Executive Summary
The ongoing decline in interest rates since the financial crisis have been a boon for those looking to refinance a mortgage or businesses looking to borrow, but an immense challenge for investors that rely on fixed income returns, from insurance companies to individual accumulators and retirees. And as bond returns grind lower, it has brought a renewed focus on costs (that eat up an ever-larger percentage of a smaller return), including the question of whether financial advisors should charge less for managing a bond portfolio compared to a stock portfolio.
In this week’s #OfficeHours with @MichaelKitces, my Tuesday 1PM EST broadcast via Periscope, we look at the question of whether advisors really should be charging separate and different fees on the fixed income versus equity allocations in a portfolio, including and especially for those who also deliver extensive financial planning services as a part of their AUM fee as well.
Of course, given that the typical bond mutual fund is already less expensive than the average stock mutual fund, arguably the asset management industry has already spoken and suggested that the fees should not be the same. If only because today's low bond yields, plus the more limited volatility of bonds (at least compared to stocks), means there's just only so much opportunity to create active management value in bonds and outearn that fee in the first place.
On the other hand, the reality is that most advisors don't manage just all-bond or all-stock portfolios as a mutual fund does. Advisors typically manage blended portfolios of stocks and bonds, sometimes tactically managing amongst all those asset classes, and an increasingly large portion of the AUM fee is being allocated to financial planning services anyway... which are based on the amount of actual financial planning work to be done, and arguably remain the same regardless of how the portfolio happens to be invested.
And in fact, with the looming Department of Labor fiduciary rule taking effect in April of 2017, charging different fees for stock versus bond allocations may become a prohibited transaction anyway, at least in an IRA where the advisor has discretion over the portfolio's overall allocation in the first place. Which means that while advisors might charge less for conservative model portfolios compared to those that are more aggressive (and in theory have more active management opportunities), or begin to unbundle their planning and investment management fees altogether, but the question of whether to charge differently for bonds and stocks within the same portfolio may soon be a moot point anyway!
(Michael’s Note: The video below was recorded using Periscope, and announced via Twitter. If you want to participate in the next #OfficeHours live, please download the Periscope app on your mobile device, and follow @MichaelKitces on Twitter, so you get the announcement when the broadcast is starting, at/around 1PM EST every Tuesday! You can also submit your question in advance through our Contact page!)
#OfficeHours with @MichaelKitces Video Transcript
Welcome, everyone! Welcome to Office Hours with Michael Kitces!
For this week's topic, I want to talk about fee schedules, and the question of how you set an appropriate AUM fee in a low interest rate environment.
The question that's come into me this week - and I've been hearing this a lot lately - is from Bob. And Bob asked:
"We have some clients who, after the financial crisis, were shifted into all-bond portfolios. Basically as an alternative for them going straight to cash. And we've been managing that ever since. So as many wealth management firms, we now manage this portfolio, and give ongoing financial planning services, all for a single AUM. But..."
And here's the question from Bob:
"Given that virtually all active bond funds charge less than active stock funds, and low interest rates over all, should we have a different fee schedule for our all-bond portfolios than our traditional stock (or blended) portfolios?
Differentiating Management Fees for Bond Vs Stock Portfolios - [Time - 1:20]
So basically, Bob is asked whether he should have a different fee schedule for his fixed income portfolios. And I've been hearing this question more and more lately.
No great surprise. As interest rates get lower and lower, it creates downward pressure on advisory fees? If I go back 15 years ago where money markets yielded almost 6%, and the 10-year bond was about 7.5%, frankly a 1% AUM fee on a relative basis didn't feel like such a big deal.
Now that we're flirting with 1.5% on the 10-year Treasury, and suddenly a 1% AUM fee is two-thirds of the bond yield, it gets a little more challenging to justify the same AUM fee! The rates are so low, prospective returns on bonds are so low... suddenly that advisory fee is chewing up more and more of the total bond return!
Beyond the issue of fees crowding out returns, we also get the fundamental challenge of: how much active value can you realistically add to a bond portfolio, when you start out with the yields as low as they are? Even in a world where arguably stock valuations are high as well and forward stock returns are likely to be lower than average, at least stocks are volatile enough that there are potential opportunities to trade and add value. Now we can have a whole separate debate about how often people do successfully trade and add value, but at least there's enough volatility with stocks for alpha opportunities to be on the table. Mathematically, at least it's possible I could time this well enough to justify an AUM fee.
Lower return bonds and lower volatility bonds makes that harder. There's just, mathematically, only so much value that you can add to the table when bond volatility is limited and bond yields are limited. Even if you're going to say "the value of the advisor is to keep people from making behavior gap errors", they can only even screw up their behavior so much when bonds aren't all that volatile in the first place! Cashing out at a bond bear market bottom doesn't risk leaving 40% on the table like cashing out during a stock bear market. There's just only so much downside risk on the table to even engage in bad market timing!
Will Low Interest Rates Lead To Unbundling Investment And Planning AUM Fees? - [Time - 3:25]
Given this dynamic, where there's more limited opportunities to add value in bond portfolios than stock portfolios - if only for the sheer volatility that's on the table to manage - as Bob notes, we typically see bond funds that charge less than stock funds. Thus Bob's question of whether, if you're in advisor that's managing an all bond portfolio, should you be charging less than what you charge for your stock-based portfolios?
The complicating part of this question in Bob's backstory was that he also said:
"We bundle together financial planning fees and AUM fees into a single fee. Regardless of what the client invests in, we don't have materially different financial planning work to do. But if we're going to do the same planning work either way [and the planning work is the most labor intensive work], then maybe it is justified charging the client the same fee?"
It's certainly true that financial planning tends to be very labor intensive and difficult to scale, while the investment management process is much more scaled and systematized. And so the 1% AUM fee itself is increasingly being dominated by the financial planning work. Or viewed another way, we're watching a slow motion shift from what used to be a 1% AUM fee for primarily doing the investment management, to a 1% AUM fee that increasingly is attributable to the financial planning value add.
This is important, because the value may well there for the 1% AUM fee, but that the nature of the value is separating from the portfolio itself? Because again, the reality is financial planning work is primarily driven by the hours of labor, which is at best only loosely correlated to the size of the portfolio. Investment management, at least, is more tied to the dollars; you've got more responsibility and more risk on the table as the advisor managing the assets.
It's Not About How You Charge, But How You Convey Your Value? [Time - 5:06]
As the fees advisors charge are increasingly for financial planning instead of (just) investment management, I see firms starting to explain this a lot of different ways.
The starting point might be to recognize that if your AUM fee is partially for the investments and partially for the planning, then maybe it needs to be unbundled. Or at least, you might start framing your AUM fee as saying, "Look, about half of this for the planning, half of this is for the investments."
Now if you want to look at charging less of an investment fee for the bond portfolio, you can look at doing so, while recognizing that the investment fee is only a portion of your total fee in the first place. So you might you cut your AUM fee by 5 bps or 10 bps, as an adjustment for the investment-only portion, but the planning fee stays the same. Which means your total AUM fee doesn't come down much, but maybe it comes down a little.
However, this creates other business issues around the salience of the fee and the scalability of the businses. The challenge is while retainer fees are maybe easier to align with the work being done, they're harder to scale as an advisory firm grows, which I think is why, as I've written in the past, I think the AUM model will be more robust than we expect.
In Bob's situation, though, I think he's already starting to articulate that a significant portion of the fee is for the planning and not the investments. So that's okay, but recognize it means you may have to start stating those fees separately, and defending them accordingly, explaining more directly the value you provide for each.
Segmenting Fees for Different Asset Classes In The Same Portfolio - [Time - 6:29]
Now the most complex version of this fee differentiating conversation I find is frankly not quite situations like Bob, where advisors have all-stock portfolios and all-bond portfolios, and they're trying to figure out if they should charge the same for the all-bonds as the all-stocks.
Most of us tend to have more blended portfolios? I might have the aggressive portfolio that's 70/30 or 80/20 stock/bond, and then the super conservative portfolio that's may be 20/80 or 30/70 the other way. But we're usually not all in and all out. We usually have blended portfolios, which might be more bond-heavy or more stock-heavy depending on whether they're conservative or aggressive.
So now the separate fee discussion comes up again: "I've got a 70/30 portfolio of stocks and bonds, should I charge one fee for the 70% that's in stocks, and charge another fee for 30% that's in the bonds?" And then maybe a third separate fee for all the financial planning work that happens on the side?
DoL Fiduciary And Conflicts Of Interest When Stock And Bond Fees Differ - [Time - 7:24]
The challenge with different fees for stocks versus bonds in the same portfolio is that it introduces a whole other layer of conflicts of interest.
I'm not the first person to note this. There was a big kerfuffle in NAPFA last year, when Bert Whitehead of the NAPFA compensation committee wrote an article raising this concern: there's a really significant conflict of interest when you're managing stocks and bonds for the client, and you get paid more for the stocks than the bonds, because you've now created an incentive system where you make more money by dialing up clients' risk!
I know that we like to say that we can manage this conflict of interest, and we try to manage this conflict... but that's a pretty hefty conflict of interest to acknowledge. It's a big deal.
And it has turned out to be a big deal not just in the context of what NAPFA. It's actually becoming a bigger deal going forward, because of the Department of Labor's fiduciary rule.
When we look at fiduciary rule as it applies for RIAs, the RIA framework is basically: you have this conflict of interest, you have to clearly disclose the conflict of interest and note the difference in fee schedules between what you charge for stocks and bonds. But you can do that. If you're able to manage the conflict of interest - or you believe you can - and you disclose to clients that it's there, and they believe you can it, that's okay.
The Department of Labor has a different view. The Department of Labor's view is if you have discretion, so you literally control the clients' allocation with differential fees, which means you control your own compensation because you can dial the equity level up or down and dial your own fee up and down along with it, that's a prohibited transaction. Not a, "Oh, you've gotta disclose it, and then it's okay." It's prohibited, as in "You can't do it, under any circumstances." You can't even do it under the Best Interest Contract, where you sign a contract that agrees that you're going to act in your client's best interest. Differential compensation plus discretion is viewed as being so conflicted, it is outright barred.
So frankly, even firms that are doing this, aren't going to be able to do it much longer. You're going to have to change, because while it was at least at a disclosable conflict of interest as an RIA fiduciary, it's an untenable conflict and a prohibited transaction under the Department of Labor. At least in an IRA where the DoL fiduciary rules apply.
Different Fee Schedules For Different Model Portfolios? - [Time - 9:33]
Given the looming DoL rules, what I think you're ultimately going to see firms adopt will be one of two paths.
Option A is you adopt different advisory fee schedules for different model portfolios. So you might charge 100 basis points for the all stock portfolio, 90 basis points for the moderate growth portfolio, and 80 basis points for the ultra-conservative portfolio. So now in essence, you're changing the compensation for the bond heavy portfolios and making it lower for the bond heavy portfolios, but you're not doing it in a manner where you, in real time, have discretion over the client's portfolio to dial your compensation up and down.
In this scenario, my comp may vary between 80 and 100 bps, depending on whether the client's conservative or aggressive, but I can't directly move the client in and out of the higher-compensating stocks, which is the conflict the DOL won't allow. If I have three different models and the client chooses the model, but once they're in the model they're locked into the model until they change it, now I don't have the same kind of conflict. Because I don't control the client changing model. My compensation varies with which model they choose, but once they choose the model I don't have discretion to change it (and my compensation along with it).
Option B is that advisors simply equalize their fees across all their portfolios, as many do already, without distinguishing between the bond-management fee and the stock-management fee.
The Real Question Is How You Justify Your Value To Clients - [Time - 10:44]
At a higher level, I think the real question is what exactly you do in the portfolio to justify your value in the first place.
If the reality is that you're purely passive, and your fee is a combination of a "behavior gap" fee and a financial planning fee, perhaps you don't need different fee schedules at all. You can make the case to the client: "I do all this financial planning work, and I provide some basic layer of portfolio asset allocation. My fee is 80% planning and 20% investments. So when I'm charging 1%, that means 80 bps is planning, 20 bps is investment management. And the investment management portion is already so low, that there's not a lot of room to make it lower for the bond portion. Besides, I'm not charging you more for the stocks, because I'm not managing them any more actively than the bonds anyway!"
So if you're passive, perhaps that's the way you're already allocating your fee internally already, if not externally. And so there's not really a fee pressure on the bond portion of the portfolio, because the investment portion of your AUM fee is low already.
If you're more active, and part of the value that you're justifying is your active management value, then there is a little more pressure here? Because you're going to have to justify why the investment fee for the bonds is the same as the investment fee for the stocks, in a world where realistically I just don't know if you can add the same amount of value for low yield, less volatile bonds that you can for higher volatility, higher return potential stocks. That fee pressure is real, and it's going to continue, and you're going to have to explain the value you provide for the fee.
Now for some firms, they're not active or passive within the stock and bond asset classes, they're more tactical amongst them. They have the opportunity to shift and move from bonds to stocks, and back again. In that case, I actually see a lot of firms charge the same AUM fee across the board, because they make the case to the client: "You're not paying me to manage the bonds as bonds and stocks as stocks, you're paying me to manage the bonds and the stocks and whether we should be more in the stocks or more in the bonds." And making those tactical shifts one way or the other is the primary justification for their fee and their primary value add.
Obviously we still have to look in the long run to see whether the firm is delivering that tactical value. But in a world where we've always said the bulk of returns are dictated by asset allocation in the first place, there's a value opportunity in adjusting the asset allocation between stocks and bonds (and maybe alternatives). And the AUM fee is for knowing where to deploy assets across those asset classes, which makes the level fee across all the portfolio asset classes more relevant. Because it's a holistic fee for a holistic tactical process. Again, you still have to justify the value for whatever fee you're charging, but at least gives a reason as to why you wouldn't have different fees for the stock portion and the bond portion of the portfolio.
What Is Your AUM Fee Really Paying For? - [Time - 13:15]
But getting back to Bob's original question... Bob, I think you've got a few issues and options here.
The starting point is just to clarify what your fee is really for in the first place. Is it mostly a planning fee? Is it mostly an investment fee? If it's mostly a planning fee, I think you're making your case as to why your fee stays the same. Now maybe there's some pressure to unbundle your fees or separate out a lower AUM fee and a standalone planning fee. But certainly you're justifying that consistent fee across all the portfolios when it's mostly for planning work that doesn't necessarily change by the portfolio allocation in the first place.
If a heavy portion of your AUM fee actually is supposed to be for the active management value you provide in the portfolio, then I do think you've got some pressure on you to justify what active value opportunities you're creating in a bond portfolio that's the same as a stock portfolio to justify the AUM fee being charged on both sides.
And then either way, for anyone out there, watch out for different fee schedules on stocks and bonds within a single portfolio where you have discretion, because come April 10, 2017, the Department of Labor fiduciary rule kicks in, and that's going to become a big no-no. Now technically that's only for IRAs, so you could have differential fees for brokerage accounts, but be careful. And either way, remember that different fee schedules for different models is okay, it's just different fee schedules for assets within one portfolio where you have discretion... that's going to be a problem.
So I hope that helps a little as food for thought around the advisory fee landscape, and charging different fees for different asset classes, and how the DoL fiduciary rule is going to impact it.
This is Office Hours with Michael Kitces, 1 p.m. East Coast time on Tuesdays. Thanks for hanging out with us, and have a great day!
So what do you think? Do you have different AUM fees for bond portfolios versus stock portfolios? Do you charge different AUM fees within a single portfolio for the stock versus bond portion of the account? How do you explain your advisory fees to clients when it includes financial planning services as well? Please share your thoughts in the comments below!
