27 – Advantages and disadvantages of FUM-based fees
Advantages of FUM-based fees
Once again, a key advantage of an FUM-based fee is that it is relatively simple to calculate. The applicable percentage is simply applied to the assets under management.
Just as a reminder: figures quoted to clients must always be converted to whole dollar amounts. That is, a financial adviser cannot simply tell a client that the fee for advice will be x%. The adviser must go on to calculate a precise dollar figure by multiplying that percentage by the actual amount to which the FUM-based fee is being applied. If the fee is 1%, and the assets are $100,000, the quoted fee must be $1,000.
One of the main advantages of FUM-based fees is that total billings are not necessarily tied to the amount of work performed by a financial adviser. To give a simple example, there is little difference in the amount of work required to manage an investment of $100,000 as against an investment of $200,000. An adviser using an FUM-based fee will receive twice the remuneration for managing the $200,000 investment as they would for the $100,000 investment.
This lets the adviser access a form of leverage. An adviser who wishes to increase his or her remuneration needs simply to find clients with more assets to manage. The same amount of time spent working can lead to an increased revenue stream for the practice.
FUM-based billing can also be of benefit when it comes to risk. The total billings are automatically higher for larger amounts invested. If the value of the investments being managed is taken as an indicator of the likely risk to the adviser should something go wrong, then the FUM-based fee allows the adviser to receive a return that is more properly calibrated to the actual risk of the work being done.
There is a good sense at work here: penalties imposed upon negligent advisers are typically linked to the actual damages experienced by their client. The amount paid to the adviser is not relevant. FUM-based remuneration automatically compensates the adviser for this increased risk. Time-based billing does not.
A further advantage of FUM-based fees is the potential for an adviser’s fee-base to increase independently of the advisers actual contribution to their client’s financial position. FUM-based fees will increase whenever the assets being advised upon increase in value. In the 20 years to December 2014, the average annual rate of return on the Australian Stock Exchange was 9.4%. An adviser charging FUM-based fees over this period would have found their remuneration increasing at quite a fast pace even if their client’s investment performance was average (or even below average).
For example, a client’s investments may have achieved a rate of return of 5% during that 20 year period. This is below average and actually suggests poor performance on the part of the financial adviser. However, an adviser charging FUM-based fees would have seen his or her annual income increase by 5% across the period.
Disadvantages of FUM-based fees
The link between investment performance and the adviser’s fee can also be a disadvantage of FUM-based fees. In years when assets perform poorly, the adviser’s remuneration will fall. Some advisers cushion any fall by charging a minimum amount for their services. For example, an adviser may set their charges such that the client pays the greater of a set fee of $100 per month or an amount equal to .1% of the total amount invested each month. If the value of an investment falls such that .1% is less than $100, then the set fee kicks in and the adviser’s revenue has a floor placed under it.
A commonly cited disadvantage of FUM-based fees is that they can create a conflict of interest. FUM-based fees can skew an adviser’s focus towards assets which are either more easily valued or to which it can be made to appear that the adviser needs to pay more attention. A common example is where a client has an investment choice between property or a managed fund. While it is reasonably easy to calculate the purchase price of the property, it is less easy to quantify periodic increases in the value of a property. This makes it hard for an adviser to justify fee increases while the property is retained: how do they show the assets have increased accordingly?
The managed fund, on the other hand, is regularly priced by the fund manager. This regular pricing provides allows the adviser to regularly increase their fee-base. This may sway the adviser towards managed funds and away from direct investments.
Accordingly, FUM-based fees typically do not suit large one-off investments such as property. Indeed, advisers seeking to charge an FUM-based fee property advice are often accused of a pretty obvious conflict of interest if they are in any way involved in the purchase decision. For example, many real estate buyers ‘advocates’ charge clients a percentage of the purchase price of any property. This is hardly likely to encourage the ‘advocate’ to negotiate the lowest possible price. A quick sale at the highest price possible – which is also the preferred outcome for the seller – is more in the buyer’s advocate’s interest.
Clients may also resist FUM-based fees. There are two main criticisms. The first is that the client may bring a large amount of wealth to the adviser. This wealth was accrued without the adviser’s assistance and so the client may not wish for the adviser to be paid more based on the client’s relatively good position before they commenced.
In addition, some more sophisticated clients may realise that the amount of work involved in providing a service to them is not affected by the size of the assets. To give a simple example, a client with $2 million to invest will know that their investment does not take any more time or expertise to manage than would an investment worth $1.5 million. So, why does the client with $2 million pay more (that client will ask)?
Of course, a client with fewer assets is unlikely to complain that their fee is lower that it would be if they had more money to invest.
A further conflict of interest may also arise where it would be in a client’s interest for their assets to either reduce or grow at a reduced rate. For example, clients with a more conservative investment profile will probably experience lowered growth in the value of their assets. This reduces the potential fee for the adviser. Advisers may therefore be tempted to encourage a client into higher-growth asset types in the hope that the growth occurs and leads to higher fees.
Similarly, it will sometimes be in a client’s interests to divest themselves of investment assets altogether. For example, a client may have $100,000 invested and be contemplating using this money to establish their own business or to buy a home, or even simply to pay down debt. A financial adviser cannot really justify an FUM-based fee on either type of asset (a business or a home). This may discourage the adviser from recommending these uses of the money.
A further disadvantage of FUM-based fees is that they closely approximate commissions. FUM-based fees are not used by other professionals such as accountants or lawyers.
FUM-based fees may also be inappropriate for clients with low amounts to invest. The reason is simple: advisers may simply not be able to derive sufficient FUM-based fees to justify providing a service.