Billing on Outside Held-Away Assets Under Advisement: Issues To Consider

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#OfficeHours with @MichaelKitces Video Transcript

Welcome, everyone. Welcome to Office Hours with Michael Kitces.

So for today's Office Hours, I want to talk about a growing trend I've been seeing amongst the RIA and hybrid RIA community over the past year or a few, which is a rising shift from billing on assets under management to billing on assets under advisement instead.

So the classic example of this would be maybe a prospective client who's 52 years old, has $150,000 brokerage account, $350,000 in a 401(k) plan, and wants to work with an advisor over the next 10 years with the intention of retiring at age 62 when he becomes eligible for Social Security. So total household assets are half a million dollars, which is sufficient to meet the minimums of most of our advisory firms, but the client's available assets to manage is "just" the current $150,000 brokerage account, given the intended retirement plan, the rest isn't going to be available for a decade or more, which is a long time to wait to work with a client.

Three Ways to Work With Clients Who Have Substantial Held-Away Assets [1:12]

So most advisory firms I know when they're faced with this situation and otherwise still really want to work with the prospective client approach the situation in one of three ways. So the first is just to take the client anyways and say, "We'll manage only the existing $150,000 brokerage account now, even if that's not necessarily profitable for us, in the hopes that we'll get the 401(k) rollover down the road, and that'll be bigger, which by then should be even larger because, with ongoing market growth and contributions, it will grow over the next 10 years."

But the reality is that, from a business perspective, an account that's going to turn or a client that's going to turn profitable 10 years out is really too far away to be a good business decision just on the hopes it will be a sizeable rollover down the road. Now, if your typical client really is $150,000 client and you can serve them profitably at that price point, great, but if you need a higher price point, a higher average revenue per client to be profitable, 10 years is too long to wait in the hopes that eventually this client is going to be profitable.

So the second way that some advisors handle the situation is to set not a minimum assets under management threshold, which this client can't reach because the 401(k) just isn't accessible and assuming he doesn't allow in-service rollovers, but rather a minimum fee per client instead. So if your normal minimum is $250,000 account, you charge a 1.2% fee on the first $250 grand, you've essentially determined that your minimum fee per client is $3,000 to be profitable, so rather than having a $250,000 minimum, just charge a $3,000 minimum fee instead and give the client the holistic advice beyond the portfolio. And if your advice is really worthwhile to the client, the client will likely pay their holistic advice fee with the minimum of $3,000, especially since relative to the client's overall net worth, which is more than half a million dollars of investment assets, $3,000 is a very reasonable holistic planning fee as a minimum fee.

The third option, though, and the one I want to talk about more today is the approach where the advisor says, "I'm going to provide you holistic financial advice in all your investment assets, including your outside 401(k) plan, and our fee starts at 1.2% for accounts under management and 0.6%, or half that fee, for outside accounts under advisement. And we'll give you ongoing advice and guidance on your 401(k) allocation, how it should be invested, whether or how much to rebalance every year. We'll do due diligence every year on the investment lineup to evaluate performance, make sure that you've still got the right investment options, you don't need to make changes." And now, even though the client's assets are held away, you're still advising on them and providing a service, and you have a reason – an appropriate value proposition – to bill something on those assets under advisement so that you can generate sufficient revenue to provide the client your overall services.

Differential Fee Schedules for Assets Under Management (AUM) Vs Assets Under Advisement (AUA) [3:44]

Now, a key aspect of this approach is the idea that the advisory firm has one fee for assets under management and then a second, typically lower fee, for assets under advisement. And the typical justification for this is simply that in an AUM-managed relationship, the firm is literally managing the money, with discretion, using the full range of investable options and the available investment universe that you can get on a modern advisor platform, whereas in the assets under advisement arrangement, in the 401(k) plan, you're generally not able to manage on an ongoing basis because there's no direct trading link to the 401(k) plan to manage it in most cases, and you're constricted to only using the list of investment options in the 401(k) plan.

And so while the AUM arrangement may have a lot of actual ongoing management and seeking out new investment opportunities, the AUA arrangement is typically just sending an annually updated allocation for the 401(k) plan and reviewing the list of available investment options. But again, there's not necessarily a lot you can do with limited access to the account and a limited range of investment options anyway... thus the lower fee.

Unfortunately, while we have good data on the average AUM fee that advisors charge, there isn't really good data on what that lower AUA fee should be. I find at least anecdotally that the emerging rule of thumb seems to be charging half your normal advisory fee as an add-on for outside accounts under advisement that can't be managed directly but you're providing some advice on.

Now, it's worth noting that I see some firms merging more than just half their AUM fee as an AUA fee and a few that go so far as to get client passwords to log on to 401(k) plans and manage them more directly with ongoing rebalancing and actually charging the full AUM fee on both directly managed accounts and 401(k) plans under advisement because it's really quasi-management through the client logins.

Now, it's crucial to note, if you pursue this kind of approach, you do have some additional cost layers as a business. First and foremost, just manually rebalancing client 401(k) accounts one login at a time can be a slow and manual process if you have a lot of clients. So you might get paid more by charging your full AUM fee and several lower AUA fee, but you may not necessarily be more profitable if you have to do this for a lot of clients.

Second, just be cognizant that having outside access to client accounts, including the login name and password for a client's 401(k), plan will likely subject you to annual custody audits as an RIA. Because that level of access in most online 401(k) plans would also give you the potential to change the client's account information, including their address of record, and in theory, you could request a liquidating distribution of the account to a new fake address and steal their money. I realize most of us are not here to do that, but the mere fact that you have that level of access and control, and could [liquidate their account], means you have custody of client accounts and need to be subjected to the SEC custody rules, which includes an annual surprise custody audit that you have to pay a CPA firm to conduct. So if you want to go down this road, be certain the costs are worthwhile for the business opportunity with your client base.

The Problem with AUM Vs AUA and Later Consolidating Accounts [6:52]

The more substantive concern, though, that you should be aware of is if you're considering the AUA approach, it's not just about the custody rule, but how are you clearly going to convey the value of what you do and don't provide in your AUM versus AUA relationship? Or what you'll find in the future is that clients don't want to roll over the 401(k) plan and have you actually manage it when the time comes.

From the advisor's perspective, there's a big difference in AUM and AUA. From the regulator perspective, you actually can't call assets managed and claim them as regulatory AUM on your ADV if you're not truly managing them. So the difference between AUM and AUA is not just billing and fee schedules, but literally what the firm claims as assets under management in the first place. And of course, you have all these different operational implementation differences because you can typically manage directly managed accounts with rebalancing software efficiently through RIA custodial platforms. But outside 401(k) plans require a more manual approach to analyze and review and rebalance.

But from the client's perspective, "Eh, my advisor helps me manage my investment accounts there and they help me manage my 401(k) plan here." Clients don't always recognize this as a big distinction in services, but they do recognize the big fee difference between full AUM fee and lower AUA fee. And as a result, I know a number of advisors who have adopted the charging on held-away assets as AUA approach, and then find the client retires and it's time for the rollover, and the client says, "Eh, why don't we just keep managing it the way that you are for the lower fee? I don't need to move it all over and get charged double. I was able to retire the way it's being managed now on the 401(k) plan so it can't be all that bad, why don't you just keep doing what you're doing there?" Which means the advisory firm has to be really clear up front about the difference in the services that you're providing by charging and managing AUM where you manage it, versus charging and advising on held-away assets under advisement where you're just advising.

Now, I don't think this is an insurmountable challenge. For firms that have their own established investment management process, the reason you can justify having the client roll over to your managed account is so you can actually manage it with your investment style. You know, perhaps on that held-away 401(k), you simply adopt a more passive strategic approach where you annually rebalance, evaluate the investment options, charge a lower fee on that. In your managed accounts, you have a dedicated investment team that implements a tactical managed volatility approach to reduce sequence of return risk in retirement. And so when the client retires, they'd want to roll over assets to have your specialized retirement-centric investment management process to manage sequence risk. Because you offer a different process for the managed account versus the account under advisement that you really probably couldn't manage that way anyways due to all the limitations in the 401(k) plan.

For advisors that have a more passive approach, though, I'd warn you to be cautious here. If you're not going to manage a managed account that you hold directly any differently than you'd allocate a held-away account under advisement, what is your value proposition when the client says, "Why would I roll over the assets? See you later!" This isn't meant to be a passive versus active debate, but it is important to point out that if you're not selling an investment management process as at least part of your AUM value proposition, it's going to be hard to convince clients to switch from a lower AUA fee to a higher AUM fee later. You might just consider a single unified fee instead, one fee for one standard investment approach without any distinction between AUM and AUA, especially if you're going to help clients actually implement it by logging into their accounts to rebalance and do the investment selection.

The other challenge to be cognizant of if you're considering adding a fee for held-away assets under advisement while you also have assets under management is, how exactly you're going to bill that AUA fee? Because there are real challenges – just sheer operational challenges – in both calculating the fee properly and then actually billing it.

Calculating the fee could be difficult because. if you charge an AUA fee that's percentage of the balance, you need to know the balance. Which means either clients giving you a statement, which is not very exciting for them when they know they're about to get billed on that statement, or you can pull values directly by logging into client's account, but again, that has both the custody issue and it's just potentially a very time-consuming manual process if you actually do this for a lot of your clients. I think the best approach if you're going to go this route is to use account aggregation tools to pull the held-away asset account balance into your performance reporting platform that you used for billing, solutions like Orion, and then calculate the fee there, which you can do in mass on a more automated billing-based system.

Billing Challenges with Combining AUM And AUA [11:23]

The second challenge, though, is how you're actually going to bill the fee. Because you can't bill an outside 401(k) plan directly without triggering a taxable distribution and the potential early withdrawal penalty on top. Because paying your bills from your 401(k) plan is a distribution!

Now, some advisors will bill the accounts they do manage for the assets they're advising outside of their scope. Which you can do. That's certainly legal and legitimate and possible, but it is problematic as well for a couple of reasons. One, if the held-away assets under advisement are a lot larger than the current assets under management, your total fee billed from just the managed account is going to look really large, right? If you bill all the assets from one account you manage, you might find that the fee out of your portion could be 2% or 3% or more of the total account just coming from the one. Which is concerning both psychologically, you know, it may be a fair fee overall but most clients don't like seeing one giant fee come from a single account and watch the account balance go down. And it's even more problematic because a lot of RIA custodians will actually red-flag your fee and at least question it if they see these fees coming out that are 3%-plus of the account balance.

And for those of you that actually have an active management process, billing the fee for all your accounts, management and advisement, from only the managed account is going to show up in your performance numbers and make your performance net of fees look even worse because the account you're managing is paying not just its own management fees but all the other fees, which most performance reporting software doesn't discriminate between those. It just nets fees out of performance.

Even worse, if you're managing an IRA, you actually can't bill the held-away assets under advisement fee directly from the IRA – that's a prohibited transaction for the IRA. It is permissible for IRAs to pay their own management fees, but not outside fees. Which means if you aren't managing any other client account, now you need to actually have the client write a check or use some third-party billing solution like our AdvicePay platform to handle the AUA billing and fee collection. Which you can do, and we see a number of our AdvicePay users doing this, but it is a more complex billing process than just the standard AUM model. And I think a lot of firms don't fully appreciate how streamlined AUM billing actually is. I'm sure you try to blend it with outside account AUA billing as well.

At a minimum, though, just be aware that you have to have some clear plan about how you're going to handle billing, especially if a large portion of client assets are expected to be outside AUA and not AUM, so it may not regularly be practical or feasible to bill the entire advisory fee from just the small portion of assets you're actually managing.

The bottom line to all of this, though, is just to understand there is an opportunity I think here for expanding the advisory relationship with clients beyond just managing the particular investment accounts that they have directly under your purview and billing on those accounts, and then trying to set appropriate minimums to ensure you generate the revenue per client that you need to justify the work that you're doing in the holistic relationship. But if you want to add this AUA offering and bill on it, you have to have a clear plan for what value you're going to provide beyond what you already do in a managed account, how you're going to explain it, how you're going to justify the fee or the differential in the fees so you don't undermine the perceived value of your full AUM fee on a fully managed account later.

Don't just make it an assets and fee grab, you know, "Hey, we decided to start billing on the money that you don't have with us, how does that sound?" Not good from the client's perspective if you haven't really figured out what the value proposition is that you're providing on that held-away account. It'll just make clients not want to tell you about their outside accounts so you don't try to bill on them, which then undermines the entire advisor relationship when you don't know about all the assets contributing towards their retirement picture.

In addition, you need to have an operational plan. How are you going to calculate fees? Do you need an account aggregation solution? How are you actually going to bill the fees? Especially if you may have clients with large outside accounts and you just can't bill directly from the IRAs that you're managing. And watch out for the regulatory pitfalls. Whatever you do, do not claim assets under advisement in held-away accounts as regulatory AUM if you're not really managing accounts. This is a big focus area for the SEC right now that they've been cracking down on. And if you're getting login credentials to try to manage them, be aware of that custody rule. And of course, bear in mind that just getting paid on assets under advisement is by definition getting paid for investment advice, which means you either have to be an RIA or have an hybrid RIA relationship to do this. It can't be done under a pure broker-dealer structure.

Nonetheless, in an environment where more and more firms that are running the AUM model are trying to work with younger clientele who are more likely to have a lot of assets tied up in a 401(k) plan that's just not available and managed in the traditional approach, we certainly see firms doing retainer fee models, monthly retainers, annual retainers, and net worth and income retainers, but there is a growing movement that is taking this approach of billing on AUA, assets under advisement, as an alternative as well.

So if you're considering this for your own firm, perhaps instead of just doing a minimum fee or retainer fees, hopefully, this is helpful food for thought on just how the AUA approach might work and some of the pitfalls and challenges to be cognizant of.

This is Office Hours with Michael Kitces. We're normally 1 p.m. East Coast time on Tuesdays. Obviously, we're a little bit late today, but thanks for joining us, everyone, and have a great day.

So what do you think? Does Asset Under Advisement fee structure make sense for your practice and clients? If so, how will you navigate the operational and regulatory challenges while ensuring that your clients understand the value in the services you are providing? Please share your thoughts in the comments below!

Disclosure: Michael Kitces is a co-founder of AdvicePay, which was mentioned in this article.