By Bert Whitehead M.B.A, J.D. © 2012
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 which requires them to act in the best interest of their clients, meaning they must set aside their personal interest and fully disclose all of their fees and any conflicts of interest.
Stockbrokers, by comparison, must meet a much lower suitability standard, meaning 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 a commission-based stockbroker faces when his livelihood depends on whether clients buy or sell securities. What’s more, it often appears that stockbrokers are prone to recommend investments that carry higher commissions, which need not be disclosed.
Charging clients on an AUM basis, however, often presents more serious conflicts of interests 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 a client 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 a client 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 investments to manage, which I find self-serving: why not just charge 1.0% for a balanced portfolio? As a result of this compensation difference, clients are almost always over-allocated to stocks.
In all the cases mentioned above 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.
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 often give a short shrift to other aspects of a client’s situation. After persuading a client to sign on, they may 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’s what they focus on.
The National Association of Financial Advisors (NAPFA) has long championed the importance of commission-free financial and investment advice. The media has recognized their 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 AUM. In terms of compensation the two types of advisers have become indistinguishable. As a pioneer and current member of NAPFA, I believe that advisers who charge AUM fees fall short what should be expected of true fiduciaries.
The current 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 conflict of interest listed above all involve transactions that are not ‘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 is not 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 now well established as the minority trend in the profession with hundreds of successful practices having adopted this approach.
Ironically, as common as AUM 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% in down markets even though their workload is much greater. If advisers are, in fact, providing comprehensive advice and are not being compensated directly for their services, they are providing them for free.
Nevertheless, AUM is an attractive pricing model, but for the wrong reasons. First, it is deceptive. “I charge 1.5% of assets I manage, so I only make more money 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 advisor’s specific recommendation may 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, the President of Cambridge Connection Inc. and Founder of the Alliance of Cambridge Advisors, is the author of “Why Smart People Do Stupid Things with Money” (Sterling, 2009). This was an editorial I wrote for Investment News Weekly which prompted a heated discussion in the on-line Wall Street Journal. I thought clients would find it interesting.