One of the common questions when it comes to financial advice is regarding the pricing models. This article will briefly highlight some of the common methods of pricing, their strengths and weaknesses, and why AdventEdge Financial has chosen a fee-only pricing model.
Commissions
One of the most common pricing models is that of commissions. The advisor sells the client a product, and in return for securing the sale, he receives a portion of the revenue of the sale. Most insurance policies and some mutual funds are still sold this way.
The major benefit in this pricing model is that the client does not need to pay the advisor separately out-of-pocket. Frequently, the client needs the product anyway and in the course of the sale, he also received the added benefit of professional advice that he otherwise may not have been able to obtain.
Having said that, a significant downside of commissions is the inherent conflict of interest for the advisor. Because his income is dependent on making sales, his interests may not always be aligned with the client’s. For instance, if a particular lower-commission product is better for the client, recommending that product would hurt the advisor’s bottom-line. The question will always linger whether an advisor truly has the client’s best interest in mind, when their income is derived from the products that they sell.
Assets Under Management
Another common pricing model in the financial industry is that of a percentage fee on assets under management (AUM). The way this pricing model works is that a specific percentage of assets is skimmed off of a portfolio under management by an advisor in set intervals. So if a client has $100,000 of assets under management, and the fee is 1% AUM, that means that $1,000 is deducted from that account annually to pay the advisor. This is the most common pricing model for investment managers, robo-advisors, and mutual funds; and 1% AUM is roughly the industry standard rate.
The benefit of this arrangement is also that clients do not need to pay a separate out-of-pocket bill to the advisor out of their cash flow, and the investments’ growth should theoretically pay for the advisor’s fee. Another benefit is that incentives are better aligned between client and advisor in this arrangement, because presumably both parties wish to see the investment portfolio grow.
Nevertheless, there is at least one downside to consider. Namely, there may be times still when the client and advisor’s interests collide. For instance, in the circumstances when a client is better served by drawing down their investments to pay off debts or to give some assets away (usually for charitable and/or estate planning considerations), the advisor faces a conflict of interest because recommending that path would reduce the assets under management from which he derives his income.
Fee-Only
The final pricing model we’ll discuss today is the fee-only model. This simply means that the client pays the advisor directly for services rendered. This can be in the form of an hourly fee, a flat fee for a project, a monthly fee/subscription/retainer, or a fee calculated through some formula. (One common one is “0.5% of Net Worth + 1% of Income.”) In all cases, there is a simple and direct transaction solely between the client and advisor, without an intermediate product.
The primary goal of this billing option is to eliminate as many conflicts of interests for the advisor as possible, and to align the interests of client and advisor as closely as possible. The advisor works for the client, and only the client, and thus should help prevent ethical lapses and ensure the highest quality advice is rendered.
However, the biggest downside of this type of arrangement is that it requires the client to pay for advice separate from his other financial products and services. This can create cash flow constraints, and may even make financial planning out of reach for some.
Blended Models
There are also blended models as well where advisors meld several of these billing methods together. For example, some mutual funds charge a commission as well as an ongoing AUM fee. Other advisors may charge a flat fee for financial planning, but if the client holds a certain amount of assets with that advisor, the AUM fee can offset some or all of the flat fee.
What We Do at AEF and Why
At AdventEdge Financial, we deliberated a long time over the best pricing model to use for our clients. In the end, we believe it most important to maintain an alignment of our interests with our clients, so we have chosen a fee-only model for our financial planning services, and investment management at an additional, low AUM rate. We chose to keep the financial planning fee and investment management AUM fee separate to minimize the incentive to recommend ever-increasing investment balances at the expense of other priorities that may be more beneficial to our clients. Our priority is to provide the highest quality advice and to retain the trust of our clients for the long-term, and we believe this arrangement best allows us to do accomplish that.
We will be continuously monitoring this and listening to our client feedback, and will certainly adjust as needed to best serve our clients.