In recent months, the CFP Board has been buffetted by criticism of its compensation disclosure rules. Those rules were built on a series of definitions that the CFP Board insists have changed since its Practice Standards were approved after a public comment process more than five years ago. However, they appear to be impacting so many advisors that it’s difficult to understand how the current way the CFP Board is interpreting its rules is anything but a change from how things once were.

The key point of dispute appears to revolve around the CFP Board’s use of its so-called “three buckets” approach to determining the types of compensation an advisor receives. That approach looks at what clients pay to the advisor, to related parties, and how the advisor himself generates income from his employment and ownership interests. In the process, the definition of what constitutes “compensation” has stretched so far that advisors can now be disciplined for failing to disclose types of compensation that don’t actually exist because no client has ever actually paid it to anyone, ever!

Accordingly, it’s time for the CFP Board to “clarify” its three buckets approach to recognize that the fundamental starting point for all types of compensation disclosure should always be what clients actually pay in the first place. The fact that no client has ever actually paid a commission to anyone, ever, should always be a valid defense for an advisor to claim that she is fee-only (and the same should apply to commission-only advisors whose clients have never paid fees, and who are equally in “violation” of the CFP Board’s current rules). By fixing its confused and problematic rule, the CFP Board can start to move past its recent compensation disclosure debacles and move the definitions in line with a clear and logical rule that consumers can actually understand, and eliminate the absurd requirement for advisors to disclose (and potentially be punished for failing to disclose) client compensation that doesn’t actually exist!

 

What Are the Three Buckets?

The basic principle of the CFP Board’s three-bucket approach is relatively straightforward, as articulated in the CFP Board’s update on fee-only disclosure webinar.

In essence, the approach states that to determine the nature of a CFP certificant’s compensation, the CFP Board looks at three different buckets: money that goes from the client to the CFP certificant; money that goes from the CFP certificant to a related party; and money that goes from the related party to the CFP certificant. This is illustrated in the graphic below. 

Accordingly, if the client pays a commission to the advisor, clearly the advisor must disclose the compensation. If the client pays a commission to a related party to the advisor, likewise the advisor must disclose the commission compensation. And if the advisor has a relationship to a related party (e.g., is employed by or has an ownership interest in) that receives commissions, then the advisor must disclose commissions. In other words, simply put: if commissions are associated with the compensation derived from any of the three buckets, the CFP certificant cannot be fee-only, and must disclose commission-and-fee compensation.

The Problem With the Three Buckets

While the three-bucket approach above may appear to make sense, it creates some very illogical and questionable outcomes in certain circumstances, particularly when the CFP Board looks only to the relationship between the CFP certificant and related parties (bucket No. 3) in the absence of bucket No. 2 and the overall situation.

For example, assume the CFP certificant generates personal income in two ways: fees paid directly from a client, and dividend distributions from a separate property-and-casualty insurance agency in which the advisor owns a small interest inherited from a parent (the P&C agency is a family business). Under the three-bucket approach, the advisor’s compensation types would be as shown below; since there is both a portion that is fees and a portion that is commissions (the compensation that leads to the bucket No. 3 dividends), the advisor would be required to disclose “commission and fee” compensation.

Of course, there’s one notable issue in this compensation disclosure outcome: at no point does any client of the advisor actually pay a commission to the related party (or anyone) at any time! The advisor has no active role in the P&C insurance agency, and simply receives dividend distributions in the same manner that he would if he owned a publicly traded financial services stock (e.g., the many bank and broker-dealer stocks in an S&P 500 index fund). In other words, the advisor is now required to disclose to a client that he is compensated by commissions despite the fact that no client is ever actually intended or expected to pay a commission to any related party (or anyone else), ever.

Certainly, if the client actually did business with the P&C agency (or the advisor tried to direct clients accordingly), then bucket No. 2 of the three-bucket scenario would be filled and clearly the advisor would absolutely need to disclose the (indirect) commissions received. But by ignoring the second bucket, the CFP Board’s rules reach a nonsensical conclusion: that advisors are required to disclose client compensation that no client ever actually pays and that doesn’t exist in the first place!

In fact, if this advisor claimed to be fee-only—because 100% of clients only ever pay fees and don’t pay commissions to anyone, anywhere, ever—the advisor could still be publicly sanctioned for failing to disclose commissions under CFP Board rules.

Similarly, because the CFP Board accounts for bucket No. 3, without regard to bucket No. 2, the end result is that virtually any ownership interest in a financial entity, such that it constitutes a “related party” by mere ownership alone, could run afoul of the rules. An ownership interest in a bank, broker-dealer or insurance agency can run afoul of the rules (as was the case with Alan Goldfarb).

In fact, a mere ownership interest in an S&P 500 index fund could trigger a requirement to disclose commissions (since the S&P 500 includes dividends from financial services companies that generate revenue via dividends), especially if the advisor has a significant net worth invested in the S&P 500 (where the dividends from their index fund could equal or exceed their compensation from clients, clearly making it “non-trivial”).

On ‘Trivial and ‘Fee-Only’
Of course, since the CFP Board doesn’t even define what is “non-trivial” in the first place, it’s not clear when a relatively small ownership interest, e.g., in a family financial services entity, can trigger the rules as well (per the example above). Similarly, if an advisory firm is owned by a parent company that has related entities that are bank or broker-dealer related (e.g., any/every advisory firm aggregator/roll-up firm that has a bank parent company or also owns a broker-dealer subsidiary), it would lose its fee-only status.

In fact, in theory just one advisory firm partner who owns 1% of an outside entity that generates some of its income from a commission-related business could taint the entire advisory firm, even if it has multiple partners, a large clientele, and not a single client ever actually pays a commission to anyone. (If a firm with 20 partners has one partner that inherits a 1% interest in a family financial services business, is the entire firm disqualified from fee-only? The answer appears to be yes according to the CFP Board’s rules, even if no client even does business with that entity!)

In fact, the common theme to all of these scenarios is that they’re all real-world situations of CFP certificants who have already contacted me, where fee-only firms are apparently not permitted to call themselves “fee only” because an “unrelated” party is associated with commissions, and the mere fact of an ownership or employment relationship exists triggers “commission” status even though the entity has no actual relationship to clients themselves and no clients have ever actually paid a commission to anyone, ever, and are not intended to do so! 

Simply put, they are all scenarios where bucket No. 3 is triggered by a nonsensical requirement to disclose commission compensation even though it doesn’t actually exist, simply based on the balance sheet of the individuals or entities that happen to have an ownership interest in the advisory firm and another party that is “related” by ownership but unrelated to any actual clients.

(Check out part two of this series: Fixing the CFP Board’s ‘Three Buckets’ Rule)