The Flat-Fee, Fee-Only Advantage – Part 1: Reduces Conflicts of Interest
In a previous post, I wrote about the different ways that financial advisors get paid. There, I argued that Fee-Only compensation is more transparent and has fewer conflicts of interest than a commission or fee-and-commission (i.e., fee-based) method. Here’s another article that highlights the benefits of Fee-Only versus commissions. I think most people can agree that Fee-Only has less conflicts of interest. But if you decide to go Fee-Only, there are other issues to consider. That’s because there are different ways to structure Fee-Only compensation and, in my opinion, some are superior to others.
In this three-part series, I compare two subsets of Fee-Only compensation: Assets Under Management (“AUM”) and Flat Fees. My goal in this series is for people to learn about the topics I write about and become informed consumers of financial planning services. After reading these articles, I hope that you agree with me that the Flat-Fee model offers three main benefits over the AUM model:
Flat Fees reduce conflicts of interest pertaining to portfolio recommendations
Flat Fees provide more clarity on pricing
Flat Fees better align value provided to fees paid.
I first want to clarify the difference between the two compensation models. Under the AUM model, an advisor charges a percent of the assets that he or she manages for the client in exchange for financial advice and investment management. The percentage charged is determined by portfolio size and is usually tiered (the first $1,000,000 at 1.25%, the next $1,000,000 at 1%, etc). The fee is often deducted directly from the account(s). The AUM model is by far the most common Fee-Only method of compensation.
Under the Flat-Fee model, an advisor charges a flat fee in exchange for financial advice. The fee can be in the form of an hourly rate (e.g., $250/hr), project-based (e.g., $4,000 for a plan), or subscription-based (e.g., $400/month). While hourly and project-based planning usually don’t include investment management because the engagement ends after a specified period, the subscription-based model does allow for it. Fees can be paid directly from a checking account, debit card or deducted from an investment account (for those with investment management).
Now that we have the basics, let’s discuss the first topic in this series: conflicts of interest.
Flat Fee Reduces Conflicts of Interest Tied to Portfolio Size
Many AUM advisors say that the AUM method is better for their clients because it incentivizes the advisor to grow the client’s portfolio. You’ve probably seen that Fisher Investments commercial: “We do better when you do better.” And there is some truth to that. If my compensation is tied to your portfolio size, I have an incentive to grow your portfolio. (However, as I explain in Part 3, advisors don’t provide market returns.)
But there are other ways the advisor can “grow” your portfolio, and some of these present conflicts of interest that many investors overlook. For example, an advisor can grow the portfolio they manage for you by recommending that they manage all your investments, even if there is no need to. I call these advisors “asset gatherers.” For example, let’s assume you’re paying Ms. Fisher-Investments 1% of your $800,000 portfolio balance, or $8,000 per year. And let’s say you have a $400,000 brokerage account out there that is already properly invested (i.e., low-cost, tax-efficient, adequately diversified, and complements your other accounts). Even though there is no clear benefit for you, Ms. Fisher-Investments is incentivized to recommend that you hand it over to her management because she can immediately increase her income to $12,000 per year. But it’s likely that she’ll allocate it in pretty much the same way that it was before so you, personally, gained nothing except paying more in fees.
So, this begs the question: When Ms. Fisher-Investments recommends you roll over your assets to her, is she doing it because it’s in your best interest or hers? In fact, conduct like this has become such an issue in the industry that regulators are looking into how to prevent investors from being abused by, or at least aware of, the practice.
An AUM advisor also has an incentive not to decrease the size of your portfolio because doing so would decrease their compensation. Therefore, they might recommend that you do not pay off your mortgage or other large debt because doing so could take a big chunk out of the portfolio. In the current era of higher interest rates, it might make more sense to pay it off as quickly as possible. That’s because it’s more difficult to generate investment returns that are higher than the interest rate of the debt. If recommending a debt payoff will significantly reduce the size of the portfolio, the advisor might justify not doing it, even if it’s not in your best interest, since their income is on the line.
Here are more ways that an adviser can increase/not decrease your portfolio size that might not be in your best interest:
Take more risk than you’re comfortable with in order to grow your portfolio faster
Not invest in real estate because it will decrease your portfolio
Not buy an annuity or contribute more to an employer retirement plan that they can’t manage and charge fees on
Let’s be clear: not all AUM advisors are engaging in shady behavior, and I venture to guess that the vast majority of Fee-Only, AUM advisors are doing great things for their clients. I mean, I give them lots of kudos for deciding to not accept lucrative commissions in the first place. But good people can sometimes act greedily when given the wrong incentives. And the AUM model gives an incentive to gather assets.
As advisors looking to do the very best for our clients, why even put ourselves in that predicament in the first place when there’s, in my opinion, a better alternative in the Flat-Fee model? This version of Fee-Only compensation reduces (and I venture to say eliminates) any incentive tied to portfolio size. In fact, we don’t care about the size of your portfolio. As long as the client has the ability to pay the fee, whether through their income, portfolio or a combination, the size of the portfolio is a non-issue. So, we are not looking for any and every opportunity to grow the portfolio in any way that is truly not in your best interest. As this article states, “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.”
You might be wondering if Flat Fee advisors have any conflicts of interest. I asked advisors of all compensation types this question. Some said yes because in any business transaction there is a conflict of interest when one party wants to pay as little as possible while the other wants to earn as much as possible. To me this issue has less to do with conflicts of interest (i.e. incentivized recommendations) and more with fair negotiation: both sides getting enough value from the relationship to justify the agreed-upon fee. But if you do consider a business transaction to have conflicts of interest, then this issue is not unique to the Flat Fee model and is inherent in all compensation types.
So, are there conflicts of interest under Flat Fee? There might be. For example, the CFP Board has cautioned hourly financial planners not to overestimate the number of hours to charge for the services provided. But this conflict of interest is not tied to investment recommendations or portfolio size. For an industry that unfortunately has such a bad reputation for being transparent in their recommendations, this can be a huge sigh of relief. Further, this type of conflict of interest is avoided with project- or subscription-based services. Under these compensation models, if you feel that you’re getting enough value from the advisor’s services, it’s a win-win.
I admit, I’m biased when it comes to the AUM vs Flat Fee debate because I’ve chosen my side and we have built our firm’s compensation on flat fees. But there is a growing number of advisors that agree with this philosophy and charge flat fees as well. The AUM was a step in the right direction to avoid commissions and the conflicts of interest they entail. But nowadays there are alternative compensation methods that reduce conflicts of interest even more.
If conflicts of interest don’t convince you of the Flat-Fee advantage, maybe fee transparency will.
Read Part 2 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.
