What is an Incentive Fee?

An incentive fee is a fee which is paid to a financial professional as a reward for good performance. Incentive fees are most commonly seen as a form of compensation offered to managers of funds such as mutual funds and hedge funds, but other people in the financial industry may receive such fees as well. The fee is structured into the contract offered by the employer, and is considered part of the person's overall compensation package. When reviewing offers of employment, people who work in the financial industry usually inspect their contracts carefully to see if the incentives and bonuses compare to those offered by other companies.

Also known as a performance fee, an incentive fee is designed to provide extra impetus for managing funds wisely and generating profits. From the point of view of the parent company, the better something like a fund is managed, the more money it makes, because the company takes a percentage of the earnings. If a fund is well managed and it grows, the parent company has a larger profit margin. In addition, it attracts more customers, because investors tend to prefer funds which generate steady returns.

While managers of things like funds are presumably intrinsically interested in making sure that the fund does well, an incentive fee is an additional reminder that doing well has benefits. The incentive fee is typically performance-linked. When the fund does especially well, the manager receives more compensation. The funds for the fee are usually taken from the fund itself, as opposed to the general funds held by the parent company.

The practice of offering incentive fees is not without controversy. Some people argue that the fees encourage risky behavior, because a fund manager eager for a fee may make dangerous investments in order to push the value of the fund up to access the incentive fee. However, risky investments also hurt the fund manager because if the fund shrinks and loses value, no performance fee will be received. Thus, the fee also acts as an incentive to invest prudently.

Incentives may also be offered when companies in other areas of the financial industry get above average returns. People such as commodities traders, general partners, and brokers can be offered an incentive fee for handling the funds in their care responsibly and promoting the growth of the parent company. These fees are separate from bonuses, although sometimes an incentive fee can be built into a bonus, depending on the terms of a contract.