Many people don’t realize that the wealth management industry is not very old and has really taken shape only in the last several decades. In that time, the breadth of services provided has changed dramatically, while the way advisors are compensated hasn’t changed much at all. Could it be time for a change in how fees are charged?
While the industry predominantly charges fees based on a percentage of assets under management (AUM), this compensation method undervalues the complexity of the issues involved and doesn’t always work in the client’s (your) best interest.
Sometimes, a percentage of assets approach is the most equitable way of paying for services if you are receiving primarily money management services. In other cases, when financial planning and financial counseling services are provided, a flat fee or even hourly fee arrangement could be more appropriate. That is why a firm’s compensation philosophy is just as important as its fee structure.
From the firm’s point of view, diligence, hard work and expertise should be accordingly compensated. From the client’s point of view, the firm should be motivated only by the client’s financial well-being.
Focusing on growing and preserving a client’s entire balance sheet is central to Highland’s philosophy, which means our role can include a broader set of services than traditional money management alone. For example, we will often advise on both traditional liquid assets as well as illiquid assets such as real estate. We also regard mortgages and other liabilities as important elements to consider when planning for a strong and sustainable financial future.
One possible solution for improving the fee system is to think outside the box and create a new approach that better suits the wealth management industry today. Just like transitioning from commission-based billing to AUM-based was a positive step towards eliminating certain conflicts of interest associated with commissioned sales, we believe it could be time to transform again by creating a retainer-type system as an alternative to AUM-based fees.
The AUM model is easy enough to grasp. On a basic level, it makes sense for a firm to earn a percentage of the assets it manages, typically only liquid assets. As those assets grow or decline, so goes the fee charged. But while AUM might be a good way to manage money (it’s not always a good way to provide financial counsel on a complete financial life). That’s because many client decisions can adversely affect the total value of managed assets. These decisions include:
- Buying a bigger home
- Giving a large gift to children or charity
- Paying off a mortgage
- Investing in illiquid assets such as real estate
- Leaving retirement assets in an employer’s 401K plan
Saying yes to any of these could be good for the client, but will influence how much a firm manages, and therefore the fees it can charge. Hence, a conflict of interest exists for the AUM-model advisor.
Furthermore, the AUM system does not always equitably reward workload. For example, if the markets (and therefore value of assets) go up, so do fees, even if advisors are not theoretically working any harder. Conversely, if markets go down, so do fees, and that is arguably when managers have to spend more time counseling and tending to client concerns created by the downturn. Note: There are other issues such as recurring or large wealth creation events and added firm liability that make this discussion more complicated but I’m not choosing to address those items in this post.
What if the fee system was tweaked and improved to eliminate these natural conflicts of interest, putting the focus on optimizing a client’s overall financial life? What if the fee system was designed to compensate for only the services needed, and that those could be defined?
The factors that might be included in determining the retainer fee would likely include the following:
1. The size and composition of the client’s net worth—the assumption being that the larger the net worth, the greater the complexity.
2. The fees calculated under traditional AUM methods—since the AUM percentage rates are widely known within the industry, it is relatively easy to compute the costs at varying asset levels.
3. Special services required—a client may need additional help with things like philanthropy implementation, alternative investment due diligence, special family meetings, or other concierge-type services that are quantifiable from a time standpoint.
This new approach, we believe, could be a win for both firms and clients. It represents the logical evolution of fee structures in wealth management, according to industry thinker Mark Tibergien, in his book Practice Made Perfect. Being a wealth manager is more complex than just simply investment returns, and can mean different things to different people. Yes, our clients pay us to invest wisely; they also pay us to know them at an intimate level, and understand their priorities. It might just be time for wealth managers to let their fee philosophy evolve into something better.
Sound off and let me know what you think.