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Practice Management > Compensation and Fees

Upping the Ante

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In my April 3 blog (See “What Morningstar’s FeeCheck Tells Us About AUM Fees,”, I wrote that because FeeCheck is based primarily on data from brokers, the high AUM fee levels it references and recommends—from 1.6% to 2.5% on a vanilla portfolio—don’t reflect what’s currently being charged in the fiduciary investment advisor market. With that said, the one takeaway in the FeeCheck data for independent advisors is this: There may be room in the retail market to raise their fees.

Dan Inveen of FA Insight recently echoed this sentiment when he told me, “A close examination of pricing practices from across the [independent advisory] industry reveals great opportunity to better leverage pricing as a means for creating more sustainable growth and profitability.” Inveen and his partner at FA Insight, Eliza De Pardo, are possibly the only two consultants today who have the data to back up this claim. They recently published a paper, “Pricing Strategies to Create Growth: An Independent Advisor’s Guide,” based on data from their 2011 advisor survey and created the Pricing Your Advice tool for Pershing Advisor Services. In their work, Inveen and De Pardo provide an intriguing solution to the question that has dogged independent advisors since the creation of financial planning in the early 1970s: How much should they charge their clients? Their answer—value-based pricing—may be the best calculator yet. Whether clients will go along with it is still up in the air.

About 25 years ago, an advisor wrote a letter to me in which he described what he called “the dirty little secret” of financial planning: Retail clients won’t pay directly for planning. He is as right today as he was then. Over the years, advisors have gotten paid for financial planning through nearly every means possible, except directly: selling mutual funds, tax shelters, limited partnerships, annuities and, starting around 1990 or so, fees for managing assets.

AUM fees have revolutionized the business of financial advisors: According to FA Insight data, in 2010, 90% of independent advisory clients were charged using an AUM fee only. Of course, AUM fees are far from a perfect compensation model. To start with, as Morningstar data shows, there’s a built-in incentive to overcharge trusting clients. 

For independent advisors, the larger issues with AUM fees are two-fold: As became painfully clear in the aftermath of the 2007-2008 market meltdown, revenues tied to assets create substantial challenges when the value of those assets falls dramatically. Both advisors and their clients would like to believe those are isolated incidents. But the reality is that we’ve seen major market declines four times in the past 25 years—’87, ’91, ’01 and ’07—suggesting that these dips in assets and revenues should be treated as business cycle-as-usual.

The advisory business is already in the first stages of a long-term trend toward depleting asset bases as growing numbers of clients transition into the retirement phase of their lives. As this phenomenon continues to gain momentum, advisors will increasingly have to wrestle with declining revenues per client, while those clients become ever more costly to service.

With these revenue pressures in mind, Inveen and De Pardo made a couple of interesting discoveries while analyzing the data from their most recent advisor survey. First, they noticed that fully 50% of the most successful advisory firms, which they call “standout innovators” (the top 33% of firms with more than $3 million in annual revenues), actively review their pricing structures at least once a year and adjust their fees accordingly. “This is a key practice in supporting dramatically stronger profitability per client,” says Inveen. “We don’t know what adjustments they make, but we do know they use either the cost or the value of their services to make those adjustments. What’s more, only 19% of all the firms we surveyed determine pricing levels primarily on the costs associated with their services. Clearly, firms can and should pay closer attention to firm profitability [and] value when pricing.”

To help advisors get a handle on service profitability, Inveen and De Pardo recommend that firms calculate the “break-even point” for each client. This can be a complex and timely exercise, but they’ve created a system to greatly simplify the process. First, they suggest making two firm-wide calculations: the average overhead per client and the average labor costs per client (the total compensation of all advisors and all staff divided by the number of clients). Combining those two figures gives the average cost per client. Then they suggest including an additional “projected profit” figure: 25% in their examples. The total figure creates a baseline service cost per client.

Inveen and De Pardo then segment clients into high, average and low groups based on the complexity of service they require. By multiplying the firm’s average cost of service per client by either 150% (high), 100% (average), or 50% (low), firms can compare the actual costs of the services they provide to each client, which can be compared with what each client actually pays, to determine whether their fees should be adjusted.

This brings us to FA Insight’s second observation: “In 2010, 56% of all firms reported employing some form of a value-based pricing structure. Use of value-based pricing increases to 70% when we examine the practices of the largest and most successful firms,” they wrote.

Yet, they weren’t entirely comfortable with simply using averages in their calculations. “A true value-based pricing model requires a firm to determine the level of value delivered to each client,” says De Pardo, “and an appropriate fee level based on this value. We think the calculation should be broadened to include both tangible and intangible value outcomes: the financial benefits of lower debt, savings on insurance [and] taxes, investment performance, etc., and softer benefits like peace of mind and trust in one’s advisor.”

Now, they are truly headed into uncharted territory. Their idea is to calculate—on a client-by-client basis—the actual dollars a firm has saved its clients, those gained by prudent investment management, and an estimate of the value of the intangibles. Then, compare that figure to the fee that each client is already paying, and if the “value added” is indeed higher, increase the client’s fee through higher percentage, an additional flat fee or both.

There are myriad problems with quantifying even tangible values added: Should clients really pay for lower insurance costs every year, forever? What’s the value of restructuring debt? What’s excessively good investment performance? (Do clients get a rebate if their portfolios underperform in a given year?) And, what firms, other than the very largest, have the resources to make these calculations every year?

But the biggest problem with value-based pricing isn’t how to make the calculations—it’s how to explain them to clients. To their credit, Inveen and De Pardo don’t recommend sharing their calculations with clients: This would obviously raise more questions than it would answer.

History tells us that effectively communicating the added value of comprehensive advice is an uphill battle—and getting clients to pay for it is a losing one. I’m guessing that the ultimate solution will be for advisors to use a system like FA Insight’s to calculate their “added value” and increase their AUM fees accordingly. That way, advisors can feel justified in what they charge, and clients won’t have to bend their minds around a new comp structure.

That begs one last question: Has it really been long enough since the Great Recession to start talking about raising fees?

“The environment is increasingly conducive to advisors talking to clients about fee changes,” answers Inveen. “And, given today’s challenges, something certainly has to give on the advisor side of equation.” Adds De Pardo: “We’ve had robust discussions with clients on fee models. At the end of the day, they weren’t concerned as long as they understood it and they felt that they are receiving value.” Probably wouldn’t hurt to have a list of answers to overcome client objections, just in case.