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What Does It Really Mean To Be A Fee-Only Financial Planner?

Posted by Michael Kitces on Wednesday, September 4th, 7:09 am, 2013 in Planning Profession

In recent months, the CFP Board has faced some high-profile cases that have tested its definitions of what it means to be a "fee only" advisor. First there was the incident with Alan Goldfarb, and more recently (though dating back to an earlier incident) a lawsuit filed by Jeffrey and Kimberly Camarda. In both cases, the incidents revolved around situations where advisors were providing services on a "fee-only" basis to clients, but also separately held a financial interest in a broker-dealer and/or an insurance agency that at least "could" potentially generate commissions. Although the CFP Board's current compensation disclosure requirements have actually been in effect since 2008, the cases have highlighted the complex realities of how many financial advisors structure their businesses, and tested where the line should be drawn regarding what does and does not constitute "fee only" compensation.

While it's hard to fault the essence of what the CFP Board is trying to accomplish with its definitions - that advisors should only describe themselves as "fee only" if they truly, solely receive compensation from fees - a broad interpretation that compensation includes not only what is received but what the advisor or a related party are "entitled to receive" has arguably narrowed the interpretation of "fee only" beyond the point it was ever intended. In fact, the CFP Board's current rules appear so tight that they may actually invalidate as much as 5% of NAPFA's own membership.

At the core of the issue is the CFP Board's viewpoint that "commission" compensation should include not only what a client does pay, but what a client could pay to the advisor or a related party. As a result, a wide range of advisors whose clients truly have only ever paid a fee to anyone must declare themselves to be "commission and fee" for the sole reason that someday, somehow, a client could pay a commission to the advisor or a related party (due to a license the advisor holds, or other advisors under the same employment agreement), even if no client ever has, or is even intended to - a standard that's virtually impossible for any but a small subset of independent privately-owned RIAs to meet.

Instead, perhaps it's time for a simpler, more straightforward definition of fee-only compensation - that "fee only" be based not on what a client could pay, but what the client actually does pay. If the client really does pay a commission to an advisor or a related party, then the advisor should be required to describe themselves as "commission and fee" accordingly. But if the client really, truly does only pay fees to the advisor and pays no commissions at all to the advisor or any related party, the advisor is permitted to call themselves "fee only" instead. Or viewed more simply - unlike the CFP Board's current rules, advisors should always be able to rely on the fact that no client has ever actually paid a commission to the advisor or any related party as a defense to calling themselves "fee only," if that is in fact the case.

Defining Fee-Only

The definitions for various types of compensation, including fee-only, are a part of the CFP Board’s Standards of Professional Conduct, which were updated in 2008 to their current form. According to the “Terminology” section, the label “fee-only” is defined as:

Fee-Only: A certificant may describe his or her practice as “fee-only” if, and only if, all of the certificant’s compensation from all of his or her client work comes exclusively from the clients in the form of fixed, flat, hourly, percentage or performance-based fees.

In turn, understanding this definition requires examining the term of “compensation” which is defined as:

Compensation: Any non-trivial economic benefit, whether monetary or non-monetary, that a certificant or related party receives or is entitled to receive for providing professional activities.

When combined together, the ultimate outcome of this definition is essentially:

Fee-Only: A certificant may describe his/her practice as “fee-only” if, and only if, the certificant or any related party does not receive and could not receive any non-trivial economic benefit, whether monetary (e.g., commission) or non-monetary, for providing professional activities, outside of fees paid exclusively from clients in the form of fixed, flat, hourly, percentage, or performance-based fees.

Although these definitions have been in place since 2008, and were substantively similar in the prior version as well, the recent case of Alan Goldfarb – the former Chair of the CFP Board’s Board of Directors who stepped down from his leadership position and subsequently received a public letter of admonition for failing to describe his compensation appropriately – have brought a new light to the strictness by which the CFP Board is interpreting these definitions, as further highlighted by their recent Notice to CFP Professionals on the Importance of Accurate Compensation Disclosures.

Fee-Only, Related Parties, And The Potential For Compensation

The primary issue at hand is not the essence of the CFP Board’s definition of “fee-only” – that advisors should only describe themselves as such if they receive compensation solely via fees. Instead, the issue is the CFP Board’s determination that the mere fact that an advisor could receive (i.e., "is entitled to receive") non-fee compensation is fatal to being fee-only, even if no such compensation has ever happened! Furthermore, the CFP Board’s definitions have been interpreted to mean that fee-only status is violated even if the certificant receives no such compensation, but a related party (including not only the advisor’s employer, but in theory any entity in which the advisor has a financial interest) could receive non-fee compensation as well. Again, the issue is not whether a related party does receive non-fee compensation, or whether the client ever actually paid a commission to anyone, ever. The mere existence of a relationship with another party, who is legally capable of receiving non-fee compensation, is apparently fatal to the fee-only label, even if there's no intention that a commission-related transaction will ever occur.

Goldfarb’s case proved to be an example of this exact situation. In the matter, Goldfarb was employed by an RIA, which in turn was owned by an accounting firm, which also held a small broker-dealer as a subsidiary. In addition, Goldfarb himself also held a small 1% interest in the broker-dealer in exchange for some small supervisory duties he fulfilled for the firm. Notably, at no time did Goldfarb ever receive compensation from the broker-dealer related to his clients. At no time did any of Goldfarb’s clients ever do business with the broker-dealer, or any other brokers affiliated with the firm. In other words, none of Goldfarb’s clients paid a commission to Goldfarb, nor any related party, ever.

But again, the mere fact that Goldfarb could have referred a client to the broker-dealer meant he should have labeled himself as a “commission and fee” advisor according to CFP Board’s definition, even though he never did send a client to the broker-dealer, never intended to send a client to the broker-dealer, and none of his clients ever paid a commission to the broker-dealer, and in fact all of his clients exclusively paid income in the form of fees to Goldfarb and his RIA.

The Problem With Fee-Only And Related Parties

So why is the CFP Board’s definition of fee-only troubling? Many advisors who have advocated on behalf of fee-only have applauded the CFP Board’s definition of fee-only, proclaiming that “fee-only” should be a way to refer to advisors who are not otherwise affiliated to any entities that can generate commissions.

The problem is that ultimately, though, fee-only is not about what clients could pay. It’s about – or should be about – what clients do pay. In other words, the way that CFP Board is defining fee-only, an advisor whose clients have never paid a commission to anyone, anytime, ever, is a commission-and-fee advisor if there’s some related party the advisor could refer a client to. Which is even more problematic, since "related party" is not defined in the CFP Board’s terminology. It’s been interpreted thus far to include the advisor’s employer, and any other firms or subsidiaries owned by that employer. Which means even if parent company owns 1% of my firm, and 1% of a completely unrelated local mortgage company on the other side of the country, the fact that my “employer” owns a commission-paying entity means I am now “commission and fee” regardless of the fact that I have no intention of ever referring my clients to this distant mortgage company 3,000 miles away. Given that there's no de minimis threshold, even owning stock in a publicly traded financial services company (e.g., the S&P 500!) could run afoul of the rules; after all, Goldfarb's financial interest in his broker-dealer was tiny, and he referred no clients to the broker-dealer, yet he was still publicly admonished. At some point, shouldn’t the fact that no client has ever actually paid a commission to the advisor or any related party (or anyone at all) be part of the discussion?

And notably, the conversation is not purely theoretical. Related parties – where no actual commissions are flowing, but in theory “could” – abound across the advisory landscape. Not only are advisors working for broker-dealers affiliated with commission-paying entities – even if their clients truly only ever pay fees – but even an RIA that is bought out by a bank or holding company could run afoul of the fee-only rules, even if no commission-related transactions ever actually occur (because the bank is separately also in the business of mortgage lending that pays a commission). Some large RIAs has broker-dealers to facilitate lower cost trading fees for their clients in a purely fiduciary transaction, but this too would run afoul of the CFP Board's rules, even if clients really do only actually ever pay fees. In fact, as a recent Financial Planning magazine story noted, the reality that a number of advisors have clients who “could” pay commissions to a related entity, even if none ever have, may end out disqualifying 5% of NAPFA’s own membership from claiming they’re fee-only, despite the fact that NAPFA's members have clients who in practice really have only ever paid fees (by requirement of the organization)! 

In fact, a direct interpretation of the CFP Board's current rules on "fee only" would essentially mean that only privately-owned independent RIAs could possibly be eligible for being fee-only, and even then such firms wouldn't qualify if any owner had any financial interest in any other financial entity that could generate commissions (regardless of whether there are any clients who actually cross over and do business with the other entity). No advisor at a wirehouse, independent broker-dealer, corporate RIA, bank, is permitted to be fee-only under the CFP Board's definition, even if the advisors clients truly solely ever pay fees. Furthermore, even any RIA that has a bank, broker-dealer, or other company that owns any financial interest in the RIA and a financial interest in any other entity (virtually ubiquitous in today's world of financial holding companies) would be disqualified from being "fee-only" including Fiduciary Network, Hightower Advisors, and more.

A Better Definition Of Fee Only

So what’s the alternative to resolve this problematic definitions scenario?

To focal point is around the definition of compensation to related parties. The starting point - which hopefully we can all agree upon - is that if an advisor actually gets paid a commission directly from doing business with a client, the advisor is commission-and-fee.

With respect to related party scenarios, it seems that there are two primary situations that need to be addressed. The first is a scenario where the client really does pay a commission, and it’s not to the advisor, but it is to a related party of the advisor – perhaps an entity related to the advisor’s employer, or another (commission-based) advisor at the same firm, or to an entity in which the advisor owns a material financial interest. Although such scenarios may have to be evaluated in some depth based on the facts and circumstances of the situation, the basic point remains valid: advisors who generate indirect benefits from commissions-related activity by referring clients to related parties should still be required to disclose that they are commission-and-fee advisors. Even if they choose not to take the commission, in this narrow scenario where they are entitled to the commission via a related party and could receive some indirect benefit even after waiving it, the advisor is commission and fee. (Sidenote: Perhaps addressing advisors who waive commissions was actually the original intention of the "entitled to receive" phrase in the "compensation" definition?)

The second scenario is where the client never actually pays a commission to any party related to the advisor, even though a related party exists out there somewhere. Perhaps the advisor works for a broker-dealer, but refers all their clients’ term insurance needs to TermInsurance.com and recommends no other commission-based products. Maybe the advisor simply directs clients to implement commission products on their own. Or perhaps the advisor simply doesn’t recommend any form of commission-related product, period. Yes, the advisor may happen to work for an employer that has other advisors that work on a commissioned basis (or is owned by an entity or holding company that happens to own other businesses that are associated with commissions), but no clients have ever paid any commissions to the advisor or to any related party, period. Under the CFP Board’s current rules, this would still constitute a commission-and-fee advisor, yet it’s difficult to see why any advisor should be compelled to declare they are “commission and fee” when no client will ever actually pay, or ever is intended or anticipated to pay, a commission in the first place!?

In other words, the bottom line is that if the whole point of compensation disclosure is to look at how advisors are being compensated, and what clients are paying, then what clients actually do pay should always be the starting point. Which means if clients do pay commissions, then it at least needs to be determined if those commissions are being paid to an advisor’s related party (or the advisor themselves), and if so the advisor should disclose the commission-and-fee compensation. But if the clients are not paying commissions at all (or they are, but it’s truly to an unrelated third party), then advisors should be able to safely declare themselves as fee-only, regardless of what could have happened, based on what actually happened. We don’t put people in jail because they could murder someone when they haven’t, and we don’t arrest people because they could commit fraud when they never have, and we shouldn’t sanction advisors for saying they’re fee-only if they could generate a commission (directly or indirectly) but deliberately never do.

Fortunately, the “fix” to this for the CFP Board is remarkably simple. All that needs to happen is the Disciplinary and Ethics Commission needs to evaluate advisors based on what they do, not what they could do. Remove the “entitled to receive” label from the definitions of “compensation” and base "fee-only" compensation disclosure on what advisors and related parties actually do receive, not on what could have but never did and never is intended to happen. Which means the new definitions would read:

Fee-Only: A certificant may describe his or her practice as “fee-only” if, and only if, all of the certificant’s compensation from all of his or her client work comes exclusively from the clients in the form of fixed, flat, hourly, percentage or performance-based fees.

Compensation: Any non-trivial economic benefit, whether monetary or non-monetary, that a certificant or related party receives for providing professional activities.

Or alternatively, if the "entitled to receive" definition remains, the CFP Board should interpret in perhaps the manner it was originally intended - that no advisor (or related party) can be "entitled to receive" a commission until and unless a client actually pays a commission, not just based on the fact that they could have!

Surely, at some point the fact that no client has ever actually paid a commission to the advisor or any related party (or anyone at all, for that matter) should be a valid defense and safe harbor to claiming an advisor is fee-only, right?

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