Why AUM Fees Are Going Away

Three of my four children are adults now, and my youngest is 13. When they were between the ages of three and five, they would incessantly ask the most irritating question faced by all parents…Why? Why do I have to eat my Brussel sprouts? Why is the sky blue? Why can’t I have a new bicycle? While “because I said so” was often my answer, I knew in my heart they deserved more. I was reminded of this after we conducted a survey of 5000 financial advisors in which we asked two questions:

1. Do you charge clients based on assets under management?
2. If you could, would your change the way you charge to a flat fee or a retainer?

88% responded “yes” to question #1. 83% responded “yes” to question #2.

From my perspective this is a trend and raises some big questions, specifically: Why? Why change at all? Advisors earn more when assets grow through market lift and additional assets being added to client portfolios.

Instead of answering “this is the way I’ve always done it” let’s take a look at why this emerging trend is taking hold.

First, take a good look in the mirror and put your self-interest and ego away. Why are your clients working with you when they can get almost identical performance and service almost anyplace else? Everyone in this business (except the clients) knows that online advice platforms have been around for a long time. They’ve just been internal to the firm. Now that “robo advisors” are gaining momentum, are here to stay and charging 25 basis points or less, clients are asking why they should pay you 1% or more. We know the answer. Advisors DO more. Consequently, it’s going to be difficult to convince clients that advisors do more when the way they are compensated mirrors that of online advice.

Second, advisors are beginning to realize that the bulk of the work they do is being done, in the clients mind, for free. Take financial planning as an example. A client has a $10 million portfolio, and financial planning is part of his 1% AUM fee. What if the portfolio is $5 million or $1 million? Does the client still get financial planning? Of course they do. Apply this concept to portfolio construction, manager selection, performance reporting, and unique services such as an analysis of the client’s real estate portfolio, oil and gas holdings, etc. When advisors put on their CEO hats and dive into what their costs are across the board on an hourly basis, including their compensation, they are finding that they lose money on about 80% of their clients. The top 20% subsidize the rest. Charging an AUM fee prevents the client from seeing what the advisor’s value proposition really is.

Leaving the third party manager pay-to-play issue for access to major firm platforms aside, the AUM fee presents the potential for a conflict of interest in the following way: Let’s say for instance that a client comes to an advisor for advice on an external opportunity into which he is considering investing $1 million. If you advise the client against making the investment, could the client come to the conclusion that you want to manage the money and make $10,000 assuming a 1% fee? If you advise him to make the investment, it just may have cost you $10,000.

In addition to the aforementioned, advisors are looking at flat fee engagements because it opens up the viability of taking on high income clients that will pay the same advice fees that an advisor would charge wealthy clients, but don’t have a minimum of $1 million to invest. True, the AUM fee model works well for advisors when markets are rising. What happens in a downturn? Costs stay the same and revenue plummets. Clients need more attention. A flat fee or quarterly retainer protects the advisor’s business.

Anyone reading this understands it’s not a question of if a downturn will occur, but when?