A Dirty Little Secret Revealed: Broker Commissions and Investment Fees
A simple fact: Investors earn returns net of expenses. The dirty little secret: There are six expenses common with most stockbrokers and fee-based financial/retirement planners. These expenses are largely hidden from the investment public; but make no mistake, they are real and damaging to a portfolio. These expenses are often so high and variable that significant conflicts of interest arise between a broker and the client.
The six expenses are: 1) commissions paid to brokers; 2) operating expenses; 3) the cost of cash (cash earns lower returns than stocks over time); 4) turnover (bid offer spreads and commissions); 5) market impact costs (when a fund buys or sells a large block of stock, it can cause the price to move below its current bid or above its current offer); and 6) taxes, for taxable accounts.
For those who believe that their adviser is not a broker but rather an “investment adviser,” “retirement planner” or “wealth manager,” most likely they are mistaken, as these salespeople are typically licensed brokers. In fact, some NASD Series 6 or 7 brokers are not as forthright as they should be in disclosing to their clients or prospective clients that they are indeed brokers, which by law largely restricts them to being commission or fee-based client order-takers (salespersons) and not “advisers” as defined by the Securities and Exchange Commission.
Conflicts of interest created by loads and commissions
Brokers are permitted to select investment alternatives for their clients based upon the amount of their commission as long as the suitability requirement is not breached. The suitability requirement is a very low legal threshold and hardly protective of the investing public. Beyond suitability, the relationship is caveat emptor or “let the buyer beware,” hardly the professional relationship that is advertised and promoted by the large brokerage firms and even further from a fiduciary relationship which is the highest duty recognized by law. Conflicts of interest, a commercial relationship (as opposed to fiduciary) and commissions do not make for an objective and independent adviser.
Commissions—a real drag
Commissions are a real and significant drag on a portfolio’s performance. Commissions are common with actively managed mutual funds and are commonly classified as Class A, B or C. A funds designated class has nothing to do with the quality of the fund; instead, it merely signifies how the load (i.e., commission) will be paid to the broker. Class A funds charge an upfront fee (typically 5.75 percent or higher). For example, if an investor invests $100,000 in a Class A mutual fund with a broker, the actual amount invested under a typical scenario would be a mere $94,250. What happened to nearly 6 thousand dollars? It went into the broker’s pocket as a load or commission—gone forever. Class B shares charge a back-end load or surrender penalty if the investor leaves the investment too soon, often covering several years. Class C funds charge a level load; that is, they constantly charge a commission.
It is important to note that with individual bonds a markup is charged by brokers. This markup is largely hidden from the investor. Unfortunately, investors often believe that they are charged only a few dollars per bond trade. They are sorely mistaken.
Another ill-conceived investment is the so-called manager of managers and wrap accounts which create layers upon layers of costs similar to annuities. Manager of managers and wrap accounts are not merely expensive but also have often failed to perform.
Take notice that these loads or commissions are paid regardless of how the actual investment performs.
Annuity commissions are often the highest
Annuities (fixed, variable and equity-indexed) are insurance, not pure investments. As insurance, these products are often extremely expensive with substantial surrender charges (typically 6-14 percent or more) to cover the outsized commissions paid to brokers. In a typical commission, you buy a $100,000 annuity and your broker makes $10,000 dollars (so much that he or she might be willing to give you part of it as a signing bonus). Beware, as you just bought yourself a very expensive annuity that you cannot get out of for several years without a substantial penalty. Meanwhile, you are paying a huge mortality and expense (M&E) annually plus investment costs on the separate accounts. Annuities should be highly scrutinized before purchase by a professional not otherwise engaged in selling annuities; otherwise avoid annuities altogether. Insurance makes great insurance but lousy (and expensive) investments.
Cost of Cash
The cost of cash is the opportunity cost associated with being uninvested while your broker attempts to time the market or use his or her supposed superior stock selection skills. Unfortunately, many brokers take direction from their marketing or sales departments as to how to invest. Brokers, as a whole, have very little education, training or experience in the complex mathematics of constructing an investment portfolio and even less in simply reading and interpreting annual reports or financial statements. The average cost of cash is 1 percent or more per year. Examples of cash or cash equivalencies are the money market, treasury bills, and certificate of deposits (CDs).
A warning: Many brokers that are unable to decide how to properly invest their clients’ money utilize high-yield bonds (known on Wall Street as junk bonds). When you see high-yield or other similar terms on your financial statements, you probably are holding junk bonds. The risk is default—just ask anyone who invested in the sub-prime lending market if default is a real possibility.
Commission-driven actively managed funds
An actively managed fund attempts to time the market and/or identify the “right” stocks. Despite the fact that this is almost always an unsuccessful endeavor over the long term, the investment public is inundated with these funds. Actively managed funds may be identified by the letters A, B or C next to the name of the fund. These letters solely indicate the commission arrangement of the funds which are often significantly higher than 5 percent with additional annual internal expenses that are several times greater than a passively managed structured fund or an index fund.
Actively managed funds have turnover that is often as high as 125 percent or more per year. This means that if you buy a fund on January 1 every stock that made up that fund would likely be sold out and replaced by September 1 of the same year. This creates the serious problem of style drift (e.g., is it really a large cap or small cap fund with all the turnover) and market impact costs (“Wall Street’s commission”—when securities are bought or sold, the floor brokers want to be paid as well as your broker), but more to the problem of taxes it can and often does create a substantial tax burden. Remember that it is a sale that creates the tax in the first place.
A solution for most high-net worth individuals: a fee-only adviser — no loads, no commissions (not merely fee-based or part fee and part commission), no bond markups, serving as a fiduciary (and not buyer beware with mere suitability requirements), investing in institutional investments as opposed to retail investments (Class A, B, C and so on), possessing substantial experience and education and not merely industry designations and certificates which are, unfortunately, mostly sales training.
Stephen L. Hicks, JD, MS, AIF® and Roger L. Millbrook, JD, CPA/PFS, are fee-only fiduciary investment advisers and principals of Siena Capital Management, LLC and Siena Accounting Services, Inc. Both hold law degrees as well as other advanced degrees and designations in the area of financial services. Previously, Hicks was one of five advisers on a nearly $1 billion dollar fund outside of Chicago.
This article was written March 2010