Executive Summary
Whether due to fears of the next bear market, a struggle to differentiate in an increasingly crowded AUM-fee landscape, or the pressure of competition from robo-advisors, a growing number of financial planners are talking about changing from the assets under management (AUM) model to adopting some form of (typically annual) retainer fees instead.
While the AUM model has challenges, though, from revenue volatility to potentially misaligned pricing for clients to non-trivial conflicts of interest, the ongoing rise of the AUM model suggests that it still has more benefits than drawbacks. And in fact, its biggest strength from the business model perspective – the ability to have revenue per client grow over time as the market grows – may be a key factor that allows it to continue to dominate the more-salient retainer fee alternative, which may struggle to keep pace with rising employee advisor costs given the industry’s demographic shortages.
Yet the reality is that the greatest potential for retainer fees may have nothing to do with competing head-to-head with the AUM business model, but instead to reach out to clients that the AUM model can’t serve in the first place – as many as perhaps 80% of all households, that simply don’t have available assets to manage (or sufficient assets to be managed in the first place). In fact, the untapped market potential for using retainer fees to expand the reach of financial planning is so large that, in the long run, while the AUM model may still survive, it could become a niche for high-net-worth clients, while most consumers access financial planning through various retainer or fee-for-service alternatives!
The Challenge Of AUM Fees And The Virtue Of The Financial Planning Retainer Fee
The growth of the AUM model has been tremendous over the past decade; while in its initial years in the early 2000s, the Moss Adams advisor benchmarking survey indicated the average firm had just $25M of AUM, by 2008 the typical firm was over $100M of AUM, and in 2013 the latest version of the study showed the average firm over $200M of AUM. Yet despite the tremendous ongoing growth of the AUM model, an increasing number of industry commentators are raising the question of whether there is trouble ahead (or as Bob Veres recently wrote, “The AUM Fee Is Toast”).
Aligning Pricing With The Value Of And Cost To Deliver Financial Planning Services
Perhaps the biggest criticism of the AUM business model in today’s environment is that it’s not an effective alignment between the pricing model and the value that an advisory firm typically provides today. In particular, as technology increasingly commoditizes investment management (especially the passive strategic investment strategies popular with many RIAs), and firms increasingly find themselves trying to deliver more and deeper financial planning services as a value-add (or the core value!) to differentiate themselves, the question arises as to why firms are still using a “portfolio-centric” pricing model for a financial-planning-centric value proposition. By contrast, a (comprehensive) retainer fee that is separate from the portfolio can more squarely place the client’s focus on the (comprehensive) beyond-just-portfolio financial planning services.
In addition, not only does the portfolio-based pricing model potential misdirect client attention towards the portfolio and away from the financial planning services, but it also risks misaligning revenue and cost. As critics are quick to point out, the actual complexity and amount of work involved for a client is not necessarily related to their level of AUM – at best, it is perhaps a crude approximation that a multi-million-dollar portfolio owner probably has a somewhat more complex financial situation than someone with just a few hundred thousand dollars of net worth (who in turn is 'more complex' than someone with even less in investable assets). In other words, someone with an $800,000 portfolio might have a little more complexity than someone with a $400,000 portfolio, but probably doesn’t have twice the complexity (and time/effort to service), despite being charged twice as much under an AUM fee structure (or perhaps just slightly-less-than-double with a graduated fee schedule).
By contrast, when a retainer fee is established, it’s easier to align the pricing of services with the cost for the business to deliver those services (which matters, since professional staffing costs are the largest line-item expense of an advisory firm!). For instance, a standard client service calendar can be established, that stipulates the exact services clients will receive throughout the year, and be priced in a manner that’s appropriate for the number of hours it will take to consistently deliver the service; in other words, if the particular client service calendar typically takes 20 hours of work to deliver throughout the year, it can be priced based on the cost to deliver 20 hours of work, rather than based on a client’s assets that may have little relationship to the work being done.
And if the firm serves a wide range of clients with a wide range of assets/income/net worth, offering multiple levels of services of varying complexity can be accomplished by crafting segmented service tiers for clients, which still articulate exactly what services clients will get at each tier; clients can then select the tier of services their want (and are appropriate for their needs), and the firm can remain confident that the service will be priced appropriately for the time/effort/cost to deliver. (And for clients with truly unique and exceptional situations, the advisor can always adjust the retainer fee to match the reality of that situation, in a manner that is typically easier and more flexible than trying to change a client’s AUM fee schedule on the spot to accommodate a situation.)
Revenue Volatility Of The AUM Model Vs Stable Retainer Fees
Beyond the mismatch between client AUM fees and the staff time (and therefore cost) it takes to service them, there’s also the problematic reality that client needs are not stable over time, and clients may be relatively hands-off in some years, but then need the most service and hand-holding after a bear market occurs.
And of course, in the midst of a bear market when client service demands peak, AUM fees decline as the portfolio declines, which means the firm ends out facing the greatest client demands on its staff at the exact moment it's generating the least revenue to compensate them! In turn, this can put an especially harsh squeeze on the profits of an advisory firm, as revenue declines but staff costs remain, since it is viewed as ‘business suicide’ for most advisory firms to lay off staff in the midst of a bear market (where firing staff to save costs leads to reduced service for clients at the exact time they need their advisor most, which in turn can result in a spike in client attrition that just causes revenues to decline even further as clients walk out the door!).
By contrast, retainer fees are not tied directly to the portfolio account balance, and thus can remain stable through bear markets, eliminating the challenge faced by the AUM model to manage the business through what can be highly volatile fluctuations in revenue. In other words, firms following the retainer fee approach don’t need to worry that the ‘dangerous’ market timing misalignment of the AUM model, where revenues decline in a bear market at the exact moment that clients demand the most service and support, and instead can be more confident that the revenue will be there to pay the advisors needed to handhold clients through a scary market situation!
Retainer Fees To Solve AUM-Fee-Based Conflicts Of Interest
Another popular criticism of the AUM model is that it still embodies several very problematic conflicts of interest. When the advisor is paid primarily (or exclusively) for managed portfolio assets, there is a classic disincentive to advise clients in strategies from paying off a mortgage to “non-portfolio” investing strategies like direct real estate purchases to entrepreneurs reinvesting into their businesses. And in an increasingly retirement-centric financial planning world, AUM fees are finding ‘new’ conflicts to manage, such as delaying the currently-mispriced Social Security retirement benefits (which may be financially superior in the long run but in the short term causes clients to withdraw more from the portfolio while waiting until age 70), or the use of immediate annuities as a mortality-credit-enhanced fixed income alternative for retirees (which may make sense for certain retirement income scenarios, but also reduces advisor AUM in the near term as funds are withdrawn to buy the annuity).
By contrast, the retainer fee model avoids many of the inherent conflicts of interest embedded in the AUM model. When client fees are determined independent of whether/how much of the portfolio the advisor manages, there is no more financial incentive for the advisor to give advice that preserves one type of asset (the portfolio) over all others. When the advisor’s compensation (based on the retainer fee) is the same, regardless of whether the client liquidates the portfolio to pay down mortgage or other debt, or to invest in real estate, or to (re-)invest into an entrepreneurial endeavor, there is no longer a conflict of interest to provide prudent advice with respect to those assets.
Of course, there can be some good reasons not to pay off a mortgage, invest in real estate, or keep plowing money into the next (or current) entrepreneurial adventure… and plenty of advisors under the AUM model still counsel clients to delay Social Security, or pay down a mortgage, or invest in a new business. A conflict of interest doesn’t automatically mean that the advice delivered under the AUM model will be “wrong” and that the advisor will succumb to the conflict (and arguably, these conflicts are still ‘less severe’ than those posed by selling high-commission financial services products). Still, the changed incentives of the retainer fee model clearly reduce the potential influence the conflict of interest could wield over the advisor.
The Problems With Retainer Fees (Vs AUM Fees)
Notwithstanding the purported benefits of retainer fees over AUM fees, it’s important to note that there are several very important caveats to consider when it comes to using retainer fees in lieu of AUM fees.
Revenue Stability Of Retainer Fees – In Bear And Bull Markets
While the stability of retainer fees in a bear market can be helpful to navigating what would otherwise be declining AUM-fee revenues, it’s crucial to note that the stability of retainer fees applies in bull markets as well. In other words, the good news is that the fee won’t go down when the markets go down, but that also means the fee won't automatically go up when markets are up.
And given that markets are up far more often than they’re down, arguably there’s a significant risk in adopting retainer fees that the business will leave significant revenue growth on the table. After all, converting from an AUM advisory firm to a practice that uses retainer fees is like shifting the firm’s revenue to go from being “stock-like” (tied to markets) to “bond-like” (tied to flat retainers) instead. And as we know, stocks go up more often than they go down, and outperform bonds in the long run on that basis (notwithstanding the volatility along the way).
So if we tell our clients – even those retired taking ongoing withdrawals – to invest in at least a moderate amount in stocks and ride out the volatility, because it produces greater wealth in the long run, shouldn’t we take our own advice when it comes to keeping the revenue of our own advisory firms hooked to long-term stock market growth, too? Or viewed another way, yes AUM fees are volatile – and that risk is rewarded with a return premium that allows AUM fees to grow at a faster pace than bond-like retainer fees! And as with portfolios taking distributions, volatility doesn't have to be avoided but instead can be managed on an ongoing basis, from more flexible compensation structures for staff, to having a cash buffer or a line of credit for the business, or using stock options as a revenue hedging strategy for the business, or simply ensuring the firm has sufficient profit margins to absorb a temporary revenue decline in the first place!
The problem of giving up market-based AUM fee growth for a fixed retainer fee is further complicated by the fact that the industry continues to face a significant demographic shortage of young advisor talent, even as more and more advisory firms hire employee advisors to service clients – which means the typical salary for advisory firm employees is growing rapidly. According to the 2013 Moss Adams Investment News Compensation And Staffing study, median compensation for Level 2 Service Advisors was up 8% over the preceding 2 years, and compensation for lead advisors was up 12%. Which means the advisory firm’s greatest line item expense is growing at an annualized rate of about 5%/year, even as retainer fees keep revenue flat (not declining, but not rising either).
The end result – even a highly profitable firm may find its profit margins chopped down to almost nothing in the next 7 years, as the chart shows below. (Michael’s Note: Chart assumes professional planning staff costs are 50% of total revenue, and rise by 5%/year, while other expenses add up to 25% and rise at 3%/year for inflation, and client revenue in the form of either flat-revenue retainer fees, or AUM-based fees growing at a conservative net-of-withdrawals rate of 3%/year.)
This suggests that at a minimum, advisory firms that look to a retainer fee structure need to figure out, in advance, how to build in automatic increases to retainer fees, just to have a chance to keep pace with the AUM business model, or risk a severe profit squeeze. Especially since if increases aren't automatic as a part of the retainer fee contract, a fee adjustment will require a new conversation with the client, every year, about raising that fee – a conversation that can be awkward for the advisor as well as the client, and lead to potential pushback (such that the retainer fees don't even grow at a pace that keeps up with inflation!).
In practice, many firms I know that have adopted the retainer fee only make adjustments every 2-3 years, for this exact reason – except that means revenue rises even more slowly (if it does at all!). And of course, in reality a mere net-3%-per-year growth rate is arguably still quite conservative for most AUM-based advisory firms, which means even escalating retainer fees by a few percent per year (or only every few years) will make it even more difficult for the firm to grow and reinvest. The last resort for some may be to simply get increasingly affluent clients who can afford to pay larger fees (and replace the "smaller" clients), but given a limited number of high-net-worth households not every advisor can pursue this strategy!
Saliency Of Financial Planning Fees
The fundamental problem of retainer fees is that they are more salient – the need to discuss them regularly makes them “top of mind” and naturally invites the client to push back on the fee and ask “what have you done for me lately” – which means in practice, it is very difficult to regularly raise retainer fees even to keep pace with inflation, much less to parallel the market growth of an AUM fee. By contrast, AUM fee adjustments happen automatically because they’re already tied formulaically to the portfolio, in a manner that doesn’t require a new conversation annually. Accordingly, it’s no coincidence that notwithstanding the damage that the 2008-2009 bear market did to bring AUM fees down, AUM-based firms have long-since rebounded to new highs since then, on the back of the subsequent bull market.
On the other hand, while the saliency of bringing up a retainer fee every year can make it harder to raise the fee in a bull market, clients may still feel compelled to ask for a fee cut in a bear market! After all, while the fee might not automatically decrease as the AUM declines (the "stable revenue" benefit of retainer fees during bear markets), clients who are feeling less wealthy in the face of a bear market may still ask for a fee cut, or otherwise become more fee sensitive as they look for places to “save” on expenses! Especially since an AUM-based advisor up the street may offer to work with the client for less – charging an AUM fee on the now-reduced portfolio – recognizing that a future market rebound means the client can still be profitable over time!
Example. In the interests of promoting revenue stability, Roger converted his client Catherine, who was paying a 1% AUM fee on a $1,000,000 portfolio, into a $10,000/year retainer client instead. In the following year, a severe bear market ensues, and Catherine’s portfolio falls to only $700,000. As a result, Catherine the client asks for a cut in her fees, noting that her $10,000/year retainer fee is now 1.4% of her reduced portfolio.
At the same time, an advisor up the street named Andrew solicits Betty to become his client instead, noting that at his 1% AUM fee, he would charge only $7,000 (which is 1% of the now-reduced $700,000 portfolio), a whopping 30% less than Roger! Andrew may be willing to do this, in part because he knows that his $7,000 fee can grow over time as the market rebounds from the crash and rises in the future, allowing Catherine the client to become a profitable client for him in the long run, and giving Andrew's business the ability to reinvest and continue to provide her more services.
Yet now Roger the retainer advisor is left in a tough spot; he can either cut his fee to $7,000 to match Andrew the AUM advisor, knowing that it will be hard to raise the fee again in the future (and still taking a decrease in fees during a bear market, even though the whole point of the retainer fee was to avoid that!), or risk losing Catherine the client and her $10,000 retainer fee altogether!
The Difficulty Of Selling A Retainer Fee Firm
Another notable challenge of structuring a firm with retainer fees is that it can be more difficult to sell.
The first issue is that, since the AUM model will generally provide better growth in revenue per client (as assets grow over time), the natural upside of the model makes it more appealing to buyers than a flat-fee retainer model. This seems to be true even for firms that have a relatively "old" retired client base, as even with ongoing withdrawals, an AUM firm will generally still enjoy revenue growth because market returns still exceed withdrawals for the typical retiree in their 60s and 70s. By comparison, a retainer fee model that struggles to grow its revenue per client, and/or is facing a profit squeeze in the coming years as client revenue fails to grow at the same pace as staff raises, will simply end out with a lower business valuation, due to the implied lower growth rate assumption that gets included in any form of discounted cash flow modeling.
The secondary challenge of selling a retainer fee model is that it adds complexity for an AUM-based firm to buy a retainer-fee model - requiring significant changes to billing and other processes - which makes it less appealing to buy in the first place. By contrast, when an AUM firm buys another AUM firm, the process is far more straightforward - AUM billing is already the standard, and the only potential challenge is to merge what are already likely to fairly similar fee schedules. This dynamic means AUM firms are somewhat more likely to want to buy other AUM firms and that retainer fee firms are more likely to be purchased by other retainer fee firms. Except since there aren't many retainer fee firms in practice already, those who transition to retainer fee firms in the near future and hope to sell in the near future may find the market of buyers much smaller, and much less willing to pay appealing revenue/profit multiples for the business!
The Real Opportunity For Retainer Fees – The Blue Ocean Of Underserved Clients
Limited Market Size For The AUM Model
As noted, it may be more difficult than many retainer advocates realize for retainer fee models to really compete head-to-head against AUM fee models. But focusing on the competition between AUM and retainer fees misses what is perhaps the greatest caveat to the retainer model in the first place: that by definition, it only “works” for those who have assets to manage in the first place! Which as it turns out, is a somewhat limited portion of the population.
According to Spectrem Group, there are a little over 1.3 million “ultra high net worth” households (wealth over $5M), another 8.8 million “millionaire” households (with $1M to $5M of wealth), and almost 30 million “mass affluent” households ($100k to $1M of net worth). To put that in context, according to the US Census, there are about 115 million total households in the US. Which means put together, barely 1/3rd of all households in the US have enough assets to meet even a $100k asset minimum!
In addition, the reality is that a significant portion of mass affluent net worth is tied up in an employer retirement plan (e.g., a 401(k) plan), which means it’s still not available to manage currently; if we assume about half of mass affluent households fall into that category, then in total barely 20% of all US households could possibly be served by the ‘industry standard’ AUM model!
In this context, the key point is that retainer fees can potentially reach a wide swath of the population who can’t be served by AUM fees at all. In other words, the greatest opportunity of retainer fees may not be to draw away clients currently paying AUM fees, but to serve the other nearly-80%-of-households the AUM model can’t reach in the first place!
Of course, for a significant subset of these households, they simply won’t have the financial wherewithal to pay for any financial planning services – arguably, there is some minimum of income and net worth where financial planning services just have limited relevance or viability in the first place (perhaps the bottom 40% of households who just can’t afford any financial planning assistance?). Nonetheless, for many households, they do have either sufficient net worth and/or income to pay for financial planning services, and a need for them, they just don’t have assets to manage and want to pay for financial planning from cash flow instead. (Or alternatively, some may even have assets to manage, but still won’t adopt an AUM-based advisor because they just want financial advice separate from investment management services!)
Which means that ultimately, the number of households that have a financial wherewithal to pay retainer fees, but can't work with an AUM advisor, may actually be as numerous as the number of clients already being served by AUM advisors!
Blue Ocean Strategy For Financial Planning
In 2005, business professors and authors W. Chan Kim and Renee Mauborgne published a book called “Blue Ocean Strategy”, in which they described the business landscape as being divided into Red Oceans and Blue Oceans. Red ocean companies were those that competed in a known market space, against established competitors, and engage in the cutthroat tit-for-tit competition that continues until one business wins and the other business dies (and the other is bloody-red from the war they are fighting against each other). In this context, using a retainer fee model to compete against AUM fees is a red ocean strategy, and one that – for all the reasons mentioned here – is unlikely to be victorious for the retainer fee model.
However, the other companies of the book are defined as “blue ocean” companies, those that enter a new and previously unknown/untapped marketplace, and one that is untainted by competition. In a blue ocean marketplace, there is potential for incredibly rapid and nearly unfettered growth, because the red-ocean tit-for-tat competitive battles simply don’t exist, because there is no competition. In fact, that’s the whole point of blue ocean companies – they don’t pursue their business models in known spaces against established competitors, but in untapped marketplaces where there is no competition. And in this context, as illustrated, there’s a tremendous opportunity for retainer fees – not to compete where AUM fees are, but to compete where AUM fees are not.
In fact, given that the overwhelming majority (as much as 80%?) of households today cannot possibly be served by AUM fees, ultimately the market potential for retainer fee models (along with the hourly fee model, although it has some business caveats too, due to high fee saliency) may be so large that, in the long run, retainer fees may become the dominant model, and AUM fees becomes a niche model for higher net worth clientele who happen to have assets to manage, in addition to needing financial planning services! In turn, the tremendous blue ocean potential of non-AUM models helps to explain the growth of non-AUM-centric turnkey financial planning platforms (TFPP) in the past decade, from the Garrett Planning Network to the Alliance of Comprehensive Planners to XY Planning Network. After all, advisors competing in that space enjoy both a huge untapped market, and almost no competition, because the rest of the industry is still pushing towards operating under the ever-more-crowded-and-undifferentiated AUM model!
Notably, in the long run retainer fee models – even or especially operating in market segments that require a higher volume of clients who generate less revenue per client – will still need to figure out how to manage some of their business challenges. Fee sensitivity will be an issue, although breaking down an annual retainer fee into a monthly retainer fee, and automating the billing process (via credit card or ACH bank transfers) may help. Scaling a retainer fee model will be challenging as well, in light of the fact that finding economies of scale in any advisory firm business model has been difficult, and it's only more challenging when staff expect annual raises (in the midst of an industry talent shortage) even as clients push back on fee increases. Although automatic escalation clauses (that automatically increase the monthly or annual retainer every year) or tying the fee to total income and net worth (e.g., 1% of income plus 0.5% of net worth) may help. A standardized process of billing with standardized pricing and automatic escalations will also help improve the long-term valuation and potential to sell a retainer-fee business in the future.
Nonetheless, even with some standardization of process and inflation-adjusting retainer fees, the profit squeeze of rising staff costs amidst slow retainer fee growth may remain a problem for “large” retainer fee firms, even as it will probably be less of an issue for small advisory firms or solo practitioners (which tend to have far less overhead and staffing costs in the first place). On the other hand, the smaller firms that are less sensitive to economies-of-scale issues may be the ones to struggle most with the need for a higher volume of clients to reach a critical mass of clients in the first place (as larger advisory firms at least have the size to scale their marketing, while smaller firms often do not). Though here again, centralized TFPP (Turnkey Financial Planning Platform) solutions that help market for their particular niche/style of advisors can help.
Notwithstanding the growing pains that the retainer fee model may still have to navigate in the future, though, the bottom line is simply this: advisors who are considering a retainer fee probably shouldn’t do it as a strategy to differentiate from (and compete against) AUM firms, given the challenges retainer fees will have competing with AUM firms for AUM-eligible clients. Firms that are feeling pressured about their AUM fees, and/or challenged by robo-advisors, need to focus on improving the value proposition of their AUM-fee firm (e.g., by focusing into a niche, deepening their financial planning services, etc.), not using a retainer fee as a differentiator (competing on price is a race to the bottom!). Instead, pursue retainer fees as an opportunity to bring financial planning to those who have a financial means to pay for advice (e.g., from cash flow) but not the available assets that so many AUM-centric firms require. In other words, the opportunity for retainer fees is not to compete in the bloody-red ocean of AUM firms, but to sail into a new blue ocean for untapped and undeserved households instead!
So what do you think? Are you considering the switch from AUM to retainer fees? Have you already made the change? How have your clients reacted to the retainer fee model? Have you been able to raise your fees over time to keep up with the rising costs of running an advisory business?
