Fees Versus Commission

Part 5:  The Investment Advisors Guide to Errors & Omissions Insurance

  By Gary Sutherland, CIC, MLIS

Historically, commissioned sales result in more claims than fee-based sales activity. Our experience is that this may be true for the frequency (number) of claims, but not necessarily for the severity (amount paid). However, we do know that the when clients are unhappy with the results of an specific investment and later learn that a large commission was paid, they become more frustrated, and are more likely to seek legal counsel and sue.

Commission sales also drive more conflict of interest claims, especially in the qualified plan space. Underwriters know they are harder to settle, and if they end up in court or arbitration, they are harder to defend. Fee agreements are generally easier to understand, and easier to explain to a judge or jury.’

Underwriters use the advisor’s annual fees/revenue for benchmarking, or predetermining premiums prior to reviewing and analyzing the full application. The percentage of fees to commissions will be of interest to the underwriter, given the bias toward fee-based business. This snapshot is particularly relevant when the advisor is working in a hybrid setting as both a registered representative and an investment advisor representative.

Underwriters look for compensation outliers on the very high or the low end of the spectrum. Consider two advisors with similar practices, where both offer 100% fee-only professional services.

– Advisor #1 has annual revenue of $180,000

– Advisor #2 has annual revenue of $430,000

In most cases the advisor with a larger revenue base will pay more in premium since underwriters use revenues as a primary baseline for premiums – assuming that a consistent relationship between fees and AUM exists. Where the outliers come into play is when the revenue to AUM relationship is askew. One might expect advisor #1’s AUM to be approximately $18MM, and advisor #2’s AUM approximately $40MM. Underwriters become concerned when the fee to AUM balance is off, and they conclude that an advisor is receiving fees that are either significantly higher or lower than would be expected. Neither scenario is considered positive.

Using the same two advisors – assuming the fee to AUM ratios are normal – if advisor #1 has been in business for only 2-plus years, and advisor #2 has had a 25-plus year practice, which one is the better risk?

There is no simple answer. Underwriters see very few claims from advisors who are newly established, and industry trends show advisors are more likely to be sued after practicing for 10 or more years. In our opinion the underwriter should also use designations, nature of practice, and other important but nuanced information to assess the risk, which makes that personal connection between agent and underwriter critical. Therefore, we emphasize these areas in our client submissions.

Culture and past experience can play a big role in the underwriter’s decision making process when rating fee versus commission advisors (or the balance of revenue in a hybrid arrangement). The late 1990s produced lots of claims from churning, poorly designed annuities, and high upfront commissioned products. Seasoned underwriters frequently mention this to their trainees, and both groups carry this biased perception with them today.

Commission revenue that changes dramatically from year-to-year is also concerning. In an effort to keep premium consistent, it’s important to provide additional details on uneven commission sales. Was it a one-time commission sale based on years of work that caused the spike? The more information you can provide improves your position.

Conclusion

It is important to understand that many underwriters are predisposed to think that fee-based advisors are a safer risk. Your agent will need to share additional details on your firm’s commission sales to secure the lowest possible premium.

Our suggestions:

1. Accurately classify your revenue between fee-based and commission sales.

2. Proactively explain any discrepancies in revenue to AUM, especially if revenue is significantly higher or lower than 1% of AUM.

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Contact us for additional information:

Gary Sutherland, MLIS, CIC    Garys@mcgowanprofessional.com    508-656-1350