Readers who have been following the fiduciary-standard-for-brokers debate since the Dodd-Frank Act became law in 2010 through to the current Department of Labor IRA proposal are going to find this very hard to believe, but I think there is one facet of brokerage commissions that has not been discussed yet (let alone beaten to death): commissions are themselves bad for commission-paid brokers.
I know, this probably sounds ridiculous to many readers, but bear with me here. And if by the end of this blog you think I’ve lost all my marbles, I’ll just have to live with that.
The basis of my thinking is the nature of the financial services industry. As with most industries, the key to understanding our industry is to follow the money. What do the most successful companies in each area of the financial industry have in common? They all manage assets. Mutual funds, ETFs and hedge funds, obviously. But you don’t have drill too deeply into the businesses of the big brokerage firms, retail banks, private banks and insurance companies to find that the vast majority of their revenues—and profits—come from managing money.
I hope I don’t really have to explain why this is the case. But just to make sure, I’ll point out that from JPMorgan Chase, to Vanguard and Fidelity, to independent RIAs, managing assets is a great business model. Unlike most industries, in which producing more revenues requires adding more people (“labor intensive,” they call it), managing assets in highly leverageable. An RIA can manage $1 billion in client AUM with just a few more people than they can manage $100 million.
Most of the employees at banks, mutual fund companies and brokerage firms are there to bring in more assets. Most insurance companies have gone one step further by spinning off their sales forces, thereby cutting employee ranks to the bone.
What’s more, asset management literally grows its own revenues by growing the assets. Even better, the assets compound. Instead of starting each year with zero sales (as do auto manufacturers or, say, Apple Inc.) financial firms already have revenues from their existing AUM: new assets are just icing on the cake. I have long suspected it’s the next best thing to having a license to print money.
How does all this adversely affect commission brokers? Along with insurance agents and bank tellers, they’re the only guys in this hugely successful asset management game who aren’t getting cut in on the asset management gravy train. And who’s fighting tooth and nail to keep it that way? The brokerage, insurance, banking and mutual fund industries, of course. Why would they want to share a piece of their ongoing AUM revenue streams? When a broker sells a mutual fund for a commission, that’s a one-time payment. The fund company (or brokerage firm, if it’s a proprietary product) gets an AUM-fee-plus-expenses revenue stream potentially for many years.
Yes, I know that some mutual funds also pay “trial commissions.” But those fall quite a bit short of the 70 bps to 150 bps that RIAs and brokers who manage money bring in every year, year in and year out. Heck, even magazine salespeople (who are paid on commission) have to re-sell advertising contracts every year, and get paid a new commission every year for doing so. This one-time commission system puts brokers under substantial pressure to sell new products and/or high-margin products such as annuities—whether or not they’re really in the best interests of their clients. For many brokers, it’s the only way they can make a reasonable living. Why do you think the turnover rate among retail brokers is so high?
And yes, a few commission brokers do quite well for themselves. But whatever they’re making, it’s still a drop in the bucket compared to the ongoing AUM fees on the investments they sell. Why do you think so many brokers have “broken away” to become independent RIAs over the past decade for so? Once brokers started to manage assets in the late 1990s, they also started to wonder why they were sharing half of their AUM fee with their BD. Apparently, there isn’t a good reason.
So when you hear the brokerage industry wailing about “business model neutrality” and how they couldn’t stay in business if their brokers were required to put the interests of their clients first, let’s not forget about the best interests of their brokers as well.
Converting pension and 401(k) assets into IRAs is one of the most lucrative areas of the brokerage business. If a fiduciary standard was applied to those transactions, those loads would have to be severely reduced, giving brokers yet another reason to jump ship and manage assets as independent RIAs.
Managing assets transformed independent CFPs and RIAs from a cottage industry in the 1980s into the hottest segment of the financial services industry. A fiduciary standard could do the same thing for brokers—and that is not in the brokerage firms’ game plan.