Robo-advisors are forcing us to revisit the ancient fees versus commissions debate. New data and new circumstances have changed the debate in powerful ways.
How? Let’s start with the middle market. Historically, defenders of commissions have persistently asserted that it’s impossible to deliver investment advice, profitably, to middle-market consumers if you only charge fees for your services.
Even in the olden days before robo-advisory platforms, it took a certain amount of courage to make this assertion. If you sell a small annuity and pocket a $300 commission, how is that more efficient than receiving a $300 check from the client for your recommendation of comparable mutual funds or ETFs?
Meanwhile, advisors all around the country have been refuting this argument for decades through their normal business practices. The Garrett Planning Network and Alliance of Comprehensive Advisors have been working with non-wealthy clients for years on a fee basis. More recently, the XY Planning Network of advisors has been charging subscription fees to younger Gen X/Y clients who have far more credit card debt than investible assets. This, at least, suggests that fee compensation is compatible with the middle market and even with those who have assets at all.
But even granting the validity that sales is somehow more efficient than fee-compensated advice when both are delivered face-to-face, we now have a plethora of online advice platforms that are willing to deliver relatively sophisticated investment services to non-wealthy customers on an AUM- (that is, pure fee) basis. Middle market consumers can get investment services from Betterment, Wealthfront or one of the competitors that are sprouting up like mushrooms after a warm summer rain.
This is a game-changer. You can no longer argue that someone has to charge commissions in order to provide services to the vast majority of Americans.
Fees in the middle market
The other argument in favor of commissions is that, aside from a small number of advisors in the aforementioned networks, most fee-compensated planning professionals are working almost exclusively with wealthier clients who meet minimums of $500,000 all the way up into the multi-millions in investible assets.
Historically, this has been an uncomfortable truth for the proponents of the fee-only model. But here again, the circumstances on the ground are changing. In the very near future, I expect that a lot of advisory firms will incorporate institutional versions of robo-technology into their practices, driving down internal costs and allowing more firms to provide basic investment advice to clients who have very little money to invest. It’s possible that fee-only advisors will be serving the blue ocean of younger, less-wealthy potential clients en masse within five years. The technology is there to completely revise the cost-benefit equation in the fee-only revenue model.
Commission demonization
The final argument in favor of commissions is an emotional one. Every once in a while, I’m confronted at an industry conference by somebody who angrily asks me why I “hate commissions.” I don’t; in fact, I don’t have any emotional connection with any form of compensation in the advisory business. My consistent position, over the years, is that commissions don’t represent the future of the profession, because they create incentives not to put the best interests of the client first. This emotional misreading of my words (and of others’) suggests that someone has convinced a lot of reps that they’re being unfairly persecuted – even demonized – for their choice of revenue model.
Is it true that fees are the future of the profession? Fifteen or 20 years ago, it was not easy to find clear evidence in favor of this position. Once again, new circumstances have changed the debate.
Today, it’s possible to look back over 35 years and see that there has, indeed, been a visible migration among advisors and planners from commissions to fees. No longer do you hear reps at industry conferences boast about their “production levels” as you did back in the 1980s and early 1990s. The number of fee-only planners has grown from fewer than 100 during the tax-shelter limited-partnership days to roughly a fifth of all advisors registered with the SEC, according to the latest data compiled by Tiburon Associates.
Many dually-registered reps are now primarily compensated by an AUM revenue model, and every independent broker-dealer has its own asset management platform to serve them. According to the various broker-dealer surveys in the industry magazines, fees represent the fastest-growing segment of broker-dealer revenues, virtually across the board.
At the same time, the ranks of brokerage firms—the primary bastions of commission compensation-- are thinning rapidly. Rest in peace E.F. Hutton (1904-1988), Drexel Burnham Lambert (1838-1990), Shearson (1902-1994), Kidder, Peabody (1865-1994), Salomon Brothers (1910-2003), Lehman Brothers (1850-2008), Bear Stearns (1923-2008), Dean Witter Reynolds (1924-2009) and Prudential Securities (1879-2011).
The point here is that it is finally possible to identify a clear trend from commissions to fees in the profession. Before, those on the commission side of the debate might have challenged the idea that commissions are on the decline as a component of advisor compensation, and argued that fees are not the future of the profession. They can’t make that argument any more.
Conflicts of interest
But what about the arguments on the fee side of the debate? They start, of course, with conflicts of interest. The argument is that consumers are benefited when advisors pledge their full loyalty to their clients’ interests, without a sales agenda, without also trying to benefit the broker-dealer and the product manufacturers. Professions exist to benefit consumers; ergo, the fewer distractions from this mission, the closer we are to achieving professional status in the marketplace.
Is this a valid argument?
Ultimately, the “loyalty” discussion starts with a basic premise: any investment that has to pay somebody to recommend it is likely to be less beneficial to the end consumer than investments that stand on their own merits. This is not a new idea. Back in the 1990s, Morningstar’s Don Phillips went on a national tour of IAFP chapters and ICFP societies to share the remarkable thing he had learned from reading thousands of prospectuses and talking with hundreds of fund managers: some managers, and some companies, have a true passion for money management. They care more about generating returns for their shareholders than they do about lining their own pockets. And many other fund companies have their priorities exactly opposite to this approach: that is, they’re in it for the money. Phillips predicted that the load mutual fund would be a thing of the past, and his prediction has largely come true today.
In the mutual fund area, you don’t get much argument any more, particularly with the rise of ETFs as a cheap substitute for asset class exposure. The biggest pushback from champions of commission revenues will involve insurance commissions, an area where only a handful of carriers offer no-load products. But here again, I think the fee side of the argument can make the same case as it has for mutual funds.
Permanent versus transparent
In the insurance marketplace, the biggest commissions are paid when a sales agent sells an insurance product that bundles investment management with risk pooling – that is, the term insurance contract that is associated with the whole, variable, universal or variable-universal life policy.
The combination is sold as “permanent” insurance, or “owning” rather than “renting” insurance, and the consumer is told that a term policy gets too expensive in the later years and usually lapses right when it’s needed.
Once again, new developments have undermined what was once a strong commission argument. With today’s $5+ million estate tax exemption, the vast majority of Americans have no compelling need for life insurance protection in their later years. And I think all sides can agree that plenty of “permanent” policies, “owned” rather than “rented,” actually do lapse each year.
But putting that aside, the structure of “permanent” insurance – the products that pay the highest commissions – can be disadvantageous to the end consumer. Just by the way it’s structured, a permanent policy reduces the policyholders’ choices from many possible investment managers to one, and at the same time makes the actual costs of the contract far less visible and transparent.
How so? We all know that every “permanent” policy includes a term insurance contract whose cost per thousand will grow over time, as the policyholder ages and becomes more likely to die, just like an annually-renewable term policy purchased outside the bundled arrangement. The only difference between a term and a cash value policy is that the “permanent” policy comes bundled with a side investment account that is invested in some way, and which the insurance company draws from to pay that increasing amount of term premium. In the case of whole life, this is designed to make the premium payments roughly level each year. In virtually all policies, the side account ameliorates the cost of insurance as clients age, to a greater or lesser extent.
How does that structure disadvantage the policyholder? It locks consumers into an investment management arrangement with the insurance company, which is unlikely to be the very best manager for each and every asset class in which the side account is invested – and which will never be the lowest-cost provider. That alone reduces the consumer’s choice from thousands of funds and ETFs down to one fund family.
In the case of variable life insurance, the consumer can choose from a menu of funds that the insurance company has chosen. Those fund companies pay for the privilege of being chosen and are often more expensive than a comparable mutual fund offered on the open market. And, unlike mutual funds in the open market, the consumer is further disadvantaged because is very difficult to determine the expense ratio on the side account of a cash value policy – in the case of whole life, virtually impossible.
Burying the costs
The consumer is similarly disadvantaged by the opacity of the insurance costs. Whenever you buy a term insurance policy outside of this structure, the cost per thousand is highly-visible and can be closely tracked over time. If the existing contract becomes more expensive than thousands of others on the market, the consumer can switch (assuming, of course, his health status doesn’t render him uninsurable). But with a cash value policy, the rising costs of the associated term policy are buried deep in the contract, where it is very difficult to see if the insurance company is raising the rates beyond the standard term rates.
The same, of course, is true of variable annuities, which insure against longevity. Instead of the transparency of an immediate annuity, where you know what you’re getting for the money you pay, the VA contract locks you into a complicated arrangement where the expense ratio and annuity benefits are confusing at best, impenetrable at worst.
In both cases – cash value insurance and variable annuities – a good financial planner could create a diversified side portfolio, drawing from best-of-breed or lowest-cost funds or ETFs, and have that side fund pay the growing term insurance costs until the policy is no longer needed. The proponent of fees over commissions would argue that this arrangement will be more effective at conserving wealth and addressing the insurance need than the bundled contracts. As a bonus, it would be a heck of a lot easier for the consumer to monitor and understand.
This is a long way to make a simple but important point in the fees versus commissions debate: Commissions are once again reliably working against the best interests of the consumer. Agents are paid much higher commissions to sell “permanent” life insurance policies and VA contracts because the insurance company sees them as more valuable to its bottom line. They lock in a certain amount of revenue to the insurance company’s asset management division, and because they give the insurance company the flexibility to raise the rates on the internal term contract without the consumer being the wiser. It isn’t cheap to get somebody to recommend a non-transparent solution when there are simpler contracts that directly address the insurance need.
And the fee proponent would be quick to point out that the extra sales expense – the cost of talking consumers into bundled, opaque arrangements – ultimately comes out of the consumer’s pocket.
Commission manias
The fee proponent would also point to periodic times when high commissions have distorted the judgment of a large number of advisors and demonstrably injured a large number of clients. The classic example of this pernicious dynamic was the limited partnership/tax shelter era in the 1980s, when a lot of good people in the business were seduced by the 10% commission payments on every dollar they sold, plus sales incentives and “due diligence” trips to the South Seas.
The broker-dealer firms, meanwhile, made three to four times as much when their reps sold a tax shelter as they did on a mutual fund sale, so firms were less-than-highly motivated to carefully examine the underlying economics of these deals.
That era ended badly, and one can see a similar dynamic today with so many advisors recommending non-traded REITs. If those reps were truly representing the best interests of the consumer, and truly believed their clients needed exposure to the real estate sector, there are many publicly-traded REITs, with excellent long-term track records, that they could be adding to client portfolios. But of course, those publicly-traded entities aren’t paying 7.5% commissions, and they are certainly not paying the broker-dealers four times as much as any other commission product.
Quality gap
A lot of advisors will occasionally collect commissions on term insurance, immediate annuities, disability contracts and so forth, and it’s hard to see the harm in that. If fees are indeed the future, if those firms expect to be a part of the emerging profession, they’ll have to either gain access to non-commission versions of those products (which eventually the insurance industry will grudgingly facilitate) or do what most fee-only planners do today: work with an outside insurance agent who recommends low-commission solutions to their clients’ insurance needs.
But there are even more advisors who are happily getting paid to recommend investment and insurance solutions that, if those products stopped paying commissions, they would never recommend as the optimal solution to their clients.
That is the pernicious effect that sales commissions are having on our profession: the quality gap between what consumers are getting when they pay commissions, and what they would get if they pay for advice directly.
Facilitating longer-term relationships
The fee side of the argument has two more points. First, when a client is paying ongoing fees, the structure of the arrangement encourages ongoing service to clients, which fosters professional advice relationships that can last for decades. Up-front commissions, on the other hand, provide no compensation or financial encouragement for the sales agent to continue the relationship except the possibility (or hope) of earning more commissions in the future. There’s nothing evil about this, but one can argue that the fee incentive is more beneficial to the client than the commission incentive.
Who pays?
Finally, commission compensation can lead consumers to the false and harmful (to the profession at large) belief that anybody can get valuable planning advice for free. Commission-compensated advisors will say to a client: “You have a choice. You can write me a check for my advice, or you can let the mutual fund (or annuity provider, or non-traded REIT syndicator) pay me instead. Which would you prefer?”
A more honest way to phrase this “choice” is to say: “You have a choice. You can write me a check for my advice, or you can have an undisclosed but probably greater amount of compensation deducted from the value of the investment product I’m going to sell you, which will be paid to my broker-dealer, and I’ll get the majority of that money after they deduct their share for supervising my sales activities. You’ll be paying me either way, directly or indirectly, clearly disclosed or very difficult to trace. The choice is yours.”
Why would the commission compensation be higher? Because, as any insurance agent will tell you, the commission is actually paying for all the sales activities that didn’t result in a sale as well as those that did – in other words, for the total time the sales agent spent on behalf of the insurance carrier or REIT syndicator. The buyer is subsidizing the agent’s/rep’s time spent trying to sell the product to a lot of other (non-paying) customers. This isn’t evil, but it is not fair to the buyer.
To the extent that product sales perpetrate the myth that investment and financial planning advice can be obtained for free, they diminish the value of that advice in the eyes of consumers generally. The service that professional advisors provide is made to seem as if it is available at roughly the same cost as the air we breathe. This may not be evil, but it is a detriment to the profession at large.
A final argument is only valid if one aspires to create a profession out of the financial planning/investment advisor industry – and it can be phrased in a single sentence. Can you name any other profession that routinely allows its practitioners to accept sales commissions for the sales of products?
Fees versus commissions is an ancient argument, and I know a lot of advisors are tired of it. But it has become relevant again due to new developments, to the point where advisors on both sides should take a fresh look at the arguments and decide where they believe they want to position themselves for the future. Whether or not to take commissions or give them up was an important and relevant argument in decades past, and it has become so again.
I look forward to responding to your comments on APViewpoint (follow the link at the top or bottom of the page that says “continue the discussion on APViewpoint”).
Bob Veres’s Inside Information service is the best practice management, marketing and client resource for investment advisors and financial planners. To get a free sample issue of Inside Information, send your request to [email protected], or order online at http://www.bobveres.com.
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Robo-advisors are forcing us to revisit the ancient fees versus commissions debate. New data and new circumstances have changed the debate in powerful ways.
