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We Told You So

The assets-under-management pricing scheme needs to be replaced.  

David J. Drucker, 07/23/2009

Since the fall of 2008 and the U.S. economic meltdown, advisors have lost hundreds of thousands of dollars in revenues that they didn't have to lose.

Consider this analogy ... you walk into a swanky restaurant ready for the full fine-dining experience, and this restaurant can deliver. It's beautifully appointed, creates an impressive yet comfortable ambiance, and features the finest gourmet delights on its menu.

What's strange, though, is the pricing. Along with your entree comes the standard steamed vegetable medley and the price of your entire experience is based on the daily price of one of its ingredients: asparagus. If asparagus is running, say, $3.60 a pound, the restaurant multiples that by 10 and charges you $36 for your dinner.

Now let's further suppose that asparagus is a vegetable that becomes gradually more costly to grow over time so, while--like most commodities--it fluctuates in value, it also enjoys a rising long-term price trend. This is perfect for the restaurant because the prices of its meals then rise, on average, to help cover inflation's effects on the restaurant's overall cost structure.

All is well until, one day, the bottom falls out of the asparagus market. Prices decline almost overnight by 30%-40%, and the restaurant takes a huge hit to its top line. Customers have become accustomed to the restaurant's pricing strategy and are now enjoying the fine-dining experience at a much lower price, causing consternation and downright financial havoc for the restaurant.

Sounds a bit silly, right? This could never happen. A restaurant would never price its meals this way, right?

And yet, financial advisors do it every day. Granted, the analogy isn't perfect but it's enough so to make the point: advisors sell the financial management experience based upon the value of one important-but-partial piece of that entire experience.

The typical independent advisor today offers an experience [see The Experience Economy: Work Is Theater & Every Business a Stage by B. Joseph Pine and James H. Filmgoer, in which he takes good care of his client financially and otherwise. The experience he sells incorporates hand-holding, analysis, friendship, investment management, social opportunity, financial planning, and the exploration of life values, goals, and dreams. What today's independent advisor offers is the financial equivalent of the fine-dining experience.

That's smart. Clients want all the pieces of the advisor's service, and they were once used to getting them in different places. The fact that the advisor can offer them all under one roof is very appealing to the client and creates tremendous value for the advisor.

So how does he price this wonderful experience? He bases the price on one piece of it: the investment management piece. As the value of investments rises and falls, so go his revenues. And so went the revenues of tens of thousands of advisors over the last year.

If advisors had based their prices on the experience they create for their clients rather than the value of the clients' investments, they wouldn't be hurting now. They wouldn't be scurrying to update their business planning and assuring employees that they still have jobs (or laying them off, as necessary, in many cases).

Most advisors would hesitate to employ a performance-based pricing structure--sharing in the gains and losses of their clients--yet they do it anyway when they tie their fees to assets under management. Why? Because no one thought what happened could happen--namely, that the stock market would lose 30%-40% of its value almost overnight. This is a once-in-century event, they reasoned, and we feel pretty secure in taking our chances. Well, that plan didn't work too well, did it? History and the law of averages caught up with every advisor employing an AUM pricing strategy--and that's most of them.

I and many other practice management writers in this industry have been counseling advisors for years to employ retainer fees. Why? Because they most clearly reflect the independent advisory experience. Retainer fees charge the client for the entire experience he enjoys based upon the totality of the services we offer. It only makes (common) sense to use this kind of a price structure.

How might it have worked over the last year? While there are many variations on the retainer fee scenario, it usually goes something like this: The advisor assesses the overall service he'll provide the client, the amounts of time he'll spend, the riskiness of the portfolio the client needs and difficulty of managing it, the complexity of his financial circumstances, the degree of personal interaction the client requires--in other words, all of the elements that make up the financial advisory experience to the client.

You shouldn't want to tie the price of this exclusive bundle of services to one service subheading but, rather, the entire experience. Granted, the fee may be arrived at by totaling up what you would charge for each of the services individually (which is the way many advisors formulate retainer fees), but the fee doesn't fluctuate with market changes.

Why wouldn't it, you ask? Because there's just as much work you do for the client when assets are falling as when they are rising in value. "But I feel guilty that I've lost so much money for my clients; I only feel right sharing in their pain." Fine, but at least do the math correctly. Investment management is still just one small piece of what you do (If not, then you're going about comprehensive planning all wrong). So why would you want to decrease your entire fee when just one service has perhaps become less valuable to the client. Either way, you're leaving money on the table and you're misrepresenting to your clients what you really do for them when you employ an AUM fee structure.

Charging by AUM says, "I'm a money manager. Any planning I might do is strictly ancillary." Does that sound like your service offering? If not, then you need a fee structure that reflects the experience you provide, not one based on the whims of the stock market--much less the price of asparagus.

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