Thursday, May 4, 2017

Investor ALERT: The Compensation Grid vs trusted advice

Investor advocates always suggest you inquire as to the method of compensation of "advisors" (actual registration category is Dealing representative or salesperson). This is because most “advisors” work to the suitability standard. Under this standard these advisors are not required to act in your best interest. They need only recommend investments that are suitable; not the best or cheapest or least risky. Knowing the method of compensation gives valuable clues as to how they will behave and how you might be able to interpret their recommendations.

In this ALERT we look at the compensation grid, a grid that depicts what percentage payout advisors will receive based on sales in a certain period of time. These complex grid structures are designed by the dealer to skew the recommendations made by investment advisors. The grid clearly puts "advisors" in a conflict-of-interest as the more they sell, the higher percentage commission rate they will receive. 

Here's an illustrative sample :

Generally speaking, advisors will be compensated more richly for producing higher overall annual commissions (as seen by the general increase in payout as you move down the columns). They will also be compensated more richly for generating higher commissions per transaction (as seen by the increasing payouts from left to right). This could be done by trading larger positions or by selling higher commission generating products (like the 5% upfront payout for Deferred Sales Charge mutual funds).
Notice how a Reps “recommendations” can be modified based on how the grid is structured. In this example, high “producers” are highly rewarded and Reps with low sales volume are given little incentive to retain the status quo (that could mean incentive to sell more product , or they resign due to lack of income). Further, incentive is given to placing trades that generate higher commissions as well (either by looking for more money to get the client to invest,recommend leveraging , putting them into a higher allocation to equities which generally generate higher commissions than fixed income products, or charging higher commissions on stock trades).

Some dealers have creative exceptions to the grid, with sales of certain types of products given special payout rates. For example, a dealer may give special incentives to sell proprietary actively-managed mutual funds, new equity issues that it underwrites (IPO’s), or securities of which it has excess inventory that it is eager to reduce . These exceptions and bonuses can be permanent or temporary. All can be harmful to the unsuspecting investor.

The full-service brokerages all have different grids. Fixed payouts can vary with some paying higher than 70% and some paying lower. And not all flat-fee dealers charge the same flat fee to their advisors. The dealers are free to structure the commission payouts as they see fit, and there are no specific rules or regulations which they have to comply with other than certain disclosures.
According to another by-product of some grids is that by the end of the year, if a Rep is near the next production level (i.e. He/she has generated annual gross commissions of $375,000 for the year), then by finding a way to generate another $25,000 in commissions in the final month moves the Rep up a grid level. The new payout may apply retroactively to all commissions for the year. For example, let’s assume that our broker has $399,999 in gross commissions for the year. If they ended the year at that level (and assuming all tickets were at the $500+ level) then they would have earned $195,999.51 in net commissions. If they made only one more dollar of commissions (gross) then they jump up a grid level and their net commission jumps to $204,000. So that $1 dollar in extra gross commissions was worth about $8,000 (net) to the advisor. Imagine the incredible motivation to sell that $1 to an unsuspecting retail investor.

Temporary sales bonuses traditionally have been referred to as "flavor of the month" promotions. The concept of offering special sales incentives for certain products, especially in-house products, has come under increasing fire since they can put the financial advisor's interests at odds with those of his or her clients. As a result, a few firms have done away with such special incentives, and tout their "open architecture" approach that leaves the financial advisor undistracted in seeking the best investment vehicles for the client. Calls for securities firms and financial advisors to be subject to the more stringent fiduciary standard, as opposed to the looser suitability standard that traditionally has bound them, often have cited practices such as "flavor of the month" promotions and trailer commissions as evidence that regulatory reforms are necessary.

Compensation grids and sales targets are coming under greater scrutiny as the Investment Industry Regulatory Organization of Canada (IIROC) steps up an assessment of how the country’s investment dealers handle compensation-related conflicts. Investment dealers will be required to turn over their compensation grids as a standard item in every upcoming business compliance exam, so the self-regulatory agency can “better review dealers’ treatment of compensation-related conflicts,” IIROC has said. The grids will help determine whether clients are being put into investments that trigger richer rewards for Reps and dealers. A 2014-2016 IIROC review, which looked at how well investment firms are meeting a requirement to manage compensation-related conflicts in the best interest of the client, found that firms were relying too heavily on disclosure of conflicts without first addressing them with clients in another way. In other words, CAVEAT EMPTOR- the grid is after your money .

No comments:

Post a Comment

Note: Only a member of this blog may post a comment.