Why the AUM Fee Model Is Better for Clients, According to a Charleston Financial Advisor

Why the AUM Fee Model Is Better for Clients, According to a Charleston Financial Advisor.

When it comes to the ways financial advisors are compensated, there is much debate about which method is best for the client. In addition, there is also a great deal of misleading information on the topic. Here we will outline why we believe that the AUM fee model is better for clients when compared to other compensation models.

For purposes of this blog we will leave out of the analysis the Commission Fee Model because this compensation model has long been exposed as putting a product at the center of a relationship rather than the client, and most people would agree it does not incentivize the advisor to take into consideration a client’s full financial picture when making recommendations.

With that point out of the way, we will also leave the detailed discussion between Fee-Only and Fee Based compensation structures for some other time, as these terms seem very similar on the surface, but they are vastly different and confusing for most people outside the industry. In general Fee Based is considered less favorable for clients than Fee-Only because it allows advisors to be compensated for both commissions and advice, whereas advisors compensated through Fee-Only models only get compensated for advice.

There are three popular advisor compensation models under the Fee-Only structure, and they are as follows:

1. Assets Under Management (AUM) i.e. paid a percentage based on the assets under an advisor’s management.
2. Flat Fee i.e. a onetime set fee for a financial plan or project.
3. Fee-for-Advice as known as Advice-Only i.e. paid hourly, monthly, or annually for advice without actually managing a client’s assets.

While no compensation model is perfect, the AUM model stands out for its strong alignment with client success, its promotion of comprehensive and ongoing financial planning, and its transparency. For a financial advisor committed to a long-term partnership and acting in their clients’ best interests, AUM often provides the most suitable and sustainable framework for delivering high-quality service.

AUM as a Better Way to Charge:

• Unparalleled alignment of Interests:
  • The most compelling argument for AUM is the direct correlation between the advisor’s revenue and the client’s portfolio growth.
  • When an advisor charges a percentage of the assets they manage, their compensation directly increases as the client’s investments appreciate.
  • Conversely, if the portfolio declines, so does the advisor’s fee.
  • This structure creates a powerful incentive for the advisor to:
    • Prioritize long-term growth:
      • Advisors are motivated to make sound, strategic investment decisions aimed at sustained appreciation, rather than short-term gains or frequent trading that might benefit them in transactional models.
    • Minimize costs and taxes:
      • By reducing investment expenses and implementing tax-efficient strategies, the advisor helps clients retain more of their gains, which in turn benefits both the client and the advisor.
    • Foster a true partnership:
      • The shared objective of growing the client’s wealth transforms the relationship into a collaborative one, where the advisor’s success is intrinsically tied to the client’s financial well-being.

• Comprehensive and Ongoing Service:
  • AUM fees typically cover a broad spectrum of services that extend far beyond mere investment management, and lay the framework for a consistent, trusted financial partner to address all aspects of a client’s financial life.
  • This holistic approach ensures that clients receive continuous, multifaceted financial guidance that helps them reach their goals, and can often lead to larger AUM.
  • Services often include:
    • Retirement Planning: Crafting strategies for a secure retirement.
    • Tax Planning: Identifying opportunities for tax efficiency and minimizing tax liabilities.
    • Estate Planning: Guiding clients through the complexities of wealth transfer and legacy planning.
    • Risk Management: Reviewing insurance needs and assessing overall financial risks.
    • Budgeting and Cash Flow Analysis: Helping clients manage their income and expenses effectively.
    • Ongoing Education and Guidance:
      • Providing continuous insights into market conditions and financial strategies.
      • Because the fee is ongoing, advisors are incentivized to provide proactive advice, regular portfolio monitoring, and timely adjustments based on changes in the client’s life circumstances.
      • Clients are encouraged to reach out with questions or concerns without the fear of incurring additional charges for every interaction, fostering a sense of accessibility and trust.

• Transparency and Simplicity:
  • Most advisors who charge AUM fees operate under a fiduciary standard, meaning they are legally obligated to act in their clients’ best interests at all times.
  • The AUM model is generally straightforward and easy for clients to understand.
  • The fee is presented as a clear percentage (e.g., 1% per year) of the assets under management, eliminating hidden commissions or complex fee schedules.
  • While the dollar amount of the fee will fluctuate with the portfolio’s value, the underlying percentage rate is typically stable, making it easier for clients to comprehend and budget for their advisory expenses.

Advantages of AUM Over Flat Fee Models:

• Direct Incentive for Growth:
  • While a flat fee offers predictability in dollar terms, it lacks the direct incentive for the advisor to grow or maintain the client’s portfolio.
  • The advisor’s income remains fixed, potentially leading to less proactive financial management beyond the initial planning.

• Scalability for Value:
  • A flat fee might be disproportionately high for smaller portfolios when considered as a percentage, potentially making comprehensive advice less accessible.
  • Conversely, for very large portfolios, a flat fee might undervalue the extensive time and expertise required to manage complex wealth.
  • AUM naturally scales with the client’s asset growth, ensuring compensation aligns with the evolving complexity of service required.

• Ongoing Engagement:
  • A flat fee often covers an initial comprehensive plan, but subsequent advice or ongoing adjustments might require additional charges or simply receive less continuous attention than under an AUM model where the fee is ongoing.
  • One-time paid for plans cannot identify and take advantage of opportunities when they arise in real-time as clients live their lives.

Advantages of AUM Over Fee-for-Advice Models: (Advice-Only hourly, monthly, or annually)

• Holistic, Continuous Partnership:
  • Fee-for-advice or hourly models are excellent for specific, one-time questions or project-based work (e.g., creating a standalone financial plan).
  • However, they generally fall short for clients seeking an ongoing, comprehensive financial partnership.

• Hesitation to Seek Advice:
  • Under an hourly model, clients might be hesitant to contact their advisor frequently due to cost concerns, potentially leading to missed opportunities, delayed decision-making, or unaddressed financial issues.
  • AUM encourages open communication and proactive engagement without the “meter running” anxiety.

• Lack of Accountability for Portfolio Management:
  • An hourly fee does not directly incentivize the advisor to ensure the client avoids making any mistakes in their financial life.
  • The advisor is paid for their time, not for the results and/or consequences of their advice.

• Unpredictability of Costs:
  • Hourly fees can be unpredictable, making it difficult for clients to budget for ongoing financial guidance, especially if their needs are complex or fluctuate over time.

Addressing Common Criticisms:

Online critics, such as those frequently observed in the financial media, often attack the AUM model by fixating solely on the fee as a “cost” and extrapolating its compounding effect over decades. They coin AUM as “expensive.” These perspectives are flawed due to several critical errors:

• “Expensive”:
  • While the dollar amount of the fee can be substantial for very large portfolios, it is often justified by the increased complexity of managing significant wealth, including sophisticated tax strategies, estate planning, and philanthropic considerations.

• The “Lost Opportunity Cost” Fallacy:
  • Critics often calculate how much a portfolio would have grown if the AUM fees had been invested instead.
  • This viewpoint creates a very misleading comparison.
    • It is akin to arguing that the money spent on a car, a house, or even education, if invested, would have yielded a fortune.
    • This argument ignores the inherent value received for those expenditures.
    • The AUM fee is payment for a valuable service, not simply money “lost.”
    • In fact, the portfolio might grow even more substantially due to the advisor’s guidance.

• Ignoring the “Alternative Reality” of Do-It-Yourself (DIY) Investing:
  • Critics frequently assume a DIY investor could achieve the exact same returns as a professionally managed portfolio, just without the fee.
  • This argument completely ignores numerous value-adds provided by a good financial advisor that most DIY investors struggle to replicate:
    • Acting as a sounding board to keep clients on track:
      • This facet is perhaps the most significant benefit.
      • Advisors prevent clients from making emotionally driven, detrimental decisions during market volatility (e.g., selling low during downturns, chasing hot stocks).
      • The behavioral gap (the difference between market returns and actual investor returns) can be substantial, and an advisor’s steady hand can save clients far more than the AUM fee.
    • Tax Efficiency:
      • Expert tax-loss harvesting, asset location strategies, and capital gains management can generate significant tax savings that easily offset advisory fees over time.
    • Proper Asset Allocation and Rebalancing:
      • Advisors ensure portfolios remain aligned with risk tolerance and goals, systematically rebalancing to optimize risk-adjusted returns – a discipline many DIY investors lack.
    • Comprehensive Financial Planning:
      • Beyond investments, advisors provide critical guidance on retirement, estate planning, insurance, debt, and cash flow.
      • These elements collectively contribute to overall financial security and can prevent costly mistakes or missed opportunities.
    • Time Savings:
      • For busy individuals, outsourcing financial complexities frees up valuable time and reduces mental burden.

• Commingling Salespeople with Fiduciary Advisors:
  • Some critics incorrectly lump all “financial advisors” together, failing to distinguish between genuine, fee-only fiduciary advisors (who operate under a legal obligation to act in the client’s best interest) and commissioned salespeople.
  • The AUM model, especially when adopted by a fiduciary, inherently reduces conflicts of interest, as the advisor benefits when the client’s assets grow, not from specific product sales.

• Motivation for Asset Gathering:
  • While some critics argue the AUM model incentivizes advisors to simply gather assets, it also incentivizes them to retain those assets through excellent service, demonstrating value, and fostering trust to ensure clients do not move their assets elsewhere.
  • As assets grow over time, the advisor’s compensation grows without requiring them to continually seek new clients or raise rates, allowing them to focus on deepening existing relationships.
  • Good advisors using the AUM model have a client retention near or even over 95%. 

• “Low Visibility” of the Fee:
  • AUM fees are often deducted monthly or quarterly directly from the investment account, making them less “visible” or psychologically noticeable to clients compared to writing a large check for a flat fee or reviewing an hourly invoice.
  • While some critics may frame this aspect as a negative, it can contribute to better client retention and adherence to advice, as clients are less likely to constantly feel and question the explicit cost.

• “Fee Taken Even in Down Markets”:
  • Clients pay the AUM fee even when their portfolio loses value.
  • However, this arrangement is part of the ongoing nature of the service, which includes managing downside risk, rebalancing, and providing emotional support and guidance during difficult market periods – crucial services that prevent clients from making rash decisions that could further harm their long-term financial health.

Conclusion: Why the AUM Fee Model is Better for Clients

In summary, while the AUM fee is undoubtedly a cost, it represents payment for a comprehensive, ongoing, and highly valuable service that, for many clients, far outweighs the fee itself. The AUM model excels in aligning advisor incentives with client success, promoting holistic financial planning, and fostering a durable, trust-based relationship. The criticisms often leveled against it tend to be simplistic, overlooking the significant non-investment-related value advisors provide and the crucial education and support that can protect clients from costly mistakes. For those seeking a dedicated financial partner committed to their long-term financial well-being, the AUM model frequently stands as the most transparent, beneficial, and sustainable compensation structure.