August 1, 2017 • Scott MacKillop
Like it or not, there is an increasing focus on fees in financial services. This is due, among other things, to the rise of passive investing, the emergence of robo-advisors and the adoption of the DOL fiduciary rule. Clients are getting the message: What they pay makes a big difference over time. In response, many advisors are re-examining their fee schedules. The percentage-of-AUM fee model is still dominant and is likely to remain so for years to come (change comes slowly in our industry). But many advisors are considering, or have already incorporated, alternative fee models into their practices. These include flat fees, retainers and hourly fees. Our Move to Flatland At First Ascent Asset Management, we recently adopted a flat-fee pricing model. That decision was the result of an internal discussion about how to make our firm stronger and more competitive in the years to come. I will share some of our thinking here. The point is not to convince you that flat fees are the way to go. There is no such thing as the “best” or “right” fee schedule. The point is to encourage you to go through your own process of critical self-examination. Test the strengths and weaknesses of various fee approaches in the context of your own firm. Make sure you can confidently answer client questions about fees and that you employ fee schedules that will make you strong and competitive in the future. Keep in mind that we are an asset management firm that serves financial advisors, not a traditional advisory firm. We do not work directly with investors; we work only through advisors. We do not provide individualized financial, estate or tax planning services. So the considerations that caused us to adopt flat fees may not apply to your firm. Nevertheless, the process we went through should be instructive. Exuberant Rationality We adopted flat fees in part because we perceived a lack of rationality underlying the AUM fee approach for our business model. In our world, it does not take any more work to manage a $1 million account than it does to manage a $100,000 account. We were at a loss to justify why our larger clients should pay so much more than our smaller clients. Some advisors don’t share our concern, pointing out that they add more “value” to larger accounts. That is, when a $1 million account goes up 10% it benefits more, in dollar terms, than a $100,000 account that goes up 10%. Our problem with this idea is that we do not control either the size of the client’s account or the direction of the market, the two factors that cause large accounts to benefit more. Saying we created more value in this context seems like we are taking credit we don’t deserve. This problem can be ameliorated to some extent by placing a cap on the level of AUM fees that can be charged to a client. A cap recognizes that, at some point, advisors have been fully compensated for whatever value they added. The AUM fee model has more logic for a comprehensive financial planning firm where larger relationships tend to involve more complexity. More complexity tends to come along with more work. Where there is a strong correlation between the size of an account and the amount of work required, AUM fees make sense. At our firm, that correlation is small, at best. Another problem we had with the value-added rationale for the AUM model is that it falls apart when markets decline. If a $1 million portfolio declines by 10%, it loses more, in dollar terms, than the $100,000 account, yet still pays more in fees. If large accounts should pay more when they benefit more in dollar terms, shouldn’t they pay less when they lose more? One could argue that an advisor using behavioral coaching could ultimately save a large client more than a smaller client in a down market and thus add more value. This may justify the higher fee for the larger account. But we rarely interact directly with clients—that is the advisor’s job—so we can’t claim to add value in this manner. A positive feature of the AUM fee model for both financial planning and asset management firms is that it imposes fees in a manner that roughly corresponds to a client’s ability to pay. This smoothing effect makes the AUM fee model easier to administer than a flat fee schedule. Planning firms that use flat fees must create tiers of service and correctly assign clients to the proper tier. If the anticipated level of service turns out to be incorrect, or if the scope of the assignment changes, the fee must be renegotiated. AUM fees are self-adjusting. Same Side of the Table AUM fee advocates correctly point out that most clients never raise concerns about the rationality of the model. In fact, if asked, many clients express support for it because they like the idea that the advisor’s income rises and falls with the value of the client’s portfolio. This view embodies the underlying assumption that advisors will work harder to improve the portfolio’s performance if they have skin in the game. In our experience, this is not how the world works. Many of us build model portfolios for our clients. They are the best models we can build. We don’t build better models for $500,000 accounts than for $400,000 accounts. First « 1 2 » Next
In response, many advisors are re-examining their fee schedules. The percentage-of-AUM fee model is still dominant and is likely to remain so for years to come (change comes slowly in our industry). But many advisors are considering, or have already incorporated, alternative fee models into their practices. These include flat fees, retainers and hourly fees.
Our Move to Flatland
At First Ascent Asset Management, we recently adopted a flat-fee pricing model. That decision was the result of an internal discussion about how to make our firm stronger and more competitive in the years to come. I will share some of our thinking here. The point is not to convince you that flat fees are the way to go. There is no such thing as the “best” or “right” fee schedule. The point is to encourage you to go through your own process of critical self-examination. Test the strengths and weaknesses of various fee approaches in the context of your own firm. Make sure you can confidently answer client questions about fees and that you employ fee schedules that will make you strong and competitive in the future. Keep in mind that we are an asset management firm that serves financial advisors, not a traditional advisory firm. We do not work directly with investors; we work only through advisors. We do not provide individualized financial, estate or tax planning services. So the considerations that caused us to adopt flat fees may not apply to your firm. Nevertheless, the process we went through should be instructive.
Exuberant Rationality We adopted flat fees in part because we perceived a lack of rationality underlying the AUM fee approach for our business model. In our world, it does not take any more work to manage a $1 million account than it does to manage a $100,000 account. We were at a loss to justify why our larger clients should pay so much more than our smaller clients. Some advisors don’t share our concern, pointing out that they add more “value” to larger accounts. That is, when a $1 million account goes up 10% it benefits more, in dollar terms, than a $100,000 account that goes up 10%. Our problem with this idea is that we do not control either the size of the client’s account or the direction of the market, the two factors that cause large accounts to benefit more. Saying we created more value in this context seems like we are taking credit we don’t deserve. This problem can be ameliorated to some extent by placing a cap on the level of AUM fees that can be charged to a client. A cap recognizes that, at some point, advisors have been fully compensated for whatever value they added. The AUM fee model has more logic for a comprehensive financial planning firm where larger relationships tend to involve more complexity. More complexity tends to come along with more work. Where there is a strong correlation between the size of an account and the amount of work required, AUM fees make sense. At our firm, that correlation is small, at best. Another problem we had with the value-added rationale for the AUM model is that it falls apart when markets decline. If a $1 million portfolio declines by 10%, it loses more, in dollar terms, than the $100,000 account, yet still pays more in fees. If large accounts should pay more when they benefit more in dollar terms, shouldn’t they pay less when they lose more? One could argue that an advisor using behavioral coaching could ultimately save a large client more than a smaller client in a down market and thus add more value. This may justify the higher fee for the larger account. But we rarely interact directly with clients—that is the advisor’s job—so we can’t claim to add value in this manner. A positive feature of the AUM fee model for both financial planning and asset management firms is that it imposes fees in a manner that roughly corresponds to a client’s ability to pay. This smoothing effect makes the AUM fee model easier to administer than a flat fee schedule. Planning firms that use flat fees must create tiers of service and correctly assign clients to the proper tier. If the anticipated level of service turns out to be incorrect, or if the scope of the assignment changes, the fee must be renegotiated. AUM fees are self-adjusting.
Same Side of the Table AUM fee advocates correctly point out that most clients never raise concerns about the rationality of the model. In fact, if asked, many clients express support for it because they like the idea that the advisor’s income rises and falls with the value of the client’s portfolio. This view embodies the underlying assumption that advisors will work harder to improve the portfolio’s performance if they have skin in the game. In our experience, this is not how the world works. Many of us build model portfolios for our clients. They are the best models we can build. We don’t build better models for $500,000 accounts than for $400,000 accounts.
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