In response to my last two blogs on the subject of advisor compensation (“Why AUM Fees Still Make (Im) Perfect Sense,” and “The Pros and Cons of Flat Fees, Part 2”), a commenter by the name of “III Financial,” who appears to be a practicing independent advisor, posted some insightful comments and observations that illuminate some key points and advance the discussion.
Perhaps most important, he points out that “there is nothing inherently evil about any form of compensation, because each can be the best solution and each can be abused.” Not only does this statement avoid the hyperbole that’s found its way into the discussion so far, it sets the stage for a reasonable exchange of views on the subject.
Next, he asserts: “You seem to be muddling ‘flat-fee’ with ‘hourly’ though.” Well, yes and no. I understand that there are significant differences between the two forms of compensation, but I cited hourly fees as an example of the unintended consequences that arise from a seemingly “much better” ways for financial advisors to get paid. Based in the anecdotal feedback that I’ve heard over the years, while hourly fees did eliminate some of the conflicts inherent in AUM fees, they tend to be more labor-intensive and less valuable in transitions. Consequently, many formerly hourly-fee-only advisors have reverted to adding AUM fees to their practices.
Flat fees have some drawbacks too, that seem to be overlooked by their advocates. For instance, I foresee three potential unintended consequences. First, firms that solely use flat-fee compensation will find it hard to raise their fees to keep pace with inflation and expenses. I suspect periodically having to go hat-in-hand to their clients to justify a higher fee will prove uncomfortable to many advisors. So I’m guessing they’ll tend to put it off as long as possible, and then when circumstances force them to do it, they’ll end up asking for increases that are way too small.
Second, due to this reticence to raise fees, flat fees will dramatically fail to keep pace with AUM fees which increase with the markets, making flat-fee firms worth quite a bit less upon transition, even if those firms are valued at the same multiples. And third, because they are so new, if flat-fees were to catch on, clients won’t have any basis to determine a “reasonable” fee—and as we saw with AUM fees until recently, some less-than-client-centered advisors will overcharge their clients.
Finally, there’s the question of identity of interest, which III Financial addresses this way: “And why is the AUM better because it rewards increasing account values and punishes lower values? We all know that we diversify and set portfolios for success, but we cannot control the market. When I used AUM, I'd watch the account balances at the end of the quarter, even though I had no control over the outcome.”
No control over the outcome?
From where I sit, advisors who have discretion over client assets under management have almost total control of “the outcome:”
They could invest in Treasuries or CDs, for instance. Or advise clients to buy fixed annuities.
No, I’m not being facetious. The point is that most independent advisors have convinced their clients to take more risk in their portfolios, under the theory that while markets may occasionally go down, they always go back up. Then, if the client stays invested long enough, they will end up with much more money than if they bought the “low-risk” alternatives.
What message does it send if the advisor has so little confidence in this long-term investing “theory” that they want to take the no-risk option themselves and get paid a flat fee? AUM fees put the advisor on the same side of the equation as their clients: if the clients make money, the advisor makes money. If the client’s assets go down, the advisor’s compensation goes down.
This is how mutual fund companies get paid, and how institutional managers get paid. All you really need to know is that most wealthy people prefer to pay AUM fees.
We invite you to view the prior blogs in this series by Bob Clark (in chronological order), a guest blog by planner James Osborne on the subject and to join the discussion.