The Flat-Fee, Fee-Only Advantage – Part 2: Clarity on Pricing
This is Part 2 of a three-part series on Fee-Only compensation methods. In Part 1, I distinguished between the AUM and Flat Fee models and discussed how flat fees reduce conflicts of interest. In this post, I compare pricing transparency on the two Fee-Only compensation methods that allow for ongoing financial planning and/or investment management: Assets Under Management (AUM) and subscription-based flat fees. As I stated in Part 1, hourly and project-based Fee-Only methods usually don’t allow for an ongoing relationship as the engagement ends after a certain period. In my opinion, the subscription-based method is clearer and fairer to clients than the AUM method when it comes to pricing.
Under the subscription-based Flat-Fee model, you pay a flat fee that is stated in dollar terms. For example, a flat fee might be $5,000 per year. The fee is usually payable in quarterly or monthly installments ($1,250/quarter or $417/month in this example). Since the fee is already in dollar terms, there are no math calculations to do. This makes it clear for clients to understand. The fee will most likely be adjusted at some point due to the rising costs of doing business. That adjustment will be at the discretion of the advisor.
Under the AUM model, you pay a percentage (usually around 1%) of your portfolio balance for an advisor’s services. At first blush, the AUM approach sounds straightforward, and the industry does a great job of selling this method as transparent. But even though the AUM method sounds simple, it turns out that it is not so clear. Not because the advisor is hiding anything from you, but because many people just don’t have a good understanding of what it means in dollar terms to pay a percentage of something. For example, 1% on a $500,000 portfolio is $5,000. But on a $1.5 million portfolio it’s $15,000. That same measly 1% makes a difference of $10,000 per year.
Further, the investment management method that most advisors use nowadays (passive, diversified, low-cost and tax-efficient) is largely a set-it-and-forget-it approach that is better aligned to flat fees. Whether your portfolio is $100,000 or $1,000,000, we’re essentially entering the same keystrokes to allocate or rebalance your portfolio because we use percentages. A 30% allocation to US stocks to a large portfolio does not cost us more time or money to type into a computer than the same allocation to a small portfolio.
The real issue under the AUM model is that the fee increases at a rate (at least) equal to market returns, but most clients are not aware of it. For example, a 60/40 portfolio has historically averaged an almost 10% annual return. That means that the amount of your fee is also increasing at roughly 10%. That is a crazy fee inflation that usually goes unnoticed by clients. Most advisors that use the Flat Fee model do not increase their fees by 10% per year. If they did, clients would notice it immediately because advisors would have to get client consent by signing a new agreement. But AUM fees adjust automatically without your explicit consent, so most clients don’t know the high fee-inflation and dollar amount that they’re paying based on an advisory agreement they signed years ago.
That disparity in fee growth makes a huge difference that only compounds with time. Let’s use an example to see this more closely. Assume that you have a $500,000 initial portfolio balance. Further, you’ll be contributing $25,000 each year and your portfolio will grow at 8.5% each year. The AUM advisor will charge you an AUM fee of 1%, whereas the Flat Fee advisor will charge you $6,500 for the first year and the fee will increase by 3% each year.
In the first year, the fee to your AUM advisor is ((500,000 + 25,000) x 1.085 x .01) = $5,696. Not bad so far—solid financial advice and almost $1,000 cheaper than the first-year fee to the Flat Fee advisor. However, as I stated above, it’s not that simple. Below is the difference the two fee models will have on the advisor’s and your bottom line in the long run.
As you can see, because of your diligent savings efforts and the effects of compounding returns, by year 10 your portfolio has grown to more than $1.4 million so the fee to your AUM advisor is more than $14,000 per year, versus $8,400 for flat fees. By year 20, the AUM advisor’s fee is $32,000 versus $11,500 to the Flat Fee advisor. And it only gets even more ridiculous with time. After 30 years you would have paid your AUM advisor more than $840,000 in fees versus $310,000 to the Flat Fee advisor. That’s an average fee of roughly $28,000/year vs $10,000/year.
Don’t get me wrong, both advisors are getting paid pretty darn well. But, in my opinion, the AUM advisor is getting paid way too much for the service being provided given that the service is not changing much year after year. Further, the client has a $1 million lower ending balance under the AUM model. That’s a whole lot of foregone trips, second homes, gifts, charitable contributions or whatever else the client had wished to achieve during their lifetime.
The AUM’s fee rate of inflation begs the question: Is your advisor doing three times the work in year 10 to justify three times the fee than in year 1? What about six times the work in year 20? I can tell you with absolute certainty that no, they’re not. They’re essentially providing the same service (financial advice and investment management) year in and year out. It might involve larger numbers, but the process is mostly the same. That’s not to say that the service isn’t valuable. It’s immensely valuable to have proper guidance on your finances. But does it justify a fee increase of that magnitude? I don’t think so.
Now, I know a lot of AUM advisors are going to bark at this analysis and say that they usually charge less on larger balances. That might be true, but I can tell you that you’ll still pay significantly more in fees under the AUM model. And I challenge any AUM advisor to show me otherwise. In fact, even if the initial flat fee is $10,000 per year and the AUM fee is .75% throughout, the total fee to the Flat Fee advisor is $185,000 less than the total fee to the AUM advisor after 30 years.
So, if the AUM model tends to be way more expensive in the long run for the same level of service, why is it so popular? There are a number of reasons:
That’s simply the way it’s been done for a long time. The AUM fee was a good step forward many years ago as advisors transitioned out of large commissions. But the AUM model looks antiquated now compared to subscription-based fees.
It’s very lucrative for advisors, especially for larger balances. Therefore, they’re not rushing to change the status quo and certainly not volunteering to give you this type of analysis.
As I stated earlier, clients simply don’t understand the dollar implications of percentages on compounded growth so they’re not asking the right questions. Their advisors are happy to keep the music playing for as long as possible.
If your advisor is not willing to offer a better pricing model, then it’s up to you, the fee-paying client, to take better care of your hard-earned money. Fortunately for you, there is a growing number of advisors that are at the forefront of change, fairness and clarity and are offering Fee-Only subscription-based models. The fees vary from $3,000 to $10,000 per year (usually paid monthly or quarterly), with approximately $6,000 being average. Further, I can tell you firsthand that the quality of work for Flat Fee planners is on par, and in many cases far superior, than many AUM advisors. This is especially true if all your AUM advisor is doing is managing your investments, which can be done very inexpensively at a robo-adviser.
Which brings us to Part 3: If your advisor is providing comprehensive financial planning, why is their fee tied to the size of your portfolio?
Read Part 3 of the Flat-Fee, Fee-Only Advantage series.
Read the entire series.
I provide a free, no pressure15-minute intro call to give you a chance to ask questions about our services, fees or whatever else is on your mind related to your finances, your future and figuring out how to live the life of your dreams right now.
