The Art of Extracting Large Commissions From Investors by David Merkel, CFA of AlephBlog
The dirty truth is that some investments in this life are sold, and not bought. The prime reason for this is that many people are not willing to learn enough to save and invest on their own. Instead, they rely on others to corral them and say, “You ought to be saving and investing. Hey, I’ve got just the thing for you!”
That thing could be:
- Life Insurance
- Front-end loaded mutual funds
- Illiquid securities like Private REITs, LPs, some Structured Notes
Perhaps the minimal effort necessary to avoid this is to seek out a fee-only financial planner, and ask him to set up a plan for you. Problem solved, unless…
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Unless the amount you have is so small that when look at the size of the financial planner’s fee, you say, “That doesn’t work for me.”
But if you won’t do it yourself, and you can’t find something affordable, then the only one that will help you (in his own way) is a commissioned salesman.
Now, to generate any significant commission off of a financial product, there have to be two factors in place: 1) the product must be long duration, and 2) it must be illiquid. By illiquid, I mean that either you can’t easily trade it, or there is some surrender charge that gets taken out if the contract is cashed out early.
The long duration of the contract allows the issuer of the contract the ability to take a portion of its gross margins over life of the contract, and pay a large one-time commission to the salesman. The issuer takes no loss as it pays the commission, because they spread the acquisition cost over the life of the contract. The issuer can do it because it has set up ways of recovering the acquisition cost in almost all circumstances.
Now in some cases, the statements that the investor will get will explicitly reveal the commission, but that is rare. Nonetheless, to the extent that it is required, the first statement will reveal how much the contractholder would lose if he tries to cash out early. (I think this happens most of the time now, but it would not surprise me to find some contract where that does not apply.)
Now the product may or may not be what the person buying it needed, but that’s what he gets for not taking control of his own finances. I don’t begrudge the salesman his commission, but I do want to encourage readers to put their own best interests first and either:
- Learn enough so that you can take care of your own finances, or
- Hire a fee-only planner to build a financial plan for you.
That will immunize you from financial salesmen, unless you eventually become rich enough to use life insurance, trusts, and other instruments to limit your taxation in life and death.
Now, I left out one thing — there are still brokers out there that make their money through lots of smallish commissions by trading a brokerage account of yours aggressively, or try to sell you some of the above products. Avoid them, and let your fee-only planner set up a portfolio of low cost ETFs for you. It’s not sexy, but it will do better than aggressive trading. After all, you don’t make money while you trade; you make it while you wait.
If you don’t have a fee only planner and still want to index — use half SPY and half AGG, and add funds periodically to keep the positions equal sized. It will never be the best portfolio, but over time it will do better than the average account.
One final note before I go: with insurance, if you want to keep your costs down, keep your products simple — use term insurance for protection, and simple deferred annuities for saving (though I would buy a bond ETF rather than insurance in most cases). Commissions go up with product complexity, and so do expenses. Simple products are easy to compare, so that you know that you are getting the best deal. Unless you are wealthy, and are trying to achieve tax savings via the complexity, opt for simple insurance products that will cover basic needs. (Also avoid product riders — they are really expensive, even though the additional premiums are low, the likely benefits paid are lower still.)