Here’s a fun game: ask a financial advisor what they do and tell them they cannot use the word “holistic.” After a brief pause, they will describe a range of functions from helping clients budget to managing their investments—primarily stocks and bonds in some form. They may bring up insurance, retirement income, asset allocation, tax strategy, or estate planning as well. All of it is accurate, as each of these subjects are reflected in most job descriptions for financial planners or advisors. (The extra credit question might be to compare a planner to an advisor.) Their clients are primarily individual investors or families. The advisor may work with hundreds of mass affluent clients, or maybe two dozen “Ultra High Net Worth” families, fewer still if the asset sizes are large enough. As you might expect, what gets done for each group differs substantially.
Financial Advisors vs Portfolio Managers
Let’s give an example: Frank the financial advisor is hired by Chuck and Charlotte after a series of interviews. Through several conversations, Frank, Chuck, and Charlotte determine that their goal is to accumulate $5 million so the couple can live off $200,000 a year (plus pension and Social Security) when they decide they’re done working. Frank handles their life and disability insurance, their 401(k)s and IRAs, and their brokerage accounts. Chuck and Charlotte also own rental real estate, which counts toward the $5 million target and generates part of the investment income they’ll eventually live on. Frank collaborates with their tax and legal professionals to minimize taxes and make sure the estate is titled correctly.
Frank’s compensation is the standard one percent of assets he manages. The rental real estate, of course, doesn’t count.
Now let’s look at institutional portfolio managers. First, let’s define what an institution might be. An institution might be a mutual fund, a pension plan, an insurance company, or an ultra-wealthy family with over $100 million in assets. The PM’s supervisor—whoever has hiring and firing authority, whether that’s a board of directors, a chief investment officer, or an investment committee—faces a tough set of decisions: over what time horizon do you judge performance? There’s an abundance of literature suggesting that performance should be evaluated by process, not simply by how the PM did against an index.
Let’s say Ian the PM manages the $100 million Giant Investment Fund. The board allows Ian to invest anywhere in the world, so long as he outperforms the All World Index. Ian uses databases and travels the world looking for appropriate investments. He attends conferences and meets with companies. He never meets the fund’s actual investors and doesn’t particularly concern himself with the tax implications of his decisions. His is purely a performance game.
Ian’s compensation is $500,000 a year. If he outperforms his index over a rolling three-year period, he gets an additional $250,000. If he consistently underperforms, he’s most likely looking for a new job.
How are Financial Advisors and Portfolio Managers Typically Paid?
So here’s the question every advisor should ask themselves: who is compensated more fairly?
Institutional portfolio managers typically work for a salary and bonus. When hired, they begin receiving a salary, and if their performance meets or exceeds some standard, they receive a healthy bonus. That structure works because the job is narrow enough to measure clearly: manage a defined pool of assets, pursue a defined mandate, and get judged on results. But financial advice is a different animal. Advisors help create goals. They structure investments to meet those goals, which differ with every client. Some clients need disability or life insurance. Others need coaching to save for retirement. Some are fiduciaries for their company’s retirement plan and need to be trained to fulfill that role properly. Some have lump sums of cash to invest and need either education or someone to do the investing for them. Such a wide range of roles!
Now consider the compensation. Many financial planners want some kind of diversified portfolio for their clients. Beginning with Markowitz’s seminal 1952 paper on portfolio selection and Solnik’s 1974 “Why Not Diversify Internationally?”, the curricula behind major planning and investment credentials strongly emphasize diversification and portfolio construction as standard practice. That helps explain why many financial advisors are paid as a percentage of the assets they manage. AUM is easy to understand, scales with client wealth, and lines up neatly with the part of the job that is most visible and easiest to bill. It also happens to be a structure clients often find more palatable: research tells us that fees debited directly from investment accounts or 12b1 fees are less emotionally painful than receiving an invoice or watching a line-item charge come out of your balance. Clients feel it less, so they resist it less.
I would propose that the compensation received by financial advisors is misaligned with their job description.
If asset management is the primary role of an institutional portfolio manager—and they are paid a salary and bonus rather than a percentage of assets, despite directly controlling performance—then why are financial advisors paid mostly for asset management when that’s often the smallest part of what they actually do? Ian gets paid to beat an index. Frank gets paid a percentage of the IRA. But Frank’s real job—the insurance, the goal-setting, the coordination with tax and legal professionals, the rental real estate that never shows up in the fee calculation—happens whether the market is up or down, and none of it is reflected in what he earns.
If dealing with insurance, taxes, goal-setting, and legal coordination are the core needs a financial advisor addresses, why is their compensation built around the one thing most of them don’t directly control?
Let’s take this a step further. Let’s say a client wants to do the investments themselves but wants help in some or all of the other areas—why not come up with a structure to make hiring an advisor more inviting to them? And if the advisor helps them with goal-setting and exploring investments they aren’t necessarily comfortable with, collaborates with their tax professional and their estate attorney, and even works with their kids and other heirs, why can’t they be compensated a fixed amount for this every month or quarter?
Done properly, the advisor is talking to the client monthly or quarterly, doing far more than producing a report and reviewing it every six months or a year. The job is far more fluid than a document. The compensation should reflect that, built around consulting instead of reporting.
Can we all agree that in many situations, this is a better approach?
