Wrap Fees: The 1% Dilution.
Wrap fees are the industry's method for monetizing inactive accounts. It is an annual fee intended to cover all account charges. Wrap fees specifically exclude portfolio management or advisory services. The fee primarily covers all trading commissions, and provides enhanced reporting and access to research. Historically, 80% of a broker's commissions are derived from 20% of his or her clients. Wrap fees change that reality as every account, active or inactive, generates revenues. Actively traded accounts, typically short-term trading accounts, will benefit from the wrap fee, but for lightly traded income accounts, wrap fees simply add an additional hurdle to long-term growth.
Characteristically, the only trading in income accounts derives from the distribution activity, most of it automated. Paying 1%/yr actually translates to 15%-20% of total annual distributions assuming investors withdraw 4%-5% annually and pay a 1% fee. Essentially you're giving away a 1% interest in your assets for what is normally available without the fee. FINRA, the self regulatory organization for the brokerage industry, issued Notice to Members 03-68 which states the responsibility to assure that fees are suitable, particularly for those inactively traded accounts. Click the notice and read it.
The business of Wrap Fee based accounts is called "Asset Gathering". The more assets under a fee, the greater the revenue. Like most investors, Asset Gatherers want to grow their Assets Under Management (AUM). There are only two ways to do that, find more investors or grow the assets. An adviser with $50 million of AUM will generate $500,000 in fees. Ideally, if the AUM are kept in equities growing at 8%/year, they will grow to $100 million in ten years, doubling fees to $1,000,000 simply by riding the market over time. This in fact is one of the arguments firms use to incent advisers to "sell" wrap fee accounts and to gather assets.
Of course this also creates a perverse incentive to concentrate assets in growth equities regardless of the ongoing distributions and the attending risks. It is also a conflict of interest, as bonds and fixed income instruments are charged substantially reduced fees of 20-30 basis points on average and do not grow. Saving 70 basis points a year for 20+ years will have a substantial long-term benefit for the investor. If you're 95 and on dialysis none of this might matter, but if you're age 50 to 70 and expecting to retire on the income generated out of your investments and still preserve principal, it will make all the difference when you reach 80.
Finally, portfolios are scalable based upon objectives, and identical allocations and mutual funds are often recommended regardless of whether the portfolio is $500,000 or $2,000,000. The annual wrap fee is $5,000 for the small portfolio yet $20,000 for the larger account from the outset and should double every 10 years or so. Considering identical benefits are available for $5,000/yr, why are wealthy investors paying exponentially higher fees in return for very little benefit. Even Finra, the regulatory organizion admits that paying commissions in inactive or income accounts will usually result in substantial savings; are the additional benefits, research and enhanced reporting worth their cost? Generally not! See Notice to Members 03-68.
In 2003, I wrote on the subject in an Bar Journal article, Click to read.
To see the impact of 1% see the table discussed in detail in my previous post, "Adviser Fee Reality".