Senate Tax Bill Could Make Stock Sales More Expensive

Senate Tax Bill Could Make Stock Sales More Expensive

While there’s been substantial recent buzz about the new tax brackets, expanded standard deduction and reduced itemized deductions, and new preferential tax rates for pass-through businesses in the recent Senate and House GOP tax proposals, there’s been growing buzz about a more “minor” provision in the Senate Tax Cuts and Jobs Act (TCJA) proposal that could have a significant impact on financial advisors: a new requirement that any time investors sell a partial lot of existing securities, they must use the FIFO (first-in-first-out) method to determine which shares were sold and the associated cost basis (although mutual fund investors would still be able to use average cost). By contrast, under current law, FIFO is the default cost basis election, but investors still have the option to identify specific lots that are sold (at the time of sale), in order to cherry pick the most favorable shares (most commonly, by choosing the shares that have the highest cost basis and therefore will trigger the smallest capital gain or the largest capital loss). With the new rule, it wouldn’t be feasible to choose specific lots; instead, investors would always have to choose the oldest shares, which is problematic because the first-purchased and longest-owned shares tend to also be the ones with the lowest cost basis and the largest gains, while more recently purchased shares are more likely to have a higher cost basis and losses in a market pullback. Which means the investor would be unable to engage in tax loss harvesting of the more recent shares at a loss, as the FIFO rule would require them to sell the oldest shares with gains first; it would also be more challenging for tax-managed mutual funds to limit their capital gains distributions, when specific lot identification is no longer an option, although a proposed carve-out would exempt mutual funds from the treatment. And notably, the proposal would also impact which shares are selected when gifting stock, or contributing (appreciated) securities to a charity or donor-advised fund(although given that charitable donations of securities tend to work best with the most highly appreciated shares, the FIFO rule may be less problematic for charitable giving). Of course, the rule is a moot point in situations where an investor sells an entire position; identifying lots isn’t necessary if the entire position is sold at once, nor is it relevant if the entire position is bought at once (which means all the shares will have the same cost basis anyway). And it remains to be seen whether the FIFO provision will be included in the final legislation once reconciled with the House version (which does not have the FIFO rule), not to mention the uncertainty about whether the TCJA legislation will pass at all. Nonetheless, given that this is not the first time mandatory FIFO treatment has been proposed – it was also included in President Obama’s Treasury Greenbook budget proposals back in 2014 – it may only be a matter of time before the specific lot identification method is eliminated.

Giving Referral Thank-You Gifts That Actually Make Someone Happier

Giving Referral Thank-You Gifts That Actually Make Someone Happier

Executive Summary

Receiving a new client referral has a substantial value for a financial advisor – so much that advisors often provide “thank-you” gifts, either as a simple expression of gratitude, or even as a means to encourage more referrals. Of course, regulators want to be certain that advisors don’t inappropriately “buy” prospective client referrals – in a conflicted or undisclosed manner – and consequently FINRA Rule 3220 limits client gifts to just $100 per year, and the SEC similarly expects RIAs to establish their own gift-giving (and gift-limiting) policies. Nonetheless, the fact remains that referral “thank-you” gifts are relatively common.

Except often the biggest challenge of giving a good referral thank-you gift is simply picking the “right” gift – something that is commensurate with the value of a referral (not too big nor too small), is appropriately personalized and relevant to the recipient, and will likely be appreciated and well-received by the referrer. Which for some advisors, is so stressful that it’s actually easier to give nothing at all – beyond perhaps a simple verbal statement of “thanks” – than risk giving the “wrong” gift.

Yet recent research on happiness suggests that the best thank-you gifts might not actually be giving a “thing” at all, but instead gifting an experience, or giving someone an opportunity to themselves spend on others. And in the modern digital age, a growing number of online platforms make this possible – from online experience-buying sites like Excitations and Experience Days, to donation sites like DonorsChoose to help teachers fund classroom projects, or even TisBest, which simply sells “charitable gift cards” that the recipient can then redeem as a donation to any one of 300+ charities.

The virtue of such services is that ultimately, it puts power in the hands of the recipient to select the final gift – whether an experience, or a donation to someone else – which helps to reduce the risk of making a poorly-matched gift. But in the end, the true value of gifting experiences or the gifting the opportunity to spend on others is that it increases the likelihood that the recipient will actually feel happier after receiving the gift… which is perhaps the most powerful way to express gratitude for a referral.

FINRA Rule 3220 And SEC Client Gift Limits

Giving a “good gift” can be very challenging. The most impactful gifts are usually the ones that have the most connection and personal meaning to the recipient – which can make the giver feel substantial pressure to find the one, perfect gift… or in some cases, not want to give a gift at all, just for the fear of coming up short. After all, it could be worse to give no gift at all than to give a “bad” gift – like giving wine to someone who prefers beer or bourbon (or worse, is a recovering alcohol!).

Yet given that financial advising is a relationship-based business, gift giving is common, especially as a means to say “thank you” for a client doing business with the advisor, and/or especially for someone who gives a referral to the advisor.

Unfortunately, though, in the financial services industry the process of gift giving is substantially complicated by the fact that regulators scrutinize gift-giving by financial advisors (in addition to an entirely separate set of rules regarding the acceptance of gifts as a financial advisor), out of (justifiable) concern that financial advisor gift-giving could create inappropriate conflicts of interest or induce inappropriate transactions.

Accordingly, FINRA Rule 3220 limits registered representatives of broker-dealers from giving any gifts or gratuities to clients in excess of $100 per year. A recent proposal under FINRA Regulatory Notice 16-29 would increase the annual limit to $175/year, but the point remains: financial advisors are quite limited in their ability to give gifts to clients (or others who provide a referral). In addition, the broker-dealer compliance department must keep records of all gifts that advisors provide.

Similarly, the SEC has also expressed concern about investment adviser representatives of an RIA giving gifts to clients (or anyone else) as well. Although the Investment Advisers Act of 1940 does not have explicit limitations on gifts akin to FINRA Rule 3220, the SEC has indicated that it expects RIAs to have a clear policy on receiving gifts. Similar to FINRA, the SEC expects RIAs to keep track of all gifts that are given, have a firm-wide policy about the circumstances in which gifts may be given, ensure a reasonable dollar limit on the amount of the gift, and have a review process to ensure gifts being given are in compliance with the firm’s gift-giving policies and procedures. Especially since, in the context of “thank-you gifts” for referrals in particular, a substantial gift in exchange for a referral could be considered “compensation” for the referral, which could trigger a requirement for the gift recipient to register as a solicitor of the RIA!

Finding The “Right” Thank-You Gift For A New Client Referral

Nonetheless, the fact remains that clients and other centers of influence do provide referrals to financial advisors, for which advisors often want to express gratitude in the form of a “thank-you” gift. Which means it’s necessary to figure out – within the constraints of FINRA Rule 3220 or SEC guidance – what the “right” gift is… that is most likely to evoke positive memories for the recipient, and not create an accidental social faux pas.

Essentialism by Greg McKeownPersonally, I like to buy books as “thank-you” gifts for people – ones that had a substantial personal impact for me, that I think would be beneficial for and want to share with others – includes Michael Gerber’s E-Myth, Greg McKeown’s Essentialism, and Verne Harnish’s Scaling Up. The challenge, though, is that my favorite books aren’t necessarily the right fit for every gift-giving situation.

Perhaps the simplest approach is simply to buy a Gift Card as a referral thank-you, that the recipient can use for whatever they wish. The virtue of this approach is that it’s hard to go wrong with the type of gift – when you leave the gift in the hands of the recipient to choose. The bad news, though, is that doing so put a potentially awkward monetary value on a social relationship – “Thanks for that introduction to your neighbor the millionaire… here’s $25 to Starbucks”. And it’s hard to deepen a relationship with a generic, non-personalized gift. But perhaps the worst aspect of the Gift Card approach is that it’s simply another way for someone to buy more “stuff”… despite the growing base of research that buying things doesn’t tend to make us happier anyway!

Instead, what the research finds is that the best way for us to spend money – in ways that actually make us happier – is to spend it on experiences (not stuff), or to spend it on others. Which in turn suggests that one of the best approaches to giving effective thank-you gifts is not to gift “stuff” at all… but instead to gift experiences, or give people an opportunity to spend your gift on others.

Gifting Experiences With Excitations And Experience Days

When it comes to gifting experiences, the biggest challenge is simply that it takes a lot of time and effort to organize “an experience” for someone. Or at least, it did. Now, in the modern internet era, there are a number of websites that are built specifically to help find, purchase, or gift experiences.

Two of the more popular platforms including Excitations and Experience Days. Each provides the opportunity to select from a relatively long list of available “experiences”, sorted first by geography (to find something local to the gift recipient), and then by type of experience (e.g., driving, airplanes, food & wine, explore & learn, tours, etc.), with the ability to screen for certain occasions (e.g., Valentine’s Day) or recipient type (e.g., “For Him”, “For Her”, “For Couples”, etc.).

Potential experiences can include everything from the relaxing (e.g., hot stone massage), to the exhilarating (e.g., ride in an old open-cockpit biplane), to a full-immersion experience (e.g., outdoor survival training). And while the purchased experiences will likely last just an hour or few at the most… the memory will live on far longer. Which is the whole point of a gifted experience – particularly when it’s something that the individual would not have likely done/bought on their own.

Stearman Biplane Ride and Barnstorming Show For One

For financial advisors – or gift-givers in general – both platforms provide an option to purchase an on-site gift certificate, allowing the recipient to choose their own experience from the available options. Or the advisor can simply purchase a particular experience that the recipient might be interested in – as the whole point is to gift an experience!

Notably, a key point of experiences is that we often value new ones – which means it’s not necessary to get the recipient something they have already done. In fact, even if it’s not an experience they end up loving and wanting to do again, the experience itself will still be memorable… which leaves a positive feeling of gratitude for the advisor tied to that memory!

Supporting Students And Teachers With DonorsChoose

DonorsChoose was founded in the year 2000 by Charles Best, a Bronx public high school teacher, who was struggling with how much he (and his teacher colleagues) were spending on books, art supplies, and other school materials. Accordingly, the DonorsChoose platform allows teachers to post their classroom projects, and request donations to fund them. What’s unique about DonorsChoose, though, is not simply that donors have the opportunity to donate in support of education, but that they can choose a specific classroom project to support, see exactly where their dollars will go, and even get a follow-up thank-you message from the teacher and class, and photos that show how the money was put to use.

That deeper level of connection and engagement to giving in the classroom has propelled DonorsChoose to help fund more than 1,000,000 classroom projects over the past 15 years, and the organization has been recognized by Charity Navigator for its especially efficient use of funds for its charitable purpose (with a whopping 94.9% of all DonorsChoose funds going to classroom projects, and a miniscule 0.9% allocated to General and Administrative overhead expenses).

Similar to other “gift choosing” platforms, DonorsChoose provides a Search tool to find projects to support, allowing you to search by school subject (e.g., History & Civics, Math & Science, Music & The Arts, etc), specifically target certain age groups (e.g., PreK-2 or Grades 9-12), or focus on certain types of projects (e.g., teacher-led vs student-led) or certain types of supply needs (e.g., lab equipment, art supplies, or educational games). Alternatively, you can also search by geography (to find school projects in your local area), or simply screen from a list of “urgent” projects.

Awesome Osmo Time

While the primary function of the DonorsChoose is to give directly to the listed classroom projects, the platform provides an option to buy a “DonorsChoose Gift Card” (which can be delivered via email or physically by postal mail), which lets someone choose how to allocate dollars to the classroom project of their choice… and actually see how their donation will be used, which gives them far more engagement to the process, and a more positive feeling about the outcome that is created (enabled by the advisor’s gift dollar)!

As a way of providing a “thank-you” gift for a referral, the power of a DonorsChoose gift card is that, rather than just sending someone a bland card that says “a donation has been made in your honor to <such-and-such charity>”, instead the recipient actually gets to engage in the process of selecting where and how the donation will be used.  Which should be far more effective at activating the “spend on others” happiness boost!

Using TisBest To Give A Charitable Gift Card (To Any Charity)

Extending the DonorsChoose concept of letting recipients choose where to “give” their dollars, another option is simply to buy a “Charitable Gift Card” as a thank-you gift for referrals.

A relatively new entrant to the world of gift cards – which more commonly have been used at retail stores like Target and Starbucks – the charitable gift card is similar to other gift cards in that it can be applied as cash, but limited in that can only be used as a donation to a charity. Which means that gifting someone a charitable gift card is effectively making a charitable donation in their honor – except they get to choose where to send the money.

Accordingly, platforms like TisBest allow someone to “buy” a charitable gift card, and then give it to a recipient who can (and must) donate its value to an available charity on the TisBest list. Notably, TisBest requires that the charitable gift card be used at one of their 300+ listed charities, to ensure the gift card will be accepted, and that the recipient has been vetted as a bona fide charity (although you can submit a nomination request for a new charity be potentially added for future years).

Fortunately, TisBest does have a very wide range of available charities – generally very sizable organizations – including Arts organizations like Dance/USA, Children’s Theater Company, and NPR; Health-related charities like the ALS Association and American Cancer Society; Human Rights organizations like the American Red Cross and Amnesty International; and even faith-based organizations like the Christian Relief Services Charities, the Jewish Federations of North America, and Young Life.

Many Charitable Causes To Chose From

Similar to DonorsChoose, the buyer of the charitable gift card can either send it electronically via email, or print and mail a physical card (which for financial advisors, can even include a custom image of the advisory firm on the card!). Fortunately, though – unlike some other types of retail gift cards – the TisBest charitable gift cards never expire.

Notably, in the case of TisBest charitable gift card donations – and DonorsChoose donations – the tax deduction for the charitable contribution goes to the person who buys the gift card (i.e., the financial advisor), and not the client who allocates the donation.

Ultimately, the key point of giving thank-you gifts for referrals using platforms like Excitations, DonorsChoose, and TisBest is not merely that it allows people to select the solution that is best “for them” – reducing the risk you choose a gift that isn’t the right fit.

The real benefit is getting away from the challenge of thank-you gifts that just add more “stuff”, which the research suggests isn’t likely to actually make us happier anyway. Instead, giving the gift of experiences, or the “gift of giving” by facilitating the recipient’s ability to spend on others, makes it possible that the gift recipient actually enjoys a bona fide lasting moment of happiness and a meaningful memory. Which is a great way to say thank-you for a great referral!

So what do you think? How do you say “Thank You” for a referral? Do you provide thank-you gifts for referrals? What do you give? Would you consider a gifted-experience or gifted-spend-on-others opportunity instead? Please share your thoughts in the comments below!

The Latest Advisory Industry & FinTech Trends From #SchwabIMPACT

The Latest Advisory Industry & FinTech Trends From #SchwabIMPACT


While it is becoming increasingly clear that “robo-advisors” are not disrupting human financial advisors, the adoption of robo technology by financial advisors themselves is beginning to shift the competitive landscape… both amongst financial advisors themselves, and the technology vendors who serve them, as the very role and value proposition of financial advisors themselves begins to get re-defined.

In this week’s discussion, will discuss the latest advisory industry and FinTech trends – including the Robo 2.0 trend currently rolling through the industry, why Robo 2.0 will spur the rebirth of next generation financial planning software, and why it’s the rise of better “small data”, rather than “big data”, that is likely to be most important to advisory firms in the coming decade.

One of the biggest trends rolling through the advisory industry right now is rise of “Robo 2.0”. Robo-Advisor 1.0 was all about companies like Betterment and Wealthfront, which made convenient and easy-to-use tech tools for opening accounts, investing those accounts, and managing them over time, and offered directly to consumers. However, we’ve learned that only a small subset of consumers actually want to buy these solutions directly, while there is a large base of financial advisors who want to use these same tools within their own businesses. As a result, Robo 2.0 tools are focused on facilitating the ability of financial advisors to quickly and easily open investment accounts, get the dollars actually transferred, invested, allocated in reasonable models, and model management tools to make it very easy to allocate and rebalance models along the way. The good news for advisors is that these trends drive efficiencies and lower business costs. But the challenge going forward is that now that all of this can be done with a click of a button, advisors need to find new ways to add value for their clients.

Looking forward a bit further, the biggest change we’re likely to see in the industry 5 to 10 years from now isn’t actually the adoption of Robo 2.0 tools, but instead, the rebirth of next-generation financial planning software as investment management receives less attention. As advisors are forced to focus on other areas of financial planning – everything from HSAs and healthcare conversations, to debt management issues, and cash flow planning more generally – advisors are going to need better financial planning software tools to help clients with these issues. Which presents a huge opportunity for those who are interested in building tools oriented towards financial planning, and advisors who want to focus more on financial planning… while for those still mostly focused on investments, the next decade is going to present more of a competitive business challenge.

Another trend that many have predicted will influence the next decade is artificial intelligence, machine learning, and big data. But I’m very skeptical about the discussion of these technologies coming into advisory businesses. Because the reality is that so many of the challenges in what we do for clients are not big data problems. Instead, it’s small data – i.e., the uniqueness of every advisory firm and the clients they serve – where better insights are needed. So while there will certainly be some applications for large firms to leverage big data and bring insights on the entire industry, at the advisor level, the most exciting advancements are in the small data areas that are directly relevant to firm owners and their clients. For instance, automated business management and benchmarking data that makes it easier to track the components of business growth and performance, and tools that automate the many business management reporting processes that advisors are manually doing today.

The bottom line, though, is simply to recognize that we’re in the midst of some big FinTech trends within the advisory industry right now. So if you are an advisor who wants to stay relevant and continue to add value to your clients in the future (or a tech provider who wants to make the tools to help advisors do so!), it is important to understand how these trends will shape financial planning in the future!

FINRA Board Rife With Conflicts Of Interest

FINRA Board Rife With Conflicts Of Interest

new report issued on Wednesday by the Public Investors Arbitration Bar Association (PIABA) is raising concerns about the structure of FINRA’s public Board of Governors, noting that of the 24 members, 10 are supposed to be from the “industry” while 13 are designated for public members intended to represent investors (with the 24th seat for FINRA’s CEO), but in practice, five of the 13 public members are actually tied directly to financial services firms as well, which means the majority of the board represents the industry instead of consumers. The PIABA report specifically calls out FINRA Board Chairman William Heyman – who is also the Chief Investment Officer of Travelers – along with Eileen Murray (who is co-CEO of hedge fund Bridgewater Associates), Shelley Lazarus (also on the board of Blackstone Group, which has multiple broker-dealer subsidiaries), Carol Davidson (also on the board of Legg Mason), and Joshua Levine (a co-founder of single family office Kita Capital Management). In addition, PIABA also notes that many of FINRA’s public board members may not be able to realistically fulfill their duties in a crisis, due to being “over-boarded” – i.e., participating on so many different boards that they couldn’t realistically put in the necessary time, as several of the public board members in question are sitting on 5+ other boards simultaneously (in addition to often having other work duties as well). Notably, though, the PIABA report praised new FINRA CEO Robert Cook, as it was his decision to release further detail about FINRA’s public governors that allowed these concerns to be surfaced in the first place.

CFP Board To Proposed New Revisions To Conduct Standards With Second Comment Period

CFP Board To Proposed New Revisions To Conduct Standards With Second Comment Period

After taking in feedback from more than 1,300 public comments, plus 8 public forums with CFP certificants, the CFP Board has announced that it will be releasing a second draft version of its proposed changes with a second comment period. The decision to issue a second draft proposal isn’t entirely surprising, as both advocacy organizations like the FPA, as well as the comment letter submitted by yours truly, suggested that there were enough substantive changes needed in the first draft to merit a revised proposal with a second comment period. The second draft itself is anticipated to be released before December 25th, with the second comment period to open for 30 days running from January 2nd to February 2nd; the CFP Board has indicated that it aims to complete the process and publish the final conduct rules by the end of the 1st quarter of 2018, with the new standards to take effect at the beginning of 2019. Thus far, the CFP Board has not indicated which areas in particular will be modified, beyond noting that “the board really looked hard at the practicalities of how the proposed standards would apply to different business models”, an apparent nod to the challenges of how the CFP Board’s fiduciary requirements – including new notification and disclosure documents – might apply in the broker-dealer community in particular. Though in public comments at this week’s Schwab IMPACT conference, CFP Board CEO Blaine Aikin maintained that the second draft will have “meaningful” changes but won’t dilute the principles-based fiduciary focus of the rules.

Financial Planning Research Highlights From The 2017 Academy of Financial Services Annual Meeting

Financial Planning Research Highlights From The 2017 Academy of Financial Services Annual Meeting


From October 1st through October 3rd, the Academy of Financial Services’ annual meeting was  in Nashville, TN – partially overlapping with the FPA’s BE Annual Conference. The event brought together many academics and practitioners to share and discuss research, with the intention of increasing academic-practitioner engagement by holding two of the largest conferences for both researchers and practitioners in conjunction.

In this guest post, Derek Tharp – our Research Associate at, and a Ph.D. candidate in the financial planning program at Kansas State University – provides a recap of the 2017 Academy of Financial Services Annual Meeting, and highlights a few particularly studies with practical takeaways for financial planners.

The 2017 Academy of Financial Services (AFS) Annual Meeting showcased research from scholars at a wide range of institutions – with first author affiliation on paper and poster sessions representing roughly 40 institutions. As expected, the core financial planning programs had a strong presence, with scholars from just seven of those institutions serving as lead authors for more than 50% of all research presentations and poster sessions.

The AFS annual meeting featured research on a number of different topics. Some notable sessions for practitioners ranged from topics such as whether having resources from friends and family reduces a household’s willingness to establish an emergency fund (not as much as you might expect!), how bull and bear markets impact the subjective assessments of portfolio risk, the links between certain types of personality traits and likelihood of financial stress, and quantifying the financial advisor’s value when it comes to making efficient investment decisions (and how that value varies depending on the investor’s existing capabilities in the first place).

Overall, holding the AFS Annual Conference and FPA BE Conference in conjunction appeared to be successful in creating greater engagement between practitioners and researchers (with some research presentations filling large rooms at standing room only capacity!). As both the AFS Annual Conference and CFP Board’s Academic Research Colloquium strive to create more robust platforms for sharing and engaging in academic research, the future appears bright for financial planning researchers (and research that can really be used by financial planning practitioners)!

2017 Academy of Financial Services Annual Meeting

Though perhaps lesser known among many financial planning practitioners, the Academy of Financial Services has a long history of promoting academic research within the area of financial services. Dating back to 1985, the AFS has aimed to promote interaction between practitioners and academics. One way the AFS pursues this objective is by publishing an academic journal, the Financial Services Review (FSR). In recent years, AFS began to publish FSR in collaboration with the Financial Planning Association, and as a result, FPA members receive digital access to the current volume/issue of the journal.

Another way the AFS encourages interaction between practitioners and academics is through holding their annual meeting. This objective was given even greater focus in 2017 as the AFS held its Annual Meeting in conjunction with the FPA BE Annual Conference, conducted as a “pre-conference” event of its own but with one day of overlap to the main FPA conference agenda (which allows practitioners to come early and participate in the AFS event, and for academic researchers to stay beyond the AFS meeting and participate in the FPA annual conference as well).

Academic Representation At The 2017 AFS Annual Meeting

The 2017 AFS Annual Meeting drew researchers from a number of academic and professional institutions. In total, roughly 40 institutions were represented as first authors on research presented in either poster or oral sessions.

For those who haven’t attended an academic conference before, academics generally present their research at conferences in one of two ways. The first is the poster session, which is a more informal presentation where a researcher stands in front of a large poster summarizing their findings. The second are oral sessions, where researchers deliver a more formal research presentation to an audience. Researchers must submit their sessions in advance for consideration to be selected for presentation.

Several of the well-known financial planning programs had a strong showing at the 2017 AFS Annual Meeting. Texas Tech led the way with scholars serving as first author on 9 oral session and 2 poster sessions. Kansas State ranked second with scholars serving as first author on 5 oral sessions and 2 poster sessions. Other schools with a strong presence included The American College, University of New Orleans, University of Georgia, Ohio State University, and the University of Alabama. In total, these 7 schools accounted for 54% of the first authors of research selected for oral or poster sessions.

Portfolio Gamma Framework By Investor Type

As is indicated in the chart above, Blanchett and Kaplan conclude that different levels of financial advisor value are experienced by different types of investors. And of course, different levels of value are delivered by different types of advisors, as not all financial advisors are going to fully deliver gamma in each category.

Specifically, their results suggest that when consumers receive average or high levels of benefit from working with a financial advisor (and when the advisor can actually deliver the value), the gamma that can be added from efficient investment strategy selection is significant enough to justify a typical AUM fee. However, when consumers receive low levels of benefit from working with an advisor (e.g., because they are already capable of self-implementing a long-term diversified portfolio), it may be hard to justify a typical AUM fee based on investment gamma alone.

And while this insight may seem somewhat self-evident, Blanchett and Kaplan provide some concrete estimates of the value that may actually be received by various types of consumers. Further, evaluating the different categories can help advisors see where they can generally add the most relative value. For instance, while asset class selection is important, helping clients to decide to save and invest in the first place is relatively more important for each type of consumer.

Blanchett and Kaplan’s study is a big step forward in terms of addressing the “compared to what” problem and many of the limitations of prior studies attempting to quantify the value of advice. By providing a framework that spans multiple dimensions of potential value-add, their quantification of value becomes much more meaningful. If a particular investor is “low” on questions 1-3, “average” on 4-6, and “low” on 7, a customized value-add unique to their circumstances can be calculated. While it may not be perfect, the benchmark in this study is beginning to look much more like a real person.

Example 1. John is a consumer who has a very good understanding of the importance of investing, appropriate risk levels, asset allocation considerations, and how the risk of his retirement goal affects a portfolio allocation, but he only has an average knowledge of what types of accounts to use, what investments to implement with, and when he should revisit his portfolio. Therefore, assuming John’s prospective financial advisor is of high competence in all areas, John’s benefit of working with an advisor (or developing the skills and knowledge on his own) could be estimated as 1.4% per year.

 Of course, this study doesn’t even attempt to quantify the value of financial planning gamma(meaning the true potential value-add would be even higher), but Blanchett and Kaplan have provided a solid foundation for beginning to more precisely quantify the value-add of an efficient portfolio.


While the importance of maintaining an emergency fund is no secret amongst financial planners, understanding the relationships between household characteristics and emergency fund preparedness can help financial planners identify situations in which extra precaution should be taken to ensure client households are prepared to face financial adversity.

Unmarried parents with children—i.e., “fragile families”—are one group that is particularly at risk of needing to rely on an emergency fund. Because non-married households are more prone to breaking apart than married households—a process which can create a shock to income while simultaneously increasing expenses (e.g., needing to make two rent/mortgage payments instead of one)—an emergency fund is even more important for fragile families.

The Two-Income Trap by Elizabeth Warren and Amelia Warren TyagiAs Elizabeth Warren and Amelia Warren Tyagi have noted in their book, The Two-Income Trap, these dynamics are not unique to low-income households. In fact, in some respects, fragility can be even higher for young, affluent, dual-income households, as an unexpected drop in income may result in larger month-to-month deficits with fewer options to offset that decline (e.g., public support or a non-working spouse entering the labor force).

In an effort to examine emergency fund preparedness among fragile families, Abed Rabbani, an Assistant Professor at the University of Missouri, and Zheying Yao, a Ph.D. student at the University of Missouri, analyzed data from the Fragile Families and Child Wellbeing Study.

In an SSRN article, Rabbani and Yao report their findings. While not all of their findings are particularly surprising—e.g., higher income, saving behavior, and homeownership were all found to increase the likelihood of having an emergency fund (defined as two months’ income in savings)—the authors also examined whether the likelihood of having an emergency fund was impacted by the gender of the individual who controls household spending, or whether the family could obtain financial support from other friends or family members.

The authors expected that financial reliance would be negatively associated with having an emergency fund (as having an emergency fund may be less crucial when households can access resources elsewhere) and that households where a female has financial control would be more likely to have emergency funds. However, the authors found that neither exhibited a statistically significant relationship with the likelihood of having an emergency fund after controlling for factors such as debt, saving, income, employment, and homeownership.

In a practical context, this study can provide a few different insights—particularly for advisors who may specialize in working with younger, non-traditional families. First, some objective factors that we would expect to be correlated with the likelihood of having an emergency fund were found to be. While this finding isn’t groundbreaking, it is good to check that professional intuitions align with empirical findings. Second, the findings suggest that neither gender of the financial decision maker, nor the availability of family/friend financial support, were significant predictors of the likelihood of having an emergency fund.

In the case of the latter, this may suggest that merely having access to funds through friends and family does not sufficiently disincentivize creating an emergency fund for one’s own household. This is actually an encouraging finding, as it may suggest that households are looking to be self-sufficient even when other friends-and-family resources may be available as a last resort. This may be particularly relevant for financial planners given that our clientele—even in the case of non-traditional clientele served through retainers and other business models—does tend to be more affluent, and likely has more affluent social networks as well. Additionally, this finding may lessen the concern of parents that serving as a financial backstop could undermine their children’s willingness to develop their own emergency funds and fiscal responsibility.


Misalignment between perceived and actual risk is a genuine threat to sticking with a financial plan, as it means that even if a client does have the “right” portfolio consistent with their risk tolerance, if they misperceive the risk of their own portfolio, they may try to make inappropriate portfolio changes anyway.

Xianwu Zhang, a Ph.D. student at Texas Tech University, explores whether subjective risk perceptions influence portfolio choices, in his paper, Do Investors’ Subjective Risk Perceptions Influence Their Portfolio Choices? A Household Bargaining Perspective.

In general, Zhang finds that investors perceive the stock market to be riskier than objective measures suggest it is. However, what is particularly interesting about Zhang’s research is his examination of the role that household bargaining plays in portfolio selection.

Traditional models of households assumed that all members of a household act as a team—altruistically putting the interests of the family ahead of their own. However, household bargaining models acknowledge various individuals within a group have different preferences, and, as a result, conflicts of interest arise within the household. Thus, households can act either cooperatively or competitively as individual members seek to maximize their own satisfaction.

When analyzing the different ways in which families can act cooperatively or competitively, bargaining power is an important concept to acknowledge. In the context of household portfolio selection, disproportionate bargaining power can mean that one spouse dominates decision making.

Zhang utilizes several proxies of bargaining power—such as gender, education, income, and hours worked—to see how risk perceptions (measured as perceived likelihood that a mutual fund invested in blue-chip stocks would experience a 20% decline over the next 12-months) of a spouse with more bargaining power may influence the percentage of risky assets in a household’s portfolio. Utilizing data from the HRS, Zhang finds that, all else equal, the subjective risk assessments of females, spouses with more education, and spouses with lower income have a greater influence on risky asset investment.

One interesting aspect of Zhang’s findings is that it is not always the household member who is assumed to have more bargaining power whose subjective risk assessment seems to influence portfolio holdings. For instance, spouses with more income are assumed to have greater bargaining power, though Zhang finds it is those with less income whose subjective risk perceptions have a greater influence on portfolio allocation. Zhang notes that this may be because the higher earning spouses may have higher opportunity costs, and thus delegate this decision making to a lower earning spouse.

Zhang does note some important limitations to this study (e.g., it is only based on one point in time rather than evaluating behavior over time), but it is certainly a fascinating and important topic.

From a practical perspective, these findings reiterate the importance of engaging both spouses in the financial planning process. And this is particularly true in light of our industry’s historical neglect of the female members of households, as even if it is the case that a higher-earning male possesses more bargaining power within a particular household, it may actually be the lower-income female’s risk assessment which is driving portfolio risky asset investment decisions of the household!

Further, this type of analysis raises all sorts of important questions. How do couples delegate portfolio decision making between themselves? How do they delegate portfolio decision making when an advisor is involved? If an advisor is struggling to get buy-in from a couple, who should they try and influence and how should they do so? It’s unlikely that any of these questions have simple answers, but they are the types of research questions that fiduciary advisors who want to help their clients fulfill their goals must consider.


In another paper examining risk preferences, David Blanchett of Morningstar, Michael Finke of The American College, and Michael Guillemette of Texas Tech University examine the effect of advanced age and equity values on risk preferences.

Utilizing a unique data set of risk tolerance questionnaire (RTQ) responses from participants in a defined contribution managed account solution offered by Morningstar Associates, the researchers are able to analyze how RTQ responses from January 2006 to October 2012 were associated with age and equity values after controlling for other factors such as account balance, annual salary, and savings rate.

The researchers find that as the S&P 500 increases, workers become less risk averse, and vice-versa. Additionally, participants who were older, had lower income, and had lower account balances were found to have higher levels of risk aversion.

Blanchett et al. note that the higher levels of risk aversion among older participants provides justification beyond time-horizon considerations for reducing equity allocations with age. Further, these findings suggest that annuitization should be more common than it is, though the authors note that several factors may decrease the attractiveness of annuitization, including mortality salience and framing effects.

The authors also note that an interaction found between age and S&P 500 levels suggests that risk preference assessment of older individuals may be influenced by stock market valuations. Specifically, if risk preferences were assessed when market values are high, respondents exhibited more desire to take on risk. But, of course, investing more in stocks because they’re up only makes investors more at risk of losing money in the next bear market! Fortunately, target date funds and other strategies can take the rebalancing responsibility out of the investors hands, which may help shield the investor form losses due to changes in shifting risk preferences.

From a practical perspective, financial planners should consider that risk tolerance assessment should not just be a one-time occurrence. A growing body of research suggests that investors exhibit time-varying risk aversion. Of course, this too raises questions.

If risk aversion is not stable, then how should it be used in practice? Does behavior change as stated risk preferences change, or are people were changing the way they answer questions related to risk preference (perhaps driven by risk perception instead)? Does a one-dimensional measure of risk aversion even tell us much in the first place? And to what extent should retirement strategies be designed differently if there’s an anticipation up front that retiree risk tolerance will decline in their later years?


As financial planners shift from simply thinking about the quantitative aspects of financial planning to helping clients achieve more holistic financial health, understanding measures of financial stress and well-being will be increasingly important.

In their presentation, Multidimensional Financial Stress: Scale Development and Relationship with Personality TraitsWookjae Heo of South Dakota State University, Soo Hyun Cho of California State University Long Beach, and Phil Seok Lee of South Dakota State University, presented their work in developing a multidimensional measure of financial stress.

In an SSRN paper covering a similar topic, the researchers provide a glimpse into some of the topics which are important in developing a more comprehensive measure of financial stress. The authors note that there are affective (i.e., how people feel), psychological (i.e., cognitive and behavioral), and physiological (i.e., bodily responses) dimensions to stress. As a result, they aim to bring these different dimensions together into a single scale that can be used to assess financial stress.

Further, the researchers used this measure in a survey of 1,162 respondents to examine its potential use and possible relationships between Big Five personality traits and financial stress. Those who exhibited the highest level of financial stress were moderately extraverted, were low in agreeableness, low in conscientiousness, high in neuroticism, and high in openness. Conversely, those who exhibited the lowest levels of financial stress were highly extraverted, highly agreeable, highly conscientious, low in neuroticism, and highly open to experience.

From a practical perspective, gaining a better understanding of what types of clients are more or less likely to experience higher levels of stress can help advisors manage client comfort and look out for various behavioral tendencies. Research in this area still has a long way to go before advisors can use such findings with confidence, but this is one area where the importance of basic research is highlighted—even if the immediate applications are limited. If we don’t even truly understand what financial stress is, we will struggle to effectively help our clients alleviate it (or identify the clients most prone to financial stress in the first place)!

Overall, the 2017 AFS Annual Meeting was successful in bringing together a wide range of scholars to share their research in personal financial planning. And hosting the conference in conjunction with FPA BE provided an excellent opportunity to increase the interaction between practitioners and academics as well.

The AFS Annual Meeting will be held in conjunction with the FPA Annual Conference in 2018—again providing an opportunity for greater engagement between financial planners and researchers. So, if you would like to stay on top of some of the latest ideas in academic research, would like to consider possibly getting involved in research yourself, or simply just want to experience an academic conference first hand, attending the AFS Annual Meeting and FPA Annual Conference in 2018 may be a convenient opportunity to do so!

So what do you think? Did you attend the 2017 AFS Annual Meeting? Do you have plans to attend in the future? What else can be done to help further engagement between practitioners and academics? Please share your thoughts in the comments below!

Why Performance And Fulcrum Fees Are Banned For Most Financial Advisors

Why Performance And Fulcrum Fees Are Banned For Most Financial Advisors


As financial advisors feel increasing pressure to differentiate themselves, a recently emerging trend for those who (actively) manage client portfolios is the idea of charging clients not an AUM fee that is a percentage of assets, but instead, a performance-based fee that is a percentage of upside (or outperformance of a benchmark index), where the advisor’s fee is forfeited if he/she fails to achieve the required threshold or hurdle rate. Such a compensation structure would compel active financial advisors to eschew closet indexing and really, truly, try to outperform their benchmarks – which can be a very compelling proposition to prospective clients.

However, the reality is that performance fees have a very troubled past. Because while a performance-based fee does incentivize the advisor to not be a closet indexer and own a substantially different portfolio than the benchmark, one of the “easiest” ways to do so is simply to take on more risk and amplify the volatility of the portfolio. After all, if the markets rise substantially – as they do on average – a high-volatility portfolio will often provide a substantial performance fee in a bull market. In when the inevitable bear market occurs, the “worst case” scenario for the advisor is simply a year of zero fees.

In fact, this “heads the advisor wins, tails the client loses” asymmetry of performance fees is why when Congress created the Investment Advisers Act for RIAs in 1940, it bannedmost financial advisors from charging performance-based fees at all to retail investors (and of course, brokers under a broker-dealer cannot charge performance fees because they are not serving as actual investment advisers in the first place!). It was only in 1970 that Congress partially relented and allow RIAs serving as investment managers to mutual funds to charge performance fees, and only then if it was a “fulcrum fee” where the advisor participates in both the upside for outperforming and at least some of the downside for underperformance. In turn, it wasn’t until 1985 that the SEC began to allow RIAs to charge performance fees in certain situations to retail clients, and even then the offering must be limited to “Qualified Clients” who meet one of three financial tests… either: a) $1M of assets under management with the RIA charging a performance fee; b) a $2.1M net worth (and thus are presumed to be financially experienced and “sophisticated” enough to understand the risks inherent in performance fees); or c) be an executive officer, director, trustee, or general partner of the RIA, or an employee who participates in the investment activities of the investment adviser.

In addition, it’s notable that research over the years on incentive fees in the context of mutual funds has failed to find any sign that incentive fees are actually associated with better risk-adjusted performance anyway. Instead, the research finds that – perhaps not surprisingly, given the problematic history of performance-based fees – mutual fund managers compensated by incentive fees tend to just generate higher returns by taking more risk, and then amplify their risk-taking activity further once they fall behind their benchmarks! Ironically, though, the researchers did find that mutual funds with incentive fees are more likely to attract client assets, suggesting that substantial consumer demand remains for paying investment managers via performance fees!

Nonetheless, the real-world operational challenges of executing what would be a more complex billing process, the revenue volatility that financial advisors introduce to their businesses (particularly if they use a fulcrum fee structure which means if the advisor underperforms, they really do take the risk of seeing their fees cut substantially), the limitations of only offering a Performance Fee structure to affluent Qualified Clients in the first place, and the conflicts of interest that must be managed, suggests that a widespread shift towards performance fees for RIAs is not likely in the near future… especially as many firms seek to shift their value propositions away from being centered around the investment portfolio and towards financial planning and wealth management instead! But for those RIAs who want to pursue charging performance fees on investment portfolios, it is an option… at least for their Qualified Clients who want to take the risk!

Fulcrum Or Other Performance Based Fees For Financial Advisors

One of the most popular and consumer-friendly aspects of the traditional “Assets Under Management” (AUM) fee is the fact that it aligns the incentives of the advisor and their client. To the extent the advisor charges a fee that is a percentage of the portfolio being managed, favorable investment results that grow the portfolio will grow the amount that the advisor can bill, and losses in the client portfolio will decrease the advisor’s billable assets. Thus, advisors charging AUM fees have a strong incentive to be good stewards of their clients’ money and see the portfolio grow, because growth for the portfolio is growth for the advisor’s business, too.

Yet the caveat of the AUM fee is that it only goes “so far” to align the incentives of the advisor and client. To the extent that markets themselves tend to grow on time – which generally happens regardless of the effort or role of the financial advisor – a portfolio’s AUM fee will tend to naturally rise over time, simply due to passive growth of the market itself. Yet the advisor is “rewarded” with higher fees for growth that the advisor wasn’t responsible for in the first place. In fact, an advisor who persistently underperforms a benchmark in a bull market will still earn the bulk of his/her annual fee increases anyway! For instance, if the market rises by 10% and the advisor underperforms by 1%, his/her AUM fee will still increase by 9% for the year, despite the poor (relative) performance!

As a result, in recent years there has been a growing discussion of whether financial advisors, particularly investment-centric ones whose value proposition is built around their investment process, should be charging some kind of performance-based fees instead. Because with a performance-based fee, the advisor’s compensation can be curtailed for underperforming a benchmark (even if the portfolio itself was up with the market). And if the advisor participates to a greater extent in the relative outperformance of the benchmark, the advisor has an extra incentive to try to beat the benchmark.

Thus, for instance, an advisor might charge a performance-based fee that provides for sharing 10% of the portfolio’s profits – which means the greater the profits, the more the upside for the advisor and the client. Alternatively, the advisor might charge a “fulcrum fee”, which stipulates that the advisor earns a base fee (e.g., 1%), but only earns an additional fee if a specific benchmark target is achieved – for instance, the advisor is compensated 10% of the outperformance above a return threshold (e.g., excess returns above a 7%/year hurdle rate) or for beating a certain benchmark (e.g., returns in excess of the S&P 500 return for the year). Notably, though, a fulcrum fee would also penalize the advisor for underperforming; for instance, if the portfolio substantially underperforms the benchmark, the 1% base fee might be forfeited altogether.

Yet notwithstanding the intuitive appeal of performance-based fees or fulcrum fees, the reality is that they have a very troubled past in the investment world. Which is why in most cases, investment advisers are actually banned from charging such performance-based fees in the first place!

How Performance Fees Incentivize Dangerous Risk-Taking

While performance-based fees provide greater reward potential for good investment managers – giving them a greater incentive to try to outperform, with the potential for investors to attract better managers who want to pursue that upside potential – the caveat is that performance fees can also incentivize managers to take more risk in order to pursue that upside.

For instance, consider a financial advisor who is going to manage a client’s equity portfolio, and will be benchmarked to the S&P 500. The advisor’s performance-fee agreement stipulates that he/she will receive 20% of any outperformance above the benchmark. If the advisor doesn’t beat the benchmark, the advisor earns nothing, as the fee is zero, ensuring the advisor has a very strong incentive to deliver outperformance!

But it turns out that the advisor’s “investment strategy” to achieve outperformance is not to try to pick superior investments and have a high active share. Instead, the advisor will be a closet indexer with a rather simple strategy: since markets go up more often than they go down anyway, the advisor simply puts all of the clients’ assets into a 2X leveraged fund that provides 200% of the daily return of the S&P 500 (e.g., ProFunds UltraBull S&P 500 Fund,ticker symbol ULPIX), and waits for the bull market’s leveraged returns to produce stints of substantial outperformance on which the advisor will earn performance-based fees.

In point of fact, since the fund’s inception in late 1997, ULPIX would have outperformed its S&P 500 benchmark in 11 out of 19 years (from 1998 to 2016 inclusive), in many years by more than 25% (and as high as 54.5% outperformance in 2013!).

Yet if the investor had started with $1,000,000 in the portfolio, at the end of 20 years, the portfolio of ULPIX paying 20% performance fees would only be worth $1,226,744, for a cumulative return of just 1.1%/year. In the meantime, the financial advisor generating performance fees would have “earned” performance-based fees of $454,526! In the meantime, if the investor had simply bought the S&P 500 and held it without the advisor involved at all, the portfolio would have grown to $2,867,761 (for an average annual return of 5.7% over this time period).

S&P 500 Vs Leveraged S&P 500 With 20% Performance Fees In A Bull Market

The end result: by taking substantial risk with the client’s portfolio and amplifying the volatility, the performance-fee-based advisor was able to demonstrate several years of strong outperformance (for which he generated a substantial profit), while the client alone experienced (sometimes dramatic) losses in the down years. Yet all the advisor did was buy a volatility-amplified index fund… which meant the performance-fee-based advisor generated substantial fees for providing little actual value to the client, as the advisor really just profited from the additional volatility to the upside (not his/her actual investment prowess), while the client bore the brunt of the inevitable losses that followed from the high-risk portfolio!

Why The Investment Advisers Act Of 1940 Bans (Most) Performance Fees For RIAs

The fact that performance-based fees can incentivize investment managers to take additional risk – which enriches the advisor during up markets, but can severely damage the investor’s portfolio during down markets – is not a new phenomenon. In fact, Congress recognized the problem in the aftermath of the bull market of the 1920s and the crash of 1929 and Great Depression that followed. And as a result, when the Investment Advisers Act of 1940 was written, Section 205(a)(1) explicitly established a ban on (most) performance-based fees for investment advisers! Because as Congress noted at the time, performance fees were effectively “heads I win, tails you lose” arrangements.

Specifically, the Investment Advisers Act provides that:

No investment adviser… shall enter into, extend, or renew any investment advisory contract… if such contract provides for compensation to the investment adviser on the basis of a share of capital gains upon or capital appreciation of the funds or any portion of the funds of the client.

In other words, after the destructive consequences of performance-based fees in the Crash of 1929 where investment advisers participated in the upside appreciation and capital gains of their investors in the preceding years (and even amplified the volatility with margin lending), but didn’t have to bear the pain of the subsequent losses to the downside in the crash, Congress banned performance fees for registered investment advisers in the very legislation that created RIAs in 1940. Instead, investment advisers were required to charge assets-under-management (AUM) fees, or a flat dollar amount (e.g., a retainer-style management fee).

In 1970, though, the SEC began to partially relax the Performance Fee rules. First, the Investment Advisers Act was amended to allow RIAs serving as the investment manager of a mutual fund to charge “Fulcrum Fees” (where the advisor can earn a performance fee to the upside but also must decrease its fee proportionately for underperforming the specified benchmark threshold) under the then-new Section 205(b).

And then in 1985, the SEC further relaxed the rules on performance-based fees for retail investors in Release IA-996, establishing Rule 205-3 which stipulated that investment advisers could charge certain performance-based fees when working with a “qualified client”.

For the purpose of performance fees, a “qualified client” is one that meets either an AUM test, a Net Worth test, or is an executive or investment-related employee of the RIA itself. The AUM test requires that the investment adviser actually be managing at least $1,000,000 of the client’s assets (originally $750,000, but increased to $1,000,000 in 1998 under IA Release 1731). The Net Worth test requires the (qualified) client to have a net worth of at least $2,100,000 (up from an original threshold of $1.5M, now annually indexed, and since 2012 investors may not include the value of their personal residence in meeting this net worth test) or be a “qualified purchaser” (ultra-high-net-worth individual, or certain institutions/entities) under Section 80(a)-2(a)(51). And the “employee” test requires that the qualified client either be an executive officer, director, trustee, or general partner of the RIA, or an employee who participates in the investment activities of the investment adviser.

Qualified Client Requirements To Pay Performance-Based Fees To A Financial Advisor

Notably, as mentioned earlier, a Registered Investment Company (i.e., a mutual fund) is also able to charge performance fees, but only if they meet the Fulcrum Fee structure requirement of Section 205(b)(2) of the Investment Advisers Act. On the other hand, hedge funds (limited partnerships that are treated as unregistered securities) are permitted to charge any type of performance fees, although they in turn are limited to only accredited investors.

Nonetheless, the key point is that a registered investment adviser that wants to charge performance-based fees to its “retail” investor clients can only do so if they are “Qualified Clients”. And of course, Series 6 or Series 7 “advisors” under a broker-dealer are not permitted to charge performance-based (or any advisory) fees at all, as they can only be compensated for brokerage services (unless they become a “hybrid” adviser and separately join or become an RIA as well).

Structuring Performance Fees And The Upside And Downside Of Fulcrum Fees

For investment advisers working with retail clients who are Qualified Clients, it is permissible to charge Performance Fees, but it’s still necessary to determine the actual structure of the performance fee itself.

Some firms simply arrange their fees to participate in a percentage of the upside (e.g., 10% or 20% of profits), while others stipulate that their performance fees are only paid if theyexceed a certain threshold (e.g., 20% of profits above a 5% return, or 10% of theoutperformance of a particular index or benchmark). In some cases, the only fee that is payable is the performance fee; in other cases, the performance fee may include a baseline AUM fee as well – for instance, 1% of the portfolio plus 10% of the excess return above a certain threshold.

In the case of mutual funds, to limit the potentially problematic incentives and conflicts of interest of performance-based fees, Congress explicitly required under Section 205(b)(2) of the Investment Advisers Act that the fee must provide for:

“Compensation based on the asset value of the company or fund under management averaged over a specific period, and increasing and decreasing proportionately with the investment performance of the company or fund over a specified period in relation to the investment record of an appropriate index of securities prices…”

In other words, a valid performance fee in the case of mutual funds must have some set measuring period of which investment performance will be compared to the underlying index, and the advisor’s compensation must both increase and decrease proportionately based on those results.

In practice, this type of performance-based fee is typically known as a “fulcrum fee”, where the investment adviser receives some “base fee” compensation, and the advisor’s fee is then increased for outperformance and the base fee is decreased for underperformance, to reduce the risk that the performance fee constitutes a “heads I win, tails you lose” structure. (Although notably, the “worst case” scenario would typically still only be that the advisor may forfeit all of their fee and have it reduced to zero, while the investor may experience outright losses, as there is no requirement for a “negative” or refundable fulcrum fee arrangement!) Nonetheless, given that the fulcrum fee approach reduces the potential adverse incentives for investment advisers to take more risk to earn higher performance fees (since they also have more downside risk), the approach is increasingly popular, even for RIAs serving Qualified Client retail investors (and not just managing mutual funds).

In addition, it’s also important to note that since IA Release 721 in 1980, a “contingent advisory fee” arrangement, an indirect version of a (non-proportionate) fulcrum fee where the advisor just receives a base fee (not a percentage of the performance upside) but does forfeit his/her fee for underperformance (e.g., where the advisory fee is waived if performance fails to clear a certain hurdle rate) will still be treated as a performance-based fee, necessitating a Qualified Client arrangement. Although a subsequent 2004 SEC No-Action letter to Trainer, Wortham & Co affirmed that a “satisfaction guarantee” refund option (where the investor can request a refund if they are unhappy with their investment advisor relationship, regardless of performance results), is permitted as long as the advisor’s fee truly is not contingent on meeting any specific investment performance threshold.

In the case of performance fees for state-registered investment advisors (i.e., RIAs with less than $100M under management), the RIA must adhere to state-level rules on performance-based fees, which may (but do not always) conform to the SEC’s regulations under the Investment Advisers Act for SEC-registered investment advisers!

Is It Worth Trying To Charge Performance Or Fulcrum Fees?

While there is some clear intuitive appeal to charging performance-based fees as a way to align the interests of the investment adviser and (Qualified) client, the mixed record of actual outcomes for performance-based fees still leave much to be desired.

As noted earlier, Congress banned performance-based fees for RIAs more than 75 years ago because of the consumer harm caused by their conflicts of interest (particularly the incentives for financial advisors to take excessive risks with client portfolios while hoping for a few good “volatile” up years), and while the rules have relaxed to some extent in recent decades, it has only been for more affluent “Qualified Client” investors who – right or wrong – are “presumed” to be more financially experienced and sophisticated and at least recognize the risks of the arrangement.

Though notably, in the context of financial advisors in particular, performance-based fees introduce non-trivial business execution challenges as well. For instance, with performance-based fees, there is a natural temptation to make trades for the biggest clients first, as getting better results for the biggest clients first amplifies performance-based fees (since for the same favorable trade that outperforms the benchmark, the performance fee is bigger for outperformance on a $10M portfolio than a $1M portfolio). In the context of amutual fund or hedge fund charging performance-based fees, this is less of an issue, because all clients participate equally in a pooled investment fund (though may still be a problem if the RIA serves as investment manager of multiple mutual funds of varying sizes); in an RIA working with retail investors, though, where it is typical to have multiple clients of varying sizes holding varying portfolios guided by numerous different investment policy statements, the issue of how trades are sequenced and allocated, along with fair execution (and being able to demonstrate that the RIA meets its Best Execution obligations), really matters.

In addition, performance-based fees can also create substantial short-term revenue volatility for the advisory business itself. Of course, to some extent, this is the whole pointof the performance-based fee – to give the financial advisor more “skin in the game” and a greater incentive to really, really try to outperform. Nonetheless, even the best investment managers may not find their strategies favored at all times, especially if performance-based fees are calculated by the “typical” quarterly billing process for an advisor. In fact, even annually-calculated performance-based fees can introduce substantial business pressure – as if the advisor only bills its performance fee annually, and has a single bad year, it means the business must run with all of its overhead costs for 2 full years because the next potential annual performance billing period! Some advisors might aim to “smooth” the performance calculation over multiple years to partially ameliorate this risk, but that means recent clients may end out being charged a performance-based fee for a long-term performance track record that predates when he/she was actually a client in the first place! (I.e., the client may end out being charged for performance that occurred before he/she ever showed up.) Alternatively, some advisors use a blended base-AUM-fee-plus-performance-fee structure to manage this business risk, but the combination of the two can potentially distort the incentives for the RIA again, as the structure returns to a “heads I win” (with performance fee) and “tails I don’t lose” (with AUM fee) outcome. (Which, again, is why Congress mandated a Fulcrum Fee structure for mutual funds under Section 205(b)(2)… to place the base fee under at least some risk in the event of underperformance.)

In addition, while with modern technology, it is potentially possible to have each performance-based fee calculated individually for each client – given that most RIAs do notinvestment client assets on a pooled basis, and so clients who start at different times may have performance fees calculated from different starting points –in practice many of the typical portfolio performance reporting and billing software solutions for RIAs do not have robust performance-based fee calculation modules (given how uncommon fulcrum and other performance fees are, in light of the Qualified Client requirements!). Which relegates the RIA to a more manual Excel-spreadsheet-based billing process that can be time-consuming at best, and at worst introduces manual billing errors. And under Rule 204-2 of the Investment Advisers Act, the SEC does expect a meticulous set of Books and Records to track all (performance-based) fee calculations!

And of course, there’s still the challenge that, even as performance-based fees are trying to come back into vogue, there’s still little evidence that they actually lead to better investment outcomes. An especially well-cited analysis by Elton, Gruber, and Blake in the Journal of Finance on incentive fees (in the context of mutual funds) found that funds charging performance fees did tend to have positive stock selection ability, but the best funds tended to actually have lower betas (and as a result the total return was not improved and the incentive fee often wasn’t even earned!). The remaining funds tended to have better relative performance, but only because they took more risk than non-incentive-fee funds, and their risk-taking behaviors tended to increase further after a period of poor performance (i.e., managers earning performance-based fees tended to take outsized risks trying to make up for losses to get back to their incentive-fee thresholds). Which meant in the end, the mutual funds using performance-based fees did not as a group exhibit superior risk-adjustedperformance results to non-incentive-fee funds… though ironically, the researchers did note that incentive-fee funds attracted more new cash flows, suggesting that the concept ishighly marketable, even if it doesn’t actually result in persistently better outcomes!

From a practical perspective, though, the biggest caveat and limitation to charging performance-based fees as a financial advisor is that, beyond the compliance oversight obligations, it’s necessary to be under an RIA (and not a broker-dealer), and limit the firm to working with Qualified Clients who meet the portfolio and/or net worth requirements in the first place (and/or to be structured as a hedge fund that works with similarly-affluent Accredited Investors instead). Which may be feasible for a subset of the largest RIA firms with the most affluent clients that can meet the Qualified Client minimums… except the largest RIA firms already are enjoying the fastest growth thanks to their marketing economies of scale and the fact that more affluent clients already tend to gravitate to the largest firms (regardless of whether they charge performance-based fees). And of course, focusing on performance-based fees may be very unappealing for more holistic financial planning and wealth management firms, that are trying to focus clients on the broader range of services they provide, and not accentuate focus on investment results alone.

Nonetheless, for RIAs that want to charge performance-based fees – whether under a mutual-fund-style fulcrum fee, or some other arrangement – and are ready and willing to work with Qualified Clients, it is an option under current law to do so, as long as all the rules and requirements are met. But it’s still crucial to be certain the firm properly manages its conflicts of interest, particularly when it comes to not just trying to “earn” performance fees by taking more risk with the clients’ investment dollars!

So what do you think? Are performance-based fees likely to grow in popularity in the coming years? Or should the SEC revive the restrictions of old on performance-based fees because of the unhealthy incentives for advisors to take greater risk in client portfolios? Please share your thoughts in the comments below!