Oct 10, 2024 | 12 min read
The Importance of Fee Structures
When it comes to financial advice, how you pay is just as important as what you pay. This article explores the differences between the two common fee structures that dominate the industry: Assets Under Management (AUM) Fees and Flat Fees.
Overview of AUM and Flat Fees
To quickly define terms: AUM fees are calculated as a percentage of your invested assets, while flat fees, as the name suggests, charge a static annual amount regardless of portfolio size.
At first glance, both models might seem reasonable. However, as your wealth grows over time, the difference in cost can be substantial.
In this article, we'll explore why flat fees often prove to be the more cost-effective choice for clients, potentially saving you thousands of dollars over the long term and boosting your investment returns.
Let's dive into numbers to see the evidence!
Understanding AUM Fees
What Are AUM Fees?
AUM fees are a common compensation structure used by financial advisors and investment managers. This fee model is based on a percentage of the total value of assets that an advisor manages for a client.
Here's a more detailed breakdown of how AUM fees work:
Calculation Method Percentage of total portfolio value (e.g., 1% of $500,000 = $5,000 annually)
Regular Assessment Usually assessed quarterly, based on current portfolio value
Sliding Scale Percentage often decreases for larger portfolios
Inclusive Services Typically includes investment management and financial planning
Market Fluctuations Fees fluctuate with portfolio value in bull and bear markets
Alignment of Interests Aims to align advisor's interests with client's portfolio growth
Transparency Considerations Actual dollar amount can be less obvious as portfolios grow
Understanding the nuances of AUM fees is essential for investors when evaluating financial advisors and considering the long-term impact of fee structures on their investment returns.
Why Do Advisors Reduce AUM Fees for Larger Portfolios?
As your wealth grows, advisors typically reduce the percentage fee, yet total fees still rise significantly. There are several reasons why advisors might reduce AUM fees as portfolio size grows:
Economies of Scale Managing additional assets often doesn't require proportional increases in effort.
Client Retention Declining fees encourage clients to keep assets with the advisor as portfolios grow.
Attracting Affluent Clients Lower percentage fees appeal to wealthy individuals who might hesitate to pay higher fees on large sums.
Alignment with Client Goals Decreasing percentage as portfolios grow promotes trust and perceived fairness
Market Competitiveness Tiered structure attracts clients seeking value in a competitive market
How Do AUM Fees Scale?
Let's break down the implications using the tiered AUM Fee Schedule:
AUM Fee Schedule
Notes: R = Reported; E = Extrapolated Source: “Median AUM Fee (Plan Bundled vs Unbundled)” The Kitces Report, Volume 1, 2023, Figure 65, P54
The Hidden Cost of AUM Fees
While the percentage decreases, the actual dollar amount of fees increases substantially:
A $1,000,000 portfolio incurs $9,500 in annual fees (0.95%)
A $10,000,000 portfolio results in $50,000 in annual fees (0.50%)
Potential Conflicts of Interest
This fee structure raises questions:
Does managing $10M really require ten times more work than $1M?
Might it discourage advisors from recommending actions that reduce AUM, even if such actions benefit the client?
Examples of AUM-Reducing Actions
An AUM fee structure might discourage advisors from recommending beneficial actions that could reduce managed assets, such as:
Paying off high-interest debt
Making large purchases (e.g., buying a home)
Investing in a private business or startup
Diversifying into assets not managed by the advisor
Gifting money to family members or charity
Using funds to start a business
Long-Term Impact of AUM Fees
Remember: With AUM fees, as your wealth grows, so do your costs — dramatically, even with decreasing percentages. This means a significant portion of your investment gains goes towards fees instead of compounding for your future.
Flat Fees: An Alternative Approach
What Are Flat Fees?
Having examined the potentially costly nature of AUM fees, let's now turn our attention to an alternative approach that offers a different perspective on advisory compensation: Flat Fees.
In comparison to AUM fees, flat fees offer a simple and transparent approach to pricing. While they do increase over time, the growth is much more modest compared to AUM fees, especially as your wealth accumulates.
How Flat Fees Work?
Flat fees typically increase annually to account for inflation. These fees are usually charged on a regular basis, such as quarterly, similar to AUM fees.
Case Study: Comparing AUM and Flat Fees
Assumptions and Methodology
Before we dive into our comparative analysis of AUM and flat fee models, it's crucial to understand the assumptions underlying our case study.
These assumptions provide the foundation for our calculations and comparisons:
Initial Portfolio Value: $500,000
Investment Growth Rate: 10% average annual market return compounded quarterly
AUM Fee Structure: Based on the tiered fee schedule provided in the table above
Flat Fee Structure: Starting at $5,000 annually, increasing by 3% each year to account for inflation
Fee Calculation Frequency: Quarterly for both fee models
Reinvestment: All returns are assumed to be reinvested (i.e., no withdrawals or contributions)
Taxes: Not included due to varying individual tax situations. Comparisons focus on pre-tax returns.
Note: We believe these assumptions are conservative and are designed to provide a fair and balanced comparison between the fee models. Actual results may vary based on market performance, specific advisor fee structures, and individual financial circumstances. For detailed projections of portfolio growth and management fees under both fee structures, please refer to Appendix A for Flat Fee and Appendix B for AUM Fee.
Why We Chose a 10% Average Market Return
We chose a 10% average annual market return for our case study as it reflects the S&P 500's long-term historical performance (including dividends). This optimistic yet historically grounded figure simplifies calculations and effectively illustrates the impact of different fee structures on portfolio growth over time.
Why We Chose a 3% Annual Increase for Flat Fees
We chose a 3% annual increase for flat fees as it aligns with long-term average U.S. inflation rates. This conservative estimate reflects advisor's common practice of adjusting fees for inflation, allowing for a clear, realistic comparison with the AUM model over time. For a year-by-year breakdown of how these fees grow over time, please see Appendix A.
Average Advisory Fees
The bar chart below provides visual comparison of average AUM fees and flat fees across different client portfolio sizes from $0.5M to $10M.
The graph above illustrates how flat fees and AUM fees evolve as your portfolio grows:
Notice how the flat fee increase (dark green bars) is gradual and predictable, growing annually at a conservative 3% to account for inflation.
In contrast, AUM fees (light yellow bars) increase dramatically as the portfolio size grows, despite the decreasing percentage rates we saw in the earlier fee schedule (see AUM fee schedule table above).
Key comparisons become clear:
At $1M, you'd pay about $9,500 in AUM fees vs. approximately $7,000 in flat fees.
At $5M, you'd pay $30,500 in AUM fees vs. only about $10,000 in flat fees - a saving of over $20,000 annually!
At $10M, the difference is even more stark: $50,000 for AUM vs. roughly $13,000 for flat fees - an annual saving of $37,000!
Flat fee model ensures that as your wealth grows significantly over decades, your fees remain reasonable and don't eat into your returns excessively. You keep more of what you earn.
Key takeaway: Flat fees lead to dramatic savings as your wealth grows over time, allowing you to keep more of your hard-earned returns. Even with conservative assumptions, the difference in costs over the long term is substantial.
Average Advisory Fee Percentages
To illustrate an even clearer comparison of AUM fees with flat fees, we calculate the flat fees as a percentage of portfolio value – we call it Implied Flat Fee. The line chart below illustrates how these percentages change across different client portfolio sizes from $0.5M to $10M.
Here are the key observations:
AUM Fee % decreases as the portfolio size increases. It starts at 1% for a $0.5M portfolio and drops 0.5% for a $10M portfolio.
Implied Flat Fee % decreases more rapidly than the AUM fee % as portfolio size grows. It starts at 0.77% for a $0.5M portfolio and drops 0.12% for a $10M portfolio
The gap between the two fee structures widens significantly as the portfolio size increases, with the implied flat fee percentage dropping much more steeply than the AUM fee percentage.
For larger portfolios, the difference in percentage terms becomes quite substantial. For instance, at $10M, the AUM fee is about 0.5% while the implied flat fee is only about 0.13%.
Remember: flat fees become increasingly cost-effective as portfolio size grows, providing a compelling argument for the potential long-term savings of a flat fee structure relative to an AUM-based fee model.
Cumulative Fees Over Time
The bar chart below shows cumulative fees (in $ thousands) for each fee model across different portfolio accumulation periods from 5 years to 30 years.
The contrast is striking. Over a 30-year period, the AUM fee model results in $566,000 in total fees, while the flat fee model totals $241,000. That's a saving of $325,000 over three decades!
This comparison illustrates how AUM fees escalate as your wealth grows. With a 10% average annual return, a portfolio would certainly grow rapidly, causing AUM fees to balloon alongside that growth. In contrast, the flat fee model increases only with inflation, resulting in substantial savings over time.
By opting for a flat fee structure, you're potentially putting hundreds of thousands of dollars back into your investments. This difference would have a substantial impact on compounding returns, long-term wealth accumulation, and your ability to reach financial goals sooner.
The flat fee structure becomes increasingly cost-effective as your portfolio grows. The base fee remains constant, with only a modest 3% increase for inflation, while the AUM fees continue to grow proportionally with your wealth.
Remember: all else being equal, most investors would prefer to keep more of their returns invested and compounding over time. The flat fee model clearly offers this advantage, potentially accelerating your path to financial freedom.
Portfolio Value Comparison
While understanding the difference in fee models is crucial, it's even more important to see how these fees impact your investment returns over time. Let's analyze this impact with the chart that compares portfolio growth under both fee models over a 30-year period.
Client Portfolio Value Over Time
This chart tells a compelling story:
Initial Similarity Both models show similar growth patterns in early years, starting from the same $500,000 initial investment.
Growing Divergence Over time, the Flat Fee model begins to outpace the AUM Fee model, with the gap widening annually.
Long-Term Impact After 30 years, the Flat Fee model yields about $8.5 million, while the AUM Fee model results in approximately $7.5 million.
The Benefit of Lower Fees This $1 million difference stems from lower fees, allowing more money to stay invested and compound over time in the Flat Fee model.
What does this mean for you?
Long-Term Perspective While fee differences might seem small initially, their impact over three decades is substantial.
Compounding Effect Lower fees don't just save you money; they allow more of your capital to compound, dramatically boosting long-term returns.
Accelerated Growth Lower fees mean more of your money keeps working for you, potentially helping you reach your financial goals faster.
Wealth Preservation The flat fee structure helps preserve more of your wealth, which could be crucial for retirement planning or legacy goals.
Remember: Choosing a fee structure isn't just about current costs — it's about long-term wealth building. The Flat Fee model, by minimizing fees, can significantly boost your investment returns over time. In this case, it results in an additional $1 million in wealth after 30 years, a substantial sum that could make a significant difference in your financial future.
Considering All Angles: Potential Drawbacks of Flat Fees
While flat fees offer significant advantages, especially for investors with growing portfolios, it's important to maintain a balanced perspective. Like any financial arrangement, flat fee structures also come with potential drawbacks that deserve careful consideration. Understanding these potential issues can help you make a more informed decision about which fee structure best suits your individual circumstances.
Less Flexibility Flat fees remain constant regardless of market conditions. During downturns, you'll pay the same fee even if your portfolio value decreases.
Service Limitations Some flat-fee advisors may limit their services to maintain profitability. Understand what's included in your agreement, as additional fees may apply for extra services.
Reduced Incentive Flat fee advisors might lack the direct financial motivation to grow your portfolio that AUM fees provide, potentially affecting the advisor-client relationship.
Higher Initial Costs For smaller portfolios (e.g., $50k to $100k), a flat fee might initially be higher than an equivalent AUM fee, making it less attractive for new investors.
Less Common Flat fee structures are less prevalent in the industry, potentially limiting your choice of advisors who align with your needs and preferences.
Making Informed Decisions About Financial Advice Costs
As we've explored throughout this article, the choice between AUM and flat fee structures can significantly impact your long-term financial growth. Let's recap the key points and provide some actionable steps to help you make an informed decision.
Key Takeaways:
Fee Structure Impact AUM fees can escalate dramatically as your portfolio grows, potentially costing you hundreds of thousands of dollars over decades
Long-Term Perspective: While fee differences might seem small initially, their compounding effect over time can be substantial.
Flat Fee Advantages: For many investors, especially those with growing portfolios, flat fees often prove more cost-effective in the long run.
Transparency and Predictability: Flat fees offer more transparent and predictable costs, making financial planning easier.
Potential Drawbacks: Consider the potential limitations of flat fee structures, such as less flexibility during market downturns and possible service limitations.
Call for Action:
Assess Your Current Situation Review your existing financial advisory agreements. Understand exactly what you're paying and how those fees are calculated.
Project Future Costs Use the insights from this article to project how your advisory fees might grow under different fee structures as your portfolio increases in value.
Evaluate Services Received Consider the range and quality of services you're receiving. Ensure they align with the fees you're paying, regardless of the fee structure.
Discuss Options with Your Advisor If you're currently using an AUM model, discuss the possibility of switching to a flat fee structure with your advisor. Be open to their perspective but advocate for your long-term financial interests.
Shop Around Don't hesitate to explore options with other financial advisors. Compare both their fee structures and the services they offer.
Consider Your Growth Stage If you're early in your wealth accumulation journey, weigh the pros and cons of each fee structure based on your projected growth.
Regularly Review Make it a habit to review your advisory fees annually. As your wealth grows, ensure your fee structure continues to serve your best interests.
Remember, the right fee structure aligns with your financial goals, provides value for the services rendered, and supports your long-term wealth accumulation. By being proactive and informed about advisory fees, you're taking a crucial step in optimizing your financial future.
Your choice today could mean the difference of hundreds of thousands of dollars in your portfolio decades from now. Take the time to make an informed decision – your future self will thank you.
At Israilov Financial, we charge a flat fee in order to promote simplicity, transparency, and cost-effectiveness in our advisory practice. If you're interested in finding out more about our services, schedule your free discovery meeting.
Appendix Section
Appendix A:
Projected Portfolio Growth, and Management Fees under Flat Fee
Portfolio Growth Rate: 10%
Flat Fee Growth Rate: 3%
Appendix B:
Projected Portfolio Growth, and Management Fees under AUM Fee
Portfolio Growth Rate: 10%
AUM Fee rate: see AUM Fee Schedule table above
Assets Under Management (AUM) Fees vs Flat Fe
IMPORTANT DISCLAIMERS
Past performance is no guarantee of future returns
The graphs and charts in this commentary are for illustrative purposes only and not indicative of any actual investment. Index returns do not reflect any fees, expenses, or sales charges. It is not possible to invest directly in an index. Stocks are not guaranteed and have been more volatile than other asset classes. Historical returns were the result of certain market factors and events which may not be repeated in the future. Financial professionals are responsible for evaluating investment risks independently and for exercising independent judgement in determining whether investments are appropriate for clients.
This material is intended for information purposes only, and does not constitute investment advice, a recommendation or an offer or solicitation to purchase or sell any securities.
Disclaimer: Investments are not guaranteed and are subject to investment risk, including possible loss of the principal amount invested. Past performance is no guarantee of future results. All allocations and opinions expressed are as of the date of this presentation and subject to change. The information contained herein does not constitute investment advice or a solicitation. Information obtained from 3rd parties is believed to be accurate, but has not been independently verified.
The opinions expressed in this article are for general informational purposes only and are not intended to provide specific advice or recommendations for any individual or on any specific security. The material is presented solely for information purposes and has been gathered from sources believed to be reliable, however Israilov Financial LLC cannot guarantee the accuracy or completeness of such information, and certain information presented here may have been condensed or summarized from its original source. Israilov Financial LLC does not provide tax or legal advice, and nothing contained in these materials should be taken as such.
As always, please remember investing involves risk and possible loss of principal capital. Advisory services are only offered to clients or prospective clients where Israilov Financial LLC and its representatives are properly licensed or exempt from licensure. No advice may be rendered by Israilov Financial LLC unless a client service agreement is in place.
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