Three weeks ago, in this space, I made the case that a lot of advisors – perhaps most – are deliberately charging less than the market will bear for their services. I'm pretty sure this is not what Adam Smith envisioned when he wrote about the "invisible hand" of capitalism.
But behind that profession-wide anomaly lies another perplexing peculiarity that may be equally pervasive. Many – perhaps most – advisors are overcharging a few of their clients and undercharging the rest. In other words, a small number of investment advisor clients are subsidizing the services that the others are receiving.
Consider what that means for a moment! Most investment advisory clients are being served unprofitably – and the disparity seems to be greatest when the advisor is also providing financial planning services.
Try this experiment
To see if your practice fits this description, try a simple experiment. Boot up a spreadsheet, and have somebody type in the names of each of your clients in the left-hand "A" column going down the page. Then have somebody look up the total fees each of these people paid you last year, from all sources. For most of you, this will be their annual AUM fees, plus perhaps a project fee for any planning work you might have done. For those of you who earn commissions, put those into the calculation. Tote it all up, and put that aggregate amount each client is paying you in the "B" column going down.
Now calculate your total office overhead last year, minus professional salaries – that is, the annual rent, the yearly cost of your computers and software, supplies, phone, salaries plus benefits of all your clerical employees, etc. Divide that total cost figure by the number of clients you have, and put that dollar figure – it should be the same for every client – in the "C" column.
Finally, calculate your compensation (I would leave out dividends the company is paying you, but include any bonus you earned plus the cost of any benefits you receive from the company) and the total compensation of your professional staff members. Then look at your client list. Are any of your clients using up more of your time, and/or your professional staff's time, than the others? Chances are, the answer is yes; you have a whiny client who calls every time the market goes down half a percent or more, and another client who always seems to be going through a crisis, and yet another client who asks you for a lot of charitable planning work – and so forth. Assign these clients a proportionately higher percentage of your professional costs (this is the creative part of the exercise), and identify a few clients who take up no professional time whatsoever. (Are they still living?) In the "D" column of your spreadsheet, assign variable professional costs to your different clients.
In the "E" column, you add up each row's "C" and "D" values – to get the total of what you’re spending to service each client – and subtract that amount from the revenues represented in each row's "B" cell. Then sort the whole thing on the values of the "E" column, so your most profitable clients are on top and the unprofitable ones fall toward the bottom. (If this whole exercise takes you more than 30 minutes, you're obsessing too much about the precision of your figures.)
Look hard at the numbers. What do you see? If you're like most advisors, only 15%-20% of your clients have a positive value in the "E" column, and they, in aggregate, represent 120% of your total profits or more. The rest are unprofitable. If you want to get fancy, add a 25% profit margin to your total cost figure, because ideally you want all of your clients to generate at least a sufficient return on your capital to make it worthwhile to be in business.
Look closer, and you notice that a few clients are obscenely profitable – so much so that you're embarrassed and may be wishing you hadn't gone through this exercise. These may not be the clients who have the largest portfolios or pay you the most money. Chances are at least some of them are the clients who never trouble you with a phone call or expect a personal meeting. (They are alive, aren't they?)
Scroll down the list, and you see a litany of pricing dysfunction: client after client who pays you less than he or she costs to service, some of them (I'm guessing this includes that whiny one) a lot less. The clients on the top are paying you to serve the clients on the bottom.
Now ask yourself: is that fair? Will they continue to tolerate this? Would that ever happen in, say, a medical office, or a law firm? Can you imagine a CPA raking in huge profits on some clients and losing money on most of the others, and not be aware of it? This, to me, is an anomaly as significant as the overall pricing dysfunctions noted in my earlier column.
The problems with AUM-based fees
Now that you know this, what can you do about it? Many of the leading-edge advisors that I talk to are starting to charge retainer fees in their practices. There are a variety of reasons for doing this. One is that it eliminates a few residual conflicts of interest that you find in the AUM model: things like advising a client on whether to take money out of the AUM portfolio to pay off a mortgage or invest in a rental real estate property. It also addresses a much bigger conflict: If you get paid only when you manage client assets, then you will always recommend to your prospects that they pull their money away from whoever is currently managing it (no matter how good or bad he or she is) and let you take over the portfolio. If you charge a retainer fee, you can say to the client, “You can keep those outside managers if you want to, because it won't make any difference in how much you're going to pay me.”
There are some business reasons to switch from AUM to retainer. One was painfully obvious in 2008; when the market plunges, every AUM-compensated advisor takes a drastic pay cut, whether they deserve it or not. Another is that many clients are going to retire someday, which means they may start decumulating their portfolios, reducing the AUM fees they're paying you year after year. And when clients die, the assets will scatter. Even if you manage to retain all the relationships with all the heirs, the resulting portfolios will be smaller and more expensive to service. They'll fall right to the bottom of your spreadsheet.
Finally, there is one big reason why all advisors should be looking hard at a switch from AUM to retainer – even if they don't intend to do it immediately. The reason can be found in a story an advisor told me some years ago, about a wealthy – and very savvy – prospect who walked in the advisor's door and inquired about his services. The prospective client wanted to move his $15 million portfolio out of a brokerage account, and the advisor agreed that this would be an excellent decision, offering an impressive description of his planning and advisory services.
Of course, the prospect asked how much he'd have to pay for all these wonderful services. The advisor enthusiastically told him that the payment would be a percentage of his assets under management.
"So let me get this straight," the prospect said after a moment. "If I have you manage the full $15 million, you'll provide me with those services you just mentioned for a percentage of my portfolio; is that right?"
"Yes," the advisor answered, confident that he was about to win the account.
"And you would offer the same services if I only had, say, $10 million?" the prospect went on.
"Absolutely," the advisor answered.
"$1 million?"
"Yes; that's my minimum," the advisor answered.
"So why don't I only give you $1 million of the total," the prospect proposed, "and even with your sliding scale, you'll provide me with all these services for less than a fifth of what it would cost me if you managed everything. Then I could put the rest in the hands of a private money manager."
You may not have had this conversation yet, but chances are someday you will, and you'll wish you had a retainer alternative for clients.
But let's get back to that spreadsheet. What do retainer fees have to do with the fact that only a handful of your clients are profitable?
If you found anything moderately compelling about the retainer fees argument, then this spreadsheet is a golden opportunity to give the idea a try. Take a few of the clients at the bottom of your list and make a decision that you're going to covert them to a retainer arrangement that will (at the very least) make them profitable for you to service. Test the idea out on them, and see how it works. What have you got to lose except a few highly unprofitable relationships?
Once you have the conversation nailed down, go through your spreadsheet and make all of your clients profitable. I might suggest that you also give your obscenely profitable clients a break and do the same for them, but that's for you to decide. (This might be an excellent way to find out if your low-maintenance clients are still alive.)
Voila! At the end of this exercise, within a year, you could wind up with a client base that is profitable from the top of your spreadsheet to the bottom.
The downside to retainers
Are there any problems with this model? Yes. Clients may be resistant to writing a quarterly check. But you can always continue to bill the fees out of the portfolio; it will just be a fixed fee rather than the variable one. Or you can give clients a choice. Some advisors report that their clients like paying their quarterly fees by credit card and getting the frequent flyer miles. One advisor gives clients the option of paying all of her fees for the coming year in late December, giving them a tax deduction in the current year.
Another problem: Retainer fees can feel, and look, arbitrary – more so, at least, than the coldly mathematical 80 basis points of the amount in the portfolio. But once you go through the spreadsheet exercise, some of that arbitrariness goes away.
Here's a big drawback: The retainer model doesn't automatically give you a raise every time the market goes up, which it will do, based on historical averages, about 70% of the time. You might want to build in an annual inflation-indexed increase in your fees, or periodically ask your clients for a raise – because, after all, you are their employee on some level. But that problem is offset by an advantage: for advisors who do financial planning casework or offer advice on things other than the portfolio itself, the retainer does a better job of reflecting the value of these other services.
Finally, smaller or more complex clients will have to pay more than they are currently paying you. But you might be able to turn this to your advantage. David Lewis, who practices in Knoxville, TN, charges a minimum retainer fee, and tells less-wealthy clients that his goal is to help them reach, as quickly as possible, a net worth point where they will be paying him just 1% of their portfolio. When clients reach that point, there is a celebration.
If you decide to embrace retainer fees, and after a year of client conversations you manage to reach the point where all of your advisory relationships are profitable – where nobody is subsidizing anybody else – then your business model will have achieved the same level of pricing function as other professions enjoy.
Monitor your progress toward that basic goal, and you, too, can quietly celebrate the day you achieve it.
Bob Veres's Inside Information service is the best practice management, marketing, client service resource for financial services professionals. To invest in your practice and professional career, the annual cost is $299 a year with discount code 55DF: www.bobveres.com.
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