Executive Summary
If there's one piece of investment advice that's almost universally agreed upon by financial planners, it's this one: don't bail out of stocks after a bear market. In fact, the entire foundation of wealth accumulation in the financial planning world is predicated on a healthy exposure to stocks for the long run, especially during the accumulation phase.
The planning world has attached itself to this stocks-for-the-long-run focus over the past two decades with its shift to an assets-under-management (AUM) business model, where revenues and value for the firm are tied to the markets in a similar manner to the client's wealth and (future) income.
Yet in recent years - and especially since the 2008-2009 bear market - some planning firms have been starting to shift away from the AUM model, opting instead for more stable income business models like retainers. Yet this raises the question: if clients are supposed to stick with stocks for the long run and stay the course through temporary market downturns, are planners being hypocritical by not doing the same thing with their AUM business model?
An Advisory Firm As A Stock Versus A Bond
The inspiration for today's blog post comes from several conversations I had last week at the FPA Retreat conference in Bonita Springs, Florida, with planners who shared that over the past two years, they have been shifting their practices away from an assets-under-management business model.
Their concern, as highlighted above, stemmed from the 2008-2009 bear market, which ravaged the profitability of the firm for a year as the markets fell. With even balanced portfolios dropping by upwards of 20%, the bear market took a 20% slice out of the firm's revenues (even assuming there was no client attrition during the turmoil). The stress to the owners of many planning firms was substantial, and simply put is not something they wish to repeat. So they have spent the past two years converting their business model to one that will generate a more stable income stream - e.g., via retainer fees rather than billing based on assets under management - so they will not be exposed to so market volatility.
Yet in hearing the discussion, I was struck that in essence, the firm owners were saying that they didn't want to stick with the ups and downs of stocks anymore; that instead, they'd rather their practice generate steady income with regular retainer fees rather than billing on a market-volatile asset base. In other words, after the bear market, they had decided to turn their financial planning firm into a bond (steady income payments, little fluctuation of principal), rather than a stock (short-term volatility, long-term growth).
Now I will grant that there are some who have very negative overall perspectives about the stock market these days, and if you really believe that the stock market is "broken", then I understand the decision to unhitch your financial planning practice from that wagon. But these financial planners don't think the stock market is broken. They're still directing their clients to stick with stocks for the long run, to stay the course through the market volatility of the recent years and over the past decade. In other words, it sounds a lot like they're telling their clients to stick with stocks for the long run, even while they convert their own financial advisory to one that bails out of stocks in favor of a bond-like business model.
To be fair, it's worth noting that the financial implications of market volatility for a financial planning practice under an AUM model can be somewhat more severe than for an individual client, because of the nature of business operational leverage. For a client, a 20% decline in the portfolio means a 20% decline in value. For a planning firm that might have 75% of its revenue tied up in direct and overhead costs with a 25% profit margin, a 20% decline in revenue can result in an 80% crash in profits (e.g., firm revenues $1,000,000, direct and overhead costs of $750,000, profits of $250,000; if the market and revenues decline 20% to $800,000, the firm's profits drop from $250,000 to only $50,000). So yes, we are talking about a somewhat riskier investment here. On the other hand, the planning firm can make up portfolio declines with new clients coming into the firm (comparable to clients who continue to save and make contributions to the portfolio). And the reality is that business ownership entails some risks; that's just part of the deal. Presumably, if firm owners weren't comfortable with business risk, they wouldn't have gone down the business ownership path in the first place?
So the contrast still remains. If we financial planners all truly believe in stocks for the long run, and continue to tell clients to sit tight in the markets with a long-term time horizon and stay the course, then why aren't we comfortable taking our own advice when it comes to anchoring our business model to AUM? Why can't we view stocks as being volatile in the short-run but superior growth in the long-run for our firms, the way we tell the story to our clients for their portfolios, and stick with a stock-like AUM fee model over a bond-like retainer fee? Why are many planners converting their practices from growing like a stock, to functioning like a fixed-income bond portfolio? If we tell clients that bond-heavy portfolios are too unproductive for the long term, failing to provide an effective growth rate in excess of inflation, then are many planning firms leaving the AUM model going to cause similar long-term damage to the growth of their own firms and business value?
So what do you think? Are planners being hypocrites about their own advice, bailing out of the markets while clients are encouraged to stay the course and keep invested in equities?
Michael,
Great topic post. I’ve had related conversations regarding this topic and investment/portfolio management in the greater context of financial planning over the past few weeks. I personally think portfolio management is still the highest perceived value to clients (note I distinguished perception vs. stating it IS the highest value). While I understand the desire to decouple (considering market movement is to some extent out of our control), I emphasize the items within portfolio management that we can control (and need to emphasize more). I think our clients like to know that when they are hurting, we are hurting as well.
The best balance is likely one that fixes a portion of revenue yet still relies on AUM to some extent. How we get there is another conversation entirely.
Here is a conflict question…. In our quest to provide ballast to our revenue (especially in periods of peak volatility), are we inherently recommending portfolios that are more conservative?…. Hmmm…
Mike Anderson
Mike,
Playing Devil’s Advocate here, but you say:
“The best balance is likely one that fixes a portion of revenue yet still relies on AUM to some extent. How we get there is another conversation entirely.”
I daresay most firms have clients that hold a blended portfolio of stocks and bonds, to provide diversification and to dampen down total portfolio volatility.
If being diversified into multiple asset classes is good enough for our client portfolios, why isn’t good enough for the revenues we based on our client portfolios?
– Michael
Michael,
Maybe to balance out the greater impact severity of the AUM model vs. the individual investor that you note above? I personally am fine with the AUM model, but I can see the desire to lock in some level of revenue (even more than the dampening effect of fixed income you note above)…. The possibility I was trying to explore was offering a fee that is say 20% fixed and 80% AUM based. There is the old ironic reality that most of us are working harder to keep clients engaged and happy when markets go south. This scenario might represent some agreed upon acknowledgement of that before hand.
Mike
Gutsy question, Michael.
I know of more than one “expert” who took his or her money out of stocks following the crash. These people had preached Buy-and-Hold for years. They justified taking their money out on grounds that the economic crisis was a special situation.
Of course it’s ALWAYS a special situation when people bail out of stocks. No one bails because things are going swimmingly.
I’m not saying these people were wrong to get out, by the way. When you don’t know what you’re doing, you are smart to get out. And the scary reality is that none of us (including Rob Bennett, to be sure!) know as much about how the stock market works as we pretend we do. At least those bailing are acknowledging this reality (in action if not in words).
I am looking forward to the time when we all start talking openly about this stuff. We learn from out mistakes. The learning process doesn’t begin in earnest until we acknowledge the mistakes.
Rob
Michael:
I think very few planners are switching to a retainer model. One of the reasons for switching to it would be to get the client’s mind off of chasing after investment performance and have them instead focus on executing the full range of financial planning items on the planner’s checklist.
Regarding the planner’s need to make his income smoother, by getting away from AUM fees and going to retainer fees, I think that would be a mistake for the planner to seek that. Instead he must accept that the career is inherently risky and learn to live with the risk. Perhaps planners should go to another planner who would instruct them to live debt free and live with low living expenses and low business overhead, or perhaps a planner could counsel another planner to buy out of the money Put options on equity indexes so that the profit from the Puts would offset the reduction in revenue during a crash. Perhaps an insurance company could invent a new product line of “replacement income insurance during crashes for financial companies” just like a business interruption insurance policy to serve this need!
An interesting question Michael and good to start some discussion, but I think you’ve missed a point that you’ve made in the past and that’s the consideration of human capital.
I suspect the clients receiving the ‘stocks for the long run’ advice are those with a split of perhaps $2-3 million human capital, and $400,000 invested – a scenario in which that makes sense. Meanwhile I doubt that many fully retired clients with a $2 million portfolio are being advised to hold nothing but stocks for the long run, most would receive advice that included stocks for the long run but also cash and fixed interest for next week/month/year.
I’d argue that the financial planning firm is a bit closer to the retiree than the investor with a low financial/human capital ratio. A planning firm is always going to retain some linkage to equity markets even if on a retainer model anyway, there are always more potential new clients around when equity markets are having a good run.
Michael,
You have an interesting point here about the “human capital” contribution, but I’d make the case that most practices are not like mature retired clients, but young accumulators.
Bringing new clients into the practice is very analogous to saving from income – both increase the “size” of the account/revenue with new contributions even while market fluctuations move the value up and down.
So from that perspective, one might make the case practices can afford to be somewhat aggressive, as they can “outgrow” market declines by bringing on new clients to help make up the shortfall (which, in fact, is what many practices tried to do through 2008-2009, as they did in the 2000-2002 bear market).
Of course, practices vary where they are in their lifecycle, as do clients, but most practices are still bringing on new clients, giving them the opportunity to add new $$$ to help make up for market declines and provide a buffer against downside volatility.
Respectfully,
– Michael
Excellent article. I totally agree with you and I live it also.