Advisers starting to make a shift to performance fees

A financial adviser’s guidance may seem worth every cent when a portfolio is on the rise, but investors might question if they’re getting their money’s worth during a period of negative returns.

That’s why a minority of financial planners are putting their money where their advice-giving mouths are by accepting performance-based fees for their work.

Performance fees, restricted by federal regulations to clients with at least $750,000 under management or $1.5 million in net worth, mean a financial adviser shares in the riches when the portfolio performs well and shares in the pain when returns lag.

However, pay for performance has been embraced by only a few advisers. The model is more commonly used by hedge funds, money managers and a small percentage of mutual fund groups. The two largest funds, Fidelity Magellan and Vanguard Windsor, do use them.

Some advisers who are paid commissions find the idea of performance-based fees attractive because they are seen as attractive to clients.

Those already offering it see themselves in the vanguard.

“I have a feeling this is the way of the future,” says Sam Jones, president of R.E. Jones and Associates Inc. in Denver, who manages $55 million.

need for performance

“In the beginning, there were transaction fees, which were a disaster. The fee-only arena has been solid for the last few years, but I think this is the new wave. I think you’re seeing more people reaching out for this. It forces the manager to produce or they don’t get paid,” he says.

“It puts us on the other side of the table with the client and makes us have a vested interest even more than a fee-only arrangement.”

Stephen Wershing, chief operating officer of Wall Street Financial Group, an independent broker-dealer and advisory in Rochester, N.Y., is skeptical. He is trying to talk reps out of making the switch, pointing out that performance fees would encourage risk taking, would not reward advisers for mitigating losses and would hurt business in off years like 2000.

“Reps believe it’s a great way to make a bunch of money, if you can make an awful lot of money for the client,” he says,”but what they often don’t realize is that if we have a bear market, the chances you will make the client a ton of money are very small or they don’t exist at all. If the average bear market is 12 months, can you go a year without pay?”

So his company, with 300 affiliated reps, has laid down the gauntlet. “If any of our advisers do it, they are going to do it elsewhere, because we are not going there,” he says.

To the argument that advisers won’t get paid during hard times, Mr. Jones responds bluntly: “Tough. That’s what the investors are saying. They want results, period.” He says it wasn’t any epiphany that made him see the light on performance-based fees. Rather, it was three multimillion-dollar prospective clients who said they’d let him manage all their money if he linked his compensation to performance.

details of a plan

Under the arrangement started in January, Mr. Jones charges a management fee of 0.5%, enough to cover costs in down years. When the portfolio earns above 12%, his company gets 30% of the profit above that benchmark. “If you’re doing your job and set those benchmarks at a reasonable level, it’s a win-win situation, because in the big years you’ll get paid well. You make 3% or 4% on an account. When you don’t make the benchmark, you’ll break even.”

Sounds good for clients, but other advisers who offer the option say they haven’t had many takers.

Stephen Barnes, co-owner of Barnes Investment Advisory in Phoenix, has offered a performance-based arrangement for more than a decade to clients who invest at least $1.5 million. Instead of the typical 1% fee for assets under management, he reduces that to 0.25%, and when the client’s portfolio generates more than a 10% return, Mr. Barnes’ company gets 10% of the profits above that amount.

In the 10 years he’s offered the arrangement, only one client has signed on. “He’s still with us, and we still have that arrangement,” says Mr. Barnes, whose company has $60 million under management. He says clients with that kind of money are just not familiar with the performance-based approach.

“It’s unconventional and would require clients to move beyond a certain comfort level with what they consider a normal fee arrangement.”

As for whether it’s worth his while, the fees paid by the client have averaged out to about 1% anyway, he says. “It’s been about a wash.”

At Pin Oak Partners, a Pittsburgh investment management company, performance-based compensation is the “preferred method of remuneration,” according to the company website. Despite the marketing, Pin Oak president Ned Siegel says there hasn’t been much interest.

“Some people have habits that are long-standing,”adds Mr. Siegel, noting it may take a number of market cycles for investors to consider it.

Apparently, there is investor interest. Surveys by Dalbar Inc. indicate that 5% to 10% would prefer a performance-based arrangement.

The Securities and Exchange Commission has rules restricting performance-based fees, though they’ve been relaxed in recent years, says Robert Plaze, associate director of the agency’s division of investment management.

Financial minimums were set so that the fee structure would be available only to “sophisticated investors,” who more likely would be aware if their portfolio was being subjected to greater risks.

As for the concerns of advisers, if institutional money managers can create performance-fee models that work, so can advisers, says Theodore Aronson, whose Philadelphia firm runs $4.5 billion in institutional assets.

Over the next few years, advisers may not have a choice if market returns are in the single digits and fees eat up a third to all of the gains, Mr. Aronson says.