How the fee-based compensation craze hurts advisors and clients

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When it comes to fee compensation models, the regulators have got you coming and going.

Is your firm’s compensation commission based? Then brace for scrutiny. These days, true or not, until recently “commission” was practically a code for churning.

Is your firm’s compensation model primarily fee-based? Then watch out, you could get dinged for reverse-churning.

Extremes of these sorts are rarely good for clients. Commission-based models may be a better fit for some clients than fee-based and vice versa.

But that’s not how the pendulum swings these days.

Currently, we are in peak fee-mania. To hear certain regulators and some vocal RIAs tell it, proclaiming yourself fee-only is the equivalent to wearing angel wings.

Big Wall Street firms aren’t unhappy with this shift. They’ve annuitized their businesses and don’t mind taking in fees year in, year out. Is that what former Secretary of Labor Tom Perez intended back in 2016 when he issued the final fiduciary rule, announcing with much fanfare and finger- pointing that financial advisors were costing the little guy $17 billion a year in lost earnings on their assets?

These days, true or not, “commission” is code for churning, writes Mark Elzweig.
These days, true or not, “commission” is code for churning, writes Mark Elzweig.

Perez particularly vilified commission-based advisors and proposed a heavy-handed rule that layered on so much paperwork to explain the rationale for any commission-based trades, that it made transactional business difficult to do.

As a result, some brokerages pushed their advisors into the fee-based model. Not that the firms themselves, in large part, really minded. As a recruiter, I’ve found that advisors who build businesses that tilt largely toward fees command top recruiting packages.

The fiduciary rule was killed off in 2018, and has since been replaced by Reg BI. Many RIAs, however, consider that a weak substitute. During his bid to become the Democratic presidential candidate, Michael Bloomberg pushed for the restoration of the fiduciary standard.

In my view, that would be ill-advised. Last time around, as a defensive posture against class actions, firms shrank client offerings in retirement accounts. Many advisors weighed jettisoning smaller accounts that would not generate enough commissions or fees to justify the increased risk and voluminous paperwork.

From a recruiting point of view, the new rules have turned firms into contortionists. Since they were not allowed to pay back-end recruiting bonuses based on revenue generated in retirement accounts, they devised clever workarounds to attract advisors with recruiting packages that were as valuable as pre- rule changes.

Where does all this leave clients — remember them?

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Some client accounts that were best left as buy-and-hold were probably converted to fee-based. And — surprise, surprise — some of these customers recognize that they are being overcharged. Fee-based accounts have created incentives for reverse churning as advisors can, at least in theory, collect their fees with a minimum of effort. Just check out the class action lawsuits for reverse churning against Raymond James and Edward Jones.

In my experience, most advisors strive mightily to do right by their clients. They enjoy developing close client relationships, which translates into good business.

There will always be unscrupulous advisors who will game the system. And the regulators should always be vigilant on behalf of unsuspecting investors.

But the system needs flexibility to charge clients appropriately for the right kind of management. The financial services industry is not a one-size-fits-all business. Regulators shouldn’t treat it that way.

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Fiduciary Rule Commission-based compensation Fee-based compensation RIAs Regulation Best Interest SEC