May 2, 2013

The AdvisorAssist CCO Series: Advisory Fees & Compensation

Advisors are becoming more innovative with how they set prices for their services and how they derive revenue for their businesses. Likewise, high net worth investors have become more discerning about the fees they pay and the services they receive.

As RIA compensation models become more dynamic, so to do compensation disclosures and the business practices that support them.

Advisory Fees & Compensation In a Nutshell

Advisory fees and compensation models (or more generally, the "cost of advice") continue to garner heightened attention from clients, advisors and regulators. Below we cover the major topics related to disclosures and best practices for advisory fees and advisor compensation.

Types of Fees
Advisory fees may be structured as asset-based (basis points), hourly (e.g. time spent producing a financial plan), or fixed (project or time-based fee for service.)

Some advisors may also assess a performance fee. Performance fees are usually a fixed percentage that is charged, subject to the advisor achieving or exceeding a predetermined performance bogey. Examples of this include: exceeding a benchmark return, exceeding a fixed hurdle rate of return, or in some cases, absolute return where the performance fee is based on all positive returns. Performance fees are usually subject to a high water mark, where the client only pays performance fees on gains that exceed their initial capital commitment.

Other Compensation
Many RIA firms have additional sources of compensation, which may include commissions on securities trading, insurance or annuity sales. These compensation sources are disclosed to clients separately, as is the financial affiliations (IBD, insurance agency) that exist to allow for them.

If your firm receives fees for referring advisory clients to third parties (law firms, accounting firms, money managers) this must also be disclosed in your Form ADV.

If any of your IARs receive compensation from outside business activities, this must be disclosed as well. Even if it is nominal, advisory clients deserve clarity with respect to all compensation sources so that they can appropriately assess any conflicts of interest or external time commitments you may have.

Disclosure
All of your advisory fee arrangements should be laid out in Item 5 of Form ADV Part 2A, including a clear connection between each fee schedule and the services you offer in Item 4. Assuming you disclose your fees as negotiable, these schedules represent your firm's high-water mark for client fees.

Fees and compensation represent the most likely sources for conflicts of interest, and therefore will remain a perennial priority for regulatory scrutiny.

Your ADV should address conflicts of interest that arise from any compensation sources. These commonly include conflicts based on commissions received for the sale of securities or insurance or payments from product sponsors. If you charge performance fees on some (but not all) accounts, you should disclose the conflict that stems from side-by-side management and address how you mitigate this conflict.

These disclosures are all about providing transparency, yet we frequently hear advisors say that their clients are not likely to read their firm's Form ADV. Some private sector companies have set out to change this by making these regulator-designed forms more accessible to the general public. The founders of Brightscope are the most recent example of these efforts. Their recent announcement that they will be publishing RIA's ADV-reported fees, while seen as controversial to some, is the latest evidence that the industry's momentum towards heightened transparency continues unabated.

Fee Billing Calculation Method(s)
Your clients should be able to easily discern how fees are calculated, invoiced and paid. Your ADV language will therefore include details about quarterly vs. monthly calculations, arrears vs. advance payments, as well an explanation of the basis upon which asset-based fees are determined.

You should also explain how you treat fees for partial periods, including prorating partial periods or rebating fees in circumstances where you bill in advance.

For hourly or fixed fees, you should include a description of how these amounts are determined (or estimated) and when clients can expect to be invoiced for them.

Through the Regulator's Eyes

As an RIA firm, your regulatory obligations with respect to advisory fees are to:
  1. charge reasonable fees;
  2. disclose them; and
  3. reimburse clients for any unearned fees.
Regulator expectations here are pretty simple. They want your clients to see a clear, logical depiction of how you make money, what they should expect to pay, and what they receive in return for these fees.

CCO Best Practices for Advisory Fees & Compensation

  • From a pricing strategy perspective, conduct some research on how your fees (and services) compare with the other alternatives available to your prospects. Be wary of sticking with the "standard 1.00%" pricing approach. (Remember when 2/20 was the "standard" for hedge funds?)
  • Periodically conduct tests to confirm the accuracy and correctness of the advisory fees paid by your clients. This should include confirming consistency with client agreements and your firm's Form ADV Part 2.
  • Check your Form ADV to confirm that all compensation sources are disclosed, including those coming from outside business activities.
  • If your firm charges performance fees, ensure that your trade allocation procedures do not favor (or give the appearance of favoring) performance-based accounts.
  • If you are state-regulated, be sure that you are invoicing clients directly (even if you are paid directly from the custodian) and that those invoices include an explanation of how the fee was calculated.
  • Review your ADV Part 2A to see how your services and fees are described in Items 4 and 5, respectively. Confirm that each of your client fee arrangements are consistent with them.
  • Periodically review fees across your client base and confirm that there is a reasonable rationale for fee differences among clients that receive similar services. If you have two clients paying meaningfully different fees for identical service, consider closing these gaps.
  • If you require any client to prepay fees exceeding $500 and six or more months in advance, you will be obligated to provide an audited balance sheet to these clients at least annually and disclose this practice in your ADV.

The AdvisorAssist CCO Series is a collection of blog posts that cover each of the elements of your RIA's compliance program.  Each post will provide an overview of one compliance topic, including our insights on how regulators view each topic as well as some practical steps to help Chief Compliance Officers address this topic. As always, we would welcome your comments and thoughts.

Brian Lauzon

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