What Hedge Fund Management Companies Need to Know About Professional Employer Organizations

Many of the nation’s leading hedge funds are now using professional employer organizations (“PEO”) for administration of human resources, payroll and employee benefits.Not long ago, the PEO industry was focused largely on blue collar companies and demonstrated little understanding of the demands made by financial service company employees.That began to change in 2002 when New York enacted the Professional Employer Act facilitating the adoption of the PEO concept by Manhattan’s hedge fund community.Today, hedge fund managers nationwide have choices among PEOs, some of which specialize in serving their specific type of workforce.

General Background on Professional Employer Organizations

PEOs operate in all 50 states in the U.S. and can be described generally as providing a single integrated service covering human resources administration, payroll administration and employee benefits.By statute in over 30 states, PEOs are treated as a “statutory co-employer” of all client employees enabling the licensed PEO to directly account for the consolidated group of employees to the various labor and tax authorities in a single automated format. Both the governments and PEO clients benefit from this arrangement because the governments dramatically reduce the number of employer accounts that need to be maintained and audited, and PEO clients are relieved of several employer responsibilities that otherwise they would be required to satisfy on their own (e.g., COBRA, unemployment insurance, workers compensation, employment tax collection and reporting, etc.).

In addition to time savings, PEO clients can save significant amounts on employee benefits because the PEO is granted authority under the various state statutes to aggregate employees of all clients into a single purchasing pool for purposes of obtaining health insurance and other employee benefits. The large purchasing pools created by PEOs have much lower average insurance administration and distribution costs as compared to small employer insurance plans, as well as a preferable insurance risk profile (PEO health plans, for example, typically cover thousands of employees located in different parts of the U.S.). It is not uncommon for PEO clients to reduce their health care and other benefit costs by 15-40%.

In the statutory co-employer arrangement, the client retains authority as the “common law employer” to control and manage the day-to-day activities of employees and make decisions affecting employment. There can be a misconception that some form of practical control is lost in this arrangement. However, the role of the PEO simply is to provide administrative efficiencies to small businesses, to offer guidance and increase compliance in the area of employment, and to reduce the amount of time and cost attributable to employees.

PEO Service Models

In addition to the usual comparison of PEO health plans and fees, more subtle differences need to be evaluated to determine whether a PEO is a good fit for a hedge fund.The PEO must understand hedge fund culture and the specific challenges of the work environment to support managers and employees effectively. Hedge fund employees are well educated, work long and stressful hours, are accustomed to rich employee benefits, and are typically compensated at levels far above national averages. The right PEO for a hedge fund will meet the demands of this type of workforce.The best way to determine whether a PEO has this level of understanding is to speak with the PEO’s hedge fund clients.It is customary in the PEO industry for the PEO to arrange reference calls for prospective clients to speak directly with existing clients.

An important differentiator between PEOs is how they interact with employees.Most PEOs use call centers to handle the large volume of service inquiries they receive each day.Hedge fund manager and/or employee inquiries relating to benefits, payroll changes, etc., are routed to a call center where questions are handled on a first-come, first-served basis. Alternatively, other PEOs deliver service through dedicated service personnel assigned to each client.A relationship is formed between the hedge fund and the PEO service people with this approach.Hedge funds considering the dedicated service approach should take the time to meet the PEO service people in advance to make sure that there is a cultural fit between their organization and the PEO.

PEO Billing Methods

PEOs use two basic billing methods: the Fixed Fee Method and the Percentage Fee Method.

With the Fixed Fee Method, the PEO and client agree on a fixed dollar fee for administration that is charged each payroll period. This is based usually on the number of employees in the company.Everything else should be pass-through charges (compensation costs, employee benefits, applicable employment taxes, etc.).Clients should insist that they are charged the exact employment taxes that the PEO pays on their behalf. For example, Social Security and Medicare taxes are reduced when employees contribute to “pre-tax” benefit plans.The client should be charged only for the reduced tax amount. Under the Fixed Fee Method, the client receives an itemized bill showing all charges for a specific pay period, and the service fee remains fixed, regardless of compensation increases or bonus amounts.It is completely transparent.

With the Percentage Fee Method, the PEO charges clients for the gross amount of compensation, plus an additional percentage to cover all employee benefits, employment taxes, workers’ compensation coverage, and administrative services.Hedge funds need to be comfortable with the lack of transparency here and understand that their invoice will not show the exact amounts they are paying for the various taxes and benefits.This can frustrate the accounting staff.The Percentage Fee Method can be excessively costly when compensation levels increase or when large bonus payments are made because the percentage amount can apply to these items and result in significant additional fees.

Partners or Members

Most hedge fund management companies today operate as partnerships or limited liability companies (LLC).This can create a situation where working partners or members are not eligible for coverage under a PEO arrangement, as they are not technically “employees.” The PEO industry handles this dilemma in different ways. Some PEOs require that partners and members take a salary and treat them as employees eligible for benefits.This can be confusing for the organization and the individuals involved when filing tax returns.It also generates unnecessary workers’ compensation and unemployment tax charges (partnerships and LLCs do not pay these costs ordinarily).

Alternatively, PEOs have crafted service arrangements in some states designed specifically for partnerships and LLCs.These arrangements respect the partner and member status, and provide benefit plan options similar to those available to employees. Under this type of arrangement, distribution payments can be made to partners and members without withholding taxes based on the IRS rules for partnership “guaranteed payments.” If your hedge fund has working partners or members, you should inquire with the PEO about separate service arrangements available to them.

The Pros and Cons

The PEO concept makes a lot of sense for hedge funds in large part because it allows the company to focus more time and resources on their business of investing and trading, and can provide small organizations with benefits and services that compare favorably to leading financial institutions.Nevertheless, the PEO concept may not appeal to hedge funds that prefer to customize their benefits and procedures in ways not offered by any PEO.

Moreover, some PEOs require a minimum number of employees before they will enter into a service agreement (e.g., 5 or 10 employees).This may limit the options for small and start-up hedge funds.However, there are PEOs that will work with small start-up hedge funds with the hope that they grow and add employees in the future. PEOs that take this approach often have a minimum administration fee which can raise the average cost per employee until the growth occurs.

About John Iorillo
John Iorillo is the Co-CEO and Co-Founder of Ambrose Employer Group, LLC, a New York City based PEO specializing in financial services companies. Prior to co-founding Ambrose in 1997, John practiced tax law with Proskauer Rose, and is the recipient of the Ernst & Young Entrepreneur of the Year® award for New York City in 2001.John Iorillo is available to respond to inquiries about PEOs at [email protected] or http://www.ambrose.com.