Thursday, June 7. 2012
The Salience of Financial Planning Fees - It's Not Just About How Much You Charge, But How You Charge
The inspiration for today's blog post is a recent study I heard about, entitled "E-ZTax: Tax Salience and Tax Rates" by Amy Finkelstein. In the research, Finkelstein tried to explore the implications of tax salience and the size of government by looking at an interesting parallel - the salience of highway tolls and the sensitivity of drivers to those toll payments, with some striking conclusions that have relevance for financial planners as well.
Pricing Salience, Taxes, and the Toll Study
The basic concept of price salience is that some methods of making payment may be more prominent or noticeable than others; as a result, we may be more or less aware of the payment amount depending on the payment method. The implication of these differences is that we may judge or perceive value differently, depending on how salient the pricing is.
In Finkelstein's research, this was studied by surveying drivers who had driven on either cash-payment toll roads or electronic-payment toll roads, and asking them if they were aware of how much the toll was. In one survey, less than 40% of drivers who paid electronically were even willing to hazard a guess about how much the tolls had been and in fact had to be further prompted just to make a guess, and ultimately 85% of them were incorrect about the toll; on the either hand, amongst the cash payment drivers, 98% were willing to make a reasonable guesstimate without being further prompted, and only 31% of them were incorrect. In another study, the results were similar; 83% of electronic toll drivers guessed the toll wrong (even though they had already paid it!), while only 40% of the cash payment drivers were incorrect in recalling the tolls that they had paid.
The significance of these results is not just an amusing look at the ignorance of drivers about the tolls that they paid. Finkelstein's research also finds evidence that the average toll rates on electronic toll roads are 20% to 40% higher than they would have been under a manual toll collection; the reduced salience of the tolls leads to less political pushback regarding toll increases. In the context of Finkelstein's research, this suggests that other nonsalient payment mechanisms - such as the Federal income tax withholding system - may similarly make it easier for politicians to raise tax rates and expand the size of government, than would have been possible with a more salient tax payment structure; separate research has also suggested that it is politically more difficult to raise property taxes than income taxes, again because the collection mechanisms for the tax tend to make the former more salient than the latter (although this conclusion is far less certain and more controversial).
In the context of individuals, Finkelstein also notes that research by Thaler and Soman and has similarly shown that credit cards - which decouple the purchase of an item from the payment for the item - may reduce overall awareness of the amount spent, leading to less spending control and accommodating greater (and potentially unhealthy) spending levels. In other words, separating the act of purchasing from the timing and impact of paying for the item also appears to reduce the saliency of the cost, making individuals less sensitive to spending amounts and thereby less capable of controlling spending levels.
Price Saliency in Financial Services
Although we often don't discuss it, the reality is that price saliency - or the lack thereof - plays a significant role in the financial services industry as well.
For instance, look at consumer willingness to purchase insurance and investment products where the agent is paid a commission by the company that delivers/'manufactures' the product. A long list of consumer studies show a lack of awareness about the compensation paid to salespeople on a commissioned insurance policy or investment offering, similar to their lack of awareness about the amount of a toll that's paid electronically. Notably, as with the toll research, this also implies that consumers may tolerate higher commission compensation systems (as they tolerate higher tolls) when the pricing is less salient; the reduced saliency of the payments to the agent reduces the pushback to the amounts that are being paid.
In a similar manner, consumer willingness for doing business also appears to be high for the assets-under-management (AUM) model, which in part may be attributable to the low saliency of the cost - when fees are deducted directly from an investment account without the client being forced to write a check or pay in cash, the saliency is reduced, which potentially makes the client less awareness to the cost, less sensitive to the cost, and less likely to object to price increases over time.
Making Prices More Salient
So what can be done to make prices more salient? Certainly, the first step is clear disclosure of the price - whether a boldly placed, large-print sign at the toll booths, or documentation along with the purchase of a financial services product or financial planning service. If the method of payment generally constitutes a low-salience pricing style, then use (or require) disclosure communication to proactively ensure that the consumer has a proper understanding of how much is being paid.
The second alternative to make prices more salient is to literally change the means of payment and compensation to make the transaction more salient. For instance, the approach being adopted in the UK starting in 2013 under their Retail Distribution Review (RDR) is to ban commissions altogether, and require clients to agree in advance to the advisor's charges, which will be paid separately (and saliently!); clients can request to 'facilitate' the payment by having it deducted from an investment, but only after a separate act of the client to provide authorization for the payment (ensuring its saliency). Similarly, some firms in the US in recent years have shifted from an AUM-style business model to a retainer model; although many made the change primarily for revenue stability purposes, separate payment of retainer fees by check constitutes a significantly more price salient approach as well.
The outcome of this process? A world where clients are more aware of and cognizant of the prices that they pay, which in turn helps to ensure that appropriate value is being delivered for the cost, and that clients are appropriately sensitive to price increases to ensure that they are justified in the eyes of the client.
Is More Price Saliency Always Good?
Although the focus of both Finkelstein's research, and much of the recent proposed and implemented reforms to financial services around the world, is to reduce the adverse consequences that occur when price saliency is low, it's worth noting that increased price saliency is not always a good thing - especially from the advisor's point of view.
While price saliency by definition means that consumers are more aware of the prices they pay - thereby ensuring they give due consideration to the value being priced for the cost being paid and don't allow prices to rise in an unjustified manner - the saliency also means a higher likelihood that consumers will push back on pricing in general. After all, not everyone weighs costs and benefits the same way - and greater price saliency simply accentuates the point.
As a result, businesses that operate on a higher-saliency pricing model may struggle more to attract and retain clients at comparable fees to less price salient business models. In fact, that's largely the point - even assuming the value proposition is identical between two firms, the price saliency research implies that the firm with the more salient cost structure will be pressured into charging lower fees and generating less revenue from the same base of clients. If the reality is that the salient prices are "right" and the non-salient ones are high, this is arguably good news for the consumer. On the other hand, if the reality is that the nonsalient price is reasonable for the services being charged, a more salient pricing structure could actually make a firm less competitive, effectively forcing the firm to undercharge what it believes it is worth to satisfy the most price-sensitive clients under a price-salient model (or alternatively, accept fewer clients and simply grow more slowly).
This may explain the struggles of many financial planners engaged in the hourly pricing model in particular - arguably the most price-salient of business models that exists in the industry. While the model has all the virtues of highly salient pricing - clear transparency, and an opportunity for consumers to immediately judge the cost relative to the benefits - it also struggles with all the disadvantages - price sensitivity and a difficult challenge to justify every last bit of cost. Which can be especially difficult given that so many of the benefits of financial planning are neither tangible nor short term, even though the cost is tangible immediately! Similarly, this also helps to explain why businesses that don't charge for financial planning up front (a more salient pricing model) often have higher prospect-to-client conversion ratios than businesses that simply charge a single (less salient) AUM price, and why firms that switch to retainer fees have difficulty raising their fees a few years later to keep up with rising staff costs.
The unfortunate reality is that highly salient costs are a double-edged sword - while arguably a positive for consumers overall in that it prevents businesses from unjustifiably raising prices, it also presents a negative for the growth of the business due to ongoing pushback from consumers about pricing and difficulty attracting clients who balk at the immediate adverse impact of making a highly-cost-salient purchase, especially given - in the case of financial planning - a rather difficult-to-quantify benefit.
Which means in the end, what may be best for consumers overall to keep financial planning costs reasonable may be worst for financial planning businesses that wish to grow. Even if the business genuinely charges a fair price for the services it renders, the ones with salient pricing are likely to have more pushback and lower prospect-to-client conversion rates than the ones that set an appropriate price but then implement on a nonsalient basis (as well as a risk of margin compression due to "sticky" prices that can't be raised as much in the future due to price saliency). Which perhaps explains why the non-salient AUM model has been the best growth model of the past decade or two?
So what do you think? How salient are the prices in your financial planning practice? Is that a help or a hindrance to bringing on new clients? Is that a positive or a negative for consumers overall? Does how the firm charges matter as much as the amount the firm charges when a prospect considers becoming a client?
As the financial planning profession continues its inexorable march towards a fiduciary client-centric standard of care that minimizes or outright avoids conflicts of interest, those most passionate about carrying the torch have often been the most vocal
Tracked: Jun 14, 07:34
As the financial planning profession continues to grow, it also continues to struggle to reach and effectively serve Gen X and Gen Y, as most planners tend to focus their businesses on baby boomers - no great surprise, given that baby boomers both control
Tracked: Mar 06, 22:17
Bill for, say, 15 hours of planning on January 1 for all clients.
Then monitor client activity throughout the year as usual.
On December 31, for those clients who didn't use all of their 15 hours, offer either to refund the unused fees, or roll the amount into the next year.
How do you think that would influence the fee vs. value proposition?
Not long ago I made a retainer presentation to a couple who were working with a broker-dealer adviser. As part of my presentation, I demonstrated to the couple how my fee was in fact lower than the cost they were currently paying factoring in expense ratios, account maintenance fees, etc. I truly believe they accepted my analysis but they still decided not to become clients. It was clear that the salience of my fee was the issue.
On the flip side, I do believe that clients who overcome the salience hurdle because they truly see the value I provide are better clients and are more likely to remain clients over time.
Could it also be that because people in general are so used to a buying most things in a more direct method; i.e. they get their car repaired and pay the bill. They buy groceries and pay for it right then and so on. When people have to write the check and don't see all that will be done immediately, they become a little skeptical of this type of purchase model.
I do like your approach Bill!!!
An inflation clause can be added to the Financial Planning Agreement in order to ensure the advisor's revenue increases over time.
Indeed, from the business perspective, reducing saliency of retainers with an automatic-debit payment system (sweeping from an investment account, debiting a credit card or bank account, etc.) would definitely make the cost more palatable.
Notably, smaller recurring payments would almost certainly be more palatable than a large annual payment - IF the saliency is low due to the payment method. If the saliency is high - they have to pay out of pocket - then a monthly payment structure would probably be even worse. It would simply make a saliency transaction point to justify value 12 times a year instead of just once!
I've worked with clients that prefer the automatic deduction (one less thing they have to think about) and others that prefer to be billed directly (so they can know exactly what they are paying every month/quarter/year). In my limited experience it's typically the direct bill type of client that questions the advisor's value.
Say it's 2008. And you spent 15 hours with client A trying (and failing) to keep her from panicking out of the market. And you spent 3 (intense) hours with client B, successfully keeping her in the market -- and her portfolio is worth 40% (hundreds of thousands of dollars)more as a result. Would you feel like giving client B a refund?
Client B deserves no refund. The fees any hourly advisor charges are not based on the outcome of portfolio performance, but solely on the quantity of services delivered.
I think a composite approach works best. In our comprehensive financial planning business we negotuate a contract rate for advice, charge hourly rates for implementation, and: for clients with investments, a FUM sliding rate fee; for those without, hourly rate fees or an annual retainer payable in monthly instalments by direct debit.
Where we assist with insurance products we offer an initial fee basis (with lower annual premiums) or a commission basis (where we always get more than the fee would have been). When doing this we talways ell the client the better deal for them is the fee basis, but suprisingly - and relevant in the context of this discussion about saliency - about half opt for the no fee higher premium approach.
People just don't like writing cheques - especially for a product or service with an uncertain, future benefit.
When I had my own practice, I charged either hourly (for one-time engagements) or on a flat-fee basis (for ongoing clients for whom I managed their investments). Michael's done a great job of highlighting the problems with both of those methods, and I completely agree.
[On a related note, we continually hear that consumers think that most financial advisors only look for wealthy clients and price out the middle-income folks. However, when I had my hourly practice, I found that middle-income people think they should be able to get a lot of financial planning advice for a small price, say $250 to $500. Many of them refuse to pay more than that. My response is -- you middle-income folks have plenty of hourly planners to choose from, but you're too cheap to pay for good advice. This goes back to the price saliency that Michael wrote about; it's too painful to middle-income clients to have to write a check for, say, $1,200 for financial advice.]
Had I kept my practice, I would most likely have dropped my hourly practice and changed from flat fee to AUM, despite the fact that I think that the AUM model has many problems with it. For one thing, the AUM approach puts the emphasis on investments even though that's just a piece of the big pie of advice (tax planning, retirement planning, risk management, etc.) that most of us provide.
For another, it's ridiculous that my compensation should drop, say, 15% if the stock market tanks and my AUM drops by that much...especially because I think that advisors provide MORE advice and hand-holding when the stock market is doing what it did in 2008.
Despite those problems with the AUM pricing model, I agree that it's still the best one to use for financial planners and, probably, for clients too.
Bob Veres has also written about the compensation issue quite a bit, and I'm sure that we'll see plenty more written in the future by Bob, Michael, and others.
Thanks for the feedback.
One quick note, regarding your comment (which I see often) - that "it's ridiculous that my compensation should drop, say, 15% if the stock market tanks and my AUM drops by that much" - to which I'd respond two things. #1, we don't seem to complain when the markets go UP by 15% and clients may be calling less! And #2, we're running a BUSINESS, and business have CYCLES, and that's just a natural part of being a business owner.
Would we be happier if the cell phone companies charged an extra $2 per call on our birthdays, holidays, and during New Year's, since they're connecting calls more often and doing more "work" (or using more of their capacity) during those peak times? Of course not.
The phone companies realize they're running a business, where utilization will vary over time, and revenue may fluctuate. The key is to run the business well enough to whether the bad environments and grow in the good ones.
I would suggest that our view of running a financial planning business should function very much in the same way. We don't have to make the MAXIMUM profit from EVERY client in EVERY meeting and EVERY phone call on EVERY day of the year. We need to make an appropriate profit over the business cycle and operate our businesses in a manner that gives it the resiliency to survive and grow through those cycles. The fact that sometimes my profit margins are higher (fees are up and calls are down) and sometimes my profit margins are lower (fees are down and calls are up) is a reality of running a business. Trying to run your business in a manner where profit margins are 100% stable through every possible market environment has ramifications - often so severe that in practice (especially regarding price saliency to consumers who get angry and resentful!), almost no one actually runs a business that way!
We all know that many other companies laid off thousands upon thousands of employees over the past few years, and I thought to myself, why don't those companies save money during the great times so that they don't have to lay off so many employees during the bad times?
I hope that financial advisory firms did a better job of planning for the inevitable downturns than many other industries did.
My guess is that simply given the number of financial planning firms that are not really very efficient businesses at the end of the day, a significant number laid off employees through the decline.
Amongst the firms that I see that are well managed, though, none had to lay off. Some actually hired the best from the other firms that were laying people off.
The well managed firms tend to:
- Have flexible compensation schedules and/or a bonus structure that helps to manage payroll in times of declining markets/revenues
- Keep an appropriate cash reserve for difficult times (shouldn't every person AND business have a healthy emergency fund!)
- Operate with strong profit margins (25%+) that gives them a cushion to absorb revenue declines as a loss of owner profits (and reduced ownership dividends/distributions) without needing to lay off staff (and of course, the owners make it up with increased dividends/distributions in the future after markets/revenues recover).
Most firms I saw that had to lay people off either had compensation that was too rigid, too much staff/compensation relative to their business (which was fine in growth years but couldn't handle a downturn), thin profit margins, or insufficient reserves so the owner had to lay employees off for cash flow purposes.
But in the end, those are business management issues that can be addressed in MANY ways. Changing your revenue model (off of AUM) is just one of them. And frankly, given a lot of the other strong virtues of the AUM model (including lower fee sensitivity and price saliency, which is a plus from the business owner's perspective), I would probably be looking to change a lot of other factors before the entire AUM foundation of the firm.
Just my $0.02.
You need both of these:
-A set of documents that is clearly written and organized
-A good process for getting that information into clients' hands
Some companies put that together themselves, or sometimes they get in touch with an expert consultant like myself. Either way, the same principles apply.