On December 12th, 1969 at the O’Hare Hotel in Chicago, Illinois, Loren Dunton held a meeting with thirteen leading financial service professionals with the specific goal of creating a profession that provided comprehensive financial advice to unprepared Americans. Overall, the meeting was successful and it became the official birthplace of financial planning as a profession. Since then the field has exploded and there are now a variety of complex service models, causing advisors, regulators and consumers to all ask, “Who is the fairest of them all?”
There are four primary business models in financial planning. The first is the product-based model, which focuses on financial products sales and subsequent commissions. This model is championed by broker-dealers and registered representatives, who are regulated by the Securities Act of 1933 and 1934, individual states, and FINRA, a self-regulatory organization that reports to the SEC.
Conceptually speaking, earning commissions for sales seems reasonable, especially when the client knows what product they want. However, this model does not make much sense for advice. After all, how can you provide unbiased advice when you have an inherent incentive to sell or base a financial plan around specific products? Dual-registration can also pose problems because, while one moment an advisor can provide fee-for-advice, subsequently they might sell a product related to that advice for commissions. This sparks a conflict of interest.
The product-based model can be beneficial in certain situations, and there has been recent regulation improving the standard of care for clients (Regulation Best Interest), but the potential for abuse is arguably still too high. As a result, many point to “fee-only” financial planning as the gold standard. Here clients pay advisors for independent advice related to securities. Advisors using this model must act as a fiduciary at all times under the Investment Advisers Act of 1940, and are regulated by the SEC and individual states. Overall, this seemingly eliminates any conflicts of interest and appears like a great deal for everybody – but is that actually true?
Perhaps the most popular fee-only model is when clients pay a percentage of assets-under-management (AUM). Here an advisor is paid a percentage fee based on the client’s investment portfolio, which can include brokerage, retirement accounts and employer plans. As the portfolio grows (declines), the percentage fee declines (increases), but the advisor’s overall compensation grows (declines). This creates an economic incentive and alignment between the advisors and investor and hypothetically there is no limit on what the advisor can earn. Additionally, the AUM fee typically covers both investment management and financial planning services.
At first, AUM seems like a fair arrangement, but there are several pitfalls to consider. First, many individuals do not qualify because they do not have enough assets to meet the advisor’s investment minimums. Second, the advisor might be incentivized to avoid holding cash, client withdrawals, or conservative investments because this can limit the portfolio size and subsequently the advisor’s fee. Third, many advisors charge using a tiered rate instead of a flat rate, resulting in higher fees.
To demonstrate, suppose an advisor charges 1.5% and 1.0% from $0-$500,000 and 500,000-$1,000,000, respectively, and the client has a $1,000,000 portfolio. With a flat rate, the client would only pay $10,000 (1% of $1,000,000). However, with a tiered rate, the fee would be $12,500 (1.5% on the first $500,000, followed by 1% on the next $500,000). Altogether, the average rate was actually 1.25%, not 1%, and the advisor “earned” an extra $2,500 despite no extra services rendered.
Another important point to consider is the passive income that AUM creates for advisors. For example, suppose a client has a $1 million dollar portfolio and pays a 1% advisory fee, or $10,000. Now suppose in the following year the portfolio grows to $1.1 million and the client still pays the 1% fee, or $11,000. How much of that extra $1,000 is attributable to financial planning versus investment management?
Given that the average financial plan only costs about $3,000, with most of the work happening either at the start of a new client-planner engagement or during periodic times of change, it seems reasonable to assume that most of the fee increase is attributable to portfolio growth rather than extra planning. And even if a client is given a new financial plan every year, do they even need it, or will a few simple tweaks suffice?
So why do AUM advisors wrap in financial planning services if part of the fee is simply attributable to portfolio growth? Perhaps the biggest reason is justification. After all, technology and commoditization has made it significantly cheaper to own, trade and rebalance portfolios; thus planning services are needed to prop up higher fees. Secondly, and depending on how you display portfolio returns to clients, many advisors simply struggle to keep pace with the stock market, let alone outperform it, so financial planning fees can help explain any underperformance. Finally, investment platforms can be expensive, sometimes as much as 35-50 basis points, so wider profit margins are needed to stay operational.
Saving the day?
Many fee-only advisors have noticed AUM’s inherent conflicts of interest and adopted alternative models. The first is the retainer model, whereby advisors charge a flat monthly, quarterly, semiannual or annual fee for services. To protect themselves against any unforeseen cancellations, advisors may also charge upfront “starter fees” to newer clients. After all, it would be painful to perform a few thousand dollars of work, only to have the client quickly cancel before even collecting the first month’s fee.
Though this is not a new model, it has been recently popularized by groups such as XY Planning Network for several reasons. First, it is very easy for clients to understand because the fees function similar to a gym or cable membership, rather than a complicated percentage of assets. Secondly, it allows advisors to work with a wider variety of individuals who may not have the accumulated assets to work with AUM advisors. It also frees advisors from the hassle of investment management compliance, assuming they only offer planning services. Lastly, and unlike the AUM model, retainer fees are not tied to the market; thus an advisor’s income becomes predictable and stable during market fluctuations.
That said, there are some disadvantages present for both clients and advisors. For clients, if they do not utilize their advisors on a fairly regular basis, they may end up overpaying for services, with the advisor earning a passive income just like with AUM. For advisors, the retainer model does not have unlimited income potential like the AUM model and loses out during strong markets. This means advisors will need a larger client base if they want higher revenue; they might experience scalability and profitability issues.
Meanwhile, other advisors have adopted hourly and fee-for-service models instead. Like retainer models, these unlock a wider range of clientele and is straightforward and transparent for all parties: clients know the fees they are paying, while advisors avoid asset management compliance headaches and implementation work. The key difference, however, is that unlike an AUM or retainer model, hourly and fee-for-service models only charge for the advisor’s time or completed projects; thus there are no passive income conflicts and the client only pays for what they need and want.
Again, this model is not new and has long been popularized by groups like the Garrett Planning Network. In fact, this model is the standard practice in professions like law, accounting, and medicine. But it should be noted that clients are at risk for their advisors intentionally padding billable hours or overpricing pre-negotiated projects; thus clients should shop around. Meanwhile, advisors are under pressure to answer questions quickly for hourly clients, even if not all information is known, and accurately price services to avoid over- or undercharging. Lastly, there are scalability and profitability issues here as well.
The untapped mass market
The wealthiest three classes are typically serviced by AUM models because they have the highest (least) profitability potential (opportunity costs) for advisors. Meanwhile, the mass-affluent leans towards retainer or hourly advisors because they lack high levels of investable assets, but have enough household income to pay advisory fees. Finally, mass-market individuals tend to receive little to no help because they lack both assets and household income.
Admittedly, the mass market is a tough sell to advisors because these clients typically cannot afford an ongoing client-planner relationship or only need limited services on a periodic basis. Secondly, many advisors have little to no experience working in this space and do not know how to build a business model that provides adequate services while remaining scalable and profitable. Finally, there is a limited supply of financial advisors (roughly 210,000 in the U.S.) whose primary focus is on higher revenue producing clients. After all, advisors need to earn a living too.
However, are these reasons enough to leave this consumer group to their own devices? In the author’s opinion, no, especially considering the mass market accounts for roughly two-thirds of the U.S. population and has numerous financial issues, besides investments, that are ready to be solved.
That said, smaller firms interested in this space will likely only serve as short-term pioneers due to scalability and profitability restraints, thus leaving the gate wide open for larger advisory firms to seize control. However, this is typical in any competitive industry.
Newer models on the way?
Practitioners and academics alike have noted the business opportunities within the mass-market segment and have proposed newer models such as “percentage of income,” or, as I call it, “income under management” (IUM). However, there are issues present here too, many of which parallel the AUM model.
First, what income is to be included in that percentage fee? For example, and similar to an advisor suggesting a client transfer a non-managed 401(k) into a managed IRA account, if IUM is based on adjusted gross income (AGI), what is to stop the advisor from making “tax” recommendations that artificially increase the client’s AGI?
Secondly, what happens during periods of income growth or decline? Like portfolio growth, it seems reasonable that a client’s income will rise over time due to inflation, job promotions, bonuses and so forth, but does the advisor’s actual workload increase or are they simply enjoying passive income? Conversely, if the client has a down year, does the advisor stick with this model or enforce a minimum retainer? If the latter is the case, why not just utilize hourly or retainer fees from the start instead of implementing a complicated billing scheme that leads to client confusion and transparency issues?
This leads to the final issue: fee saliency and perception. As alluded earlier, clients often do not make the effort to translate percentage fees to nominal dollars. It is also easy for these fees to go unnoticed since they are often automatically deducted from the investment portfolio on the client’s behalf. Conversely, hourly and retainer fees are transparent. So much so, in fact, that even if it is a better deal in comparison to percentage-based models, the transparency can create sticker shock among clients and backfire into difficult conversations about pricing or even the client firing the advisor. To avoid this scenario, many advisors may opt for percentage-based fees.
Regardless, percentage-based fees have caused rifts within the advisor community, with many critiquing their fairness and transparency in comparison to dollar-based fees. In addition, many have questioned the upholding of the fiduciary standard among these fee-only advisors and ponder why the profession continues to operate differently despite similar professions using dollar-based fees instead. Overall, IUM contains many of the same issues as the AUM model and clients will need to perform their due diligence when looking for an advisor.
No compensation model is perfect. Perhaps the best approach moving forward is a hybrid model whereby planning service are charged under an hourly, project or retainer structure, while investment management falls under AUM, albeit at a lower percentage due to service unbundling. This will help capture and mitigate the best and worst features of all the service models and allow for greater customization by clients and advisors. Meanwhile, attention should be paid to the mass market, as they are the largest consumer class in the United States that has gone relatively unserved. Some firms will be unwilling or unable to serve this group, but the business opportunity is present. Thus, we anxiously await to see who will be the first to truly go after this promising market segment.