In the last Advisor Do’s and Don’ts column, we talked about some of the contents of a service agreement, recommending that you be clear about which services you will and won’t perform. This column focuses on fees and a proper characterization of your role.

Do: spell out your compensation clearly… and completely. This may seem so obvious that it doesn’t require comment, but that usually means that specific comments are in order. This applies to both fiduciary and non-fiduciary advisers.

  • Under ERISA, in order for a contract between a plan and a service provider to be exempt from the prohibited transaction rules, the contract itself and the compensation paid to the service provider have to be “reasonable.” The DOL is currently working on revisions to a regulation that will require up-front disclosure of the amount of compensation, direct and indirect, monetary and non-monetary, that a service provider will receive. Failure to provide the disclosure will result in the contract being a prohibited transaction–which means that the adviser will be required to give back to the client some or all of its compensation. While the regulation hasn’t been published yet, it is coming and the prudent adviser will be ahead of the game by making sure to disclose all of his compensation now.
  • Notice that we said “direct and indirect, monetary and non-monetary” compensation will need to be disclosed. If you want to know what this means, look at the DOL statements about what needs to be disclosed on Schedule A or the newly released description of the disclosures on Schedule C. The DOL is talking about not just cash, but extras like trips, “reimbursement of expenses” or “marketing allowances”, “profit sharing” payments–anything of value that is given to the adviser in connection with the relationship between the plan, the adviser and the plan provider.
  • For fiduciary advisers, the issue is even more important because they are also prohibited from using their position as a fiduciary–through giving investment advice–to affect the amount of their compensation. And while it is possible to set a fixed fee or a fixed percentage of assets as the base fee, what about year-end bonuses? What about compensation that an affiliate receives as a result of the advice given? All this needs to be not only disclosed in the contract, but offset against the established fee, to avoid the prohibited transaction rules.
    Without putting too fine a point on the matter, the bottom line is to disclose, disclose, disclose.

Don’t: overstate your role.

One of the most common mistakes we see in financial advisory agreements–almost entirely in the context of an adviser that is explicitly assuming a fiduciary role–is to describe themselves as an investment manager. Under ERISA, this term has a specific meaning that an adviser should avoid unless he is agreeing to assume this role. An “investment manager” is a bank, insurance company or registered investment adviser that is given discretion over the plan’s investments and acknowledges in writing that it is a fiduciary to the plan. If an investment manager is appointed, the plan’s general fiduciaries are relieved of any responsibility for the plan’s investments, except for the prudent selection and monitoring of the manager.

If you do not have discretion over the investments–and wouldn’t want it if the client tried to give it to you–then don’t use the term “investment manager.” It says more about your role than you would want it to.

Disclaimer Required by IRS Rules of Practice:
Any discussion of tax matters contained herein is not intended or written to be used, and cannot be used, for the purpose of avoiding any penalties that may be imposed under Federal tax laws.

Source: The Adviser Report