Compliance Considerations for Net Worth and Income Fee Structures

Increasingly in the industry, we are finding more and more firms that leverage client net worth and/or income calculations as a part of their fee structure. In addition, as financial planning continues to permeate the more traditional AUM-centric industry, many advisers are looking for ways to address the “affordability” factor of financial advice from the perspective of the client’s wallet. At the same time, Net Worth and Income calculations allow advisers to address the complexity of a client’s overall financial picture to provide customized and tailored financial planning solutions. All of this, while ensuring that firm profitability remains at a level that affords the adviser to continue serving clients.

In principle, the process seems straightforward. The adviser communicates the fee structure to the client, executes the contract, and administers invoices and payments according to the fee schedule and signed client agreement. The client agrees that the fee is fair for the services. The principles of “free-market” give way to the forces of supply and demand, and the costs are reasonable so long as the consumer and service provider agree to the value of the service. Unfortunately, from a regulatory perspective, these fee schedules leave extensive opportunities for regulators to poke holes in the extent to which fee calculations derived from client net worth and income are reasonable. Here are the most common regulatory deficiencies stemming from these fee schedules.

Reasonableness of fees

This deficiency item is low-hanging fruit for regulators examining firms that use net worth and income calculations as a part of their fee structure. Why? Compared to the standard AUM calculation, the “value” of financial planning services is subjective. At any point, a regulator can unilaterally determine that the financial planning service provided was not valuable enough to merit the fee charged, regardless of what documentation the adviser provides as evidence of services rendered. If there are no clearly defined quantifiable metrics by which to “measure” services (such as an hourly fee or AUM calculation), then the onus is on the adviser to “prove” the worth of their services. The most effective way to overcome this regulatory objection is for firms to itemize detailed descriptions of services provided during the payment period on the invoices they provide to clients. It’s a pain, but it appears to be one of the most effective ways to resolve this deficiency in regulatory exams.

Documentation of client net worth calculation

As a general best practice, firms are advised to keep track of all documentation supporting the calculation of fees charged. This can be accomplished in an AUM fee structure by evaluating the client’s statement and account balances for the fee billing period and applying the percentage at that tier to the client’s account balances. The firm will maintain evidence of the client account balances used to calculate the fee and present that information when requested. Simple.

But what happens when a net worth and income calculation leverages independent values to create the fee amount? In most cases, the requirement to maintain documentation of each independent value remains a responsibility of the firm. For example, let’s consider this sample net worth calculation, an excerpt from a current Form ADV Part 2A Item 5.

“Net Worth is defined as the sum of the following assets: Cash & Cash Equivalents, net income after taxes from most recent tax returns, all investment accounts (Including trusts, qualified retirement accounts, charitable accounts, 529 Plans), cash surrender value of life insurance/annuities, principal residence and other real estate, and less debt (credit cards, mortgages, student loans, auto loans, and any other notes payable).”

In this example, the adviser does a fantastic job presenting detailed disclosures of how net worth is calculated. However, the adviser also creates the potential burden of maintaining documented evidence of each value used in the calculation. In other words, in the above example, it would not be unreasonable for a regulator to require supporting documentation for the value of the client’s principal residence or the cash surrender value of life insurance policies. With AUM calculations, the adviser only needs account balances to support calculations. With the net worth and income calculation, the adviser may need to maintain a significantly higher volume of documents to verify fee calculations. The best way to prepare for this potential deficiency is to keep up-to-date documentation of each element of the net worth calculation and execute periodic testing of billing and invoicing processes.

Transparency of Fees

Another entirely subjective element of this equation is the transparency of fees. Regulators retain the right to decide if they feel that a fee structure is easy for clients to understand. Generally speaking, the more elements and inputs a firm includes in their fee calculation, the less “transparent” regulators will deem the fee structure. This element becomes further complicated because many firms will charge one fee for both investment management and financial planning services, based on the net worth and income calculation. When setting one price for two services, regulators tend to struggle to determine what portion of the fee is attributable to financial planning services and what portion is for investment management. As a result, the tendency is to view the entire fee in the context of a percentage of assets under management, in which case the total fee charged can often seem excessive. The best practice by which to preemptively address this deficiency is twofold:

• Itemize Financial Planning Services provided on each client invoice.
• Create an addendum to the client contract that displays the net worth calculation, and if possible, have the client sign off on their understanding of that calculation.

Deliverables for Financial Planning Services

 This compliance hurdle reaches beyond the scope of this particular fee structure and extends into an industry-wide compliance obstacle for financial planning-focused advisers. Whether calculating financial planning fees through net worth and income on a project basis or by charging an ongoing monthly fee, regulators are challenged with determining what level and quality of deliverables justify costs on a case-by-case basis. In a compliance sense, by “deliverables,” we are referring to the work product provided or “delivered” to the client during the billing period in which the client fee was assessed and charged. Instances in which fees were assessed but no work was done for the client create regulatory concerns that the firm is taking advantage of clients.  In compliance, there’s a saying: “If it’s not documented, it didn’t happen.” Thus, even if the adviser spent time on the client during the billing period, regulators can claim that the client shouldn’t have been billed if there is no work product documentation. The most common practice to address this deficiency is to maintain evidence of deliverables provided to clients and give clients the option to pay in arrears instead of in advance. The logic for the latter practice is that clients charged in arrears will be allowed to assess the value of services provided and cancel the financial planning service before being billed, should they deem the deliverables insufficient.

I wouldn’t anticipate a sense of urgency on behalf of regulators with respect to revamping examination procedures to accommodate innovative financial planning fee structures. However, through preparation and effective ongoing procedures, firms can successfully minimize the risks associated with fee structures that leverage net worth and income calculations.

These materials have not been reviewed or approved by any regulatory agency, and represent solely the interpretative opinions of Synergy Compliance Education (“Synergy”). To the fullest extent permissible pursuant to applicable laws, Synergy disclaims all warranties, express or implied, including, but not limited to, implied warranties of merchantability, non-infringement, and suitability for a particular purpose. In no event shall Synergy have any liability for damages, losses, and causes of action for accessing these materials.