Understanding how different advisors and companies make money is really important when you’re in the market for a financial advisor, because it can end up saving you tens or even hundreds of thousands of dollars.
Unlike pure fiduciary advisors (also referred to as fee-ONLY) who earn money solely by providing services for their clients, broker-dealers representatives (aka hybrid advisors or fee-BASED advisors) can be compensated in multiple ways. And oftentimes, this isn’t disclosed in a very transparent manner. In fact, it’s usually hidden somewhere inside a 50+ page disclosure.
However, since this type of advice can be devastating to your portfolio (and your wallet), it’s important to understand exactly how it works.
So, how do these broker-dealers make their money? And more importantly, how does it impact you? Let’s dig into it.
For many broker-dealers, the easiest way to make money is by pushing products on their clients. The reason being: peddling certain products enables them to earn profits faster as they’re able to receive additional compensation in the form of kickbacks and commissions.
However, as you might imagine, this layering of fees isn’t good for you. In fact, it means you’ll likely end up paying a lot more than needed to line the pockets of the broker-dealer and the companies they work for. It also means you’ll probably end up with products, services and investment accounts that aren’t actually designed to help you achieve your goals. In some cases, they may even work against you.
And if that isn’t enough, paying for these products (and paying to work with the broker-dealer), will ultimately result in less money in your actual accounts.
While it may seem easy enough to spot a broker-dealer, it can actually be really difficult to do.
For instance, some advisors claim that they’re fee-only and charge only for managing your investments, but may also receive additional compensation for using certain investments in your account. To make things even more complicated, some even mistake themselves for actually being fee-based (I know the terms sound the same but they’re far from it). These advisors are able to remove their fiduciary hat and put on another where they now represent a broker-dealer and can sell you commissionable products. Only pure fiduciaries can claim they are 100% fee-only.
It may surprise you to hear that companies like Chase, New York Life, MassMutual and Prudential just to name a few, all have multiple revenue sharing arrangements with other financial institutions. And they receive kickbacks for getting their clients to invest in certain mutual funds. For example:
Even reputable and main street friendly companies like EdwardJones aren’t immune from this broker-dealer conflict of interest. In fact, in the fine print of their most recent annual report, they disclosed to receiving over $225 million in revenue sharing profits from various mutual funds.
In addition to the kickbacks they receive from investing their clients’ money in these mutual funds, many brokers also love to push annuity and other life insurance products. The reason for that is selling 1annuities can yield commissions as high as 7%.
To illustrate just how much this amounts to: a $500k annuity would produce as much as $35,000 in upfront commissions – not including the ongoing residual commissions that come along with several other fees including mortality & expenses, administrative fees, 12b1 fees, and other added expenses that fall directly on you that are often well over $5,000 per year.
Meanwhile, the average fee-only advisory firm (these firms can’t accept commissions or sell you products) would charge less than $500 after the first month, and still have to cover their own related expenses associated with managing the account. The result is massive savings to the consumer and less money lining the pockets of insurance companies and their agents.
To make matters worse, these mutual fund companies also strike deals with insurance companies to get their funds packaged into insurance products. This enables the mutual fund companies to dominate more corners of the market, while charging exorbitant prices for their funds. And all of the extra profits are funneled right back to the sales people.
This is similar to a wholesale supplier paying retail stores extra money to put their flagship products in desirable locations in the store, raising their prices, and keeping most competitor’s products off their shelves. The agreement benefits both the retailer and the seller, as both get more money from the arrangement. However, the buyer (in this case, you) gets the short end of the stick. Because of the limited options, you're forced to spend money on something that not only isn’t worth the price it's being sold for, but also isn’t the best option for you.
In both scenarios, you could find alternative options with lower price points. And if you looked hard enough, you might even find the same product in a different location for less money. But because you're working with a specific broker-dealer (or shopping at a certain retail store) you're stuck with the options they give you. For this reason, it can definitely pay to do your homework when searching for an advisor.
While all of this is bad for your wallet, these tricks of the trade pose a bigger problem. Since broker-dealers and insurance companies get the lionshare of their payout right at the outset of your contract, they have little incentive to provide you with ongoing service.
That typically leads to one of two things. Either you end up with a poorly managed portfolio or you’re reapproached and offered new products to provide ongoing income for the advisor via more commissions.
If the first happens, you’re likely to lose lots of money due to bad investing. And if the latter happens, you’ll get slapped with even more fees, on top of the ones you’ve already paid. But either way, you lose.
The reality is, this is just the tip of the iceberg. And most consumers are completely in the dark when it comes to the ins-and-outs of commissions, kickbacks, and fees.
But it’s hard to expect consumers to understand what’s going on, when most so-called “advisors” have difficulty seeing through the complexities of these products themselves or are more concerned about their own commission payouts.
So how do you go about navigating the investment advisory industry? You work with someone you can completely trust. Someone who doesn’t have any skin in the game – whose interests are aligned to help you reach your financial goals. In essence, a pure fiduciary advisor.