Why RIA Custodians Should Start Charging A Basis Point Custody Fee

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#OfficeHours with @MichaelKitces Video Transcript

Welcome, everyone. Welcome to Office Hours with Michael Kitces.

For today's Office Hours, I want to talk about a topic that's been coming up more and more frequently in my consulting work lately, which is the idea that RIA custodians may soon have to actually charge a basis point fee for custody to the advisors who use their platforms, and why I think this is actually a good change for the industry to make in the long run.

For the existing world of RIAs, 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 without paying a platform fee may sound horrible, but the reality is that RIA custodial platforms aren't free, they're "free". As the saying goes, "If you're not paying for it, you're the product." Or really it's not us as advisors that are the products, it's actually our clients who are the products and we're effectively bringing the product to the RIA custodian.

And to understand why, you have to look at how RIA custodial platforms actually make their money today. In practice, most RIA custodial platforms make money in three ways.

1. Earning money on cash:

It may seem like a little thing, the few percentage points of cash that you have holding in a client's portfolio, I guess part of the asset allocation or because the client needs to have some cash on the side to handle retirement distributions for spending or just our own fee sweeps, but when that money sits in cash, the RIA custodian makes money on the money. Either because it's a proprietary money market fund on which they might earn a 50-basis point expense ratio, or because they sweep the cash to a related bank subsidiary and actually earn net interest margin on the cash at the bank by doing what banks do. They pay a lower rate on deposits then lend out the money and get a higher rate on the loan and then earn the difference, the margin between what they pay to depositors and what they receive from lending.

This may sound like a trivial thing, earning just 50 basis points in money market expense ratios or perhaps 1% or 2% in an interest margin through a subsidiary bank on just a tiny allocation of cash, 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, and earning 50 basis points on money market funds or 1% more in net interest margin on that much money is not a small dollar amount. In fact, if you look at 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. RIA custodians earn profits is through servicing fees for mutual funds and ETFs:

So that includes both the sub-transfer agent fees or what are called sub-TA fees that mutual fund companies pay to custodial platforms to hold and administer their mutual funds now that most mutual funds are held through brokerage firms and custodial platforms instead of in days of old where it was typically done directly with the mutual fund company. And those sub-TA fees can be anywhere from 5 to 15 basis points. Technically, 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 custodial platform to be on the platform.

And in addition to the sub-TA fees, RIA custodians also make money through their increasingly popular no-transaction-fee (NTF) platforms. Because the reality is that when you buy funds through an NTF platform, you may not pay a ticket charge, but what clients typically do pay is a 12b-1 fee because the platforms deliberately only put funds into their NTF platforms that pay a 12b-1 fee. That's what the custodian uses to cover the cost and then let them make the profit or even compel the fund companies just to make a platform payment to be included in the NTF list.

And in the case of Schwab, that was about $1 billion in mutual funds last year just from the fees, either through their OneSource NTF platform along with 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. That's just OneSource and third-party fees.

3. RIA custodians make money is through those ticket charges that they earn whenever we buy a mutual fund or an ETF:

Thanks to price competition, that's actually not even a huge portion of revenue anymore. In the case of Schwab, all those trading commissions in the aggregate is only 7% of their revenue, or about $600 million, which sounds like a big dollar amount when you're doing commissions at like 5 bucks a trade at a time, 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 only about 2 basis points of revenue on their aggregate assets.

But the key point here is that RIA custodial platforms aren't free. They're free to us as the advisors because we bring our clients to the platform and send them into the platform's money-making machines. So we hold at least a little cash, and then the custodian earns money market fees or net interest margin from a related bank. We use NTF platforms, or at least choose funds that pay platform sub-TA fees, and then they make their $5 or $10 a trade every time we do a transaction with the client. So in other words, we get the platform for free because the RIA custodians want us to bring them clients and then feed our clients into their money-making machine.

How RIA Custodians Are Misaligned With The RIA Advisors They Serve [Time - 5:39]

And the reason this structure matters as a problem is that it means RIA custodians are fundamentally misaligned with all of us the advisors that they serve. Because it's now 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, right? The custodian makes most of their money off the money market and bank sweep that pays ultra-low interest rates so the custodian can profit, great, then either we use rebalancing software to always keep clients fully invested so they don't have more than, like, a 1% allocation they have to, or we buy ultra-short-term bond funds just so that 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 anyways.

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% to 1.5% a year.

Similarly, if RIA custodians make money off sub-TA fees, we choose mutual funds or ETFs that don't pay sub-TA fees. That's the major reason why Vanguard and DFA funds have lower expense ratios than most of their competitors offering similar solutions, because their expense ratios don't include all the back-end payments to the custodians. So we seek out the lowest cost funds for our clients and we 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 of advisors to use mutual funds in those NTF platforms because they have higher expense ratios because they use 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 as advisors? When clients have sizable assets, we skip the NTF platform, pay the ticket charges instead because it's cheaper for our clients at the expense of the custodian losing revenue. The only clients we put in NTF funds, clients whose accounts are small, where 12b-1 fee is cheaper than paying the ticket charge. Which means we're simply making sure as advisors that it's lose-lose for the custodian.

And then, of course, there's the ticket trading charges themselves which are completely commoditized, 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?" Using rebalancing software to ensure we're trading efficiently. Maybe just if we do a lot of trading, negotiating a fee-based wrap account arrangement anyways for the client or that particular investment strategy with the high-volume trading to bring the total cost down. Basically, it's another lose-lose situation for the custodian.

Because again, the problem is that as RIAs, custodians have put us in the position now where we look better by sticking it to the custodian. The more we play the game and dismantle the custodian's profit centers, the more money we save our clients, and the better we look in front of our clients. And ironically, that means the more fee pressure there is on us as 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 when we could say, "Look at how much money I'm saving you by helping you avoid all these direct and indirect investment expenses," many of which are coming from the custodial platform and used to be the revenue of the custodial platform.

This is the problem when RIA custodians operate a business model that's in fundamental conflict with the advisors they serve.

The Future Of RIA Custody Is Paying A Basis Point Custody Fee [Time - 8:51]

And this is why I think the future of the RIA custody business will eventually be, as RIAs, we will simply pay a basis point custody fee to the custodian instead.

I realize that this is a huge leap relative to the "free" that we are used to getting as RIAs with our custodians, but hear me out on why I think this is actually better for all of us in the long run.

Imagine for a moment that an RIA custodian charged us a custody fee to use their platform, all their tools, all their technology and then all the actual brokerage platform stuff itself and the funds and the ETFs and the stocks and the bonds, we get all of that, and instead of getting it for "free", where they 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 your assets grow.

Which is simply 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 2 on average in ticket charges and a few basis points off the sliver of client assets and NTF funds and then the 50 to 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.

If all the RIA custodians it was our custody fee, we would rightly be pissed off as RIAs because now they're double-dipping, right? They're charging us to use the platform and they're still making money off our clients. But the point here is not to charge us custody fee and to make money off our clients, the point is to charge us a custody fee in lieu of making money off our clients and simply charging a custody fee that averages out to the same dollars they were already making from us anyways when you calculate it as a percentage of the revenue based on the total assets of their platform.

But here's why it matters. Because once the RIA custodian switches their model to a custody fee, now their incentive is not to try to figure out how to gauge more money indirectly from our clients and playing that game with us, now their incentive is actually just to make it the best darn RIA custody platform out there for gathering client assets.

So imagine an RIA custodian that because they don't need to make money off their money market funds because it already earns the uniform custody fee, they pay 1.5% to 2% yields on their money market like other leading online banks, how much more can we attract in clients by having the best money market rates out there? And because the RIA custodian would be making their custody fee, there'd be no ticket charges at all. They're just wrap-trading to the custody fee at that point. Wouldn't it be nice to be able to stop whacking clients with all those ticket charges, which even though they're pretty small, a couple bucks a trade, is still a big nuisance for clients? Now we don't have to decide whether they're going to pay for it or we're going to pay for it, it just vanishes into a custody fee.

And because the RIA custodian will be making their custody fee, I would expect they then go back to all the fund providers and renegotiate new versions of true, clean shares. No 12b-1 fees, no sub-TA fees, no nothing, a special version of advisor class shares where no back-end fees are needed because the custodian is earning their custody fee, which means you get the cheapest funds that exist of any fund company at any time. You don't just have to go to Vanguard or DFA to find the cheapest funds, you can go anywhere because the costs will come down for all of them because we've stripped out the sub-TA fees and the 12b-1 fees because we're simply paying a custody fee.

In other words, once the RIA custodian gets a custody fee, they're free to actually try to give us the best solutions for our clients. The best cash returns, the zero trading costs, the true lowest cost funds. And the custodian doesn't have to care now whether we use Vanguard or whether we use American Funds. And if we do which F class share we use and the one that is the sub-TA fee or not, because all of them would just be uniform low-cost share classes and the fund companies could be urged to make them just to get out of the hot, new RIA custodial platform.

Because what this does in the aggregate is that now instead of us being incentivized to game the system, minimize cash, create workflows and processes to reduce ticket charges, swap it in and out of NTF platforms against the size the client, avoid share classes with sub-TA fees in order to minimize custodial revenues, now we as advisors would actually be incentivized to consolidate client's assets into a common platform that clients would want to use because they have the best solutions, not the ones that make the custodian the most money. We would legitimately be able to have the best solutions in the marketplace. And why wouldn't clients want to consolidate at that point if you actually have the lowest cost options in each category of what you're doing, or the best yield or the lowest rate, the lowest charging rate in a good way?

It helps us as advisors validate our fees for providing that value. And the more we consolidate, the bigger the RIA custodian gets as well because they earn the custody fee on all the assets regardless of the type. That's what happens when the models get aligned. And it also helps the RIA custodian that just won't have to struggle any longer with the fact that passive RIAs are less profitable than active ones that generate more ticket charges. And firms that use rebalancing software are less profitable than those that don't manage the portfolio as well and carry excess cash balances because all the RIAs would be consistently profitable with the platform based on their uniform custody fee. And there wouldn't be incentives to try to game the system anymore. The only incentive we'd have is to grow, which makes everybody win.

The Challenge Of Pivoting To Paid RIA Custody Arrangements [Time - 14:03]

Ironically, though, the fact that not all RIAs are equally profitable right now will actually be one of the biggest blocking points for reinventing the RIA custody model. Because those of us who are already good at playing the game essentially get a below average fee and won't want to switch. We are being subsidized by the subset of firms that are the most profitable because they do a lot of trading or they're not careful with their cash balances. Which means from the RIA custodian's end, the firms gaming the system will want to keep gaming the system by not switching to a custody fee, and the firms that were previously profitable will want to go to the custody fee because they get a price cut, which unfortunately is something the RIA custodians have brought on themselves by misaligning their models with the RIAs they serve.

This was never an issue in the broker-dealer world because broker-dealers are a transactional business and they just got a slice of those transactions. If a custodian charges 5 bucks or 10 bucks a trade, broker-dealer charges 15 bucks and takes the markup. If the custodian makes 50 basis points on cash, the broker-dealer gets another 10, and so on down the line. This was never a necessary shift in the broker-dealer world. The RIA custody model ironically is actually more aligned to broker-dealers, though. It's not aligned to the RIAs they're serving now. This is just what happens when you have a transactional broker-dealer model and you apply it to a relationship-oriented AUM/RIA model.

That's why I think it ultimately has to shift. Because it lets RIAs avoid this constant conflict with their custodial platforms, and it lets custodial platforms grow without being gamed by their RIAs. A true alignment of business model is a powerful thing. I mean, arguably, the alignments to the RIA model is why it's grown so well itself because it better aligns the advisor and the client's interest in an ongoing relationship rather than being transactional. And the same is possible for the RIA custodian and the firms they serve, by making one simple, clean, well-aligned custody fee.

Not blended with having minimums for cash or minimums for trades or other requirements, just one that simply says, "Hey, advisor, you want to break on your fees? Grow bigger and hit the next asset break point." And rather than begging us as advisors to make our clients more profitable for them by trading more or holding more cash or using more expensive funds.

And well, we'll see who makes the shift first. My gut is that some RIA custodian is going to offer this soon, perhaps because of just the competition. As RIAs get better and better at gaming the system, we're bringing all the revenue lines lower and lower for the custodians as a percentage of assets. We may force it at some point anyways. Especially as we get more efficient cash management tools and we start moving cash off custody platforms, it's actually a very material threat 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...

But this is the opportunity for us to actually have the best custody platform we've ever seen with the best fund solutions, the lowest ticket charges, real high yielding money markets along with whatever else they can throw in, lower margin loan rates, lower rates on securities-based lending. Because again, the whole point is that once you price the RIA relationship with a basis point fee, you don't have to nickel and dime the clients to profit on each product line. Instead, the custodians make this product compelling to use with clients and attract RIAs and client assets instead.

I hope this is helpful as just some food for thought about why I think the future of the RIA custodian model is to charge a custody fee, and why even though it's going to feel really awkward for us when we're not used to paying their custody fee, it will ultimately be better in the long run, both for the custodian and for the RIA itself (that gets better than ever solutions to offer their clients), which means, in the end, it's better for the client too.

This is Office Hours with Michael Kitces. We're normally 1 p.m. East Coast time on Tuesdays. Obviously a little bit off today, but thanks for joining us here on Wednesday. Have a great day!

So what do you think? Should RIA custodians start charging a basis point custody fee? Would this business model allow custodians to provide better resources to RIAs? Would a basis point custody fee ultimately be better for clients as well? Please share your thoughts in the comments below!