The Pay and Product Disconnect

By April 1, 2013Financial Planning

Integrity is key. For Advisors, it’s easy to lose sight of integrity because the framework of the financial services industry creates conflicts of interest.  In many cases, there is a disconnect between the cost and the service provided.

In general, if a client is paying for a product one could argue the cost is irrelevant as long as the salesperson has told the truth about what is being sold.  The salesperson clearly works for a company and therefore is obligated to act in a way that increases profitability for shareholders.  The argument could continue to be made that anyone purchasing the product can evaluate it against other similar products and come to an independent buying decision. In the financial services industry, integrity could possibly be maintained in this scenario, but only on some distant planet in a parallel universe. Here in the U.S., we have created a quagmire of conflict that continues to evolve and complicate the lives of financial consumers.

Problems arise initially in two areas:  complex modern financial products and advanced consultative sales practices. Regulators have stepped in over the years to try and help level the playing field as financial products have become more complex. This is absolutely necessary, but complexity breeds complexity so today few, if any, clients actually read all of the prospectuses, disclosures and statements they receive. In modern financial times, it is very difficult for most investors to navigate through and evaluate complex products and their supporting documents and disclosures. In response, the industry has over the years adopted a consultative sales approach to provide badly needed guidance and recommendations to clients.

This consultative approach started in the life insurance industry where complex products have been presented to average Americans for over 150 years and well before mutual funds ever existed. There are many variations; interestingly, the method I first learned almost twenty years ago was an excellent program called Integrity Selling by Ron Willingham.  The CFP Board Practice Standards that define the Financial Planning Process are a direct descendant of these consultative sales methods first developed for life insurance agents.

Today, clients receive beneficial planning information and recommendations to assist them in making a good buying decision. However; there is a crucial disconnect between the service (planning process) and the compensation. If the Broker or Agent does not make the sale, she does not get paid and neither does the financial services company whose product is being provided. Additionally, in some cases the compensation is what we call front loaded meaning the Broker or Agent is paid a large lump sum at the closing of the transaction. The expectation from the client (and the financial services company along with the regulators) is that the Agent or Broker will continue to provide consultation and service on an ongoing basis.  However; compensation after the initial sale may be negligible to nonexistent. Can an Agent or Broker reasonably be expected to provide ongoing service to the client on behalf of the financial services company for little or no compensation? The regulators and financial services companies think so and require it to a certain degree in their regulations and contracts.  The salesperson can generally only afford to provide ongoing service if continual ongoing sales are made. Again, what the client is paying for is disconnected from where compensation is derived.

The pay and product disconnect has motivated many clients and advisors to try another avenue; that of the Registered Investment Adviser. Under the Investment Advisers Act of 1940, Registered Investment Advisory (RIA) Firms and their Investment Advisor Representatives work under a completely different set of rules. The basic level of client care required by advisors under these regulations is one of fiduciary care. A fiduciary is defined many ways but in its simplest form means that the Advisor is required to always do what is in the best interests of the client. The fee charged for advice can usually take the form of either a flat planning fee or percentage of assets charge that is directly taken from the client’s accounts.

Most in the industry who work under the RIA rules and guidelines believe their practices are set up to deliver service and products to clients with better integrity and I agree.  However; we are not out of the woods, yet.  There are a couple of elephants in the room nobody wants to talk about.

The first elephant in the room is life insurance.  The life insurance industry has been slow to change with regard to front-end loaded compensation and how their products are marketed. It is very difficult to find life insurance policies that are not front loaded with 50% to 90% of the first year premium built into the product costs as commission.  The commissions from life insurance sales that are created through the planning process are a relevant revenue source for many, if not most, Advisors and therefore difficult to forgo.  Properly disclosed and documented as suitable and in the best interests of the client; the sale of life insurance in conjunction with planning or investment-related advice is allowed and prevalent. However; I believe it would be best to avoid commission life insurance sales with clients paying a fee for fiduciary advice due to this pay and product disconnect issue. Avoiding life insurance sales with fee clients is easier said than done as there are few qualified life-only brokers available for the referral of clients, and fewer still commission-free life insurance products.

The second elephant in the room has to do with how the fee for advice is charged. Most Investment Advisor Representatives providing fiduciary planning do so under the Wealth Management practice model. Under this practice model, we charge a percentage (usually around 1%) on assets being managed for the client. This asset-based charge pays us to invest the assets for them but also pays for planning and coordination with tax and estate advisors. Yet another disconnect! It may be better to separate out the two distinctly different services with charges for each. Charge a flat annual planning fee for planning and an asset-based fee for the management of money.  Invoicing clients separately for advice is relatively uncommon due to an unfounded fear in the minds of advisors that clients are unwilling to pay hard cash money for expertise and advice. I have found just the opposite to be true; as a recent informal survey of my clients revealed they believe I do not charge enough.

Did I mention there was a third elephant in the room?  It’s 12b-1 fees. This one is RARELY talked about and, yet again, can potentially create conflict in the minds of advisors and their companies when it comes to choosing products that are in the best interests of their clients. 12b-1 fees are charged as a part of the operational expenses of a mutual fund and generally are in the range of 0.25% to 1% of the invested amount on an annual basis. In many cases, the 12b-1 fee is used by a mutual fund company to reward intermediaries (like clearing firms, wirehouses, or RIA’s) for marketing and distributing their funds.  It is difficult for RIA’s and their Advisors to turn a blind eye to such a potentially large revenue source and still remain competitive in the industry.  However; can an RIA or Advisor justify the additional expense to their clients within a fiduciary relationship?

It is easy for those of us in the financial services industry to lose our sense of direction. This holds true whether we call ourselves Reps, Brokers, Advisors, Fee-based Advisors, or Fee-only Advisors. Furthermore; due to the already complex state of our regulatory environment, it is not likely to improve or become any easier to navigate. We must identify, evaluate, and mitigate the pay and product disconnects that exist in our practices. The client relationship can do nothing but dramatically improve when we are able to clearly and distinctly show how we are getting paid and what services are being provided.  If we can rid ourselves of some of the conflicting distractions rampant in our profession we can preserve integrity and build solid client relationships.

Rob Schulz, CFP®

By Rob Schulz

Rob Schulz, CFP® is a Principal with First Texas Financial Services, Corp., and a Registered Representative through Cambridge Investment Research, Inc., a Broker/Dealer, Member FINRA/SIPC. He is also an Investment Advisor Representative through Cambridge Investment Research Advisors, Inc., a Registered Investment Advisor. Cambridge and FTFS are not affiliated. These are the views of Rob Schulz and not those of Cambridge, FTFS, or any of their affiliates. Material discussed herewith is meant for general illustration and/or informational purposes only, please note that individual situations can vary. Therefore, the information should be relied upon when coordinated with individual professional advice.

 

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