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Determining Reasonable Compensation

As advisers who work with ERISA-governed retirement plans already know, an adviser’s compensation cannot be more than a reasonable amount. How might that change under the new fiduciary regulation?

For ERISA plans, the standards aren’t changed, but the new fiduciary regulation and the associated prohibited transaction exemptions (84-24 and the Best Interest Contract Exemption (BICE)), the reasonable requirement will be imposed on investment and insurance recommendations to IRAs. In a recent blog post, ERISA attorney Fred Reish notes that under Internal Revenue Code Section 4975(d)(2), it is already a prohibited transaction for an adviser to earn more than reasonable compensation from an IRA. However, because of lack of enforcement by the IRS, that requirement is often overlooked.

Reish goes on to note that in order to appreciate the “reasonable compensation” requirement, a person needs to understand that the amount that is reasonable is determined based on the services that are provided. In its guidance, he points out that the DOL explains how reasonableness is to be determined:

“The reasonableness of the fees depends on the particular facts and circumstances at the time of the recommendation. Several factors inform whether compensation is reasonable including, inter alia, the market pricing of service(s) provided and the underlying asset(s), the scope of monitoring, and the complexity of the product. No single factor is dispositive in determining whether compensation is reasonable; the essential question is whether the charges are reasonable in relation to what the investor receives.”

Reish notes that there is a difference between “market” compensation and “customary” compensation, primarily whether the market is transparent and competitive. As the DOL notes:

“Ultimately, the “reasonable compensation” standard is a market based standard. As noted above, the standard incorporates the familiar ERISA section 408(b)(2) and Code section 4975(d)(2) standards. The Department is unwilling to condone all “customary” compensation arrangements and declines to adopt a standard that turns on whether the agreement is “customary.” For example, it may in some instances be “customary” to charge customers fees that are not transparent or that bear little relationship to the value of the services actually rendered, but that does not make the charges reasonable.”

So, how will an adviser determine whether its compensation is reasonable? Most likely, according to Reish, it will be done in the same way that is in the 401(k) world: The value of services will be determined by the competitive marketplace. However, since competitive market data is not generally available for IRAs, he notes that RIA firms and broker-dealers will need to work with service providers who have that information – a.k.a. benchmarking services.

That said, there are some benchmarking services that are better than others – and Reish says that the “better” benchmarking services will consider both the range of services and the compensation of the adviser. Moreover, that determination of “reasonable compensation” would be based on the services provided, but not just on the size of the account, he says. Furthermore, the benchmarking will need to consider services and compensation in the first year and in subsequent years (for example, will the adviser be monitoring the investments).

Be on the lookout for the emergence of these services in the months to come.