Thirty years ago, Bob Veres gave me my first job as a financial journalist. Since then, I’ve grown to respect both his insight into the financial services industry and his commitment to the profession of independent advice. Over the years, Bob’s been right about a lot things: but like most of us, he hasn’t been right about everything.
Case in point is his June 11 posting on Financial-Planning.com titled Why the AUM Fee Is Toast.
As the title suggests, Bob’s contention is that the independent advisory world is moving away from AUM fees, and toward some form of annual retainer or other flat fees. While he has done quite a bit of work on the fee issue, in his article he cites this experience in support of what he calls “the trend.”
“At a recent NAPFA conference, I asked everyone in the audience to raise their hands if they were charging their clients based on assets under management. Virtually every hand went up. Then I asked how many of them were considering a switch to retainers or other fixed compensation at some point in the next couple of years. Once again, virtually every hand went up. Does that look like a trend to you?”
I don’t know about you, but my answer would be “yes and no.” That is, I’ve always had great respect for NAPFA (not that the organization hasn’t made its mistakes) and its members, but they do offer a rather small sampling of the independent advisory world, and haven’t always exhibited, shall we say, the height of business acumen. What’s more, in the often-trendy independent advisory world, I’m not sure that “considering a switch” sometime in the vague future constitutes hard evidence.
Still, Bob is right that moving away from AUM fees has a number of vocal advocates these days, as well as a few skeptics (including yours truly). To move the discussion along, Veres addresses some of the “most urgent objections,” because “…it’s important to consider some of the reasons why so many advisors are now, for the first time, planning to make this complicated transition.”
Here are the four issues he discusses, in my order, not his:
1. Blatant Inequality
“Many advisory firms, when they run the numbers, are shocked to discover that 80% of their clients are unprofitable… …At the other end of the spectrum, a few wealthy-but-undemanding clients are subsidizing the services provided to the rest. Is that fair?
This is very curious question: Assuming that the AUM fees for both small and large clients are reasonable, I’m not sure where “unfairness” enters into the equation, especially since most firms offer lower percentage fees to wealthier clients. If larger clients are in effect subsidizing smaller clients, to my mind this is purely a business question. Moreover, while many advisory firms arguably don’t operate as efficiently as they might, under most conditions this arrangement makes good business sense.
Consider: an advisory firm has five wealthy clients that generate $500,000 in annual AUM fees. To service those clients, the owner-advisor has a junior advisor and three staffers. They’re all making good money, but no one is working near their full capacity. But if they take on 15 smaller clients, they can generate an additional $300,000 in fees, with no appreciable increase in overhead. Sure, they couldn’t afford to work with the smaller clients alone, but who’s being harmed here? The wealthy clients get the same high-quality advice, the smaller clients also get high-quality advice, and everyone in the firm makes more money.
2. Conflicts of Interest
Charging based on assets introduces extra conflicts of interest. Veres offers an example of a client who asks for advice about taking $500,000 out of his securities portfolio to invest in a business.
“If the advisor says no, and he’s paid based on assets under management, wouldn’t a client wonder if he was simply protecting $5,000 a year in revenue? And if he says yes, it just cost him $5,000 in revenue to give good advice. Does that make any sense?”
First, this isn’t the conflict that most anti-AUM fee advocates cite. More common are paying off client mortgages, holding non-portfolio cash reserves, and/or gifting to relatives or charities. All are valid concerns. AUM fees aren’t conflict free; no business model is. But the good news is that these are clearly transparent conflicts to the clients, and therefore are easily managed. Advisors should have consistently applied guidelines for how they arrive at their advice in each situation, clearly disclose their conflict and let the clients make their final decision.
But the other side to the conflict-of-interest coin is the “identity of interest” with the clients that AUM fees create: When client portfolios increase in value, the advisors make more money, too. As I client, I prefer that arrangement, rather than a flat fee that pays the advisor the same no matter how my portfolio performs.
3. Revenue Mismatch
Veres writes: “The AUM model creates a dangerous countercyclical mismatch between revenues and workload at your firm. In most other businesses, if you run into a downturn, your firm will consequently have less business to do. You weather the storm by laying off workers or cutting capacity.”
Having been an employee of six financial/publishing firms over the years, I can safely say this isn’t really how those businesses work, either. With that said, the cycle nature of markets is certainly a challenge for independent advisors. Yet as many industry consultants will attest, many of the problems are self inflicted.
Inexplicably (as with financial publishers), many advisors run their firms as if bull markets will never end. Then they are “shocked” when client portfolios take an inevitable hit. However, the smart firms circle the wagons after extended bull runs, and weather the storms virtually pain free. Once again, the identity of interest with the clients should not be understated: when portfolios go down, advisors make less. I haven’t seen a poll on this, but I can’t help but think that this isn’t not a bad thing in the eyes of most clients.
4. Where’s Your Value?
To illustrate how “getting paid based on assets leads people to misunderstand where the great majority of [an advisor's] value lies, Bob tells a story about an advisor who explained his AUM fee structure to a wealthy prospect.
The prospect responded by saying: “If I let you manage my $6 million portfolio, you’ll charge a percentage of the assets and also provide financial planning services, right? Suppose I give you just $1 million? Would you still give me financial planning advice?”
Back in 1987, a prominent financial planner called it “the dirty little secret of financial planning.” That is, few financial planners actually get paid for doing financial planning. For the past 40 years, planners have lamented this fact, and the current flat fee movement is just more of the same. Financial planning may be what people need, but more money is what they want—and what they will pay for.
Financial planning is a tool that strengthens an advisor/client relationship by increasing the client’s peace of mind.
The current AUM fee model is gaining momentum with advisors in every area of retail finance services—brokerage, insurance, banking, accounting, etc.—for a reason.
There’s nothing wrong with trying to improve on an old model, but in our zeal to make things better, we need to remember why we went to the old model in the first place, so we don’t end up repeating history and making things worse.