Prior to starting my fee-only retirement planning and investment management firm in November 2019, I spent nearly 20 years working primarily in institutional capital markets, investing and banking. I also worked a few years in insurance. I’ve been an adjunct professor of finance for over 10 years at a major university. Additionally, both my undergraduate and graduate degrees were in finance.
I like to think my experiences and education prior to starting my own firm gave me a deep understanding and appreciation of the businesses we’re all in. Furthermore, having come from the institutional and academic side of the world, I feel I have a different perspective — and less preconceived notions — of the business compared to most advisors who spent their whole careers on just the retail advisory side.
But enough about me, let’s talk about the industry. Specifically, let’s talk about how the industry charges fees. Yes, this is yet another article challenging the way things have always been done with regards to fees. With that said, many of you are probably rolling your eyes and saying, “It ain’t broke, so what is this joker trying to fix?”
I’m here to say that I think the way advisors charge fees is broken. In particular, I’m referring to charging a fee that’s an annual percentage of clients’ investable assets under management, otherwise known as “% of AUM.”
How Advisory Fees Should — and Shouldn’t — Be Determined
Like almost every other professional service, the fee paid to the provider should be commensurate with the hours of service provided, the resources used in providing the service, the level of experience or expertise of the provider, etc.
Or, alternatively, the fee could be some portion of the value provided. However, in the financial advisory industry, “value” is a nebulous and opaque thing that is literally impossible to define and quantify in virtually every case. But more on that later…
Additional Reading: Are You Really a Financial Advisor?
I can say firsthand (and I know many of you would agree, even if you won’t admit it in public) that client asset size is a really poor gauge of the amount of time, resources, knowledge and expertise required to provide advisory services.
Don’t get me wrong, there will occasionally be times where client asset size does coincidentally correlate to the time, effort, resources and complexity involved in serving that client. But there will be many more times where asset size is a laughably bad proxy of those things.
Asset Size Does Not Equal Value
In theory, if it was feasible to objectively define and measure the value provided from financial advisory services, then it would make sense to set the advisory fee to be a percentage of that value. In this case, the value delivered would be pure advisor “alpha,” which is value provided that is uniquely attributable to the work the advisor did. In other words, had the client not hired the advisor, the client would have never received any of that value, or alpha. As such, if the advisor can indeed provide alpha, why not take a portion of it as the fee?
This is easier said than done for the simple fact that there is no feasible way to clearly articulate and define the value provided, especially considering much of the value is emotional and subjective and can vary wildly from client to client. (Yes, I’m aware there are “advisor alpha” studies that attempt to put a % of AUM figure on how much alpha an advisor could potentially provide. However, the findings in such studies have very large outcome ranges and are based on a lot of educated guessing. As such, these studies are far short from quantifying the value actually provided by any given advisor.)
For advisory relationships that are pure investment management without any broader financial planning, alpha could potentially be clearly measured. For example, if an advisor’s value proposition is the ability to provide annual investment returns that are X% greater than those of some agreed upon benchmark, then it would make sense for the advisor to take a cut of the returns above the benchmark returns.
But what happens in the years where the advisor’s investment returns are inevitably less than those of the benchmark? I would argue the advisor should get no fee those years. Or, if the advisor wants to be really honest about what value they’re actually able to provide, pay something back to the client since the alpha was negative …
The above investment management alpha example was a fun little exercise, but we all know that the majority of advisors realize investment management has become increasingly cheap, easy and commoditized to do well. As such, most advisors now offer broader financial planning as part of their service. And trying to quantify the value provided from financial planning is where things quickly become futile, at least for those who are intellectually honest about it.
The Disconnect
Percentage of AUM is a means-tested subsidy pricing arrangement … not a value-based arrangement.
Many advisors have client scenarios that look something like this:
Client A:
- Has $2,000,000 of investable assets, all of which are in an IRA.
- Prefers a low-touch passive index-based investment philosophy where the account is rebalanced twice a year and upon taking distributions.
- Understands markets go up and go down and isn’t concerned about inevitable swings in the portfolio.
- Wants $80,000 distributed out of the IRA each year via recurring distributions.
- Has no especially complex financial planning needs.
- Is hands-off and rarely ever reaches out to the advisor outside of the regularly scheduled semi-annual check-up meetings.
- Pays the advisor $10,000 to $30,000 per year under a % of AUM arrangement.
Client B:
- Has $600,000 of investable assets spread across an IRA, Roth IRA and taxable brokerage account with a couple dozen individual securities that have varying levels of unrealized gains and losses and were transferred in from an account managed by the client’s previous advisor.
- Is generally okay with a low-touch passive index-based investment philosophy with semi-annual rebalancing, but will occasionally call up the advisor to ask about investing a little bit in stock ABC or bond XYZ.
- Understands markets go up and go down, but gets nervous when they go down and writes or calls the advisor to ask if it’s time to do anything different with the portfolio.
- Will call up about once a month requesting distributions in varying amounts, and leaves it to the advisor to figure out which account is best to take the distribution from a tax perspective.
- Owns a couple rental properties, has a special needs child, has a few annuities and cash value life insurance policies purchased from the previous advisor.
- Pays the advisor $6,000 to $9,000 per year under a % of AUM arrangement.
“No one can say with a straight face that it’s logical or fair for Client A to pay two to three times what Client B is paying. Without question, serving Client B involves more time, complexity, skills, etc.”
No one can say with a straight face that it’s logical or fair for Client A to pay two to three times what Client B is paying. Without question, serving Client B involves more time, complexity, skills, etc.
This is where defenders of % of AUM would likely say Client A has more assets and is therefore receiving more value. However, what if Client A has a generous pension and Social Security that more than covers her expenses, has no particular legacy plans and knows she has more money than she’ll possibly need? Meanwhile, Client B knows she needs to squeeze the most growth as possible out of her $600,000 to meet her retirement goals and loses sleep seeing her account values fluctuate by only a few percentage points.
In this case, can anyone seriously say Client A is getting more “value” simply because Client A has more investable assets? It would be intellectually dishonest to answer “yes” to this question.
In this example (which admittedly is manufactured, but it’s not far off from actual scenarios most advisors experience in their businesses), Client A is paying too much while Client B isn’t paying enough. I’m sure Client B doesn’t mind underpaying. But is it fair that Client A is ultimately subsidizing the work done for Client B?
Market Downturns Often Mean More Work, Not Less
I have to make one more critique of the % of AUM model before moving on to my recommendations for better fee structures. Under a % of AUM model, the dollar amount of fee the advisor receives each quarter is variable and tied to the performance of the overall markets. Even with the most customized of portfolios, there is still some element of market “beta” that moves security prices up or down, which means forces outside of the advisor or client’s control are changing the fee each quarter.
I’m sure almost all of you reading this can attest that advisors often work more when markets (and account balances) decline. Yet % of AUM means getting paid less during those times. Down markets generally mean more communicating with clients, more tactical opportunities like Roth conversions or tax loss harvesting, etc. On the other hand, when markets are humming along upward, clients are generally content and things are often more so on autopilot so there is generally less work actually being done. Yet % of AUM means getting paid more under this scenario.
More Fair, Logical and Intellectually Honest Fee Structures
I’ll be the first to say that no fee structure is perfect or free from conflicts. And many % of AUM defenders do indeed acknowledge % of AUM has its flaws. However, in a business where advisors are supposed to act in clients’ best interests, isn’t it incumbent upon advisors to charge clients in ways that are as fair and minimally flawed as possible? For the reasons laid out above, % of AUM is not the least flawed way to charge for services.
In my opinion, charging a pure hourly structure (inclusive of managing investments) is the most mutually equitable and logical fee structure. However, I feel pure hourly would be counterproductive for ongoing advisory services as many clients would be reluctant to call or email the advisor for fear of running the clock. Considering a lot of the work advisors do and value advisors provide is proactive in nature, clients shouldn’t be disincentivized from reaching out.
The next most logical fee structure for ongoing planning and investment management would be complexity-based. Under such a structure, the fee would be tied as closely as possible to the amount of time, resources, expertise, etc. actually provided. However, in order to properly implement a complexity-based fee structure, there needs to be an elaborate matrix of capturing and charging on a plethora of different things. In doing so, a thorough complexity-based fee model can quickly become unwieldy, which may render it ineffective.
Next in line, in terms of logical and fair fee structures for ongoing planning and investment management, would be flat annual fees. To be fair, coming up with the appropriate flat fee amount is not an exact science. Additionally, no two clients are exactly the same and therefore their annual fees ideally shouldn’t be identical. However, particularly for advisors who have a niche in client type or service offering, it’s no doubt feasible to set a flat fee or range of flat fees that charge much more fairly than % of AUM.
As mentioned above, if it was possible to actually define and quantify the value provided from advisory services, then it would make sense to charge a fee that’s a percentage of the value provided. However, I have yet to see anyone come up with an accurate and objective way to measure said value. Furthermore, using investable asset size a bastardized proxy for measuring value is a random and disingenuous way to attempt to put a number on it.
What Fee Method Should You Use?
We live in a capitalist economy. With that said, clients and advisors are largely free to use whatever fee amount they want. I fully acknowledge that.
However, should advisors charge clients as much as possible simply because clients let them? Especially in this industry — where it is literally advisors’ jobs to help clients make the most of their finances— how can advisors in good faith not use the most fair and logical fee structure available? And how are advisors okay with letting clients with a lot of assets subsidize the work being done for clients with smaller amounts of assets?
I’m not saying every advisorneeds to switch their fee structures to hourly, complexity-based or flat fee. Moreover, I realize many advisors may agree with the merits of making a fee change, but are hamstrung by their firm, RIA aggregator, broker-dealer or service providers to being stuck in the inertia of charging % of AUM.
Still, advisors need to reconsider how and why they charge clients. Are their fees really in the client’s best interest? Or are they simply charging in the way it’s always been done? Or is their goal to charge a lot because clients will let them? Or do their % of AUM fees from higher net worth clients subsidize the ability to provide services to clients of lesser means? Or are their fees the result of service providers that won’t easily permit a change?
To set fair fees, advisors first must be honest with themselves about why they’re doing things the way they’re currently doing them.
Andy Panko, CFP, RICP, EA, is the owner of Tenon Financial, a fee-only firm in Metuchen, N.J., that provides tax-efficient retirement planning and investment management. He’s also the founder and moderator of the Facebook group Taxes in Retirement, creator of the YouTube channel Retirement Planning Demystified and host of the podcast Retirement Planning Education.
