EDITORIAL: FEES FOR WHAT YOU DO, NOT WHAT MARKET DOES

Performance-based fees are an idea whose time is coming. As reported in last week’s InvestmentNews, the Securities and Exchange Commission is considering new rules that would make it easier for wealthier investors to negotiate fees that are pegged to how wonderfully — or woefully — an adviser actually performs.

That’s good news. But the SEC also should require full, written disclosure — in everyday English, not legalese — of the agreed-upon fee structure. And it should insist that any performance-based fee be symmetrical: If the manager or adviser receives a higher fee for above-benchmark performance, he or she also should receive a lower fee for performance below the benchmark.

A fine model might be the performance-based structure used by the GTE pension fund. There, a manager earns a fee approximating that of an index fund for performance only equal to the agreed-upon benchmark. The rationale: The manager has added no value. He or she begins earning a normal management fee after exceeding the benchmark by a significant amount (say, 200 basis points), and from then on earns higher fees based on additional performance.

The fee begins declining when returns slide below the benchmark. But since no manager should be expected to work for nothing — it does take a certain amount of revenue to turn on the lights each morning — there is a minimum fee. And to prevent the manager from taking excessive risk, the performance can be risk-adjusted. In addition, fees are calculated not on one-year performance, but on rolling three-year cumulative performance.

Performance-based fees like this can be transferred to the world of the investment adviser and financial planner. Why? First, because more sophisticated investors increasingly want them. Second, because they align the interests of the client and the adviser more closely (which is probably why wealthier investors are demanding them).

Under the standard percentage-of-assets-based fee, the manager or adviser can make a nice living while adding no value to the investment portfolio year after year. In fact, as the market lifts assets under management, the fee income rises. The manager or adviser can rest on his or her laurels, rather than working hard to find investment value, and still have an improving life style.

Under a performance-based fee arrangement, an adviser who adds no value above an agreed-upon benchmark will receive a fee equal to indexed management — i.e., low. And an adviser who subtracts value by underperforming the benchmark will see his or her fee income, and life style, decline.

That’s only fair.