Why is this Topic Important to Wealth Managers? This blogticle presents discussion on proposed rules that would affect wealth managers who charge performance fees in association with asset management. Given the proposed rule some clients may become exempt from the performance fee structures allowed, thus staying informed on the subject is critical for some wealth managers.

Earlier this week the Securities and Exchange Commission provided a public notice of its plan to raise certain dollar thresholds that would need to be met before investment advisers can charge their clients performance fees.

Generally, section 205(a)(1) of the Investment Advisers Act generally prohibits an investment  adviser from entering into, extending, renewing, or performing any investment advisory contract  that provides for compensation to the adviser based on a share of capital gains on, or capital  appreciation of, the funds of a client. [1]

Congress prohibited these compensation arrangements (also known as performance compensation or performance fees) in 1940 to protect advisory clients from arrangements it believed might encourage advisers to take undue risks with client funds to increase advisory fees.

By 1970 however, Congress provided an exception from the prohibition for advisory contracts relating to the investment of assets in excess of $1,000,000, if an appropriate “fulcrum fee” is used. [2]

Congress subsequently authorized the SEC to exempt any advisory contract from the performance fee prohibition if the contract is with persons that the SEC determines do not need the protections of that prohibition. [3]

The SEC thus adopted rule 205-3 in 1985 to exempt an investment adviser from the prohibition against charging a client performance fees in certain circumstances.

Currently, Rule 205-3 under the Investment Advisers Act allows an adviser to charge its clients performance fees in certain circumstances. Two of the circumstances are:

1. The client has at least $750,000 under management with the adviser.
2. The adviser reasonably believes the client has a net worth of more than $1.5 million.

Section 418 of the Dodd-Frank Act requires the SEC to issue an order to adjust for inflation these dollar amount thresholds by July 21, 2011, and every five years thereafter. As a result, the SEC issued its recent notice that it intends to issue an order to revise the dollar amount tests to $1 million for assets under management and $2 million for net worth.

The SEC also proposed related amendments to Rule 205-3 that would:

• Provide the method for calculating future inflation adjustments of the dollar amount tests.
• Exclude the value of a person’s primary residence from the determination of whether a person meets the net worth standard.
• Modify the transition provisions of the rule to take into account performance fee arrangements that were permissible at the time the adviser and client entered into their advisory contract.

The SEC is now seeking public comment on these proposed related rule amendments.

For previous coverage of recent SEC rulemaking in Advisor’s Journal, see SEC Unprepared to Implement a Fiduciary Standard for Broker-Dealers (CC 11-33), SEC Fiduciary Standard Study Answers Few Questions (CC 11-25), Study Finds that Universal Fiduciary Standard Will Hurt Investors (CC 10-97) & What You Don’t Know Yet Might Hurt You: A Broker’s Duties under the Financial Reform Act (CC 10-40).

Next week’s blogticles will discuss current wealth management issues.

We invite your questions and comments by posting them below, or by calling the Panel of Experts.

[2] A fulcrum fee generally involves averaging the adviser’s fee over a specified  period and increasing or decreasing the fee proportionately with the investment performance of  the company or fund in relation to the investment record of an appropriate index of securities  prices.  See rule 205-2 under the Advisers Act.

[3] Section 205(e) of the Advisers Act.

Republicans on the House Financial Services subcommittee are pushing back on the issue of Registered Investment Advisor user fees, citing the cost to small businesses. But the SEC insists that it cannot conduct adequate RIA examinations without either charging user fees or delegating examination authority to an SRO that will charge user fees. The argument over user fees was prompted by the release, earlier this year, of the Dodd-Frank mandated SEC study on enhancing RIA examinations. Read this complete analysis of the impact at AdvisorFX (sign up for a free trial subscription with full access to all of the planning libraries and client presentations if you are not already a subscriber).

For previous coverage of recent SEC rulemaking in Advisor’s Journal, see SEC Unprepared to Implement a Fiduciary Standard for Broker-Dealers (CC 11-33), SEC Fiduciary Standard Study Answers Few Questions (CC 11-25), Study Finds that Universal Fiduciary Standard Will Hurt Investors (CC 10-97) & What You Don’t Know Yet Might Hurt You: A Broker’s Duties under the Financial Reform Act (CC 10-40).

Last month, we discussed the obvious relevance of pricing competitiveness to overall life insurance product suitability. This month, we discuss the stability of pricing representations which is also a factor of suitability.  After all, pricing that appears competitive at the time of sale/purchase but which cannot be maintained can be worse than a less-competitive product with more stable pricing representations.

For instance, while premiums are often considered the price/cost of a life insurance policy, the premium is not the price/cost of a life insurance policy (unless contractually guaranteed like in term life insurance or guaranteed universal life insurance) any more than the $2,000 contributed to an Individual Retirement Account (IRA) is the cost of the IRA. In both cases, the cost is the sum of what is deducted from the premium/contribution.  Read this complete analysis of the impact at AdvisorFX (sign up for a free trial subscription with full access to all of the planning libraries and client presentations if you are not already a subscriber).

For previous coverage of suitability in Advisor’s Journal, see Life Insurance Product Suitability (CC 10-90), Financial Strength and Claims-Paying Ability (CC 10-115) & Cost Competitiveness of Life Insurance (CC 11-11).