Asset-Based Fee Models Are Under Scrutiny
July 13, 2018 by Rich Blake
Sometimes in financial services, what is accepted practice can come under a new light and suddenly seem fraught with conflicts that in hindsight should have seemed obvious. Goals can shift as if picked up by heavy gusts (often in the form of newspaper headlines). Just ask mutual fund managers who used to allow some large clients to do after-close trading of fund shares circa 2003.
In recent years, a growing chorus of industry voices have begun calling out a practice at the core of money management: charging an asset-based fee.
The discussion gained traction as part of the debate over the Department of Labor’s fiduciary rule, which, had it not been delayed by the Trump administration and then ultimately struck down by courts, would have created higher standards for advisors with a hand running retirement assets. A push for improved advice-giving practices is now in the hands of the Securities and Exchange Commission, and so the debate still has room to rage on.
This past spring, the Wall Street Journal published a piece, “Is It Time to Adopt a Uniform Fee-Only Standard for Financial Advice?” Around the same time, more heating fuel came courtesy of RIA executive Bert Whitehead, president of Cambridge Connection, a Bloomfield Hills, Mich.-based RIA, who wrote an article for Advisor Perspectives, “Why AUM-Based Fees Don’t Meet Fiduciary Standards.” In the March 2018 piece, Whitehead wrote that while the Investment Act of 1940 specifically permits advisors to charge fees as a percent of assets, this “was intended for managers of mutual funds, not for advisors.”
The main problem, he said, is the conflict inherent in the way charges vary based on asset classes. A few years ago, Whitehead encountered this conflict firsthand and in dramatic fashion. “A new client, who had been working for a… stockbroker and who called himself a fee-only fiduciary, hired us,” Whitehead said. “My client had about $2 million under management. In transferring the assets, I noted that 97 percent were in stocks. Since the client was 67 years old and planning to retire in two years, this was too heavily weighted in equities.”
May Day Movement
On May 1, 1975, the SEC mandated the death of high commissions and set the stage for the growth of the AUM percent fee, according to securities lawyer John Lohr. A couple years prior to that, the wrap fee had been invented by EF Hutton. By the late 1980s, wraps took off and started to become the norm as did the phrase, “I only do well if you do well.” Less common were specifics regarding how much of the bundled expense was for advice versus investment management.
There’s almost no common consensus or industry standard about how much of an advisor’s AUM fee should really be an investment management fee versus not, according to research done by financial planner Bob Veres. And a Fidelity RIA Benchmarking Study two years ago found that there is virtually no relationship between an advisor’s fees for a client with $1 million in assets and the breadth of services the advisor offers to that client. “Not to say that financial planning services aren’t valuable, but that there’s no clear consensus on how to value them effectively,” financial planning expert Michael Kitces wrote last summer.
Kitces noted the movement away from asset-based fees starting back in 2015. “Whether due to fears of the next bear market, a struggle to differentiate in an increasingly crowded AUM-fee landscape, or the pressure of competition from robo-advisors, a growing number of financial planners are talking about changing from the assets under management (AUM) model to adopting some form of (typically annual) retainer fees instead,” he wrote at the time.
“This is indeed a debate and a useful one,” said Knut Rostad, cofounder of the Institute for the Fiduciary Standard. “Especially as market forces increasingly inform the discussion.”
Stanford University professor Ashby Monk, an expert in institutional money management, concurs that it is a debate and sees the trend as viable. “It seems to me that budget-based fees are the future,” he said.
Trouble Spots
Even if no major changes come out of the SEC’s newly proposed “best-interest” rule set, existing fee regulations — and instances where industry members run afoul of them — are numerous, as spelled out in an April 2018 Risk Alert issued by the SEC’s Office of Compliance Inspections and Examinations.
The terms of a client’s advisory fees and expenses are typically detailed in an advisory agreement and described in an advisor’s Form ADV and other materials provided to the client.
Among the most frequent deficiencies that OCIE staff has identified pertaining to advisory fees and expenses: fee-billing based on incorrect account valuations, billing fees in advance or with improper frequency and applying incorrect rates.
