Executive Summary
With the ongoing rise of technology commoditizing pure investment management, a growing chorus of critics are raising the question of whether the AUM model is “toast”, or at the least that financial planning fees may soon need to be unbundled from AUM fees.
Yet a look at the most recent Investment News and FA Insight benchmarking studies reveals the exact opposite trend: the most profitable and highest growth firms continue to be those that embrace the AUM fee, and are not adopting financial planning fees en masse. And in fact, the larger the advisory firm, the more likely the top performers are to focus solely on the AUM model!
In fact, the benchmarking data reveals that the only firms successfully implementing standalone financial planning fees are the smallest “solo” advisor firms who tend to serve the least affluent clientele – for whom planning fees may be effective simply because their clients don’t have the assets to fit an AUM model in the first place (and also because they don't have the overhead demands of large firms).
More broadly, what this data suggests is that to the extent there is any rise in the use of standalone planning fees by advisory firms, it is primarily being done by firms serving clients who can’t even be reached as effectively by the AUM model anyway (i.e., they don’t have a large amount of assets available to be managed), rather than competing head-to-head with the largest AUM firms that continue to be more profitable and capable of reinvesting more to outgrow their non-AUM competitors!
The Rise (And Fall?) Of The Advisor AUM Fee Model
The Assets Under Management (AUM) model has experienced explosive growth amongst financial advisors in the past 15 years. In the early 2000s, the Moss Adams advisory industry benchmarking survey pegged the average independent advisory firm with just $25M of AUM, but by 2008 the typical firm was over $100M of AUM, and that amount grew to nearly $200M of AUM in the most recent 2015 industry benchmarking survey. Another even more recent study found that in the aggregate, advisors now derive more total revenue from fees than commissions, an astonishing shift in just a decade or two, given the industry’s deep commission-based roots.
Yet in parallel to this trend, recent years have witnessed the rise of the robo-advisor, and more generally technology’s ongoing commoditization of pure investment management services. Advisors are being driven to differentiate themselves by providing financial planning and wealth management advice beyond just portfolio management alone, and the growth of advisory firms away from investment management services is raising the question of whether it’s also time to migrate away from investment management business models – i.e., the AUM revenue model. In fact, industry commentator Bob Veres has already suggested that “the AUM fee is toast” and it’s only a matter of time before advisors transition en masse to financial planning project and retainer fees as an alternative.
Nonetheless, the caveat of all this concern and criticism is that the AUM model appears to be remarkably robust. The behavioral finance research suggests that because clients don’t like writing checks and prefer less “salient” payment mechanisms, alternatives to the AUM model – like hourly or project fees – may have difficulty gaining traction. And although it has become more popular amongst independent advisors in recent years, the roots of the AUM model date back literally hundreds of years in the world of asset management services (back then, primarily for trusts and wealthy merchants at sea).
In fact, arguably the biggest change to the AUM model in recent decades has simply been that a compensation model historically only available for the ultra-high net worth client and institutional firm has been “democratized” to an ever-larger share of “merely affluent” clientele. A trend that’s only accelerating with the entrance of mega-financial services firms like Vanguard Personal Advisor Services and the retail segments of Schwab and Fidelity.
Of course, if a change is going to occur, it has to start somewhere. One of the best opportunities to identify new trends in advisor business models is to look at the aforementioned industry benchmarking surveys, and see what they show in terms of the “best practices” of advisory firms and their business models. So what does the data show regarding the AUM fee and the prospective rise of non-AUM alternatives like hourly, project, or retainer fee models?
Adoption Of Non-AUM Planning Fees – Top Financial Advisory Firms Vs The Rest
In today’s environment, the two leading financial advisor benchmarking studies are those produced by Investment News (in collaboration with Philip Palaveev’s Ensemble Practice), and from FA Insight. In both studies, the researchers examine the metrics of a broad swath of advisory firms, and compare them to the subset of firms that have the best profitability and growth, which are dubbed the “top performers” group.
So what do we see when we look at how top performing advisory firms are using AUM vs non-AUM fees, compared to the average advisory firm?
Investment News 2015 Financial Advisor Compensation And Staffing Study
The latest Investment News Financial Advisor Compensation and Staffing Study came out in 2015 (based on 2014 business data).
The advisory firms in the study were segmented into four groups:
1) Solo advisory firms – which have one owner, but may include several staff members and vary from $100k to over $1M of gross revenue
2) Ensemble firms – which have multiple owners (and staff) working to build a common business, sized up to $5M of revenue
3) Enterprise Ensemble firms – multi-owner ensemble firms that have grown to more than $5M of revenue (generally $500M+ of AUM)
4) Super Ensemble firms – the largest multi-owner ensemble firms with over $10M of revenue (generally $1B+ of AUM)
As noted earlier, the researchers then analyzed the business strategies of top advisory firms by segmenting out those with the highest profit margins and growth rates. And as shown below, there was in fact a substantial difference in the profitability metrics of the top advisory firms versus the rest!
So when it comes to the revenue models of the “top” advisory firms versus the rest, what does the Investment News study show?
Broadly speaking, revenue amongst advisory firms can be broken into three categories: AUM fees, planning fees (which may include hourly, project, or retainer fees), and “other” revenue sources (which includes commissions paid on new business, commission trails on old business, and other forms of solicitation or third-party revenue-sharing fees).
As the chart above shows, there are some clear trends in how the “top” most profitable and fastest-growing advisory firms structure their revenue, versus the rest. Top performing firms are more likely to rely on AUM fees over adopting planning fees. For the “Ensemble” firms in the middle, efficient staffing and infrastructure appears to drive profitability more than fee structure, but as firms grow larger, they become more and more likely to focus purely on AUM fees, to the exclusion of planning fees (and the elimination of commissions)! In fact, the most successful of the largest advisory firms do so little in planning fees, that it rounds down to 0%!
FA Insight 2015 “People And Pay” Study
Similar to the Investment News study, the FA Insight “People And Pay” study was also conducted in 2015, based on data from the trailing 2014 fiscal year.
Also similar to the Investment News study, the FA Insight research segments advisory firms into multiple groups by size. However, FA Insight defines its group categories slightly differently, as follows:
1) Operators – which have one owner, may or may not have employees, and generate $100k to $500k of revenue
2) Cultivators – larger one-owner “solo” firms, typically with multiple supporting staff members, and generating between $500k and $1.5M of revenue
3) Accelerators – multi-owner ensemble firms with a large and growing staff, generating between $1.5M and $4M of revenue (akin to “Ensemble” firms in the Investment News study)
4) Innovators – the largest multi-owner ensemble firms, with $4M+ of revenue (a combination of the “Enterprise Ensemble” and “Super Ensemble” firms from Investment News)
As with the Investment News study, FA Insight then examines the differences between the “standout” top performers (by profits and growth) versus the rest. (Notably, “profitability” is analyzed slightly differently; Investment News focuses on profit margins of the entity, while FA Insight “standout” profitability is based on the total “take-home pay” per owner – a combination of both profit margins and the owner’s salary compensation in the business. Nonetheless, both studies are similar in identifying top/standout firms based on the amount of net income they generate.)
So when it comes to the FA Insight firms, how do the revenue models of the standout firms compare to the rest, in terms of the breakdown between AUM, planning, and “other” (commission-based) revenue sources?
From a size perspective, the results of the FA Insight affirm the data from Investment News: for the largest advisory firms (FA Insight “Innovators” include both Enterprise and Super Ensembles in the Investment News data), the most profitable advisory firms are the ones that focus the most on AUM fees. For the largest of the standout firms, they are significantly more likely to use AUM fees and less likely to charge planning fees! (And similar to the Ensembles in the Investment News study, the Accelerators in FA Insight have similar revenue models between standouts and the rest, as their profitability is driven by staffing and infrastructure decisions.)
However, because FA Insight delves deeper into solo advisory firms (Investment News groups them all together, while FA Insight segments “smaller” Operators versus “larger” solo firms as Cultivators), a notable counter-trend occurs amongst the smallest advisory firms: for solo Operators, the top standout firms are substantially more likely to focus less on AUM and charge significant planning fees (still a smaller component of total revenue than AUM fees, but drastically larger than other Operator firms, or firms of any size in other categories).
The Business Problem With Non-AUM Fees For Large Advisory Firms
So what should advisors make of this trend that the most profitable advisory firms actually eschew planning fees (and commissions) to focus almost solely on AUM fees (and focus more and more on AUM fees as they grow to a larger size)?
To some extent, the trend shouldn’t actually be surprising. While some advisors have lauded the stability of planning fees – especially recurring revenue retainer fees – as a virtuous opportunity to defend against a potential bear market, the reality is that because markets go up far more often than they go down, eschewing AUM fees is more likely to forfeit fee increases than to buffer against fee declines.
In fact, to a large extent the superior profitability of AUM-centric fees is simply a reflection of the current 7-year bull market we’re currently in. That’s the whole point. When markets go through a significant bull cycle, the profit margins of AUM firms expand as portfolios (and the associated AUM fees) rise, allowing the firm to both build a buffer against the inevitable future bear market. Thus even though AUM fees do take a hit in a bear market, the firm still ends out significantly larger and more profitable in the long run.
In addition, because markets growth at a real rate above inflation on average, tying the revenue of the firm to AUM fees ensures the firm will have the long-term growth in revenue-per-client to give steady compensation increases to the staff serving those clients. In other words, to the extent that a retainer-fee firm has trouble raising their retainer fees every year (as the saliency of retainer fees tends make them “sticky” with clients and more resistant to increases) while staff expect annual raises, the profit margins of the advisory firm get squeezed over time. AUM-based firms don’t have this problem as the rising tide of markets lifts revenue as well, allowing more room for staff raises.
In this context, it is also easier to see why solo Operator firms become the “exception to the rule” for the success of charging standalone planning fees: because they’re the firms with the fewest staff members in the first place. In other words, to the extent that “flat” planning fees creates a long-term squeeze on profit margins due to staff raises, the smallest firms with the fewest staff face the least potential squeeze and the most success using planning fees.
Notably, though, even in the FA Insight data, the planning-fee-heavy solo Operator firms are actually still smaller on average (with 22% less in total revenue) than the AUM-fee solo Operator firms. They become “standout” firms with superior profitability because they also tend to serve 22% fewer clients, and therefore rely on fewer staff to service their clients, allowing their solo owners to take home a larger share of the firm’s smaller revenue base as profits. (To some extent, the same is true of Cultivators as well, where standouts are slightly more likely to charge planning fees and average 12% less in revenue, but are more profitable because they serve 5% fewer clients and manage to operate with slightly less staff overhead expenses.)
AUM Fees For Wealthy Clients, Planning Fees For Smaller Ones?
Another notable distinction in the industry benchmarking trends is that not only do firms differ in their use of AUM vs planning fees by size – with the largest and most profitable firms the least likely to adopt planning fees – but they also differ in who they serve… given the well-documented trend that the largest advisory firms also tend to have the wealthiest clients in the first place.
In other words, when we’re talking about the tendencies of “large firms vs small firms”, we’re also talking about how advisory firms tend to serve “wealthy vs smaller clients” too. And in this context, a different trend begins to emerge: advisory firms are tending to use AUM fees for their wealthier clients, and planning/retainer fees for their smaller clients.
To a large extent, this trend makes perfect sense. AUM fees work well for wealthier clients who have assets, and who are already accustomed to paying AUM fees. And the profitability of the larger firms serving the larger clients gives them the capital to reinvest into further marketing and growth and bring in the highest volume of new clients.
Conversely, AUM fees are less effective for smaller clients, in many cases because the smaller clients don’t even have assets to be managed via an AUM fee in the first place. Classically, such clients have been deemed “unprofitable” by advisory firms – or are the kinds of clients that hybrid advisors service by selling commission-based products. So, for the (smaller) firms who are serving these (smaller) clients, planning fees appear to be emerging as a viable (non-commission-based) alternative to work with them profitably. (So profitably, in fact, that solo advisors serving small clients are actually one of the most profitable segments of all advisory firms!)
More broadly, though, what all of this suggests is that – at least based on the latest 2014 data – there is zero evidence that financial planning fees are undermining AUM fees. Instead, the situation appears to be the exact opposite – the firms most focused on the AUM model are the most profitable, and the larger advisory firms that are most capable of attracting the wealthiest clients are the most likely to be sticking with AUM fees. To the extent that non-AUM-fees are being adopted successfully at all, they tend to be offered by the smallest advisory firms, serving the least wealthy clients, for whom planning or retainer fees are more effective in part because those clients may not even have the assets to fit an AUM model.
In turn, this implies that if non-AUM planning or retainer fees do grow in adoption in the coming years, they are more likely to grow amongst new segments of clients who don’t fit the AUM model in the first place – in other words, that planning and retainer fees are opening new markets of clientele to be served, while remaining less profitable than AUM fees for the clientele who actually have assets to be managed and fit the AUM model in the first place. Which means firms considering a switch to, or expansion into, a retainer fee model may be better served to think of it as a way to reach new non-AUM clients, rather than a path to convert their existing (and currently profitable) AUM clients to what may be a less profitable business model in the long run (especially for the largest firms with the most staff to squeeze their long-term margins!).
(Michael’s Note: A special thanks to Matt Sirinides from Investment News, and Dan Inveen from FA Insight, for their timely responses to follow-up questions and willingness to provide further slices of their benchmarking data!)
So what do you think? Is your firm focusing on AUM fees or planning fees? For which types of clients are you using planning fees – those who could also be served by AUM fees, or those for whom AUM fees wouldn’t have been a fit anyway? Please share your thoughts in the comments below!
