A few clients and potential clients have asked why we can't structure their Asset Management Agreement in such a way that I'm compensated by a % of their profits, rather than a % of the assets under management. In short, the reason is because it's illegal. But, I think it’s worth responding to why it's illegal, b/c many misunderstand the purpose for the law.
Under the pressure of making money solely on the
gains of other people’s portfolios, the unscrupulous advisors out there (and
they're definitely out there, I've interacted with some of them) would be
incented to take substantial risks that might not be in the best interest of
their clients. Here’s an example… you give advisor X 30k and agree that he
gets 10% of your gains each year. Seeing that he’s only compensated by
upside, and doesn’t lose anything on downside, he could easily shoot for the
moon in your portfolio and one of two things happens: 1) the risky investments
pay off and you both make money or 2) the risky investment fail, your account is
cut to 15k, you fire your advisor, and he finds another client to replace you by
using the “pay for performance… I only win if you win argument”. In other
words, he loses nothing. This is clearly not what the average client wants
as the advisor's incentives are not aligned with your interests. The
government is VERY concerned that’s what they would get from some advisors if
the % of gains method of compensation were allowed.
Now, it may seem unfair to have to pay for financial service that might not
return any money. And it might seem like your advisor doesn’t have the
incentive to go the extra mile for your portfolio if there isn’t a % of gain
arrangement. Here I’ll give you the alternate argument, and it happens to
be one I believe, not just textbook. By paying an advisor a % of assets
managed, the advisor is definitely incented to make you money. 3 primary
reasons:
1) The only way he can keep you as a client is to keep you satisfied. He
doesn’t want to lose you as a client b/c without the “pay for performance, I
only win if you win” argument, it’s pretty hard to get new clients. A lost
client is essentially lost revenue, and lost referrals. Not to mention bad
word of mouth publicity, which is kryptonite to a planning business.
2) The only way for the advisor to make more money is to make you more money so
that his management fee grows when your assets grow. It’s slower than in the %
gain scenario, but it’s more lasting too. If your portfolio loses money, his
business takes a hit the following year.
3) Under this method, you really have to trust your advisor. You need to know
him personally, or get recommended to him by someone you personally know and
trust. If you trust him, you know he's not going to lazily take your money
without giving anything back.
Now, it’s possible that you do lose money, especially short-term. No
denying that. But, that’s the reason why I want my business to be more
than a stock-picking service. If I get to know what’s important to each
client and help them set goals for their future, then I can help them set up a
plan to achieve them. The focus becomes achieving the returns that are
required by the client’s goals and making sure you’re not taking any more risk
than you must to achieve them. Short-term gains and losses, even for a
couple of years are irrelevant when you look at goal-based planning. Over
the medium and long term, exposure to the market will earn you money. And
in the meantime, you get all the other services like making sure you’re tax
efficient, getting your taxes done, knowing you’re insured for the case where
something terrible happens, having your 401k in the right place, etc.
I’m convinced this is the right model and that if everyone who didn’t have the
time and inclination to do this all themselves would find someone who can do it
for them, starting when they graduate from school, there would be a lot more
“financially independent” or “perpetually wealthy” people in the world.
Paying a few bucks each year to get back your life’s goals sounds like a pretty
good plan. That’s what I want to provide for people.
Feedback on this argument is welcome. My business depends partly on the fact
that I can make this clear to prospective clients. And I truly believe the
existence of my business will help each client be more successful, which is as
important to me as my own success.
Tom Nardozzi
President - Perpetual Wealth Advisors, L.L.C.
Tom Nardozzi is President and Founder of Perpetual Wealth Advisors, L.L.C. If you have questions or comments on this publication, please email tom.nardozzi@perpetualwealthadvisors.com or call 404-380-1977.