THE THREE COMPENSATION MODELS FOR INVESTMENT MANAGERS MANAGING CLIENTS’ MONEY

When a client hires an investment manager to be their Trusted Advisor, that client should know exactly how he or she will pay for that advisor’s advice. This is the case whether a client is investing millions of dollars or just dabbling in the New York Stock Exchange.

It’s also worth pointing out that until most Trusted Advisors came along, the financial advice that clients received probably cost them next to nothing. They got their information from reading the Wall Street Journal or a mutual fund company’s promotional material. Additional data may have come from watching a television show or attending a workshop hosted by a bank, or from talking to their dentist or friends and family.

This “free” information, incorrectly applied by a client, could turn out to be very costly. A client for life understands that valuable financial advice does not come cheap. He or she should be willing to pay for the right advice from a qualified financial professional.

Several years ago, I read a short piece by John Ruskin, the 19th century English social reformer, entitled: “It’s Unwise to Pay Too Much”. This expresses my thoughts on the subject of the true value that the Trusted Advisor provides to his or her clients:

It’s unwise to pay too much, but it’s unwise to pay too little. When you pay too much you lose a little money. That is all. When you pay too little you sometimes lose everything, because the thing you bought was incapable of doing the thing you bought it to do. The common law of business balance prohibits paying a little and getting a lot. It cannot be done. If you deal with the lowest bidder, it is well to add something for the risk you run. And if you do that, you will have enough to pay for something better.

Although some advisors may feel uncomfortable talking about how they earn their keep, it is vital that clients understand how the Trusted Advisor is compensated. Whether the Trusted Advisor is starting a new client relationship or re-evaluating a current one, there are three basic models of compensation for providing the asset management solutions or any other financial advice.

Model One: The Trusted Advisor can be paid on the commissions generated when a client makes transactions. One example of this approach is the stockbroker, who earns a commission every time a client buys or sells a stock, bond or some other product purchased through the broker.

Model Two: The Trusted Advisor may be paid according to the growth or shrinkage of a client’s assets. For example, some advisors’ fees are set as a percentage of a client’s portfolio (e.g., 1% a year). If a client’s portfolio grows through appreciation, then so does the advisor’s fee. If assets shrink, the fee follows suit.

Model Three: The Trusted Advisor may be paid by a client per project or by the hour (e.g., a flat fee for an initial evaluation of a portfolio). The client is buying the Trusted Advisor’s experience, expertise and time.

Each one of these compensation models rewards the Trusted Advisor in different ways. In the first model (the “transaction or commission” base), there is a financial incentive to generate transactions in a client’s account. A commission-based financial advisor might determine that the most appropriate investment for a client is 100% allocation to T-Bills. But he or she may not be able to afford to tell the client this opinion because there is almost no commission involved to reward the advisor. Even though we put the needs of the client first and act ethically, the best interests of the advisor may not always match the best interests of the client.

When an advisor is using the commission compensation model, it is important to explain all of the commissions and fees the advisor may earn from a deal. Full disclosure can help reduce any potential conflict of interest that may result from this model.

The Trusted Advisor whose pay is based on the size of the client’s assets (model two) has an incentive to see those assets grow. Growth can come from appreciation of existing assets or from new assets that a client places under the advisor’s management. If the client pays the Trusted Advisor a straight percentage of assets, then the client and the advisor will both want to achieve exactly the same thing — making money.

A fee-for-service-only (model three) Trusted Advisor has the incentive to take as much time as necessary to do a client’s work, but has no incentive to steer the client towards any particular product. Like other professionals who bill by the hour, there is an incentive to spend more time than necessary (the “over-billing problem”) to complete any project.

To some investors, this “fee-for-service-only” approach appears to be the most expensive. For this reason, very few Trusted Advisors have adopted the fee-for-service-only model. However, those who use this model have the potential benefit of obtaining increased referrals from other professionals in related financial fields. This occurs because accountants, lawyers and other professionals often feel more comfortable referring business to other professionals who are compensated in the same manner.

Investment advisors who earn their living by adopting model one (transaction or commissions) and model two (management fees on assets under management) can find it very profitable to work closely with a fee-for-service-only Trusted Advisor (model three). A fee-for-service-only Trusted Advisor, for example, may discover new investment and insurance opportunities that the referring investment advisor can implement. Think of how an investment guru who writes a newsletter can work well with a model one or model two investment advisor. The guru is compensated on a fee-only basis (via a yearly subscription to his or her newsletter, for example), while the transaction or “fees on assets under management” professional helps to implement this advice.

How do Trusted Advisors operating in model one and model two know when they have found another professional who complements their professional services working in model three? Simple. This occurs when the clients find more value in the Trusted Advisor’s services when he or she is working together with that other professional to serve the clients’ needs compared to when the clients have access to the Trusted Advisor’s services alone. A professional is the Trusted Advisor’s competitor if the clients are less attracted to what the Trusted Advisor does when the other professional is brought into the picture.

Today’s clients are becoming more knowledgeable about how financial professionals are paid. An advisor who dodges this topic or gives vague answers might find his or her clients looking elsewhere for advice. As such, to be deserving of the Trusted Advisor title, you must be willing to candidly discuss your methods of compensation.

The bottom line: Stand tall and be proud of the value you bring to the table. Most importantly, be upfront with how you get paid for the valuable advice you provide. Great clients are willing to pay when they perceive that you bring value to their financial lives. Remember that as Trusted Advisors, all we truly have to sell is our time, whether we are compensated for it by earning a commission, fees on assets under-management, fee-for-service-only or a combination of these income models.

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