Understanding Brokerage Incentives

In the book Freakonomics, authors Levitt and Dubner offer several compelling scenarios illustrating the surprising way individuals respond to incentives.

Simply put, incentives are a mechanism to influence someone to do more of a good thing and less of a bad thing. Incentives can be either economic, social, or moral. I'll touch on the economic and moral ones in this post.

Financial advisors aren't an immune profession. Quite the opposite in fact. The revenue incentives a financial advisor must respond to can either be viewed as good (more revenue is viewed as good by a brokerage firm) or bad (more brokerage revenue is almost always bad for the consumer).

When deciding to work with a financial professional, it's critical to understand how their advice may be biased according to the set of incentives that rule their world.

To illustrate the point, here are a few examples why financial advice may not always be in your best interest.

Your Mutual Fund Includes A 12b-1 Fee. This one is probably the most common. 12b-1 Fees are part of a fund's "expense ratio", i.e., its operating cost. This extra fund cost is actually a rebate paid to advisors for selling their funds. This additional cost to investors is 0.25% on the low end and 1.0% on the high end. This form of compensation is in addition to any and all initial sales charges (unfortunately this is still common), trading commissions, and advisory fees.

For example, you might own a large cap mutual fund that charges an 1.11% expense ratio (that's about the average). The rub is that the advisor could have recommended a much lower cost fund instead; there are several large cap index funds and ETFs that cost 0.20% or less. However, this would have diminished their compensation ($250 annually for every $100,000 invested). If the advisor manages even a modest amount like $20M, that's an extra $5,000 a year they would collect versus doing the right thing by offering a low cost fund instead.

The tragic part of this scenario is the investor suffers a higher cost and only a 10% chance that extra cost is going to pay off via market outperformance*. The advisor clearly chose a product in their best interest, not yours. Incentives...

You're Sold A Variable Annuity With A Surrender Schedule. Don't feel bad, this is pretty common. The product can be pitched a number of ways; guaranteed income, guaranteed growth, tax deferral, or the worst one- "This strategy will complement the other strategies we're employing for you".

The first issue is the financial products you utilize should always be liquid. If your goals change or if you eventually figure out you were ripped off, you shouldn't be penalized for getting out of the product. The reason you're getting penalized is a commission was generated to the selling individual. That commission was fronted at the time of sale, and your desire to get out of the product represents money squandered with the broker commission. Insurance companies are smart, and are good are CYA.

Instead of recommending the variable annuity with a surrender schedule, why wasn't a "surrender free" annuity recommended? The answer is because a commission was involved. If you need the money sooner than expected or if your situation changes, my opinion is you should be able to get out of the thing without getting your ass kicked on the way out the door. Annuities currently pay out some of the largest commissions, sometimes in excess of 7% (that's $7,000 in commission for every $100,00 investing, whoa mama!). As an alternative, companies like Fidelity and Vanguard offer surrender free options; I've recommended them many times to my clients.

You're Told To Invest Instead Of Paying Off Your Mortgage. Logically it's almost always more efficient to increase your net worth with the investing route. The after tax cost of borrowed money is usually 3-4%, yet you could earn a 4-7% after tax return on investments (depending on tax bracket, level of portfolio risk, etc).

Mathematically, investing makes more sense. But humans don't always make sensible decisions. Many times our values trump logic. For example, if debt makes you uncomfortable and you can afford to put less away for retirement, then you should probably pay down your mortgage so you sleep well at night.

The issue arises when a financial advisor talks you into investing versus what you want to do. They get paid when you invest. They don't if you use extra cash flow to pay off debt. Without a proper conversation around values, see how this can become a problem?

Your Annual Review Revolves Around Investment Transactions. Instead of a comprehensive discussion on how you're tracking towards your financial goals, you spend almost the entire meeting listening to a pitch on why changing from whatever your current investment strategy is to something new. And by the way, there's a cost to change.

Investing is supposed to be long term, right? So, why is it that the investment you employed a year or two ago is no longer good anymore? Are the benefits of the shiny new investment worth the transaction cost? Give me a break...

Financial advisors are notorious for "churning", which is defined as periodically moving investors in and out of investments to generate commissions. You, the trusting client, believe the advisor has executed hours of due diligence and has calculated the break even on expected returns. Mmhhmmm.

What You Can Do About Any Of This. It's actually really, really easy- work with a completely independent, Fee-Only advisory practice. Next week I'll walk you through the many benefits of working with a truly independent financial advisor. In the meantime, I'm happy to help you understand if your mutual funds charges 12b-1 fees, as well as what to do if you own a variable annuity that might not be in your best interest. Just send me an email so we can chat (scroll down to the footer, easy!).

* SPIVA® U.S. Scorecard, Year End 2014.