Reasonable Compensation Versus Neutral Factors
This is my twenty-fifth article covering interesting observations about the fiduciary rule and exemptions.
In my last post, I wrote about the Best Interest Contract Exemption (BICE) and the requirements for “neutral factors” and “differential compensation” between “reasonably designed investment categories.” As I pointed out, the purpose of neutral factors is to determine the relationship of compensation between different categories of investments and services. In other words, neutral factors don’t establish a dollar amount of compensation, but instead they are used for determining the relative compensation between different reasonably designed investment categories. Think of it as evaluating degree of difficulty in terms of work, complexity, value, etc.
But that begs the question, if neutral factors are used to establish the ratio of compensation, how is the compensation determined?
The best way to approach that question is to look at a single reasonably designed investment category. Within an investment category, the compensation of an adviser must be both reasonable and level. Stated slightly differently, the compensation of the adviser cannot exceed a reasonable amount (based on the services rendered) and the adviser’s compensation must be level regardless of which products are recommended . . . and regardless of the payments made to the adviser’s supervisory entity (e.g., broker-dealer or any affiliate or related party). For example, if the compensation paid to the individual adviser is 1% per year for providing non-discretionary investment advice on a portfolio of mutual funds, that compensation needs to be tested for reasonableness and needs to be level regardless of which mutual funds are recommended and regardless of the payments, if any, to the adviser’s broker-dealer (or any affiliated or related party).
“Level” is fairly easy to grasp. In my example, a level fee is 1% regardless of which mutual funds are recommended. “Reasonable” is a bit more difficult. As explained in prior posts, the DOL says that reasonable compensation is based on market data—in an open, transparent and competitive market. The easiest way to obtain that information is through a benchmarking service. It is important, though, to review the reasonableness of compensation at least every two or three years. The experience of advisers in the 401(k) world is that, as the marketplace has matured, the level of reasonable compensation has become lower and lower.
Also, advisers should be aware that, when a prohibited transaction exemption—such as BICE—is being used, the burden of proof is on the person claiming the exemption, that is, the adviser. So, you need to have information in your file that supports the reasonableness of your compensation.
Forewarned is forearmed.