Asset-Based Fees

Private Wealth Management: Fee and Compensation Models

The private wealth management sector, known for its higher fees compared to retail banking, is a lucrative field for professionals. It’s essential for advisers to understand the regulatory mandates requiring detailed and regular disclosure of all fees to clients, especially considering the reporting rules in the countries where their clients reside.

A transparency shift is currently underway in the wealth management industry, led by new online wealth management firms that prioritize clear fee structures. This contrasts with traditional institutions, which may offer personalized services at higher fees but with less transparency.

Business Models and Industry Drivers

Understanding the revenue-generation capacity of a wealth management firm requires a comprehensive analysis of various factors. These factors extend beyond the current market conditions and include the firm’s business model, operating licenses, company size, geographical presence, and the efficiency and experience of its staff.

Revenue Categories

Revenues in a wealth management firm can be broadly divided into:

• Recurring: These are revenues generated from regular activities such as portfolio management, investment funds, custody, tax planning, and other service-related activities. For instance, a firm like Vanguard Group generates recurring revenue through its portfolio management services.
• Non-recurring: These are revenues that arise from life events or “one-off” events such as death, divorce, sale of business, etc. Special projects like bespoke analysis and reports requested by clients can also result in fees. For example, a firm like Goldman Sachs may charge for a bespoke investment strategy report.

Revenue Types

Revenues can also be classified as:

• Fixed Revenue: These include service fees charged on a periodic basis, like a monthly account maintenance fee.
• Variable Revenue: These typically include transaction fees or assets under management (AUM)–based fees. For example, a firm like BlackRock may charge a variable fee based on the AUM.

External Drivers Impacting Revenues: Industry Trends

• Global Capital Markets Connectivity:With the advent of globalization, capital markets worldwide are becoming increasingly interconnected. This has led to heightened market sensitivity to macroeconomic and geopolitical events. For instance, the Brexit vote in the UK had ripple effects on global markets. While this connectivity offers benefits like access to global opportunities, it also comes with costs such as increased asset sensitivity to geopolitical risks.

• Private Markets Investments: There’s a rising trend towards private markets investments like private equity, debt, real estate, or venture capital as alternative investments. These investments, like investing in a startup through venture capital, can provide diversification and a return premium due to their low liquidity. However, the impact of lower liquidity is a topic of debate. Some argue that infrequent valuations and low turnover make alternatives lower volatility choices, while others believe that less frequent valuation leads to less pricing information and unreliable volatility measurement.

• Technology adoption: such as robo-advisers and low-cost trading platforms, is on the rise. This could lead to lower client costs but also lower industry revenues. However, technology could also create opportunities for small investors to use wealth management firms for the first time, potentially raising industry revenues.

• ESG awareness: is becoming a crucial factor in portfolio management. However, ESG-related services are not costless to advisory firms. If costs related to providing the service cannot be passed to clients, they will compress net revenue.

The trends mentioned above, along with other factors, reflect the increasing intensity of competition in wealth management. Additional initiatives could further compress industry revenues.

Internal Drivers impacting revenues: Growth Strategies

Wealth management is a crucial aspect of financial planning that involves providing suitable investment products and services to clients while ensuring the firm’s profitability. There are four primary strategies that wealth management firms employ to increase their revenue.

• Increasing Returns on Client Portfolios: The first strategy involves enhancing the returns on client portfolios. Since a significant portion of fees in this industry is based on Assets Under Management (AUM), higher asset returns lead to increased assets and revenue. However, this strategy is subject to market fluctuations and may not be reliable in a competitive market.

• Increasing Fees: The second strategy is to increase fees. However, this is challenging in a competitive and transparent industry. Advisors with unique products or services may have more pricing power. For instance, advisors who specialize in managing discretionary accounts, which are less cost-sensitive, may have a higher ability to raise fees.

• Soliciting New Clients:The third strategy is to attract new clients. If the growth in clients leads to an increase in net assets, this should raise the firm’s revenue. However, it’s not feasible for most small to mid-sized firms to cater to all market segments. Therefore, it’s crucial for wealth management firms to focus on the relevant client segment and monitor the efficiency of their efforts.

• Client Retention: The fourth strategy is client retention. A strong focus on client retention can minimize AUM and revenue losses. This is a defensive strategy, but it’s good business practice as satisfied clients are more likely to stay with the firm and refer new business. Some firms use scorecards to monitor advisors’ effectiveness in adding and retaining clients, as well as success across products and market segments.

• Revenue Management Metrics:Two common metrics related to revenue management are Net New Money (NNM) and Net New Business Volume (NNBV). NNM focuses on bringing new client money to the firm, while NNBV captures the volume of new business across new and existing clients.

Pricing Strategies and Characteristics in Wealth Management

Understanding the pricing strategies and characteristics in wealth management is crucial for both wealth management firms and their clients. This involves understanding the types of fees, how they are applied, and the importance of transparency and updates.

For instance, a firm like Morgan Stanley aligns its pricing strategies with the price sensitivities of its clients. The pricing strategies revolve around fees which can be recurring like annual management fees or non-recurring like setup fees. These fees can be fixed or variable and can be bundled together or charged separately. For example, a firm may charge a fixed annual fee for managing a portfolio, but also charge a variable fee for any transactions made. Pricing consistency should be the norm at the firm level, with special pricing as occasional exceptions rather than a standard practice. In most markets, firms are legally bound to provide clients with transparency on how fees are assessed.

Types of Fees

Fees can be levied on most activities undertaken by a wealth management firm. While fees are often described as advisory fees or management fees, direct fees often take one of these forms:

• asset-based
• transaction-based
• interest- and margin-based
• service- and maintenance-based
• additional or supplementary

Certain indirect or hidden fees are applicable to each of those categories. For example, a firm like Goldman Sachs may charge an asset-based fee for managing a client’s portfolio, but also charge a transaction fee for any trades made on behalf of the client.

Transparency and Updates

Because no client likes to be surprised by unexpected fees, best practice requires active transparency and updating clients on changes to both direct and indirect fees. A fee schedule should be presented at the beginning of the client relationship and updated periodically, or when fees change. This is mandatory in many jurisdictions. Major costs associated with each service should be outlined clearly, either in a pricing brochure or in a formal agreement or both.

Asset-Based Fees

Asset-based fees are a common form of charges in the financial industry, particularly in wealth management and investment services. They are recurring fees calculated as a percentage of the total market value of a client’s assets. These fees are variable, provisioned daily, and typically invoiced on a quarterly basis.

Calculation of Asset-Based Fees

Asset-based fees are calculated using a fee rate, expressed in basis points, which is multiplied by the period-end value or the average value of client assets. The fee rate is often degressive, implying that as the value of the assets increases, the marginal fee for additional assets decreases. For instance, if a wealth management firm charges 1% (100 basis points) on a $1 million portfolio, the fee would be $10,000.

Types of Asset-Based Fees

• Custody Fees: These are charges for holding securities. Despite the administrative costs, these fees are significantly lower than asset management fees. For example, a bank may charge a small percentage for holding a client’s stock portfolio.
• Investment Mandate Fees: These are fees for managing a client’s investments. These fees are typically three to five times higher than custody fees. For instance, a financial advisor may charge a higher fee for actively managing a client’s investments.

Asset-Based Fees and Investment Funds

Asset-based fees are also applicable at the level of the underlying investment funds used in clients’ portfolios. These fees are sometimes expressed as the total expense ratio (TER), which reduces a fund’s return by the costs of running it. Firms may offer discounts at the investment mandate level to incentivize clients to use their proprietary products.

Role of Wealth Managers

Wealth managers play a crucial role in considering embedded costs in mutual funds/ETFs when constructing portfolios. The goal is to minimize the overall cost for the clients while maintaining returns. Many wealth managers are shifting to constructing portfolios using less ETFs instead of more expensive mutual funds if the performance is similar, especially in large liquid markets.

Transaction-Based Fees

Transaction-based fees are charges applied to client account transactions, often as a fixed amount or a percentage of the transaction value. These fees are common for securities, funds, structured products, fiduciary deposits, money market instruments, and securities delivery.

For example, buying shares of a company like Apple Inc. through a brokerage incurs transaction fees based on the shares’ total value. Similarly, investing in mutual funds may lead to fees based on the invested amount.

These fees often adjust based on transaction size and asset class, typically disclosed upfront by firms. While equity securities trading fees are usually transparent, fees related to other securities, like secondary market bonds, may require clearer communication to clients.

Investment funds may also entail additional fees such as management fees, subscription and redemption costs, or distributor fees. Alternative funds, like real estate funds, may incorporate premium or discount fees based on market demand.

Interest and Margin-Based Fees

Interest and margin-based fees are charges associated with lending programs. These fees are typically applied by financial intermediaries who possess a banking license or an equivalent, such as the ability to accept client deposits. The fees or margins are applied to various financial transactions including negative cash balances, mortgages, Lombard loans, and securities lending. For instance, a bank might charge a margin fee on a mortgage loan to a homebuyer.

Factors Influencing Margins

Several factors can influence the margins applied to financial transactions. These include:

• The size of the transaction: For example, a larger mortgage loan may have a different margin compared to a smaller one.
• The length of the engagement: A long-term loan may have a different margin compared to a short-term one.
• Prevailing interest rates: The current market interest rates can influence the margins. For instance, higher interest rates may lead to higher margins.
• Associated risks: The level of risk associated with the transaction can affect the margins. For example, a loan to a borrower with a poor credit history may have a higher margin.

Financial Intermediary’s Ability and Willingness to Lend

The ability of a financial intermediary to lend is directly linked to its financial strength, as indicated by the robustness of its balance sheet (capital requirements), and its risk appetite. Without a banking or equivalent license, wealth management firms cannot directly earn income from lending.

Client’s Borrowing Capacity and Lending Ratio

Before lending, substantial preliminary work is required to evaluate the client’s borrowing capacity, especially for mortgages. Lombard loans require an assessment of pledged portfolios and underlying securities to establish a suitable lending ratio.Lending activities can significantly boost revenues, potentially matching or even surpassing those from investment mandates.

Service and Maintenance Fees

Service and maintenance fees are fixed charges that are either recurring or one-time, associated with the upkeep and functionalities of an account. These fees encompass a range of costs such as administrative fees, charges for payments and transfers, fees for initiating new services like loans or mortgages, and costs for mail, checks, and safe deposit boxes.

Unlike asset management fees, these charges are not tied to the size of the asset but are instead based on the volume of transactions or the number of payments made. Minimum fees may be applied to client accounts, and these can either have a cap or be uncapped.

In specific scenarios, such as account closure, wealth management firms may levy substantial closing fees and high charges for transferring stock market securities. These fees are occasionally waived by the client’s new bank as a gesture of goodwill.

Additional Fees and Client Acquisition

In the realm of private wealth management, additional fees often arise from services that are not directly related to portfolio management. These can include services such as accounting, taxation, legal support, or operational and technological support like the distribution of portfolio data. For instance, a client may require legal advice for estate planning, which would involve hiring a lawyer whose fees are not part of the traditional wealth management offering.

Additional fees also apply for held-away assets that are not directly custodied and related assets under advisory. These assets can be diversified across different financial intermediaries, digital platforms, or even non-liquid assets like art collections. Dedicated providers offer both consolidation services and overall portfolio analysis for these assets, which can also incur additional costs.

These additional fees can generate remarkably high expenses for clients, particularly when specialists with significant hourly rates are involved. For instance, lawyers’ fees can escalate in the face of complex, lengthy succession planning.

New clients can be obtained via digital channels, or thanks to the public recognizing the expertise of a specific wealth manager, or in response to the outstanding reputation of a wealth management firm. They can also be brought in by introducers, who can be remunerated based on either new Assets Under Management (AUM) or the revenue generated.

Compensation Structure for Wealth Managers

The compensation structure for wealth managers is a complex system influenced by a multitude of factors. These factors include the firm’s structure, which could be either public or private ownership, the size of the firm, its global presence, the complexity of its business model, and its annual financial performance. For instance, a wealth manager at a large, publicly traded firm like J.P. Morgan might have a different compensation structure than a wealth manager at a smaller, privately owned firm.

While the compensation structure is influenced by various factors, the primary determinant is the net revenue generated by the manager for the firm. This emphasizes the importance of the wealth manager’s role in contributing to the firm’s financial performance. For example, if a wealth manager at Goldman Sachs generates a high net revenue, their compensation would likely be higher.

Key Performance Indicators (KPIs) and Key Risk Indicators (KRIs)

The final remuneration package of a wealth manager is also determined by adherence to criteria around key risk indicators (KRIs) and key performance indicators (KPIs). These are important metrics that measure the performance and risk associated with the wealth manager’s activities.

Wealth Manager Remuneration Models

The compensation structure for wealth managers is crucial as it often begins even before the start of employment, typically in the form of a welcome bonus. This bonus can be part of the manager’s remuneration package or it can serve as compensation for a bonus forfeited from the previous employer.

Components of Remuneration

The remuneration of a wealth manager usually consists of four elements:

• Fixed Salary: This is a base salary that is paid throughout the year. For example, a wealth manager at a top-tier bank might have a fixed salary of $100,000 per year.
• Variable Remuneration: This is often performance-based and is commonly referred to as “the bonus”. For instance, if a wealth manager exceeds their targets, they might receive a bonus of 20% of their base salary.
• Long-term Incentives: These could be deferred payments that vest and are payable over a period of one to five years. Continuation of employment with the firm is typically a requirement for these incentives.
• Deferred Pay or Equity Participation: A portion of the deferred amount may be in the form of stock shares, especially for publicly traded firms. For example, a wealth manager might receive $10,000 worth of company shares as part of their remuneration package.
• Fringe Benefits: These are additional benefits provided by the employer, such as health insurance or a company car.

The combination of these benefits can vary significantly from one firm to another and even within the same firm, depending on the employee’s role and experience. Many firms focus on total compensation when recruiting new employees or communicating annual amounts to employees.

Fixed Remuneration

Fixed remuneration, also known as a fixed salary, is a crucial aspect of employee compensation. It is determined by a combination of employee-specific and firm-specific factors. For instance, an employee’s role, experience, and network, along with their educational background and industry tenure, significantly influence their fixed salary. Similarly, the size and compensation structure of the firm also play a vital role.

Traditional firms that prioritize client retention may structure their compensation with a larger fixed component and a smaller variable component. The effectiveness of in-person interaction and the perceived ability of wealth managers to retain and attract clients also impact fixed remuneration. In partnership firms, the fixed compensation may be minimal, with variable pay linked to the firm’s financial performance.

Variable Remuneration in Wealth Management

Variable remuneration is a crucial aspect of compensation for wealth managers, typically comprising an annual bonus. This bonus is a recognition of the contributions made to the earnings of the previous year. While bonuses are usually paid in full, a portion might be held back for future distribution. Variable compensation, including bonuses, can be risk-adjusted, particularly for senior roles or in response to local regulations. Claw-back provisions can be invoked to withhold or rescind variable compensation in cases of misconduct.

Levels of Determining Variable Remuneration

Variable remuneration is determined at three distinct levels: the firm, the department, and the individual. At the firm level, remuneration is influenced by the overall financial performance, taking into account both profitable and challenging years. The firm’s culture around growth and risk appetite can also have a significant impact. For instance, a company like Goldman Sachs might have a different approach to variable remuneration compared to a smaller, more conservative firm.

At the department level, remuneration is linked to the team’s performance, efficiency, and growth in the respective region or client type. For example, the financial results of the Latin American team at JP Morgan may differ significantly from the Middle East and North Africa team at Citigroup.

At the individual level, the performance of the wealth manager greatly affects variable remuneration. Their results can be based on the number of accounts under a discretionary or advisory mandate, along with the associated profitability, the net new business volume acquired over the calendar year, and how well margins on client relationships are maintained.

Profit-Sharing Remuneration Models

Profit-sharing remuneration models show relationship managers retaining up to a third of the income produced from their clients’ portfolios. This proportion could be higher in smaller structures with less overhead and fixed costs, reaching up to two-thirds of the generated income.

Legal Requirements for Variable Compensation

Variable compensation must comply with internal and external legal requirements. In some jurisdictions or at some firms, there may be a limit on the ratio of fixed-to-variable compensation in order to balance incentives for advisers to perform core duties well, with creating incentives to expand business and revenues. In the European Union and the United Kingdom, the pay of those who are in senior roles and are deemed to be material risk takers (MRTs) may be subject to additional regulation.

Long-Term Incentives, Deferred Pay, or Equity Participation

Senior relationship managers, such as those at multinational corporations like Apple or Google, often receive equity or stock ownership as part of their compensation. This strategy is designed to retain key personnel and foster loyalty. Long-term incentive plans (LTIPs) are commonly used for this purpose. These plans typically include vesting periods, requiring the manager to remain with the company to fully benefit. After three to five years, a portion of the accrued benefits are distributed as registered shares or cash payments.

Fringe Benefits

Compensation models in wealth management, such as those at firms like Goldman Sachs or J.P. Morgan, vary due to differences in growth models and risk appetite. However, portfolio size and profitability often indicate the total compensation package. Fringe benefits can include insurance packages and retirement perks. Special pension categories for senior managers and preferential terms like reduced mortgage rates may be offered. Other non-financial benefits may include access to exclusive training and recognition programs.

Professional Conduct

Regardless of the compensation model, wealth management firms and relationship managers, like those at Merrill Lynch or Morgan Stanley, must serve clients impartially. They must adhere to transparency and disclosure requirements, and apply the relevant sections of the CFA Code of Ethics and Standards of Professional Conduct.

Practice Questions

Question 1: In the private wealth management sector, it is essential for professionals to understand the fee and compensation models that are prevalent. This sector is known for its higher fees compared to retail banking, which results in increased revenue for professionals. However, regulatory mandates require detailed and regular disclosure of all fees to clients, especially considering the reporting rules in the countries where their clients reside. The industry is currently experiencing a shift towards transparency, led by new online wealth management firms that prioritize clear fee structures. This is in contrast to traditional institutions that may offer personalized services at higher fees but with less transparency. which of the following statements is correct?

1. Traditional institutions in the wealth management sector are leading the shift towards transparency in fee structures.
2. Regulatory mandates in the private wealth management sector do not require detailed and regular disclosure of all fees to clients.
3. New online wealth management firms are leading the shift towards transparency in fee structures.

Answer: Choice C is correct.

New online wealth management firms are leading the shift towards transparency in fee structures. The passage clearly states that the industry is currently experiencing a shift towards transparency, led by new online wealth management firms that prioritize clear fee structures. These firms are leveraging technology to provide more transparent and cost-effective services to their clients. They are disrupting the traditional wealth management sector by offering lower fees and more transparent pricing models. This is in contrast to traditional institutions that may offer personalized services at higher fees but with less transparency. Therefore, it is clear that new online wealth management firms are at the forefront of this shift towards transparency in the industry.

Choice A is incorrect. The passage does not suggest that traditional institutions in the wealth management sector are leading the shift towards transparency in fee structures. In fact, it states the opposite, that these institutions may offer personalized services at higher fees but with less transparency. Therefore, it is incorrect to say that traditional institutions are leading this shift.

Choice B is incorrect. The passage clearly states that regulatory mandates require detailed and regular disclosure of all fees to clients. This is a key aspect of the regulatory environment in the private wealth management sector, aimed at protecting clients and ensuring fair practices. Therefore, it is incorrect to say that these mandates do not require detailed and regular disclosure of all fees.

Question 2: A wealth management firm is evaluating its revenue structure. Currently, the firm charges a fixed service fee on a periodic basis. However, it is considering introducing transaction fees or assets under management (AUM)–based fees, which would vary depending on the client’s AUM. Which of the following changes is the firm considering?

1. Shifting from non-recurring to recurring revenue
2. Shifting from variable to fixed revenue
3. Shifting from fixed to variable revenue

Answer: Choice C is correct.

The wealth management firm is considering shifting from fixed to variable revenue. Currently, the firm charges a fixed service fee on a periodic basis. This is a fixed revenue model because the firm earns the same amount regardless of the client’s assets under management (AUM) or the number of transactions the client makes. However, the firm is considering introducing transaction fees or AUM-based fees. These fees would vary depending on the client’s AUM or the number of transactions, making them a variable revenue source. Variable revenue fluctuates based on the volume of business activity. In this case, the more assets a client has under management or the more transactions a client makes, the more revenue the firm would generate. This shift would allow the firm to potentially earn more revenue if its clients have large AUM or make many transactions, but it also introduces more uncertainty into the firm’s revenue stream because it would now depend on the clients’ activity.

Choice A is incorrect. The firm is not considering shifting from non-recurring to recurring revenue. Recurring revenue is the portion of a company’s revenue that is expected to continue in the future, while non-recurring revenue is one-time revenue. Both fixed service fees and transaction or AUM-based fees can be recurring, depending on the frequency of billing and client activity.

Choice B is incorrect. The firm is not considering shifting from variable to fixed revenue. In fact, it is considering the opposite: shifting from a fixed revenue model (fixed service fees) to a variable revenue model (transaction or AUM-based fees).

Glossary

• Transparency Shift: Trend towards clearer disclosure of fees in finance.
• Assets Under Management (AUM): Total value of investments managed for clients.
• Global Capital Markets: Marketplace for securities and fund-raising.
• Private Markets Investments: Investments in private equity, debt, real estate, or venture capital.
• Net New Money (NNM): Net assets acquired by a firm from new and existing clients.

Private Wealth Pathway Volume 1: Learning Module 1: The Private Wealth Management Industry;

LOS 1(b): Discuss typical fee, revenue, and compensation structures prevalent in the private wealth management industry