Compensation Blog Posts

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This Mistake Cost Merrill $9 Million: Mitigating Conflicts of Interest (Part 3)

The SEC’s proposed Regulation Best Interest seeks to impose a duty on brokers to mitigate certain conflicts of interest. This series of articles will explore the various ways firms can effectively mitigate or eliminate conflicts of interest.

Part 1 – Introduction

Part 2 – Level fee

Mitigating Conflicts of Interest – Part 3: Controlling Conflict-Inciting Information 

On August 20th the SEC imposed sanctions on Merrill Lynch related to its handling of a conflict of interest, which cost the firm nearly $9M. Apparently it could have cost much more because this was an offer submitted by Merrill, which was accepted by the SEC.  I thought this might be a good opportunity to step out of the abstract discussion of conflicts and look at a real world scenario that played out over 5 years ago.  In a somewhat overly simplistic summary, it went a little something like this.

Merrill had a Due Diligence Committee responsible for recommending to the Governance Committee what managers and products would be part of a particular set of platforms. The Committee recommended terminating a manager on the platform who was a Merrill subsidiary (“Subsidiary”) and who also had a strong business relationship with BoA.  Subsidiary learned of the upcoming termination prematurely and a “plan of action” was put in place involving members of both Subsidiary and Merrill. This led to a string of events, with the crescendo being an email by an Officer of Subsidiary to a Merrill employee responsible for writing up the Governance Committee meeting agenda which read:

“It was recently communicated to us that the proposal to terminate will not be part of tomorrow’s Governance Committee agenda and [the U.S. Subsidiary] will be afforded an extension of time to further and fully demonstrate our commitment and capabilities in the SMA space…. As it stands now, this news is so new that it may be filtering through your organization, down to the key players in Due Diligence [and other areas, including the product group] but I wanted to inform you directly.”

The Subsidiary’s termination decision was put on hold and Subsidiary ultimately remained on the platform. 

This scenario is not hard to imagine and none of the actors behaved in a way that shocks the conscious (although the email was a little shady). In conversations with Merrill, Subsidiary executives expressed their appreciation for the due diligence team’s autonomy and presented legitimate concerns about the fairness of the termination. For example the due diligence committee often conducted on-site due diligence reviews before terminating a manager, but did not do so in this instance.  The main thrust of Subsidiary’s plea to have the termination put on hold was the fact that such an on-site review was not conducted. And while hindsight is 20/20, it’s interesting to note that the Subsidiary’s new management team did in fact perform well over the relevant period, in fact better than the would-be replacement. As innocent as these actions may have seemed, if not for the outside influence that was exerted on the Due Diligence and Governance Committee, the manager would have been terminated. The Committee did not prove to have the autonomy that was described in Merrill’s ADV and on which investors relied.

The SEC sanctioned Merrill for violating the anti-fraud provision of the Advisor’s Act as well as failing to implement policies and procedures reasonably designed to prevent violations of the Act. But where did Merrill go wrong, what policies and procedures did it fail to implement and what can we learn from this?  To answer this question we need to identify the point in time within these events where policies and procedures could have made the most difference. I would suggest that the only time that a policy could prevent this conflict with reasonable certainty is at the very beginning, BEFORE Subsidiary had any reason to adopt a “plan of action.”

Our cognitive biases as humans can make ethical decision-making very difficult because we identify and analyze facts in a self-serving manner to rationalize why a particular action is allowed or justified. In a competitive corporate environment, these physiological factors make it extremely difficult for a firm’s policies and procedures to stop these human behaviors. In this case, once the horse was out of the barn, reeling her back in was next to impossible. The only way to keep the horse in the barn was by preventing the horse from knowing it should leave the barn. Subsidiary should never have known it was on the chopping block.

In this case, the horse was let out of the barn when an operational employee from Merrill contacted the soon-to-be terminated Subsidiary to get started on all the legwork that would have to be performed to actually remove Subsidiary from the platform.  Usually, a Merrill employee would notify the third party manager after the termination decision had been made by the Governance Committee. However, as the SEC keenly pointed out, no written policy or procedure governed this process.

Had the operational employee at Merrill either not possessed the information about Subsidiary’s termination or had he been trained on a policy to keep such information strictly confidential, Subsidiary would have had no reason to act in a conflicting manner until it was too late to do anything about the termination. The Committee would have acted with the autonomy that it represented to its investors in its ADV and that was required to avoid a conflict of interest. I’d be willing to bet that Merrill at this very moment has extensive policies and procedures governing the confidentiality of Due Diligence Committee recommendations, particularly with respect to the managers who have been recommended for termination.

When designing your policies and procedures, first think about the types of information that could trigger interested parties to act in a manner that conflicts with client interests. Seek to limit the number of people who have access to such information to only those who need to know. Once you have effectively limited the number of people with such information, policies and procedures must put a gag order on such information (both internally and externally) until the passing of a certain event. Had this firewall of information been in place, Merrill would be $9 million richer and I would be writing this article about something else.

                                                                                             ###         

                Cory Clark is a Director at DALBAR, Inc., the nation’s leading independent expert for evaluating, auditing and rating business practices, where he has worked since 2006. Cory holds his Juris Doctor from New England Law |Boston where he graduated Cum Laude and holds a Bachelor of Arts degree in Economics from the University of Massachusetts, Amherst. Cory resides near Boston, Massachusetts with his wife and 3 children.

These articles are provided for general information only, and does not constitute legal advice, and cannot be used or substituted for legal advice.

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Mitigating Conflicts of Interest - Part 2

In Part 1 of this series on mitigating conflicts of interest, I discussed the SEC’s proposed Regulation Best Interest and the potential significance of the mitigation requirements for financial incentives.  The mitigation requirement would appear to be one area where broker/dealers and their reps could be responsible for some significant changes.

When tackling conflicts of interest, it’s helpful to look to a place where disclosure has never been a sufficient remedy; employer-sponsored retirement plans. ERISA is perhaps the strictest regulatory regime related to financial services and under ERISA, an advisor’s conflict of interest is always a prohibited transaction (subject numerous potential exemptions).  Even those not familiar with ERISA parlance can surmise that a prohibited transaction is bad news. However, there are two well established methods of avoiding prohibited transactions in ERISA that serve as a good starting point to neutralizing conflicts of interest in the broker community. Those two methods are (1) fee leveling and (2) the use of a computer model. Fee leveling is the subject of this Part 2 article. Subsequent parts to this series will discuss the use of computer models and other financial technology as a means for elimination and mitigation of conflicts.  

Fee leveling is not the same as fee-only and does not require a shift to a wholly new business model; it simply implies an offsetting arrangement to avoid variable compensation. The distinction between fee leveling and fee-only is an important one.  First, shifting to a model where fees are deducted directly from the client’s account could be disruptive to some client relationships.  Second, shifting to a truly fee based compensation structure and no longer relying on commissions, markups, and markdowns would constitute “special compensation,” in which case the broker may magically morph into an investment adviser with respect to that client.

Regulators have been consistent that when compensation cannot be increased by the advisor, there is no conflict of interest. The Department of Labor stated in a landmark advisory opinion known as the Frost Letter that when fees are passed through to the investor, the advisor is not being benefited. Congress would later codify the concept of level fee in the Pension Protection Act when it created a new level fee exemption for advisors under ERISA §408(g). The SEC specifically mentioned the option of an offsetting arrangement in its Regulation Best Interest proposal.

Fee leveling does more than mitigate conflicts of interest, it eliminates them. Firms should explore the possibility of eliminating some conflicts altogether because in some cases it may be the only appropriate action. The SEC noted that the nature of the conflict, its inherent lack of transparency involved, and the level of sophistication of a particular investor are all factors which may lead to a determination that disclosure and mitigation are insufficient. In these cases, elimination will be the firm’s only viable option. Nonetheless, fee leveling will often be over and above what is required to mitigate a financial incentive, but serves as a preemptive strike against the continuous cost of procedures designed to police lingering incentives. It may pay long term to simply cut the head off the snake and eliminate financial incentive completely through fee leveling or other methods.

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     Cory Clark is a Director at DALBAR, Inc., the nation’s leading independent expert for evaluating, auditing and rating business practices, where he has worked since 2006. Cory holds a law degree from New England Law |Boston where he graduated Cum Laude and earned his Bachelor of Arts degree in Economics from the University of Massachusetts, Amherst. Cory resides near Boston, Massachusetts with his wife and 3 children.

These articles are provided for general information only, and does not constitute legal advice, and cannot be used or substituted for legal advice.

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Mitigating Conflicts of Interest – Part 1

In the wake of the Fiduciary Rule’s slow and painful extinction, a new regulatory initiative has emerged front and center, albeit with much less angst and trepidation attached. The SEC's proposed Regulation Best Interest; what one might consider the Commission’s bite at the “fiduciary rule” apple, was released for public comment last spring. The initial reaction to Regulation Best Interest for many was “nothing to see here.” It was difficult to discern how this regulation materially differed from existing regulations and it certainly had far less bite than its Department of Labor predecessor. What Regulation Best Interest does do is mark an apparent shift on the part of the SEC from a scheme of disclosure to a scheme of mitigation and this philosophical change should not be taken lightly.

Regulation Best Interest carves out a distinction between conflicts of interest generally and those arising from financial incentives (it’s safe to say that we care most about the financial incentives). It then imposes a duty on the broker/dealer to identify, disclose, and mitigate the financial incentives. This represents a significant change for brokers who previously relied on disclosure to properly receive compensation that amounts to financial incentives. Adopting policies and procedures to mitigate financial incentives will certainly prove to be more vexing, involve many more moving parts, and cost much more money than putting words on a page. The good news is that at the very same time, changes in the industry are giving B/D firms and their reps more viable options for mitigating conflicts.

 These series of articles will explore various questions emanating from the proposed Regulation Best Interest with a focus on the policies and procedures that are available to properly mitigate financial incentives. The next two articles will look at two prominent methods for conflict mitigation used today: fee levelizing and computer models.

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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
                          $500
Assess risk tolerances
                          $300
Develop equity portfolio
                          $700
Develop fixed income portfolio
                          $500
Create strategic asset allocation
                      $1,200
Select investments
                          $450
Make recommendations
                          $750
                Total Payout Required
                      $4,400


A share class breakdown by assets produces this payout:



Load

12b-1

Assets

Compensation

Payout @ 80%

A Shares (at breakpoint)
                       2.00%
                       0.25%

$185,000

$4,163

$3,330

T Shares
                       2.50%
                       0.25%

$50,000

$1,375

$1,100

Clean Shares
                       0.00%
                       0.00%

$265,000

$0

$0

                Total 


$500,000 

$5,538 

$4,430 


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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ASSESSING COMPENSATION REASONABLENESS OF RETIREMENT INVESTMENT ADVISERS

Abstract

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.

Introduction

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

      $11,340
  • 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:

        $52,763
    • 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:

        $184
  • 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:

        $2,940
  • 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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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.