Follow the money

How your advisor gets paid says a lot. Here are some facts you should know.

In the movie All the President's Men, the Bob Woodward character is teased from clue to clue with cryptic tidbits from "Deep Throat", his confidential source. In one exasperating exchange Woodward says, "All we've got are pieces. We can't seem to figure out what the puzzle is supposed to look like..." To which Deep Throat cooly replies "Just...follow the money."

Following the money eventually helped Bob Woodward and Carl Bernstein uncover the shady dealings in the Nixon Administration. The same approach can help you understand if your advisor is someone you should trust. Here are a few facts to get you started.

Some unsavory facts

Fact #1) Most financial products are sold. Think about this for a minute.When you decide to buy a gallon of milk, you don't need a salesperson convincing you of the fact. You just go to the store and buy milk. Buying a car is a bit more complicated, but even with a car you generally know you need a car before you go looking. Salesmen simply help you refine your choice of model or color and represent the dealer when you negotiate the price.

Buying a financial product is different. Most people have only vague sense of what they want to do like save money for retirement. They rely on an "expert"--maybe a broker or a financial planner--to help them figure out which product will be best for them. As we will see, most experts have a very strong interest in which product you end up buying.

Fact #2) The financial services industry is a tangled web of conflicting interests driven by incentive-based compensation. We'll talk more about these later, but whenever compensation favors one particular product over another, the expert has an incentive to act in a way that could be contrary to the interests of the investor. Barbara Roper, director of investor protection for the Consumer Federation of America, recently stated:

Taken to its logical conclusions, the whole system of compensation [in the financial services industry] is riddled with conflicts of interest. No one seeking todesign a system to encourage sales practices in the investor's best interest would come up with the system we have.

Fact #3) The financial services world is divided into two main branches: product management and product distribution. Product managers (like investment management companies and insurance companies) create products to be sold by product distributors (like brokers, financial planners, and insurance agents.) The product managers have technical expertise; the distributors have client relationships. Product managers and distributors long ago recognized that they have common interests, By working together, both sides can generate higher revenues and profits than either can achieve on their own. It is the collusion between these branches that resulted in the tangled web of conflicts we highlighted previously.

Fact #4) Several types of compensation schemes tie the two branches together. Here is a brief summary:

  • Commissions and loads - many brokers and financial planners earn commissions for selling financial products. Commissions paid to mutual fund companies are generally called "loads." Loads can be charged at the time of purchase (front loads) or when the fund is sold (rear loads.) The Financial Industry Regulatory Authority (FINRA) limits the maximum load on a mutual fund to no more than 8.5%.
  • 12b-1 fees - these are fees investors pay to most mutual funds to cover distribution costs. Part of the fee is passed along to the salesperson who sold the fund. FINRA limits 12b-1 fees paid for distribution to no more than 0.75% of assets under management each year.
  • Payments for "shelf space" - sometimes product companies pay a fee to brokerage or financial planning firms in order to be included in the menu of products those firms offer their clients.
  • Revenue sharing arrangements - some product companies agree to split revenues with brokerage firms or other distributors in exchange for favorable treatment in the firm's distribution network.
  • Differential commission scales - sometimes certain products pay representatives higher commissions in an attempt to encourage representatives to sell those products.
  • Soft dollars - some investment management firms earn credit against the purchase of other products and services in exchange for routing trades through particular brokers.

Fact #5) Sometimes the conflicts of interest require digging to uncover. For example, Morgan Stanley (primarily a distribution company) was recently fined by the SEC for failing to disclose that an unnamed investment manager it recommended to clients paid Morgan Stanley$3.3 million in commissions on trades done in its portfolios. The commission payments beg the question about whether they were normal business or part of a "pay for play" scheme.

Questions you should ask your advisor

With these facts in mind, I encourage you to think about how you pay for your investment advice. Ask your advisor the following direct questions and listen carefully to the answers:

  • What are your personal sources of compensation?
  • What are your firm's sources of compensation?
  • Do you have alternative sources of compensation or other compensation schemes?
  • If you earn commissions, what are the commission rates on the products you recommend to me? Are these rates different from other products you represent?
  • Why did you choose your particular compensation scheme?
  • If you charge a fee for advice, do you also get compensated in any way for selling a particular product?

Conclusion

I understand that some people may be a little uncomfortable asking direct questions about another person's compensation. For obvious reasons, this topic is taboo in polite company. However, given the kind of world we live in today, you owe it to yourself to fully understand the conflicting pressures pulling on your advisor. If your advisor is getting paid to tell you a particular story, you should be wary of the punchline.

What if your advisor doesn't want to talk about how he or she is paid? In that case, I recommend moving on. Look for someone whose compensation scheme aligns their interests as closely as possible with yours. Remember, you advisor should be one of your closest allies. Make sure you find one who gives you every reason in the world to trust him and avoid those tainted by self-interest. In my opinion, most people are best served by "fee-only" advisors. Fee-only advisors accept no compensation other than the fees they charge for the advice they give. You never have to worry that their advice is a sales pitch because they have no incentive to sell you anything.