As I recall it, AUM percentage fees on the retail level was created by Jim Lockwood and John Ellis when they proposed retail money management to EF Hutton in 1973. The “wrap fee “ was born.
On May 1, 1975 when the SEC mandated the death of high commissions, the stage was set for the growth of the AUM % fee. It took until 1988 to really start to grow. It hasn’t changed much in 30-40 years. Now, half a lifetime later, the DOL in their infinite wisdom thinks that AUM percentage based fees are a better way to go conflict free for retirement accounts. Not much thought went into that, did it? Still, even today some financial advisors are talking about going to fee-based advisory business as if it were the latest thing since sliced bread.
Starting in the 70s Brokers were sold on “annuitizing their business” Only $10 million is client assets at let’s say 2% all inclusive (commissions, management and consulting) would generate $200,000 gross to the broker, which translates to pretax net to the broker $90,000 every year they keep the client. And if the account grew 10% a year….
The client sale was:
“Now I sit on the same side of the table as you, the client.” (Frankly, that would make me uncomfortable). “The only way I get paid more is if your portfolio goes up” (Or if you put more in, and give me your business, retirement, custodial accounts….) “We’re conflict free”.
I beg to differ.
However, The preponderance of retail asset management business today is charged a percentage of assets managed. NAPFA, the National Association of Personal Financial Advisors touts the fact that their members are not conflicted because,”No other financial reward is provided by any institution— which means that the advisor does not receive commissions on the actions they take on the clients’ behalf. Compensation is based on an hourly rate, a percent of assets managed, a flat fee, or a retainer.”
Lets think about it.
Is there an incentive for an Advisor to keep fee accounts under advisement even when it may not be the best idea for the client? What about advising a client on taking early social security benefit payments rather than withdrawing from their managed portfolio? Or, not buying an immediate annuity that may be appropriate rather than that portfolio withdrawal? There is an inherent conflict in that the broker/advisor is financially invented to encourage you to keep your account managed. The biggest retail asset management firm in the country, Hutton Sheraton Smith Barney Morgan Stanley (or whatever they’re called now) had a question on account closing forms, “why is the client closing this account? “Because they don’t like me” was never the right answer. But, I digress.
In an AUM fee based account, if the investor’s account grows, they pay more. Does it take more work to manage a $2 Million account that it does a $1Million account? In today’s model driven investment world, you know that answer. Does it make sense for a client to pay a percentage of assets under management year in and year out for a passive portfolio of index funds of ETFs—maybe a rebalancing once in awhile?
Should an investor pay a percentage of assets for financial planning? According to Cullen Roche, “ Paying someone 1.5% to help you “manage” a portfolio of Vanguard index funds (in which he will actively choose your allocation) is really no better than paying a stock picking mutual fund 1.5% to manage your assets. Yet it is regularly sold as something that’s “passive” and superior when all it really is is more high fee salesmanship.
How does an investor rationalize paying a percentage of assets under management if the Advisor is only making non-discretionary recommendations which the investor can freely reject?
There is no rational relationship between the assets under management and the complexity, skill and time it takes to manage a portfolio, unless the advisor is a true stock picked with customized portfolios built around the needs and wants of each client. Maybe even not then. It’s even a further disconnect if the Advisor is not the investor’s discretionary manager. Look at the relationship between AUM and fees according to the Bloomberg chart below. Even on a graduated grid Advisors get paid more as assets grow. It just doesn’t make sense.
So, accept it or not, AUM fees are fraught with conflicts.
For decades, financial advisors have wanted to be regarded as members of a profession, but how do professionals get paid: CPAs? Attorneys? Doctors? The answer is generally based on the amount of work they do, hourly fees, fixed fees or retainer fees. It’s time Advisors got paid like professionals. It’s time to ditch the asset based fee.
Here are ways for Advisors to charge retainer-based or fixed fees:
1. A flat fee per account for all financial planning, asset management, rebalancing and reporting. Let’s say $4500, for instance.
2. A base fixed fee for planning, management, advisory services with incremental fixed fees for additional services like trusts and number of tax returns they had, as well as other time consuming activities like monitoring defined benefit plans or evaluating service providers. It’s the market basket approach.
3. Charge clients a flat fee based on the amount or work the Advisor actually has to do. Not hourly, but different clients with the same assets and different requirements pay more or less, depending. (Not dissimilar to #2)
4. Hourly. Sure an accounting nightmare, but also fair.
Would this benefit investors? It’s more predictable. It’s in line with other professions. It creates fewer inherent conflicts. It enables investors to evaluate their advisors on services rather than performance, which is mainly market-based anyway. Does it mean lower fees for investors? Probably not much, and in some cases it may be higher, but the investor will know exactly what they’re paying for what they get ( and vice versa). Besides it gives investors a more concrete reason to fire an advisor rather that a variable reason.
Contrast that with the reasons why asset-based fees are the better choice for investors. Because it is cheaper than paying commissions? Think again. In the days of model driven portfolio management, the availability of investor research (like at Seeking Alpha, for instance), and $7.95 trades at Scottrade, et cetera, the conclusion is somewhere between “not always” and “not often”
So will this argument result in a fundamental change in the way investors are charged. Not likely because the vast financial service industry led by big firms has a lot invested in AUM pricing. Warren Buffet said, “Wall Street markets are so big, there’s so much money, that taking a small percentage [of assets] results in a huge amount of money per capita in terms of the people that work in it. And they’re not inclined to give it up.” The chance of a wholesale change in pricing methodology at bigger firms is slim. Boutique and independent advisory shops, though would do well to adopt a fixed model, and some have.
More will. I’d like to hear your thoughts.