Your Financial Advisor Makes HOW MUCH?!?

"Here's one of many Canadian myths, that, like many Canadian myths, just happens to be true." --Gord Downie, Three Pistols, 1991 There’s a problem with the investment industry—and it goes right to its core. The problem is the way advisors are paid. Advisor compensation rewards behaviour that is not in the best interests of their clients; in fact, it’s often directly contrary to the client’s best interests. And unless we do something about it, more people are going to get hurt. I know—I was an advisor for many years, and I watched it happen in the industry all around me. Financial advisors should be legally obligated to do what’s best for the client. There can be no confusion: investment advisors should have a fiduciary responsibility, ethically, morally, and legally, just like lawyers or doctors, to act in the best interest of their clients. This isn’t the case today—only Discretionary Portfolio Managers have that obligation under law—but that’s ridiculous. Anyone providing financial advice should be required to do what’s right for the client above all else. Mon dieu, at least that. Since Advisors and their firms haven’t ensured this is the case on their own, the regulators must. But remember, people tend to act according to the manner in which they are incentivized. So, let’s take a look through that lens at how the investment industry incentivizes advisors. Commission Transactional advisors are paid a commission when they buy or sell a stock for a client. It doesn’t matter if the stock goes up or down; they get paid either way. They get paid when they buy a stock and they get paid when they sell a stock. Period. What type of behaviour does that encourage? Buying and selling stocks. Often. Because the more they buy and sell, the more money the advisor makes. And it doesn’t matter if they’re right or wrong, or how their client fares. That’s a serious misalignment of interests. Deferred Sales Charges (DSC) These are especially nasty. When an advisor buys a DSC mutual fund for their client, the mutual fund company pays the advisor approximately five years’ worth of fees up front—the day they buy it! If the client sells the fund before five years are up, the fund company wants that commission back. So, they take it—not from the advisor, but from the client when they sell the fund. This egregious penalty often traps clients into holding on to bad mutual funds that they might otherwise sell. Advisors claim DSC charges encourage clients to think long term and avoid switching investment strategy mid-stream. Of course, the advisor also gets five years’ worth of fees in one day. Could this be a conflict of interest? What type of behaviour does that incentive structure encourage? Well, don’t worry, because earlier this year, the Canadian regulator decided that in 2022 (why wait two years?), these DSC charges would be banned—everywhere in Canada, except in Ontario—which decided not to adopt the ban. WTF, Ontario. New Issues Sometimes, your advisor may call you with a suggestion that you buy a certain stock. Perhaps it’s an IPO or a preferred share, or perhaps it’s any old stock. If the stock they’re recommending you buy is part of a “new issue,” which is when a company pays an investment bank to help it issue shares and sell them to the public, then your advisor is likely getting two to three years’ worth of fees on the amount you invest in that stock. Did they tell you about the commission they’d earn? Did they tell you the stock was part of a “deal” or “new issue”? Could the hefty commission they’ll be receiving factor into their desire for you to buy it? Make sure you ask if it is next time your advisor recommends a stock. Asset-based percentage fee Under this structure, the advisor charges the client a fee based on the amount of money the client has invested with the advisor. This is typically around one percent a year. Instead of commissions, this fee is charged each and every year, irrespective of how active or inactive the advisor is with the account. The industry will tell you that this aligns the interests of the advisor and the client, but does it really? They say that if the account goes up, the one percent fee is now on a bigger pool of assets so it also goes up. If the account goes down, the fee also goes down, because it is based on a smaller amount. Sure, fair enough, but let’s drill down and look at the economics of it all: A client with $200K to invest would pay $2K/year if being charged one percent. But a client with $300K to invest would pay $3K. Should a client with $300K pay fifty percent more than a client with $200K? Should a client with $400K really pay thirty-three percent more than a client with $300K? Further, every time a client makes a deposit of their hard-earned money into their investment account, their fee goes up and the advisor makes more money. Does that seem fair? Here’s the real crux of it: if an advisor signs up a new client with $500,000 to invest, their annual fee at one percent would be $5,000. If the advisor performs really well for their client, and the client’s portfolio goes up by 10 percent, the advisor’s fee would instead be $5,500—an increase of $500. Meanwhile, if the advisor instead spends their time trying to sign up new clients rather than on research or investing, they can possibly sign up another $500,000 client, increasing their income by $5,000 again—far more than the $500 increase they’d get for performing well for their existing clients. What type of behaviour does this encourage? To this author, it encourages salesy behaviour. In my career, I was told by management more than once that the job of an advisor was to bring in assets—full stop. What type of people does this attract to the industry? Salespeople. Not professional, educated, thoughtful investors, but salespeople. Because if you can bring in clients, you make way more money than you do by focusing on doing well for the ones you already have. And then you end up with an industry full of salespeople (with exceptions, of course)—many of whom don’t know what they’re doing—but talk a great game and can convince people to trust them. Are you angry yet? You should be. Wait—it gets worse. Grid payouts An advisor doesn’t get to keep all of the fees they charge. They get split with their firm. The exact split varies, but typically, a “successful” advisor who is making a lot of money from their practice keeps roughly fifty percent of the fees and the firm keeps the other half. However, if the advisor generates more money from their practice by charging higher fees, commissions, or by selling new issues to clients, they get to keep more—perhaps sixty percent. And if the advisor produces less revenue from their practice, perhaps by avoiding new issues or by reducing their fees, regardless of how well they’re doing for their clients, they get to keep less—maybe only thirty-five percent of the fee. So, for an advisor, the way to “move the needle” is to bring in more clients and charge more fees. And their firm rewards that by letting the advisor keep more of the fees and punishes those who don’t by giving the advisor a smaller percentage of the fees they charge. What type of behaviour do you think this might encourage? The problem and the solution "Something is rotten in the State of Denmark." --Bill Shakespeare, Hamlet There’s a theme here. Nothing about these structures are client-focused. They’re all advisor- focused. If the advisor brings in clients, buys and sells frequently, and sells new issues, they make money—irrespective of how their clients do—whether or not they achieve their goals and whether or not the advisor adds any value. Shouldn’t the interests of advisors and clients be truly aligned? Shouldn’t the advisor’s compensation actually be based on how well they do for their clients? The industry and its regulators don’t seem particularly bothered by this. It seems investment firms are just fine with making money regardless of the client’s success, and they’re quite happy to attract and reward salespeople instead of professional excellence. There are many ways this problem could be solved. I’ll introduce three of them here: Growth-based compensation Instead of charging a percentage fee based on the value of the client’s account, the advisor could charge a percentage fee based on the growth of the investments in the account. That is, the advisor gets no credit for client deposits, but earns a fee based on how the investments perform. Under the current model based on percentage of assets, every time the client makes a deposit, the advisor’s fee goes up. That doesn’t seem right; it’s only the growth of the client’s money that should be considered. This would encourage a focus on investing successfully for clients rather than on just signing up more of them. (Thanks TC!) Hurdle-based compensation You begin with the rate of return available in risk-free investments (like a GIC or T-Bill). To the extent that the advisor helps their client earn a superior return to the GIC in any given year, they are paid. If the client would have been better off holding cash, the advisor doesn’t get paid. That would encourage a focus on absolute returns—making money regardless of what the markets are doing. Work-based (and goal-based) compensation Advisors are paid for the time spent on a client’s file. They charge an hourly rate for phone calls, meetings, letters, etc. The time they spend researching and conducting due diligence is allocated proportionately to their client base. This would encourage more time spent working and less on the golf course. This type of compensation can also be tied to the achievement of specific objectives set at the beginning of the year by the advisor and client together to address items such as planning, tax-minimization, etc. This would encourage a serious focus on financial planning and the needs of the client. There are a number of ways this colossal problem can be addressed and any of the above potential solutions can be implemented with or without a base retainer fee. How the issue of misaligned interests is ultimately solved can be debated and addressed collaboratively. It doesn’t matter whether the cat is black or white, as long as it catches the mouse. What’s important is the commitment from the industry, its regulators, and its advisors to base their fees on client success, rather than salesperson success. I know, I know. As Upton Sinclair said, "It is difficult to get a man to understand something when his salary depends upon his not understanding it." But enough is enough. Conflicted advice isn’t advice at all--it’s a sales pitch. It’s high time that the investment business put clients first. If your advisor isn’t open to a new way of thinking that puts your success above theirs (or at least equal to), then perhaps it’s time to look for one who will. -J Jesse Kaufman is the founder of AdviceCheck, which he started to help investors determine if their financial advisors are doing a good job for them. AdviceCheck provides unbiased, objective assessments of financial advisors and their work so investors can determine if they are on the right path. Jesse is a Chartered Alternative Investment Analyst, Chartered Investment Manager, Accredited Investment Fiduciary, and a Fellow of the Canadian Securities Institute. In 2016 and again in 2017, he was named Best Advisor in the Country for Alternative Investment Expertise at the Canadian Wealth Professional Awards.