In the April issue of SmartMoney, Dyan Machan conducted a little test. Posing as a prospective client who needed various kinds of financial advice, she visited eight brokerage firms in Manhattan and northern New Jersey. Machan suggests that in giving financial advice per se, the brokers she visited may have violated SEC rules. That may be true, but it's not our concern here. Our concern is with the poor quality of many of the reommendations she received. Here's a typical lowlight:
Our twin sons are less than two years away from attending college. That means they aren't great candidates for a 529 college-savings plan, because they don't have much time to take advantage of the plan's tax-free earnings. But brokerages can collect hefty commissions by enrolling clients in such plans. So--surprise--they often advised us to join up. They also steered us to state-sponsored plans with which they had special fee arrangements, even when another state's plan was the better deal for us.
For what it's worth, we think brokerage firms' too-cozy arrangements with specific 529 plans is one of the worst constraints their brokers face. Here's another jaw-dropper:
Are you a fiduciary? It's an important question. A fiduciary has to put his client's financial interests above his own and his firm's. But every broker but one either botched the answer or gave us a blank look. The exception: A broker at Dreyfus, when asked whether he would be our fiduciary, answered: "No, but I play one on TV."
What about asset allocation? Fees and expenses? Here's Machan:
The advice we'd received had ranged all over the map. Smith Barney thought we should have 95% of our assets in equity-only mutual funds. Merrill Lynch advocated 56%. The annual fees ranged from 0.5% of our assets at Charles Schwab up to 2.25% at Morgan Stanley--and that doesn't include the sales loads on some of the products they recommended.
This is not a pretty picture. Now, we want to be clear: even if Dyan Machan didn't find any, there are plenty of conscientious, professional, sophisticated brokers out there. We happen to know quite a few fine brokers ourselves. But let's also be honest about this: There are far too many hacks in the business, and one might reasonably wonder why. We'd point to four reasons, and we're sure there are more.
- Brokerage firms are more interested in teaching new brokers to sell than they are in teaching them to manage money responsibly. The result? New brokers who want to learn about the disciplines of money and risk management, in any sense beyond the most superficial conventional wisdom, have to do so on their own. Trust us: That can be a lonely feeling.
- The industry has remarkably low barriers to entry. The brokerage business puts few obstacles in the way of someone who wants in. Exams like the Series 7 or the Series 65? They're important, and they require some preparation because the volume of material is relatively large, but they aren't especially demanding from a technical perspective.
- Inertia. Brokers aren't alone in this, but they tend to get locked into certain ways of doing business, practices that tend to become dated and often inferior to newer, smarter ways of managing money. For practical and financial reasons, it can be difficult to break out of established modes (say, for example, selling actively managed mutual funds in spite of abundant evidence that such funds are rotten deals for most investors).
- Perverse incentives. This is the mother of all problems. Here's a good example. In a fee-based brokerage platform with which we're familiar, client fees--and thus broker revenues--vary by asset allocation. The more stocks and stock funds in the account, the higher the fee. The more bonds and bond funds, the lower the fee. From every perspective, including the broker's, this is an awful incentive system. And that's in a fee-based platform, which is often touted as aligning everyone's interests. In addition, as Machan found, there are far too many many product-driven incentives to sell mutual funds, insurance, specific (often inferior) 529 plans, and so on.
Again, the point here is not to indict the entire brokerage industry and every broker working in it. In some sense, these facts of life in the industry make the good brokers all the more impressive, because they have to swim upstream every day, fighting the currents we've just described.
So how can you distinguish good advice from bad? We'll answer that question in future posts.
Dyan Machan, "Many Brokers Offer Financial Advice They Shouldn't Give," SmartMoney, March 13, 2007