Thursday, September 23, 2021

Why the Asset-Based Fee Model Has To Go

AUM fees have become more flawed as investment management has taken a backseat to other advisor services. 

Andy Panko
Andy Panko

The fee model based on a percentage of assets under management is a relic that is silly, arbitrary and unfair to clients. There, I said it!

I’ve had these feelings about the AUM fee structure since the beginning of my career more than 20 years ago, but I’ve always been in the very small minority of people who espouse this view. It now appears others in the industry are coming around to the realization that charging for financial advisory services purely on the size of clients’ investable assets should go the way of the three-martini lunch.

The Wall Street Journal recently published an article titled, “Say Goodbye to the 1% Investment-Adviser Fee?”  and, in August 2020, Investment News published “Asset-Based Fee Models are Lazy – and Flawed.”

It’s great to see such well-respected industry outlets finally bringing attention to how the AUM fee is rightfully starting to lose its stranglehold to alternative fee structures that are more fair and logical.

It’s Not Completely Terrible

First, I have to acknowledge there are some positive things to say about the AUM model:

  • It’s easy to implement.
  • It can be very lucrative for advisors who are able to set high asset minimums and only work with clients who don’t have extraordinary areas of financial complexity in their lives.
  • Everyone else is doing it and has been for a long time! (I have to admit there is some value in the comfort of following the crowd. Also, inertia is hard to overcome.)

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Sure, the AUM structure obviously works, as decades of history have shown. The Investment Adviser Act of 1940, which established new rules designed to eliminate conflicts of interest among those providing investment advice, sparked a move away from high-priced commission-based investment sales that usually benefited brokers more than clients. The investment-advice industry promoted AUM fees as much fairer because the client and advisor would be on the same side of the table — the advisor didn’t have to make a sale to get paid and therefore would offer more comprehensive, unbiased advice in the client’s best interest. But just because AUM fees were an improvement over past practices doesn’t mean they work best for most clients now, especially if we want our industry to truly become a profession.

Times Have Changed

Historically, advisors who provided only investment advice charged fees based on a percentage of assets under management.-. The job they were doing then was more labor-intensive and less scalable than it is now. With the proliferation of effective passive investment products, widespread accessibility to information and robust technology solutions, good investment management has become increasingly cheap, easy and scalable.

Furthermore, most advisors have since realized investment management isn’t where they can add the most value. As a result, many advisors have begun expanding their services to include broader financial planning beyond just picking and rebalancing securities. Considering this increased focus on financial planning, assets size is that much less relevant in gauging the services and value that advisors provided.

Difference of Opinion

So, why do advisors continue to justify charging a percent of AUM for their advisory services? Here’s the rationale I often hear:

  • Advisor interests are aligned because advisors do better when clients do better.
  • More assets means greater financial complexity and therefore more work to properly serve the client.
  • Even if advisors are providing the same amount of time and resources to everyone, clients with more assets get more value, for which advisors should be compensated.

It’s true that the AUM structure pays the advisor more when the client has a larger amount of assets under advisement. However, I wouldn’t necessarily say that means the client is doing “better.” Or at least, the client isn’t necessarily doing better as a result of the advisor.

When it comes to managing investments, the vast majority of advisors use portfolios that more or less perform in line with the broader financial markets. Therefore, it’s not really advisors that are growing clients’ accounts; it’s the market itself.

Three Flaws With AUM Fees

Should advisors get paid more simply because markets go up? No. Conversely, should advisors get paid less simply because markets go down? No.

If, on the other hand, advisors are truly providing unique and quantifiable valuable — whether from pure investment management or from broader financial planning — then it makes sense to charge on that. More on that in a bit …

“Many advisors say larger account sizes mean the client has more financial complexity and therefore it’s more effort and resources to provide services. This is categorically false.”

Next, many advisors say larger account sizes mean the client has more financial complexity and therefore it’s more effort and resources to provide services. This is categorically false. It’s possible that the percentage fee under an AUM structure may coincidentally line up well with the amount of time and resources provided. However, that is typically not the case. Most advisors have multiple clients with high assets but are less work to service than clients with fewer assets.

Finally, the notion that larger account sizes lead to larger value for those clients is, at best, only hypothetically defensible. There are “advisor alpha” studies that show the value an advisor can add could be about three percentage points of assets per year. However, unless advisors can quantifiably and unquestionably define and measure the alpha provided, it’s not fair to try to charge on it. Otherwise, there are a lot of hypotheticals and what-ifs that go into saying larger accounts realize larger value.

Seeking Logic and Mutual Fairness

As I mentioned before, it’s completely sensible for advisors to charge a percentage of the alpha provided. For example, if an advisor’s selling point is providing investment returns that are greater than the market, there’s nothing wrong with charging a percentage of that outperformance.

However, this requires clearly establishing how to define and measure that outperformance. For example, a fee of 20% of any returns above and beyond those of the S&P 500 is clear and measurable.

So, if charging for financial advisory services based on asset size isn’t the right solution, what is?

I fully admit there is no single “right” or “best” method. However, the closer an advisor’s fee aligns with the amount of time, effort, resources, skill and/or knowledge provided, the more logical and mutually fair it is to advisors and clients alike. Only with a widely accepted rational fee structure will the financial advisory industry start to be viewed as a legitimate profession.”

Multiple Alternatives to AUM Fees

I admit I have found no fee structure that will work for every advisor and every client. I do feel a pure hourly fee model is unquestionably the most fair. However, many clients might be reluctant to call or e-mail their advisors for fear of running the clock and accruing fees. In some cases, this could lead to clients’ small issues not getting addressed when they should and eventually becoming much larger ones.

A small retainer fee might alleviate this problem. However, traditional retainers and hourly fees would likely lead to relationships that are transactional instead of ongoing. For some clients, maybe a few transactional engagements is truly all that’s needed. But for many clients and the complex and intertwined nature of the various aspects of their financial lives, limited transactional advice may not adequately address their big pictures and related planning needs.

In my opinion, retainer and hourly fees work much better for legal services because lawyers are typically only addressing a specific and well-defined client objective; they’re not providing broader advice on multiple aspects of clients’ lives.

I really like the idea of complexity-based fee structures. They would start with a base fee and then adjust for areas of extraordinary complexity, like owning a business, owning rental properties, etc. However, it’s easy for complexity-based models to become complicated and unwieldy to the point that advisors and clients may be reluctant to use them.

Flat annual fees make a lot of sense, but mainly in cases where the advisor is essentially offering the same services to all clients. This could be the case when the advisor has a well-defined niche or type of client. Otherwise, charging every client the same amount may not be best for advisors who are providing markedly different amounts or types of services to clients.

Another variation of flat annual fees is a subscription-based fee. While these two fee structures are functionally kind of the same, I think of a subscription-based fee as one that is paid monthly and doesn’t require assets to be managed. On the other hand, flat annual fees are more akin to traditional AUM fee structures in that they often require assets to be managed and the fee is deducted quarterly. Subscription-based fees likely work best for younger clients in the early stages of their careers who haven’t yet accumulated much wealth.

In my firm, I charge a flat annual fee that is typically the same for every client (other than the fee is lower for single persons than married couples). In my case, flat fees work really well because I only work with clients in the same stage of life who are all looking for the same general services and advice: tax-efficient retirement income planning and investment management.

Furthermore, I don’t work with anyone who has extraordinary areas of financial complexity such as business ownership, international considerations, or special needs planning, etc. If I were to work with such clients, then I’d have to build in some sort of complexity-based fee add-on to account for the additional time, knowledge and resources provided. In other words, a simple flat fee structure wouldn’t work.

Additional Reading: Advisors Wind Down Interactions with Retired Clients 

As explained, there isn’t a perfect financial advisory fee model. However, continuing to charge purely on clients’ asset size isn’t the way to move the industry forward. If we want to be treated and viewed more like a real profession, we have to charge for our services like a real profession. How many doctors, lawyers or accountants charge purely on clients’ wealth or the hypothetical amount of value that may be provided by the services offered? Exactly.

Andy Panko, CFP®, RICP®, EA is the owner of Tenon Financial, a fee-only firm in Metuchen, NJ that provides tax-efficient retirement planning and investment management. He’s also the founder and moderator of the Facebook group, Taxes in Retirement and creator of the YouTube channel, Retirement Planning Demystified.

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