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the long view

Attention, financial advisers: I have a modest proposal for you.

The inspiration is a new report from mutual fund giant Vanguard Group Inc. that attempts to put a number on the value of financial counsel. The report claims that state-of-the-art professional advice can add "about 3 per cent" a year in net returns to the client.

This comes as sweet music to the ears of Canada's wealth management industry, which is facing regulatory changes that will force it to more thoroughly reveal its fees to clients over the next couple of years. With that disclosure will come increased pressure to justify the charges.

Vanguard's defence of the industry is therefore quite timely, and it leads to an obvious thought: If financial advice is so advantageous, why doesn't the profession change its business model to reflect that happy fact?

An industry that believes it can generate 3 per cent a year in excess returns for clients should be delighted to operate under a system that splits the extra performance with the customer.

Here's how things could work: A client would start by naming a reference portfolio of funds or stocks – what the client would have invested in if left to his or her own devices. Then the adviser could put the client into a professionally constructed portfolio. The two could agree to split the after-tax margin by which the advised portfolio beats the reference portfolio each year.

If there's no excess performance, or if the advised portfolio lags behind the reference portfolio, the advice would be free. But if the Vanguard calculation is right, advisers should pocket an annual fee that averages out to 1.5 per cent of assets. Meanwhile, clients should do substantially better than they could themselves.

At least, that's the way it should work in theory, according to Vanguard's report. But I'm not expecting many advisers to rush to give up their current stream of safe, stable fees and start implementing my modest proposal.

Even Vanguard doesn't sound entirely convinced. On the one hand, it highlights the 3-per-cent advantage of professional advice. On the other hand, it introduces the report by saying things such as: "While virtually impossible to quantify, in this context, the value of an adviser is very real to clients, and this aspect of an adviser's value proposition, and our efforts here to measure it, should not be negatively affected by the inability to objectively quantify it."

So is the value of financial advice impossible to quantify, or is it 3 per cent? Vanguard did not return a call for comment.

What is clear is that its 3-per-cent contention runs counter to most independent research on the value of portfolio advice.

The President's Council of Economic Advisers issued a damning report in February on the effects of "conflicted" advice on retirement savings in the United States. After examining a mountain of research, the report concluded that advisers who have financial incentives to steer savers into certain products or investment strategies wind up chopping about a percentage point off customers' returns – transforming a 6-per-cent return into a 5-per-cent return, for instance. The total cost to retirees is around $17-billion (U.S.) a year.

A study published last year arrives at a similar conclusion for Canada. Stephen Foerster and Alessandro Previtero of the University of Western Ontario, Brian Melzer of Northwestern University and Juhani Linnainmaa of the University of Chicago found Canadian financial advisers encourage clients to take on more risk than they otherwise would.

The problem is that advisers also encourage clients to invest through expensive mutual funds that more than wipe out any extra return from the extra risk.

Even planners' own numbers suggest that fees are bumping up against the limits of sanity in a world where low interest rates are likely to put a damper on potential returns. The Financial Planning Standards Council, a not-for-profit group that oversees the certified financial planner designation, issued new guidelines in April for long-term planning. It recommends that advisers assume a balanced portfolio of stocks, bonds and cash that will return 5.05 per cent a year over the decades to come.

At first blush, that doesn't sound so bad, but the 5.05-per-cent return includes inflation. If you adjust for likely inflation of 2 per cent a year, investors are left with roughly 3 per cent a year in real return. And that's before management fees and taxes.

There's simply not much room in this scenario for an investor to pay a lot for financial advice and still derive meaningful rewards.

A customer who shells out 1.8 per cent a year in management fees (typical for a mixed blend of stock and bond mutual funds in today's market) would be left with a scant real return of 1.2 per cent a year – and, in most cases, would still have taxes to pay, which would reduce the return even further.

Given all this, it's no wonder that robo-advisers and virtual advisers are rocking the industry. Both use technology to deliver planning at much lower costs than traditional advisers.

To be sure, there are many smart planners out there who deliver great value, especially in areas such as tax and estate planning. They deserve to be compensated well for their time. The natural strategy, to my way of thinking, would be for these advisers to begin charging clients in the same fashion as lawyers and accountants do – with an hourly fee that would allow clients to buy as much or as little expertise as they want.

Failing that, of course, there's always my modest proposal.