For centuries, incentives have been used to produce results when success is in the balance. From the Roman gladiators to corporate CEOs, success-based compensation is nothing new and acts as a key lever in producing results and aligning the interests of two parties. The efficacy of success-based compensation depends on the extent to which results can vary and if the incentives are being paid for results that may not be possible.
When dealing with a mechanic, for example, most people assume the majority of mechanics are capable of executing certain basic repairs. The result is quite binary: Either the car gets fixed or you bring it back in; there are no style points. Most importantly, success is not in question. There’s no concern that achieving this repair will fall outside your grasp—the car’s going to get fixed. The ability of the mechanic to successfully repair the car doesn’t make a higher bill more reasonable, because the ability to make the repair was a prerequisite. In this case, the customer doesn’t pay for the achievement of a result, they pay for time and materials that both parties presume will create that result. Therefore reasonableness will rightly be based on cost. Was the hourly rate within industry norms? Were the materials reasonably marked up?
Asset-Based Compensation is a Fuel for Success
For a retirement plan, success in achieving retirement income is anything but a forgone conclusion, and there are infinite degrees to which one can succeed or fail. A participant is not paying for time and materials, and therefore reasonableness should not be evaluated based on the cost to provide the service. The participant is paying for results, for success in securing adequate retirement income. Under these circumstances, it’s impossible to assess reasonableness of plan fees without having success as the cornerstone of the analysis.
If it’s success we’re after, asset-based fees create the greatest incentive to produce that success. The ideal compensation structure is one that directly favors successful behaviors and negatively affects behaviors that diminish the success of the plan. Fees based on cost provide less incentive to produce results and more incentive to increase costs. This is not to say that a provider would purposely increase costs, but it is far less likely that it will lower them. This cost bias occurs most frequently in compensation paid for processing of loans, hardship withdrawals, investment advice, etc. Under an asset-based fee, a firm that can bring successful results more efficiently is rewarded, and this breeds ingenuity and ultimately brings us closer to achieving success.
This is not to say that an asset-based scheme is not without its drawbacks. While it may seem like a no-brainer that more assets equal more retirement security, the incentives that exist in an asset-based compensation scheme create distortions that should be addressed. For example, there are greater incentives to pursue eligible employees who make maximum contributions (at the expense of those who may not) and to favor investments with greater growth potential.
Using Success to Bring ‘Reasonableness’ into Focus
If a plan sponsor is factoring the success of the plan into a determination of reasonableness, it is accepting the notion that greater success can result in greater compensation and still be reasonable, regardless of the cost to provide the service. This is exactly the case with an asset-based fee because as the participants’ account balances rise, the compensation will rise. Put another way, as the success of the plan rises, so too does the threshold of reasonableness.
That brings us to the nebulous question of “what is reasonable?” The answer certainly isn’t “reasonable is at or below a benchmark” or “reasonable is at or below what an RFP [request for proposals] process yields.” These approaches are all too common, but antithetical to the success-based approach. A success-based approach to assessing reasonableness fully embraces an asset-based fee and rejects benchmarking that ignores the success of the plan.
A success-based approach could look something like this. Start (don’t end) with an asset-based fee that could be derived from benchmarking or an RFP. From that starting point, apply appropriate positive weighting to outcomes that increase the success of the plan and support the reasonableness of fees. Examples include:
- Income replacement ratio
- Default deferral rate
- Participation rate
- Deferral escalation
The process must also apply negative or zero weightings to factors that hinder successful outcomes, such as:
- Premature withdrawals (particularly taxable withdrawals)
- Use of predictably low-yielding investments
- Portfolios that are inconsistent with participant’s goals/situation
- Low levels of contributions
There’s no doubt that this approach requires an additional layer (or two) of analysis, but the process results in superior plan governance and puts a plan sponsor in the best possible position to mitigate risk.
By adjusting the threshold of reasonableness up or down based on positive and negative factors, success becomes the key variable in the reasonableness determination. The net result is that successful plans are no longer held to the pricing standards of the unsuccessful plans, which are unable to hide among their similarly priced, but more successful counterparts.
Cory Clark is chief marketing officer at DALBAR Inc. Over the years, Clark has worked with retirement plan specialists, investment managers, advisers, broker/dealers and insurance companies to optimize their communications, compliance and business practices. He is also a licensed attorney in Massachusetts.This feature is to provide general information only, does not constitute legal or tax advice, and cannot be used or substituted for legal or tax advice. Any opinions of the author do not necessarily reflect the stance of Institutional Shareholder Services or its affiliates.
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