There are many different ways that people pay for and receive advice around their retirement planning, estate planning and investments. Over time, the financial industry has invented many different models of how best to deliver this advice. However, some of these models of delivering advice are rife with conflicts of interest. Unfortunately many investors are not aware of the conflicts that do exist and how they can work against you. Let’s fix that!

Our goal today is to educate you on one of the current and largest models of delivering advice.  We will address the broker-dealer model of delivering advice and where the conflicts of interest may lie in that business model.

For our purposes a “broker” is an individual or firm (Broker-Dealer) which acts as an intermediary between a buyer and seller, usually charging a commission. These firms are often called “wirehouses” and are regulated by FINRA. These are the big-name firms you see advertising everywhere. All of their brokers will have passed the FINRA Series 7 exam. They oftentimes will take on the title of advisor (or adviser) but they are bound by a different set of rules than advisors registered with the SEC. (A.K.A: Registered Investment Advisor)

Let’s dive in!

Conflict #1 – Sales Fees and 12b-1 Fees

Mutual funds charge investors (a portion of which goes to pay brokers) in two separate and distinct ways.

1. A “Sales Charge” – up front (A Shares), or deferred (C Shares)
2. A “Management Fee” or “Expense Ratio” that includes something known as “12b-1 Fees”

The sales charge is obvious and rather transparent. In most A share class of mutual funds the broker receives a fee for placing you in that fund. For example, if the fee is 5%, only $95 of every $100 you invest actually goes into the mutual fund. The conflict of interest is quite obvious here.

However the 12b-1 fees are not so transparent…

In the late 1970’s the mutual fund industry was fighting with the negative effects of excessively large mutual fund redemptions.  The funds needed to maintain liquidity for their existing shareholders and the result was rule 12b-1 enacted in 1980.  12b-1 is an SEC rule authorizing mutual funds to deduct a portion of the fund’s assets to pay for “marketing and promotion expenses.” At the time it was a good idea to help the mutual funds bring in new assets which would in theory help these funds maintain their liquidity requirements.  However, that good idea morphed over time into a conduit for direct and ongoing compensation for brokers and their firms. Unintended consequences!

Today, 21b-1 fees are a little known additional compensation structure for brokers and their firms. In fact, according to an ICI survey of 95 member funds in 1999, 63% of 12b-1 fees are used for compensation of broker-dealers and related expenses. So not only are you, the investor, paying your advisor the original sales charge in this example, you are also paying an additional ongoing fee to the mutual fund company, a portion of which is being directed BACK to the broker as compensation!

CLASS	Initial Sales Charge	Expense	12B-1
A	5.75%	0.64%	0.24%
C	0.00%* *deferred	1.44%	1.00%

Above is a typical mutual fund sales charge schedule. As you can see, depending upon the share class you are invested in, you may be paying upwards of 1% in compensation  in the form of a 12b-1 fee back to your broker and their firm with little of your knowledge.

If your broker is being compensated for keeping you in a mutual fund regardless of the performance or cost structure to you of said fund then the conflict of interest is apparent!

Note: Shorepine Wealth Management never takes sales charges or 12b-1 fees.

Some questions to ask:

Do you accept 12b-1 fee compensation?

Does your firm?

Is there a share class for this fund with no sales charge? Why am I not in it?

Conflict #2 – Shareholder & Management Obligations

Publicly traded firms and their managements have interests that are aligned with their shareholders, not their clients. They place profits above all else and job #1 is to grow their earnings and the stock price of the firm.

How do you grow earnings and potentially increase your stock price? Here’s a few more common ways:

1. Increase the number of accounts or clients per broker.
   1. They put immense pressure on the brokers to grow the number of households they work with or get more accounts from each household.
   2. This activity is time that is taken away from managing existing relationships, forget the additional stress it induces in your advisor.
   3. The average broker at the larger firms serves about 150 clients with an ongoing expectation to serve more! There is only about 260 working days in every year!
2. Increase assets under management per broker.
   1. They will incentivize their brokers to drop any small or time consuming clients.
   2. This leaves more time for the brokers to find new clients or sell new products to existing clients.
3. Increase the number of trades per broker. (sell, sell, sell)
   1. More trades means more revenues for the firm.
      1. All revenues produced by a broker are recorded and compensated accordingly.
   2. Thus, the broker is actually incentivized to have higher the number of trades in your account than may be necessary.
      1. This is a practice known as “churning” and it happens more often than one would think.
4. Increase the number of brokers at the firm or fire advisors that “underperform”.
   1. The brokers that are are simply helping clients and not trying to find more clients  are often pushed out of these firms.
      1. Simply because they are allocating their time to their current clients.
   2. This is very disruptive to current clients.
5. Sell, sell , sell.
   1. Most larger firms also have investment banking divisions. They will use their private wealth clients to sell the products “du jour”
      1. Private wealth clients are simply viewed as a distribution channel for the IPO’s and debt offerings of their corporate clients. Watch out for that “hot new IPO”!

Some questions to ask:

What is your current capacity for # households? How close are you to that?

What is your firm requiring you to grow in households per year? What happens if you don’t?

Conflict #3 – Legal Obligations & Standards

“Brokers” have no legal obligation to monitor your investments on an ongoing basis. Registered Investment Advisors do.

Brokers can sell you investments you may not necessarily need as long as they feel the investment is “suitable”. Educate yourself on the difference between a fiduciary standard and a suitability standard.

Suitability vs. Fiduciary

Suitability = broker’s duty is to the firm, not the client. Their only obligation is to make recommendations that they “reasonably believe” are suitable to the client’s financial needs, objectives and unique circumstances. This is enforced by FINRA.

• Example – under this standard they can make trades that result in higher commissions as long as they believe it is suitable for the client.

Fiduciary = put your client’s interests above your own. They have a duty of loyalty and care to the client, not the firm.

• Example – under this standard they cannot make trades that result in higher commissions.

Some questions to ask:

Are you a fiduciary?

Will you sign a fiduciary oath?

Conflict #4 – Promoting Proprietary or “Partner” Products

Some Broker-Dealers incentivize their sales force to sell their own products. This is because it is better for the firm’s profits. The firm gets to keep the management fee that would otherwise go to the other mutual fund company. The conflict of interest is obvious.

Another strategy they employ is to only allow or incentivize their sales force to sell funds from “partner” firms. Partner firms are mutual fund companies that pay a fee to the firm to be one of the “partner” funds. All the firm’s clients somehow end up in the same mutual funds! Conflict of interest?

Some questions to ask:

Am I in any proprietary products? Why? Is the fee comparable to similar funds?

Have you put me in any products that your firm receives additional compensation for?

While many other conflicts likely exist, I think these four are the largest potential detriments to an investor being treated fairly. While the vast majority of brokers likely in fact do work in the best interest of their clients, it is important to understand that these conflicts exist.

Lastly, ALWAYS use brokercheck before deciding to work with anyone in the industry. It will alert you to potential malfeasances in any advisor’s or broker’s history.

I hope this post helps you better understand our industry.

If you want to discuss further please do not hesitate to contact me by clicking on the contact link at the top of the page.

Stay safe out there!