Kitces: The benefits of fee severability
In the advisory business, our compensation structures give us a natural incentive to provide quality, ongoing service. Fees under the AUM model are more severable than the types of costs that attend the sale of, say, an annuity, and that difference provides a measure of consumer protection not afforded by commission-chasing broker-dealers.
Yet ironically, with the profusion of alternative compensation models — i.e., retainer, subscription, hourly or other fee-for-service models — some advisors may be incentivized to seek out compensation structures with lower fee severability and consumer protections, making it easier for them to charge more and do less.
When the Department of Labor proposed its fiduciary rule, the White House made the case that conflicted advice compensated by commissions resulted in additional costs to consumer retirement accounts to the tune of at least $17 billion per year. Accordingly, a key aspect of the fiduciary rule was a significant curtailment of commission-based compensation and a regulatory safe harbor that would have nudged the industry toward level-fee fiduciaries who simply would charge an ongoing AUM fee instead of receiving commissions.
Yet as many critics noted, paying ongoing advisory fees can be equal to or even more expensive in the long run. After all, earning a 7% commission for the up-front sale of an annuity that has a seven-year surrender charge ultimately adds up to the same 1% yearly AUM fee for an investor that holds for all seven years.
Most annuity carriers recover their 7% upfront commission by levying a 1% yearly additional expense ratio charge — or scrape a 1% interest rate spread — against the annuity contract and charge a surrender fee for whatever portion of the 7% upfront that hadn’t yet been recovered. Thus, when an investor purchases an annuity with a 7% upfront commission and holds it for three years, the remaining surrender charge would be 4% — that is, to recover the remaining 4% not yet recovered from the higher expense ratio.
When they were popular, B-share mutual funds worked the same way, often paying out as much as a 5% upfront commission to the selling broker, but then typically charging an expense ratio 1% higher than the A-share alternative. Thus again, if an investor bought a B-share mutual fund and sold it after two years, there was a 3% contingent deferred sales charge to recover the three years of not yet having paid an extra 1% per year.
The key distinction is that while the final commission-based charge on the annuity may be the same 7% after seven years as the 1% yearly AUM fee, they’re only the same for the client who stays all seven years. Unless the advisor continues to provide value for all seven years, that is unlikely to happen.
In other words, the commission-based advisor only has to perform at the moment of sale to earn 7% for the next seven years, while the fee-based advisor has to be good every year for the next seven years to earn the same amount. That drastically changes the incentives for the advisor in how much time, effort and resources to put toward servicing existing clients, versus trying to move on to the next one.
In our recent study we found that RIAs under the AUM model spend almost 60% more hours per client on direct client activity than more sales-based brokerage advisors, including almost 50% more in meeting hours per client and more than double the amount of time spent providing client service.
So even if the costs are identical in the long run, advisors whose fees are more easily severed — i.e., the client can terminate the advisor’s fee as soon as they’re not satisfied — are incentivized to provide more and deeper ongoing client service, which is reflected in the research on service time spent per client. In other words, if advisors don’t provide service that demonstrates ongoing value, they get fired. Holding the advisor accountable for providing value effectively makes the relationship safer for the consumer.
SAFETY IN SEVERABILITY
While fees under the AUM model are far more severable than an upfront paid commission that typically isn’t refundable at all, the AUM model is not exactly the most severable.
Many advisory firms bill their AUM fees in advance, which means the client then has to request and obtain a refund of excess fees paid but not earned — a hassle at best. But because in many cases terminating an advisor also creates a necessity to move and repaper the entirety of the client’s investment accounts.
Fortunately for the consumer, when it comes to many RIAs that use custodians with retail-facing options as well — e.g., Schwab, Fidelity, TD Ameritrade — it can be as simple as converting an existing account from advisor-managed to retail. That may still entail not only a call to the advisor, but additional calls to the custodian to convert the account.
For fee-based accounts at many hybrid broker-dealers or other institutions that don’t have a direct-to-consumer retail division, there is no direct path to convert. And of course, if the whole point is not only for the consumer to terminate their current advisor but to switch to a new one, the AUM model again necessitates moving and repapering the client’s entire set of investment accounts to the new advisor’s platform.
Thus, while the AUM model is more fee-severable than a commission-based relationship, it still forces the consumer to not only decide to terminate the advisor, but also to find a new institution or advisor. This all creates a lot of additional work for the consumer, not to mention increasing the temptation of inertia to stay with an only marginally valuable advisor.
Accordingly, it shouldn’t surprise that not only do good advisory firms often have 97% or higher retention rates according to traditional advisor benchmarking studies, but a recent PriceMetrix study showed that even mediocre advisory firms in the 10th percentile still have an 84% retention rate.
By contrast, advisory firms that charge on an hourly basis have what is arguably the ultimate in fee severability, as the moment the client doesn’t value the services being provided, they can simply walk away from the relationship and the fee stops. Clients tend to be acutely aware of the fee they’re paying on the hourly model, and knowing they’re on the clock makes hourly fees highly salient. This ironically can put so much pressure on the hourly model that it’s often difficult to ride it to a sizable client base.
In between the hourly model and the AUM model are various types of retainer or subscription fee-for-service models.
Relative to the AUM model, retainer and subscription models have greater fee severability because they don’t necessarily require the movement of accounts and changing of investments to end the advisory relationship and start a new one. Rather they merely require a decision by the client to terminate the advisor, and the fee stops.
Still, because retainer/subscription models are ongoing relationship models, they are still less severable than a pure hourly model, which by default terminates at the end of every meeting.
In addition, not all retainer or subscription fee models are alike because the less frequent the payments are, the more time passes before the client has an opportunity to decide whether to continue renewing the advisor or terminate them.
Of course, a retainer fee paid in advance must still be refunded for the unearned portion of the fee. If an advisor bills quarterly and the client terminates one month into the quarter, the remaining two months’ worth of fees must be returned. But in practice, clients aren’t often even reminded of the ongoing fee until they receive an invoice tied to a bill. In other words, they may not even recall that they’re dissatisfied with the service until the end of the quarter when the next bill comes — and at that point it’s likely too late to ask for a refund.
Consequently, the less often the billing frequency, the less severable the service tends to be. Meanwhile the greater the billing frequency, the more the client is reminded that they’re paying, as well as how much.
REGULATORY BLIND SPOT?
From the advisor perspective, fee severability becomes an issue of client retention. The more severable the fee model, the more burden on the advisor to justify their fees — especially if the fees are highly salient.
From the consumer’s perspective, fee severability is an issue of protection. The less severable the advisor’s compensation model — upfront commissions representing the logical extreme — the less recourse the consumer has if they’re not satisfied with the value received and services rendered.
From a regulatory perspective, the less severable the compensation model, the more regulatory scrutiny is necessary up front to ensure consumers are protected. The more severable the compensation model, the more that natural market forces can operate. The key takeaway is the more severable the fee, the less the consumer needs a regulator’s protection.
In turn the implication from the regulatory perspective is that for low-severability models, it’s especially important to establish up front that the advisor will deliver value for the compensation they receive.
This helps explain why the burden of FINRA regulation is to determine whether the sale was suitable for the client. Conversely, the regulation of RIAs is much more focused on whether the advisor provides ongoing services commensurate with the ongoing fee.
Similarly, advisory firms that charge retainer fees — already a highly severable model — are generally limited to collecting fees of no more than $1,200 more than six months in advance, per Release No. IA-3060. This ensures advisory firms don’t turn an otherwise highly severable fee-for-service model into a low-severability version where the firm might charge significantly up front and not deliver.
From the perspective of current regulation, the fee severability spectrum suggests that recent state regulatory efforts may not be following the most effective track to actually ensure consumer protection.
For instance, several state regulators have worked to compel advisors to disclose the exact number of hours they will work in exchange for their fee, as a means of determining whether services rendered come at a reasonable price— e.g., no more than $150 to $250 per hour.
A number of state regulators have questioned the appropriateness of charging an ongoing monthly fee if the advisor doesn’t necessarily do something or meet with the client every month, effectively discounting the availability of the advisor’s services down to $0. Yet research suggests that advisors provide the behavioral alpha that helps clients stay the course during bear markets. That may be a huge value, but it is only relevant once or twice a decade when the bear market cycle occurs.
Ultimately, mismatched regulation can unwittingly cause advisory firms to switch away from more consumer-protected models toward ones that have less fee severability. For instance, in the face of recent state regulation a number of firms have shifted from charging monthly subscription fees to instead charging an annual fee, payable monthly — whereby the consumer receives a committed list of annual services and the annual fee is simply financed on a monthly basis. This ironically converts a consumer-friendly, highly severable fee model into a less severable commitment for the consumer.
Through the lens of fee severability, the better regulatory approach may be to drive more firms toward fee-for-service models, which make it easier for consumers to quickly terminate. Regulators in turn could limit advisors from charging significant upfront fees for a full year of service — per the existing regulations limiting prepayments that are more than $1,200 and more than six months in advance — while still ensuring consumers can easily terminate.
Stated more simply, encouraging shorter recurring billing periods reduces consumer risk over longer prepayment periods. From there, consumers can simply fire an advisor who isn’t delivering — something they are clearly capable of, given failure to proactively communicate and engage with clients is by some measures the leading reason consumers fire their advisors.
SALIENCY AND SEVERABILITY
The other issue related to fee severability is ensuring that consumers know what they’re actually paying. It wouldn’t help that the relationship and fees are severable if those costs aren’t transparent — i.e., salient — to the consumer.
Still, saliency and severability are separate issues. A highly salient fee that isn’t severable just means the client knows they’re paying too much and receiving too little — and they can’t break free.
Effective regulation of highly severable models should ensure fees remain both severable and salient — that is, transparent enough for consumers to know what they’re spending for what they’re getting.
From this perspective all compensation models should progress toward the upper right of the graphic above, ensuring consumers are aware of what they’re paying and are able to stop when necessary.
Accordingly, regulation of the AUM model often focuses on making fees more salient and ensuring they remain severable. In contrast, while the load for A-share mutual funds is paid up front and comes immediately out of the fund’s deposit — making it salient — it is not refundable and therefore, not severable.
The key point to recognize is that fee-for-service models are already more salient and more severable than the alternatives. As we in the advisory business know, these are the keys that tend to drive not only better consumer protection, but higher consumer satisfaction. It’s just a matter of regulators coming around to our point of view.