What’s next in the evolution of fee compensation models for financial planners?
As the profession has shifted from product sales to providing and implementing a client’s financial plan, compensation models have also adapted. Now, with the Department of Labor’s pending fiduciary rule, planners and their clients are reconsidering the relationship between fees, service and accountability.
By virtue of its simplicity, profitability and scalability, charging clients a percentage of assets under management has emerged as the predominant fee model. But factors working against the AUM standard have also become apparent.
Such fees rely on sizable investable assets, yet the U.S. Census reports less than 13 percent of US households have a net worth exceeding $500,000. More firms operating under the AUM model means less overall differentiation.
What's more, increased competitive forces, including low-cost tech-based asset management platforms, encourage firms to offer more value-added services, such as cash flow analysis or concierge services, which further reduce profits.
COMPLEXITY FACTORED INTO RETAINER FEES
And then there's fiduciary rule, which will be implemented beginning in April.
Retainer fees are eminently compatible with this shifting practice landscape.
Determined at the outset of client engagement and remaining fixed throughout the term, a financial planner’s retainer fee calculation can take many forms. Usually it’s determined based on a combination of a client’s income, net worth and other financial metrics such as business ownership and taxes.
A retainer fee might also be based on overall complexity. As a result, retainers better align the adviser's compensation to the services provided — and with fiduciary standards.
Consider, for example, one client who owned a family business. His top issue was retirement and whether to sell his enterprise. His adviser’s retainer was based on total net worth, so selling the business or holding the business did not matter to the adviser’s compensation.
Even though selling makes sense, the adviser determined selling in installments over five years would save $50,000 to $75,000 in tax by taking advantage of the zero percent capital gains tax rate before starting Social Security.
BATTLE OF THE FEE MODELS: PERCENTAGE OF AUM VS. RETAINER
By contrast, an adviser charging a percentage of AUM would only be paid more if the business was sold and funds reinvested into the portfolio, so the recommendation might well be to sell more quickly. Even if the AUM adviser were to give the exact same guidance, the client could have been left wondering whether the recommendation was for the client’s benefit or for the adviser’s.
Likewise, a client may see rental property, with its tangible nature and the lure of passive income, as a safe investment. In reality, real estate carries many risks and, often, an unexpectedly large time commitment.
An adviser’s guidance on expected returns and taxation, for example, may rightly dissuade the client from the purchase. While the client might question an AUM adviser’s motivation in raising these valid issues, retainers can be structured to prevent concern about the adviser's compensation influencing the advice provided, by eliminating the conflict itself.
Retainer models are also resistant to commoditization, allow for more profitable service to a much broader market, and are adaptable to a wide variety of value-added services.
A fee may be lower for a client requiring less access to the adviser, or higher if the adviser is expected to monitor the plan’s implementation and prevent costly mistakes due to client inertia or indulgence.
PRICING FOR A BROADER SET OF SERVICES
In contrast to a commission or asset-based fee, the retainer model allows the adviser to base the fee on — and be compensated for — a broader set of services. They could include cash flow guidance, property/casualty insurance recommendations, or detailed income tax planning, which under the AUM model may appear to the client as ancillary to what they’re really paying for.
Critically, the retainer model is compatible with a fiduciary standard of care for client relationships.
The DOL’s fiduciary rule may require many advisers to execute Best Interest Contract exemption, increasing compliance burdens and, possibly, the professional’s liability exposure. A retainer model may qualify the adviser for the Level-Fee Fiduciary exemption where the fee is based on the client’s entire situation, including real estate, debt, tax exposure and 401(k) retirement accounts.
A retainer using total net worth or total marketable assets also allows the adviser to remain agnostic as to account location for fee calculations.
No one compensation model is perfect for every practice. We believe, as others have noted, that the retainer is the future direction of professional compensation. While the percentage-of-AUM model implies that investment services are the single subject of value to the client, the advent of the DOL fiduciary standard provides an opportunity for firms to consider the message sent by their compensation structures.
Our experience suggests that the retainer model’s flexibility enables advisers to charge a fee that better reflects — and affirms for the client—the value of all the services the financial planning professional provides.