Fee-only financial advisers have long held themselves out as being more ethical than commissioned stockbrokers. Fee-only advisers claim to adhere to a fiduciary standard that requires them to act in the best interests of their clients, meaning that they must set aside their personal interests and fully disclose all their fees and any conflicts of interest.
Stockbrokers, by comparison, must meet a much lower suitability standard, meaning that they must make sure that investments sold are suitable for a client.
Certainly, charging a client a fee based on the percentage of assets under management reduces the conflicts of interest that commission-based stockbrokers face when their livelihood depends on whether clients buy or sell securities. What's more, it often appears that stockbrokers are prone to recommending investments that carry higher commissions, which need not be disclosed.
TYPICAL SITUATIONS
Charging clients on an AUM basis, however, presents more-serious conflicts of interest than those faced by brokers, because the conflicts may involve much more money than the value of a trade.
Here are some typical situations where asset-based fee compensation poses conflicts for advisers:
• When advising a client to roll over a 401(k) for the adviser to manage, even when the client has equivalent and less costly options if they leave their funds with the employer's fund manager.
• When advising not to pay off a mortgage (thus diminishing assets), even when the mortgage carries a high interest rate.
• When advising against making a large charitable contribution to get a tax deduction (but decrease assets under management).
• When advising not to give large gifts to children to avoid estate taxes.
• When advising not to buy a larger home.
• When advising not to buy an annuity or set up a charitable annuity.
• When advising not to invest in real estate.
The most egregious conflict of interest inherent in the AUM compensation model is the common practice of charging a higher fee — often 1.5% — for managing equities than for managing bonds and cash, which typically are managed for 0.5%. Advisers routinely justify the difference by claiming that equities are more complex to manage, which I find self serving. (Why not just charge 1% for a balanced portfolio?)
As a result of this compensation difference, clients are almost always overallocated to stocks.
In all the cases mentioned, there may be good and impartial reasons for an adviser's recommendation. But in all these cases, and many others, the temptation to protect or enhance the adviser's own compensation is too great.
COMPREHENSIVE PLANNING
These conflicts are magnified when an adviser claims to be a comprehensive financial planner rather than merely an investment adviser. Comprehensive
financial planning includes more than overseeing asset allocation and making individual investments; it encompasses all financial aspects of a client's situation:
estate planning, tax planning, insurance coverage, debt management (including mortgages) and more.
Many comprehensive financial planners who charge a fee based on assets under management give short shrift to other aspects of a client's situation. After persuading a client to sign on, they might speak or meet with the client relatively rarely.
This is what would be expected, as people generally do what they are paid to do. If they are paid for gathering assets, that is what they focus on.
The National Association of Personal Financial Advisors has long championed the importance of commission-free financial and investments advice. The media has recognized its contribution in exposing unethical practices fostered by commission-based compensation.
Now, however, most stockbrokers and fee-only advisers, including NAPFA members, charge fees based on assets under management. In terms of compensation, the two types of advisers have become indistinguishable.
As a pioneer and member of NAPFA, I think that advisers who charge AUM fees fall short of what should be expected of true fiduciaries.
The NAPFA fiduciary standard limits adviser activity to the “purchase or sale of a financial product” rather than “any transaction.” A clear standard should require that an adviser's compensation not depend on any transaction where a client is relying on the adviser's counsel.
The examples of conflicts of interest listed earlier all involve transactions that aren't purchases or sales of investments.
To avoid most conflicts of interest, it is simple enough for advisers to charge a flat annual retainer fee that isn't affected by a client's decisions regarding any specific transaction. The structure of a flat fee — which may be more or less than an AUM fee — insulates the adviser from any taint of conflict attributable to compensation.
This pricing model is well-established as the minority trend in the profession, with hundreds of successful practices having adopted this approach.
TERRIBLE BUSINESS MODEL
Ironically, as common as assets under management is for compensation, it is a terrible business model. By tying themselves so closely to forces over which they have little control, excellent advisers can see their annual revenue plunge by 50% even as their workload grows.
If advisers are, in fact, providing comprehensive advice and aren't being compensated directly for their services, they are providing them for free.
There are other reasons that the AUM pricing model is flawed.
First, it is deceptive. “I charge 1.5% of assets I manage, so I make more money only if you do” is an enticing but misleading sales pitch.
Most people can't or don't do the math, and don't realize that 1.5% of $1 million amounts to $15,000 a year — a fee they likely would resist paying if it were transparently stated as a dollar amount rather than as a percentage. Moreover, AUM fees are deducted directly from a client's account, and so the fee is seldom overtly seen.
A strict ethical approach would require that these potential conflicts be disclosed at the time of engagement, and again whenever an adviser's specific recommendation could be construed as a conflict of interest. When a situation involves an egregious conflict of interest, such as advising an investment in the adviser's own investment schemes, an adviser should be required to recuse himself and recommend that the client get a second opinion, a practice common in other professions.
If fee-only advisers want to hold themselves out as being the most ethical practitioners of their profession, they should commit themselves to adhering to the highest possible and least conflicted standard.
Bert Whitehead, founder of the Cambridge Connection Inc. and the Alliance of Cambridge Advisors, is the author of “Why Smart People Do Stupid Things with Money” (Sterling, 2009).
