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.