Many financial advisors have built their practices around the amount of assets that they manage. Their bread and butter comes from the fees that they charge which are based on the size of their clients’ portfolios. But this form of compensation has come under fire in recent years by some industry experts. The advent of robo-advisors has also made this practice more difficult for advisors to justify. Although the assets under management (AUM) fee seemed like a good idea for a long time, current market trends may be making it a thing of the past.

Why It’s Worked

When advisors began charging AUM fees to their clients, it represented a shining step up from commission-based sales. Under that model, the broker or planner won regardless of how the investment performed, because they were simply paid to effect a transaction. So the AUM fee model seemed like a good solution, as it aligned the advisor’s financial interest directly with the client’s. When the client’s assets increase in value, so does the planner’s fee. Therefore, planners will be much more inclined to actively oversee their clients’ funds to make sure that they are increasing in value. Many clients view this fee model as being much fairer than the commission arrangement. (For more, see: Trends Challenging Financial Advisors).

Why It’s Flawed

Although the AUM model does seem like a better alternative than commissions in many cases, it doesn’t address the issue of economies of scale very well. The fact is that it often doesn’t take any more time or effort to service a large account than it does a small one. For example, a client with a $1 million portfolio may be using the same investment strategy as one who only has $10,000 invested with the same advisor. But the strategy will require that the same type and number of trades be placed in both accounts. However, the large account will be charged 100 times the amount that the small account will pay for the same service. This type of discrepancy is hard to justify in most cases.

Of course, most advisors provide many more services than mere asset management. But these services also often require the same amount of time and effort on the part of the planner, regardless of the size of the client’s account. Crafting financial and investment plans and meeting with clients in person can be equally time-consuming and challenging for clients of all sizes, but the ones with large accounts are usually subsidizing the small clients with their AUM fees. In fact, many advisory firms that run a cost-profit analysis on their client base that weighs revenue against the total cost of maintaining each account may discover that they are losing money on their small clients, and that only a relatively small percentage of their clientele is actually making them money. (For more, see: Shrinking Management Fees: How Advisors Can Protect Them.)

Conflicts of Interest

Another key drawback to the AUM fee model is the potential conflict of interest that is built into this arrangement. For example, an advisor who is a registered investment advisor (RIA) and a certified financial planner (CFP) is approached by a client about a substantial investment opportunity. The advisor is bound by the fiduciary standard to give unbiased advice to the client, but the client is wanting to take a million dollars out of the account he or she has with the advisor to buy a piece of property. If this is genuinely a good idea, then the advisor is cutting him or herself off at the knees just by providing the right answer. This dilemma can be hard for advisors to swallow in many cases, and it has led to a growing sentiment in the industry that a flat retainer model may be a better solution. This can ensure that even small accounts will be profitable and eliminate the economy of scale issue that plagues the AUM model.

The advent of robo-advisors is also going to make it increasingly difficult for advisors to charge a percent or more to clients for performing routine asset management chores when these automated programs can do the same thing at a fraction of the cost. But these programs cannot provide emotional reassurance during bear markets and cannot meet in person with clients when they need advice or input on a sticky financial matter that involves other family members or beneficiaries. Advisors, therefore, may be wise to start charging more for the things that only they can do and scale back their asset-based compensation in return. (For more, see: What the DoL’s Fiduciary Policy Means for Advisors.)

The Bottom Line

The AUM fee is likely to be used for some time to come by many advisors, but its usefulness is coming increasingly into question by both consumers and industry observers. A flat retainer model may be a fairer way to charge for financial planning, but this could drastically reduce the total compensation earned by advisors. (For more, see: How Financial Advisors Can Adjust to Robo-advisors.)