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Charging AUM fees does not conflict with financial planning

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Okay, I lied. My last blog wasn’t the final chapter in the flat fee/AUM fee debate. But in the immortal words of John Belushi in “Blues Brothers”: “It’s not my fault: a friend came in from out of town, I had a flat tire, the dog ate my homework…” 

Actually, the great comments I received on that blog were just too good, advancing the discussion even further, with more than a couple of new points that warrant exploration.

First, Carolyn McClanahan wrote: “…if I am a ‘financial advisor,’ I am assisting the client with multiple aspects of their financial life—goal planning, cash flow planning, tax planning, investment planning, estate planning and all the other financial curveballs life throws. To charge for all those services based only on investments is denigrating the value of the other services. In my fourteen years in this profession, I have truly come to appreciate that the full financial planning process is extremely important to the main goal financial advisors should help their clients achieve: a life with minimal financial insecurities. By charging only based on AUM, advisors reinforce the incorrect message that it is only the investments that are important.”

This is a very valid concern. It’s also not just a recent one. I can remember financial planners back in the mid-‘80s lamenting that the majority of their peers were compensated through the sale of annuities—one wrote that it was the “dirty little secret” of financial planning. Today, it’s still quite common for planners to feel that financial planning is “denigrated” by basing compensation on AUM fees

Yet while I agreed with that sentiment 30 years ago (that financial planning was being used as a sales tool), the same cannot be said about assets under management. In fact, I’m puzzled by the notion that managing client assets is somehow separate from the “planning process,” because it seems to me that portfolio growth is the engine that drives the financial plan. Which is exactly why the vast majority of clients—both HNW and not so much—have readily accepted AUM fees as an appropriate form of advisor compensation. 

Then, Jim Schwartz, a retired financial planner, one of the founders of NAPFA, the author of the seminal financial planning guide “Enough,” and currently the writer of “Healing Financial Anxiety,” took “financial planning” to another level in his own inimitable style: “AUM compensation is not only a conflict of interest between planner and client (I win maybe you win; I win you lose) but it is inherently in conflict with the essence of personal financial planning: aligning personal financial resources to achieve life goals, values and payoffs.”

“But if the masquerading asset manager in personal financial planning clothing was managing goals instead of relative rate of return then comparison to indexes would be irrelevant. The planner might actually seek to return less than the market though with significantly less risk because the goal has been met or is on target and preservation of capital from risks would be primary. Thus, Dow might be up 15% but all that was necessary for the goal was 8%; why not lower risk to insulate the goal? Why not? Assets under management compensation is reduced.”

This, too, strikes me as a curious argument, particularly coming from one of the founders of the planning profession. Again, for most people, “achieving life goals” depends in large part on the protection and growth of their investment portfolio. Giving a financial advisor an incentive to achieve that growth seems reasonable.

What’s more, it seems inaccurate to claim that AUM-fee charging advisors don’t “lose” when their clients’ portfolios lose value. In fact, it’s quite the opposite: when asset values drop, advisor compensation literally goes down. That’s a loss, in my book. At the same time, if the client doesn’t sell when the market is down (and it’s usually an advisor’s job to see that they don’t), they haven’t “lost” anything.

The same situation exists for risk. Inexplicably, Mr. Schwartz suggests that asset-managing advisors have a financial incentive to urge their clients into taking undo investment risk. Yet both reality and logic contradict this assertion.

Over the years, financial planners have spent countless hours discussing the appropriate stock/bond portfolio mix for clients of various ages and risk profiles. While these advisors have been appropriately concerned that their clients would run out of money, the discussions I’ve heard/read have all focused on taking the lowest risk practicable.

Which, to address the “high-risk” incentive concern, actually makes perfect economic sense for advisors. Higher portfolio risk, by definition, means higher portfolio volatility.

And, as I mentioned, while portfolio volatility costs nothing to clients who ride out the dips, it does decrease AUM fee revenue. So an advisory firm’s actual financial incentive would be to lower portfolio risk and smooth out steadily growing revenues.

Which, to my mind, is a nice identity of interest. Rather than “denigrating” financial planning, asset management fees simply reflect the reality that a plan isn’t worth much without the funding to make it happen—and that financial incentives to act in the client’s best interest are a nice addition to a fiduciary duty


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