Advisors Blog Posts

Found 7 relevant result(s)


The 5th Circuit decision to vacate the DoL Fiduciary Rule (“Rule”) creates a dilemma for the Robo Advice arrangements that depend on the relief granted by that Rule.

Rolling back the Rule means that regulations revert to the 1975 rules[1]. Applying 1975 rules make virtually all Robo advisors to IRAs and defined contribution plans into fiduciaries, without the benefit of an exemption (since the Best Interest Contract Exemption also goes away).

It would appear that institutions that have created/acquired Robos will be unable to use these automated solutions for IRAs or DC Plans, without some additional exemption being created for them.

Presumably, the roll back would include the “no enforcement policy[2]”. Without that policy, Robos may not be permitted to operate.

Financial institutions and advisors must therefore make changes necessary to qualify for an existing exemption or seek a private exemption.

[1] In 1975, the Department issued a regulation, at 29 CFR 2510.3-21(c), defining the circumstances under which a person is treated as providing “investment advice” to an employee benefit plan within the meaning of section 3(21)(A)(ii) of ERISA (the “1975 regulation”), and the Department of the Treasury issued a virtually identical regulation under the Code.[15The regulation narrowed the scope of the statutory definition of fiduciary investment advice by creating a five-part test that must be satisfied before a person can be treated as rendering investment advice for a fee. Under the regulation, for advice to constitute “investment advice,” an adviser who is not a fiduciary under another provision of the statute must—(1) render advice as to the value of securities or other property, or make recommendations as to the advisability of investing in, purchasing, or selling securities or other property (2) on a regular basis (3) pursuant to a mutual agreement, arrangement, or understanding with the plan or a plan fiduciary that (4) the advice will serve as a primary basis for investment decisions with respect to plan assets, and that (5) the advice will be individualized based on the particular needs of the plan or IRA. The regulation provides that an adviser is a fiduciary with respect to any particular instance of advice only if he or she meets each and every element of the five-part test with respect to the particular advice recipient or plan at issue.

[2] FAB 2017-01…during the phased implementation period ending on January 1, 2018, the Department will not pursue claims against fiduciaries who are working diligently and in good faith to comply with the fiduciary duty rule and exemptions, or treat those fiduciaries as being in violation of the fiduciary duty rule and exemptions.

On March 28, 2017, the Treasury Department and the IRS issued IRS Announcement 2017-4 stating that the IRS will not apply § 4975 (which provides excise taxes relating to prohibited transactions) and related reporting obligations with respect to any transaction or agreement to which the Labor Department’s temporary enforcement policy described in FAB 2017-01, or other subsequent related enforcement guidance, would apply. The Treasury Department and the IRS have confirmed that, for purposes of applying IRS Announcement 2017-4, this FAB 2017-02 constitutes “other subsequent related enforcement guidance.”

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Cost Structures Needed for Advisors

In every other profession that serves the public the cost of delivering services is the gold standard for doing business. Health care costs are so compartmentalized that there are full time jobs to apply cost codes to every procedure. Attorneys, architects, educators and engineers all have cost structures for professional activities. These cost structures are by no means uniform but vary widely so clients can compare quality, convenience and cost.

Financial advisors do not need thousands of cost codes to manage their business but knowing what various professional services cost changes a primitive “pot luck” approach into a sustainable one. The knowledge of the cost of services enables the business owner to tailor services to a client’s budget and ensure ongoing profitability of the business. Cost structures also avoid the danger of unknowingly charging excessive fees and concerns of compensation disclosure. A cost structure provides a rational basis for selecting share classes that aligned with the services provided. (Fees can now be properly explained.)

Cost structures begin with an inventory of activities. The typical cost of performing each activity is then calculated, resulting in a menu of services that the advisor offers.

The inventory of activities contains all tasks that are performed in the business. Many of these are services to clients but many are not. Client services are those activities, where the value is immediately visible to clients. For example, client services may include activities such as:

  • Assess needs
  • Assess risk tolerances
  • Develop solutions
  • Create strategic asset allocation
  • Select investments
  • Make recommendations
  • Provide education
  • Monitor portfolio
  • Answer questions and concerns

Non-service activities include activities such as:

  • Client acquisition
  • Research
  • Compliance
  • Continuing education
  • Staff and management activities

Determining the cost of activities is the second step. This includes variable costs and allocation of fixed costs. Variable costs are determined by the resources expended on the activity. Resources include direct expenditures as well as the typical amount of time spent.

Variable costs can be shared by two or more activities. In this case, the variable cost is divided among the applicable activities. Typical variable costs are:

  • The value of time spent on the activity
  • Third parties paid to support a specific activity such as an estate planner or tax expert
  • Tools, subscriptions and services applicable to the activity(ies)

Fixed costs are those which apply to every activity. The business owner must decide on how the fixed costs are allocated to each activity. Typical fixed costs include:

  • Sales and marketing expenses
  • Office space, facilities and utilities
  • Equipment and communication
  • IT Services
  • Travel & Entertainment
  • Indirect employment expenses
  • Taxes
  • Profit

The result after creating a cost structure as described here is a menu of services that can be paid for in a number of ways… commissions, assets under management, flat fees, hourly rates, etc. The critical factor is knowing how much compensation is needed. The method of payment is secondary.

An advisor can use this information to prepare a cost statement that may be private or disclosed as the advisor sees fit. Such a cost statement would incorporate all the costs described here and might look like this:

The Service Cost Summary described here can also be used to create a blend of mutual fund share classes that properly pays the advisors cost of doing business. Take a situation where the foregoing example was the advisor’s cost and the advisor can use a blend of A, T and clean shares for a client’s portfolio. The objective is to use a blend that produces the compensation that covers the cost of servicing, including a desired margin of profit.

For our example, the client has a total of $500,000 to invest in mutual funds and requires only the following services:

Assess needs
Assess risk tolerances
Develop equity portfolio
Develop fixed income portfolio
Create strategic asset allocation
Select investments
Make recommendations
                Total Payout Required

A share class breakdown by assets produces this payout:





Payout @ 80%

A Shares (at breakpoint)




T Shares




Clean Shares








The total payout of $4,430 is within $100 of covering the advisor’s cost and profit. More assets would be allocated to A and T shares is more services were required.

 As this example shows, advisors can control payout to ensure that costs are covered without a compliance risk or threat of excessive fee litigation.

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Anatomy of Investor Returns

Investment returns have been simplistically reduced to a single percentage that disguises the incredibly complex issues that investors experience. This article is intended to shed some light on these complexities. It shows how deceptive the most frequently published investment returns are.

These complexities are presented in the form of a narrative of an investor, Harry, and his adventures with his retirement plan.

What happens to real people: Harry’s Story

A $500 payroll deduction is automatically put into Harry’s 401(k) each month. Unfortunately, this is $500 less to pay bills and for the essentials and pleasures of life. But this is worth it because it means a more comfortable retirement for Harry and his family when that time comes.

Harry’s monthly pay stub holds some good news.  The $500 deduction is a lot less painful because his employer sweetens the deal with an additional $250 plus there are no taxes withheld! The $500 payroll deduction instantly becomes a $750 contribution to Harry’s retirement, with no taxes taken out.

There is even more good news at the end of the quarter. Harry gets a statement showing his three monthly investments are now worth $2,350, but contributions only add up to $2,250! Another $100 appeared as though it was by magic.

Harry is also delighted to see on the statement that the markets had gone up by 10% in the quarter. Compare that to a CD that earned a measly 0.1%! That would explain the magical $100.

But wait a minute, 10% of $2,250 is $250. Why did Harry’s $2,250 only go up by $100?

Harry figured that this difference could amount to a great deal of money in 20 years when he retires so he was not happy and called the number on his statement for an explanation. Harry learned the important lesson that while the balance of $2,350 was his, other figures had nothing to do with his account.

The 10% return applied only to investments that were in place from the start of the quarter to the end of the quarter and since his came in at different times the magical money was not as much. Harry’s total contribution for the quarter would have to be made on the first day of the quarter for the entire 10% to apply. Even if Harry had the money, this day one investment could not be done due to constraints of the 401(k) plan. Harry concluded that the 10% really did not apply to his account, even though it was on his statement!

Additionally, Harry found from the friendly representative at the number on his statement that there were a number of other factors that were not shown which also lowered the magical figure. He was totally confused after learning that his money was allocated and not fully invested, that there were expenses not shown on his statement and that he was paying trading costs and fees that were only shown in legal disclosures.

The 10% return on his statement did not reflect the fact that only 65% of his account was invested in comparable stocks. The remaining 35% was held in low yielding bonds and in cash. This means that it would be impossible to earn the 10% on over one third of his money! The representative explained that this is done to limit his losses when the markets went down. Harry saw the benefit but still felt that the 10% on his statement was misleading. By this time Harry had been on the phone for half an hour and the representative was becoming less friendly.

Harry then tried to understand what the expenses were and why they were not shown on his statement. Harry was comfortable after learning that the expenses covered items like administrative costs, record keeping, managing investments and for the services of an advisor. He remained concerned that these expenses were not reflected in the 10% return shown on his statement. He asked the representative, “Why show the 10% if you know it is wrong?” The representative’s frustration was growing.

Harry was not giving up, he wanted to get the whole story so he asked about the trading costs. He immediately understood that there was buying and selling of investments and that commissions had to be paid when transactions occurred. Harry was becoming angry when he realized that these commissions were not reflected in the 10% on his statement! It is all the representative could do to calm Harry down. His concerns had grown to accusations of illegal activity!

Harry had to hear the end of this. What additional fees apply to his account that are not included in the elusive 10%? Harry learned that there were fees that apply if he were to take out a loan or had a personal hardship and had to withdraw some funds. Harry thought this unfair, but it would be his choice to take the loan or withdrawal.

Harry learned about something else that he thought would answer many of his concerns but there was yet another cost and burden on him. The representative described the self-directed brokerage account. This would mean that Harry need not use the low yielding investments if he chose not to. He could use very low expense investments like ETFs and Index funds. The trading commissions would be lower. Harry was not so happy to find that the self-directed brokerage meant just that, he would have to enter every investment himself and if he made a mistake it would be his loss. Furthermore, the cost of this type of account would exceed what Harry was currently paying. By now Harry and the representative had been on the phone for an hour and a half and both were totally stressed out.

Harry thanked the representative who had confused him and decided to be thankful for the magical $100 and forget about the possibility of earning any more.

Life went on for Harry until one statement showed that his balance was actually less than it was on the previous statement. By now Harry’s balance had grown to $50,000 on the previous statement and the new statement showed only $47,500. How was this possible? Harry had not withdrawn any money. In fact $2,250 was added to his account. To make matters worse, the market had gone down by 4% but Harry’s balance went down by 5%.

Harry again called the number on the statement and learned that the expenses, trading costs and fees were being incurred, even when Harry’s account was losing money.

What was Harry to do? By this time he realized that he was not earning as much as was possible but the taxes and penalties of withdrawing his money made it impractical… He was trapped!

Harry was now committed to avoiding future surprises. He wanted to understand what might be in store for him in the future. What if he changes jobs? What happens when he retires?

By this time Harry had become famous in the phone center. He had won the contest multiple times for time spent on the phone! But Harry remained undaunted.

Harry found that changing jobs could cost him money.

First was the “unvested” portion of his account that he would lose. At the time Harry made the inquiry, his unvested balance was $25,000. Yes, that was a nasty surprise that changing jobs would cost $25,000. But that’s not all. If Harry decided to take the money out of the old employer’s plan, he would owe taxes on that money plus a 10% penalty unless it was reinvested in 60 days.

The taxes and penalties could be avoided if the new employer permitted Harry to invest the money in the new employer’s plan. This is a great solution if the new employer’s plan is as good and cost no more than the old plan.

The other option is to shop for a “Rollover IRA”. Harry could transfer his plan money into this account, avoid the taxes and penalties and never have to worry about future job changes. The problem here, Harry found out is that these “Rollover IRAs” could cost as much as twice as much as the 401(k) plan.

Harry kept wondering, “When does all this end?” Unfortunately, the answer was “Not yet.”

When Harry decides to retire he will face a new set of issues. With some careful planning beforehand, Harry can avoid some of these.

The first problem Harry will face is taxes. As currently configured (the usual practice), Harry will owe taxes on every dollar he withdraws from his retirement plan. This is treated as ordinary income and is subject to withholding, just like his paycheck is. Ouch!

But there is an alternative that Harry can use to avoid this nasty retirement surprise. Instead of using a regular 401(k), Harry could use a Roth 401(k) if his employer offers it. With the Roth, Harry pays the taxes on the contributions and at retirement can withdraw the contributions and all the appreciation tax free. This is an attractive option if Harry is willing to pay the taxes along the way because all the growth (the magical money) is tax free!

The next problem is outliving his retirement funds. Surely, if Harry decides to spend like a drunken sailor after he retires, his funds won’t last very long. But even if Harry controls his spending, he could live to use up his entire account. In addition to controlled spending two other actions can help.

Harry can invest wisely so that his retirement funds continue to grow during his retirement years. This usually requires an investment strategy that is connected with the spending controls. Such an arrangement adjusts spending to what investments can sustain.

Another action is for Harry to create his personal pension plan that will continue to pay him for as long as he lives. This is called an annuity and is more expensive than the sustainable spending described above. However, it eliminates the risk of running out of funds.

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Response to Edesess Article Published in Advisor Perspectives

In response to article published on 10/09/2017: 

If this was a first offense and had no visibility, I would laugh it off as uninformed rambling. But this is not the first offense and the article has gained some credibility by being carried in a respected publication.

This is not a laughing matter, but a serious threat to all who seek to act in the best interest of investors.

The underlying premise of the article as carried in its headline is that “Investors do not underperform their investments”. The article promotes the notion that investor performance is as good as it can be and gives an absurd reason for any belief to the contrary… a fictional error in a DALBAR calculation.

All who champion the cause of improving investor returns must rise up to challenge this nonsensical conclusion and the preposterous and false argument on which it is based. The facts of underperformance are published on DALBAR’s Website, .

The conclusion that “Investors do not underperform their investments” flies in the face of the basics of mutual funds. These basics make it impossible for any more than 1% of investors to ever outperform an applicable index and causes the average investor to lag that index by several percentage points. The author and anyone who chooses to believe this absurd conclusion should understand the myriad of performance limiting factors that guarantees that over 99% of investors have and will underperform indices:

  • Non-uniform acquisition and withdrawal dates… performance is measured over specific time periods but investors transact on every business day
  • Sales charges (loads, 12-1 fees, redemption fees, etc.) are not included in the calculation of benchmark returns
  • Operating expenses that pay for the management, operations and distribution of investments are not factored
  • Portfolio trading costs that are incurred every time a fund buys or sells a security are absent from indices that trade “free”
  • Asset allocations into low performing asset classes such as cash and other defensive investments
  • Dividends and capital gains taken in cash are excluded since indices assume that all distributions are reinvested
  • Leakage from loans, margin interest, fees or other deductions never occur in an index
  • Opportunity cost of being out of the market during periods of appreciation is never experienced by an index which is assumed to always be fully “invested”
  • Investor trading activity ebbs and flows unlike an index that reflects a buy and hold posture
  • Psychological factors such as loss aversion, herding and excessive optimism do not influence the benchmarks
  • The irrational belief that higher prices (expenses) will yield better investments is derived from consumerism where the expectation is that prices in some way reflect value

The theory that most investors actually earn benchmark level returns is in contradiction to the fact that the balances in their individual accounts show underperformance.

If investors did earn index level returns, there would be no point in educating and advising them or creating solutions that improve performance. In other words, the work that the investment community and DALBAR have done to bring investor performance closer to index level returns would have been pointless since “investors do not underperform”. This supposition is contradicted by the fact that investor performance has significantly improved over the two decades since DALBAR’s analysis has been published.

Furthermore, there is the economic absurdity that the revenue generated within the financial community is created without a net loss of investor returns. Compensation received by the entire financial community is derived from investors.

Claiming to have discovered a (non-existent) calculation error in DALBAR’s methodology and blaming this for the general acceptance that investors underperform applicable indices is ridiculous on its face, in addition to being false.

The author goes on to accuse Morningstar of being a co-conspirator in this alleged massive fraud. Morningstar stands accused of quantifying one of the causes of investor underperformance. This implausible theory of a conspiracy underscores the absurdity of the article.

For the record, QAIB uses the actual balances in investor accounts each month to calculate investor profits or loss after all performance limiting factors are considered. This reflects the personal return that the average investor would see on a statement. Representations to the contrary are false. Additional research is used to identify solutions that reduce the underperformance. A compendium entitled Managing Investor Behavior that covers two decades of such solutions was recently published and is available from DALBAR.

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  • By Lou S. Harvey
  • |
  • 10/10/2017
  • |
  • 1
  • |
  • Categories: Advisors

What Advisors Want

You can tell a lot about advisor priorities by looking at the requests they make to the providers they partner with. DALBAR has monitored thousands of post-sale advisor interactions with financial services firms’ contact centers – here is a breakdown of the reason for their calls:

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  • By Brendan Yeager
  • |
  • 1/1/2017
  • |
  • 0
  • |
  • Categories: Advisors



The 21st century has seen an escalation in the focus on retirement adviser compensation coming from a plethora of lawsuits, new laws from Congress, Regulatory action and even the President promising to cut $17 billion from adviser’s pay.

This unprecedented activity has led many to conclude that compensation will be cut. The basis for all this activity is the firm belief that advisers are excessively compensated for the work they do. Such a belief may have been fueled by the high profile case of Bernie Madoff. 

While it is entirely possible that unreasonable and excessive compensation exists, it is unreasonable to expect that such excesses are widespread.

Unfortunately the hunt for unreasonable compensation is being fueled by advisers and advisory firms that fail to see the threat to their own existence. Instead many carry out this destructive behavior by lowering their own compensation in an imprudent effort to avoid possible penalties.

This paper is intended to inform and to limit the damage to advisers who perform at a high level for reasonable compensation.

Supporting this initiative to limit the damage to good advisers, is the unanimous 2010 Supreme Court decision that stipulates that reasonable compensation must be based on factors of value described in the Gartenberg Standard.

The Gartenberg Standard incorporates the varied relationships and arrangements that exist between advisers and clients,developed from decades of understanding client needs and situations and molded into a framework of regulation and enforcement.

The Court warned about the use of benchmarks to compare advisers, limiting such tools to “arm’s length benchmarks” that include only those arrangements derived from arm’s length bargaining. The Court ordered that even “arm’s length benchmarks” were unnecessary and only ancillary to the other Gartenberg factors.

BICE II(c)(2) The recommended transaction will not cause the Financial Institution, Adviser or their Affiliates or Related Entities to receive, directly or indirectly, compensation for their services that is in excess of reasonable compensation within the meaning of ERISA section 408(b)(2) and Code section 4975(d)(2).
ERISA 408(g)(1)(b)(3) (B) Any investment advice takes into account investment management and other fees and expenses attendant to the recommended investments;

ERISA 408(b)(2)(c)(1) (i) General. No contract or arrangement for services between a covered plan and a covered service provider, nor any extension or renewal, is reasonable within the meaning of section 408(b)(2) of the Act and paragraph (a)(2) of this section unless the requirements of this paragraph (c)(1) are satisfied.


The 21st century ushered in a witch hunt to find and punish advisers who take unfair advantage of consumers by charging unreasonable compensation. After three decades of largely failed efforts at pursuing fees charged by institutions, attention has turned to advisers.

There has been a history of success in reducing adviser compensation in the late 20th century. Of particular note are:

  • Deregulation of brokerage commissions 
  • The demise of contractual plans by requiring refunding of commission advances 
  • Cutting sales charges from 8.5% to 5% by the action of the self regulatory organization 
  • Reduction in retirement plan charges by the competitive onslaught of mutual funds 
  • Introduction of expense criteria in investment policy statements

Advisers are today faced with threats to retirement business from four directions:

  • Litigation from Retirement Investors 
  • Limitations of the Best Interest Contract Exemption (“BICE”)
  • Reasonableness requirements of the Pension Protection Act Exemption 408(g)
  • Fee Disclosure Regulation (ERISA 408(b)(2)

All of these seek to eradicate unreasonable fees, but it is the Supreme Court that provided the guidance of what a reasonable fee should be. It is up to the investment adviser community to adopt an appropriate standard of reasonableness that complies with this guidance.

Determining what is and is not reasonable for clients whose wealth ranges a thousand fold in a mosaic of relationships, services, products and compensation systems is complex. As the Court affirmed, simple comparisons of what others charge “are problematic because [they] may not be the product of negotiations conducted at arm's length”.

Assessment of reasonableness involves consideration of a host of factors that may be relevant to one situation but immaterial in another.

Answering these threats requires a course of action that recognizes and enhances the value that advisers provide so as to limit the exposure to massive compensation cuts.

2010 -JONES ET AL. v . HARRIS ASSOCIATES L. P. (a) A consensus has developed regarding the standard Gartenberg set forth over 25 years ago: The standard has been adopted by other federal courts, and the Securities and Exchange Commission’s regulations have recognized, and formalized, Gartenberglike factors.

The Guidance on Excessive Fees

In 2010 the US Supreme Court affirmed (Jones1) the historical standard for determining when investment related fees and expenses are excessive. The Court also added further guidance for lower courts to apply in judging whether compensation is excessive.

The affirmed standard are the Gartenberg Factors that require compensation be examined from multiple perspectives before a finding of excessiveness can be made, including at a minimum:

  • Services and Quality

    The nature, extent, and quality of the services to be provided by the investment adviser;

  • Adviser Performance

    the investment performance of the investment and the investment adviser;

  • Costs and Profits

    the costs of the services to be provided and profits to be realized by the investment adviser and its affiliates;

  • Economies of Scale

    the extent to which economies of scale would be realized as the investment grows and other circumstances increase efficiency;

  • Benefit to Investor

    whether fee levels reflect these economies of scale for the benefit of investors.

2010 -JONES ET AL. v . HARRIS ASSOCIATES L. P. “The essence of the test is whether or not under all the circumstances the transaction carries the earmarks of an arm’s length bargain. If it does not, equity will set it aside.” Gartenberg’s approach fully incorporates this understanding, insisting that all relevant circumstances be taken into account and using the range of fees that might result from arm’s-length bargaining as the benchmark for reviewing challenged fees

Conclusions of the Court

In its decision, the Supreme Court pointed out that in order to be excessive:

  • “…an investment adviser must charge a fee that is so disproportionately large that it bears no reasonable relationship to the services rendered and could not have been the product of arm's length bargaining."

The Court also warned against placing too much emphasis on a comparison of one advisory fee against fees charged to others by other advisers (Statistical benchmarks). The Supreme Court wrote:

  • "These comparisons are problematic because these fees, like those challenged, may not be the product of negotiations conducted at arm's length.”
  • and
  • “Gartenberg uses the range of fees that might result from arm’s length bargaining as the benchmark for reviewing challenged fees.”

Arm's Length
adj. the description of an agreement made by two parties freely and independently of each other, and without some special relationship, such as being a relative, having another deal on the side or one party having complete control of the other. It becomes important to determine if an agreement was freely entered into to show that the price, requirements, and other conditions were fair and real. Example: if a man sells property to his son the value set may not be the true value since it may not have been an "arm's length" transaction

DoL FAB 2007-01 With regard to the prudent selection of service providers generally, the Department has indicated that a fiduciary should engage in an objective process that is designed to elicit information necessary to assess the provider’s qualifications, quality of services offered and reasonableness of fees charged for the service.

Arm’s Length Benchmarks

The Supreme Court discouraged the use of benchmarks, ascribing only marginal usefulness to “arm’s length benchmarks” that excluded many adviser arrangements in the market today. This lay to waste benchmarks that contain arrangements between parties who:

  • Are family members
  • Are employer/employee
  • Have other material business relationship(s)
  • Have controlling influence (Superior/subordinate)
  • Have a significant knowledge advantage of the market
  • Engage in bartering in which goods or services are exchanged
  • Are referred in a quid pro quo arrangement
  • Use temporary low pricing to capture market share

These exclusions make the collection and calculation of “arm’s length benchmarks” difficult, expensive and unreliable.

The process is made difficult by the need to identify only those arrangements that are arm’s length. The existence of these exclusions may only be known to the parties involved.

The process is expensive due to the slow manual process required to select the arrangements that qualify as “arm’s length”. The results are likely to be unreliable for the reliance on a manual process and the relatively small sample that can be obtained by this means.

A further consideration is that “arm’s length benchmarks” can only be applied to arm’s length arrangements.

Why Regulators Pass the Buck

In considering regulation regarding fees, regulators have had to avoid being reversed in court, and in particular by the Jones and Gartenberg precedents. Regulations have therefore stayed away from defining what compensation is reasonable and therefore not excessive

While the DoL and IRS have both expressed support for considering compensation in all vendor selection, they have generally been silent on what specific methods would be acceptable.

Endorsing benchmark comparisons would also contradict the Supreme Court decision that limits the use to “arm’s length benchmarks”.

Product Dependency

Unlike products that are generally cut from the same mold, advisers have evolved to meet a non-homogenous mix of client needs, preferences, fears and desires. Compensation for advisers based on products that are in the client’s best interest will invariably yield over-compensation in some cases and under-compensation in others.

The imbedded compensation received from product manufacturers presents a further challenge to regulators seeking to curb excessive compensation.

The first issue is jurisdictional.

A dually registered adviser may be paid by an investment manager and insurance company for products held in a combination of taxable accounts, IRAs and ERISA plans. In this case the adviser may come under the Jurisdiction of the SEC, Finra and one or more insurance commissioners. The IRA business is in the jurisdiction of the IRS and ERISA is the responsibility of the Department of Labor.
So who will be holding the adviser accountable?

The second issue is complexity.

The payment of this compensation can take very intricate routes. Starting with the client the funds may come first to a broker/dealer, a bank for certain activities, an insurance agency or a payroll provider for payroll deductions. It may then flow to a number of product providers who distribute the funds as directed, including back to the broker/dealer.
Imagine trying to follow the money!

The third issue is conflicting laws.

This entangled system is further knotted up by the growing number of laws that sometimes contradict each other. The list of these are so long it would be impractical to attempt to list them here, but consider just the categories of State and Federal laws covering securities, insurance, taxes, money movements and consumer protection.
And excessive compensation could potentially violate any of them
The Gartenberg Standard cuts across these jurisdictions, complexities and laws to provide a rational way to assess reasonableness.

Why Rely on Gartenberg

Specifics of the case is fairly narrow but the principles of the Court’s decision have wide application.
These principles can be summarized as follows:

  • The reasonableness of Adviser’s compensation cannot be determined by a single measure but require at least the five considerations embodied in the Gartenberg Standard in addition to other relevant facts.
  • The compensation received by other advisers under similar circumstances may have no bearing on the reasonableness of another for several reasons, but in particular transactions are often not “arm’s length” and involve other relationships and services.

These principles guide regulators and courts and are applicable to individual clients as well as institutions and large investment pools.

The Gartenberg Standard also addresses the variation in the portfolio mix that an adviser’s client owns. Examining each adviser recognizes the difference in time and skill required to serve very simple portfolios (say indexed mutual funds) from portfolios that are more complex (with insurance products, alternative investments, etc.) as well as every possible combination. With Gartenberg, advisers with complex client portfolios are not penalized for the time it takes to serve them.

Employing these principles provides advisers with the greatest protection since they are based on a Supreme Court decision. In the event of a charge of excessive or unreasonable compensation the adviser can answer the plaintiff or regulator with a value argument. The value provided by the adviser is represented in the Gartenberg Standard which can often be demonstrated to exceed the compensation that the adviser receives.

Operating outside of these principles exposes advisers to excessive compensation penalties, regardless of other regulatory compliance. If a client should suffer a loss, and an adviser cannot show evidence of meeting the Gartenberg Standard, it is far more likely that the adviser or firm will be forced to restore losses or worse, pay penalties.

It becomes clear that while nothing is certain, the prudent choice for advisers is to operate under the Gartenberg Standard and the opinion of the Court.

Exceptionally high service requirements.

Applying the Gartenberg Standards to Various Situations

The four examples that follow show the misleading results that can be produced by using simple peer group averages without considering the Gartenberg factors.

Example 1: Reasonable above average compensation for an IRA

  • The client is retired and has only one account with assets of $700,000 to fund retirement in addition to Social Security. Investment requirements are to hold a substantial portion of assets in the energy sector but to avoid health care. The client requires quarterly reviews to monitor the IRA portfolio and update personal preferences and risk tolerance.

    The adviser receives compensation of 95 basis points which is 50% higher than other similarly situated clients with other advisers.

    This give the misleading impression that this client is overpaying for the adviser’s services.

    Applying Gartenberg, the finding is that this client should be paying more:

    • The first step is to calculate what the client is actually paying the adviser:

      $700,000 X 95 bps = $6,550
    • Next is to determine the cost and profit of providing the services to this client. Adviser spends 24 hours per year servicing this client at an internal cost + profit of $350 per hour.

      $350 X 24 hours = $8,400
    • Additional factors are then considered and weighted. These may increase or decrease the hourly calculation to arrive at a “Reasonable” compensation.

      Adviser performance: + 10% ($840)
      Economies of scale: +0% ($0)
      Benefits to client: +25% ($2,100)
    • Summing to a total reasonable compensation of

  • The reasonable compensation in this case is far in excess of what the adviser earns.

  • Example 2: Reasonable above average compensation for 401(k) Plan

    • This client is a 401(k) plan with $13 million and 300 participants. Participation rate is 93% of eligible employees and contributions average 7.5% of salaries. The average age of participants is 46. Plan asset allocation is rated at moderately aggressive. The adviser visits quarterly and provides regular training sessions with employees. The adviser is responsive to calls from participants 24 hours per day.

      The adviser receives a net of 40 basis points as broker of record on the plan. This is nearly double the average for plans of this size.

      Applying Gartenberg, the finding is that this client should be paying more, not less:

      • The first step is to calculate what the client is actually paying the adviser:

        $13,000,000 X 40 bps = $52,000
      • Next is to determine the cost and profit of providing the services to this client. Adviser spends 52 hours per year servicing this client at an internal cost + profit of $450 per hour. An analyst in the practice spends 45 hours per year at $150 per hour

        $450 X 52 hours = $23,400
        $150 X 45 hours = $6,750
                           Total = $30,150
      • Additional factors are then considered and weighted. These may increase or decrease the hourly calculation to arrive at a “Reasonable” compensation.

        Adviser performance: + 25% ($7,538)
        Economies of scale: +0% ($0)
        Benefits to client: +50% ($15,075)
      • Summing to a total reasonable compensation of:

    • The reasonable compensation in this case is close to what the adviser earns.

  • Example 3: Unreasonable below average compensation for large client

    • This client has total assets of $47 million with the adviser that includes a $100,000 IRA on a separate platform that pays the adviser 65 basis points. This account receives no services from the adviser and is considered a “convenience” for the client.

      The average adviser compensation for IRAs of this size is 85 basis points, but this simple average does not consider the scale of the entire relationship.

      Applying Gartenberg, the finding is that this client should be paying less:

      • The first step is to calculate what the client is actually paying the adviser

        $100,000 X 65 bps = $650
      • Next is to determine the cost and profit of providing the services to this client. Adviser spends ½ hour per year discussing this account at an internal cost + profit of $350 per hour.

        $350 X ½ hour = $175
      • Additional factors are then considered and weighted. These may increase or decrease the hourly calculation to arrive at a “Reasonable” compensation.

        Adviser performance: + 0% ($0)
        Economies of scale: +0% ($0)
        Benefits to client: +5% ($9)
      • Summing to a total reasonable compensation of:

  • While this scenario is not likely to be called out as a problem, it is an irritant since it technically violates the Gartenberg Standard. In reality, the adviser could simply decline this compensation.

  • Example 4: No average compensation for situation

    • This client purchased an annuity for his IRA, but seeks to surrender it now. The surrender charges are 4% of the account valued at $250,000. There are no ongoing services to this client.

      The adviser received a 5% commission at the time of the sale but will not participate in the surrender charge. The issue is, however, that the client is now paying for compensation that the adviser received two years ago. There is no available peer group average for this scenario.

      This scenario illustrates the need to consider a variety of factors when assessing the reasonableness of adviser compensation. Using Gartenberg, the adviser compensation received at the time of the sale was simply an advance. The analysis is therefore performed as if the payment and receipt occurred concurrently.

      Applying Gartenberg, the finding is that this client should be paying less:

      • The first step is to calculate what the client actually paid the adviser:

        $250,000 X 5% = $12,500
      • Next is to determine the cost and profit of providing the services to this client. Adviser spent 4 hours discussing this account at an internal cost + profit of $350 per hour

        $350 X 4 hours = $2,450
      • Additional factors are then considered and weighted. These may increase or decrease the hourly calculation to arrive at a “Reasonable” compensation.

        Adviser performance: + 10% ($245)
        Economies of scale: +0% ($0)
        Benefits to client: +10% ($245)
      • Summing to a total reasonable compensation of:

  • The reasonable compensation in this case is considerably less than what the adviser earned and would be considered excessive.

What Profit is Reasonable?

One aspect of Gartenberg that has been the subject of confusion is the determination of a “reasonable profit”. The adviser’s profit is one component of compensation, but left unchecked could be excessive.

In attempting to provide some parameters, DALBAR gathered data on the pre-tax profit margins in financial services and related industries. The findings were unsurprising in that the range is close to initial estimates:

  • The average margin was 35.9%
  • The minimum was 16.1%
  • The maximum was 54.5%

Margins within these ranges are arguably reasonable and would reign in extreme cases.

How to Prove Reasonableness

Proof is having the evidence before the fact, not trying to create it afterword. There is very little credibility in trying to explain that taking home a five figure compensation was fair after a client lost $1 million.

The answer is making it undeniably clear beforehand what the pay will be and what facts were available to support your decision.

While the cost and profit factors of the Gartenberg Standard can be quantified, it is necessary to establish a credible method of weighting the other factors to establish the reasonableness of compensation.

This proof can be accomplished by estimating the time spent and allocating the cost to each client. This is a well-established practice and has been used by professionals for centuries.

The proof of reasonableness is a comparison of the compensation calculated from allocated costs and profit.

Advisers must estimate the time spent on:

  • Delivering services to the client
  • Discovery, research, analysis and monitoring required to achieve the results produced.

Economies for clients where applicable are used to reduce the allocation to those clients.

A further refinement is changing the allocation based on skill, knowledge and experience of each practitioner in a multi practitioner office

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The Broker/Dealer business model was created to distribute products to investors but has now incorporated the delivery of investment advice. When viewed as an investment advice business the inherent conflicts of interest has alarmed regulators and consumer advocates and driven the regulatory changes we see today. Michael Kitces offers some thoughts on how this incompatibility can be resolved, but “something’s gotta give!”

Mr. Kitces’ position is supported by DALBAR products such as the 408(g) Model Certification that separates the personality driven business of relationship management from the scientific probabilities of asset allocation and investment selection. The 408(g) Fee Leveling eliminates the conflicts of interest with an audit that complies with DoL and IRS regulations..

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About Lou Harvey

Louis S. Harvey
President & CEO

Founder and leader of DALBAR, Lou Harvey is relentless in the search for the forces that are shaping the world of financial services today, tomorrow and for years hence. Using Dalbar’s research capabilities, Lou Harvey seeks insights from inside and outside the industry to understand and anticipate changes in customers’ needs and the ways products are distributed.