Financial Advisors are Crooks. Or, Are They?
Retail investors have gotten the short end of the straw for far too long. This is causing a fundamental shift in their behaviour and is creating a distrust of financial “professionals” everywhere. In particular, the financial advisor may become extinct. This is due to the lack of structure in their world that allows unscrupulous advisors to prosper.
Fundamentally, there are a few reasons why financial advisors are ineffective at maintaining and growing people’s wealth.
Number 1: Their incentives are skewed.
There are two main incentive structures financial advisors can operate on: Commission-based and Fee-based.
Most financial advisors are incentivized by commissions. This means they make money every time you buy a financial product, such as a mutual fund, or when you buy or sell a stock or bond, not when you make a return. When your goal is to grow your money and their goal is to sell you products or do more transactions, there’s a conflict of interest that creates a whole host of issues. For example, a financial advisor may buy or sell stocks when the best thing may be to hold, just so he/she can net more commissions. This is more common than most expect, as financial advisors are only held to a “suitability standard”. See below.
The fee-based incentive structure is a little more progressive, even though it is used more sparingly. Fee-only advisors are paid based on an agreed upon rate whether it’s a percentage of assets under management or on an hourly rate. In both of these situations, it certainly removes a lot of the negative incentives associated with the commission-based structure. However, it does not eliminate the conflict of interest. The goal of the advisor will be to ensure the client keeps their money in the investment account, even when it is not necessarily the best way to leverage their capital. For example, if a client asks a fee-based financial advisor whether they should use funds in their investment account to pay off a mortgage early, there’s a conflict of interest. The advisor’s interest will be in keeping that money in the account so that he/she can continue to earn a fee. Whereas, the interest of the client may be in paying off the mortgage early.
Unfortunately, there isn’t currently an incentive structure that avoids these conflicts of interest. This problem is further extenuated by financial advisors holding no fiduciary duty to their clients.
Number 2: No fiduciary duty.
For those unfamiliar, a fiduciary duty is a legal relationship of confidence or trust between two or more parties, where one party, the fiduciary, is trusted to act in the best interests of another party, the beneficiary. In this case, financial advisors would be the fiduciary and their clients, the beneficiary. However, financial advisors don’t have a fiduciary duty to their clients.
In other words, financial advisors don’t have a legal duty to act in the best interests of their clients. Kind of mind-blowing, right? Especially considering that they are dealing with people’s retirement and life savings.
The only standard financial advisors have to meet is what’s called a “suitability standard”. Instead of having to place the interests of the client above theirs, they merely have to “reasonably believe that any recommendations made are suitable for clients, in terms of the client’s financial needs, objectives and unique circumstances” (source).
That’s a pretty low standard of care. It’s fairly easy to argue that an investment is suitable for a client, as long as you’re not being completely reckless. This leaves a lot of room for moral flexibility. Whereas, if they had a fiduciary duty, financial advisors would need to ensure that whatever investments they were recommending were in the best interests of their client. To me, this makes a lot more sense. Financial advisors are handling the financial future of millions upon millions of people. They need to be held to a high standard.
The lack of fiduciary duty and skewed incentives causes issues for retail investors. In particular, they’re faced with financial advisors who have the ability to withhold recommendations to benefit themselves and also churn their portfolio.
This can occur where brokerages and mutual funds structure the sales commission to the financial advisor based on the amount the client invests. An example scenario would be where the sales commission an investor would pay is 6% on an amount invested less than $30,000 but it drops to 5% once they invest $30,000 or higher. In this case, $30,000 is considered the breakpoint.
Advisors may withhold recommending you invest more in a particular product so that you are unable to take advantage of the lower sales charge. Instead, they can recommend splitting your capital between similar products. This would still meet the “suitability standard” and would help maximize the amount of money they stand to make. This is one great reason to apply a fiduciary duty to financial advisor and client relationships.
Churning a portfolio
Another result of the skewed incentive structure and lack of fiduciary duty is that financial advisors can “churn” your portfolio. This is the act of trading a client’s account unnecessarily to increase commissions. It can be disadvantageous for financial advisors to hold positions for the long term as it means they make less commissions. The commission structure was built on the idea that financial advisors are adding “value” every time they make a trade. However, it has the unintended effect of encouraging financial advisors to make trades where it may be unnecessary, just to generate more earnings.
We’re not here to rag on financial advisors individually but as a group, their incentive structure and legal duty to their clients just don’t make sense. These people are managing the retirement and life savings of millions of people and it’s not something to be taken lightly. Yet, the structure in place doesn’t match the seriousness of the task they undertake.
This post was written by Yoseph West, co-founder and CEO of Vuru.