The Dark Side of Wall Street, Part 3

“Not infrequently, brokers become disenchanted and leave the business. Occasionally, they will even become fee-only advisors, whose compensation is not tied to trading.” – William J. Bernstein.

In a previous post, I asked the rhetorical question, “Why would you even consider working with a financial advisor who warns you in writing that ‘Our interests may not always be the same as yours’ and ‘Our profits, and our salespersons’ compensation, may vary by product and over time.’”

Friday’s post quoted exclusively from William Bernstein on the subject of stock brokers’ competence and compensation.

Today’s post quotes a former stockbroker on the incentives and pressures he observed. Scott Dauenhauer, of Meridian Wealth Management, is a colleague who spent five years working for the “big three” brokerage firms. He has written a vivid expose called Secrets of the Wirehouse and How to Protect Your Best Interests.

( “Wirehouse” is an industry term for a large national broker/dealer. Merrill Lynch, Morgan Stanley, Lehman Brothers, and Bear Stearns are all examples of wirehouses.)

Scott’s article covers many topics including broker training, compensation, and the various investment products you should avoid. Here is what he says about broker competency, compensation and the conflicts of interest endemic in the financial community.

How much training do brokers actually have in financial planning? Major brokerage firms tout intensive training programs almost as much as the stocks they peddle.  They brag about the high level of education their “consultants” receive. The truth is the only requirements are that individuals pass the Series 7, and a state insurance exam.  The Series 7 is an industry test that requires memorization of facts about the markets and represents a minimum standard of knowledge.

The Series 7 does not teach an individual how to manage personal finances, let alone create a comprehensive financial plan. The Series 7 doesn’t even teach about how to properly diversify a portfolio.  The insurance exam is an even bigger farce. While the Series 7 actually requires a bit of studying the state insurance exams only require minimal memorization.

Anyway, once a “recruit” passes the Series 7, he/she is sent to company headquarters to go through “intensive training.”  The training is definitely intensive, though not in financial planning or investment management.  The programs focus solely on sales & product training and lasts anywhere from 1-4 weeks. I attended one such program and 95% of the training focused on cold-calling sales and learning proprietary product. Proprietary products are ones that are sold directly (and typically only) by the brokerage firm and typically have much higher profit margins, though mainly benefit the firm, not the person they are sold too.  Brokerage firms want “salespeople,” not highly skilled financial planners.

If the firms hired highly skilled financial planners, the firm wouldn’t be able to sell proprietary products.  This is because the planners would know better.  When the firm hires somebody with no previous industry knowledge, or experience, they have the opportunity to fill that person’s mind with fairy tales, not fact.  The firms’ way of doing business is to focus on proprietary products, high & hidden fees, cold calling, and quotas.  The truth is that very few new recruits have any experience in handling another family’s wealth.  You end up paying high fees for a service that puts you directly on a recruit’s learning curve.  Even brokers who have been at the firm for years may not have any training in financial planning; they are stockbrokers, not trusted advisors.

When dealing with brokerage firm, conflicts of interest abound and for the most part are not disclosed.  The following is a few conflicts that you should watch out for.

First, please understand to whom a public company owes their loyalty; it is to their public shareholders.  The people who own stock in a company must have their interests protected.  A public brokerage firm’s loyalty cannot be 100% to you.

Let’s take a further look at where other strings are attached. A broker gets paid a percentage of the revenues that he/she brings to the firm, typically 25-40%.  It is not, however, that simple. Brokerage firms determine the payout percentage for each individual “product.”  They control product flow by paying higher amounts to brokers for product they want sold (typically products with higher margins).  While this makes sense from a business stand point and from a shareholder standpoint (why wouldn’t you want to incentivize your staff to sell the most profitable products?) it doesn’t work out so well for the end user, the client.  Each firm works differently but depending on the product a firm wants to emphasize, they will pay a broker a higher percentage of the revenue to induce him to sell what the company wants him to sell.  For example, if the company wants a broker to sell a Separate Account Platform product (individual money managers, more to come on this), they may tell the broker that they will receive a higher percentage of the fees they generate from that particular product and that product may generate more fees than other products.

Let me give you a real life example so that you understand.

Imagine that you had only two products to choose from to sell your client; one is a mutual fund that costs the client 2.25% annually and pays the firm 1% annually.  Of the 1% paid to the firm the broker collects 35% of it or .35% annually. On a $1,000,000 account the firm generates $10,000 in revenue and pays the broker $3,500 (you the client pay $22,500).  The other product is a Separate Account where you have an individual money manager.  This product is sold as the latest, greatest way to have your money managed and costs 2.5% annually.  However, this product pays the firm 1.5% annually and the firm will pay the broker 40% of that revenue or .60% annually. On the same $1,000,000 account the firm generates $15,000 in revenue and pays the broker $6,000 (you pay $25,000 annually).  Now, in all likelihood both accounts will have similar returns over time and will probably under-perform the market.  You the client in either situation are stuck in a lousy product that is expensive; however the firm has an incentive to sell one over the other, even if the other isn’t in your best interest.  The separate account sale earns the firm 50% more revenue and the broker 70% more revenue – which product do you think will be presented?  Each firm has their own system and they are all different, but the mechanisms are in place to manipulate the broker into selling what makes the firm and/or the broker more money.

In addition to higher revenue on proprietary products, the broker many times is under tremendous pressure from management to sell you the latest mutual fund offering from that brokerage.  Branch manager compensation is determined in part by the amount of proprietary products his branch sells. His interest is in getting the highest bonus possible, so he in turn puts the pressure on the brokers to “pound the phones,” and sell their “latest offering.”  The brokers are enticed by management with trips, dinners, and a host of other items. It goes unspoken that if a broker does not participate in selling the new offering then things will not be easy for him/her.  I know of one broker who was told, “I don’t think this firm is the right place for you,” after the broker refused to sell the new fund offering.  It turned out that he was the only one to not succumb to the pressure, he eventually left that firm.  I can’t begin to tell you how many voice mails & e-mails I received from management to ‘sell’ the “new” offerings, I never succumbed because it was not in my client’s best interest. Be aware that the pressure is on your broker to sell certain products or else he/she risks losing their job.

Conclusion

Brokerage firms (wirehouses) train (brainwash) recruits in sales techniques and product knowledge, not portfolio management and financial planning. They use carrots and sticks to influence brokers to recommend investment products that are profitable to the firm.

According to William Bernstein, brokerage firms target how much they are going to earn from clients’ accounts.

At the end of the day, most wirehouses operate on the “2% rule” – collect 2% in fees and commissions, overt or hidden, on your clients’ assets, or you’re out.

My experience is that the 2% figure is extremely conservative – it is not unusual to see accounts from which as much as 5% annually is extracted.

You will not see these fees and expenses outlined, because they are not easy to discern. Unless you are a detective, they will be hidden from your view.

Is there a better way? Certainly. It is choosing a fee-only financial advisor, who acts in your best interest, as a fiduciary.

To be continued.