Varying Fees

Art by Tim BowerADVISER QUESTION: I am a fiduciary adviser to ERISA [Employee Retirement Income Security Act] plans and IRAs [individual retirement accounts], and I charge an asset-based fee. I don’t receive any other payment, direct or indirect, in connection with these services, and my fee satisfies the definition of “level fee” under the Best Interest Contract [BIC] exemption. May I charge a level fee for advising on the portion of the client’s portfolio that is allocated to equities but a lower level-fee for the portion allocated to fixed-income ­investments?

ANSWER: It depends. If you have the authority or responsibility to make recommendations about the asset allocation in the plan or IRA—that is, about the percentage of assets to be allocated to fixed-income investments and equities—then this fee structure results in a prohibited transaction. To receive the prohibited compensation, you will need to satisfy an exemption such as the BIC.

The prohibited transaction rule at issue is the self-dealing rule. Under that rule, you may not use your fiduciary authority—i.e., your authority to make allocation recommendations—to cause yourself to earn additional compensation. This rule is found in both ERISA and the Internal Revenue Code (IRC) and, therefore, applies to both ERISA plans and IRAs. The rule pertains  to you because you could exercise your fiduciary authority and allocate more to equities, resulting in additional compensation to you.

To receive compensation under this arrangement, you will need to use a prohibited transaction exemption (PTE); most often, that will be the BIC exemption—when it becomes applicable, if ever. However, this exemption will not be available if you exercise discretion over the allocations. In other words, it can be used only if you have nondiscretionary investment authority over the investment allocation decisions and the investor retains the final decisionmaking authority.

Assuming the Department of Labor (DOL) does not replace the current version of the BIC exemption, the requirements are so burdensome that using it for this fee structure would be impractical. While the registered investment adviser (RIA) firm may receive variable compensation under the BIC—i.e., so long as the compensation is reasonable for the services—the individual adviser may not. Instead, the latter’s compensation must be reasonable and level. If the individual adviser’s compensation varies among different investment categories, it must be level within each category and must be based on “neutral factors tied to the differences in the services,” e.g., charging a higher fee for a complex annuity product than for a mutual fund investment.

To meet this requirement, you will need to establish that there are neutral factors that support the higher fee charged for advice about investment in equities. Stated another way, there will need to be differences in the services provided to equity, as opposed to fixed-income investments, that justify the higher fee charged. In most instances, this requirement will be difficult to meet.

Further, there are other onerous BIC requirements, including numerous disclosure requirements, plus a contract requirement in the case of IRA clients. Class action lawsuits will also be permitted, you must maintain a website with the required disclosures, and so on. All that said, it is unlikely that RIA firms will use the BIC exemption for this fee structure.

However, there is another solution to consider: Charge a blended fee that is level across the whole portfolio. For example, you could consider charging 100 basis points (bps) for advising on an equity-only portfolio, but 80 bps on a fixed-income-only portfolio. If you intend to recommend a 50/50 asset allocation to the investor, you could charge, for example, 90 bps for advising on that portfolio.

Similarly, if you have several portfolio mixes, you can have an established fee that reflects the general considerations of each asset allocation. For instance, you might charge 100 bps on the 80% equity/20% fixed-income portfolio, 95 bps on the 60% equity/40% fixed-income portfolio, 90 bps on the 50% equity/50% fixed-income portfolio, 85 bps on the 40% equity/60% fixed-income portfolio, and 80 bps on the 20% equity/80% fixed-income portfolio.

This structure will not result in a prohibited transaction as long as the level fee is reasonable and is charged across the whole portfolio on an ongoing basis.

Fred Reish is chair of the Financial Services ERISA practice at the law firm Drinker, Biddle & Reath. A nationally recognized expert in employee benefits law, Reish has written four books and many articles on the Employee Retirement Income Security Act (ERISA), Internal Revenue Service (IRS) and Department of Labor (DOL) audits, as well as pension plan disputes. Joan Neri, who has been associated with the firm since 1988, is counsel on the Employee Benefits and Executive Compensation Practice Group. Her practice focuses on all aspects of employee benefits counseling.