We don't pull punches pointing out all the ways working with a non-fiduciary advisor can be a nightmare for clients. We've made the case that brokers without that special fiduciary badge of commitment tend to oversell shoddy mutual funds, underperform their fee-only peers and overcharge to boot. But have we ever stopped to address what life as one of these brokers is actually like? Have we asked, if fee-only is so superior, why do commission-based advisors continue to exist?
The Registered Rep
I began to ponder this question after asking an old colleague why they were still working as a registered representative (a person who works for a brokerage company). His answer was surprising. He told me that as a condition of joining the company, he had been promised he'd be sponsored for the Series 7 exam within two to three years. He had worked hard, built up business and clients for himself and met every expectation. When the time was approaching, one of his co-workers lent him the study materials and he began taking practice tests.
In between working long hours and weekends for his company, he started placing in the top percentiles for the practice test. He waited patiently for the go ahead to schedule his exam. It never came. He went to his manager and asked when he would be scheduled, to which he replied "Not yet. Keep working at it and we'll talk later." (For related reading, see: How to Distinguish Advisors From Salespeople.)
This exam was critical to my colleague's advancement and they were keeping it from him. They were dangling the promise of sponsorship for important licensing exams like a carrot in front of his and all their employees' faces to ensure loyalty and hard work. Then, after years of work and results, yanked the carrot a little higher. My old colleague became so discouraged at this, he began to shop his options with other companies.
The reality is that my colleague selling in-house mutual funds for the company was so profitable, and legitimate advising using tools like individual stocks and bonds was so much less profitable for the company, that their incentive was to keep him as a broker of mutual funds and mutual funds alone forever. Why sponsor him and give him advancement and opportunities, when he's done such a good job of selling something that results in an immediate 5.75% gain in sales charge for the company, and 1.5% every year thereafter for the expense ratio in perpetuity?
Registered Reps vs. RIAs
So why not leave and become an independent registered investment advisor (RIA), therefore becoming a fiduciary and charging only a management fee, forsaking the darkness and walking in the light happily ever after? It's not that simple either. (For related reading, see: Should You Choose a Fee-Only Financial Advisor?)
The incentive structure for a registered representative is vastly different than that of an RIA. Many RIAs have lofty account minimums and accept only the wealthiest clients. This is because they are compensated by a percentage, say 1% a year, of their client's balance. Therefore, the ideal reality for many fiduciaries is 10 clients, with net assets of $2-5 million+ each. This can make finding a fiduciary as an average investor an extremely difficult task.
Where do these clients with less than $1 million to invest go? Largely, to registered representatives and the like. For a registered rep, the incentive is to catch a lot of smaller investors extremely quickly. This is because of breakpoints, reductions in the sales charge that incentivize new investors to plop lots of money down upfront. I can't speak for all mutual fund companies obviously, but a fairly typical breakpoint table looks like this:
Purchase Amount % Sales Charge
$1,000,001+ 0.0% (1% paid to the broker by the company)
The first thing to note is that sales charges on investments are outdated, archaic things that are 100% unnecessary and should be argued by every investor, but that's just the fiduciary in me talking. Look at what a better cut the broker gets if you invest in smaller quantities. For this reason, a broker would vastly prefer 20 investors with $50,000 each (totaling $1 million) over a single investor with $1 million. Assuming your broker gets 75% of that sales charge (the other 25% going to their company), a broker makes $43,125 off of those 20 investors, and only $10,000 off of that $1 million investor. (For more, see: How to Find the Best Wealth Manager.)
So when I asked my colleague why he hadn't chosen to go fee only yet, I perhaps should've expected his answer. The fact was his level of assets under management (AUM) was too small with too many clients to support himself on the fee-only model, but still quite profitable on the commission side. I think that says a lot about the industry as a whole.
So while it is tempting to blame brokers for their greed, many simply feel they do not have any other choice. And to be fair, altogether too many fiduciaries are happy being obscure, catering only to those who can meet their lofty account minimums. Brokers exist because there simply aren't enough fiduciaries and the ones that are tend to be a bit exclusive. Meanwhile, breakpoints provide reverse incentives for brokers to chase as many smaller investors as soon as possible for maximum turnover. (For more, see: Don't Listen to Advice Without Considering Taxes.)
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