When changing broker-dealers, transition time is typically brief—only one or two months. Yet often, financial advisors place the weight of the world on this early part of the relationship, the “honeymoon period.” They are enticed by what appears to be a sweet offer and end up making a compromise that undoes their reasons for making the change in the first place. That compromise is usually in the form of up-front transition money.

Up-front Transition Money Doesn’t Always Pay Off

Making the right choice when switching to a new broker-dealer is crucial in terms of retaining clients during the transition. We encourage our clients to set their sights on the long-term goal because, ultimately, it’s the whole package that they have to live with in the coming years that should capture their attention, not a lump sum of money at the beginning of a relationship. Still, we see human nature rear its ugly head as advisors become blinded by an offer of a forgivable note.

Here are a few examples of how reps have compromised their goals when changing broker-dealers:

  • Going with a firm that offers to cover $20,000 of initial expenses when in fact the rep would earn over $30,000 more per year at a firm offering a higher payout
  • Taking a 10% forgivable note when another firm would save them more than that amount each year through lower ticket charges
  • Accepting a large forgivable note even though the rep’s original intent was to achieve lower administrative fees on their advisory accounts (The new firm would have netted them around 85% while the sign-on bonus firm netted them 65% on advisory business, which equated to $40,000 more per year with the firm that netted them 85%.)

Instant Gratification: Going for the Marshmallow

This irrational human nature is well-illustrated by an experiment done in the early 1970s by American psychologist Walter Mischel at his Stanford University laboratory. The experiment was simple: Invite four-year-olds to eat marshmallows. Mischel would make each child an offer. They could eat one marshmallow right away or, if they were willing to wait for a few minutes while Mischel ran out to do an errand, they could eat two marshmallows when he returned. Initially, nearly every child decided they wanted to wait so they could get two marshmallows. Who doesn’t want more sweets?

Before Mischel left the room he told the child that if he or she rang a bell, Mischel would return and the child could eat a marshmallow. However, by ringing the bell, the child would forfeit the second marshmallow. Not surprisingly, most four-year-olds couldn’t resist the sugary treat for more than a few minutes. Comically, several children covered their eyes with their hands so they couldn’t see the marshmallow while others would start kicking the desk or pulling their hair in order to restrain themselves. Most of the children lasted less than one minute, while only a few were able to wait up to 15. Some of the children ate the marshmallow as soon as Mischel left the room, not even bothering to ring the bell.

Results from the marshmallow experiment demonstrated that some individuals were better at managing their impulses than others. Tracking these children to adulthood revealed some interesting trends. Children who rang the bell within a minute were much more likely to have behavioral problems later on in life. They got lower grades, struggled with stressful situations, were more likely to have substance abuse issues and had quick tempers. SAT scores were also lower on average than for those kids who waited several minutes before ringing the bell. The children who were able to wait before ringing the bell loved sweets and wanted the marshmallows just as much. However, they were better at using reason to control their impulses. These children went on to get higher SAT scores. They got into better colleges and had, on average, better adult outcomes.

Two Types of Advisor Personalities

The personality differences demonstrated by the children tempted with sweets can also be seen in advisors seeking our consult. Speaking in general terms, an advisor who is an active stock trader tends to be more emotionally wired, thus more likely to be motivated by transition money. A financial planner on the other hand looks at investing as a discipline and relies less on emotion when making decisions. These types of advisors are less likely to let transition money skew their decision. They generally don’t like the idea of being beholden to a broker-dealer for four to six years for the sake of a bit of money paid at the beginning of the relationship.

The Dark Side of Forgivable Notes

Forgivable notes come with issues rarely brought up, but can become a nightmare for unsuspecting advisors. A 10% to 20% forgivable note will typically be forgiven over a five-year period. The advisor needs to maintain 80% to 100% of his trailing 12-month production (on which the note is based) for the first year at the firm. That amount increases 10% per year for the following years. What happens if production drops below those requirements? Likely scenarios include:

  • Extending the note for another year or two
  • Charging interest on the note
  • Calling the note, asking for what is owed to be paid immediately

Another Word of Caution

Advisors also need to be cautious of the wording in the note contract. Some notes don’t forgive one-fifth of the note per year, but rather bunch up the forgiveness toward the end of the five-year period. For example, let’s say you want to leave after two and a half years. On the surface you would think you owe half the money back. However, with some contracts you could end up still owing 80% to 90% of the money. 2008 was a big problem year for many firms giving out forgivable notes, with many of those notes now underperforming loans. Imagine being a $500,000 gross dealer concession producer at the beginning of 2008. You change your broker-dealer and get a 15% note ($75,000) paid up front. Market conditions turn south and you produce $250,000 in the next couple of years. Result? Your note is extended several years in length, you’re paying interest on the loan or they ask for the money back. The other question that reps fail to ask themselves is what if they become ill for an extended time? It’s for reasons like these that you need to look at the good, the bad and the ugly of accepting any forgivable note money.

Take the Up-front Incentive Only When All Things Are Equal

The marshmallow experiment was a test of self-control for four-year-olds. Up-front sign-on bonuses are a test of self-control for advisors. If you’re down to the choice of two firms, and all attributes seem equal with one firm offering a more generous transition package, then there’s nothing wrong with going with the firm offering more. The key here is all things being equal. Often, when the forgivable note is dangled before you, it’s easy to start to rationalize and minimize your original criteria. Your focus becomes fixated on the short-term honeymoon rather than the long-term marriage to the broker-dealer. Making this choice, you become the kid taking the marshmallow without even ringing the bell. Focus on the long term and you’ll likely get the sweeter deal.

This article is part of Investment Advisor’s 2012 Career Guide. Click below for more articles:

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