investing

Why Commission-Based Compensation Can't be Transparent

The cost of investing through a broker-dealer may not be what you think it is. Believe it or not, your broker might not know the full cost structure, either.

Admittedly, commission-based brokers do have a compelling story to tell prospective clients. They will “consult” with them for free, put together a financial or investment plan at no charge and they will even make a product recommendation that won’t result in any charges unless the client decides to buy. In many cases, clients won’t have to pay the adviser anything for purchasing the investment. How could that be bad?

Today’s consumers are savvy enough to know that there are no free lunches. Most people are willing to pay for what they perceive as quality advice. In fact, with their financial futures at stake, most people want to know that their adviser is being well compensated. This is why, when told that an investment product won’t cost them anything, they are quick to ask, “Well, how do you get paid?” To which a commission-based adviser might answer, “I get paid by my firm,” or “[the name of the product provider] pays me.” This is, to a great extent, very true. In fact, with most commission-based or fee-based product sales, the adviser is not paid directly by the client, but rather by a third party in the form of a commission or fee, which is the essence of a “sales transaction.”

So, the broker cannot be accused of obfuscation because it’s how the process works. The client is satisfied that the broker will receive compensation, and he is especially pleased that there is no out-of-pocket cost for the investment purchase. But that is the extent of the compensation disclosure. The client will never know how much the broker earned on the sale, nor will he know what the firm or the third-party provider earned. While the client may not feel worse off for not knowing – after all, it didn’t cost him anything – his ignorance may be costing him a great deal more than he knows. In fact, to some extent, the broker-dealer relies upon client ignorance in order to maximize its revenue.

What the client doesn’t know about the way commission-based advisers are compensated, or how the revenue food chain works, allows the broker-dealer to mark up the price of products, or increase their share of the revenue generated by third-party fees charged against the client’s assets. Whatever the method used by the broker-dealer, the net result is a more expensive investment product for the client over the long run. To understand the revenue food chain is to understand that investments sold through broker-dealers must be able to compensate all parties in order to make it worthwhile to offer the product.

If it sounds convoluted, it is. Even the brokers often aren’t privy to the food chain compensation structure; so, the lack of transparency cuts across two layers – the client level and the adviser level. That means, in many cases, brokers couldn’t provide full disclosure to the client even if they wanted to.

The crux of the problem in commission-based sales is that the broker is not compensated directly from the client, but from the firm or a third party. Ultimately, brokers represent the source of their compensation. The only way they can represent their clients exclusively is if they are compensated directly by the client. In the end, the client cannot be assured that he is receiving unbiased advice because the broker is being compensated by the firm.

In a fee-only fiduciary relationship, the adviser is compensated directly by the client, which means the adviser is in a position to fully disclose how the fee is applied and how all parties to a transaction are compensated. That kind of transparency is a crystal-clear benefit to consumers saving for retirement.

About the Author

Pete Woodring, RIA

Founding Partner, Cypress Partners

Woodring is founding partner of San Francisco Bay area Cypress Partners, a fee-only wealth consulting practice that provides personalized, comprehensive services that help retirees and busy professionals to enjoy life free of financial concern.

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