Defining Reasonable Comp: 3 Mistakes to Avoid

by Jeff Marsden
on November 18, 2016in Fiduciary

Reasonable Compensation – a key element of the DOL Fiduciary Rule – is unclear, complicated and time consuming. And it’s a ticking time bomb for firms and advisors that approach it poorly.

The Department of Labor has left it up to the investments industry to sort out how to implement a Reasonable Compensation approach – both what it is and how to determine it. In normal circumstances, the industry would likely do a fine job. However, under the current circumstances facing investments firms – massive change and upheaval whilst dealing with incredibly aggressive implementation time frames – the risk of developing and pursuing a sub-optimal approach is high.

How a firm approaches Reasonable Compensation will have potentially significant long-term effect on the business and its advisors. Do it well and it becomes a powerful tool of engagement and even revenue growth. Do it poorly and it is likely to lock in revenue attrition for years to come.

Be wary of any or all of the following approaches:

Generalizing Reasonable Compensation

Taking a generalized approach to determining Reasonable Compensation is a crutch – and a wobbly one at that. In this case, ‘easy’ (or easier) isn’t your friend. There is nothing ‘general’ about the unique value offered by an advisor to a specific client. It is one-to-one. It is tailored. It is most certainly not generalized. Attempts to generalize reasonability will result in great advisors being under compensated for the value they provide, it will erode and undermine great relationships where value and compensation are mismatched and, ultimately, may potentially expose advisors and firms to more litigation risk.

Action: Get specific. Focus on developing a Reasonable Compensation approach that is specific to each advisor-client relationship.

Excessive Reliance on Benchmarking

A bad benchmark or a badly used benchmark is worse than no benchmark at all. The industry is running headlong into ‘benchmarking’ as a means to justify the reasonability of compensation. Excess reliance on benchmarks should only be embraced with significant caution, for the following reasons:

  • Benchmarks that exclusively use rates will not equip the advisor well and are disconnected from value. Additionally, rates also make it more challenging to relate advisor costs and profits.
  • Benchmarks – especially rate-based – are almost guaranteed to decline over time as they compress towards a floor. Not a wagon to get hitched to.
  • Most important, finding an appropriate benchmark is likely incredibly difficult. Fiduciary is a different value proposition, indeed a higher value service than suitability-based advice. Existing benchmarks (internal or external) are unlikely to reflect this value.

An old, misaligned or wrong benchmark will ultimately be of little value and in fact could be harmful.

Action: Use benchmarks as a tool for validation (think guardrails), NOT as the primary instructive input in determining Reasonable Compensation.

Isolating Advisors from the Reasonable Compensation Process

Don’t hide it. Advisors need to be forward, direct and clear with their clients about value, cost and remuneration. They should to do this regularly. Firms must help advisors learn to discuss their value and relate it to fees and reasonable compensation. This is no small feat. It starts with building a strong understanding of the totality of the value added by the advisor for each client. It’s a new business model.

Action: Make sure your advisors are involved and understand how to determine, explain and defend Reasonable Compensation. Push the analysis forward. Enable it to be made fully transparent and explicitly understood between client and advisor. Train advisors to discuss Reasonable Compensation.

Reasonable Compensation could mean either growth or attrition for the firm – the choice is yours.