We may spend more time interacting with our larger clients because they are more important, economically speaking, to our business. But we are not working harder on their portfolios. As fiduciaries, we have already built the best portfolios we could build for all our clients.
You Pay For My Mistakes
Still, the AUM fee model’s advocates point out there is more liability associated with larger accounts than with smaller ones. A trade error in a large account could cause significantly more damage than the same error in a small account. The increased potential liability justifies increasing fees.
There is economic logic to this argument. But in our case the higher AUM fees for the larger accounts would far exceed the increased variable cost of adding the insurance necessary to cover trade errors for larger accounts. We also had a more basic subjective concern about asking our clients to pay an insurance premium that protects us against our own incompetence.
Client Friendly
Another reason we adopted flat fees is that we believe clients like transparency and simplicity. We thought the advisors we work with would appreciate being able to tell their clients exactly what they were going to pay for our services at the beginning of each year.
Studies show that clients often do not understand what fees they pay for financial services. Most clients have no idea what a basis point is. But as they become more educated about fee issues, this will change. As it does, we thought advisors who work with us could use our low, flat fees to lower total costs to their clients without affecting their own revenue stream.
Is transparency always a good thing? Flat fees may be unpalatable for some clients, especially if the fees are set at a relatively high level. A $1 million client may not hesitate to pay a 1% annual fee, but may balk at paying a $10,000 fee. Seeing the actual dollar figure can be shocking. This is not a concern for us since our flat fee is very low in dollar terms.
Consider also that, outside of the financial services industry, charging a variable fee for services based on the benefit to the end user is highly unusual. For example, accountants don’t charge variable fees based on how much they save you on your taxes. Today, this does not seem to be an issue for most clients. But as they become more educated and have more alternatives to choose from, they may become less satisfied with the variable aspect of AUM fees.
Eliminating Potential Conflicts
Flat fees also eliminate a potential conflict of interest that is inherent in the AUM fee model. If an advisor’s fee is based on the size of the client’s portfolio, there is an incentive to shade advice toward maintaining assets in that portfolio. Encouraging a client to pay off a mortgage or pay down credit card debt directly reduces the advisor’s compensation.
AUM advocates correctly point out that most advisors deal quite effectively with this conflict and do not succumb to it. But as clients become more educated on the fee issue, will this potential conflict plant the seeds of discontent? Flat fees eliminate this possibility.
Increasing Flexibility
Another reason for advisors to become familiar with alternative fee approaches is to increase the flexibility they have in dealing with atypical situations. For example, a wealthy individual with all her assets tied up in a business might have significant financial planning needs and be an excellent long-term client, but may not be a good candidate for AUM fees because she lacks liquid assets. A flat fee for financial planning may solve the problem. Likewise, hourly fees may be a useful solution for projects of uncertain scope or duration.
No Perfect Fee Schedule
Understandably, many advisors are resistant to considering alternative fee models. Change is uncomfortable. It requires thinking about the value of your services in a new way. It feels like an attack on the traditional AUM fee model, which has served the industry so well for so long as it has transitioned away from commissions. This topic generates heat and emotion.
Chill out! There is no such thing as a perfect fee schedule. Every alternative fee model has its shortcomings, too. But as alternative fee models emerge, advisors should learn about them and consider how they can be used to remain competitive in this dynamic environment.
Clients are becoming more inquisitive about fees, too. Advisors should be ready to explain how their fees link to the value of the services they provide. Even if you stick with the AUM fee, make sure you are familiar with the strengths and weaknesses of the various fee alternatives and can respond effectively to any questions your clients have on this topic.
Scott MacKillop is CEO of First Ascent Asset Management, a Denver-based firm that provides investment management services to financial advisors and their clients. He is a 40-year veteran of the financial services industry. He can be reached at [email protected].