Retrocession: Definition, Types, Example, Criticisms

What Is Retrocession?

Retrocession refers to kickbacks, trailer fees or finders fees that asset managers pay to advisers or distributors. These payments are often done discreetly and are not disclosed to clients, although they use client funds to pay the fees.

Retrocession commission is a heavily criticized fee-sharing arrangement in the financial industry because money flows back to marketers for their efforts in raising interest for a particular product. Therefore, this raises the question of impartiality and favoritism on the part of the advisor. The system would seem to encourage advisors to promote funds or products because they will receive a fee for doing so, not because the products are the best option for the client.

Understanding Retrocession

Retrocession fees are commissions paid to a wealth manager or other new money manager by a third party. For example, banks often pay retrocession fees to wealth managers who partner with them. The bank will encourage and compensate the managers for bringing business to the bank. Banks may also receive retrocession fees from third parties, such as investment funds, for distributing or promoting specific financial products.

Some consider retrocession fees a dubious compensation model because they can influence a bank or wealth manager’s decision to recommend products that may not be in the best interest of their clients. This suggestion of an investment product where the advisor receives retrocession appears inherently problematic. However, the suggested product is usually suited for the client, as they are mostly high-quality investment products, such as mutual funds. But the issue remains of motivation and agenda, when two roughly equal products are available, one with compensation attached and one without, where some advisors may find themselves unduly influenced.

Types of Retrocession

Retrocession fees typically refer to recurring compensations, as opposed to a one-time deal. A one-off payment is generally called a finder’s fee, referral fee or acquisition commission.

There are three types of retrocession fees:

1. Custody banking retrocession fees are where a wealth manager receives compensation for attracting a new customer who brings that customer's investment funds into the custody institution. With frequent changes in the service provider association, a wealth manager can generate retrocession fees that benefit them financially but do not necessarily benefit their client.
2. Trading retrocession fees are compensation for various trading transactions, such as buying and selling securities. The more sales that occur, the higher the retrocession fees become. Because most trades include a brokerage fee for the transaction, which the customer must pay, this again may benefit the money manager.
3. Financial product purchase retrocession fees are part of the recurring total expense ratio (TER), which customers must pay and are typical with investment funds. These recurring sums flow back to the client acquirer. Because the total expense ratio is charged to the customer each year, the acquirer receives retrocession fees every year as recurring commissions.

Real World Example

In 2015, JP Morgan settled a case with the Securities and Exchange Commission (SEC) for $267 million. The SEC stated that JP Morgan selected third-party hedge funds based on hedge fund managers' willingness to provide fees to a bank affiliate. In these instances, the bank did not inform clients it suggested and preferred the mutual funds willing to share their royalties and instead implied no particular partiality. According to Forbes, the JP Morgan settlement was the first time the term retrocession was introduced to U.S. investors.