Majority of today’s advisers, whether they are fee-only (that is, they are paid only by the client, not by third parties for selling products), or fee-based (having a mix of fees and commissions from product sales) are compensated by charging a percentage of assets under management (AUM) fees. AUM fees can range from about 0.25% to as high as 2%, not including the fees paid for mutual funds, which can be as high as 2%. Proponents say that this type of compensation is good for the client because the adviser has ‘skin in the game’ – that is, the adviser makes more if the clients’ portfolio performs and less if it does not. A closer look, however, shows that the AUM model is not what it is made out to be.
1) AUM vs. fee for work.
Everything else being equal, managing a $100k portfolio and managing $1M portfolio if all the assets are in an IRA-type account will require the same amount of work, so someone with $1M can potentially pay 10 times the fee that someone with $100k pays for the same amount of work. AUM fees are around 1% for many advisers for assets less than $1M. While AUM fees are often lower for higher assets under management, it typically requires assets of $1M or more to qualify for lower fees, so a client might pay only 5 times the fee with $10M if charged 0.5% than they would pay for $1M if charged 1%. Even if there is more work required to manage $10M than $1M, a fee that is 5 times higher can hardly be justified. An accountant or an attorney rarely if ever charge AUM fees – they are compensated for the time spent on doing specific tasks. Thus, AUM fees are unfair to the clients, especially to those with sizable assets.
2) Having a cash reserve or paying off a mortgage.
For some clients, a cash reserve of as much as $100k may be a great idea. Imagine if such a client has minimal investable assets other than their cash reserve, and they come to see an AUM adviser. What would such an adviser recommend? The adviser can only take this client if they can get enough AUM, thus the client might be pushed to move their money from cash to investments. Especially now when the markets are flat and bond yields are low, paying off a mortgage makes a lot of sense for some clients. An AUM adviser might not want to recommend this if it takes away a good portion of their fees.
3) Asset minimums.
Since many clients may not have enough investable assets, they might simply be unable to work with a good AUM adviser because such advisers might have high AUM minimums ($500k is typical, though many start at $100k). Still, most members of Generation X and Y do not have $100k to invest outside of their 401k plans, thus they cannot take advantage of advisory services which they badly need. Even fee-only financial planners who manage assets will charge AUM fees and often have asset minimums.
4) Managing portfolio risk.
The flip side to having ‘skin in the game’ is excessive risk taking. In search for higher return (and higher revenue from their clients), many AUM advisers put their clients’ money into high risk investments which according to Modern Portfolio Theory should reward the investors with higher returns. Unfortunately, the results are exact opposite – higher risk portfolios blow up when the markets crash, leading investors to pull their money out at just the wrong time. Advisers are just as guilty as their clients for not being able to hold steady and stick with a single strategy. Since advisers do not have any special predictive skills, they get caught just like everyone else by fast-moving markets. It is not easy for advisers to convince their clients to hold steady when their clients’ portfolios plunge 50% or more.
AUM fees especially hurt the more conservative portfolios which rely for much of their return on dividends and interest. To manage investment risk, we use government bonds and bond funds (such as treasuries and TIPs), and for clients in the high tax brackets we often recommend that they invest in high quality individual municipal bonds. Charging a 1% fee for having a good portion of clients’ portfolio invested in high quality fixed income that return 2%-4% can not be justified, thus AUM advisers usually do not consider this option, which happens to be one of the best ways to manage portfolio risk.
5) Comprehensive financial planning.
Because everyone’s financial situation is different, advisers should avoid one-size-fits-all approach that centers on investment management, but this is exactly what many AUM advisers concentrate on. Investment management is only a small part of most clients’ financial situation. For some client, saving on taxes can net a higher return than investing in the stock market. A business owner in the highest tax bracket making six figures can receive higher return from managing tax liability though tax planning and retirement accounts such as 401k and Defined Benefit than from investment returns. Fee-only financial planners typically examine every aspect of their clients’ finances. While some fee-only planners don’t manage assets, most do, so in addition to AUM fees there is often another layer of financial planning fees on top of the AUM fees.
6) Collaborating with other advisers (accountants, attorneys, insurance brokers).
Once the AUM adviser has clients’ assets, they do not have much incentive to pursue what is truly necessary – close collaboration with clients’ other advisers. Working proactively with accountants and estate planning attorneys can potentially save the client and their family a fortune (quite literally in the case of estate and tax planning). Because AUM advisers mostly concentrate on investments, they are not very likely to manage their clients’ non-investment risks proactively.
7) Investment products.
Unless the adviser is truly independent (that is, not tied to a particular broker-dealer or company) they may be unwilling to find the best products or get the lowest prices for their clients. A typical AUM adviser is tied to a particular platform which allows them access to mutual fund families which often pay the firm and advisers a portion of the fees they collect from the clients. The mutual funds pay advisers a share of the fees to place the clients into specific funds, so unless the client is using a fee-only adviser, mutual fund fees can and will be on the high side (anywhere from 1% to 2%, compared to an average of 0.2% for a typical Vanguard fund) on top of advisory fees. Many advisers use stock funds as much as possible (including expensive ‘alternative’ funds) instead of using high quality and lower cost bond funds to create balanced portfolios. Some of this may be due to the lack of adviser education, but much comes from the fact that stock mutual funds pay out higher share of fees to advisers, thus putting client portfolios at much higher risk than necessary.
8) Fiduciary standards.
The Certified Financial Planner is supposed to adhere to the highest fiduciary standards. Yet, very often a CFP designation serves as a cover for an adviser who is just like everyone else – charging high AUM fees and using funds and products with high fees. Nothing in the CFP code of ethics prevents the CFP from overcharging the client, even though time and time again Morningstar and others have shown that low cost funds beat high cost funds, and that an average adviser is not able to add much value (other than provide adequate asset allocation using low cost funds for their clients), thus high AUM fees are rarely if ever justified even when charged by a CFP holder.
9) Adviser revenue volatility.
It goes without saying that advisers who use mostly equity portfolios for their clients will experience high revenue volatility during market crashes. This is not very good for advisers who also have expenses that need to be taken care of, so instead of serving their existing clients they may be scrambling to make up for the lost revenue.
10) Working in clients’ best interest.
What is the best way for the adviser to be compensated such that both the client and adviser are winners? Many AUM advisers are doing well, but do their clients receive a benefit from this arrangement? As we can see, just because everyone uses this compensation model does not make it the best one for the clients. Charging AUM fees creates multiple conflicts of interest and encourages an AUM adviser to work against their client’s best interests. While this does not apply to all AUM advisers as there is a great variety of them out there, all of the above-mentioned considerations made us drop the AUM model in favor of a flat fee, which is based only on the amount of work that has to be done to implement our recommendations.
A simple calculation can demonstrate the difference between AUM fees vs.
flat fees. Assume that only investment management services are
provided. A client starts with nothing and contributes $50k annually
over the period of 30 years. In one case, AUM fees are charged – the
client pays 1.5% (1% management fee and 0.5% in mutual fund fees). In
another case, the client is charged a flat fee of $5,000 (and pays 0.15%
in fund fees). In both cases, assume the return is a 7% annualized over
30 years. After 30 years, the client would have paid as much as $1M
more in fees to the AUM adviser for no additional benefit. In fact, most
of the fees come towards the later years when the portfolio has grown
to over $1M. Because flat fees are paid after-tax, they are also
tax-deductible as a miscellaneous expense on Schedule A or as a business
expense (if advice is related to business retirement plans).
Figure 1. Long term cost of flat fee vs. AUM fees.
Our conclusion is that AUM fees cannot be justified on any basis, and that a flat fee is the only type of fee (along with other fees for work such as hourly and per-project) that would be fair towards the client and would compensate the adviser adequately for their work.