wab it­self ac­knowl­edges, most of it is mak­ing money on cash. Sch­wab gen­er­ated $4.6 bil­lion last year in in­ter­est alone.

2. On fees:

That in­cludes both the sub­trans­fer agent fees or what are called sub-ta fees that mu­tual fund com­pa­nies pay to cus­to­dial plat­forms to hold and ad­min­is­ter their mu­tual funds, which can be any­where from 5 to 15 ba­sis points. Tech­ni­cally, this is part of the ex­pense ra­tio of the un­der­ly­ing fund, but the fund com­pany col­lects the ex­pense ra­tio from the client and then pays those dol­lars to the RIA cus­to­dian to be on the plat­form.

In ad­di­tion to sub-ta fees, RIA cus­to­di­ans also make money through their in­creas­ingly pop­u­lar no-trans­ac­tion-fee (NTF) plat­forms. You may not pay a ticket charge when buy­ing funds through one of th­ese, but clients typ­i­cally do pay a 12b-1 fee be­cause the plat­forms de­lib­er­ately put funds only into their NTF plat­forms that pay a 12b-1 fee. That’s what the cus­to­dian uses to cover the cost.

In the case of Sch­wab, about $1 bil­lion in fees was col­lected last year just on mu­tual funds — ei­ther through Sch­wab’s One­source NTF plat­form or through other sub-ta fees from third par­ties and plat­form pay­ments. And that’s not in­clud­ing the few hun­dred mil­lion in fees they gen­er­ated from their own pro­pri­etary Sch­wab funds.

3. On ticket charges:

Look­ing at Sch­wab again, all those trad­ing com­mis­sions in the ag­gre­gate rep­re­sented only 7% of to­tal rev­enue, or about $600 mil­lion. This may sound like a big dol­lar amount when you’re do­ing com­mis­sions at $5 a trade, but bear in mind that Sch­wab has be­tween the RIA in­sti­tu­tional and re­tail di­vi­sions close to $3 tril­lion in as­sets. And so on $3 tril­lion, earn­ing just $600 mil­lion in trad­ing com­mis­sions amounts to about 2 ba­sis points of rev­enue on their ag­gre­gate as­sets.

The key point here is to ac­knowl­edge that RIA cus­to­dial plat­forms are free to ad­vi­sors pre­cisely be­cause cus­to­di­ans want us to bring them clients — and then feed our clients into their money-mak­ing ma­chine.

The prob­lem is that cus­to­di­ans have put RIAS in a po­si­tion where we look bet­ter to our clients when we stick it to the cus­to­dian.

Misalign­ment

This means RIA cus­to­di­ans op­er­ate a busi­ness model that is fun­da­men­tally mis­aligned with the ad­vi­sors they serve. And it has cre­ated a sit­u­a­tion where we as RIAS can cre­ate value for our clients by try­ing to sys­tem­at­i­cally dis­man­tle the cus­to­dian’s rev­enue and profit lines.

Cus­to­di­ans make most of their money off the money mar­ket and bank sweep that pays ul­tra-low in­ter­est rates. Con­se­quently, a cus­to­dian can profit, while we use re­bal­anc­ing soft­ware to al­ways keep clients fully in­vested so they don’t have more than, say, a 1% al­lo­ca­tion. Al­ter­na­tively, we buy ul­tra-short-term bond funds just so we don’t have to keep any­thing in ac­tual cash, or we tell our clients to keep their cash some­where else that gives them bet­ter yields if they’re not about to in­vest it.

There’s even a ser­vice now called Maxmy­in­ter­est, which will help au­to­mate the process of tak­ing client cash away from cus­to­di­ans and send it to third-party banks that pay dras­ti­cally higher yields, boost­ing client cash re­turns by as much as 1%-1.5% a year.

Sim­i­larly, if RIA cus­to­di­ans make money off of sub-ta fees, we choose mu­tual funds or ETFS that don’t pay sub-ta fees. The ma­jor rea­son Van­guard and DFA funds have lower ex­pense ra­tios than most of their com­peti­tors of­fer­ing sim­i­lar so­lu­tions is be­cause their ex­pense ra­tios don’t in­clude all the back-end pay­ments to the cus­to­di­ans. So we seek the low­est­cost funds for clients and dis­man­tle the cus­to­dian sub-ta fee line.

The same thing hap­pens with 12b-1 fees in NTF plat­forms. It’s usu­ally not a good deal for most clients to use mu­tual funds in those NTF plat­forms be­cause they have higher ex­pense ra­tios — ow­ing to their us­ing the share class with the 12b-1 fee, which still in­di­rectly comes out of the client’s pocket and goes to the cus­to­dian.

So what do we do? When clients have siz­able as­sets, we skip the NTF plat­form en­tirely and in­stead pay the ticket charges be­cause it’s cheaper for our clients — at the ex­pense of the cus­to­dian’s rev­enue. The only clients we put in NTF funds are those whose ac­counts are small, where the 12b-1 fee is cheaper than the ticket charge. This means we’re mak­ing sure as ad­vi­sors that it’s lose-lose for the cus­to­dian.

Then of course there’s the ticket trad­ing charges them­selves, which are com­pletely com­modi­tized and get­ting pres­sured lower and lower, for which we as ad­vi­sors then reg­u­larly ask for more con­ces­sions. “New clients com­ing on board with a whole bunch of trades. Can we have a break so we can get the client?” That’s an­other lose-lose sit­u­a­tion for the cus­to­dian.

Again, the prob­lem is that cus­to­di­ans have put RIAS in a po­si­tion where we look bet­ter to our clients when we stick it to the cus­to­dian. The more we

play the game and dis­man­tle the cus­to­dian’s profit cen­ters, the more money we save our clients. Iron­i­cally, that means the more fee pres­sure there is on ad­vi­sors, the more in­cen­tivized we are to put pres­sure on the cus­to­di­ans to re­duce their prof­its, be­cause it re­duces the client’s costs and that makes our fee look more man­age­able.

A New Base­line

This is why I think that in the fu­ture, we as RIAS will sim­ply pay a ba­sis point cus­tody fee to the cus­to­dian.

Imag­ine that an RIA cus­to­dian charged us a cus­tody fee to use their plat­form, tools and tech­nol­ogy, as well as for ac­cess to funds, ETFS, stocks and bonds. But in­stead of get­ting it all for free — where they then try to ex­tract the value from our clients — we pay for it di­rectly, maybe for some­thing like 10 ba­sis points, tear­ing down to 7 and 5 and 3 ba­sis points as our as­sets grow.

This is meant to be an ap­prox­i­ma­tion of how much the RIA cus­to­dian al­ready makes off the typ­i­cal RIA, but in­stead of mak­ing a ba­sis point or two on av­er­age in ticket charges and a few ba­sis points off the sliver of client as­sets and NTF funds — and then the 50-100 ba­sis points that they make off a few per­cent of cash that we hold — they just charge us one uni­form cus­tody fee on ev­ery­thing, with break­points at higher as­set thresh­olds.

The point here is to charge a fee that sim­ply av­er­ages out to the same amount the cus­to­dian was al­ready mak­ing from us when cal­cu­lated as a per­cent­age of rev­enue based on the to­tal as­sets of their plat­form. In such a model, the cus­to­dian would sim­ply be in­cen­tivized to make the best darn RIA cus­tody plat­form out there.

And be­cause the cus­to­dian will be mak­ing the fee, I would ex­pect they then would go back to all the fund providers and rene­go­ti­ate new ver­sions of true, clean shares. No 12b-1 fees, no sub-ta fees — a spe­cial ver­sion of ad­vi­sor class shares where no back-end fees were needed be­cause the cus­to­dian would be earn­ing his cus­tody fee.

This would guar­an­tee us ac­cess to the cheap­est funds that ex­ist of any fund com­pany at any time. You wouldn’t just have to go to Van­guard or DFA to find the cheap­est funds; you could go any­where be­cause the costs would come down for all of them.

In the ag­gre­gate, ad­vi­sors would then be in­cen­tivized to con­sol­i­date as­sets into a com­mon plat­form that clients would want to use — be­cause it would have the best so­lu­tions, and not be­cause it would be the one that made the cus­to­dian the most money.

And the more we con­sol­i­dated, the big­ger the RIA cus­to­dian would get as well be­cause it would earn the cus­tody fee on all the as­sets, re­gard­less of type. That’s what hap­pens when all our mod­els get aligned.

Mak­ing the Pivot

Iron­i­cally, the fact that not all RIAS are equally prof­itable would be among the big­gest block­ing points for rein­vent­ing the RIA cus­tody model. In­deed, those of us who are al­ready good at play­ing the game es­sen­tially get a be­low-av­er­age fee and have lit­tle in­cen­tive to switch.

This was never an is­sue for bro­kerdeal­ers, who sim­ply re­ceived a slice of those trans­ac­tions; if a cus­to­dian charged $5 or $10 a trade, the bro­kerdealer would charge $15 and take the markup. If the cus­to­dian made 50 ba­sis points on cash, the bro­ker-dealer would get an­other 10, and so on down the line. The RIA cus­tody model, then, is more closely aligned to bro­ker-deal­ers than to the RIAS they’re serv­ing now.

That’s why I be­lieve a shift has to oc­cur. RIAS would avoid con­stant con­flict with their cus­to­dial plat­forms, while the plat­forms would grow with­out be­ing gamed by their RIAS.

Gone would be the re­quire­ments for hav­ing min­i­mums for cash or trades, and in their place would be just one guide­line that sim­ply said, “Hey ad­vi­sor, you want a break on your fees? Grow big­ger and hit the next as­set break point.” This would also pre­vent the cus­to­dian plat­forms from ever beg­ging us to make our clients more prof­itable for them by trad­ing more fre­quently, hold­ing more cash or us­ing more ex­pen­sive funds.

My gut says that an RIA cus­to­dian is go­ing to of­fer this soon — if only be­cause as RIAS get bet­ter at gam­ing the sys­tem, the rev­enue lines get lower for the cus­to­di­ans as a per­cent­age of as­sets. And more ef­fi­cient cash man­age­ment tools, which al­low us to move cash off of cus­tody plat­forms, con­sti­tute very ma­te­rial threats to the en­tire cus­tody busi­ness model. Or per­haps some RIA cus­to­dian will just do it to be the dis­rup­tive in­no­va­tor that chal­lenges the rest of the cus­to­di­ans.

This is the op­por­tu­nity for us to have the best cus­tody plat­form we’ve ever seen. And even though it’s go­ing to feel awk­ward for us when we’re not pay­ing a fee, it will ul­ti­mately ben­e­fit ev­ery­one — our clients in­cluded. FP

As RIAS get bet­ter at gam­ing the sys­tem, rev­enue lines get lower for cus­to­di­ans as a per­cent­age of as­sets.

Source: Com­pany data; in­dus­try es­ti­mates*

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