Perhaps the biggest obstacle to understanding the financial services industry—by investors, journalists, lawmakers, regulators and even some advisors—is that is it complex. And because it’s complex, if you see only part of the picture, rather than the whole picture, you can come to some pretty squirrely conclusions.
An excellent example of this has been the ‘debate’ over whether all retail financial ‘advisors’ should have a fiduciary duty to their clients. One of the arguments put forth by the financial services industry against such a duty is that paying a one-time commission for ‘advice’ is less costly than paying an annual AUM fee. Yes, that’s true, but only if you’re looking at part of the picture. In the bigger picture, many commission-paying products also charge investors an ongoing 12b-1 fee, calculated as a percentage of AUM.
But for this discussion, let’s ignore the 12b-1s, and focus on the sales commissions vs. advisor AUM fees. As I said, the commission is cheaper, but what’s left out of that myopic analysis is that the services provided in each of those relationships differ as well. A more complete picture of the comparison would come into focus by asking the investors if they’d be happy to pay a bit less for financial advice to someone who legally works for his/her BD, not you, and who therefore is allowed to recommend products to you that are way more costly than equivalent alternatives, and therefore are more financially beneficial to the advisor and their firm? I’m just guessing here that few investors would be okay with that big-picture relationship.
Now the reason I told you that story is to tell you this story. On January 10, British financial advisor Alan Smith posted a blog on citywire.co.uk titled “Why the Advice Market is Heading Towards Flat-fees.” As you might expect from a possible descendant of Adam Smith (although I believe he was a Scot), Smith offers a detailed and well-reasoned case for the advantages of flat fees over AUM fees, based on an analysis conducted by his advisory firm. But as you read through them, I encourage you to keep in the back of your mind whether he is truly presenting the ‘whole picture.’
“Like many firms,” Smith wrote, “our compensation model was largely based on a percentage of assets model that varied in line with the amount of assets our client entrusted to the firm. Upon deeper examination, we concluded the percentage model was past its sell-by date and there was a better alternative. We summarized the key problems we had identified as the ‘four Cs’: Cross-subsidy, conflict of interest, contingent charging, and cost.”
Here’s Smith’s analysis of each of those ‘problem’:
“The persentage of assets model means clients with larger portfolios pay proportionality larger amounts each year in annual fees. For example, a client with £1 million invested with an adviser or wealth manager operating on the typical 1% model pays £10,000 each year in fees. A similar client with £100,000 invested pays only £1,000 a year. One client pays 10 times the amount each year in fees than another with a similar service experience and adviser. That seems fundamentally wrong and does not happen in other areas of professional services such as medicine, accountancy or law.”
This has always seemed like a specious argument to me, regardless of the side of the Pond upon which it’s proposed. For one thing, wealthier clients do in fact have more complex financial issues including tax and estate issues, but also investment diversification, access to more complex financial products, business interests, employer stock holdings and options, gifting, charities and other investment opportunities. These are the reasons that many wealthy clients turn to the vast resources and expertise of private banks (which charge AUM fees, btw). To compete with them, independent advisors have to add extraordinary expertise, and spend additional time working with wealthy clients’ many other advisors: lawyers, accountants, bankers, etc.
What’s more, Smith’s assertion that this kind of financial subsidy “does not happen in medicine, accountancy, or the law” is patently false.
You don’t think that massive operations such as heart bypasses or hip replacements subsidize the cost of broken fingers and simple arrhythmias, or actually pro bono care? Or that large corporate clients enable law firms to take contingency fee lawsuits or small estate issues? It seems ironic to me that at time when many segments of U.S. and British society are bemoaning the “fact” that the “rich” don’t pay their “fair share,” that some advisors concerned about AUM fees that the “wealthy” have been happy to pay for literally hundreds of years.
2) Contingent Charging
A couple of years ago, the then Financial Conduct Authority [the U.K. version of the SEC] chief executive Martin Wheatley expressed concerns about what he referred to as ‘dealing bias’ in relation to percentage charging adviser fee models. In other words, to be compensated, the adviser must recommend products or services upon which a percentage charge can be applied. This would mean advisers may be reluctant to recommend national savings products, investing in a business, or buying a holiday home: none of which can produce a percentage-based adviser fee, but all of which (and many more) can be legitimate decisions within a comprehensive family financial and investing plan.”
All of which is absolutely true, of course. Yet Smith’s analysis seems to assume facts not in evidence: to wit, whether this is a bad thing or a good thing? With or without AUM fees, this is a built-in dynamic of the financial advisor/client relationship. That is, most clients want to spend money on things that will make them happy now; most advisors advise them to save and invest for the future.
Most advisory clients realize this, and seek the counsel of an advisor to save them from themselves. So rather than a nefarious secret to trick people into sound investments, financial advice and planning are what clients want: someone to challenge them when they are contemplating doing something that will adversely affect their financial plan—and future.
The good news is that both sides know it: clients are well aware that if they take money out of their investment portfolio to buy a second house, it will cost their advisor money. So they evaluate the reasoning behind his/her advice to not buy it. Would you rather stake your financial future on an advisor who has a sizeable incentive for you to grow the largest portfolio possible; or on a crazy uncle who encourages you to indulge your short-term impulses just to stay in your good graces?
3) Service vs. Costs
“A client’s desire for advice does not rise and fall in line with the investment markets,” wrote Smith, “and therefore the revenue they generate for the adviser. They are inversely correlated, as a client may need more advice in times of market stress, during which the adviser may be experiencing a 20% or 30% reduction in income on a percentage-based model.”
And there it is: the argument that always seems to be slipped in at the end of briefs in favor of flat fees: “Why should advisory fees go down just because markets fall?” Here’s a newsflash: virtually all industries are cyclical. Sometimes they go up, sometimes they go down. But rather than bemoan this fact, the businesses that succeed over time prepare for down markets during up markets.
Perhaps more to the point, advisory revenues should go down because it creates a powerful ‘identity of interest’ with their clients: client portfolios shrink, and their advisors make less. Everyone feels the pain. And that’s the big picture. What do you think is the better pitch?
1) “We charge a flat advisory fee so that when markets go down, our revenues don’t change a bit, and we can continue to give you the same sound advice led to the loss of half your portfolio.”
2) When clients panic and want to sell at the bottom, their advisor can tell them: “We feel so strongly that the market will recover as it always has, that we’ve bet our future on it. So you can, too.”