From the January 2008 issue of Investment Advisor • Subscribe!

The Compensation Food Chain

For the majority of advisors, the payment paradigm holds three forms: fees, commissions, or a hybrid commission and fee compensation. However, a controversial fourth option has started to gain momentum. Performance-based compensation is the future of advisor compensation.

Fundamental flaws encumber the traditional schemes. Commission-based pay is company-centric, not customer-centric. Conflicts of interest exist between the advisor and the client. Since advisors make money from the commissions on investment transactions, their goal is to attract more capital from their clients to invest in their company's products. Advisors are impelled to actively trade their clients' accounts even if that style is not in the best interest of the client. The advisor's incentives are to sell/trade more products and seek good referrals. Although many companies manage quality products in a multitude of asset classes, their advisors are still paid employees, i.e., they are salespersons of the company's products. The key advantage of commission-based advisors is their ability to leverage their firm by utilizing its facilities, professional traders/analysts, and reputable brand name. However, this is not an optimal payout scheme as the clients' interests are not served first.

Moving a step up, we come across fee-based advisors. Albeit a better choice than commission-based pay, fee-based compensation still falls short. In general, fee-based advisors tend to exemplify a greater degree of objectivity than the commission-based. However, fee-based pay promotes complacency: Advisors seek to provide average returns without actively seeking superior investments, since there is no added incentive for them to do so. The average financial advisor will perform well enough so as not to be dismissed by his clients. I am generalizing, of course, because diligent advisors do exist. Nonetheless, without an incentive to find the best investments, the majority of fee-based advisors slip into a mundane routine in which they do not maximize portfolio performance.

Along the same lines, a mixed hybrid of fee-plus-commission compensation still falls short of the benchmark. Although the commission incentive pushes advisors to seek the best investments, they are still, at heart, fee-based employees with a conflict of interest.

That leaves us with performance-based compensation. Although used for years in the mutual and hedge fund industries, performance-based pay is just starting to gain momentum with financial advisors. Under this scheme, advisors are galvanized to seek the best investment vehicles for their clients and constantly monitor capital growth and returns. No conflicts of interest exist as advisors are forced to actively manage their clients' portfolios and treat clients' money as if it were their own because their pay is linked to clients' returns. Professional competency is fostered through performance-based pay. Some may wonder if advisors would thus place their clients' assets in overly risky assets in order to maximize possible returns. The answer is no, because if this occurs and money is lost, advisors not only lose their pay from the clients but the clients as well. Performance-based pay emerges as the superior alternative, limiting conflicts of interest while fostering professional skills in the advisor industry.

The move to performance-based compensation is occurring rapidly across the industry and is directly correlated to the general public's recognition of aligned advisor/client interests. Hopefully, the trend will continue, and total alignment between client and advisor will emerge.

Dave Pike

Marquette Associates, Inc.

Chicago, Illinois

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