Originally published in Advisor Perspectives, November 21, 2016
Several studies found that, for the largest advisory firms, the most profitable ones focused the most on AUM fees. Clearly, this fee structure is good for these firms.
In my article last week, I gave five reasons why the asset-based fee model is unlikely to survive. Here are five more:
The conflicts are pervasive
An article posted on November 27, 2011 in Investment News by Bert Whitehead set forth additional conflicts of interest when fees are based on a percent of assets under management. These included:
- Advising whether to rollover a pension plan or leave it with a former employer;
- Advising about charitable contributions;
- Advising about gifts to children to avoid estate taxes;
- Advising about annuities, including charitable annuities;
- Advising about purchasing a larger home and investing generally in real estate.
- If the fee is different for managing stocks and bonds, the advisor’s self-interest may result in an over allocation to stocks.
In the first five examples, a conflict arises because the suggested action (e.g., a pension rollover) would decrease the AUM and the advisor’s fees.
Whitehead concludes: “If fee-only advisors want to hold themselves out as being the most ethical practitioners of their profession, they should commit themselves to adhering to the highest possible and least conflicted standard.”
It’s not equitable
As noted on the web site of Litovsky Asset Management, charging a high-net worth client a multiple of the fees charged to a lower net worth client “can hardly be justified.” It doesn’t take many multiples of the amount of work required to manage a $10 million portfolio to manage a $5 million portfolio.
Mr. Litovsky, an engineer and mathematician, concludes: “Our conclusion is that AUM fees cannot be justified on any basis, and that a flat fee is the only type of fee (along with other fees for work such as hourly and per-project) that would be fair to the client and would compensate the advisor adequately for their work.”
The premise is flawed
There’s no doubt a competent advisor can add meaningful value on the investment side by helping to determine an appropriate asset allocation, making sound investment recommendations based on peer-reviewed evidence, keeping the client disciplined and adhering to a carefully crafted investment policy statement.
However, as a fiduciary, you have an obligation to do all of those things regardless of how you calculate your fees.
The argument that an asset-based fee aligns your interest with the interest of your client has no merit. Your interest is already aligned by well-established law.
It encourages overreaching
Advisors frequently attempt to justify AUM-based fees by extolling the value of their non-investment services. These services include financial planning, insurance review, and coordination with accountants, estate planning lawyers and other service providers.
Offering these services may tempt advisors to render substantive advice when the client might be better served by consulting more qualified professionals. Here are some examples:
- Clients with routine tax issues should consult with a Certified Public Accountant;
- Clients with complex tax issues should consult with a qualified tax attorney;
- Clients with estate planning issues should consult with an attorney specializing in wills and trusts;
- Clients with insurance issues should consult with a fee-only insurance consultant.
When you abandon an asset-based fee, you eliminate the temptation to render services in these areas and will be more willing to refer to professionals with more specialized expertise.
It’s in your best interest, but may not be in your clients’ best interest
Several studies (summarized here) found that, for the largest advisory firms, the most profitable ones focused the most on AUM fees. Clearly, this fee structure is good for these firms.
Most RIAs advertise their fiduciary status and describe the high standard that relationship encompasses. The Institute for the Fiduciary Standard notes that: “Loyalty requires that fiduciaries put the best interests of clients first. Doing so means clients’ interests are put ahead of the advisor’s interests, the interests of their firm, and the interests of all others at all times.”
Advisors who calculate their fees based on assets under management should question whether they are living up to this standard.