Over time, good financial advice can easily make a difference of hundreds of thousands of dollars to a client. So can the way the client is charged for that advice.
Advisory fees have been tied to investing ever since the days when clients paid a percentage of the price of securities bought or sold. As more investors prospered and trading costs shrank, commissions on trading came to be replaced by a percentage of assets under management.
It was only a matter of time before lower-cost competition — technology-driven robo-advisors — aimed squarely at that target. By offering investment planning and management for a fraction of the usual AUM fee, robos (or eRIAs, as Cerulli Associates calls them) have accelerated soul-searching among human advisors who want to differentiate the value they provide.
Willy-nilly, how your firm is compensated becomes part of its business strategy. As industry veteran Matt Lynch put it, “The challenge, if you’re a typical advisor with your own RIA — $100 million to $200 million in assets — is to find a better pricing model and a way to get there without negatively impacting your business.”
A Hodgepodge of an Industry
“If the Investment Advisers Act of 1940 didn't exist and we were going to start from scratch with smart people in a room, the financial services industry wouldn't look like it does today,” said Lynch, managing partner of Strategy & Resources, a financial services consulting firm in Dayton, Ohio. “It's been cobbled together.”
Broker-dealers, custodians, RIAs, tax and accounting professionals, bank investment reps and insurance agents, with a variety of regulators, business models and payment structures, are all lumped together in the popular view as “financial advisors.” As such, they tend to be regarded by consumers (and sometimes by regulators) with a jaundiced eye. Just 23% of consumers have confidence in financial advisors, according to a January 2015 LIMRA survey.
“I see robos driving a change in positioning and how advisors charge,” Lynch said. “The first driver is the market. Consumers want more transparency. This isn't exclusive to high-net-worth clients; it's cascading through most market segments and will flow through to the mass affluent.”
Competitive threats are the second driver of change, in Lynch's opinion. “Robos aren't the first attempt to commoditize investment advice,” he said. “If you think back to the early days of [Vanguard Group founder John] Bogle, the robos, ETFs and new offerings from both Vanguard and Schwab are simply accelerating the growth of this threat.”
The third driver is regulatory interference. From Dodd-Frank to the wrangling at the Securities and Exchange Commission and the Department of Labor over imposing a fiduciary standard of care on all advice givers, real and potential regulation constantly looms over the financial advisory industry.
“To get ahead of these developments, you need to ask, ‘What role am I playing? How am I adding value for the client?’” Lynch said. “If I’m solely an investment manager, am I adding value by improving performance, or am I just outsourcing to asset managers or strategists whom clients could access directly?”
Where Do You Provide Exceptional Value?
“A lot of businesses confuse their regulatory model — RIA, broker-dealer, etc. — with what they actually do,” Lynch observed. If you allow this regulatory label to determine how you get paid, it may lead to a “fundamental disconnect” with your value proposition.
Some advisors’ beliefs about their chief value were summarized by Investment Advisor columnist Bob Clark in a recent ThinkAdvisor.com post: “Financial planning may be what people need, but more money is what they want — and what they will pay for.” This school of thought suggests that a percentage of AUM should be the preferred payment model, since the advisor is rewarded when the client's assets grow and penalized if they shrink.
But does a fee based on investment performance really equate to identity of interest? How objective can an advisor be if the client wants to make charitable gifts or invest in a business, reducing assets under management? What about a client in retirement, who is spending down assets?
In any event, asset growth may not be how the client measures success. As generational change expert Cam Marston has reported, well-educated women have an increasing say in financial decisions. Research shows that they tend to focus on having the wherewithal to meet a lifestyle goal, such as buying a house or traveling in retirement, as opposed to beating a benchmark. Another demographic shift — the proliferation of nontraditional families, as profiled in Allianz's 2014 LoveFamilyMoney study — indicates a need for complex financial planning, not just management of investable assets.
Moreover, while robos may be smart enough to handle asset allocation and tax-loss harvesting, they’re not so good at right-brain stuff. “The hardest thing to manage in our industry is emotions,” said Nathan Bachrach, who is co-founder, chairman and CEO of Simply Money in Cincinnati. “Emotions are what make clients pull their money out at the wrong time, invest at a market high and invest in the wrong things. As an advisor, I get people to do things they need to do, or need to not do, but can't seem to do or stop doing until they come to see me. If robos can figure out how to help people manage their emotions, I’ll have to refigure where the industry is going.”
The Five Models
So what is the fairest way to charge clients? Let's look at five different models.
Model 1: Assets Under Management
Simply Money, which Bachrach described as “a very middle-market firm,” uses an AUM payment model. “It doesn't guarantee growth, but it does align us with the client,” he said. “When we make a recommendation to preserve value or help the client's money grow over time, it puts us on the same side of the table.” It also allows him to smile as he tells a new client, “I hope this is the least I ever charge you.”
Bachrach feels that no other payment model would compensate Simply Money as fairly for the value of its CFP-credentialed advisors’ and analysts’ professionalism and training. Commissions are a nonstarter: The firm wants to get away from a transaction business.
The idea of an hourly billing model has encountered “a lot of resistance,” he said, because “nobody likes to write a check for work [behind the scenes] they didn't see.”
Monthly retainer? The drawback is that to increase revenue, a firm needs to either add clients, which requires staffing up, or ask for a fee increase. “If you do more work, you want to be compensated for it,” Bachrach said. “But I don't like having those [fee] conversations.”
Model 2: AUM Plus Fees for Service
Waldron Private Wealth in Pittsburgh courts a high-end market segment. Its clients (minimum net worth: $5 million) pay individually customized fees that may include asset-based, hourly or fixed charges. “Since we have only 140 clients, we can be flexible in the way we charge,” explained President Matt Helfrich. “AUM is our primary payment method. For larger, more complex accounts, such as those involving multiple generations, we may charge a retainer fee.”
Revenue from AUM and fees is calculated to produce a minimum income of $25,000 a year.
Helfrich noted that any single form of compensation can be flawed. “There's an inherent conflict in the brokerage model,” he said. “Incentive performance is also conflicted. There are conflicts with everything. We believe our hybrid model fairly aligns us with our clients.” Given Waldron's long-time retention rate of more than 97%, the clients seem to agree.
Model 3: Retainers
Suppose the clients you want to serve are still in the early stages of building wealth. Michael Kitces, a partner and director of research at Pinnacle Advisory Group in Columbia, Maryland, spotted an opportunity to serve younger clients — Generations X and Y — who typically can't get in the door with advisors compensated via AUM.
“Young people are focused on cash flow,” he pointed out. “They pay almost everything on a monthly basis. So we decided on a monthly retainer model” for the XY Planning Network, which he co-founded last year to help younger advisors serve younger clients. Members typically charge monthly fees of $99 to $199 a month, and some include an additional onboarding fee of anywhere from $499 to $1,999. In its first 15 months, over 100 advisors joined XYPN with a median age of 35.
Kitces particularly likes the idea that a monthly retainer promotes use of planning services. (You’re already paying for them, so why not take advantage of them?) Going with an hourly billing model, he suggests, makes people more cost-sensitive and can discourage clients from using these services.
Although the XY model is designed to help younger advisors work with younger people, the whole nature of a non-AUM model opens the door to a broader swath of potential clients. It also offers an opportunity to structure fees for the segment that advisors want to serve.
When working with the middle market, for example, “structuring the fee at $1,200 a year may yield very different results than pricing at $100 a month,” Kitces said. “From a client's perspective, $1,200 a year is like buying a giant flat-screen television, whereas $100 a month is more like the monthly cost of cable.”
A client with the cash resources to make a $1,200 payment is probably not living paycheck to paycheck as a $100-a-month client may be. They’re two different market segments.
Model 4: Hourly Rate
Sheryl Garrett is one of the advisory world's leading proponents of an hourly rate payment model (and has appeared on Investment Advisor's IA 25 several times). “I argue that most Americans — well over 80% — need occasional advice rather than a full-time financial planner/advisor/manager, nor can they justify the cost,” said Garrett, a CFP. “The simplicity and clarity of an hourly fee is much easier on everybody. It's easy to describe, and there are no barriers to entry” in the form of minimum asset requirements.
Early on, Garrett discovered that this payment model attracted beginners, middle-income clientele and “validators” — do-it-yourselfers who may have already done a good job of investment planning. Fearing to be sold investment products or investment management services they weren't interested in, this untapped market segment resisted consulting advisors about such issues as a second opinion on their investment portfolio, developing a Social Security strategy, choosing the right homeowners insurance or financing their kids’ college education. With Garrett's hourly model, they could simply ask, “What will it cost me for what I want done?”
“Within a year, three-quarters of my business came from just three other advisors who had minimums and wanted to refer to someone trustworthy,” she said. Leveraging with other professionals helped her serve more clients and generate more revenue than she could have done by herself. Soon afterward she founded the national Garrett Planning Network, to which some 300 like-minded advisors now belong.
Model(s) 5: Other
In some cases, advisory firms have stitched together a patchwork of revenue from AUM, 12b-1 fees, annuity trails and so on. As desirable as it may be to simplify this crazy quilt (if only to have a single regulator), Simply Money's Bachrach noted that older income sources, such as mutual fund 12b-1 trails, may contribute disproportionately to profits. Some advisors may not be eager to throw out this baby with the bathwater.
How Transparent Are Your Charges?
In a June 20 Wall Street Journal article, Bert Whitehead, president of Cambridge Connection in Bloomfield Hills, Michigan, and founder of the fee-only Alliance of Comprehensive Planners, reported being told by a prospective $5 million client that his current advisor charged him 1.5% a year. When Whitehead asked how much money that was, the client guessed, “$7,000 or $8,000?” Sadly, he was off by a factor of 10; 1.5% of $5 million is an eye-opening $75,000 a year.
Similarly, John Dominge, managing partner of Uptrex Wealth Advisors in Sunnyvale, California, was told by a long-time client of a Morgan Stanley broker that her account was free. “Why would you think there's no fee? How could they afford to do that?” Dominge asked. Unfazed, the woman insisted that she was paying nothing for the firm's services.
According to Bachrach, almost 50% of investors with $500,000 and under in assets don't know how they’re being charged or think it's free. “Nobody reads ADVs, which are incredibly informative documents,” he lamented. For example, a client who thinks he's paying his advisor 1% of assets might learn from the ADV that he's paying another 1% to an outside money manager. If you don't know the total cost of ownership, Bachrach said, you’re probably paying too much.
“The most important thing is that people can trust you,” he said. “Everything should be out there in a way that people can understand it and later feel good about it.” If there's a problem with the ADV, it's TMI — too much information. “Too much disclosure is the worst form of disclosure,” Bachrach said. “Disclosure needs to happen in a way that's digestible.”
“A client should be able to say, ‘Oh, so that's how you make your money,’” Helfrich agreed. “It's the responsibility of the financial advisor to educate the client. [The model of] commissions — not telling the client what they’re paying, giving the impression of working for free — that's going by the wayside.” A prospect or client shouldn't have to ask, “So how do you get paid?”
Recapping his point that consumers want more transparency, Lynch said, “Advisors need to consider if their pricing model will stand up to scrutiny. If not, perhaps they should reconsider [that model]. For example, if most investment services can be done by computer and your client just needs your help to keep from making bad decisions, perhaps you shouldn't charge by AUM.” In the final analysis, he said, “If the light of day shone on what you’re actually being paid, would your client still choose to do business with you?”
Kitces, whose XY Planning Network advisors primarily use monthly retainers, likes the fact that “a retainer is very transparent in a world where most payments are a complex percentage-of-assets calculation. You also have the opportunity to take financial planning to places that can't be served by the AUM model.”
However, the greater visibility (or saliency, in Kitces’ term) of retainer payments can backfire, especially when they’re paid annually. He was once told by a fellow planner, “I loved the idea of [a retainer]. But no matter how much work I did for my clients, they really pushed back on writing that annual check.”
In Kitces’ view, AUM is still easier for many clients to accept. “Would you rather pay 1% of AUM or a $10,000 retainer? AUM pricing doesn't feel like a big fee slap in the face.” As a result, he noted, “I’m skeptical about whether AUM will be replaced. It may have far more longevity than some suspect.”
But in a 2012 comment on a Kitces blog post about fee saliency, Cambridge Connection's Whitehead objected, “AUM is easier for most clients because: 1) they cannot convert a percentage to a dollar amount […]; and 2) most clients can't or don't read their brokerage statements so they are never aware of how much they are paying. To me, this just doesn't square with a true fiduciary relationship.”
Hourly-fee advocate Garrett summed up tersely, “As fiduciaries, transparency is our reality. So embrace it.”
In the Client's Best Interest
Transparency is one aspect of a quality shared by many RIAs: a moral commitment not just to put clients’ interests first, but to help them live more financially secure lives. Dominge is baffled by debates about the fiduciary standard. “Don't I have a fiduciary responsibility every day? Shouldn't it go without saying?” he said. “Imagine an ad where a firm says, ‘We put our own interest ahead of yours.’ You think we’ll ever see that ad?” He wants consumers to expect their advisor to be a fiduciary. “This is a tough way to make a living if you’re not interested in doing the right thing.”
“I’m 100% behind the SEC and DOL,” Garrett agreed. “There should be one set of rules, a high standard of care.”
Noting LIMRA's low ranking of consumer confidence in financial advisors, Kitces pointed to the industry itself. “Anyone who wants to be a financial advisor only needs to earn a high school diploma and take a one- to two-hour regulatory — not competency — exam,” he said. “We don't evaluate new advisors for knowledge. That's why so many do a terrible job and produce terrible outcomes.”
So fiduciaries’ “best interests” standard alone isn't the answer. As Kitces cautioned, an advisor who adheres to the duty of loyalty can still cause massive financial harm if he's ignorant. In any comparison with what it takes to qualify for a securities license, he said, CFP certification is “light years ahead” as a competency standard.
Consumer Expectations: Be Transparent
“If the industry doesn't lead and come up with reasonable changes going forward, then the government will step in and make changes for us,” Lynch predicted. He blames weak industry leadership on a lack of pressure so far from confused consumers. “Consumers don't understand the difference between suitability and a fiduciary standard,” he said. “And because of the way regulation has worked, consumers can't get access to information. The infrastructure hinders transparency.”
Advisors need to get ahead of the regulatory curve by making sure that the way they charge and the services they deliver are in sync with what consumers expect. “The consumer needs to know, ‘What is it costing me to do business with you, the advisor?’” he emphasized. “Advisors need to draw the supply chain for the client, showing the components and explaining what each one does and how they add value.”
“If you’re forthright, you’ll never have to worry about buyer's remorse or sticker shock,” agreed Simply Money's Bachrach. “Every quarter, your client will have a chance to say, ‘Were they worth it?’”
It appears that no advisors or consulting firms have ever polled clients to ask if what they’re being charged feels fair. High retention rates may imply that clients are satisfied with what they pay — but it's questionable how many of them really know what that is.
“In school, there are two things we never learn: how to raise children and how to manage money,” Bachrach noted.
Lynch concurred: “High school students are receiving little education in economics. And we see little interest in financial services careers. The industry needs to step up to its responsibility to get out there and educate them.”
“I’ve given talks to 13- to 14-year-olds in junior high school who had credit cards, but couldn't explain how credit card companies make their money,” Dominge said. “And in pro bono seminars at senior centers, I quickly learned that I was talking at too high a level. People didn't know the difference between a stock and a bond.”
Get Going or Get Out of the Way
“Given that different elements of our industry have different rules and different regulators,” argued Dominge, “advisors need to figure out ‘How do we build trust while better regulating ourselves?’”
There's no advantage to further delay. “In response to a few bad apples, the common reaction is more regulations — ‘Let's have clients sign three more forms,’” he said. “But this emphasis on disclosures is burdensome and sometimes confusing. More forms don't always equate to more clarity, as every home buyer knows who's been handed a stack of mortgage documents to sign.
“I believe most advisors are trying to do the right thing to the best of their ability,” Dominge continued. “It starts with being up-front about how you’re paid. The more people understand what they are paying for and why, that's what will move us forward.”
Lynch, too, contended that consumer education is necessary to rebuild trust in financial advisors. “The industry has a job to do to win back the confidence of the consumer with greater transparency, unbundling [of services], compensation per product and retainers.”
“Ours is the last great industry not touched by consumerism,” added Bachrach. “It will be interesting to watch how it affects our business.”
Where Do We Go From Here?
At Waldron Private Wealth, Helfrich sees the most significant change in advisory compensation occurring in the mass affluent segment. “Wealthfront and other robo-advisors are creating a payment ceiling for investment-only financial services,” he said. Robos’ AUM-based fees, currently ranging from 0.15% (Betterment) to 0.50% (SigFig), will compress revenue for professionals dependent on portfolio management for their bread and butter. “There will be real pressure on business models in the $250,000 to $1 million space,” Helfrich said, “but less so with high-net-worth and ultra-high-net-worth accounts, given their inherent increase in complexity.”
Uptrex's Dominge is optimistic about the impact of the robos. “I think they’ll make us better as an industry. They’re going to pull people into investing in their 20s and 30s. It may not be profitable, but it's a very positive thing.” Will robos’ clients recognize if and when they need more comprehensive, hands-on advice from a trained financial professional? Dominge acknowledged a lot of discussion on that point. “My guess is yes, when their life becomes more complicated with home and family needs.” A bear market might also drive investors from an impersonal robo to an empathetic advisor who has guided clients through previous downturns.
Bachrach sees robos in a future hybrid role with advisors, doing the power lifting of data crunches and account administration. “We’re money-life managers,” he said. “That's what CFPs should be spending their time doing. When a client is trying to decide, ‘Should I lease or buy, take out a HELOC or get a low-rate auto loan?’ you want them to say, ‘Wait a minute. Let's call Simply Money.’”
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