How your broker gets paid (I)–the individual broker’s share

This isn’t really one question, but two:

1.  How is the individual you deal with compensated?, and

2.  How does the organization the person is a part of get profit from your business?

In this post, I’ll write about how the individual broker is paid.  In the following one, I’ll write about how the broker’s firm benefits from having you as a customer.

Ask your broker

The easiest way to find this information out is to ask the person you’ve selected to advise you.  After all, if you can’t talk openly with him/her about money, what will you be able to talk about?  And it would seem pretty foolish to purchase services of any type without knowing what the price for those services is going to be.  Despite this, it’s my impression that many customers are reluctant to ask.

I’m going to limit myself to writing about financial advisors who help you to develop a financial strategy (which may, or may not, have any investment merit) and to oversee its execution.  There are also advisors who specialize in the first task alone.  You go to them with your financial information, they develop a plan for a fee, but it’s up to you to execute the plan by investing the money yourself.  I’ve never met one, so I can’t comment.

The broker/financial advisor

two payment possibilities

A client typically can choose between two options in paying for investment advice:

1.  paying a commission on each transaction, or

2.  paying a continuing fee for all services.  The fee is usually a percentage of the assets the broker is supposed to be watching, typically between 1%-2%, although it’s sometimes higher.

Twenty-five years ago, the predominant choice was paying commissions.  As with everything else, there were ways to “game” the system.  The broker could recommend excessive trading, or “churn” the account.  He/she could also “forget” to tell the client about lower-commission ways to buy mutual funds (today’s computer systems won’t allow this sort of transaction to go through).  But it was probably the scandalous days of the late Eighties that persuaded the industry to emphasize the wrap fee business.  At that time, brokerage firms sold tones of gigantic-fee, no-value (something anyone who stopped to read the prospectuses–including clients–would have immediately found out) real estate and oil and gas tax shelters to their customers.  Not only did that destroy the brokers’ reputations, but subsequent lawsuits took back much of the money the brokers “earned.”

The percent-of-assets method is much more common today.  It, too, has its “gaming” potential.  In this case, though, it’s collecting the fee and providing little or no investment advice.  There has been mild regulatory questioning of why, for example, in an account that’s 100% in government bonds and where no trading occurs, the client is better off having his advisor deduct 2% of his assets from the account each year rather than pay a fee for each transaction.

gross fees vs. net

A broker working for a traditional brokerage house like Merrill Lynch or Smith Barney only receives a portion of the overall (gross) fees that his clients pay to the firm.  That percentage, called net fees, is typically 30%-50% of the gross, depending on the skill and client base of the broker in question.  The firm’s share goes to pay for office space, advertising (and maybe sales leads), administrative, regulatory and computer support, an investment research staff, plus a profit element.

At the other end of the spectrum, a financial planner or broker may elect to work independently or as part of a loose organization that provides trading and recordkeeping support.  The individual, however, provides his/her own office and administrative help.  In this case, the net commissions may be 80% or more of the gross.

Compensation your broker may not talk about

There are several other ways a broker benefits from clients’ business, namely:

“trailing” commissions, or 12b1 fees: The SEC allows mutual funds to pay a small portion of their assets, usually 25 or 30 basis points, for marketing.  The idea is that this gets more new money into the funds, thereby spreading administrative expenses over a larger asset base.  In practice, these fees are virtually always paid to the broker who sold the fund shares to a client, as an inducement/reward for the client continuing to hold the fund.  It’s not much of an inducement, though, since every fund group pays the same.  Still, it can mean $1000 a year or more for each client a financial advisor has.

“perks”: These would include an administrative assistant, a corner office–or even separate office space, a higher net commission percentage, access to analysts/portfolio managers that would normally denied to most brokers.

“educational” travel: Reward trips might be sponsored by the brokerage firm or by third-party asset managers.  Meetings are usually held at resort locations, with activities like golf available after formal sessions.  The sessions typically cover investment strategy, marketing techniques and the characteristics of the products the sponsoring organization offers.

broker hiring wars: This is a big one.  Brokerage house periodically try to rebuild/upgrade their sales forces by headhunting successful salesmen from their rivals.

The employment offers typically consist of three elements:

–a contract binding the broker to the new firm, usually for three or four years,

–a signing bonus, and

–an increased net commission percentage for the length of the contract.

The signing bonus is usually some multiple of the prior year’s compensation, verified by a W-2 form.  Over the years, signing bonuses I’ve been aware of have ranged from 50% of prior year’s pay to the 260% reported earlier this year by the Financial Times. This makes job-hopping the equivalent of the professional athlete’s free agency–the biggest payday of the broker’s career…until the next job hop.

(An aside:  years ago, brokerage houses encouraged their salesmen to concentrate on selling in-house funds.

Two reasons:

–they were more profitable for the brokerage and,

–more importantly, they tied the client to the firm.  Rivals’ computer systems weren’t set up to accept the in-house funds or to provide any strategy/holdings/performance information about them.  So clients literally couldn’t transfer their accounts if their broker left for another firm.  That amounted to having to leave a lot of existing clients behind, thereby making leaving hugely more difficult.

The broker response?–sell only third-party funds, which all firms’ systems could handle.)


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