ERISA Blog Posts

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Mitigating Conflicts of Interest - Part 4

Mitigating Conflicts Through Technology

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

Part 3 – This Mistake Cost Merrill $9 Million

Last week, the SEC adopted Regulation Best Interest (“Reg BI”) which established a new standard of conduct for broker-dealers in retail relationships as well as other interpretive guidance related to the standard of conduct required of investment advisers under the Advisers Act.

The proponents of Reg BI appear to outweigh its detractors because the regulation is workable for b/d’s and doesn’t necessitate the type of wholesale business changes that a regulation like this could have, or as the advisory community thinks it should have, or that the now vacated DoL fiduciary rule would have. The regulation does put mandates on firms to put in place processes and procedures to comply with Reg BI, specifically to identify and mitigate conflicts of interest.

Much of the heavy lifting around Reg BI compliance will be accomplished through technology but most of what I’ve heard regarding technology has been centered around record-keeping to support disclosure or surveillance to identify conflicts. However, the real power of this technology is not to identify conflicts of interest or mitigate them. The power of the technology is its ability to eliminate conflicts of interest, and with that comes a beautiful degree of freedom and power; let me explain.

For some time, the use of technology has been relied upon in the ERISA space to eliminate conflicts of interest in the form of a computer (don’t call me a robo) model. A computer model that uses generally accepted investment theory to make impartial recommendations, without human intervention as to the final result, has been found to eliminate conflicts of interest and protect the fiduciary advisor and plan from a prohibited transaction.

SunAmerica Advisory Opinion -  In 2001, the DoL issued its SunAmerica advisory opinion which stated a fiduciary advisor can use a computer model developed by an independent financial expert to implement model asset allocation portfolios (offered on both a discretionary and non-discretionary basis), and that increased compensation to the fiduciary that resulted from the model asset allocation portfolio would not be a prohibited transaction under ERISA §406(b)(1) or (3). The reasoning and crucial take away is that if the model is recommending the asset allocation portfolios and is developed by an independent financial expert, the fiduciary would not be using any of the authority, control, or responsibility which makes that person a fiduciary to cause the plan to pay additional fees to fiduciary. The key was the relationship between the fiduciary advisor and the developer of the model (independent financial expert). There were many parameters outlined in the opinion that led to an inference of independence as between the fiduciary and expert. Some of these factors include the control and discretion of expert, lack of any affiliation between fiduciary advisor and expert, financial arrangements between the fiduciary advisor and expert, and proportion of expert’s revenue derived from fiduciary advisor. 

The Pension Protection Act, ERISA §408(g) and IRC 4975(f)(8) – The Pension Protection Act gave rise to a new prohibited transaction exemption in the spirit of SunAmerica, which leaned on the existence of a computer model to eliminate conflicts of interest. In almost identical regulations, ERISA §408(g) and IRC §4975(f)(8) allow  the developer and fiduciary to be affiliated or even the same entity, but require the model to be certified by an independent financial expert. This exemption allows the fiduciary advisor to recommend through the computer model proprietary products and products that pay the fiduciary advisor a commission.

So why am I talking so much about ERISA prohibited transactions when Reg BI has nothing to do with ERISA? It’s because an arrangement that passes muster under ERISA’s strict fiduciary prohibitions will most certainly pass muster under Reg BI. And by the way, a new fiduciary rule from the DoL is coming down the pike and while nobody expects it to be as disruptive as its predecessor, it could give brokers a reason to want to take on the fiduciary role. Technology that eliminates conflicts of interest means brokers can take on the fiduciary role with the plan and keep their indirect compensation with no prohibited transaction.

Firms should look to leverage technology to execute their investment process in a repeatable, documented, reliable, un-conflicted manner.  Doing so will allow brokers to service clients unfettered, at the highest standard of care, and with current compensation structures intact.

                                                                                               

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Cory Clark is Chief Marketing Officer at DALBAR, Inc., the nation’s leading independent expert for evaluating, auditing and rating business practices. Cory is also a practicing attorney licensed in Massachusetts. He resides near Boston with his wife and 3 children.

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

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Consequences of Unrestricted MEPs

With the lifting of restrictions on Multiple Employer Plans “MEP” two major shifts are likely to occur in the retirement plan market. First is that all small plans will gravitate to local MEPs that do not include their direct competitors. The second is a massive increase in demand for local MEPs.

The MEP requirement that participating employers must be in the same industry has stunted any chance of growth. Small businesses for whom MEPs would offer great benefits would have to join forces with the very companies they face every day on the competitive battlefield. This problem is made even more acute by the fact that most small businesses serve a local area so the baker would have to join forces with the baker in the same town. To provide economies of scale, the small businesses must be geographically close together.

The unrestricted MEP would permit multiple MEPs in one locality, each serving a diverse set of non-competing businesses. With the removal of the requirement to collaborate with competitors, it is reasonable to assume that small businesses would find the better, cheaper and less risky plan to be irresistible.

The second shift is anticipated to be for new MEPs. This market would be unattractive for large service providers with centralized operations. Locally situated advisors could fill the need but often lack the technical expertise to administer an MEP. The most likely sector are third party administrators (TPAs) who possess the knowledge and skill and already serve these local customers.

The TPA need only become familiar with how to mitigate the fiduciary risk and could almost immediately establish an MEP.

The MEP also opens a new market that consists of small businesses that do not currently offer plans to employees. There is the potential to double the size of the small plan market within two years.

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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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Consequences of Unrestricted MEPs

With the lifting of restrictions on Multiple Employer Plans “MEP” two major shifts are likely to occur in the retirement plan market. First is that all small plans will gravitate to local MEPs that do not include their direct competitors. The second is a massive increase in demand for local MEPs.

The MEP requirement that participating employers must be in the same industry has stunted any chance of growth. Small businesses for whom MEPs would offer great benefits would have to join forces with the very companies they face every day on the competitive battlefield. This problem is made even more acute by the fact that most small businesses serve a local area so the baker would have to join forces with the baker in the same town. To provide economies of scale, the small businesses must be geographically close together.

The unrestricted MEP would permit multiple MEPs in one locality, each serving a diverse set of non-competing businesses. With the removal of the requirement to collaborate with competitors, it is reasonable to assume that small businesses would find the better, cheaper and less risky plan to be irresistible.

The second shift is anticipated to be for new MEPs. This market would be unattractive for large service providers with centralized operations. Locally situated advisors could fill the need but often lack the technical expertise to administer an MEP. The most likely sector are third party administrators (TPAs) who possess the knowledge and skill and already serve these local customers.

The TPA need only become familiar with how to mitigate the fiduciary risk and could almost immediately establish an MEP.

The MEP also opens a new market that consists of small businesses that do not currently offer plans to employees. There is the potential to double the size of the small plan market within two years.

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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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Computer Model Certification

Introduction

The Fiduciary Rules go into effect April 10, 2017 and must be fully operational by January 1, 2018. These applicability dates set the timelines for decisions, preparation and implementation of alternatives to comply with these regulations.

The Conflict of Interest Rules (“COIR”) replace the 1975 definition of what constitutes a fiduciary for ERISA plans and IRAs. The effect of COIR is to transform currently permitted practices into prohibited fiduciary acts.

Institutions and individuals must cease these prohibited fiduciary acts or use an exemption to legitimize these activities.

The Chosen Exemption

Among the exemptions is the provision in the 2006 Pension Protection Act that exempts advice delivery by a certified computer model from prohibited conflicts of interest (408(g)). The use of 408(g) has certain advantages when business circumstances permit its use and the requirements are achievable. Advantages can include:

  • Overcome conflicts of interest and differential compensation from related businesses

  • A superior solution for investors

  • Lower risk for the fiduciary

  • Lower cost to implement, operate and to maintain

  • Shorter time to market

  • Scalable to handle high volumes

Flexibility to make changes and adapt to new investment types and practices

DALBAR Qualifications

Under 408(g) Computer Models can only be certified by an eligible investment expert, with the appropriate technical training or experience and proficiency to analyze, determine and certify, in a manner consistent with the regulation. DALBAR has met these qualifications and has been performing certifications since the inception of the regulation in 2009.

AREAS EXAMINED DURING CERTIFICATION

Scope

The certification attests to five dimensions:

  • Regulatory Compliance
  • Capabilities, strengths and weaknesses
  • Performance
  • Consistency with offers and agreements
  • Reasonableness and cost

Compliance

In addition to compliance with securities laws the computer model may be certified as compliant with regulations as they apply to:

  • ERISA Plans

  • Managed account QDIAs

  • IRAs

Capabilities

Capabilities are evaluated in three areas:

  • Discovery… information gathered about the client and defaults used when information is not available

  • Interpretation… how client information is applied

  • Investments… universe of investments available

Performance

Historical Results:

  • Participation in up markets

  • Capital preservation in down markets

Consistency

Consistency of communication and model results:

  • Contracts, descriptions, brochures and other materials

  • Appropriateness for audience and expected knowledge to meet the requirement: “Calculated to be understood”

  • Tests run with multiple scenarios

Reasonableness

Reasonableness is an overall evaluation of all observations taken together in relation to the cost to users of the mode

REQUIRED STEPS FOR CERTIFICATION

Process

Application

  • Application with attachments received in good order

Pre-Qualification Review

  • Review materials for disqualifiers and terminate engagement if uncorrectable

Additional Disclosures

  • Determine and request any additional materials

Investment Theory Evaluation

  • Determine if exception procedures will be required

Performance Record

  • Examine samples in up and down markets Cost Evaluation

  • Determine if direct and indirect cost to the client is reasonable

Regulatory Checklist

  • Review items specifically suggested by DoL

Model Tests

  • Test models and communication for consistency

Management Letter

  • Review any exceptions or deficiencies and determine if resolution is feasible

Certification

  • Issue certification, good for one year from date of issue

SERVICES AVAILABLE TO ENHANCE USE OF CERTIFIED COMPUTER MODEL

Additional Support

DALBAR offers a number of services to enhance the utility of the computer model and the effects of the Fiduciary Rule on the use of the model as an alternative to the Best Interest Contract Exemption. These services are separately purchased and are not included in the certification.

Upgrade Analysis

Current implementations of the computer model are examined for possible violations of the new Conflict of Interest Rules, Areas of concentration include handling of rollovers and potentially conflicting exemption requirements.

Pre-Certification Review

DALBAR will perform a subset of the certification process before changes are made to comply with 408(g). In this way, findings from the pre-certification can be incorporated add to or reduce the changes being made. The cost of pre-certification lowers the cost of the actual certification.

Usability Analysis

The usability is based on criteria for a particular target audience. The access to, use of, exception conditions and the follow through are evaluated.

Contact Center Monitoring

Contact center representatives who use the certified computer model must comply with the requirements of 408(g). The contact center monitoring adds a level of oversight of the required practices and is evidence of “best efforts” in the event of a failure to comply or litigation.

Consulting

Consulting engagements may cover planning, diagnosis, cost/benefits, research and other services that utilize DALBAR’s expertise, knowledge of the market, practices and regulations.

Contact

Cory Clark (617) 624-7156

CClark@DALBAR.com

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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.