Michael J. Nathanson, JD, LLM
Chairman & Chief Executive Officer
June 10, 2020
As appeared in Family Wealth Report
Even though stocks have rallied, the sudden and precipitous decline in the equity markets earlier this year caused many registered investment advisors to reevaluate their business models.
The disclosure by many advisors that, after only a few weeks of heavy market losses, they needed government support under the Paycheck Protection Program cannot be ignored. In this context, among the practices being reevaluated by many advisors are their fee models, which, for some, triggered painful reductions in revenue tied to the market declines.
It is always appropriate to reevaluate business models, but the current debate about fees has been inappropriately reactive, dogmatic, binary, and simplistic.
With the decline of other fee models, the dominant advisory fee model for RIAs involves charging a percentage of assets under management – the model that got some advisors into trouble this year.
Proponents of this model argue that, while it is susceptible to market volatility, it aligns best with the interests of clients. They also argue that it most accurately compensates the advisor for the magnitude of work involved, and the risks assumed in performing that work. This approach, according to advocates, is most transparent and adjusts automatically over time as asset values and the costs of providing advice increase.
Others take the position that retainer fees are better. This model has gained some traction of late, though partly for the wrong reason – because these fees, unlike asset-based fees, didn’t go down during the recent market decline.
This camp argues that retainer fees are necessary to serve clients with substantial needs for advice but lower levels of manageable assets. Along the same lines, they argue that retainer fees align with holistic advice that doesn’t center on managing money. They argue further that retainer fees are transparent and mitigate potential conflicts of interest that can occur with other models.
As is often the case, the proponents of each model reveal their biases. They are either already tied to a model or otherwise have something to gain by arguing for one over the other. They also tend to be absolute in their arguments, which, in turn, precludes them from seeing that perhaps a better approach is to combine the concepts. One possibility is to use:
— Asset-based fees for services primarily related to asset management; and
— Retainer or hourly fees for services such as consulting, intensive financial planning, tax compliance, bookkeeping, and bill-payment.
This approach not only combines the best of both models but also allows an advisor to diversify their revenue, making it less correlated to the markets.
But why stop there? Advisors should also consider innovative fees that serve more specific needs of clients.
Advisory fees are generally no longer tax deductible, for example. But there may be innovative options for larger clients who pay substantial fees, such as wealthy families who could use a family LLC or partnership structure as the vehicle through which its wealth is managed.
In addition to the typical planning opportunities associated with such a structure, another advantage is that, rather than pay its advisor a typical management fee, the partnership could grant a non-taxable, redeemable profits interest to the advisor (subject to qualifying for an exemption from certain securities-law restrictions).
Through this interest, the advisor could receive a small allocation of investment gains in lieu of or in addition to any traditional fee. To the extent a portion of the taxable income is allocated to the advisor, the partnership effectively would be receiving the same benefit as a tax deduction.
Alternatively, a family office can be established in a manner that comports with the facts of the Tax Court case Lender Management v. Commissioner. Under that case, if a family office is structured properly, it can be treated as a business, thereby enabling it to claim an allowable business deduction – as opposed to a personal deduction – for fees paid to an advisor.
Importantly, implementing either of the above structures would require securities, tax, and other legal expertise to make it both effective and legally compliant. The point, however, is that advisors need to think about their fee structures without bias, without absolutism, and, whenever possible, with creativity – always, of course, with the best interests of clients in mind.