The point of this post: If your financial advisor is paid a commission based on what products they sell to you, instead of a straight fee for their advice, that advice is compromised by self-interest.
What if I told you that your otherwise competent and experienced mechanic received a bonus every time he sold you a part or convinced you to pay for a service?
Would it change your perception of his trustworthiness, even if you knew he was competent and experienced?
Would it even matter?
It should matter because it means that the advice your
mechanic financial planner gives you is now powerfully influenced by his bottom line, not your best interest.
Recently I had a chance to talk to a gentleman – let’s call him Jim – who had been offered the choice to keep his pension with his former employer or take the (substantial) commuted value and invest it himself.
He had previously spoken to a representative of an investment company that shall remain nameless (but was founded by Satan and staffed by illiterate teenagers and people who have failed at every other profession), who promptly advised Jim that he should absolutely, definitely, no doubt about it take the lump sum and – surprise – invest it with him.
Jim isn’t a dumb guy, he just doesn’t have the experience to weigh the risk of leaving his pension with a private company against the risk of taking the commuted value and investing it himself.
So what does a smart guy who doesn’t have the right expertise do? He goes to a professional for help in figuring out the very best decision to make.
The problem is that although Jim thought he was talking to a professional financial planner, he was really talking to a salesman.
This salesman gives his advice away for free, but is compensated for every investment he sells. I imagine he had a hard time keeping his eyeballs from exploding when he saw the amount of money Jim was talking about.
How does a savvy salesman earn his paycheque?
At this particular investment company – and I’m quoting from their prospectus, here – the salesmen earn “a sales commission of up to 4.20% of the amount you invest” when you purchase mutual funds with deferred sales charges. They also earn a 0.37% annual trailing commission “based on the average monthly value of all qualified client assets that the Consultant services“. This commission is paid on a sliding scale, meaning that the salesman gets 0.37% annually on all assets invested in equity and balanced funds, 0.185% annually if those same assets are invested in income funds, and 0.0925% if those assets are invested in “Money Market-like funds”.
Sound like gobbledegook? Let me try to translate: based on Jim’s assets, the advice that the salesman gave him was going to result in a $25,200 paycheque as soon as Jim’s money hit his books, and an ongoing $2,200 payment for every year that it remained in those deferred sales charge funds, no matter how well those funds performed. By investing Jim’s money in a fund without deferred sales charges, the salesman stood to earn only the $2,580 annual trailing commission paid on no-load funds.
Does Mr. Salesman get paid no matter what happens to Jim’s performance or his satisfaction with the investment choice? You bet he does.
Not only that, Mr. Salesman paycheque increases as the risk level of Jim’s portfolio increases.
Does Mr. Salesman have any incentive to help Jim plan for the wise withdrawal of his income through his impending retirement years? Nope. In fact, he has a negative incentive to spend any further time with Jim. He’s earned his big lump sum. He’s going to earn his annual commission every year regardless of how the fund performs or how Jim’s finances change during retirement.
As a sharp businessman, why would Mr. Salesman spend any more of his presumably valuable time on a fish he’s already landed, when he could be using that time to go catch new, unsuspecting fish who are now worth more than the ones he’s already got?
Does that mean that his advice to Jim to take the lump sum was wrong?
That’s a trick question. There is no technically wrong answer to a question like Jim’s; at least, not one that anyone can identify until years after its already been made.
I can tell you this much, though: his advice to invest the money in high fee, high risk, deferred sales charge loaded, actively managed mutual funds was wrong.
Which makes me believe – without a shadow of a doubt – that every bit of Mr. Salesman’s advice was motivated by his own wallet, and not Jim’s best interest.
How do you get advice that you can trust to be in your own best interest?
This one isn’t a trick question.
All else being equal (that is: if we take as read that the necessary experience, competence, and qualifications are present), you are more likely to get trustworthy advice if the professional advising you doesn’t sell anything other than his or her advice.
If all of the incentives to purchase particular investments, lending products, or insurance are removed, and you pay your advisor directly for their advice, the only incentive that remains is to give good advice.