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Financial Advice

Setting Fees That Serve Both Clients and the Advisor's Business During Market Turmoil

How best to bill advisory clients has been, and continues to be, a controversial topic–for good reason.

There can easily be an inherent conflict between lowering costs for clients and managing a profitable business. That’s true in normal market conditions. When severe market downturns like the one we have just lived through come along, they not only take a bite out of client portfolios, they also put significant pressure on an advisor’s business and our ability to service our clients.

But I think my firm has found a way to bill clients that enables it to be a successful, long-term-focused business that can weather severe market setbacks and, in the process, keep clients’ interests in the forefront.

Part of the challenge is that the options are limited: fixed retainers, assets-under-management-based fees, net asset-based fees, or a combination of these. But from where I sit, none of these methods gets it right. Compared with commission sales, advisors' fee structures are certainly "fair" to clients, but are not always equitable to advisors, and that matters.

As a fiduciary, I make a promise to put my client’s long-term interests first when it comes to their investments. But we’re not a charity. I have overhead to cover, including the salaries of 15 employees.

In this article, I will review the pros and cons of current fee structures and then offer up our solution.

Current Fee Structures

AUM Billing:

Currently, most advisors charge based on a percentage of assets under management. Although specific rates and breakpoints differ by firm, fees are typically drawn directly from client accounts quarterly. The advantages of this methodology are numerous:

  • It's easy to calculate.
  • Collections are seamless.
  • Revenue increases as portfolio values increase
  • Clients don't "feel the pain" in their normal cash flow.
  • Fees seem fair as they are based solely on the amount managed and vary according to how well the portfolio performs.

Despite the simplicity and long-term revenue growth, there are disadvantages to AUM-based billing:

  • There is no differentiation between high-work and low-work clients: Those with similarly sized portfolios will pay similar fees.
  • There is no differentiation for clients with substantial outside investments that require advice and coordination with assets managed.
  • Fee emphasis is on AUM with no value recognition for financial planning, coaching, and other services.
  • Reduction in revenues during down markets can have a serious impact on the financial stability of the firm.

It’s this last point I want to focus on, given the market turmoil of recent months.

Let’s take an example of an advisor who charges 1% on AUM. In a normal quarter, employee wages and overhead run about $250,000. With AUM of $150 million, quarterly profit is about $125,000.

That’s a nice salary, with enough for the principal to pay family living expenses, taxes, and a small cushion.

When average portfolios fall by 30%–declines we approached with some client billings in 2008-09–revenues become $105 million and quarterly profit drops to $12,500. In other words, in this example, when clients' portfolios drop by 30%, the advisor’s profit was slashed by 90%. This is not enough to cover the principal’s ongoing expenses.

In this time of COVID-19, advisors are also facing increased costs. Not only are they required to maintain offices, they must absorb additional costs for employees to work remotely. These costs can include new laptops, licenses for remote meeting applications, higher-capacity data plans, and more. Along with the increasing costs, advisors must deal with greater client needs, both in terms of communication and services. Down markets lead to more tax-loss-harvesting opportunities and a higher number of rebalancing trades, work that requires time and employee resources. And, in today’s world of frequent new legislation, we also need to understand and interpret the new laws for the benefit of our clients.

The higher workload and needs of our clients mean that, if we’re really thinking about what’s best for our clients, we cannot lay off employees or reduce their work hours. (And, would it really be fair to employees as well?) The bottom line is that AUM fees put advisors in a precarious financial position at the very times when their services are more critical than ever.

Retainer Fees:

A far second in the use of billing structures is retainer-based fees. In this structure, the advisor typically charges a fixed quarterly fee for providing investment services and advice. The fee might be loosely based on AUM, net worth, anticipated amount of work, or a combination of the above. The benefits to this fee structure are certainty, a perception of greater “fairness,” less emphasis on portfolio performance, and simplicity of billing. The downsides could include the necessity for clients to pay outside of their managed accounts, regulatory justification for fee disparity, no automatic revenue increases, and the need for a conversation/negotiation when requesting an initial fee or rate increase.

In my experience, I have never seen an advisor move from AUM billing to retainer fees without initially decreasing revenue. For example, assume a client’s AUM fee for a prior quarter was $4,185. An advisor negotiating for a fixed fee would likely not request $4,500 or $5,000 for fear of client resistance. Instead, the advisor is more likely to request $4,000 per quarter–or, at best, $4,200 per quarter. Having ongoing fixed fees while portfolio values rise and internal costs increase annually can lead to tight finances for advisors. On the other hand, what about clients who are in retirement and drawing down their portfolios? Should their fees be reduced as their balances decline?

Other Billing Structures:

The top two billing structures are clearly not ideal. Other fee methodologies include a hybrid of AUM and retainer, net worth billing, and hourly billing. No matter which method is utilized, the same drawbacks discussed above can apply. Both the AUM and net worth methods can lead to disparate billing results. Those with higher AUM or net worth might actually be less complex and work-intensive than other clients with lower AUM or net worth. Is it truly in the best interest of clients to bill on assets not directly managed? Is it fair to charge vastly different retainer fees to clients with similar AUM or net worth? How can you charge hourly when much of an advisor’s time is spent on activities benefiting all clients?

Our Solution

The Back Story:

Having lived through the 2008 market plunge, I learned firsthand how the AUM fee structure put my firm’s existence at risk. With the workload and my sense of morality in play, I couldn’t lay off employees or ask them to accept pay cuts. Along with the stress of the market, I had to deal with real financial stress. Would the market recover before my business situation became critical?

My firm survived–barely. But 2008 taught me a big lesson: I knew I didn’t want my practice to risk closure because of any future market declines.

The Thought Process:

Considering the attributes of the existing fee structures, I wanted to find a solution that would capture the advantages while minimizing the disadvantages–not an easy balance!

Although the AUM model has its downsides, it is the industry standard.

The mismatch of fees versus complexity could be handled by billing separately for significant add-on work, such as structuring a business buyout. It’s not perfect because there will always be some clients needing more time than others. Over time, that should even out.

But what about market downturns? If we get higher revenues when the market is positive, shouldn’t our revenues decrease when the market is negative? Outside of extreme drops, I would say yes. The advisor is paid based on assets managed; the fees should reflect both up-market and down-market periods. After all, that puts us on the "same side of the fence" as our clients. But our drop should not be geometrically higher than that of our clients!

Unfortunately, when there is an extreme drop, advisor profit plummets.

Is it in the best interest of clients for their advisor to stay in business? Is it in the best interest of clients to pay enough so that their advisor is reasonably compensated for working harder than ever? In the long run, there needs to be a “stop-loss” on AUM fees. That is how my firm bills.

AUM With Minimum Fee:

Our clients pay an AUM fee that will not be less than a certain minimum amount. The minimum is set at the beginning of the year and only comes into play if a calculated fee is less than 95% of the minimum fee, adjusted for deposits and withdrawals. So, although our revenue declines along with market dips, it does not drop below what we feel is a reasonable compensation–and our firm stays in business.

How Did Our Clients Handle It?

We changed our Advisory Agreements in 2009 and notified all clients. We explained the need for a minimum fee provision noting the same points as above. Our clients understood, and not a single client refused the amendment.

In the years since the change, we've had minimum fees kick in only occasionally (during down markets such as the third quarter of 2011 and the second quarter of 2010) and typically for just a handful of clients. But during the COVID-19 crisis, minimum fees applied to almost all our clients–the first time that has occurred.

Along with our April invoices, we included a note explaining and reminding clients of the minimum fee calculation. Aside from one client asking for further information, we heard no objections and received several supportive emails.

And how were our April quarterly fees? Since we added new clients during the quarter, our collections were greater than the previous quarter.

Did our clients benefit? Although my team was feeling the stress of the COVID-19 pandemic, financial stress did not add to that. My firm was and continues to be 100% operational. We were able to harvest millions of dollars of tax losses and rebalance all portfolios as needed. Additionally, we digested all the new legislation and guided our clients on pressing needs including PPP, EIDL, stimulus checks, unemployment, charitable giving, and Roth conversions. Finally, we've been there to hold our clients' hands with personal conversations and virtual meetings, webinars, emails, and blogs.

Time for a Change

There is no perfect fee structure. One size does not fit all. Advisors need to determine what is right for their own firms and clients, weigh the pros and cons for each methodology or combination of approaches, and during the process, consider how best to sustain a business that can support clients during times of market turmoil.

Sheryl Rowling, CPA, is head of rebalancing solutions for Morningstar and principal of Rowling & Associates, an investment advisory firm. She is a part-time columnist and consultant on advisor-focused products for Morningstar, and she continues to actively run her advisory business, from which Morningstar acquired the Total Rebalance Expert software platform in 2015. The opinions expressed in her work are her own and do not necessarily reflect the views of Morningstar.

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