Advisers: You Will Soon Abandon AUM Fees

Here’s my not-so-bold prediction for challenging times:

In less than 5 years, AUM fees will no longer be the main compensation mechanism for independent registered investment advisory firms.

I’m not alone in my prediction (I wish I had published this post months ago when I intended!), as Andrew Gluck of Advisor Products, Inc. wrote the following in a recent October article in Financial Advisor magazine titled Fixing AUM Fees:

The mode of compensation that most advisors use is broken. The system of charging clients based on the amount of assets they place under your management is fatally flawed. The AUM compensation often forces clients with simple financial lives to pay you more, while those clients with highly complex financial arrangements can demand more and get away with paying you less.

The AUM Dilemma

There are two reasons behind this prediction.  First, advisers continue to recognize the need to align the amount of fees paid by clients with the services provided.  Second, coupling compensation with an arbitrary number like assets under management (AUM) subjects the firm to decreasing revenues in volatile market periods such as the one we’re experiencing now, arguably when service demands are at a high.

AUM Fees Are Decreasing

The PracticeEdge newsletter, available at the Investment Advisor magazine website, provided a fee revenue breakdown chart for investment advisers from 2000 to 2005.  It shows that planning and consulting fees grew from about 11.5% of firm revenues to 24% in that time period.  The article doesn’t say, but I assume the revenue figures come from an annual survey by Rydex Invesetments, echoed in Aaron Siegel’s August 2008 article at Investment News.

Planning fees or retainers, what I call “service-based compensation” will soon become the dominant way advisers are paid for their time and effort.

So Why AUM?

Why is the AUM billing model so ubiquitous in the independent adviser industry?

I don’t have the research on the origins of the AUM billing model, but I suspect that it came from the days when brokerage accounts began to offer “wrap” features.  A wrap account replaced individual security transaction fees with a catch-all wrap fee (typically 1% of the account balance).  Brokers could then trade frequently in a client’s wrap account with much lower risk of being accused of churning the account simply to earn more commissions.

What I do know is that charging AUM is an easy billing process for most advisers.  At the end of each quarter, advisers run an asset balance report on the entire book of business and then run each client’s asset amount through the fee schedule.  Out comes an amount owed and it’s either automatically debited from the client’s account or an invoice is mailed to the client.

But just because charging AUM is easy doesn’t mean it’s the most appropriate (and effective) mechanism for being compensated for financial planning services.

The Replacement

Obviously, one replacement of the AUM model is to simply charge an hourly fee for service delivered to clients.  I believe there are a lot of resources elsewhere that discuss the pros and cons of hourly compensation models, so I won’t rehash them here.

However, if you read Gluck’s article linked above, you’ll read about one adviser that developed a WCU, or Wealth Complexity Unit.  This is one attempt to align fees charged with the amount of services delivered for a client.  Not all clients’ needs are the same, so the WCU is an attempt to quantify the unique circumstances of each client and therefore bill them appropriately.

Unfortunately, the article leaves many details out on how the WCU is determined and what factors are used to calculate the appropriate fee to charge.  Nevertheless, the establishment of such a system is a step in the right direction to replace the AUM billing model.

What Do You Do?

Are you an adviser who bills clients fees based on some unit of measure different from AUM?  I’m interested in knowing what system you have created and how successful it has worked in your practice.

Feel free to comment below or send me an email privately to bill [at] fppad [dot] com.

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