Written by: Michael J. Francis, Esq.
EXECUTIVE SUMMARY
This article examines how common investment adviser compensation structures can create conflicts of interest that undermine retirement outcomes and increase fiduciary risk for plan sponsors. It outlines key conflict areas and explains how these arrangements can influence recommendations. The paper provides practical guidance for identifying and mitigating conflicts, emphasizing the importance of fee transparency, independent advice, and compensation models that align with participants’ best interests.
When hiring a professional adviser—whether for tax, legal, or investment advice—some methods of paying for professional advice are widely accepted, such as hourly-based or project-based fees, while others, though legal, are less optimal. Retirement plan fiduciaries should be familiar with the many less-than-optimal ways investment advisers are compensated because failing to recognize where conflicts arise inevitably leads to plan participants having less money for retirement.
Why Plan Sponsors Need to Understand Compensation Arrangements
Conflicts of interest are not hypothetical; they are well-documented and measurable. As the U.S. Government Accountability Office has noted, conflicts arise when an investment adviser’s financial interests compete with those of retirement investors. In practice, these conflicts can influence the products recommended and the services offered.1
Conflicted investment advice costs investors around $17 billion a year in unnecessary investment management expenses.3
Decades of research show that conflicted advice can materially affect investor outcomes. Studies have found that investors receiving conflicted advice earn lower returns over time—about 1 percentage point lower annual returns on retirement savings—which translates directly into reduced retirement savings for participants.2 More than a decade ago, the Council of Economic Advisers estimated that conflicted investment advice costs investors around $17 billion a year in unnecessary investment management expenses.3 That is an extraordinarily large amount of money, undoubtedly understated today, invisibly transferred from America’s workers to their investment advisers.
Arrangements with Investment Advisers that Create Conflicts of Interest
Asset-Based Fees: Many investment advisers are compensated based on a percentage of assets under advisement. While this model is common and legal, it is worth noting that in the tax and legal fields, courts routinely discourage this method of compensation and, in many circumstances, prohibit it.
Where’s the conflict? In some circumstances, it may be in the plan sponsor’s interest to choose a course of action that reduces plan assets. For example, the industry historically showed reluctance to recommend Roth accounts because they were believed to reduce contributions to the plan, even though they were clearly beneficial for younger employees. More importantly, an asset-based fee means the adviser’s compensation is essentially uncapped and continues to grow regardless of the amount of work performed in the future—a situation many courts find unethical for legal and tax advisers because of its propensity to generate compensation well above a reasonable level.
What’s the solution? The only time a plan sponsor should agree to pay for investment advice with an asset-based fee is when an investment adviser with discretion is being paid to outperform a specific and meaningful benchmark. Otherwise, fund selection, performance monitoring, and asset allocation advice should be paid on an hourly or project basis. The same principle applies to the plan’s recordkeeper; whenever possible, a per-participant recordkeeping fee should be negotiated.
Managed Accounts: A managed account solution is essentially a financial product. While it can offer additional personalization, a managed account solution often introduces unnecessary complexity and cost for participants, along with a lack of transparency in pricing and adviser compensation.
Where’s the conflict? Although their purpose is very similar to that of a target date fund series, managed account solutions typically involve investment expenses two to five times higher. Advisers often increase their own compensation by recommending managed accounts over simpler, lower-cost, and often better-performing target date funds.
What’s the solution? To justify the significantly higher expense, a managed account solution should demonstrate a track record of performance superior to the low-cost target date solutions that dominate the marketplace for qualified default investment alternatives. The track record under review should focus solely on investment performance; claims of increased savings rates or better risk alignment should be considered separately, as both can be achieved more cost-effectively with the assistance of an hourly-paid investment adviser.
ERISA Section 3(38) Fiduciary Services: Investment advisers offering ERISA section 3(38) investment management services often position the service as a liability-reducing solution that “requires” an asset-based fee. More recently, this service has been pitched as a cost-saving measure because advisers with discretion can aggregate client assets to reach fee breakpoints from asset managers that are not available to individual clients.
Where’s the conflict? By signing over fund selection discretion to an investment adviser, the plan sponsor is required by ERISA to monitor the quality of that adviser’s performance and the reasonableness of its fees against ever-changing industry benchmarks. Most plan sponsors lack the data and expertise to adequately perform this task and are therefore duty-bound to hire an additional section 3(21) adviser to provide this opinion. It is also important to understand that aggregating client assets to gain access to an investment manager’s discount creates a conflict in which the adviser’s desire to achieve or maintain a certain level of accumulated client assets in a strategy can impair its objectivity in evaluating that strategy’s ongoing merits.
What’s the solution? A 3(38) investment adviser does relieve the plan sponsor of the day-to-day responsibility to select and monitor the plan’s investment menu of designated investment alternatives. Such an arrangement can provide real-time savings and a measure of liability protection for busy retirement plan committees. However, hiring a 3(38) investment adviser does not relieve the plan sponsor of ultimate responsibility for the performance and cost of the plan’s designated investment alternatives; the sponsor retains the ERISA-mandated duty to monitor the adviser to whom it delegated this duty. If the plan sponsor does not possess the internal expertise to adequately perform such monitoring, it must hire an independent third-party expert to assist.
Hiring a 3(38) investment adviser solely to gain access to a lower-cost share class than the plan can otherwise qualify for, and accepting the conflicts that come with such an arrangement, may not add meaningful value after the plan sponsor accounts for the cost of hiring an additional 3(21) adviser to assist with monitoring.
Compensation from Third Parties: Some investment advisers accept compensation from recordkeepers, fund companies, or other service providers in exchange for being included in vendor searches and investment menus.
Where’s the conflict? Providing investment advice for a fee to a qualified retirement plan is a fiduciary act under ERISA. As a plan fiduciary, it is prohibited for an adviser to benefit financially from the recommendations it provides. The fact that the Department of Labor has granted certain exemptions to the prohibited transaction rules does not make the recommendation any less conflicted, no matter how fully disclosed and carefully monitored it may be. These payments—often referred to as revenue sharing or referral fees—can influence which providers or investments are recommended, and advisers may be incentivized to recommend vendors or funds that impose unnecessary investment expenses on participants.
What’s the solution? When hiring an adviser for a search of any kind—investment manager, recordkeeper, and so on—always request a written acknowledgment that the adviser will act as an ERISA fiduciary throughout the process. If the adviser refuses, it is likely because it plans to receive some form of remuneration from the providers it recommends. Whenever possible, investment advice should come from an unconflicted source to help ensure that the recommendations received are in the best interests of the plan and its participants.
Participant Advice from Investment Advisers with a Product or Wealth Management Agenda: Plan sponsors have a fiduciary duty to properly educate participants about the complex saving and investment decisions required by their retirement benefits. There is no shortage of investment professionals willing to provide this service; some focus on education, some on guidance, and others on full-fledged advice. While this service is badly needed, many advisers use access to plan participants to promote proprietary products or managed accounts in the plan, or to bolster their retail wealth management business through rollover advice.
Where’s the conflict? An investment adviser with a financial interest in one or more of the plan’s designated investment alternatives—or in a wealth management business—has a strong financial incentive to make recommendations that may run contrary to the participant’s best interest. Investment management fees within a plan are often institutionally priced and meaningfully lower than what an individual can obtain through an IRA rollover. It is often in a recordkeeper-owned adviser’s interest to encourage terminating employees to roll their retirement savings out of the plan into significantly more expensive investment alternatives. Third-party retirement plan advisers with a wealth management business often discount their plan advisory fee in exchange for a warm introduction to a company full of future retirees.
What’s the solution? When an employer presents plan participants with an investment adviser, there is an implied endorsement and an expectation that the advice will be free from conflicts. Plan sponsors should therefore begin by reviewing the service contract with their recordkeeper and demand that any provision granting anyone the right to “market” its “other” products and services to plan participants be removed.
At the same time, plan sponsors should recognize that inserting non-solicitation language into a contract with a third-party investment adviser does not solve the conflict problem. Such language tends to simply encourage advisers to focus on high-wage earners and large account balance holders, effectively ignoring everyone else. Instead, sponsors should seek participant advisory programs with strong educational components and, if they choose to offer advice, services that lack the ability to influence their own compensation through recommendations made to participants.
It is important to note that advisory services with fully disclosed conflicts, promises not to solicit, and promises of rigorous supervision are still meaningfully inferior to services without conflicts. Research suggests that simply disclosing a conflict may not meaningfully reduce its impact and, in some situations, may even lead to more biased recommendations if advisers feel they have “checked the box” by disclosing the issue.4 For plan sponsors, the goal is not merely to find advisers who disclose conflicts, but to understand the nature and extent of those conflicts and to evaluate whether they are manageable and whether their consequences are acceptable.
Research suggests that simply disclosing a conflict may not meaningfully reduce its impact and, in some situations, may even lead to more biased recommendations if advisers feel they have “checked the box” by disclosing the issue.4
How to Identify and Prioritize Conflict-Free Advice
There are actually more examples of conflict-free professional advisers than advisers with conflicts; these are found primarily in the tax and legal professions, where hourly and project-based fee structures remain the norm. In contrast, the investment advisory industry has largely normalized business models that allow advisers to meaningfully influence their own compensation based on the advice they provide. It can feel as though conflicts in financial services are simply the water in which everyone swims and are therefore unavoidable. But while conflicted advice may be common, it is not the only option. There are investment advisers whose business models are significantly better aligned with ERISA and the interests of plan sponsors and participants.
The following are practical steps plan sponsors can take to minimize conflicted investment advice:
Understand How an Adviser is Paid: Compensation drives behavior. Avoid business models that rely on steering plan participants into proprietary products and IRA rollovers, asset-based fees, revenue sharing, finder’s fees, or commissioned product sales, as they introduce conflicts that can meaningfully affect investment results.
Prioritize Hourly or Fee-for-Service Models: Research points to hourly-based compensation as one of the least conflicted approaches, although it is less common in the marketplace.1 Fee-for-service models that resemble legal or tax billing practices typically align more closely with fiduciary obligations under ERISA.
Ask Direct Questions: Do not hesitate to ask, “How are you compensated across all your services? Do you receive payments from third parties? What incentives exist for recommending certain products or strategies? What is your firm’s ownership structure, and what are its sources of revenue?” Clear answers to these questions help identify where conflicts may arise and how significant they may be.
Learn How to Read an Investment Adviser’s SEC Form ADV: As more plan sponsors ask harder questions, investment advisers have learned how to provide what sound like the “right” answers. Because some advisers respond creatively to direct questions, reviewing their Form ADV is highly advisable to understand the reality of potential conflicts. The Form ADV is an SEC-required disclosure document that every registered investment adviser must complete and update annually. It’s a federal offense to lie on a Form ADV.
To find an investment adviser’s Form ADV, go to www.adviserinfo.sec.gov, click on the tab at the top of the page labeled “Firm,” type in the firm’s name in the box provided, and click “Search.” From the results list, click on the box of the firm being researched, and then click “View Latest Form ADV Filed” to access an electronic copy of its Form ADV.
Specific items within Form ADV can be especially useful in evaluating conflicts of interest:
Wealth management business: Go to Item 5, Section D (Type of Clients). Here, the adviser must disclose how many “Individuals” or “High net worth individuals” it serves, and the amount of assets it manages for those clients.
Compensation creating conflicts: Go to Item 5, Section E (Compensation Arrangements). The adviser must disclose whether it accepts asset-based fees, commissions, or other forms of compensation.
Competing products or strategies: Go to Section 5.K.(1), “Separately Managed Accounts,” and review the information about assets under management. This information may also appear in Item 5.D.(3), “Amount of Regulatory Assets under Management.”
Referral compensation: See Item 8, section I: “Do you or any related person, directly or indirectly, receive compensation from any person for client referrals?”
Affiliations creating conflicts: See Item 7, section A, which requires information about the adviser’s financial industry affiliations and activities.
Criminal or regulatory history: See Item 11, sections A–H, which require disclosure of the adviser’s disciplinary history and any criminal or regulatory actions taken against the firm.
Non-employee shareholders: Review Schedules A and B, which list all direct and indirect owners of the firm and may reveal non-employee owners whose profit expectations can influence business practices.
Final Thoughts
For a retirement plan sponsor, the standard of care you are expected to demonstrate is that of a “prudent expert.”5 The vast majority of plan sponsors rely on professional investment advisers to help meet this expectation, yet the financial services industry’s pursuit of outsized profits has normalized compensation arrangements that too often place the adviser’s interests in opposition to yours. Other professional advisory industries (tax, legal) have long ago figured this out and largely avoid these compensation arrangements in order to protect their clients.
Understanding which conflicts to look for, what questions to ask, and how to use SEC Form ADV to verify the truth about an investment adviser’s potential conflicts can help plan sponsors look through the marketing language and uncover the incentives that truly drive adviser recommendations.
Ultimately, the goal is to protect employees’ hard-earned retirement assets and to secure the fiduciary protection that comes from aligning the adviser’s interests with those of the plan sponsor.
The information contained herein is provided for informational purposes only and does not constitute legal, tax, or investment advice. The information provided is from sources we believe to be reliable, but we cannot guarantee its accuracy or completeness. Neither the information nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. Francis LLC does not offer personal legal advice.
¹ “Retirement Investments: Agencies Can Better Oversee Conflicts of Interest between Fiduciaries and Investors,” U.S. Government Accountability Office (GAO-24-104632), 2024.
² “The Effects of Conflicted Investment Advice on Retirement Savings,” The White House Council of Economic Advisers, p.13-17, February, 2015.
³ “The Effects of Conflicted Investment Advice on Retirement Savings,” The White House Council of Economic Advisers, p.20, February, 2015.
⁴ Daylian M. Cain, George Loewenstein, and Don A. Moore, “The Dirt on Coming Clean: Perverse Effects of Disclosing Conflicts of Interest,” The Journal of Legal Studies, 2005.
⁵ Robert H. Jerry, “The Prudent Person Rule and ERISA: A Legal Perspective,” 33 Financial Analysts Journal 66 (1977).
