This is an ongoing series exploring the various financial advice fee models. In part one, I looked at the overall fee and commission landscape and discussed the incentives inherent in the commission only model. In this post I will be discussing the fee only model, specifically fees based on a percentage of the assets being managed by the advisor.
While the ability to charge fees for investment advice has been around since the Investment Advisor act of 1940, for most of the 20th century it was common for retail investment firms to be mostly compensated by commissions.
Around 20 years ago there was an acceleration in advisors starting independent Registered Investment Advisory firms (RIAs). These Advisors would offer to manage money in a fiduciary capacity, did not charge commissions, and would be compensated based on a percentage of the assets managed.
The Assets Under Management (AUM) model has become increasingly popular over the last 20 years amongst fiduciary RIAs and broker-dealers alike. Some of those pioneering RIAs, through organic growth and M&A, have become national in scope.
This model has almost entirely replaced the commission only model. Most of the largest firms are now either entirely fee only, or charge a combination of fees and commissions.
The typical fee is around 1% annually on portfolios up to $1,000,000. Fee schedules are usually lower for larger portfolios.
Pros:
- Because the client is paying a fee directly for financial advice there is no incentive for the advisor to recommend certain investments over others. This alleviates one of the main conflicts of interest in the commission model.
- There is potentially an alignment of incentives regarding portfolio performance between the client and advisor. The revenue of the advisor and advisory firm is directly tied to the amount of assets being managed. As the portfolio grows in value, the dollar amount of the fees being paid increases. If the portfolio declines in value the dollar amount of the fees being paid decreases.
- There is an incentive for the advisor to provide ongoing value to the client. This is a very profitable model if a client stays with their advisor. It is much easier to retain a happy client than onboard a new one. There is a strong incentive for advisors to continue to provide value added services to the client.
- Unlike commissions, this model results in consistent reoccurring revenue for the advisory firm. In turn, this allows firms to add services and build out teams of specialists. These services include financial planning, insurance, tax, and estate strategy. I would consider these services even more valuable than the portfolio management that the fee is based on!
- Many of the best independent advisory firms have moved to a fee only model. These firms increasingly employ the most talented advisors and can attract and retain quality new advisors.
Cons:
- The fee is tied directly to portfolio performance. This may cause undue focus on the portfolio at the expense of what in my opinion is the more valuable financial planning. Professional investment management is certainly valuable. However, the combination of individualized financial planning with competent investment management is what I think most benefits the client.
- The AUM model is potentially more expensive over the long run than other models. Because it is based on a percentage rather than a flat dollar amount, as your portfolio balance exponentially grows over time, so will the cost. The fee will essentially be a hurdle on performance vs. investing on your own. This cost should be weighed against the significant value that is derived from an ongoing relationship with your financial advisor.
- There is a potential disincentive for the advisor to give advice that would reduce the amount of assets being managed. For example recommending using assets to pay off a mortgage or gifting assets to charity.
- The firms using the AUM model tend to have high minimum investments of at least $500,000. Many of the best firms have minimums of over $1,000,000.
The AUM model is currently dominant in the Registered Investment Adviser space. It is likely that if you are a high net worth investor engaging with an RIA firm your Advisor is working under this model.
In a future post I will explore additional fee based models including hourly, project based, and subscription. These increasingly popular models have the potential to expand investment advice access to more investors who would prefer to not work with an Advisor under the commission model, do not meet the minimum investment amounts of the AUM model, or who would prefer to pay for financial planning advice on a one time or periodic basis.
Further Reading:
Financial Advice Fee Models Part 1: Commissions (Musings On Wealth)
Kitces & Carl: Is Any Financial Advisor Business Model Truly Conflict Free? (Transcript from Nerd’s Eye View)
What Fees Do Financial Advisors Charge? (Investopedia)
