Imagine for a moment that financial advisers and wealth managers were paid based on their performance. What if they couldn’t make money unless they made money for their clients?
Lonnie Rush had enough faith in his own abilities to try. He’s the president and chief executive of Rush Capital Management and the managing partner of RCM Partners Fund.
In his limited partnership fund, he gets nothing in a given year until his investor-partners earn 6 percent. After that, he gets 25 percent of any profits, and the partners split the remaining 75 percent.
Rush is a rare bird in the investing world. People who manage other people’s money are paid either a flat fee or a slice of the wealth under their care, typically 1 or 2 percent a year. But as the economy tries to regain its footing after a sharp fall in 2008, more advisers and managers are willing to look at new forms of compensation. Or, in the case of Rush, an old form.
“I can’t take credit for it. I lifted it off of none other than Warren Buffett,” Rush says. “Buffet despised the financial industry and how they charged investors for not making money.”
In college, Rush investigated the partnerships that Buffett had set up in the 1950s with friends and family members. They were structured so that for Buffett to do well, his investment partners also had to do well.
“There’s a second fold to this, which is key: To keep expenses down, not only do you have to keep the pay down for the manager, you have to keep the pay down in terms of all the overhead,” Rush says. Any rent, research, equipment or labor comes out of his own pocket rather than the partners. If he has to travel to Chicago to poke around a company and talk to people, it’s on his own dime.
“Unless you have an incentive structure that keeps expenses down, you are likely to underperform the market over time,” he says. In fact, expenses are one of the reasons that 80 percent of mutual funds are underperforming in the market over the long term, he says, rather than the 50 percent one might expect.
That helps explain why Rush works out of his Folsom home instead of an office tower.
He knew he was taking a risk. What Rush didn’t know was that his timing couldn’t have been worse. He’d been investing on the side while working full-time as director of grid operations for the California Independent System Operator, which manages about 80 percent of the electrical grid in California.
“I left the California ISO in late 2007 to launch this partnership, which went live Jan. 1 2008,” he says.
At that point, the Dow Jones industrial average was 13,264.8, or about 93 percent of its all-time high. It would close the year at 8,776.3, having lost almost a third of its value.
Rush says he outperformed the market, in the sense that his picks didn’t lose as much value. But they still lost money, and he didn’t earn a penny on them in 2008. Fortunately, following the advice given to many startups, he had socked away enough savings to withstand a long dry spell at the beginning.
“If I am not making money for my partners over a three- to five-year period, something is wrong. I probably shouldn’t be in business,” he says.
In 2009, the market roared back, the Dow ending the year at 10,428. Rush says he “really outperformed the market” this time, and he’s getting paid for his performance.
Less than 1 percent of funds are run this way, Rush says. Even some other people he knows who have set up similar structures still take something — maybe 1 percent plus 20 percent of the profits rather than his formula of 0 and 25.
Rush says it’s easy for him to sleep at night with his arrangement.
“My wife and I happen to be the biggest investors of my own fund. Anything I do to my partners, I do to myself,” he says. But plenty of other financial managers and planners seem to be sleeping just as well with business as usual. And why not? They are making money.
Sometimes a big shift in the market justifies a change in approach, says Chase Armer, a certified financial planner with Planned Solutions Inc. in Sacramento, and president of the Financial Planning Association of Northern California.
One of those times was when the tech bubble burst in 2000. As tech stocks fell, real estate held strong. Some planners at that time chose to switch their compensation model from a percentage of assets under management to a percentage of the client’s net worth.
In the current recession, when real estate and stocks took a dive, there was little incentive to shift to a new approach.
“I think some people are going more to flat fee or hourly, but I don’t see that being a huge trend,” Armer says. “The planners that did well before this are still doing OK. The planners who were not doing well are doing poorly or have left the business.”
The fallout from the fraud committed by financier Bernard Madoff hasn’t prompted many clients to take a harder look at what they are paying for, Armer says, or how they are paying for it.
“The reality is there is not one absolute best way for the fees to be structured.”
Mel Marten, president, ClaroConnect
“With our existing clients, generally we have had such long relationships with them that even if they see it in the news, they aren’t worried,” Armer says, though some new clients do need additional reassurances.
“I think the sad thing is the clients don’t understand the difference between how Madoff worked and how the average financial planners worked, so they don’t even know what questions to ask to screen them,” Armer says.
In fact, most clients aren’t able to differentiate between a registered investment adviser and a stockbroker, says Michael Genovese, a partner in Sacramento wealth management firm Genovese, Burford & Brothers, and he’s not happy about that.
When people are putting more than $1 million into someone else’s hands to manage, they should ask questions and they should negotiate the compensation, he says.
“Clearly, money talks. Our fee schedule is a progressive one: The higher the value of the portfolio, the lower the percentage is,” he says. “There are all types of arrangements out there. I think the client and the adviser need to come to terms that work on both sides of the aisle.”
When the client has more than $5 million to manage, his firm negotiates a fee that deviates from the typical schedule entirely. In the past half-dozen years, Genovese’s firm has gone to some of its larger retirement plan clients and voluntarily lowered the compensation, locking in the arrangement for a few years and then opening it again to renegotiation.
“Part of it is that plans get a lot of contributions. At some point, it is very hard to look somebody in the eye and say, ‘We can justify you paying us a quarter of a million dollars for running your retirement plan.’”
It’s not pure altruism. Like Rush, Genovese’s firm has held a lid on its overhead as a way of maximizing income. It owns its building near Cal Expo and doesn’t have to support a big staff in New York or train new recruits. And as an independent firm, Genovese and his partners also don’t have to split their compensation with a larger firm.
“Merrill Lynch is selling XYX Fund company, [and] we are putting the same thing on the table. The compensation for both is going to be the same,” Genovese says. But Genovese keeps 95 percent of any commission, while a competing broker might have to give up 60 percent to his employer.
Compensation plans are generating a lot of discussion among financial advisers, says Mel Marten, president of ClaroConnect, a firm in South Florida that matches individual wealthy investors with financial advisers across the country.
“The reality is there is not one absolute best way for the fees to be structured,” he says. A simple buy-and-hold portfolio might be best handled on a straight commission. A complex portfolio might justify a percentage arrangement.
These days, clients investing $500,000 or more have room to negotiate, Marten says. More firms are taking the sliding-scale approach that Genovese uses, taking a smaller percentage on larger portfolios.
The federal government is paying more attention too, Marten says. “Congress is right now debating laws to increase regulation of the industry, and they may even increase regulation of the type and level of actual fees,” he says. Last November, Sen. Christopher Dodd, a Democrat, introduced the Restoring American Financial Stability Act of 2009 to Congress.
Another approach to compensation is to charge by complexity rather than size. One proponent is Bluemont Capital Advisors, an investment advisory firm in Great Falls, Va.
Usually, larger clients pay a smaller percentage. But if the adviser is doing the same work on a $1 million portfolio that she is doing on a $100,000 portfolio, why should the smaller client be penalized, asks Carolyn Stys, Bluemont’s president.
“If it is a situation where I might have to go out and look at hedge funds for part of the account, it gets more complex and time consuming. For that larger portfolio and increased complexity, I don’t want to base my fee just on the size of the assets,” she says.
In some cases her firm gives a break to clients who have simple needs now, such as a 401K or IRA and a brokerage portfolio, but expect life to get complex down the road. Some might have to liquidate real estate in four or five years to send their kids to college, for example. That’s when the higher fees might kick in.
Referrals have been huge, Stys says, mentioning a client who is an airline pilot.
“If she is sitting in the cockpit and talking about us, that’s great,” she says.
A common thread running through the alternative pricing structures for Rush, Genovese and Bluemont is that clients end up paying less than they would have with other firms, according to the company’s principals.
The trend that may have the biggest effect on fees is that more advisers are leaving the large wire houses to start independent firms, says Marten. On their own, they’ll have more freedom to get creative with fee structures. Nationwide, brokers leaving major firms took an estimated $188 billion in client accounts with them in 2009, according to Cerulli Associates, a Boston research firm.
For the client, he says, there is more scrutiny. People are getting second opinions before handing over their savings, and fighting harder for a deal on fees.
Finance is one of the few areas of life where you pay for something knowing that you might not get something in return. Now the trends may be bringing finance more in line with the rest of the world.
Michelle Christison knows what successful family communication looks like when it comes to wealth transfer issues. A potential client approached her with a problem — she had money she didn’t need.
On the list of problems everyone should have, deciding how to pay a financial adviser is near the top, just below picking a Porsche mechanic and choosing between Hawaii and Barbados for vacation.