During the past few months, there has been considerable discussion about the relative advantages of charging clients flat retainer fees as opposed to AUM fees: in conferences, in the media (such as my ThinkAdvisor.com blog) and particularly on industry websites. I’ve tried to keep abreast of the exploding number of conversations, and despite my bias toward AUM fees (both as an advisory client and an industry observer), what follows are what I believe to be the most salient and popular points on both sides of the argument.
Flat retainer fees create fewer conflicts with advisory clients. On the surface, this assertion is true. While AUM fee compensation in an independent advisory firm eliminates many of the conflicts inherent in commission sales (churning, heavily loaded products, etc.), it still involves other conflicts, including clients’ outside business investments, paying down one’s mortgage, cash reserves and gifting. Yet many AUM advocates (including me) feel that this view only looks at one side of the equation, ignoring the client benefits that are lost in a flat retainer relationship.
The biggest casualty of flat fees is the loss of the alignment of advisors’ financial interests with client interests. When client portfolios grow (which is the primary reason people retain an advisor), their advisor’s compensation grows proportionately. This identity of interest from AUM fees isn’t found in any other financial services relationships. A number of advisors have pointed out that this relationship creates a motivation to encourage clients to make decisions in their own best interest, including investing in growth-oriented portfolios, staying the course in down markets and taking the time to educate clients about investing and the financial services industry — incentives that are lacking in flat-fee relationships. In fact, more than one observer noted that flat fees create an incentive to spend the least amount of time working with the largest number of clients possible.
AUM fees send the wrong message. I think it’s fair to say that nearly all flat fee advocates are troubled by the perception created by AUM fees that their only value is managing portfolios. Yet it’s not clear to me and other observers how flat fees solve this perception problem: The clients still pay one fee, and the result they see is the growth or decline of their investment portfolios. Virtually since the day the financial planning movement began back in 1971, financial planners have tried to get paid solely for financial planning, and except for a few, very rare cases, they’ve failed every time. In my view, this is because from the start, financial planners have focused on the wrong thing. I know this is hard for many financial planners to hear, but most people don’t care how their advisor guides them to financial security, as long as they get the job done. While many people see the wisdom in using a financial plan to help them get there, that’s not what they’re paying for any more than we pay our doctors to monitor our vital statistics. It’s not that financial planning isn’t important; it’s that planning is only a means to an end, not the end itself.
AUM fees are unfair to wealthier clients. The essence of this concern seems to be that because wealthier clients are far more profitable than the less-wealthy clients in many advisory firms, this creates a troubling inequity. One observer even put it this way: “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?”
To me and many others, this is a very curious question. Assuming that the AUM fees for both small and large clients are reasonable, where does unfairness enter into the equation? Even if larger clients are in effect subsidizing smaller clients, isn’t this purely a business question? Do firms want to use their revenues to “underwrite” advising smaller clients? If the profit margins on Cadillac make it possible for General Motors to sell the Volt at a reasonable price, why would that be unfair to Cadillac drivers?
What’s more, many observers seem to feel that flat fees are mostly cosmetic anyway. They observe that because many firms using retainer fees set their fees so that they generate the same revenue as an AUM fee, the switch feels more like a repackaging than a fee overhaul.
Markets, not advisors, produce performance. So far, this wins my award for the most curious argument. The advisor who made this observation explained: “The idea that a percentage fee puts the advisor ‘on the same side of the table’ assumes that 1) they are the source of performance; and 2) it eliminates conflicts of interest. Both are false. Markets produce performance, not advisors […].”