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 actually 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’re 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. That‘s not small money.

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. On fees:
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, 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 only about two 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.

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% to 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 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 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 simply 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 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.

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 for a moment 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 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 two 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.

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, no nothing — a special version of advisor class shares where no back-end fees were needed because the custodian would be earning their 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, we as 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. The only incentive we’d have is to grow, which makes everybody win.

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 broker-dealers, who simply received a slice of those transactions; if a custodian charged $5 or $10 a trade, the broker-dealer 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 ultimately why I believe a shift has to occur. RIAs would avoid constant conflict with their custodial platforms, while the platforms themselves would grow without being gamed by their RIAs. A true alignment of business models is a powerful thing.

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.

So we’ll see who makes the shift first. 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.

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.

Michael Kitces

Michael Kitces

Michael Kitces, CFP, a Financial Planning contributing writer, is a partner and director of wealth management at Pinnacle Advisory Group in Columbia, Maryland; co-founder of the XY Planning Network; and publisher of the planning blog Nerd’s Eye View. Follow him on Twitter at @MichaelKitces.