Once again, the thoughtful comments on my last blog (“Flat Fees or a Fee on AUM, Part III: Revenge of the Assets”) raise a number of issues that advance the discussion of whether flat retainer fees will be the new compensation model of choice for independent financial advisors. But before we get to those, we should probably clear up what appears to be a bit of confusion about what proponents mean by “flat fees,” as illustrated by this comment by Jon Sullivan: “One drawback to the retainer model is this: lower-service clients are in effect subsidizing higher-service clients. If you have one client who needs 3 hours of your time per year and another that requires 12 hours yet both pay the same annual retainer, the former is subsidizing the latter's extra time spent with the advisor.”
It’s my understanding from talking with advisors who use the “flat fee” model, both recently and over the years, that “flat” refers to a pre-agreed fixed dollar amount that a client will pay, annually or quarterly, which would remain constant until both parties agree on a change. Far more often than not, the advisor determines the amount of the flat fee by considering the amount of work each client will require, based in large part on the size of the client’s investment portfolio.
In this way, the initial fees often closely mirror the amount an annual AUM fee would have been. Consequently, larger clients (or clients with special needs) usually pay more for their higher level of service. So the question of some clients subsidizing other clients doesn’t really come up much.
As I’ve written, a major challenge for flat fee advisors will be to regularly raise their fees to keep pace with AUM fees on growing portfolios. Elliot Weir of III Financial believes he can: “If we are truly adding value, can point to increases in account value, and can provide comparable fees (re: AUM) and service models, then raising fees seems easier to me than justifying an AUM fee increase for no perceived difference in value delivered.”
I don’t take issue that in a “rational” world things should work this way: but human nature being what it is, I have my doubts about clients being that rational, and about whether most flat-fee advisors will bring themselves to have those discussions every couple of years.
The size of client fees, whether flat or AUM, also raised questions about fairness. Brett Alexander wrote: “In my humble opinion the flat-fee vs. AUM debate is really a glossing over of what each adviser and the advisory profession in general should be asking themselves, which is, ‘What is a fair compensation for the services my firm provides?’ …Most firms charge way too much for both [asset management and financial planning]. One can debate what the appropriate annual fee is for AUM, but if most of the greybeards were to be injected with truth serum, we would willingly admit that the standard 1% fee far exceeds a fair fee."
A quick look in the mirror reveals a preponderance of grey in my beard, so perhaps that qualifies me to reply (despite the comment on one of the Twitter discussions that I’m clearly too old to understand the subtle nuances of the brilliance of flat fees).
Many years ago, I shared the sentiment that AUM fees were too high—and that was even before the breakaway brokers jacked up the top end for management fees to well over 2%. But over time, the question of “value” has reshaped my thinking. Among academics and analysts, a 30-year debate has raged over whether active mutual fund and institutional managers can add even 1% annually in value over time, compared to their relevant indexes.
But the “downside” for retail clients isn’t underperforming an index, it’s being out of the market altogether at the wrong time—or worse, it’s investing in products with loads so high they negate all the returns, or simply losing their investments in some long-shot deal they heard about at the country club. What’s it worth for unsophisticated investors to be protected from the darker side of the financial services world? ‘Priceless’ may be overstating it, but 1% sounds pretty good to me.
What’s more, fairness in advisor compensation is about more than the size of the fees. It’s also about incentives, and the conflicts they create with the clients’ best interests. To my mind, one of the major advantages of AUM fees is that if advisors are successful in achieving one of their primary goals—to grow client assets over time—their compensation automatically goes up.
To most clients that is “truly adding value,” a very tangible value they can relate to. Frankly, I wish more of my professional and business relationships were on the same basis: that both my mechanic and Chevrolet got paid more for every year my pickup stays on the road; that my doctor got paid more for every year I didn’t have a major illness; and my dentist got paid more for every year I didn’t need another root canal. And I happily pay a financial advisor more when my assets are growing. It’s hard to argue with success.