Like it or not, there is an increasing focus on fees in financial services. This is due, among other things, to the rise of passive investing, the emergence of robo-advisors and the adoption of the DOL fiduciary rule. Clients are getting the message: What they pay makes a big difference over time.

In response, many advisors are re-examining their fee schedules. The percentage-of-AUM fee model is still dominant and is likely to remain so for years to come (change comes slowly in our industry). But many advisors are considering, or have already incorporated, alternative fee models into their practices. These include flat fees, retainers and hourly fees.

Our Move to Flatland

At First Ascent Asset Management, we recently adopted a flat-fee pricing model. That decision was the result of an internal discussion about how to make our firm stronger and more competitive in the years to come. I will share some of our thinking here.

The point is not to convince you that flat fees are the way to go. There is no such thing as the “best” or “right” fee schedule. The point is to encourage you to go through your own process of critical self-examination. Test the strengths and weaknesses of various fee approaches in the context of your own firm. Make sure you can confidently answer client questions about fees and that you employ fee schedules that will make you strong and competitive in the future.

Keep in mind that we are an asset management firm that serves financial advisors, not a traditional advisory firm. We do not work directly with investors; we work only through advisors. We do not provide individualized financial, estate or tax planning services. So the considerations that caused us to adopt flat fees may not apply to your firm. Nevertheless, the process we went through should be instructive.

Exuberant Rationality
We adopted flat fees in part because we perceived a lack of rationality underlying the AUM fee approach for our business model. In our world, it does not take any more work to manage a $1 million account than it does to manage a $100,000 account. We were at a loss to justify why our larger clients should pay so much more than our smaller clients.

Some advisors don’t share our concern, pointing out that they add more “value” to larger accounts. That is, when a $1 million account goes up 10% it benefits more, in dollar terms, than a $100,000 account that goes up 10%.

Our problem with this idea is that we do not control either the size of the client’s account or the direction of the market, the two factors that cause large accounts to benefit more. Saying we created more value in this context seems like we are taking credit we don’t deserve.
This problem can be ameliorated to some extent by placing a cap on the level of AUM fees that can be charged to a client. A cap recognizes that, at some point, advisors have been fully compensated for whatever value they added.

The AUM fee model has more logic for a comprehensive financial planning firm where larger relationships tend to involve more complexity. More complexity tends to come along with more work. Where there is a strong correlation between the size of an account and the amount of work required, AUM fees make sense. At our firm, that correlation is small, at best.

Another problem we had with the value-added rationale for the AUM model is that it falls apart when markets decline. If a $1 million portfolio declines by 10%, it loses more, in dollar terms, than the $100,000 account, yet still pays more in fees. If large accounts should pay more when they benefit more in dollar terms, shouldn’t they pay less when they lose more?

One could argue that an advisor using behavioral coaching could ultimately save a large client more than a smaller client in a down market and thus add more value. This may justify the higher fee for the larger account. But we rarely interact directly with clients—that is the advisor’s job—so we can’t claim to add value in this manner.

A positive feature of the AUM fee model for both financial planning and asset management firms is that it imposes fees in a manner that roughly corresponds to a client’s ability to pay. This smoothing effect makes the AUM fee model easier to administer than a flat fee schedule.

Planning firms that use flat fees must create tiers of service and correctly assign clients to the proper tier. If the anticipated level of service turns out to be incorrect, or if the scope of the assignment changes, the fee must be renegotiated. AUM fees are self-adjusting.

Same Side of the Table
AUM fee advocates correctly point out that most clients never raise concerns about the rationality of the model. In fact, if asked, many clients express support for it because they like the idea that the advisor’s income rises and falls with the value of the client’s portfolio. This view embodies the underlying assumption that advisors will work harder to improve the portfolio’s performance if they have skin in the game.

In our experience, this is not how the world works. Many of us build model portfolios for our clients. They are the best models we can build. We don’t build better models for $500,000 accounts than for $400,000 accounts.

We may spend more time interacting with our larger clients because they are more important, economically speaking, to our business. But we are not working harder on their portfolios. As fiduciaries, we have already built the best portfolios we could build for all our clients.

You Pay For My Mistakes
Still, the AUM fee model’s advocates point out there is more liability associated with larger accounts than with smaller ones. A trade error in a large account could cause significantly more damage than the same error in a small account. The increased potential liability justifies increasing fees.

There is economic logic to this argument. But in our case the higher AUM fees for the larger accounts would far exceed the increased variable cost of adding the insurance necessary to cover trade errors for larger accounts. We also had a more basic subjective concern about asking our clients to pay an insurance premium that protects us against our own incompetence.

Client Friendly
Another reason we adopted flat fees is that we believe clients like transparency and simplicity. We thought the advisors we work with would appreciate being able to tell their clients exactly what they were going to pay for our services at the beginning of each year.

Studies show that clients often do not understand what fees they pay for financial services. Most clients have no idea what a basis point is. But as they become more educated about fee issues, this will change. As it does, we thought advisors who work with us could use our low, flat fees to lower total costs to their clients without affecting their own revenue stream.

Is transparency always a good thing? Flat fees may be unpalatable for some clients, especially if the fees are set at a relatively high level. A $1 million client may not hesitate to pay a 1% annual fee, but may balk at paying a $10,000 fee. Seeing the actual dollar figure can be shocking. This is not a concern for us since our flat fee is very low in dollar terms.

Consider also that, outside of the financial services industry, charging a variable fee for services based on the benefit to the end user is highly unusual. For example, accountants don’t charge variable fees based on how much they save you on your taxes. Today, this does not seem to be an issue for most clients. But as they become more educated and have more alternatives to choose from, they may become less satisfied with the variable aspect of AUM fees.

Eliminating Potential Conflicts
Flat fees also eliminate a potential conflict of interest that is inherent in the AUM fee model. If an advisor’s fee is based on the size of the client’s portfolio, there is an incentive to shade advice toward maintaining assets in that portfolio. Encouraging a client to pay off a mortgage or pay down credit card debt directly reduces the advisor’s compensation.

AUM advocates correctly point out that most advisors deal quite effectively with this conflict and do not succumb to it. But as clients become more educated on the fee issue, will this potential conflict plant the seeds of discontent? Flat fees eliminate this possibility.

Increasing Flexibility
Another reason for advisors to become familiar with alternative fee approaches is to increase the flexibility they have in dealing with atypical situations. For example, a wealthy individual with all her assets tied up in a business might have significant financial planning needs and be an excellent long-term client, but may not be a good candidate for AUM fees because she lacks liquid assets. A flat fee for financial planning may solve the problem. Likewise, hourly fees may be a useful solution for projects of uncertain scope or duration.

No Perfect Fee Schedule
Understandably, many advisors are resistant to considering alternative fee models. Change is uncomfortable. It requires thinking about the value of your services in a new way. It feels like an attack on the traditional AUM fee model, which has served the industry so well for so long as it has transitioned away from commissions. This topic generates heat and emotion.

Chill out! There is no such thing as a perfect fee schedule. Every alternative fee model has its shortcomings, too. But as alternative fee models emerge, advisors should learn about them and consider how they can be used to remain competitive in this dynamic environment.

Clients are becoming more inquisitive about fees, too. Advisors should be ready to explain how their fees link to the value of the services they provide. Even if you stick with the AUM fee, make sure you are familiar with the strengths and weaknesses of the various fee alternatives and can respond effectively to any questions your clients have on this topic.