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Practice Management > Compensation and Fees

Groundhog Day: Do You Really Want to Justify Your Fees Again and Again?

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Harvard philosophy professor George Santayana is famously quoted as writing: “Those who cannot remember the past are condemned to repeat it.” I often think of this quote as I am constantly bombarded in the news with Americans’ seemingly abysmal ignorance of how we got where we are in areas ranging from history and economics, to politics and science, and technology and medicine. Apparently, despite the best efforts of many of us who have been around long enough to remember advisory “history,” I need to add the independent advisory industry to that list, at least as far as advisor compensation goes.

As you may have guessed, I’m (once again) talking about the current movement to shift independent advisor comp to flat fees (as opposed to AUM fees). Some of you old timers, like me, will remember back to the mid-1980s, when the sales of tax-shelter investments literally dried up overnight (due to the Tax Reform Act of 1986), and consequently, there was a big push in the financial planning world to charge directly for financial plans (which had until then been essentially loss-leaders for the sales of investment and/or insurance products).

During the ensuing three or four years, most financial planners came to realize the “big” flaw in the planning fee strategy: not only did clients have to physically write a check for planning fees—they had to do so once a year, every year. This created an “event” during which each client had to make a decision to “buy” financial planning again, and the planner had to resell the idea of financial planning all over again, too. 

Even the best salespeople did not re-close all their clients every year. So when the stock market took off, following the “correction” of Oct. 1987, and the newly created Schwab Advisor Services introduced the ability to deduct AUM fees directly from client accounts, independent advisors jumped on the AUM bus—and transformed the retail financial services industry. 

In his September 21 blog post “Retainer Fees vs the AUM Model,” Michael Kitces provides a comprehensive and well-reasoned analysis of the pros and cons of the retainer fee model in today’s advisory world. In addition to many other salient points (including the lower value of retainer-fee firms), he comes to essentially the same conclusion about flat fees: “The fundamental problem of retainer fees is that they are more salient: the need to discuss them regularly makes them ‘top of mind,’ and naturally invites the client to push back on the fee and ask: ‘What have you done for me lately?’ [which] means in practice, it is very difficult to regularly raise retainer fees even to keep pace with inflation, much less to parallel the market growth of an AUM fee.” 

To my mind—and consistent with the history of independent advice—the inherent danger in creating these regular “decision points” cannot be overstated—at least for clients as a whole. No matter how well an advisor makes the case for ongoing financial planning, simply raising the issue of whether clients should continue to write a retainer check each year (actually, or automatically) will almost certainly result in some attrition. 

What’s more, as Kitces also points out, flat fees create even stickier problems when markets go down. “On the other hand,” he continued, “while the saliency of bringing up a retainer fee every year can make it harder to raise the fee in a bull market, clients may still feel compelled to ask for a fee cut in a bear market! After all, while the fee might not automatically decrease as the AUM declines (the “stable revenue” benefit of retainer fees during bear markets), clients who are feeling less wealthy in the face of a bear market may still ask for a fee cut, or otherwise become more fee-sensitive as they look for places to ‘save’ on expenses! Especially since an AUM-based advisor up the street may offer to work with the client for less—charging an AUM fee on the now-reduced portfolio…”

As I’ve written before, in my view, the biggest advantage of AUM fee compensation is that it creates a very tangible identity of interest between advisor and client: enabling advisors to offer compelling responses to both issues that Kitces raises:

1) Why does advisor compensation increase? “I only get a raise when I’ve done a good job and the value of your portfolio goes up.”

2) When the value of client portfolios shrinks? “I’m not any happier about the market drop than you are: But I believe that riding out bear markets (as opposed to market timing) is the smartest way to grow your investment portfolio, and I’ve taken a hit to my revenues right along with you.” 

Here’s how Kitces put it: “So if we tell our clients to invest in at least a moderate amount in stocks and ride out the volatility, because it produces greater wealth in the long run, shouldn’t we take our own advice when it comes to keeping the revenue of our own advisory firms hooked to long- term stock market growth, too?”

History would tell advisors that you should link your revenue to portfolio growth. It’s better for clients, better for advisors and avoids reselling every client—every time you want a raise.