How Are Your Financial Institutions and Advisor Compensated? It's Important.
Wells Fargo is the latest example of a financial institution harming its clients by creating a compensation structure that incentivized employees to act contrary to their clients' best interest. Regulators found over 3.5 million fake credit card and bank accounts created by Wells Fargo employees who were pressured by managers to meet unrealistic sales goals. Wells Fargo was also caught selling nearly 1,500 renters and term life insurance policies to clients without their knowledge.
How in the world could this ever happen?
Some Wells Fargo customers said bank employees lied to them saying they were giving them a quote when in fact they were unknowingly being signed up for a policy.
When these issues were initially uncovered, Wells Fargo fired thousands and tried to lay the blame on these rouge employees. But as the truth came out, it was obvious that the problem lay with management’s incentive compensation structure. In reality it was the leadership who had put extreme pressure on employees to sell products in an effort in increase profits and thereby increase bonuses.
Misguided Incentive Structures Are the Rule, Not the Exception
Some people were surprised at what Wells Fargo was up to. I was not in the least bit surprised.
In general, financial institutions and their salespeople exist to maximize the profits of the corporations they work for, and hence compensation. To generate higher profits you need to sell products that have higher profit margins which are naturally more expensive to clients.
Let’s take a look at a simplified example to show how powerful these incentives really are.
For our simple example, let’s say an investor walks into a financial institution with $1,000,000 that they just inherited and need to invest into a long term investment.
The financial salesperson discusses two options for this investment. The first option is an annuity plus a private REIT (real estate investment trust). The second option is a portfolio of low cost no load mutual funds. Remember this investor is relying upon the sales person to tell him which option is the best option for him. In most cases, the unsophisticated investor will go with whatever the professional’s recommendation is.
Now let’s look at how the compensation works in both scenarios:
If the prospective client goes with option one, the financial institution will earn a commission of $50,000 or more as soon as the investment is made and then a much smaller trailing commission each year thereafter.
If the prospective client goes with option two, the financial institution will earn a fee of $2,500 as soon as the investment is made and then they will be paid roughly $2,500 a quarter, increasing each quarter as the value of the portfolio increases going forward.
As you can see, it would take over five years for the compensation paid from option two to even begin to approach option one. The incentives to sell option one are enormous.
Even if the broker feels that option two is a better one for this client, the pressure from his manager and company to sell option one will be severe because the rewards to the institution are so much higher.
Step 1: Hire a Financial Advisor Who Works Only for You – Not for a Financial Institution
You can beat these self-serving, conflict-ridden financial institutions simply by hiring an advisor that is 100% compensated by you and 100% loyal to you. Such an advisor is known as a 100% fee-only advisor.
The advisor must be free and independent of all financial institutions. Because such an advisor is only paid by you, he or she will naturally be completely loyal only to you.
It makes sense because now your advisor is being paid to work for you rather than for a financial institution. Your advisor is being paid to research, know and introduce you to the best financial institutions and financial strategies without an ulterior motive of selling you products that will boost some financial institution’s bottom line.
They will introduce you to institutions known for their low cost and solid performance such as Vanguard Investments and Dimensional Fund Advisors. If you need insurance, your advisor is now being paid to help you find a carrier offering the least expensive (yet highest quality) insurance products without an incentive to steer you in any particular direction.
Hiring a 100% fee-only advisor can transform your financial and investment planning.
Step 2: Hire an Advisor Who is Committed to a Systematic, Detailed & Integrated Process
To get the absolute most out of your fee-only financial advisor, be sure to select one that is committed to a systematic, detailed & integrated financial & investment planning process.
Your advisor’s process should integrate and coordinate all areas of your finances, and your advisor should work in concert with your other advisors such as your CPA and estate planner. If you select your advisor well, you should look back years from now and feel that this was one of the best decisions that you ever made.
If you would like to know if your advisor is truly acting in your best interest, contact us for a fiduciary review.