Why do we have Commission-Based Financial Advisors?

I have already discussed the forces that led to individuals managing their own retirement money. In his book, The Intelligent Portfolio, Christopher L. Jones explains how this led to product-based compensation for financial advice.

For wealthy people, investment advisors traditionally charged a percentage of the total portfolio each year. For this money, advisors were expected to have high levels of expertise over a broad range of financial topics. Investors got personalized attention requiring substantial amounts of the advisor’s time.

Now that there are so many small investors managing their own retirement money, this model doesn’t work well. Advisors simply don’t make enough money on $50,000 portfolios to justify the time and effort. Something had to change.

Enter commissions. When an advisor sells a mutual fund or insurance product, he gets a commission that is often invisible to the client. The result is, in Jones’ words:

“This approach suffers from a big conflict of interest, as some products invariably result in larger commissions for the broker or advisor than others. The result is that the advisor may have a vested interest in selling certain products (such as the funds of their own firm), even if it is not necessarily in your best interests.”

In my opinion, the biggest problem is that the size of the fees is hidden from the average investor. These fees are mostly commissions and management expense ratios (MERs). By law these fees have to be disclosed in a prospectus, but these documents are written to be unintelligible by the average person.

Imagine the following scenario. Tina the typical investor walks into the office of Frank the financial advisor. Frank works out a mutual fund plan for Tina’s $50,000 retirement savings. Then Frank tells Tina that following his advice will cost her about $8000 in fees over the first 5 years! Tina would likely balk at such a high cost.

But, this is how much Tina would pay if Frank got a 5% commission up front, and Tina paid a 2% MER on the mutual funds each year. The bottom line is that hidden commissions and other fees make it possible to extract a lot of money from small-time investors by exploiting their ignorance.