Beware Advisors with Conflicts of Interest

Do you know how your financial advisor is compensated?  Is he or she incentivized to act in your best interests?

Conflicts of interest are all too common in the financial industry, particularly when commission-based salesmen posing as impartial “advisors” make investment decisions that increase their own compensation.

The New York Times recently highlighted a horror story of fee churning discovered by a daughter caring for her aging mother, who has Alzheimer’s:

After about six months, she learned that the account, worth roughly $1.3 million at the start of 2017, had been charged $128,000 in commissions that year — nearly 10 percent of its value, and about 10 times what many financial planners would charge to manage accounts that size.

In August 2017 alone, Mr. Rahn had sold two-thirds of the portfolio, or about $822,000, and then reinvested most of the proceeds, yielding about $47,600 in commissions, according to monthly financial statements and an analysis by Genesis Forensic Consulting, the firm Ms. Dewart’s lawyer hired.

I don’t care what the client did or did not agree to, or what the fine-print in the customer agreement said, THERE IS NO EXCUSE FOR TAKING 10% OF ACCOUNT VALUE IN COMMISSIONS!

This didn’t occur at some boiler-room operation, but at J.P. Morgan Securities.  The broker in question has 26 years experience in the industry all at top firms and, according to BrokerCheck, no prior customer disputes.  Engaging an experienced broker at a large, brand-name firm was no protection from excessive fees.  As of the writing of the Times article, the broker in question still works at J.P. Morgan.

This case highlights a key problem with much of financial advice: The compensation structure frequently causes direct conflict of interest between the best interests of the advisor and the client.  Here, the investigation by the client revealed a massive restructuring of the account which generated numerous commissions due to the high volume of trades.  The broker sold small batches of shares multiple times a day rather than trade larger blocks as one trade, generating commissions on each trade.  Although not mentioned by the Times, analysis by a securities litigation consultant shows that the broker likely invested the proceeds from investment sales into high-commission closed-end funds.  

The case reveals a key problem in much of the financial advisory industry: many brokers are not required to act as fiduciaries.  Advisors who are fiduciaries are required to put the client’s interests above their own.  Instead, many brokers only need to make investment recommendations that are suitable for the client in light of the client’s financial needs, objectives and circumstances.  This is key because it is highly likely there were plenty of lower-fee alternatives that would accomplish the same goals for the client as closed-end funds or other proprietary investments offered by the firm.  Naturally, such alternatives would also mean lower compensation for the broker, so you can easily see the conflict of interest here.  A fiduciary relationship would require the advisor to put the client’s interests above their own compensation incentives.

Aside from ensuring their advisors are fiduciaries, investors should also make sure their advisors are compensated in a way that incentivizes them to protect and grow their assets.  Brokers earning commission are encouraged to trade too often and invest in high commission products rather than do what’s best for the client.  Ditch the commissioned salesmen and make sure your advisor is paid in a way that doesn’t affect his or her advice.  When it comes to investment management, look for managers with skin in the game – those that have their personal assets invested alongside their investors.

Don’t get me wrong – there are plenty of honest brokers out there who work in the best interests of the client despite the conflict of interest.  However, stories like these show that it is hard to know who is and isn’t honest.  The better way to protect yourself is to make sure your investment advisor’s incentives align with yours.