How Business Models Created The Culture of Financial Advisory Firms
Why not just make the necessary changes to correct what’s broken?
At this point in our blog series, you might be asking yourself the question, “If things are so bad with the current state of financial planning, why not just make the necessary changes to correct what’s broken?” That is a logical conclusion, but while the problems are obvious, the solutions are challenging (possibly a little like some of the political debate topics you will be hearing for the next few months!).
There are two real challenges here
One that we have already mentioned: nothing big is wrong. It is a host of smaller pieces that are broken, and those small pieces accumulate into a perception of confusion and mistrust and suboptimal financial planning outcomes.
A second challenge is that the core problems are so deeply rooted in the culture and systems that make up the industry that even obvious needed changes are difficult to address. It is the proverbial turning of the Titanic, if you will. So, a better place to begin might be defining the culture through the lens of how we arrived at where we are currently and identifying some of the elements of the culture that make it so sticky and unwieldy.
As forecasted last time, there are many weighty systemic issues woven into the culture of financial services that make this move to a better model extremely difficult. These are true anchors working against a migration to something better. In this piece, we are going to start at the top and take a look at the business model of most financial planning firms and set the stage for why things are as they are.
How financial services make money
As we have discussed, the financial planning profession has its roots in investment services and the insurance industry. Firms make money largely be selling either investment products (stocks, bonds, mutual funds, real estate trusts, options, etc.) or insurance products (whole life, variable life, annuities, etc.).
Each of these products are sold with a commission and the firm makes money with each product sold. It is quite possible that a firm gets paid $10,000, $15,000 or even $20,000 or more for selling one variable annuity product. So, as you can imagine, this system is full of agency problems or conflicts of interest and has brought about many pieces of regulation to try to control these built-in conflicts. Selling products often comes at the expense of offering services.
It is for this reason that we ended our last post talking about “fiduciary.” Fiduciary is a legal requirement imposed to make sure that planners/advisors are acting in a way that is in the client’s best interest. And, as we asked last time, who else’s interest would they be serving when they offer advice?
The very fact that a fiduciary standard is required reveals the problematic state of the industry
This problem and others have led to a slow migration to other business models. Improvement. The commission-only paradigm began to change into a business model that is comprised of both fees for service and commission on products. This has further extended into a model where revenue comes exclusively from fees, with no commissioned products being sold. In fact, the CFP Board recognizes three different categories of compensation for planners:
Commission only
Commission and fee
Fee only
In order to be considered a fee-only advisor (or firm), no commissioned products can be sold. The CFP Board has defined the term “fee only” in the following way: “A certificant may describe his or her practice as “fee-only” if, and only if, all of the certificant’s compensation from all of his or her client work comes exclusively from the clients in the form of fixed, flat, hourly, percentage or performance-based fees.”
While the definition might seem to align with what you would expect of a fee-for-service relationship, the dominate model looks much different. Instead of being paid to produce a financial plan or paid on an hourly basis, the vast majority of financial planning firms generate most of their revenue through what is called an “assets under management” (AUM) model.
WHAT THE ASSETS-UNDER-MANAGEMENT model MISSES
There are planners who do hourly work or charge by the plan, but that is the extreme minority of revenue dollars produced. The assets under management model assigns a percentage fee to the client assets that are managed by the firm. The more assets managed, the more money made. It is typical for the amount charged to be on a sliding scale so that the percentage applied to assets goes down if you hit certain targets. For example, if a firm charges 1.25% of AUM for assets under $1 million and 1.00% of AUM for assets over $1 million, a client with $500,000 invested would pay $6,250 for the year. A similar fee structure would be used to calculate annual fees during each future year. If the client had $3,000,000 invested, that client would pay $30,000 annually.
There is nothing inherently wrong with this model, but it does explain why most financial planning firms look like investment service firm silos, or what we have termed “product-focused financial planning.” Other services can be offered and truly comprehensive financial planning can be conducted, but it is most often done without direct compensation. In other words, you are not paid for it. This is the largest and heaviest anchor working against a change from a culture of product-focused financial planning to truly comprehensive financial planning.
The incentives are stacked too heavily towards products and wealth management. In order to change the incentive, the entire business model would need to change. And as you can imagine, that is a big ask. The more hidden cost is one of being stuck—of knowing what would and could be better, but experiencing the seemingly impossible task of getting there. In life, the one thing more frustrating than not knowing or being able to figure something out is the ability to observe, understand and know what needs to happen but not being able to do anything about it.
Associated costs are a continued and mired state of public distrust, a ridiculous amount of regulation and required disclosure, an opaque world in which terms like “advisor” and “planner” are almost impossible to decipher, and ultimately failing to offer the community the entirety of what they need… truly comprehensive financial planning.
Check out the rest of the series with Ryan and Marc:
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Ryan Halley, Ph.D., CFP® is Director of Planning Practices and Research at Human Investing. He holds a doctorate in Personal Financial Planning from Texas Tech University and an MBA with a concentration in Finance from The Ohio State University. Ryan has his CERTIFIED FINANCIAL PLANNER™ certification. Dr. Halley is also a Professor of Finance and Financial Planning at George Fox University, where he directs a CFP® Registered Program located near Portland, Oregon. He has co-authored a book and has numerous peer-reviewed journal articles. Additionally, he has been an invited professor and lecturer at various universities in the United States, Canada and China.
