Charles Schwab made its planned acquisition of TD Ameritrade official on Monday, and the news caused many to question the impact on the firms’ registered investment advisor custody units. For one, some industry observers expect the acquisition to lead Schwab to start charging a basis point fee for custody services, which have traditionally been paid for through cash balances, order flow, transaction fees and 12b-1 fees, many of which are disappearing as sources of revenue.
“In short, I’d say we are seeing the start of a winner-take-all struggle between Fidelity and Schwab,” said Will Trout, head of wealth management at Celent. “We should expect the ‘Big Two’ custodians to start charging advisors for custody services—I think generally they will start to be a lot more frugal with their advisor networks,” he said.
Mike Durbin, president of Fidelity Institutional, recently told editors at a Wealthmanagement.com roundtable that a “not insignificant minority” of advisors who custody with that brokerage firm already operate under a fee-based model. Schwab currently does not charge for custody. Until the deal closes, which the company expects in the second half of 2020, the two firms will remain separate entities, so Schwab would not make any changes until the integration efforts begin.
Currently, most RIAs don’t pay for custody services; the firms make money in other ways, but many of these revenue sources are drying up. Schwab made the first move in early October to eliminate trading fees altogether, and competitors followed suit. And as the Fed continues to slash interest rates, the revenue on cash accounts could go away. Regulators are increasingly scrutinizing sales of share classes with 12b-1 fees, and the vast majority of fund flows are going to investments without these fees.
It would make sense to start charging RIAs, many industry leaders argue, as it would provide a more predictable and stable revenue source.
“It’s really hard to believe there’s going to be free RIA custody for the long term in the future,” said Aaron Klein, CEO of Riskalyze. “It’s hard to believe you can afford to do RIA custody without transaction fees or asset-based fees. If you’re a custodian, you’re making money only on cash balances, maybe order flow and then maybe the last vestiges of the 12b-1 revenue, which everybody believes it’s rapidly going away.”
Schwab also makes money on selling order flow, which Klein argues is an opaque process, and not even the brokerages know whether investors are being disadvantaged or not.
“At the end of the day, custody has value and it’s going to be interesting to see how the industry makes this transition,” Klein said. “There are a lot of advisory firms out there who effectively have been enjoying the enhanced margins of not having any real direct cost for custody.”
The simplest way for RIAs to deal with the additional custody charges would be to total all of the other costs into one additional “platform fee,” which they charge on top of their advisory fee, Klein and others argue.
“They’re going to have to create good messaging to help their clients understand why their costs are going up,” he said.
He and others expect asset-based pricing to vary by custody largely based on the trading patterns that an RIA has exhibited in the past.
“It’s fascinating to me how the custody business still today is largely based on highly personalized pricing with wide variances in how that pricing plays out from one firm to another.”
The Impact on Smaller RIAs
Perhaps the hardest hit by a basis point custody fee will be smaller advisors. While Schwab made a decision several years ago to focus on larger RIAs, TD Ameritrade has continued to service and attract smaller advisors.
“The greatest question facing RIAs after this merger is, will the new Schwab have room for smaller RIAs? Nobody is clear on that yet,” Klein said.
Peter Mallouk, president of Creative Planning, which manages $45 billion in assets, does not expect Schwab to change its policy and start working with smaller RIAs.
“They're either going to boot them out, or they're going to quickly introduce a basis point fee to those RIAs,” he said. “And I think once they see how that goes, they’re going to start to move upstream to the larger RIAs, $100 million, $500 million and so on and charging them fees as well.”
Mallouk expects Schwab to start charging 2 to 3 basis points at first, then other custodians will match, and it will become a trend. That doesn’t sound like a lot, but it could be 20% of a firm’s margins.
“The one checkpoint in the market that was the most aggressive at accommodating smaller RIAs is gone; that was TD Ameritrade. So Fidelity and Schwab without a TD Ameritrade have much less reason to be competitive.” “There’s going to be some tipping point, and it might be a year from now, it might be four years from now, where it’s going to get extremely difficult for smaller firms to compete. This was not a feeling I had too long ago.”
Trout doesn’t believe Schwab will simply boot out the smaller RIAs, although their service levels may diminish. For example, maybe they’ll shift them from a sort of relationship or account manager to a call center model.
“You could get to a tipping point where Schwab starts to push its weight around with regards to the advisors—not thinking they’ll dump them, but they’ll definitely squeeze them and compete against them,” Trout said. “That’s kind of like the third rail of custodial politics—that competition.”
But a poor level of service may hit an advisor’s margins more than you think. Dan Skiles, president of Shareholders Service Group, which serves some 1,600 RIA firms, said poor service compromises an RIA’s economics and efficiency. Skiles likes to remind advisors he speaks with of his firm’s same-day guarantee: Any service request that comes in before noon gets addressed the same day.
When discussing the quandaries diminished service levels might present for the industry—whether large firm or small—Skiles notes that something much discussed in the industry of late, paying for service with basis points, has to be on the table.
“Everyone understands that it costs more to get better service and some advisors are clearly thinking that they are going to have to pay the custodian for better service in this new world, especially if they don’t hold a lot of cash and they don’t trade enough,” said Skiles.
Steve Lockshin, founder and principal of AdvicePeriod, said charging a fee for custody can be a good thing; it can push forward the idea of appropriate fees for appropriate services. His firm, for instance, charges a fixed fee for 95% of the business.
“I think the long-term solution will hopefully be more of a capitalist structure, where they say, ‘Hey, we’re providing a service that’s of value. We want to charge an appropriate fee for that. It’s linked to complexity, value, etc.’”
Additional reporting by Davis Janowski