Secrets Of The Wirehouse

Scott Dauenhauer spent five years working for the “big three” brokerage’s and gained his knowledge first hand. He is now a Certified Financial Planner and is the President of Meridian Wealth Management, a firm dedicated to protecting client interests. He believes in focusing on people not products. Though he believes there are some good people at brokerage firms, he thinks the vast majority fall extremely short of what is needed to advise a family on a subject as important as Financial Planning.

1. Most Brokers do not have Formal Training in Financial Planning.

How much training do brokers actually have in financial planning? Major brokerage firms tout intensive training programs almost as much as the stocks they peddle. They brag about the high level of education their “consultants” receive. The truth is, the only requirement is that the brokers pass the Series 7, an industry test that requires memorization of facts about the markets and represents a minimum standard of knowledge. The Series 7 does not teach an individual how to manage personal finances, let alone create a comprehensive financial plan. Once a “recruit” passes the Series 7, he/she is sent to company headquarters to go through “intensive training.” The training is definitely intensive, though not in financial planning. The programs focus solely on sales & product training and lasts anywhere from 1-4 weeks. I attended one such program and 95% of the training focused on <cold-calling> sales and learning proprietary product. Brokerage firms want “salespeople,” not highly skilled financial planners.

If the firms hired highly skilled financial planners, then the firm wouldn’t be able to sell its proprietary products. This is because the advisors would know better. When the firm hires somebody with no previous industry knowledge, or experience, they have the opportunity to fill that person’s mind with fairy tales, not fact. The firms’ way of doing business is to focus on proprietary products, high & hidden fees, cold calling, and quotas. The truth is that very few new recruits have any experience in handling another family’s wealth. You end up paying high fees for a service that puts you directly on a recruit’s learning curve. Even brokers who have been at the firm for years may not have any training in financial planning; they are stockbrokers, not trusted advisors. Who do you want to manage your wealth, a stockbroker, or a competent fee-based Certified Financial Planner who has the documented experience and knowledge to help you meet your needs and goals?

Your advisor should have prior experience in financial planning and be Certified Financial Planner, if not, you are putting your family’s wealth at risk. Please don’t let your finances be somebody else’s training ground.

Mutual funds have grown into a huge industry. Once a small subset of money management, they have grown into a product that is now held by a large percentage of American households. There are now more mutual funds in the U.S. than stocks that trade on the NYSE. The proliferation of this medium of investing has empowered the individual investor. However, at the same time it has powered the Mutual Fund and Brokerage industry to record profits. Many of these companies are pulling the wool over your eyes. Most investors do not understand the fees accessed in their mutual fund. Even “no-load” funds have expenses. Though most of the costs are disclosed in the prospectus <good luck deciphering>, some are not. You will never see a bill for your mutual fund because the expenses are hidden. They may be hidden, but believe me, they exist. There are three major expenses involved with mutual funds (and a few minor ones). The first expense is the Expense Ratio, this compensates the manager, analysts, board of directors, and pays printing, mailing, & overhead costs and ranges from .20% to 2.0% annually. The average is about 1.5%. The next cost is what the industry refers to as a 12b-1 fee; this is basically a hidden commission. The 12b-1 fee pays to bring in new shareholders and has zero benefit to you. It varies depending on what share-class is sold to you and runs from .25% to 1.0% annually. The last expense is not actually printed anywhere, you have to calculate it yourself. This expense is the transaction expense; every time your mutual fund buys and sells stock there are costs. John Bogle, Former Chairman of The Vanguard Funds has said that turnover can have a profound impact on performance. To find how much turnover adds to your cost find the annual turnover and multiply it by 1.00%. For example, if your mutual fund turns its portfolio over 100% annually (meaning it completely replaced it’s portfolio during the year) then you would multiply 1.00% X 1 (for 100%), which yields an additional expense of 1.00 for the year for that fund. If the portfolio experiences a 200% turnover then the cost would be an additional 2.0% annually (1.0% x 2). As you can see, turnover can have a large impact on the cost of your mutual fund. Another cost you do not see is what John Bogle refers to as the “cash drag factor,” basically most mutual funds are not fully invested, they keep anywhere from 1-10% cash on hand. This hurts the performance on the upside but cushions it on the downside, since the market has gone up more often than down, the cash in the fund brings down the performance. Bogle estimates it to be about .6% on the high end. Lets add up all the potential costs of a mutual fund, keeping in mind that brokerage firms are known for being on the high end.

Passive Low End Active High End

Cash Drag 0% .6

Expense Ratio .20% 2.0%

The low end cost represents a person not receiving any advice, the average fee for a professional advisor/planner is about 1.0% of assets annually bringing the total low end cost to 1.26%. Not all broker sold funds have costs that are as high as shown above, however the average is somewhere between 3 – 5% annually.

Does your broker have your best interests in mind when he is charging you 2 – 4 times what a professional competent financial planner might charge. I would argue not. We have been in a bull market for a long time and have experienced higher than average returns, we haven’t notice the effects of these costs. However, when equity returns revert back to their historic average of about 11 - 12%, you will notice. After deducting fees you end up with a return that is similar to a money market account, even though you are assuming the risk of stocks. In fact your broker sold fund has to outperform the market on a pre-tax basis by 25-50% each year just to match the market after expenses, not likely to happen. Over the past 15 years the S & P 500 has beat over 90% of all active managers. Can you trust a broker/advisor who lets you assume all the risk, while they and their large firm reaps all the rewards. You need a trusted advisor who discloses his fees upfront and has your best interest in mind. Broker sold mutual funds have more hands in your pockets than you can count.

Do you know how much your broker is charging you on your mutual funds? We can run a free analysis to let you know.

3. Conflicts of Interest Abound – We Have More Strings Attached Than A Marionette Puppet.

Conflicts of interest exist in almost any business, the mere presence of a conflict does not automatically lead to a persons interests being wrongfully represented. However, all conflicts that are known should be disclosed in writing to the potential client before a relationship starts.

When dealing with brokerage firm conflicts of interest abound and for the most part are not disclosed. The following is a few conflicts that you should watch out for.

First, please understand to whom a public company owes their loyalty; it is to their public shareholders. The people who own stock in a company must have, their interests protected. A public brokerage firm’s loyalty cannot be 100% to you.

Let’s take a further look at where other strings are attached. A broker gets paid a percentage of the revenues that he/she brings to the firm, typically 25-40%. It is not, however, that simple. Brokerage firms determine the payout percentage for each individual “product.” They control product flow by paying higher amounts for product it wants to move (sell). Each firm works differently but depending on the product a firm wants to emphasize, they will pay a broker a higher percentage of the revenue to induce him to sell what the company wants him to sell. For example, if the company wants a broker to sell a “wrap account” [1], they may tell the broker that they will receive a higher percentage of the fees they generate from that particular wrap account. Obviously, the broker wants the higher revenue so he/she will migrate toward selling you that product. This is done behind the scenes; you will never know what products pay more. Do you know if what your broker is recommending is in your best interest or his? You just don’t know without asking how he/she gets compensated on different “products.”

A more blatant conflict is a practice that people thought was eliminated a long time ago. Some brokerage firms pay their brokers more for selling proprietary (company managed) mutual funds. To be fair, most firms have eliminated this practice, to which I applaud them, however there is still at least one major brokerage firm that sill pays brokers up to 25% more commissions to sell their company managed mutual funds over other competing funds. In addition, the more company managed funds a broker sells, the more perks they receive. Whether it is a trip, an expense account, or personal gifts, they do not receive these perks if they sell other companies funds. How can you be sure that your brokers’ recommendation fits your best interest when he/she recommends their company’s managed products? The answer is you can’t be sure.

In addition to higher revenue on proprietary products, the broker many times is under tremendous pressure from management to sell you the latest mutual fund offering from that brokerage. Branch manager compensation is determined in part by the amount of proprietary products his branch sells. His interest is in getting the highest bonus possible, so he in turn puts the pressure on the brokers to “pound the phones,” and sell their “latest offering.” Have you ever been called by one of these annoying people during your spaghetti dinner? The brokers are enticed by management with trips, dinners, and a host of other items. It goes unspoken that if a broker does not participate in selling the new offering then things will not be easy for him/her. I know of one broker who was told, “I don’t think this firm is the right place for you,” after the broker refused to sell the new fund offering. It turned out that he was the only one to not succumb to the pressure, he eventually left that firm. I can’t begin to tell you how many voice mails & e-mails I received from management to ‘sell’ the “new” offerings, I never succumbed because it was not in my client’s best interest. Be aware that the pressure is on your broker to sell certain products or else he/she risks losing their job.

I also have a suspicion that there are some brokerage firms that churn their own proprietary mutual funds in an effort to squeeze out more profit. Proprietary mutual funds trade through their parent company, the more the fund trades, the more the parent company makes. From my research I do not believe this happens at all firms, in fact only a select few, one of which is very prominent. If you were to take a look at the turnover ratio at several of this firms largest funds you will find them outrageously high. Studies have shown that it costs a mutual fund shareholder about 1.00% for every 100% in turnover. Some of these funds have turnover of 2, 3, 4 & even 500% annually. All of this data is available from morningstar.com if you want to research your individual funds, or call me and I will be happy to send you a report.

The conflicts don’t stop there, they go on, but I think you get the picture. Be a wise consumer and ask your advisor about conflicts of interest’s and how they can be resolved.

Guess how many entities get paid on your mutual fund purchase? You’d be astonished.

O.K., we’ve established that you pay higher cost to work with an advisor at a major brokerage firm. But who actually receives the fees that your mutual funds, and managed accounts generate? You wouldn’t believe all the entities that must be paid from your simple purchase. Most investors believe 100% of the expenses or fees go directly to the broker. Actually a very small percentage actually ends up in your broker’s pocket. In most cases the portion of the fee that the broker receives is 25-40% of a smaller portion of the total fees. If this sounds confusing, it is, most brokers don’t even understand their own pay structures (exactly what the firm wants).

To help you understand, let’s take a look at a mutual fund. A typical broker sold mutual fund will have total expenses of about 3-5% (assuming turnover of 100-300%). The commission portion is usually about 1%; of this 1% the broker gets paid 25-40%, or .25- .40%. In other words, if you made a $100,000 investment you would pay $3-5,000 annually; of that amount the broker would receive $250-400 before taxes. So where does the rest go? It goes to pay for the fancy office, the mutual fund manager, branch manager, profits, internal departments, performance reporting, analysts, wholesalers, and a myriad of other things. I am not saying profit is a dirty word, however there is a difference between profit and price gouging. Your costs are high because there are so many people and departments and corporations that must receive a portion of your costs.

Let me break down the food chain for you. A person referred to as a wholesaler supports your broker, the wholesaler is the person who sells products to your broker from his/her company. The wholesaler works for the mutual fund or brokerage company that managers your funds. The fund that employs the wholesaler also employs your fund manager and analysts to support him/her. The fund must also pay to transact business (although this cost is passed onto you, though not disclosed). The fund company must then pass along profits to it shareholders by either a higher stock price or dividends. As you can see, there are more entities getting paid on your mutual fund than you can count on one hand. I call this the Broker Food Chain.

Are you tired of being at the bottom of the food chain? Are you tired of supporting the brokerage industry? There is a better way to manage your wealth.

5. Insurance costs! What your broker doesn’t disclose about their commissions.

Did you know that your stockbroker or advisor at your major brokerage firm now sells insurance? That’s right, everything from Term life to Long Term Care. Most brokers got their insurance license so they could sell you annuities (we will get to that next), they discovered however that commissions are much more lucrative in insurance than anything else. So are you to believe that your broker is now an expert in matters of insurance? Don’t believe it. Unless he/she has been through special programs like the CFP, CLU, or CHFC, they may not be qualified to offer you advice; of course that does not stop them. Of the three the CLU is the by far the strongest mark for insurance. Insurance is a complex world and if purchased incorrectly it can do a lot of harm to you and your estate.

Commissions can run anywhere from 50-120% of your policies first year premium. Surprised, don’t be, they’ve always been that high. Actually, it’s not the commission that really upsets me. If a professional does his/her job correctly and has the knowledge, training, & expertise and makes an unbiased recommendation than the commission can be justified. The problem I have is with disclosure, or rather the lack there of. Very rarely will your broker disclose what he/she is being compensated or about the potential surrender charges. The other problem I have is that many times the broker will see commissions and the appropriateness of the product as separate decisions, giving more weight to the commission than the appropriateness product. Many times this is done in haste because the broker simply doesn’t understand what is or isn’t appropriate. Most brokers receive sales & product training, not financial & wealth management training. In most cases your broker is a marketing representative for a large publicly traded company, not a trusted advisor like they claim.

I once received a quote from an insurance company website, the quote was for an individual wanting to buy a term life policy directly from that company. I then went to that same company as a broker and asked for a quote on the same policy, the quote I received was two times higher than what the client would be paying by going directly to the insurance company and bypassing me. He would have saved over $10,000 over the life of his policy. I decided it was in his best interest to purchase direct, yes, I lost a commission, but it was the right thing to do. Would your broker do the same, would he/she even look for a direct quote? You need to have your wealth managed by an experienced credentialed professional; anything else could be hazardous to your wealth.

Annuities are an interesting product. They come in all sizes, shapes, and forms. You have probably heard of both fixed & variable annuities. Fixed annuities pay a fixed interest rate as stated in the contract for a specific time period (similar to a CD). Variable annuities performance is based on an underlying “sub-account,” basically a mutual fund. The major benefit to an annuity is the ability to defer taxes until the money is withdrawn. Another highly touted benefit is that an annuity can pay an income stream for life. Let me lay out a case for why variable annuities may be hazardous to your wealth.

It has always been said that annuities are “sold,” not bought by investors. Over 90% of all annuity sales are through brokers or life agents, a viable no-load Variable annuity industry has not emerged. Why are so many people sold annuities? The answer is simple…. high commissions. There are some annuities that brokers sell that pay the broker in excess of 10% commission. This leaves you with an expensive policy and surrender charges that may last more than a decade. The expenses inside an annuity are one of the main problems. There are several expenses involved. Today most annuities do not charge you an upfront commission, the fee is charged as an annual fee (which you don’t see). This fee is deducted daily from your balance, there are five possible costs. The costs are: The policy charge, Mortality & Expense, Rider charges, underlying sub-account expenses, & transaction costs associated with those sub-accounts. Below is a range of what these cost can add up to:

Turnover costs - .10 – 2.00%

The average cost runs about 2.5 – 4% a year. These expenses take a toll on the ability of the portfolio to match, or even beat the market. The annuity has to earn 2.5-5% before it breaks even for the year. Add the fact that gains in an annuity are taxed as ordinary income when withdrawn and the chances of your annuity beating your taxable account come close to zero. In addition, if you die with an annuity you do not receive any favorable tax consequences. You lose what the tax code refers to as the “step-up” in basis, meaning that if you die with a taxable account the entire account gets passed on to your heirs with no income or capital gains tax, not so with an annuity. Studies have shown that even low cost annuities do not produce tax benefits big enough to beat an index fund in a taxable account. In a taxable account you receive a tax break if you hold your fund or stock for one year or more, not so with an annuity. Lastly, you have very limited choice of investments in the annuities and if you want to take your money out before age 59 ½ you are out of luck, you would owe a 10% tax penalty.

You may ask “what about the guaranteed death benefit?” It is basically worthless in most circumstance. Annuities are long-term investments, they are not meant for periods of less than 10 years. If you end up being one of those poor unfortunate souls that bought at the top and still have less money than you started with 10 years ago (extremely unlikely) then your loss exposure will probably be less 10%, if that (unless of course you had a horrible investment advisor that didn't understand diversification). An amount that will be less than what you probably paid for the insurance over that period. In any event, the death benefit is not a logical reason to purchase an annuity.

Let’s recap the problems with Variable Annuities. High expense, high marketing costs, tax penalties if under 59 ½, loss of capital gains status, loss of step-up, limited choice of investment vehicles, & worthless death benefits. So why do people continue to be sold these products? High commissions, and high profitability to the companies involved. Profit is the bottom line, not your interests. Variable annuities have become such a problem that the SEC (regulator) has issued a booklet available online through its website www.sec.gov. that lists the pros and cons of annuities. In addition they are in the process of taking legal action against several major companies and brokers over selling tax-deferred annuities to people whom already have tax deferred accounts. Having an annuity inside of an IRA is in most cases worthless, the main advantage of an annuity is its tax deferral. Putting an annuity in an IRA, another tax-deferred vehicle negates its number one benefit. There are certain cases where it is appropriate. Some 401(k)’s may be Variable Annuities; depending on the options available and the cost structure this may be O.k., but it needs to be considered very carefully. Remember, Buyer Beware.

If you are an annuity holder, chances are you have been approached by an insurance agent trying to sell you an annuity that pays you an ‘upfront’ bonus. Whatever you do, do not succumb to the sales pitch for the new “bonus” annuities. This is a new and highly aggressive tactic of the industry, to keep investors “imprisoned” in a high cost product, and generate new and even larger commissions for the sales force. Annuity holders with a few years left in their surrender charge period are approached with the following “typical” story:

“I understand that you are unhappy with your current variable annuity because of poor performance, lack of investment choices & a fading death benefit. I also understand that you have a surrender charge left. We are going to “help” by giving you an up-front “bonus” of 3-6% to cover the surrender charge. It will not cost you anything to switch.”

Unfortunately, the only “bonus” is to the salesperson. The new sale starts the surrender period all over again. The salesperson gets an upfront bonus and an increase of revenue on an annual basis that is sometimes 200% higher than what they are currently receiving. It is a great deal for the agents, they get two commissions from you.

To pay for the bonus and the commission and any extras, the insurance company raises the expenses on your investments. Since these expenses are buried in the prospectus and hidden from you on your statements, you never know that you are being taken advantage of. When all is said and done, everybody is making money except you! I have actually been in meeting and heard brokers laugh at how they duped another person into a “bonus” annuity. They refer to the extra commission internally as the “Yield to Broker.” It appears that the SEC is coming down hard on this practice. On June 5^th, 2000, they issued an “investor alert” and placed a brochure on its website to help investors understand the benefits, costs, and risks of variable annuities, which combine features of mutual funds and insurance.

Insurance companies have been hit with rounds of lawsuits stemming from churning and suitability. It seems that the real “bonus” will be new business for trial lawyers!!!

[1] A “wrap account” is an agreement where a broker manages a client’s asset in one account for an annual fee.