In Defense of AUM Fees

Over the years, I occasionally find myself defending something I never expected to have to defend. This has included investing in stocks, investing in real estate, financial advisors, index funds, bonds, 401(k)s, earned income, insurance agents, and unconventional asset location decisions. This post is going to be a little bit like those.

I'm actually mostly anti-AUM fees, but the pushback against them has gotten out of hand—and it's time for something to be said.

Advisors Deserve the Anti-AUM Criticism

The first thing I need to do is to make clear that I am absolutely NOT defending the typical “financial advisor” out there, giving crummy advice for way too much money. Most “financial advisors” are product salespeople giving terrible “advice” in exchange for commissions. The highest commissions tend to be paid by the worst products, so the incentive to do the wrong thing is just too high for even a good person to resist for long. There is no price low enough for bad advice.

Even those few “real” advisors who are actually giving good advice are usually charging too much. One percent of assets under management might be a fair fee when you're managing $300,000. It certainly is not when you're managing $3 million, much less $30 million. It's a ripoff for the clients because capable advisors are out there willing to do just as good a job for $5,000-$15,000 a year.

AUM Is Fee-Only

Some people don't seem to realize that AUM fees are fees. They say dumb things like, “I want a fee-only advisor, not one that charges AUM fees.” Or worse, they say they want a “fee-based” advisor, even though that term means the advisor charges fees and commissions. Guess what? If your advisor only makes money from fees, they're fee-only—whether those fees are charged on an hourly basis, as an annual subscription, or as an AUM fee.

More information here:

The Perfect Financial Advisor

How to Negotiate Lower Advisory Fees

Advice-Only Is a Validator Model 

The next thing people say as they get educated is, “OK, fee-only isn't good enough. You need an ‘advice-only' model.” Advice-only is a model where you just pay the advisor to tell you what to do. You then have to actually do it. Well, that model works fine for a certain type of investor that we'll call validators. These are folks who aren't quite confident and educated enough to do it themselves but who are capable of following directions and showing a little discipline. They want to check in with an advisor every year or two or three to make sure they're on track.

You know why the “advice-only” model is so rare? Because it's hard to stay in business. It's very transactional. An advisor needs a constant flow of new clients because the ones they have don't need them all that much and not for all that long. They're mostly not building long-term relationships here either, so it is often not as gratifying for the advisor. They have to charge so much an hour to keep the doors open that nobody wants to pay it, even if it is much less than what a typical delegator (someone who has an advisor to take care of everything) pays.

Worse, lots of people who are actually delegators pretend they're validators because they're cheap. They get the advisor's advice and then don't do squat with it until they come back to see the advisor 18 months later without any insurance, without a will, and with all their money still sitting in cash. Neither the advisor nor the client is doing well when that happens.

The advice-only model is fine for the right type of client but not for all clients. DIYers struggle to understand this. They can't understand why anybody would want to pay someone thousands of dollars a year to do a little financial planning and maintain a portfolio consisting of a handful of index funds. That does not change the fact that those people (delegators) actually exist and need to be served well to avoid a lot of financial catastrophes.

Do the Math

The biggest problem among delegators is that too many of them aren't willing to do a basic math equation once a year. It isn't hard to calculate your fees when you are paying an AUM fee. You multiply your assets under management by the asset under management fee. If you have $700,000 and your fee is 0.9% of AUM, then your fee is $6,300 this year and hopefully more next year.

Guess what? That's a fair price.

But in a few years, it won't be unless you do something. For example, let's say you now have $3 million and the advisor charges 1% for the first million, 0.9% for the second million, and 0.8% for the third million. Now, you're paying $27,000 a year for financial planning and investment management. And there are good advisors out there willing to do it for $12,000. Now, you're being ripped off since you refuse to do a math equation once a year and negotiate a little or change to a new advisor. I don't want to say you're getting what you deserve, but there's a little bit of truth to that.

Why Do Advisors Charge Outrageous AUM Fees?

Why are all of these advisors ripping off clients? Four words.

Because Clients Pay Them

Seriously, that's it. It's good business. When you're in business, you charge what people are willing to pay. We're in business here at WCI. We charge as much for ads as we can find businesses willing to pay. If we're charging too much, people stop buying them, and we have to lower the prices or not get any income at all. It's a constant balancing act.

It turns out an AUM fee business is a GREAT business. Sure, when you first pick up your clients, they only have $300,000 or $1 million or whatever. But for the next 20-50 years, they're only getting wealthier. And most of them are very sticky. They don't like this money stuff, so they don't do a simple math equation every year, they don't negotiate, and they certainly don't want to go find another advisor.

You don't need very many clients like that to have a viable solo financial advising practice—50-100 families is plenty. If they average $1 million in assets and you're charging 1%, 75 families generate $750,000 in revenue. If $250,000 goes to overhead, the advisor earns $500,000 in profit. That's a nice living.

But that's not the way it starts. It starts with 20 families with an average of $350,000 in assets. That's only $70,000 in revenue. That's really lean, and you're certainly not hiring any help. But as the years go by, you fill the practice with 100 clients and they become richer and richer and richer. When those clients average $2 million, that's $2 million in revenue for the practice each year. Maybe $500,000 is going to overhead now, and you're taking home $1.5 million. It'll be even more next year if the market doesn't crash and not too many people fire you after reading this article (delegators don't tend to read financial blogs like this one).

Why would you change your model now? Even if you lose a handful of clients a year, the other 95 will easily send you five more to replace them. And you feel like you deserve it because you remember how hard you worked during those lean years to find 100 families willing to not do a math equation every year.

Defending AUM Fees

“Wait, I thought you were going to defend AUM fees. It doesn't sound like you're doing that at all.”

All of the above had to be said before I got into today's topic: reasonable AUM fees. Guess what? We all already pay AUM fees. They might be called “expense ratios,” but that's exactly what they are. If you invest in the Vanguard Total Stock Market Fund like I do, you're paying Vanguard (Gerry O'Reilly and his team) 0.03% of the assets under management each year. If you have $10,000 invested, that's $3. If you have $100,000 invested, that's $30. If it's $1 million, it's $300. If it's $10 million, it's $3,000.

It's an AUM fee, so don't get all high and mighty that you don't pay AUM fees. You do, unless you're only investing in those Fidelity Zero Expense Ratio Index Funds, which probably aren't any better than the Vanguard index funds despite the minimally lower expense ratios.

What's the difference? The difference is that you're paying a REASONABLE AUM fee. The problem with AUM fees isn't that they are AUM fees. The problem is that they are often not reasonable. However, that does not mean they cannot be reasonable.

Lots of DIY investors talk about my friend Rick Ferri as though he's a saint. He actually is kind of a saint, but he also used to charge AUM fees in his practice. That fee was dramatically lower than 1% a year, but it was an AUM fee. DIYers often tell people to go to Vanguard Advisory Services. Guess how it charges its clients? That's right, an AUM fee. It's 0.35% and don't expect much financial planning, much less anything physician-specific.

More information here:

Leaving a Bad Financial Advisor

Managing a Lot of Assets Is Risky

It's perfectly fine to pay a flat fee for ongoing asset management. If you're paying $10,000 a year, it's about the same amount of work to manage $400,000 as it is to manage $3 million. Ten thousand dollars is a fair price for either one. But what about $30 million? Is $10,000 a fair price to pay for asset management of $30 million? I would argue that it is not. No, it may not be dramatically more complicated to manage $30 million than $3 million, but it's probably somewhat more complicated—and it is definitely much more risky. The financial planning is likely to be a lot more complicated, too. People with $30 million have lots of different accounts and complicated asset protection concerns and estate planning needs. Unlike most financial advisory clients, they've got an estate tax problem and probably some trusts. They should cost a little bit more.

But how much more? Well, that's hard to say.

Some of the flat fee advisors I know don't actually charge any more for those clients. That may be fine when you only have one or two of them. But what about when you have 25 of them? You can no longer run a profitable practice when all that extra effort is expended. But what if an advisor charged $12,000 a year to do financial planning and asset management of up to $8 million, then 0.15%-0.3% above that? Would that be a fair price? I think it would.

At $30 million, they'd be paying something in the range of $47,000-$78,000 a year. Yes, that's a lot of money. But so is $30 million. When an advisor makes a mistake managing assets, the clients generally expect them to make it right. That correction often comes out of the company's profits. The more money being managed, the more those mistakes cost. At a certain point, it becomes worth it for the advisor to make a claim against their errors and omissions (E&O) insurance. You better believe the cost of that insurance goes up as assets under management grow. Shouldn't that cost be passed along to the investor? Of course it should.

The Bottom Line on AUM Fees

I hope all of that rambling was helpful to you. I want to make sure WCIers walk away from this post with a little bit of new knowledge. Let me summarize it:

AUM-charging advisors are fee-only advisors. The AUM model is not inherently unfair, although it is much easier to abuse. Reasonable AUM fees are fine to pay, but you must do the math each year to ensure they are still reasonable. Not every potential client is a validator, much less a DIYer. Many are delegators. Deal with it. Don't tell your delegator friends to be DIYers. It doesn't work. You're hurting them. Just send them to delegator-serving advisors who charge a fair price for good advice. If you become very wealthy, you should expect to pay more for financial planning and asset management. Being your own financial planner and investment manager is still the best-paying hobby in the world, especially when you become very wealthy.

What do you think? Why does the AUM model draw so much flak? If you have an advisor, do you pay an AUM fee? Why or why not? 

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