Should You Pay More for Financial Advice Simply Because You Have More?
Consider paying a flat fee instead of the assets under management fee charged by many financial advisers.
Remember when the cost of a stock trade could run into the hundreds or even thousands of dollars? That was when the wirehouses charged commissions based on the volume and price of shares traded. If you remember that, then you remember when an upstart named Charles Schwab came along and told investors his firm could handle all of the stock trades they wanted for a mere $150 per trade. With that move, he may have put some stockbrokers out of business, but he did all investors a favor by helping them realize there is very little cost difference between putting $10,000 and $1 million in the market.
The discount brokers of today have simply taken that concept a step further. How many investors would pay a flat $150 per stock trade now knowing they could pay a discount broker just $7 a trade?
The cost of financial advice has taken a similar path. Since 2008, when the veil was lifted on the shady dealings of Wall Street product manufacturers, the assets under management (AUM) fee compensation model, which charges clients a flat percentage (typically around 1%) of AUM, has spread rapidly. It's thought to be fair, fully transparent and conflict-free, especially when operated by fiduciary-bound, independent advisers. But is it?
Problems With the AUM Fee Model
While it is more transparent, questions have been raised as to its fairness and its immunity to conflict. Let's go back to the Charles Schwab example. If the cost differential between a $5 million trade and a $5,000 trade is negligible, is it fair for the larger investor to pay a higher commission than the smaller investor? The same question has been posed for assets under management. If it doesn’t cost any more to manage a $5 million portfolio than it does to manage a $1 million portfolio, why should the larger investor pay five times more? While it is true that someone with a $5 million portfolio may have more complex issues than someone with a $1 million portfolio, is it five times as complicated?
Thanks to a relentless bull market, many investors, especially those who utilize a passive investment strategy, have seen the value of their portfolio double in the last seven years. The $5 million investor who paid his adviser an annual fee of $50,000 in 2009 may now be paying him $100,000 annually. Has the value of that adviser’s service doubled in that time? Chances are he is providing the same level of service now as he did in 2009. Why then is he earning twice as much (or slightly less if a graduated fee schedule is used)?
The AUM-fee model is also coming under criticism for potential conflicts-of-interest issues. An adviser who is paid primarily for managing assets has little incentive to offer advice in areas that could reduce AUM, such as using assets to pay off a mortgage or invest in a business. Investing in an income annuity might be the right strategy if you want to ensure lifetime income sufficiency, but an AUM-fee-only adviser would not be compensated for the investment. Most adviser-fiduciaries strive to be conflict-free in dispensing advice, but the method of compensation may at times influence that advice.
Plus, through technology and competition, investment management has largely become commoditized. As a way to add value, many advisers are shifting more of their focus towards holistic planning by delivering more financial planning services. Yet they are still using AUM-centric pricing model, which tends to keep your focus on your portfolio rather than your planning needs.
The Flat Fee: A Completely Client-Centric Alternative
In recognition of these potential conflicts-of-interest, as well as the issue of fair pricing, the advice-pricing model continues to evolve. In recent years, the advisory landscape has been experiencing a shift towards a flat-fee-for-advice or retainer-fee model that removes all potential conflicts of interest and is based solely on the level of services provided.
With a flat-fee model, you simply pay for unbiased advice, rather than an investment product. It provides the most complete transparency and fairness in that it aligns the pricing of services directly with the cost of delivering those services.
More importantly, an annual flat retainer completely changes the client-advisory relationship, with the emphasis placed on the holistic nature of financial planning. Although portfolio management should remain an integral part of the relationship, it is more aligned with all the elements of your financial life, including retirement planning, estate planning, income tax planning, risk management and cash flow planning, as well any investments the adviser is not managing. Under a flat-fee arrangement, all elements receive the appropriate attention based on their priority at any given time.
The amount charged under a flat-fee arrangement is typically based on how much input the adviser gives you, not the amount of assets you bring him, regardless of the direction of the market. So you can rest assured that you will receive the same level of service and attention in good and bad markets. Most advisory firms that charge flat fees will price them according to multiple levels of services they provide, allowing you to select the one that is appropriate for your needs.
While AUM-based fees may not completely go the way of commissions and other product-centric forms of compensation, investors today are leading the charge for more transparency, fewer conflicts-of-interest and fairness in their advisory relationships. One day, we will be asking, “Why would anyone pay 1% on AUM knowing they can pay a simple flat fee for advice?”
Pete Woodring is founding partner of San Francisco Bay area Cypress Partners, a fee-only wealth consulting practice that provides personalized, comprehensive services that help retirees and busy professionals to enjoy life free of financial concern.
Craig Slayen, a new partner with Cypress Partners, contributed to this article.
About the Author
Founding Partner, Cypress Partners
Woodring is founding partner of San Francisco Bay area Cypress Partners, a fee-only wealth consulting practice that provides personalized, comprehensive services that help retirees and busy professionals to enjoy life free of financial concern.