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Does Client Philanthropy Pose a Conflict for AUM Advisors?

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A financial advisor sent me the following insightful email, in response to my August 31 blog Financial Advice and the Age of BS about the lack of substance in the ongoing attacks on AUM fees by the “flat-fee” folks. Like many such flat-fee folks, he’s concerned about the conflicts of interest inherent in the AUM model, while in my view, these conflicts are relatively minor and greatly outweighed by the way AUM fees align most advisor/client interests.

Him: Bob, you make some good points. I would be curious on your perspective when it comes to clients and philanthropy. In other words, clients that have the ability and finances to make a difference by donating to worthy causes will reduce their investment balances. Certainly the advisor can help clients make the best choices on how to maximize their bottom line in the process (i.e,. potentially donate appreciated assets to save on taxes, etc.), but in the end, their investment balances will go down. It seems to me there is a bit of a conflict of interest in this case with the AUM model, but would be curious how you see it.

Me: You are right: charitable donations are usually a conflict for an AUM-paid advisor (unless he/she will continue to manage the money for the charity, etc.). Still, in my view, one of the primary advantages of the AUM fee model is that most if not all of an advisor’s conflicts are obvious to the client: it’s obvious that a smaller portfolio will result in lower AUM fees. (As opposed to, say, the “marketing” fees that some mutual fund companies pay to broker-dealers.) 

We could probably think of a few similar situations: Gifting to children and grandchildren to reduce estate taxes, investing in real estate, starting a small business, buying a racehorse, etc. But, of course, the final decision in each of these cases is always the client’s. 

What’s more, it’s not clear to me that these conflicts would be eliminated (or even mitigated) under flat-fee compensation.

It’s my understanding that most firms charging flat fees raise those fees periodically as client portfolios grow. So  it would seem reasonable that a flat fee would be reduced in the event that a substantial portion of a portfolio is donated to charity. And, of course, if the fee isn’t reduced, it seems as if it would become ridiculously high, relative to the remaining assets. (In addition, a similar fee imbalance would/will occur when the market takes its next inevitable nosedive.) 

I think it’s important to remember that a fiduciary’s duty is not to eliminate all conflicts but rather to avoid conflicts when possible, and to mitigate and/or manage them when it isn’t possible.

To my mind, the AUM fee model avoids most conflicts, and provides for more easily managing the remaining conflicts, through their transparency to the clients, and that the clients have the final say in the conflicted strategies.

While flat fees eliminate most of the few AUM conflicts, they create a major one in down markets (without a fee reduction, which I haven’t heard of any advisors doing; probably because it has to be a very hard sell).

On the other hand, it’s a lot easier to convince clients to “stay the course” with their allocated portfolios when their advisor is feeling the financial pinch right along with them.