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In Focus #70: June 9, 2009


Financial Advisers in Motion; A Primer On the Employment Issues Facing Those in Transition


Retirement Income: Repairing the Damage to Assure the Flow


Train Wrecks of Estate Planning


A Complex Game: The Life Settlement Process
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Avoiding The Latest Retail Brokerage Marketing Gimmick: "Fee Based" Compensation


o one will dispute that investors are entitled to receive objective advice when they consult an investment advisor. Advisors should serve only one master -- their clients -- and no one else, if for no other reason but that they are paid for that service.

The Conflict

However, the retail brokerage community operates in an environment where there are two masters, not one. Like the client, the second master also pays the broker. But not for advice. Instead, the second master pays the broker to induce him or her to sell its product, in lieu of another's product, to the client.

For example, a second master can be a mutual fund company that pays a handsome commission, while other mutual fund companies do not. Another example is when brokerage firms sell investments that are "proprietary" or "syndicated". In these cases, firms basically are "insiders". This can include the brokerage firm's being an owner, principal, distributor or investment manager of the investment product.

There are two problems with having this kind of second master. First, it creates a conflict of interest. Second, the brokerage firms, and their employee brokers, do not act as independent, objective advisors, for which their clients are paying them. On the contrary, they are parties interested in consummating the sale, for which great profits can be made.

At a minimum, brokerage firms and brokers should fully disclose that they have a conflict of interest, and they should discuss why the conflict will not obscure their objectivity. Nonetheless, we find that often there is no disclosure. To the extent that disclosure is made, usually it is not communicated sufficiently for clients to understand.

Fee Only

Approximately 40% of money managers and financial planners (not retail brokers) charge "fee only" for their services. They receive no commissions. Their fee is a small percentage (1.5% or less at Advocate Capital Management, Inc.) of the assets that clients place with them to invest.

Is fee only better than sales commission? Consider these opinions. Jane Bryant Quinn stated in Newsweek that those who "take commissions have a built in conflict of interest ... even with disclosure, my choice would be a fee only planner". Similarly, Money Magazine counsels, "Start with the general practitioner, a financial planner whose compensation should be from fees alone". Finally, Forbes advises, "The most important matter is how the planner is compensated. Hire the planner who has no financial stake in your investments".

Fee Only Versus Fee Based

Savvy consumers have begun to realize that sales commission relationships may not be in their best interest. Wall Street has reacted to this sentiment by offering what it calls "fee based" compensation programs.

Name the retail brokerage firm and, chances are, it will have, or plans to roll out, a new fee based compensation program. For instance, A.G. Edwards has "Spectrum", Dean Witter has "Choice", Everen has "Fund Allocation", Paine Webber has "PACE", Prudential has "VIP", Smith Barney has "Asset One", and Merrill Lynch has "Financial Advantage". Each charges (with the exception of Everen) a 1.5% or less asset based fee.

However, fee based compensation is not fee only compensation. Conflicts of interest still exist. Objectivity still may be obscured.

Consider one of these fee based programs. This program allows clients to select no-load and non-proprietary mutual funds. Will their brokers steer them in that direction? Probably not. Brokers may focus their clients' attention on the proprietary, syndicate funds. Why? Extra compensation! Indeed, not only does the broker receive a portion of the 1.5% asset based fee, he or she receives additional money -- a sales commission -- from the firm (up to several percent) for selling those proprietary, syndicate investment products.

Is this good for the client? John Markese, president of the American Association of Individual Investors (AAII) commented about the program, "There is a built in potential for bias that can cloud the relationship. I think the SEC could recognize that this could be a case where there is an incentive [for brokers] to push product, and that may not be in the best interests of investors in the long run".

The retail brokerage firm defends itself by claiming that it discloses the extra compensation arrangement to clients. Specifically, the following brief disclosure is made within a lengthy account agreement: "...[the firm] will receive a selling concession, or other compensation ... in addition to the [account] fees payable hereunder". However, the disclosure does not alert clients to the broker's conflict of interest, and no disclosure whatsoever is found in the mass marketing materials disseminated to the public.

In conclusion, fee only compensation (not fee based) continues to be the only arrangement that provides investors with truly objective investment advice.





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