Portfolio > Portfolio Construction

The Dead Horse Bounce. And Another Thing About Flat Fees…

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Before I get to the point there, let me preface this blog (which is a response to a comment to my January 19 blog (“Flat Fees in the UK: Different Country, Same Lame Arguments”) with an apology to “III Financial.” Here’s the comment he/she posted to that blog: “We get it, Bob. You’re are a proponent of AUM fees instead of other compensation methods. You have some who agree with your logic and some (like me) who do not. Circling back again and again isn’t likely to change many minds at this point.”

III Financial is right, of course: like many groups in our society these days, proponents of flat advisory fees seem to be “true believers” who are not inclined to give much credence to contrary opinions. But I’m not writing to them. Instead, my concern is the thousands of younger advisory firm owners who might be persuaded to adopt a flat-fee model, but who might not be aware of why the vast majority of independent advisors have not adopted flat fees or that, historically, most of those who did eventually switched back to AUM fees. (See Top 10 Investing, Business Ideas for Advisors in 2017: Mercer).

Toward that end (and at the risk of, as one of my ex-wives would say, “beating a dead horse to death”), here are some further flat vs. AUM thoughts in response to some thoughtful comments by Scott MacKillop to the aforementioned blog:  

Scott: “You seem to misread Alan Smith’s (“Why the Advice Market is Moving to Flat Fees, at first point and respond to it as a complaint about large accounts subsidizing small ones. I don’t actually see him use the word “subsidy” anywhere in his statement. Instead, I think his point is about the irrationality of having clients who are buying essentially the same service paying wildly different prices for it.

This seems like a very valid point. You seem to acknowledge this point, but dispute it based on the fact that larger accounts are more complex. While this is sometimes true, it is by no means always true. A $1 million account and a $2 million account may be equally complex and require precisely the same service, but the larger account may pay twice the amount for the same service.

The answer is not to pretend that accounts increase proportionately in complexity with size, which is simply not true, but rather to impose additional fees for additional services. If an account is more complex, it will pay more because it is complex, not simply because it is large.”                 

Me: I don’t mean to be argumentative here, but the title of the first point of Smith’s critique is “Cross-Subsidy” and the issue of wealthier clients essentially “subsidizing” less affluent clients is a common criticism of the AUM fee model. But your focus on the “fairness” of wealthier clients paying more on an actual dollar basis is also a commonly voiced concern.

With that said, I find the argument that “larger accounts aren’t always more complex than smaller accounts” to be curiou, for two reasons. First, I have never talked to an advisor who uses the same number of stocks/bonds/mutual funds/ETFs/separate accounts, in all of their model client portfolios, regardless of size. Instead, larger portfolios are generally considered to require greater diversification: which requires more research, more monitoring, more account activity and more complicated reporting.

What’s more, even though “all” wealthier clients may not have more complex financial issues—tax and estate issues, business interests, employer stock holdings and options, gifting, charities and other investment opportunities, etc.—they generally tend to. And to deal with them, independent advisors usually “have to add extraordinary expertise, and spend additional time working with wealthy clients’ other advisors: lawyers, accountants, bankers, etc.”

While your suggested solution to “impose additional fees for additional solutions,” sounds more equitable, from what I’veeard it’s not very practical: requiring additional “service packages,” each requiring its own “sales pitch” and creating an additional client decision point. Which is why I suspect that, historically, everyone from small independent advisors to the large private banks have opted for the simplicity of an AUM fee that is usually discounted for larger accounts.

Scott: “Under ‘Contingent Charging’ your argument seems to accept Smith’s point that there is an inherent conflict of interest in the AUM fee model, which there most certainly is, but then you suggest that the conflict somehow produces a good result. Why not just acknowledge that there is a conflict of interest and further acknowledge that an advisor who charges a flat fee does not have that conflict and yet is still motivated, as a professional, to encourage the client to do the right thing?

Me: Maybe it’s just me, but my antennae always go up when someone plays the “motivated as a professional” card. If we can assume that flat-fee advisors are “motivated as professionals to encourage the client to do the right thing,” why can’t we make the same assumption of AUM advisors? The fact is that this is a common over-simplification of the dynamics involved.

It’s true that AUM advisors have a vested interest in growing client portfolios rather than depleting them. But is this really a conflict of interest? I doubt 999 clients in a thousand would see it that way. The reason clients hire advisors is to help them save and invest their money, rather than spending it. Of course, if a client really wants to spend his/her money frivolously, there’s no stopping them, but a good advisor gives them an opportunity to listen to reason.

On the other side of that coin, is it really true that flat-fee advisors have no conflicts in these situations? Isn’t their sole financial interest in client relationships to keep the clients? If so, what’s their incentive to tell clients things they don’t want to hear? Such as that taking money out their retirement portfolio to fund their son’s chinchilla farm might not be a smart move. Sure, their “professionalism” might prompt them to speak up, but, as many advisors have commented in recent years, there is a strong financial incentive not to.

Seems to me that giving an advisor a stake in growing one’s portfolio creates a greater chance of getting sound financial advice than paying an advisor the same amount every quarter no matter what happens.

See some of Bob Clark’s most recent blog postings and columns:

Everplans: A Tech Tool That Could Be an Estate Planning Game-Changer

Can You Hear Me Now? The Tech Scam Better Explained