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| First Person: Industry View |
The Costs of Counsel
Scott Welch
11/01/2005
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To
paraphrase the old cliché, families often don’t know what they don’t know. More
specifically, they don’t know they need something until they need it. So it is
not uncommon for the family to look at a higher-priced wealth manager that
offers a broader array of services and think, “Well, we don’t need all those
other services, so why pay for them?” In some cases this is true, but many
clients who are not committed to managing their investments themselves will
eventually want to delegate most of the wealth management responsibility to an
outside party so that they can focus on whatever it is that interests them.
Also, while a family may not need a particular service now, it may find itself
in need of that expertise in the future.
Another consideration of the %-AUM
approach is the need for full transparency regarding the wealth manager’s
revenue model. A seemingly low %-AUM fee may simply be the loss leader to higher
revenue business on products or transactions. For example, a wealth manager
might charge a seemingly low advisory fee expressed as a %-AUM, which is being
subsidized by fees from other sources—e.g., trading fees, custody fees or asset
management fees on in-house captive products that are used within the client
portfolio. This is fairly common at larger banks, brokerage firms and trust
companies. As a steward of your family’s wealth, you should know how your
advisors make money; you may not be able to avoid all conflicts of interest, but
you should certainly know when and where they exist.
One final issue to
consider with the %-AUM approach is that if the wealth manager is, in fact,
offering a wide variety of services in addition to investment advice, this type
of fee structure may result (perhaps unconsciously) in too much focus on only
the investment side of the offering. The dollar amount of the fee rises or falls
with the performance of the portfolio, which can overshadow other real value the
wealth manager may be adding in other areas. To use an extreme example, many
wealth managers really earn their keep when the markets go down because they
keep their client families disciplined and diversified, yet under the %-AUM
approach their fee goes down!
Flat retainer fees don’t really solve any of
these problems, except perhaps the last. Flat fees, assuming they have been
negotiated correctly, are usually preferable for the wealth manager because they
allow more certainty with respect to budgeting and capital investment planning.
They often make sense for the family, as well, because of the added certainty
and the “unlinking” of the wealth manager’s fee from investment performance,
which removes any risk (small though it may be) that the wealth manager is
taking more investment risk than is appropriate in an attempt to increase
returns (and therefore fees). But this works only if the fee has been set
appropriately.
The main issue with the flat-fee approach is the potential
for “scope creep,” a situation in which the parties agree to a flat fee based on
an assumed level of service, but the needs or complexity of the family wealth
plan grows past what was agreed to. In an increasingly competitive marketplace,
many wealth managers find it difficult to go back to the family and raise the
fee when this happens, and the result is an unprofitable relationship for the
wealth manager. Contrary to what some families may think, a “good deal” that
results in an unprofitable pricing model for the wealth manager is not in a
family’s long-term best interest. Families should want their wealth managers to
be reasonably profitable; it is the only way they can continue to upgrade their
service offering, make necessary capital investments and attract and retain
high-quality professionals.
With the flat-fee approach, it is critical that
the wealth manager have appropriate internal systems for tracking and
calculating the actual cost of servicing clients. If these systems are not in
place, then any discussion with the client regarding the profitability or
viability of the relationship has no supporting evidence, and the family should
rightly push back on any proposed fee increase. Clients should ask potential
advisors about their systems before hiring one.
If the wealth manager can
document sufficiently that the current fee arrangement is not profitable given
the scope of service provided, and the family continues to want that level of
service, then it should be amenable to an appropriate increase in fees.
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