TPP: I’ve spent quite a lot of time discussing financial advisor fee-models. The reason is that it is important to understand conflicts of interest. Otherwise, you might be taken to the woodshed and have no idea. The truth is that conflicts impact the advice you receive.
Long-time readers will know that I recommend a “gold-standard” for financial advising. This involves four key ingredients. (1) Fee-only, (2) Flat-fee, (3) Fiduciary, and (4) someone with extensive experience working with doctors. Today’s author, Mr. Donovan Sanchez, meets that criteria. This explains why you will find him on the very short list of recommended financial advisors on the Physician Philosopher.
This guest post by Mr. Sanchez will discuss one of the four aspects of the Gold-Standard mentioned above. AUM fees versus a Flat fee model. Tag along as a financial advisor discusses the conflict from his perspective. For other posts on this topic, you can check out the following:
- Why some models are better than others.
- A post on all of the different fee-models and potential conflicts of interest. This post includes an awesome picture outlining the differences.
- The Code and Conflict of Financial Advising.
- Why you should avoid conflicted financial advice.
- Why you shouldn’t trust the financial industry.
Enjoy this insider perspective on fee-models. It is worth the read. Take it away, Donovan!
A Flat Fee Only Advisor’s Take on “The AUM Fee Dilemma”
My experience in the financial services industry has taught me many things. One of the most important being that the way you pay for advice will have a tremendous influence on the type of advice you receive.
Much has been written about conflicts that arise when physicians engage “financial advisors” who are paid on commission. Less has been written about the issues that arise when advisors are paid based on a percentage of assets under management (“AUM”). For those unfamiliar with advisor compensation structures, it’s worth noting that AUM fees are often around 1% on a $1,000,000 portfolio; or $10,000 per year.
The purpose of this submission is to offer an “insider” perspective into why I believe AUM fees don’t make sense. I’m obviously and unapologetically biased considering that I’ve built my firm on a “pure” flat fee only model, though I would note that my perspective is informed by past experience as a financial advisor under both the commission-only and AUM-only compensation models.
A flawed compensation structure.
After leaving Northwestern Mutual, I worked for a rapidly growing Registered Investment Advisor with a fiduciary obligation to put client interests first. This firm earned revenue based on a percentage of assets under management (AUM). In general the situation was much improved from the sales-oriented culture I had experienced at Northwestern Mutual.
However, it didn’t take long to note some irrationalities in the compensation structure. I first became concerned with the fact that under the AUM model it wasn’t really feasible for advisors to work with individuals that didn’t have much by way of assets to manage. One percent of a $20,000 portfolio is only $200 after all.
So on the one hand, when you have no or few assets to manage, many firms that charge based on AUM are not really interested in working with you. Their compensation is entirely tied to your assets. Naturally, if you don’t have much for an AUM advisor to manage, don’t be surprised if all you get is a smile, maybe some brief advice, and then you’re shown the door.
On the other hand, I also observed that fees under the AUM model become increasingly ridiculous as your assets grow. Though individuals with $100,000 and $1,000,000 portfolios might receive the very same service, at 1% the fees are drastically different ($1,000 v. $10,000 per year). If the advisor is a fiduciary and obligated to provide best interest advice no matter the size of your account, how can it possibly make sense to see such disparities in total yearly cost?
Are Total Asset or Net Worth a Good Proxy?
Some advisors contend that total assets or net worth is a good proxy for complexity, and that the increase in fees is really just due to the nature of your situation. To this I suggest that advisors stop using assets as a proxy for complexity and simply bill based on complexity.
As is probably already apparent, clients on both ends of the asset spectrum suffer from the inherent flaw in AUM fees—compensation is tied, not to the time the advisor dedicates to your case, the skill that they offer, or their professional care, but to the amount of money that you have for them to manage.
The matter of aligning incentives.
Some advisors like to toute how AUM fees align advisor interests with your interests.
They argue that the AUM advisor is incentivized to encourage you to save more (thereby increasing their fees) and to help you obtain favorable returns.
It’s a fair point, but that same incentive can also motivate your AUM advisor in ways that are less advantageous to you, the client. Consider the following from The Physician Philosopher’s November 12, 2018 blog post titled, “Do I Need a Financial Advisor? The Simple Truth”:
When someone asks for 1% of your assets each year, this implies that as you earn more money in the market, your financial situation becomes more complicated. Therefore, they should get paid more. I don’t buy that.
Potential Conflicts of Interest
Also, it adds conflicts of interest that don’t need to be there. Here are some examples of things that would negatively impact the take home pay of a financial advisor operating under an AUM, if they recommend it to you:
- Paying down your debt sooner instead of investing in the market.
- Taking your social security at age 70 instead of 62 or 66.
- Paying off your mortgage in twenty years instead of in thirty.
- Investing in real estate.
“Flat Fees” that are tied to assets or net worth.
As flat fees become increasingly popular, I’ve observed some advisors partially adopt the model while continuing to tie compensation to some aspect of client assets or net worth.
What this looks like in practice is that your fees are capped at a flat amount until your assets or net worth reach a new threshold. Once the higher threshold is reached, the advisor’s fees corresponding increase to a new flat fee level.
To me this feels a lot more like an AUM fee when compared to a flat fee structure that doesn’t increase as your assets grow.
That said, this model may represent some cost savings for the client that is between asset or net worth thresholds when compared to AUM fees.
Flat fees for planning, but not for investment management.
Even more advisors are advertising flat fee financial planning services in addition to asset under management fees. Many firms set up a monthly “subscription” structure where you make regular payments in order to compensate your advisor for services that they provide. For those with few assets to manage, this is appealing to both the advisor and the client as it allows a way to receive much-needed financial planning, while not demanding the traditional AUM levels required by AUM-centric firms.
But as your portfolio grows, a flat fee planning engagement plus advisory fees for investment management may be redundant. Why? Because there are firms that offer comprehensive financial planning and investment management for a single flat annual fee.
So be very cautious when an advisor advertises “flat fees.” Are they really flat, or only when it comes to financial planning?
Challenging the value of AUM fees in light of passive investment strategies.
Modern investing has seen (and is seeing) a wonderful shift from costly actively managed funds to more cost-efficient passive index mutual funds and exchange-traded funds. There are parallels between the fund industry and financial advisory profession in terms of cost. Always remember Jack Bogle’s refrain that you get what you don’t pay for.
Unlike active management, passive investment strategies attempt broad diversification and returns similar to those being generated by the indexes they track. Exceptional diversification may be obtained with only a few funds. In my opinion, too many advisors hide behind an illusion of complexity, making the portfolio more complicated than it need be in order to justify their fees.
You Aren’t Paying To Beat the Market
So, when you hire a firm that smartly adopts a passive investment strategy, remember that you aren’t paying them for market-beating performance. Rather you are paying them for an important service: to set up the proper asset allocation based on your circumstances and disposition, select the most suitable investments available, determine how to allocate the funds in the most favorable way possible, and then help you maintain this portfolio for a timeframe that amounts to something like forever.
Obviously there are other services provided, and there will likely be adjustments over time. The point I’m trying to make is that the advisor is providing a service—one that I believe should be valued through reasonable hourly or annual retainer fees, rather than as a percentage of the money you invest with their firm.
In this light, it does not seem reasonable to me that the advisor be entitled to an increased fee simply because your portfolio has increased in value.
But what about when AUM fees are better?
To be intellectually honest, it should be noted that there are times when AUM fees are less than those of a flat fee only advisor. The most simple example of this is when an AUM advisor works with a client with a “small” portfolio.
As a thoughtful consumer, you should seek out the best advisor for your situation at the best price possible.
But for many of the physicians reading this blog, I suspect that a long term engagement with a reasonably priced flat fee only financial advisor would cost considerably less than a similar engagement with an AUM advisor.
Some Final Thoughts
The most important problem with AUM fees is that they tie the value of the advisor to the value of your investment portfolio. This is not the same as tying compensation to the value of the services the advisor offers.
Though it’s a heck of a deal for those with a $50,000 portfolio to pay $750 per year for ongoing financial planning and investment management, it’s hardly fair for the advisor. The other end of the spectrum seems equally unfair when those with a $2,000,000 portfolio pay $15,000 to $20,000 simply because they have accumulated wealth. My main contention is that a flat fee for ongoing financial planning and investment management grounds the advisor’s compensation to their service and not to product sales, your assets, or net worth.
The best part about flat annual fees is that there aren’t hidden costs, you know the total price of services beforehand, and the value of your portfolio is irrelevant (thereby further reducing conflicts). Obviously DIY readers will vehemently point out that you could just save it all and do it on your own, which is fine. Not everyone has to outsource this part of life.
Am I an idealist?
Sure. But I think finding the most equitable fee arrangement available is an ideal worth pursuing. Isn’t it about helping you find good advice at a fair price? Obviously I’ve concluded that a truly flat fee structure (i.e. not tied to assets, net worth, etc.) provides the least friction to putting client interests first for those looking for ongoing financial planning and investment management.
If a flat fee only arrangement is, in fact, a better model for the client, be advised that change isn’t likely to come from the advisor community. Would it surprise you that advisors are happy to continue extracting large fees based on your assets?
As with many other things, change in my profession isn’t likely to come unless and until you demand it. So by all means, demand it.
At that time advisors will quickly adapt.
The content provided is for informational purposes only and represents my personal opinions based on my experience, study, and practice. Yes, I’m a financial advisor, but this article isn’t intended as advice for you specifically. Your unique situation needs to be taken into account, and the ideas presented here may not apply.