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Flat Fees vs. AUM Recap: The Good, the Bad and the Really?

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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 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 […].”

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While it’s certainly true that “markets produce performance,” this observation completely ignores the fact that clients only benefit from market performance if they are 1) in the market; 2) not reducing their performance through excessive fees and loads; and 3) not devastating their investment portfolios through poor life decisions. Advisors add value by helping their clients avoid these mistakes. The result is larger client portfolios — why shouldn’t advisors get paid on this success?

Advisors who are compensated by AUM fees take a hit to revenues every time the markets go down. Many flat fee advocates point out the dilemma that when markets — and revenues — go down, advisors’ workloads (in terms of client handholding and communications) go up. This is a problem for advisors, yet it’s not unique to the independent advisory industry: Financial services companies and financial publishing firms have been dealing with this challenge for well over 100 years. While some have been more successful meeting it than others, very few have successfully become “market neutral.”

To many observers of today’s advisory world, replacing AUM fees with flat retainer fees doesn’t seem to be a promising solution to that issue. The biggest problem appears to be the reverse effect that flat fees have on the amount that clients pay for advice. Consider a client with $1 million in AUM paying his advisor 1%, or $10,000, a year. If the advisor converts to flat advisory fees, the annual fee will more than likely work out to be around $10,000 a year, so the client doesn’t see any real difference.

That is, until the markets suffer a major correction. If it’s as bad as the one in 2008-2009, the client’s portfolio is now worth $500,000, which, as we know, isn’t a disaster as long as the advisor does his or her job and keeps the client from panicking and selling out before the market recovers.

Under the new flat-fee arrangement, the client is still paying an annual fee of $10,000, which keeps the advisor’s revenues nicely flat. However, from the client’s perspective, that $10,000 annual fee now represents 2% of the client’s AUM, which I think we can all agree is rather exorbitant, especially as it will continue at that level as long as it takes for the markets to build themselves back up (four years in the case of ’08-’09). Clearly, this business model is better for the advisors who use it; but is it really better for their clients?

Flat fees enable advisors to work with clients who have small portfolios. This is a contention of flat fee advocates that both sounds good and probably makes a lot of sense. They point out that many younger professionals, executives and business owners have reached the point where they have relatively large incomes, but haven’t yet accumulated substantial portfolios. Charging them a flat fee that is reasonable but lower than a firm’s average AUM fee may make good business sense — chances are, with the help of an advisor at this point, they will become good clients in the future. Ignoring that this almost certainly would fall into the “unfair subsidizing” category under the third objection cited above, this situation doesn’t conflict at all with AUM fees, but rather, works in tandem with asset management: creating a steady stream of future AUM clients.

To my mind, this “benefit” illustrates the flaw in much of the thinking about flat retainer fees: that they are incompatible with AUM fees. The reality is, as in the case of younger clients, flat fees not only make a great deal of business sense, they are a perfect complement to an AUM advisory business. Other examples of this kind of synergy between flat and AUM fees include college planning, health care advice and tax preparation.

Used in conjunction with AUM fees, flat fees have the potential to take advisory firms to the next level. However, as a replacement for AUM fees, flat fees seem to be two giant leaps backward.