Financial Incentives Drive Advisor Behaviour

Financial incentives are a big factor in driving behaviour. Understanding how mutual fund salespeople are paid helps in predicting how they will do their jobs. Investors who understand this are better able to protect themselves from conflicts of interest.

A friend of mine, who I’ll call Tim, was caught between careers and tried selling mutual funds for a few years. His pay was commission-based. When he signed up a new client, he got 5% of the invested money immediately, and each year he got 0.5% of the invested money as a “trailer” commission. Some of this money had to be shared with other salespeople in his firm.

The up-front 5% commission is sometimes paid for with a front-end load that the mutual fund charges the investor. In other cases the up-front commission is paid for with either the yearly MER fees that investors pay, or if investors pull their money out of mutual funds within about 5 years, they are charged a back-end load to help cover this up-front commission.

Tim dreamed of working hard signing up clients to build up to $10 million worth of client investments so that he could semi-retire collecting $50,000 per year in trailer commissions. This dream evaporated quickly as he found how difficult it is to sign up clients, particularly those with 6-figure portfolios.

Many of Tim’s clients didn’t stay invested with him for decades as he had hoped, and the trailer commissions never amounted to very much. For the most part, he lived on the up-front commissions as he signed up new clients.

This incentive structure explains why mutual fund salespeople work so hard to get new clients (and why so many try to get clients to borrow large sums of money to invest). Unfortunately, the incentive to work hard at keeping clients is weak, and advisors often ignore clients after signing them up. Not all advisors ignore clients after the initial sign-up, but the financial incentives push them hard in that direction.

Less scrupulous advisors may even try to get clients to switch to new mutual funds so that the advisor can collect a new up-front commission. We’d like to think that people are basically honest and wouldn’t do things like this, but mounting bills can make some people desperate for income.

These realities of what life is like for most mutual fund salespeople drove Tim to a career outside the financial industry.

So, if you feel ignored by your financial advisor, or he keeps trying to get you to borrow money or switch to new mutual funds, you can blame both him and the way he is paid.