The growth of the fee-based advice model has been one of the most significant developments in financial services over the last 30 years. We have gone from a world totally dominated by commissions to one where fee-based accounts are approaching $3 trillion in value. For the first time in history advisors now derive more revenue from fees than from commissions.
This trend will certainly continue. Brokers fleeing the wirehouses for a more client-focused environment will fuel its growth. The Labor Department’s new fiduciary rule already has caused many brokerage firms to discontinue the use of commissions in retirement accounts. The Securities and Exchange Commission’s own long-promised fiduciary rule will put further pressure on broker commissions in the future.
Remember, the Goal Is to Help Clients
The trend toward fee-based advice has been driven primarily by a desire to find a business model that removes some of the conflicts of interest inherent in the commission-based model. Compensating an advisor based on a percentage of assets under management removes the incentive to recommend unnecessary trades solely for the purpose of generating a commission.
But charging for advice based on a percentage of assets under management does not perfectly align an advisor’s interests with the client’s. For example, it may be in a client’s best interest to liquidate a portion of investments to pay off a mortgage, but it is certainly not in the advisor’s financial interest. Will this affect the advisor’s advice?
The AUM pricing model also holds a more subtle potential conflict. Paying an advisor more as an account grows could cause the advisor to take greater risk in order to generate greater returns. The SEC has always identified this as a potential problem with performance-based fees, but the same potential exists with the AUM pricing model.
The AUM pricing model has an even more fundamental problem: It can sometimes be hard to reconcile the fee charged with the services provided.
A recent Dilbert cartoon makes the point. Dogbert says to his client, Wally, “I’ll manage your portfolio for a standard industry fee of 1% per year.” Wally replies, “I’m investing a billion dollars. Your fee would be $10 million per year.”
Dogbert responds, “Those index funds aren’t going to pick themselves.”
Firms that provide services in addition to asset management have a much easier time rationalizing an AUM pricing model. For example, firms that offer financial planning services often see a direct correlation between the size of the client and the amount of work required to service the client. Larger estates frequently come with greater complexity.
Firms that focus solely on providing asset management services have a harder time justifying an AUM pricing model. With today’s technology there is really no more work involved in managing a $1 million account than a $100,000 account. Back in the days of manual trading and individually handcrafted portfolios, advisors could rationalize AUM pricing, but not in today’s era of automated trading and model portfolios.
A common defense of the AUM pricing model is that it puts advisor and client on the same side of the table. There is a surface appeal to this argument—the advisor’s fortunes do rise and fall with the client’s. But it also suggests that linking their fates will cause the advisor to work harder or do more for the client.
The reality is that the market determines most of the rising and falling and it is not within the advisor’s control. Plus, it raises the question of why the advisor isn’t doing his or her best for the client without need of an incentive payment.
Is There a Better Way?