As financial advisors, we’re well aware that behavioral biases influence our clients’ decision making. However, it’s sometimes easy to forget that biases influence the consumption of financial planning services as well, which may have an impact on client satisfaction, retention, and our ability to grow and sustain our business.
In this guest post, Derek Tharp – our new Research Associate at Kitces.com, and a Ph.D. candidate in the financial planning program at Kansas State University – explores the “Bottom Dollar Effect” and its varying influence under different financial advisor business models.
The “Bottom Dollar Effect” refers to the tendency of consumers facing financial hardship to transfer negative emotions associated with their hardship onto the last few products or services that, at the margin, they perceive as straining their budget. The unfortunate consequence of this effect is that consumers may become dissatisfied with a purchase based not on their actual satisfaction with the goods or services purchased, but instead, on the timing of that purchase and the resources they happened to have available at that time.
Within the context of financial planning, various business models – from hourly or retainer fees, to charging on assets under management – possess different degrees of potential susceptibility to the Bottom Dollar Effect, driven primarily by the various “mental accounts” that client fees typically come out of. In addition to being highly salient and possessing some other negative behavioral characteristics, hourly fees are particularly prone to the Bottom Dollar Effect, as planning fees tend to be relatively large, irregular, and funded through current income (thus, more likely to strain a client’s budget). On the other hand, AUM fees have low susceptibility to the Bottom Dollar Effect, given that fees come out of a long-term mental account tied to a dedicated goal (retirement) that is insulated from current income fluctuations. Retainer fees vary in their susceptibility to the Bottom Dollar Effect based on their design, including especially their size relative to client’s income and net worth, and from what account(s) the fees are paid.
The fundamental point, though, is simply to understand that decisions about how to pay advisory fees are subject to behavioral biases as well, and those biases may influence both your ability to succeed as an advisor and your clients’ inclination to retain your services (particularly in bear markets, when they may need your help the most!). In order to maximize the chances of establishing a relationship that benefits both you and your clients long-term, behavioral biases – including the Bottom Dollar Effect – should not be ignored!