Over time, good financial advice can easily make a difference of hundreds of thousands of dollars to a client. So can the way the client is charged for that advice.
Advisory fees have been tied to investing ever since the days when clients paid a percentage of the price of securities bought or sold. As more investors prospered and trading costs shrank, commissions on trading came to be replaced by a percentage of assets under management.
It was only a matter of time before lower-cost competition — technology-driven robo-advisors — aimed squarely at that target. By offering investment planning and management for a fraction of the usual AUM fee, robos (or eRIAs, as Cerulli Associates calls them) have accelerated soul-searching among human advisors who want to differentiate the value they provide.
Willy-nilly, how your firm is compensated becomes part of its business strategy. As industry veteran Matt Lynch put it, “The challenge, if you’re a typical advisor with your own RIA — $100 million to $200 million in assets — is to find a better pricing model and a way to get there without negatively impacting your business.”
What Your Peers Are Reading
A Hodgepodge of an Industry
“If the Investment Advisers Act of 1940 didn’t exist and we were going to start from scratch with smart people in a room, the financial services industry wouldn’t look like it does today,” said Lynch, managing partner of Strategy & Resources, a financial services consulting firm in Dayton, Ohio. “It’s been cobbled together.”
Broker-dealers, custodians, RIAs, tax and accounting professionals, bank investment reps and insurance agents, with a variety of regulators, business models and payment structures, are all lumped together in the popular view as “financial advisors.” As such, they tend to be regarded by consumers (and sometimes by regulators) with a jaundiced eye. Just 23% of consumers have confidence in financial advisors, according to a January 2015 LIMRA survey.
“I see robos driving a change in positioning and how advisors charge,” Lynch said. “The first driver is the market. Consumers want more transparency. This isn’t exclusive to high-net-worth clients; it’s cascading through most market segments and will flow through to the mass affluent.”
Competitive threats are the second driver of change, in Lynch’s opinion. “Robos aren’t the first attempt to commoditize investment advice,” he said. “If you think back to the early days of [Vanguard Group founder John] Bogle, the robos, ETFs and new offerings from both Vanguard and Schwab are simply accelerating the growth of this threat.”
The third driver is regulatory interference. From Dodd-Frank to the wrangling at the Securities and Exchange Commission and the Department of Labor over imposing a fiduciary standard of care on all advice givers, real and potential regulation constantly looms over the financial advisory industry.
“To get ahead of these developments, you need to ask, ‘What role am I playing? How am I adding value for the client?’” Lynch said. “If I’m solely an investment manager, am I adding value by improving performance, or am I just outsourcing to asset managers or strategists whom clients could access directly?”
Where Do You Provide Exceptional Value?
“A lot of businesses confuse their regulatory model — RIA, broker-dealer, etc. — with what they actually do,” Lynch observed. If you allow this regulatory label to determine how you get paid, it may lead to a “fundamental disconnect” with your value proposition.
Some advisors’ beliefs about their chief value were summarized by Investment Advisor columnist Bob Clark in a recent ThinkAdvisor.com post: “Financial planning may be what people need, but more money is what they want — and what they will pay for.” This school of thought suggests that a percentage of AUM should be the preferred payment model, since the advisor is rewarded when the client’s assets grow and penalized if they shrink.
But does a fee based on investment performance really equate to identity of interest? How objective can an advisor be if the client wants to make charitable gifts or invest in a business, reducing assets under management? What about a client in retirement, who is spending down assets?
In any event, asset growth may not be how the client measures success. As generational change expert Cam Marston has reported, well-educated women have an increasing say in financial decisions. Research shows that they tend to focus on having the wherewithal to meet a lifestyle goal, such as buying a house or traveling in retirement, as opposed to beating a benchmark. Another demographic shift — the proliferation of nontraditional families, as profiled in Allianz’s 2014 LoveFamilyMoney study — indicates a need for complex financial planning, not just management of investable assets.
Moreover, while robos may be smart enough to handle asset allocation and tax-loss harvesting, they’re not so good at right-brain stuff. “The hardest thing to manage in our industry is emotions,” said Nathan Bachrach, who is co-founder, chairman and CEO of Simply Money in Cincinnati. “Emotions are what make clients pull their money out at the wrong time, invest at a market high and invest in the wrong things. As an advisor, I get people to do things they need to do, or need to not do, but can’t seem to do or stop doing until they come to see me. If robos can figure out how to help people manage their emotions, I’ll have to refigure where the industry is going.”
The Five Models
So what is the fairest way to charge clients? Let’s look at five different models.
Model 1: Assets Under Management
Simply Money, which Bachrach described as “a very middle-market firm,” uses an AUM payment model. “It doesn’t guarantee growth, but it does align us with the client,” he said. “When we make a recommendation to preserve value or help the client’s money grow over time, it puts us on the same side of the table.” It also allows him to smile as he tells a new client, “I hope this is the least I ever charge you.”
Bachrach feels that no other payment model would compensate Simply Money as fairly for the value of its CFP-credentialed advisors’ and analysts’ professionalism and training. Commissions are a nonstarter: The firm wants to get away from a transaction business.
The idea of an hourly billing model has encountered “a lot of resistance,” he said, because “nobody likes to write a check for work [behind the scenes] they didn’t see.”
Monthly retainer? The drawback is that to increase revenue, a firm needs to either add clients, which requires staffing up, or ask for a fee increase. “If you do more work, you want to be compensated for it,” Bachrach said. “But I don’t like having those [fee] conversations.”
Model 2: AUM Plus Fees for Service
Waldron Private Wealth in Pittsburgh courts a high-end market segment. Its clients (minimum net worth: $5 million) pay individually customized fees that may include asset-based, hourly or fixed charges. “Since we have only 140 clients, we can be flexible in the way we charge,” explained President Matt Helfrich. “AUM is our primary payment method. For larger, more complex accounts, such as those involving multiple generations, we may charge a retainer fee.”
Revenue from AUM and fees is calculated to produce a minimum income of $25,000 a year.
Helfrich noted that any single form of compensation can be flawed. “There’s an inherent conflict in the brokerage model,” he said. “Incentive performance is also conflicted. There are conflicts with everything. We believe our hybrid model fairly aligns us with our clients.” Given Waldron’s long-time retention rate of more than 97%, the clients seem to agree.
Model 3: Retainers
Suppose the clients you want to serve are still in the early stages of building wealth. Michael Kitces, a partner and director of research at Pinnacle Advisory Group in Columbia, Maryland, spotted an opportunity to serve younger clients — Generations X and Y — who typically can’t get in the door with advisors compensated via AUM.
“Young people are focused on cash flow,” he pointed out. “They pay almost everything on a monthly basis. So we decided on a monthly retainer model” for the XY Planning Network, which he co-founded last year to help younger advisors serve younger clients. Members typically charge monthly fees of $99 to $199 a month, and some include an additional onboarding fee of anywhere from $499 to $1,999. In its first 15 months, over 100 advisors joined XYPN with a median age of 35.
Kitces particularly likes the idea that a monthly retainer promotes use of planning services. (You’re already paying for them, so why not take advantage of them?) Going with an hourly billing model, he suggests, makes people more cost-sensitive and can discourage clients from using these services.
Although the XY model is designed to help younger advisors work with younger people, the whole nature of a non-AUM model opens the door to a broader swath of potential clients. It also offers an opportunity to structure fees for the segment that advisors want to serve.
When working with the middle market, for example, “structuring the fee at $1,200 a year may yield very different results than pricing at $100 a month,” Kitces said. “From a client’s perspective, $1,200 a year is like buying a giant flat-screen television, whereas $100 a month is more like the monthly cost of cable.”
A client with the cash resources to make a $1,200 payment is probably not living paycheck to paycheck as a $100-a-month client may be. They’re two different market segments.
Model 4: Hourly Rate
Sheryl Garrett is one of the advisory world’s leading proponents of an hourly rate payment model (and has appeared on Investment Advisor‘s IA 25 several times). “I argue that most Americans — well over 80% — need occasional advice rather than a full-time financial planner/advisor/manager, nor can they justify the cost,” said Garrett, a CFP. “The simplicity and clarity of an hourly fee is much easier on everybody. It’s easy to describe, and there are no barriers to entry” in the form of minimum asset requirements.
Early on, Garrett discovered that this payment model attracted beginners, middle-income clientele and “validators” — do-it-yourselfers who may have already done a good job of investment planning. Fearing to be sold investment products or investment management services they weren’t interested in, this untapped market segment resisted consulting advisors about such issues as a second opinion on their investment portfolio, developing a Social Security strategy, choosing the right homeowners insurance or financing their kids’ college education. With Garrett’s hourly model, they could simply ask, “What will it cost me for what I want done?”