One of the first lessons young financial advisors learn as they prepare for their licensing exams is the significance of diversification — the concept of investing in a variety of investments and assets so that a significant economic event that heavily impacts the markets will not, it is hoped, create a disastrous situation for an investor. Over time, diversifying an investment portfolio lowers the amount of risk and can hedge returns, as well.
Given that this basic investing principle is widely known by all financial professionals, it's interesting to see that financial advisors often don't follow their own advice when it comes to their businesses. In general, financial advisors have three main options when it comes to generating revenue for their firms:
- Transactional fees or commissions
- Fees for services
Over the past decade, advisory practices charging fees based on assets under management have become the primary — and in some cases the only — source of revenue for the practice, with no diversification of the fees charged for all of the services rendered.
In many ways, the flight toward AUM-based fees makes sense. As advisors grow their client bases, reliance on one-time commissionable business can certainly compensate for time spent developing new business. On the other hand, the upfront one-time revenue can't sustain an expensive service model long term.
Why is this the case? While the advisor is compensated at the point of sale, the transaction is often only the beginning of a long-term client relationship. Without any additional revenue to support the needs of the firm, it's unlikely the advisor would be able to afford dedicating time and resources to serve the client year in and year out.
Using an advisory platform and an asset-based approach creates an ongoing revenue stream that can support the time needed to prepare for and deliver a quality client service experience. As both investment products and our financial lives become more complex, advisors must dedicate more and more time to serving the growing needs of their clients. Unless they increase their fees, they aren't receiving compensation for the extra work they're putting in on a regular basis.
In the financial services industry, there's a commonly used adage that suggests that advisors are "highly overpaid during the good times and highly underpaid during the bad times." This is because variable economic conditions cause the time demands by clients to vary greatly. During bear markets when clients can be more pessimistic, anxious and uncertain, an advisor must work far more diligently to serve those clients. However, clients often require very little attention during bullish times, as investor optimism generally rises with the tide of markets.
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By tying their fee structures solely to AUM-based fees, financial advisors will see sharp decreases in revenue at the times when they are most in demand. While no sound businessperson would set out to create a business model that has an inverse relationship between demand and revenue, such a result is exactly what happens.
So what is the client truly paying for?
While it's necessary to determine what an advisor should be charging his or her clients, it's also important to understand how an advisory fee is used. Is it for access to an advisor and all that he or she offers in advisory services? Or is it, as defined in the Securities and Exchange Commission's Form ADV, for access to an investment management program that in turn provides the client access to managers, models, rebalancing functions, reporting and additional offerings?
Most individuals would agree that it's the latter, and most advisors tendering these services would also agree that they provide far more than access — rather, they offer some level of comprehensive advice on matters such as education, tax, estate and retirement planning. Such guidance is valuable and essential to clients and merits compensation that's separate and distinct from the advisory access fee.
"The advisor who is determined to deliver a value proposition that goes beyond access to models must also be confident in delivering that value in exchange for separate and distinct compensation."
How, then, does an advisor who practices comprehensive financial planning and service become fairly compensated for providing the additional 1.5 percent of value? The answer is becoming ever more apparent: The advisor who is determined to deliver a value proposition that goes beyond access to models must also be confident in delivering that value in exchange for separate and distinct compensation.
A financial advisor needs to be able to quantify his or her value.
Behavioral financial advice, risk-management strategies, estate planning and charitable giving advice are all critically important concerns of today's individual investors. Addressing these effectively requires an advisor's expertise, demands ongoing maintenance and must be delivered to the client properly.
Therefore, an advice-based fee model (financial planning and service for a fee) offered in conjunction with an AUM- or commission-based model is the means by which to deliver it properly and profitably.
— By Jeff Magson, executive VP/client experience officer of 1st Global
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