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Exclusive: Some wealth advisers take a fee for client fund assets

By Jed Horowitz

(Reuters) - At least three wealth management firms that market themselves as objective financial advisers are getting payments for investing their clients' money in certain mutual funds, a practice that even some of these firms say could create conflicts of interest.

The firms, known as registered investment advisers, are typically paid by clients with fees tied to the growth or contraction of client assets, and not to specific products. But Fidelity Investments and Charles Schwab Corp are paying these financial advisers as much as 0.25 percent of the assets that their clients put into no-transaction-fee mutual funds.

Such funds are popular with ordinary investors because they don't have to pay commissions to buy or sell them, although some advisers say they have higher expenses than funds with commissions. Brokers such as Fidelity and Schwab make hundreds of millions of dollars in fees selling funds that they and others manage.

The three wealth management firms receiving product-related fees are Luminous Capital, a division of First Republic Bank ; Sontag Advisory LLC, a unit of National Financial Partners Corp ; and PHH Investments Ltd, which specializes in managing retirement income for pilots, a Reuters review of regulatory filings shows.

A fourth firm, Dion Money Management LLC, had also been taking payments from Fidelity, according to a 2012 regulatory filing disclosing its business practices. Last month, however, the Williamstown, Massachusetts-based firm made a new filing that no longer mentions such payments.

The payments can potentially add millions of dollars of annual revenue for the wealth management firms, but also create incentives for advisers to direct clients to those funds for their own benefit.

Greg Berardi, a First Republic spokesman, said Luminous invests less than 4 percent of client assets in Fidelity's no-transaction-fee funds. Luminous, founded in 2008 by former Merrill Lynch brokers, is among the 20 largest independent financial advisory firms, with $5.5 billion in client assets, according to its regulatory filings.

"Clients trust us to make investment decisions that are always in their best interests, and that is the way we have always conducted business," Berardi said. The founders of Luminous, who sold their firm in December to First Republic for $125 million, declined to comment.

Calls to Addison, Texas-based PHH, which markets itself as Retirement Advisors of America, and executives at New York-based Sontag Advisory, were not returned. A spokeswoman at Sontag's parent, National Financial Partners, declined to comment. Dion executives and a spokesman at its parent company, Focus Financial Partners, did not return calls seeking comment.

Under securities laws, investment advisers registered with the U.S. Securities and Exchange Commission or state regulators are "fiduciaries" to their clients, which calls for undivided loyalty to the client and full and clear disclosure of any conflicts of interest.

In interviews, other advisers, compliance consultants and former regulators said these firms may not be properly disclosing these payments. For example, Luminous and PHH disclose these payments as fees they get for providing back-office, administrative, custodial support and clerical services to Fidelity, which the experts said does not appear to make sense. That's because these are the very services that Fidelity and Schwab provide to independent wealth managers, they said.

Improper disclosures or the lack of disclosure could trigger sanctions by regulators, including a possible return of the money received from Schwab and Fidelity. The conflict of interest could also dent the image of fee-based independent advisers, the fastest-growing sector of the wealth management industry, who pride themselves on giving unbiased advice to affluent investors.

A source familiar with the SEC's thinking said the regulator's investment management division is working on a "pipeline" of examinations and investigations regarding payments to registered investment advisers (RIAs) by brokers and mutual funds, and the level of disclosure.

Schwab "on rare occasion" pays advisers for sales of its OneSource no-transaction-fee funds if they provide some services to end clients, said Susan Forman, a spokeswoman for the firm. "It is the responsibility of the adviser to disclose this arrangement," she wrote in an email.

Forman and Fidelity spokeswoman Nicole Abbott, who also confirmed that the mutual fund giant selectively pays independent advisers, declined to comment on specific firms, the criteria for choosing who is eligible for the payments or the total number of firms they are paying.

Schwab earned $680 million from the average $216.6 billion of client funds on its OneSource no-transaction-fee platforms in 2012. Fidelity is privately held and does not disclose its sales numbers.

CLIENTS FIRST

In their business practice disclosure documents, each of the advisory firms says that despite the payments, they remain true fiduciaries and put their clients interests before their own. They also stressed they were transparent about acknowledging the possibility of a conflict of interest.

For example, in the filing dated March 26, San Francisco-based First Republic said: "This relationship creates a potential conflict of interest as First Republic Investment Management, Inc. would benefit more by recommending (no-transaction fee) funds for clients."

"In fulfilling its duties to its clients, First Republic Investment Management, Inc. endeavors at all times to put the interests of its clients first," the firm added.

In its disclosures, PHH says that it is the firm's policy to place the interest of its clients first, so the decision to invest in a particular fund or to have clients establish accounts with Fidelity is not dependent on the fee arrangement.

Clients of Sontag, which discloses payments from both Schwab and Fidelity, can direct the firm in writing to turn down payments, its disclosure says.

Industry executives, however, remain skeptical. "My first question is, 'What are they doing to justify getting it,'" said Cindi Hill, a California-based compliance consultant and former officer of the National Association of Personal Financial Advisors, which promotes fee-only financial planning.

"It's a stick in the eye for RIAs," added Geoff Bobroff, a mutual fund industry consultant. "They really are in a conflict position when they take those. They need to sanitize it, and disclosure may be a way to do that."

David Boardman, a pilot and a registered investment adviser who heads the pension committee of American Airlines' Allied Pilots Association, said he doubts many pilots are aware of the extra fees because "disclosure documents go instantly into garbage cans." The union does not recommend wealth managers, but allows PHH and other advisers to make presentations to its members.

The only way the registered investment advisers can justify fee-sharing arrangements is if they pass along the benefit to their clients by reducing their asset management fee, said Charles Goldman, who has served in the past as the head of the RIA service arms of both Schwab and Fidelity.

RIAs typically direct brokers to put any additional payments into an omnibus account used to defray trade commission and other costs their clients pay to the brokers.

None of the disclosures reviewed by Reuters mentioned such offsets.

The practice of accepting such fees appears to be rare. Industry sources first described the practice at one firm to Reuters more than a month ago. A subsequent review of the top 50 firms ranked by discretionary assets by RIA Database found only Luminous disclosed such payments.

(Reporting By Jed Horowitz; Editing by Paritosh Bansal, Martin Howell and Tim Dobbyn)

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