Many UHNW individuals are and can be confused about the array of business models pitching for their business. This article - the first of a five-part series - explores the terrain.
The agency dilemma
All financial advice has some inherent conflict of interest. Any form of compensation for the advice creates some level of self-interest and is unavoidable. However, clients can be better informed of their advisor’s objectivity, how their firms’ incentives effect their behavior and objectivity, and the potential for conflicts of interest when they render advice. Understanding agency theory can illuminate some distinctions between the various business models.
Agency theory is a management and economic theory that assumes both a principal and an agent are inherently motivated by self-interest. The predominant academic focus has been on the economic incentives and accountability frameworks between parties where the duty of an agent is to avoid conflicts of interests or the temptation of a potential conflict of interest when representing another party's interests.
When we apply agency theory to financial advice or wealth management, one reaches a simple interpretation - any financial adviser has a duty to disclaim and disclose all conflicts of interest to a client notwithstanding the interest of their firm or their affiliation to a parent company acting as a principal. This “agency dilemma” is at the heart of a pronounced shift in wealth management demand as the so-called fiduciary standard debate pits various corporate (i.e. principal) interests against a broadly applied fiduciary standard in the conduct of an advisor-client relationship.
Keep in mind, broker dealers who operate under selling agreements with asset management companies are distribution agents for another third party. Their agency duty is to a manufacturer (internal or external asset management firm). Selling agreements between manufacturers and distributors are not on their face wrong, but they are wrong when they’re non-transparent and/or where firm representatives intentionally mislead clients that they are acting as a client’s agent by calling themselves an “advisor” or other like-kind term that implies impartiality when in fact they are salesmen acting as distribution agents for a manufacturer of a product.
Despite recent efforts by the Department of Labor (DOL) in its jurisdiction over retirement plans and the Securities and Exchange Commission (SEC) pursuant to “Dodd-Frank,” the fiduciary standard issue has not been settled and can be expected to be debated for the foreseeable future. Certainly, “harmonizing” the application of a fiduciary standard across various business models appears unlikely.
Regardless of the regulatory outcome, the debate between various financial institutions has raised the issue as a matter of public discourse for investors. Clients are beginning to ask questions about their advisors’ alignment of interest with their own interests and about their advisors’ compensation systems and the incentives that those systems create.
The current focus on conflicts of interests and their disclosure can only be expected to increase. It will be arguably the fulcrum of client demand in the near future as clients become better informed and transparency in the information age becomes a sine qua non. While it is very hard to legislate ethics, with more information consumers have the power to force change.
In this context of the agency dilemma, who are clients to trust? "Trusted” means different things to different clients. Some clients view “trusted” with an emphasis on conflicts. Other clients view “trusted” as meaning an advisor who is candid and transparent and in practice puts the client’s interest before his/her own. There are some teams even at the most product-centric firms who do this and their clients are quite happy with them, despite the fact that there are real potential conflicts. Clients with these advisors value the advice they receive and are comfortable with the potential conflicts, either because they trust their advisors and/or they feel like they know about and can assess the advice they receive despite the conflicts.
While we have endeavored to define wealth management and apply the definition to the ultra-high net worth client segment, the term remains confusing for even the most discerning families.
Families tend to work with wealth management advisors for a host of reasons best summarized as relationship good will and not because they’ve examined each of the business models. They are too often ill-equipped to compare and contrast the various firm approaches and service capabilities.
With the above as context, in the next four parts, we will describe each of the four business models independently and offer observations on their respective advantages and limitations so that families can better understand the various business models and service platforms and thereby better put into context and assess what they read and hear.
1, While pursuant to the Investment Adviser’s Act both firms and individuals can be advisers, we use the term advisor.
2, For 2018, the exemption limit rose to $11.18 million per individual and $22.36 million per married couple. For 2019, an inflation adjustment lifts it to $11.4 million per individual and $22.8 million per couple. The increase in the exemption is set to lapse after 2025 reverting to its 2017 level of $5.49 million (plus an inflation adjustment).
3, Wealth-X and Deloitte define UHNW as $30 million. BCG uses a household definition of $100mm liquid net worth.