Who Moved My Cheese?

Compensation And The New Compliance

How the Fiduciary Standard will accelerate change in advisor compensation

by John Ludes

Mr. Ludes is , VP Business Development, Finance and Account Solutions with Broadridge Financial Solutions. Visit www.broadridge.com/

The introduction of a Fiduciary Standard around the provision of advice to ERISA accounts by the Department of Labor has been a seminal event across the Financial Services Industry, forcing change over a broad spectrum of the Industry’s business model.

One of the Rule’s most fundamental impacts has been to the compensation relationships that have historically existed between manufacturers and distributors and between the distributors and their field forces as they move to conform to the standards laid down in the Rule.

As the DOL ruling reshapes and formalizes the defined fiduciary relationship, both Advisors and the platforms they represent are coming to grips with some challenging decisions.

The New Compliance

From a compensation perspective, the Rule effectively has two main tenants:

  1. Ensure the Advisor acts in the best interest of the investor by addressing conflicting compensation incentives
  2. Provide investors with transparency surrounding the fees and commissions they are being charged

While the DOL Rule stipulates the new compliance standards that fiduciaries are responsible for meeting, it does not specify how firms and advisors are supposed to achieve these standards. This uncertainty has resulted is a divergence in industry approaches:

1. Level Compensation
this is the most commonly adopted approach. Effectively, the Broker Dealer (or Advisory Platform) changes the structure of how Advisors are compensated by creating and using the same commission schedule regardless of “supplier”. Under the current structure, a given Fund “A” may offer a greater distribution commission incentive than Fund “B”. Level Compensation removes that difference by paying the Advisor the same regardless of which fund they recommend.

  • PRO – Highly objective methodology as the Advisor no longer has any specific incentive to push one product over another
  • CON – Has the potential to result in a significant decrease in Advisor Compensation and requires dynamic management & maintenance of the respective fee schedules

2. Reliance on BICE
The Best Interest Contract Exemption introduces a new component to the Advisor/Investor fiduciary relationship. In essence, it is a commitment on behalf of the Advisor that they will always act in the best interest of their client/investor.

  • PRO – the simplest approach as no change in the current compensation structure is required. Add the BIC to the overall Investment Management Agreement and you’re done.
  • CON – Relies heavily on added pre-transaction suitability and due diligence on the part of the Advisor. While it’s a contract, the BIC does not actually prevent or alert if an Advisor is executing a transaction that violates the best interests of the investor. Involves a heavy reliance on pre and post trade compliance monitoring.
Today, there are a range of more nuanced compensation models, including options for commissions, asset based fees, level fees and service based fees

3. Transition from Commission to Fee Based Compensation (based on Assets Under Management)
As a near-term trend, this is likely the direction many in the industry will head. This trend has been gathering momentum since the Financial Crisis and the Fiduciary Rule is likely to accelerate this change. Instead of calculating a commission on each transaction the Advisor executes, a periodic ongoing (monthly/quarterly) fee is established for the Advisor’s oversight and appreciation of the investor’s assets under management.

  • PRO – Basing the Advisor compensation on the overall appreciation and well-being of the investor’s total assets as opposed to individual transactions is inherently better for the end investor. Puts Advisor and Investor more in-line with the same goals.
  • CON – Requires a re-paper of the existing Investment Management Agreement with the Investor and restructuring how the client is charged as well as the Advisor’s method of compensation. This is a much more difficult implementation for some firms (but a problem that Broadridge has solved through the development of our robust and sophisticated Fee Management and Advisor Commissions platforms).

The compensation model in the Financial Services Industry has been evolving slowly from the traditional transaction based, commission-driven model that dates back to the Buttonwood Tree.

Today, there are a range of more nuanced compensation models, including options for commissions, asset based fees, level fees and service based fees. While this trend has been building over time, the shift to a Fiduciary Standard – whether ultimately driven by the DOL, the SEC, or the Industry itself – has had and will continue to have the effect of rapidly accelerating the transition from a purely commission to a hybrid to a full fee based model.

As noted above, each option comes with Pro’s and Con’s and for the Institution to successfully negotiate this transition requires strong, flexible, business rule oriented technology that’s capable of managing the many different selling agreements and payment structures that FSI’s will adapt.