A New Dimension

Five years ago, 90% of Gallagher Retirement Services’ revenues came from commissions and 10% from fees, but that has changed. This year, 30% of the firm’s revenues will come from commissions and 70% from fees. Gallagher made a conscious business decision to evolve from being a broker to a value-added consultant, says Michael J. DiCenso, National Practice Leader with Gallagher Retirement Services in Itasca, Illinois.

Gallagher’s decision has proved to be a wise one. The firm has had an explosion in growth attributable, in part, to the change in revenue model. “Revenues have grown dramatically as well as assets under care, not because we’re charging more but because we are acting as an independent, unbiased, objective consultant,” DiCenso says. In the last two years, Gallagher’s assets under care have grown from $5 billion to $30 billion, while staffing has increased from 50 people to 70 people. That 40% growth in staff at the firm, notes DiCenso, supports a 70% growth in assets under care.

The plan adviser universe has gone through a transition of sorts—moving from a commission-based revenue model to a fee-based one. That transition started five years ago, but gathered additional speed last year. “Basically, we’ve seen an acceleration toward fees for services or ERISA budget ­accounts,” says Michael E. Goss, Executive Vice President with Fiduciary Investment Advisers, LLC, in Windsor, Connecticut. That trend, he says, will further quicken because of the new disclosure rules. Acceleration toward fees for services is due to transparency—it allows fiduciaries to evaluate plan costs more effectively. Plan sponsors, says Goss, understand that this is a critical element in fulfilling their fiduciary obligations to the plan.

The end result, say some, may lead to the ultimate demise of the commission-based revenue model. The question, say industry insiders, is not whether advisers should change revenue models, but why have they not done so yet?

The two long-established revenue models for retirement plan advisers are what are sometimes called the broker model, based on product sales and paid commissions, and the so-called “consultant” or registered investment adviser (RIA) model in which services are performed for a fixed fee. In the former, the adviser is compensated via 12b-1 and finder’s fees, with no explicit fees charged for actually providing services to the plan, says Goss. Plans with more than $50 million in assets historically have been handled by consultants receiving flat disclosed fees and little in the way of commissions, while smaller plans traditionally have relied on the broker/commission model.

The broker/commission-based revenue model, however, has come under scrutiny in the last few years as lawsuits continue to be filed against large plans over the fees they are paying, Congress holds hearings over proposed disclosure rules, and mainstream media outlets have articles about 401(k) fees front and center. Sponsors, even in the micro and small-plan markets, are increasingly aware of their fiduciary roles, and the potential conflicts in a commission­based model. “What we are seeing from plan sponsors is a desire to have more transparency and simpler fees, and you don’t always get transparency in the commission model,” says Ryan Gardner, a Principal and Consultant with Fiduciary Investment Advisers, LLC.

“There’s a lack of trust in the old system. Employers want to understand what employees are paying and to whom,” says Paul Grutzner, a Managing Partner with ClearPoint Financial LP in Seattle, Washington. The problem, he says, is that it is difficult to provide fee transparency in the commission model because subtransfer and administrative fees are traditionally hard to track. These types of fees are hard to track, he says, because custodians have traditionally not revealed them. “[A] lot of insurance-based platforms do not even admit or reveal how much revenue in total they have negotiated from fund companies.”

Change Will Do You Good?

The industry definitely is trending toward hard-dollar fee-based arrangements, says Grutzner, who adds that, like Gallagher, upward of 70% of ClearPoint Financial’s new clients are fee-based. New clients that steer away from fee-based arrangement, he says, generally prefer to share costs with employees. His firm has always used both fee-based and commission-based revenue models, he says, but it has aggressively sought out fee-based work over the last four years. While ClearPoint prefers to be paid via a fee-based arrangement, says Grutzner, it ultimately allows the clients to dictate the method by which they prefer to make payment. However, he adds, no matter what the compensation arrangement, ClearPoint always provides full fee transparency.

The founders of Fiduciary Investment Advisers (FIA) made the decision to leave a wirehouse firm and become a fee-only registered investment adviser two years ago, says Gardner, because it was the best solution for servicing clients. “With no broker/dealer or investment manager affiliations,” he says, “we are able to deliver truly objective advice for our clients.” Two years after the decision, says Gardner, FIA is beyond the transition period and focused on growth. “The initial transition period went very well and we are growing at a healthy rate,” he says.

Another firm that left a wirehouse commission model is Walker Bafs Retirement Group in Indianapolis. Now a member firm of NRP Financial, Walker Bafs had been with Merrill Lynch through March 14, 2008. The move was predicated on what was best for the clients and what was best for the team, says Wade Walker, Senior Vice President. Merrill Lynch, he says, would not let the firm sign on as a fiduciary to client plans and would not let the firm monitor investment policy statements. It also limited the firm’s ability to work with other vendors, which in turn was limiting the team’s ability to seek out other opportunities, he says. Merrill Lynch was contacted for this article, but chose not to respond.

Walker says that his firm would have remained with Merrill Lynch had the wirehouse, among other things, allowed them to sign on as a fiduciary and monitor investment policy statements. Had they done so, he says, there would have been no reason for his firm to switch. After setting a March 2008 deadline for Merrill Lynch to agree to changes, the firm made the switch after the deadline was not met—Walker Bafs had given Merrill approximately 90 days. The transition, says Walker, was smooth. “The transition from cutting tape on one side to rebuilding the race car on the other really only took a couple of weeks. There were a couple of bumps but, otherwise, it was a smooth transition.”

However, while the commission-based revenue model may become a thing of the past in the middle market and up, brokers and 12b-1 fees still will be very much part of the landscape. Smaller plans, in particular, will resist paying hard-dollar fees out of pocket, so new revenue models are being developed for this market that enhance transparency of fees, while still allowing for plan fees to be paid through investment fees. Under the “administrative budget” or “ERISA budget” revenue model, a sponsor sets up an account within the plan to capture fees and pays the plan adviser from that account (see “A New Way to Pay“). Small to mid-size sponsors prefer this model to the straight-fee model because all fees are disclosed, yet still paid from the plan, says Goss.

What the movement to a fee-based environment means for a plan adviser can depend on who his broker/dealer is. In the past, if an adviser was at a wirehouse, or even some independent broker/dealer, in order to switch revenue models, the adviser had to leave the firm, as demonstrated by the members of Fiduciary Investment Advisers and Walker. However, many providers are responding to the transformation in the marketplace. In the last few years, vendors have changed their defined contribution plan platforms to allow flexibility and accommodate different revenue models, and broker/dealers, including some wirehouses, also have changed to allow brokers more flexibility in structuring their fee arrangements. UBS, Smith Barney, and Raymond James now all allow their retirement plan brokers to use fee-based revenue models.

The platform provided by Wachovia Retirement Services supports all different forms of revenue payment arrangements, says Ralph Pallante, a Vice President of Marketing Services with Wachovia Retirement Services in Charlotte, North Carolina. The Wachovia platform, he says, takes in all revenue streams, then allows advisers to set their own payment arrangements, generally in agreement with the plan sponsor. “If an adviser wants a finder’s fee, we’ll do that. If an adviser wants 15 basis points of assets, we’ll do that,” he says, “If the adviser wants to get 12b-1 fees, the system is set up for that, and, if the adviser and sponsor agree that fees will be paid out of an ERISA account, that can be set up as well.” Wachovia also can accommodate hard dollars, Pallante says, but, no matter what the arrangement is, the platform is set up to give full fee transparency to all amounts paid.

Five years ago, Pallante says, the system was largely devoted to paying out 12b-1 fees to advisers. The ability to accommodate other revenue models existed, he says, but the products were not promoted. Wachovia is also somewhat flexible when it comes to allowing its advisers to assume fiduciary status. When the adviser is paid from Wachovia’s revenue streams, the firm, like other wirehouses, prohibits the financial adviser from positioning himself as a fiduciary. However, when the financial adviser enters into a separate agreement with a plan sponsor to be paid from plan assets, Wachovia does allow him to sign on to the plan in a fiduciary capacity. Additionally, when the financial adviser is an affiliate of Wachovia, he can act in a fiduciary capacity if he is being paid out of plan assets, but he also must adhere to other requirements set by Wachovia.

One-Hit Wonders

However, even though the vendors are changing to accommodate different revenue models, some are predicting a shakeout in the industry. As fees become a larger focus, those active in the retirement plan space will be expected to be providing superior services for the money they are receiving. Grutzner predicts that “one-hit wonders”—personal financial advisers who have five or fewer retirement plans—will be pushed out of the market in favor of advisers who specialize in servicing retirement plans. “There will be a shake-out in the industry over the next five years.” Generalist advisers, he says, cannot provide the services that a plan specialist can.

Consolidation is already under way in the broker/adviser industry, agrees DiCenso, with retirement-plan work moving to businesses that specialize in retirement plans. The reason is obvious. Plan sponsors are starting to realize what their fiduciary liabilities are, he says, and are looking for ways to manage that liability. “We have the staff to help clients manage their fiduciary obligations,” he says, “particularly in areas where smaller groups cannot keep up.”

Yet, while some predict the future of commissions is grim, Pallante argues there is still a future for small advisers looking for 12b-1 fees (and for those not wanting to go the RIA route). Products offering “zero fees’ are still popular with smaller sponsors, he says, although sponsors will need to understand that recordkeeping, administration, etc., is not actually “free’ and that they are paying for these services. “You’ll still see 12b-1 payments,” he says, “but there will be a lot more disclosure of those payments.” Pallante believes that any new regulations regarding fee transparency will apply to all plans regardless of the size.

In any event, advisers who service plans well will be well-positioned no matter what their revenue model is, says Goss, but advisers who collect fees while providing little or no service will be in trouble. With the new disclosure regulations, sponsors will get reports detailing adviser fees, says Goss. Fee disclosure is coming, says Goss, so it is a good idea to talk to clients about what fees they are paying and different revenue models as opposed to just letting the regulations dictate it. Sponsors that did not know their broker was getting fees may be shocked to realize the broker is getting $30,000 a year from the plan. The broker either will have to start earning that fee or the plan will get itself a new adviser, he says.

Tiburon Predicts Strong Growth Among Fee-Only Advisers

The number of fee-only financial advisers has been relatively flat in recent years—there are 10,466 Securities­ & Exchange Commission-registered­ fee-only financial advisers—but the number will increase to 27,000 by 2012, predicts research from Tiburon Strategic Advisors.

Tiburon, a market research and strategy consulting firm, says fee-only adviser average assets under management will grow to $310 million by 2012 and fee-only adviser clients will increase to 3.2 million by 2012. The number of fee-only advisers served by custodians will increase to 27,000 by 2012.

Fee-only advisers currently generate $30 billion in revenues, which will increase to $55 billion by 2012, Tiburon predicts. The net income of these advisers will grow from $15 billion currently to $20 billion by 2012, says the research report, “An Initial Overview of the Fee-Only Financial Advisors (RIAs) Market.” However, Tiburon says their profit margin will decrease to 36% in 2012.

Current Marketplace

As for the current marketplace, Tiburon says many advisers are really fee-based; fee-only financial advisers account for just 35% of all fee-only and fee-based financial advisers. Fee-only advisers have 25% fewer accounts, on average, than fee-based and commissioned advisers.

Fee-only financial advisers with a firm size smaller than $25 million and no assets account for one-half of financial advisers, and more than half of all fee-only financial adviser assets are controlled by the 2,000 advisers with greater than $200 million in assets.

One-third of fee-only advisers’ assets come from plan rollovers and another third is money moved from a different broker. The ultra-high-net-worth investor clients of these advisers have increased 2% in 2006, while their high-net-worth clients have decreased 8%. Most fee-only ­advisers commented during the research that offering wealth management services is a key to attracting high-net-worth clients, according to Tiburon. Fee-only financial adviser mergers and acquisitions are up more than 600% since 1999, with 81 deals taking place in 2007, Tiburon’s research finds.

Investments

When it comes to investments, fee-based financial advisers may buy $75 billion per year in annuities, and will invest more than half of their assets under management in mutual funds and individual securities. These advisers prefer to receive contacts quarterly, and financial advisers generally prefer less contact as the portion they accept in commissions increases, and fee-only financial advisers and fee-based independent financial advisers are far less likely to want in-person visits than fee-based wirehouse advisers.—Rebecca Moore

Micro to Large
Different fee structures for different sizes

Historically, the commission model in the large plan—plans with more than $50 million in assets—market has been pretty much nonexistent.­ Commission-based adviser compensation, however, long reigned supreme in the small to mid-size plan market, with fee-based arrangements rare.

It is in the small to mid-size plan market—plans with $3 to $50 million in assets—that Gallagher is seeing the most movement from commissions to fees, says Di Censo. While five years ago, those Gallagher clients were almost 100% commissions, they are now 30% commission and 70% fees.

Although industry experts predict the evolution will continue, the micro to small-plan market is still resisting moving to fee for service. At ClearPoint, the plans still compensating the firm using 12b-1 fees are mostly small plans with less than $5 million in assets, says Grutzner. Right now, says Di Censo, 100% of Gallagher’s micro clients—plans with less than $1 million in assets—are still on the commission model. That, however, will change as well, say the experts, albeit slowly. Grutzner predicts that, in the next four to five years, the clients still compensating the firm via 12b-1 fees will move to a fee-based revenue model.

However, while the small to micro markets may move away from straight commissions, says Goss, they still will be reticent to pay an out-of-pocket fee. “Smaller companies,” he says, “have smaller resources.” —ED

*Illustration by Chris Buzelli