What’s a Reasonable Fee?

How do advisors and their financial institutions determine the reasonableness of their fees?

In a recent blog post, noted ERISA attorney Fred Reish explored that issue – starting with the definition of compensation and then turning to the definition of reasonableness.

Reish explains that ERISA and the Internal Revenue Code use the term “compensation” to cover all payments, monetary and non-monetary, that are compensatory, which is to say something that is “partially or entirely, directly or indirectly, attributable to an investment or insurance recommendation.” He goes on to explain that the Labor Department uses a “but for” test to determine if a payment is compensation; that is,whether the broker-dealer or RIA firm would have received the payment “but for” the investment recommendations. “If the payment is partially or entirely, directly or indirectly, attributable to investment recommendations, it is compensatory,” he writes.

As for “reasonableness,” Reish notes that the Labor Department explains that the reasonableness of compensation is determined by the services provided by the advisor. “In effect, the marketplace defines ‘reasonable’ because, in most cases, the ordinary and customary compensation for the services associated with particular transactions is reasonable,” he notes.

Reish then turns to the steps that advisors and their supervisory entities should take to determine whether the compensation for a particular type of investment transaction is reasonable, suggesting that they need to obtain information about the marketplace pricing for various types of transactions. And while it may be possible for financial institutions to collect that information on their own (and to update it periodically … perhaps annually), he comments that a more practical and cost-effective answer is to work with a benchmarking service that obtains and updates that information (though he cautions that they should investigate the experience and quality of the benchmarking service, and the integrity and timeliness of its data). Moreover, he notes that since it is likely that the levels of reasonable compensation will change over time, that information should be updated at reasonable intervals.

He concludes by noting that the reasonable compensation limits are in the prohibited transaction rules, and – as a result – the burden of proof is on the financial institution, and not on the retirement investor.

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