The assets-under-management model for financial planning firms has become increasingly popular in recent years. However, its rising popularity has also brought a great deal of criticism, especially regarding the volatility of revenues as markets cycle up and down. As a result, some firms have begun to shift to a retainer-style model in an attempt to smooth out fees, rather than pricing on a strictly AUM basis. Unfortunately, though, an annual retainer model where clients have to write a check for services makes the fee significantly more "salient" and can actually force firms to either cut prices or work harder to generate the same income, and may result in worse client attrition during down markets as fee-sensitive clients choose not to renew during difficult times. As a result, some firms that shift to annual retainers are even shifting away from retainers and back to AUM pricing after a few years of business pain! Of course, the reality is that the AUM model can't serve all clients, and retainers may be necessary in some segments of the marketplace; nonetheless, in situations where there is a choice, the AUM model may have far more longevity than some expect.
The inspiration for today's blog post was a recent conversation I had with a fellow planner who transitioned his practice to an annual retainer fee model... and two years later, is converting his practice back to the AUM model he had originally. "I loved the idea of it," he said, "especially to get off the revenue rollercoaster of AUM fees that went up and down with the markets. But no matter how much work I did for my clients, they really pushed back on writing that annual check."
"I'm not surprised," I replied, "that's the unfortunate problem with such a highly fee-salient business model."
The Importance Of Price Saliency
As I've written in the past, clients do not view all mechanisms of payment equally; some methods of payment make the cost more tangible and "salient" while others are less salient. The importance of saliency is that, as the research shows, more salient payment mechanisms cause people to more actively question the price that they're paying and the value that they're receiving; stated more simply, the higher the saliency of the payment, the more likely we are to question whether the cost is really worth it.
In some contexts, high price saliency is good. We tend to make more prudent decisions as consumers, and are more cost conscious, with high saliency pricing. This is why we object to toll increases we pay in cash/coins more than toll increases we pay electronically. It's why we tend to question property tax increases more than income taxes (the former is often paid by high-saliency check, the latter by low-saliency payroll deduction). The creation of Health Savings Accounts paired with High Deductible Health Insurance plans was done with the intention of raising the price saliency of the healthcare we purchase in the hopes of making us more proactive, cost-conscious consumers.
The caveat of price saliency is that while high saliency can be an effective consumer protection - by helping to make people more cost conscious so they make "better" decisions - it can also be a downside for businesses. Even if the business offers a compelling value proposition, making prospective clients more cost conscious inevitably leads some to choose an alternative that either is less expensive, or is at least less fee-salient so the cost of services doesn't feel as painful. Thus, while low-saliency pricing can sometimes lead to unjustified and consumer-unfriendly price increases, it also can be positive for businesses by making it more comfortable and less of a slap in the face for consumers who purchase the business' bona fide goods and services.
The Saliency Of Retainers Versus AUM
In point of fact, the comparison of retainers versus assets-under-management (AUM) models represents a classic example of a high versus low saliency business model decision. After all, most firms charging retainers ask clients to write an annual check (high saliency), while most firms operating on an AUM basis extract fees directly from the client's investment accounts automatically (low saliency).
Given the research on fee saliency, this suggests that even if firms charge the exact same price as what would have been paid on an AUM basis, or even a little bit less, that clients will be more likely to question the value of the firm and less likely to purchase or renew services. In fact, the impact of saliency would suggest that, in order to remain competitive with a lower-saliency AUM model, a retainer-based firm would actually have to charge less money per client for the same services just to overcome the saliency barrier!
And notably, because of the high saliency of retainer fees, clients are forced to deeply analyze the value proposition of the firm not just initially when becoming a client, but every year, because of the high-saliency fee that must be paid every year! Which means charging retainers may not only require the firm to charge less per client for the same services, but may also require the firm to do more work and provide more service just to get the same client renewal. In turn, this means retainer fees can actually still be somewhat "volatile" - if markets decline and a firm tries to keep the same retainer fee, they may simply be undercut by an AUM competitor who would charge less, for the time being, on the decreased asset base (and with a high saliency fee, the client is more likely to check around and discover this!)! Furthermore, the high saliency of the pricing can also make it difficult for the firm to raise fees over time - which, over a 5-10 year time horizon, may threaten the viability and profitability of the firm, as staff and overhead costs will potentially rise faster than retainer fee revenue.
Limitations Of The AUM Model
Of course, the reality is that while the AUM model may allow the firm to be more financially viable than a retainer model for a similar client base, the AUM model isn't capable of serving a large swath of individuals who don't have an asset base to which AUM fees can be applied. Thus, the point here is not that AUM is the only model to operate and that retainer fees can't or will never work; the point is that for clients where AUM fees can work, using a retainer model just raises the saliency of the advisor's payments, cutting down on the number of new clients, reducing client retention rates as more clients question whether it's really worth renewing the retainer fee, and putting pressure on the firm's profit margins as inflation may push staff and overhead costs up faster than the firm can raise a high-saliency fee structure.
Notably, though, the research on price saliency does provide guidance about more effective ways to implement a retainer-style approach. For instance, not all retainer billing structures are as salient as others. Furthermore, when prices are salient, they often invite a comparison to other expenditures; as a result, a good decision about pricing structure can also control the "compared to what" conversation when setting a price on planning with a client. For instance, when working with the middle market, where an AUM fee is often not feasible and a retainer fee is preferred, structuring the fee of $1,200/year may yield very different results than pricing at $100/month. From the client's perspective, $1,200/year is like buying a giant flat-screen television (ouch!), whereas $100/month is more like the monthly cost of cable - or the cost savings available by shifting from a daily cup of Starbucks to self-brewed coffee! By choosing the less salient pricing structure - such as a low, recurring, automatic pricing schedule instead of a single, "large" (relative to the client's comparison points) annual written check - and anchoring it to a cost clients can more reasonable envision themselves giving up, you can enhance the feasibility of retainer fees for clients where that is an appropriate billing structure.
Retainers Versus AUM Where There's A Choice
But the fact remains that for clients where an AUM fee structure is feasible, the lower price saliency model continues to outperform the high-saliency retainer model, as my friend discovered - a story I have heard anecdotally repeated over and over again in recent years, as firms shift from AUM fees to retainer fees (usually to stabilize revenues), discover the challenges of a high saliency pricing structure, and switch back after a few years of business pain. While the retainer fees are intended to be stable revenue, it becomes more difficult to renew clients and attract new ones, and some firms find they have to do even more work to justify their retainer fees and keep clients renewing, rendering the business even less profitable than when fees just went up and down with the markets!
In addition, it's worth emphasizing that retainer fee structures are not necessarily more stable, in addition to likely being less profitable. As practice management consultant Angie Herbers recently noted on Advisor One, the reality is that in economic downturns, people tend to worry about and constrain their spending - which means a subset of retainer clients may simply not renew if they are worrying about their finances in the middle of a recession. In fact, arguably the AUM model is actually better to retain clients in the midst of a difficult economic environment - where at least their fees are "discounted" while their asset values are depressed, and the saliency of the pricing doesn't shock them at the worst possible moment.
That doesn't mean retainer models are universally bad - given that they may be the only feasible way to serve certain segments of the marketplace - but the research is clear that, when offering comparable services and comparable value, businesses with higher saliency models will struggle more, all else being equal. Or stated more simply - it doesn't really matter whether retainer fees are a "more accurate" representation of the work you do for clients each year or not, if the cost is such a slap in the face they choose not to pay it at all.
So what do you think? Do you use a retainer fee model or an AUM model? Have you ever switched from one to the other? What was your experience? Do you think price saliency is relevant in your business model? Would it impact how you charge clients going forward?