AUM-Based Compensation and Financial Advice

Abstract

Usually financial advisers are paid primarily or entirely according to the value of the assets they manage, that is, the assets under management (AUM). Increasingly, they have a fiduciary duty and use AUM-based fees. This compensation model results in an incentive to maximize AUM, which is widely considered to be a desirable feature. This article examines a class of situations in which that incentive may cause a conflict of interest and lead to advice, or the lack of advice, that is not in the clients’ best interests. Advisers have an incentive to avoid recommending actions that would decrease their AUM. The Securities and Exchange Commission (SEC) relies on an outmoded economic model that views disclosure as an adequate remedy to conflicts of interest. However, the SEC does not require disclosure of the types of conflicts discussed here. This article examines alternative compensation models, such as by the hour. Recognizing that information and the ability to process it are scarce and valuable resources, a more efficient use of resources may be to provide specialization in financial literacy through advisers, rather than to expect widespread financial literacy, at least in some areas. Changing the way the SEC regulates financial advice could improve that approach. This article examines effects of the new SEC rules in those types of situations. Changes in the SEC regulatory approach are recommended.

TOPICS: Long-term/retirement investing, pension funds, retirement, social security, wealth management

Key Findings

• • Financial advisers’ AUM-based compensation may affect the advice they provide if it concerns the scope of assets they manage; for example, a failure to advise beneficial options that would result in reducing the adviser’s AUM.

• • The AUM-based model of adviser compensation may not result in the best advice concerning the payout phase.

• • It may be more efficient for financial literacy to be a specialized skill in some areas, such as pension investing, but clients who are not financially literate may not be able to evaluate whether they are receiving good advice.