The growth of the fee-based advice model has been one of the most significant developments in our industry over the last 30 years. We have gone from a world dominated by commissions to a world where advisers now derive more revenue from fees than from commissions.
The trend toward fee-based advice has been driven primarily by a desire to find a business model that removes some of the conflicts of interest inherent in the commission-based model. Compensating an adviser based on a percentage of assets under management removes the incentive to recommend unnecessary trades to generate a commission.
But charging for advice based on a percentage of assets under management does not perfectly align an adviser’s interests with the client’s. For example, it may be in a client’s best interest to liquidate a portion of their investment account to pay off their mortgage, but it is certainly not in their adviser’s financial interest. Will this affect the adviser’s advice?
The AUM pricing model also holds a subtler potential conflict. Paying an adviser more as an account grows could cause the adviser to take greater risk in a client’s portfolio to generate greater returns.
The AUM pricing model has an even more fundamental problem. It can sometimes be hard to reconcile the fee charged with the services provided. A recent Dilbert cartoon makes the point:
Dogbert: “I’ll manage your portfolio for a standard industry fee of 1 percent per year.”
Wally: “I’m investing a billion dollars. Your fee would be $10 million per year.”
Dogbert: “Those index funds aren’t going to pick themselves.”
Firms that provide services in addition to asset management have a much easier time rationalizing an AUM pricing model. For example, firms that provide financial planning services often experience a more direct correlation between the size of the client and the amount of work required to service the client. Larger estates often come with greater complexity.
Fee-based advisers in increasing numbers are grappling with these issues and are migrating to hourly or retainer-based fees. These alternative fee models are intended to deal with some of the potential conflicts of interest inherent in the AUM pricing model and provide a more rational connection to the service provided and the fee charged.
Another benefit of these alternative fee models is their transparency. The client sees very clearly what they are paying for advisory services. In contrast, the AUM pricing model has a way of masking fees by translating them into mysterious units called “basis points.”
The evolution of the fee-based model will, no doubt, continue, but the truth is, there is no such thing as the perfect fee schedule. Well-intentioned advisers can serve their clients’ needs well using commissions, AUM pricing, hourly/retainer-based pricing or a combination of all of them. The “best” pricing model depends on the situation and the needs of the client.
We are entering a new era where client sensitivity to, and government scrutiny of, fees will be ever increasing. We will all be held accountable for the compensation we receive. The focus will be less on the structure of our fee schedule and more on the impact our fee schedules have on our clients in specific situations.
You can wait until you are forced to defend your fee schedule or you can get ahead of the issue. Now is the time to reexamine the fees you charge and their impact on each of your clients. You should be able to demonstrate a reasonable relationship between the fees charged and the services delivered. Saying, “Those index funds won’t pick themselves,” won’t cut it.