For the most part, financial advisors from banks or “full-service” brokerage firms are paid based on commissions. They’re sales people. Having been one myself, I thought it might be worthwhile to discuss the specifics involved and the conflicts of interest that can arise as a result of such a payment structure.
40% Payout
On average, most financial advisors/brokers receive a commission equal to 40% of the revenue they generate for the firm. (At some firms it’s a bit higher or lower.)
So what is it, exactly, that they’re receiving 40% of? Let’s take a look…
Trade Commissions
Whenever an investor executes a stock trade (whether buy or sell), the broker receives a 40% cut of the commission. This is the single most famous example of a conflict of interest between a broker and his client, because it gives the broker an incentive to persuade the client to move his money around more often than is beneficial.
For the most part, the regulators have cracked down on excessive “churning” as it’s called. But I can tell you–because I’ve seen it firsthand–that there are plenty of brokers who don’t mind testing the limits here.
Sales Loads & Breakpoints
Of course, today, most financial advisors do the bulk of their business with mutual funds rather than individual stocks. Most advisor-sold funds charge a front-end commission known as a sales load.
These sales loads vary as a function of how much the investor is putting in. As the investor invests more money with a given fund family, he reaches various “breakpoints” at which the percentage of commission decreases. A typical breakpoint structure might look like this:
- $1-$49,999: 5% sales load
- $50,000-$99,999: 4% sales load
- $100,000-$249,999: 3.5% sales load
- $250,000-$499,999: 2.5% sales load
- etc
Unfortunately, this creates an incentive for brokers to encourage their clients to spread their money around more than is really necessary in order to avoid hitting the breakpoints. Again, I can tell you with confidence that this does happen.
Real Life Example: At one point, I took over several accounts from a broker who went to another firm. A perusal of the “amounts invested” column for his clients’ accounts showed something to this effect:
- Client invested $60,000? He put $30k in one fund family and $30k in another. No breakpoints. Maximum commission.
- Client invested $105k? He put $35k in each of 3 different fund families. No breakpoints. Maximum commission.
- Client invested $300k? He put $240k in one fund family (getting the $100k breakpoint, but narrowly missing the one at $250k) and $30k in each of two others (thereby getting no breakpoints).
Ugh.
12b-1 Fees
12b-1 fees (named after the SEC rule that authorized their creation) are fees charged by the fund family to cover marketing/promotional expenses. Often, a large part of these fees goes to the brokerage firms that sell their funds.
For example, American Funds’ Growth Fund of America (A shares) has a total expense ratio of 0.65% of assets. Of that, 0.24% is simply a 12b-1 fee paid each year to the brokerage firm that sold you the fund.
In other words, you’re paying your broker not only in the form of a sales load, but in the form of higher expenses as well.
“Extras”
Just like any other company, brokerage firms have quarterly meetings where all the financial advisors/brokers get together to discuss sales strategies, company news, etc.
Generally, these meetings are held at fancy hotels where they put the brokers (and perhaps their families) up for free for a couple days–including dinners at high-end restaurants (typically followed by all-you-can-drink partying at a nearby bar).
Want to guess who foots a large part of the bill for these events? The fund companies.
Think that has anything to do with which fund company is the first one a financial advisor will recommend to his clients?
Also of note: The funds’ portion of the bill for these events goes directly into the expense ratios for their funds. I don’t know about you, but I have doubts that this does anything to improve returns for fundholders.
What you need to know:
If you decide that you want to work with a financial advisor, one of the questions you must make sure to ask is this: “How do you get paid?”
And after you hear the answer, ask “Is that it? Or is there another way also?”
Then do it again. And again.
There’s no way to make an educated decision until you’re heard the whole story.
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{ 8 comments }
I was interested to learn (when I was just starting to write about investing) the way bond commissions work. Since the broker just makes his commission on the spread between his buying price and your buying price, you can’t even really tell how much profit he’s taking from you. Now, at least, people can look up recent bond sales to see other guys’ prices, but it seems like bond trading has lagged behind while stock commissions got lower.
Anyway, as far as the financial adviser issue goes, it seems like a lot of the commission problems are solved by going with someone who gets paid a fixed fee instead of a commission.
Joe: I’d agree as to fees vs. commission. Not because fees are cheaper necessarily, but because they provide for a greater degree of transparency.
And you’re absolutely right about bonds: Most investors have no idea that a pretty juicy commission comes with a bond sale.
Wow. Bitter much?
Seriously, don’t you even make room for the idea that there are folks out there who really want to do what’s best for their clients and thus build a business based on trust and respect? What about those who choose to offer a choice of commission based investments to young couples just starting out and only contributing 50 or 100 dollars per month – thus saving them money over an advisory account?
What about brokers who are driven to find the best deal for their clients because they believe they’ll only stay in business if they can consistently prove they’re doing more than the next guy? Or fee-based advisors who don’t bother doing any research at all because they’ll get paid in any case?
Sure there are some criminals out there who put on the nametag “advisor” every day, but I believe there are dozens or even hundreds of good and responsible financial professionals for every greedy bastard.
Nope. Not bitter at all actually. In fact I maintain contact with multiple brokers from the firm where I used to work. They’re good people working to help investors succeed.
My only point is that before you can decide whether or not to use a given advisor, or whether or not to take their advice, you absolutely must know all of the different ways he or she is being paid.
Mike,
I actually thought you were very fair considering the subject is filled with heated arguments either way. I think the problem with financial gurus, or even amatuer bloggers, is that they forget some people just have no interest in learning about “this world.”
It is an often used analogy but could I save a ton of cash if I did my auto repairs, yes, but there is zero chance of that. So I hire an expert, maybe he gets paid hourly (then why would he want to rush the job? this would be akin to the mutual fund expenses) or maybe he gets paid by the job (i.e. just like the fees).
Regardless, great post.
Broker/financial adviser fees are probably the major reason why most people’s portfolio underperforms. In addition to your great advice, I would also say that people should ask financial advisers about total fees paid, the amount the adviser gets, and they should get the answer in writing. Clients have a right to get this information and an honest adviser will not hold back that information anyway.
12b-1 fees are an extra fee charged by some mutual funds designed to mainly cover promotional materials, marketing expenses, etc. They are not always passed back to brokers in the form of commissions.
Oops, you’re absolutely right, Hank. Making the correction now…
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