Economics

Why AUM-Based Fees Don’t Meet Fiduciary Standards

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Clients lie to their assets under management (AUM)-based advisors. Those advisors know they are lying, and are dis-incented from acting as fiduciaries.

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See 2017 Hedge Fund Letters.

Asset-Based Fee Model
Image source: The Blue Diamond Gallery

This conflict became a central issue in June 2017 when the Department of Labor ruled that charging clients based on AUM did not meet fiduciary standards if different rates were charged on different asset classes. Fee-only advisors were stunned.

But it is difficult to imagine charging otherwise. For example, although an advisor may be charging 1.5% of AUM, which is reasonable for stocks, no clients in their right mind would pay 1.5% on cash and bonds that are earning less than 0.3%.

The Investment Act of 1940 specifically permits advisors to charge fees as a percent of assets. This act was intended for managers of mutual funds. It was not intended for advisors serving the general public, because of the conflicts of interests that arise when providing personal financial planning services. One such conflict is the need to charge variably based on asset classes.

A few years ago I encountered this conflict dramatically when a new client, who had been working for a Raymond James stockbroker, who called himself a fee-only fiduciary, hired us. My client had about $2 million under management. In transferring the assets I noted that 97% were in stocks. Since the client was 67 years old and planning to retire in two years, this was too heavily weighted in equities. As I knew the broker involved personally, I talked to him and asked how he came up with the asset allocation of 97% stock, 3% cash, and the broker replied, “Well, how do I know how his other money is invested?”

The broker was clearly incented to allocate heavily to equities, because that would maximize his income.

Along the way I have talked to many members of the National Association of Personal Financial Advisers (NAPFA) who use Schwab for custody, as well as to several Schwab regional investment managers, who all confirmed that firms charging AUM-based fees have always used different rates for stocks and bonds.

The Securities Exchange Act of 1934 and the Investment Act of 1940 are designed to assure that financial advice rendered by professional advisors is unbiased. AUM-based advisors respond to charges that they have practices that create a conflict of interest by saying that all compensation methods involve some conflict of interest. But it is hard to imagine a system that is as egregious as the AUM-based model, since most of those advisors charge from 1% to 1.5% of AUM for stocks, but they have a reduced rate of .25% or less for cash and bonds they are managing.

The natural proclivity of the advisors with this arrangement is of course to invest most of their clients’ money in the stock market, since the advisor’s compensation is 10- to 15-times greater for stocks than on cash and bonds. Accordingly, the Raymond James broker was doing what he was incented to do from the standpoint of his compensation.

I talked to the new client and asked him if he knew how much he was paying the Raymond James broker and he said, “1%,” which was correct. I pressed him for how much he thought he was paying in dollars. He said $2,000 a year. The truth is that nonfinancial consumers cannot multiply fractions quickly; he was aghast when I pointed out that 1% of $2 million actually amounted to $20,000 a year.

AUM-based advisors typically explain and justify their rates by emphasizing that they don’t earn commissions and say, “I only make money if you make money!” The result of this is, of course, that clients never disclose all of their assets to their AUM-based advisors to avoid being charged for managing cash or bonds. This was confirmed to me when a NAPFA vendor who had heard about the Cambridge Index1 asked us if she could invest $100,000 in this product (which charges 22.5 basis points), but emphasized that I could not let her NAPFA advisor know about this because he would want to charge his 1.5% ($1,500) per year, based on AUM.

Rad the full article here by Bert Whitehead, Advisor Perspectives