Executive Summary
When considering a purchase, we all evaluate the value that we will receive relative to the cost of the transaction. Yet research shows that some methods of payment make us more sensitive to the cost than others - which in turn can distort the cost-benefit analysis and change the decision, but also impacts the ability for sellers to raise prices without changing the buyer's willingness to pay.
For instance, research on toll roads shows that consumers are less sensitive to toll increases when they pay electronically than in cash; similarly, we are more willing to spend money when we pay by credit card than when the cost it made salient by paying in cash. The upshot of highly salient pricing is that it helps to ensure businesses don't raise prices unfairly and abuse their customers; the downside, however, is that it can make it more difficult for honest, fairly priced businesses to attract new clients and grow their revenues due to price sensitivity.
In the financial planning world, this helps to explain the popularity of both commission and AUM models, and the relative difficulties of hourly and retainer fee models - it's not just about how much the firm charges, but also about how the firm charges!
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?
