Why the Future is Bright for AUM-Based Advisors
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Over the past several months, I have been reading Dan Solin’s thought pieces in Advisor Perspectives and believe his gloomy outlook for the planning profession, and, more specifically, for advisors who are compensated via AUM-based fees, is misguided.
I appreciate the contributions of financial planning industry thought leaders, including Dan, Bob Veres, Suleman Din and others, and nothing in this article is intended as an affront to the valuable insights they often provide. However, Dan’s outlook belies the economics of the planning profession and the subtleties of independent advisors’ value propositions.
In this rebuttal, I will provide an empirically supported deconstruction of Dan’s primary lines of reasoning, in order to assess the validity of his underlying assumptions. My goal in presenting this counter-perspective is not to push back against Dan (in fact, I appreciate the discussion he has stimulated as a “devil’s advocate”), but rather to give fellow advisors a framework for assessing their place in today’s competitive market place and for helping them better articulate the value they deliver for the fees they charge.
Economics and conflicts of interest in advisor compensation models
The last two decades have seen a dramatic shift away from commission-based brokerage sales to asset-based investment advisory fees. This sea change was fueled by increasing public awareness of the lack of disclosure and conflicts of interest inherent in the commission-based sales model. Today, asset-based advisory fees are by far the dominant compensation model for the financial planning profession. However, in his December 2016 article, Dan asserted that the seeds of the asset-based fee model’s imminent demise lie in the fact that it is no less conflicted than the commission model. Specifically, the AUM model creates a clear disincentive for advisors to give planning advice that might be in the client’s best interest when the transactions reduce assets under management. For example, an advisor might be reluctant to advise clients to liquidate advisory assets to pay down a mortgage or invest in real estate.
That obvious conflicts of interest may arise under the AUM fee model is not in dispute. In fact, I made the very same point in a 2007 Journal of Financial Planning paper, Who's the Fairest of Them All? A Comparative Analysis of Financial Advisor Compensation Models. I also wholeheartedly agree with Dan’s position that fiduciary advisors would do well to disclose such conflicts in SEC Form ADV Parts 2A & 2B and in their ongoing communications with clients. Where Dan’s argument falters, however, is in his view that alternative hourly and flat-fee planning models, which he suggests will soon displace the AUM model, are somehow “conflict free.”
With respect to hourly planning, a strong case can be made that it is actually the most conflicted of all of the compensation models. In simple terms, the advisor has an incentive to bill as much has he or she can, while the client has an inherent disincentive to spend time sharing information with the advisor or to call the advisor for planning advice. For evidence to support this view, look no further than the legal profession, where consumer ire for hourly billing is well documented. Examples of articles on this topic are as follows:
The Inherent Client Conflict of Interest Caused by Hours-Based Billing – Legal Executive Interest
The Conflicted Billable Hour – Lexis Nexis Legal Newsroom
The Tyranny of the Billable Hour – New York Times
Suit Offers a Peek at the Practice of Inflating a Legal Bill – New York Times
In addition to the obvious conflict presented by the advisor’s or attorney’s incentive to wield a heavy pencil in recording billable hours, this model also presents a subtler conflict in the form of so-called “value-billing.” For instance, it might take a planner 20 hours to write a financial plan from scratch, but because he or she has created many plans over the years, that advisor may develop time-saving templates or adopt new technology that may reduce the preparation time down to, say, five hours. Should the advisor now bill 20 hours or only five?
Conflicts of interest in the flat-fee/retainer model are less obvious than with hourly billing, but the basic of the principles of economics reveal their existence. Incentives drive behavior, and in the flat-fee/retainer model, the advisor’s incentive is to charge as much as possible for doing as little work as possible. Support for this innate proclivity can again be found in the legal profession, where retainers have also long been a common form of billing. An excerpt from a public awareness piece produced by the American Bar Association entitled, Attorney Fees: How to Avoid a Conflict with Your Client informed consumers, “There is an inherent conflict in almost every attorney-client relationship – it’s called ’attorney fees.’”