In recent months, a significant amount of media ink has been devoted to examining the ethics of various compensation models within the financial services industry. While certain compensation models frequently get a bad rap, it is important to note that each model has both advantages and potential ethical challenges.
Assets Under Management Model (AUM)
AUM is touted as a “conflict-free” compensation model since it aligns the interests of the professional with the interests of the client. The financial service professional’s compensation increases (or decreases) in proportion to the growth (or losses) in the client’s account. Since the advisor is compensated solely on the basis of account performance clients can be more confident that their advisor is only recommending financial products or strategies which are in their best interest.
AUM can bolster client confidence by not only aligning the interests of the client and the advisor, but also by removing the perception of a conflict of interest. To the extent that the AUM model increases confidence in the integrity of the financial advisor, this is an advantage.
But this model also creates ethical challenges. While the client’s assets remain in the account under management by the advisor, the interests of the advisor and the client are neatly parallel. However, these interests may diverge when clients choose to move assets out of their accounts.
Since fee-based advisors are compensated on the basis of the assets they manage, fee-based advisors have an interest in maintaining (and increasing) the total amount managed for the client. Additionally, since compensation is tied to the growth of the client’s account, it is subject to fluctuations that are not entirely within the control of the professional. Thus, rather than compensating professionals on the basis of their expertise and skills, advisors may be rewarded excessively in times of economic prosperity and penalized harshly in times of downturn and recession.
Flat-Fee Model
Under a flat-fee model (also referred to as a retainer) an amount is agreed upon by the advisor and client. This amount is usually based on the client’s net worth rather than the value of the portfolio and is paid in quarterly installments.
An advantage of the flat-fee model is that since the compensation is tied specifically to the perceived value of the advice provided (and not to the quantity of products sold or the performance of particular investments), it is possible for the advisor to be more objective in his recommendations. Because the advisor is compensated based on the net worth of the client and not on the basis of the portfolio, the interests of the advisor and the client remain more closely aligned in a variety of circumstances.
As was the case in the AUM model, the alignment of interests may make clients more comfortable with the recommendations of their financial advisors and encourage the trust and confidence, which is essential to a profitable and productive relationship.
Like each of the models under consideration, however, the flat-fee model raises a unique set of potential difficulties. A problem found with attorneys, who also use the flat-fee model (retainers) is shirking. Individuals who “shirk” do only the minimum amount of work necessary to maintain the relationship. The hypothesis is that since the advisor’s compensation is not tied explicitly to the products sold or portfolio growth, the advisor may not be incentivized to aggressively pursue growth opportunities that are in the best interest of their clients.
Commission-Based Model
The commission-based model is the original form of compensation for many financial services providers. The main objection to the commission-based models is that the interest of the professional and the firm/issuing company may be contrary to the interests of the client. The fact that the client may not be aware of the advisor’s other obligations can exacerbate this misalignment.
Within this model, professionals materially benefit from selling products with a higher commission, and there can be little material motivation to recommend products that are in the best interest of clients. Additionally, this model can tempt practitioners to engage in “churning,” a practice that involves originating empty transactions solely to generate additional commissions or meet production goals.
Yet the commission-based model has important advantages. The first is that it creates a system of motivated practitioners incentivized to market “hard-to-sell” products. Particularly in the life insurance industry, it is often difficult to convince potential clients of the benefits of purchasing adequate insurance coverage, even though the possession of such coverage is good for both the individual and society. Moreover, the mere existence of a conflict of interest certainly does not mean that practitioners will exploit these conflicts in order to materially benefit themselves at the expense of their clients.
Commission-based compensation systems are not “one-size-fits-all.” Commission-based models can be structured to reward different behaviors and priorities.
Finally, a commission-based compensation system allows consumers to purchase the level of advice they believe they need from the financial services professional. Some clients may only be looking for a broker to execute their trades or provide access to foreign markets and are not looking for comprehensive financial planning. The commission-based model creates options for these consumers to act in their own interest.
Compensation for financial services professionals continues to be a hotly debated and contentious issue. Financial services professionals committed to doing business in accordance with the highest ethical principles should always bear in mind that whatever form of compensation they receive, they are obligated to always act in the best interest of the client.
