One of the trickiest issues in wealth management today is in the area of product education. In most wealth management firms, there are two very distinct but interdependent divisions that are responsible for this education. The capital markets area that invents and manufactures new financial products, and the sales force of financial advisers that are responsible for distribution.
Though linked, these two divisions are very different when examined through a prism of education, incentives, and workplace culture. These differences often lead to the sale of unsuitable investments to investors in the worst case. Or a misunderstanding of what an investment does in milder cases. Either way, the result is often complaints, arbitration, or litigation.
While the average broker/advisor has a bachelor’s degree and is 51 years old, today’s average capital markets associate is in his or her 30s and has an MBA.
The financial incentives for the capital markets associates that create and manufacture the financial products are driven by dollar volume. In a world where innovation is constant and differentiation is critical, the complexity of financial products created by these associates keeps growing. With tens of thousands of investment vehicle alternatives, capturing the attention of the brokers is a necessity that demands increasingly complicated investment products aimed at solving more nuanced investment objectives.
The sales force’s financial incentives are a function of two numbers – the dollar amount invested multiplied by the commission percentage. The commission percentage is normally higher for more complex products and smaller for less complex products. For example, the commission for a common stock, preferred stock, or individual bond is usually no higher than 2.5% and is commonly under 1%. By contrast, variable annuities, structured products, mutual funds, or hedge funds often pay the broker as much as 4% or even higher. Additionally, these products often have additional revenue enhancements for the offering broker’s firm over and above the commission cost. Which leads to a greater level of internal marketing of the product.
These incentive structures can function to achieve very specific and nuanced financial objectives. Thus increasing investor satisfaction. Or they can create a perverse incentive for poorly educated advisors to sell the most complex products to uninformed investors. The actions taken by investment firms, advisers, and investors will determine which of these two the outcome is.
Some examples of the disconnect between complexity, incentives, and education commonly occur and are the subject of complaints and litigation are:
- Complex option strategies such as writing uncovered puts where the downside risk can be many times the amount of money or assets held as collateral or writing covered calls where investors are sometimes shocked to find that long term stock holdings are called away – creating an unexpected capital gain.
- Variable annuities are a particular area of contention as investors are often unaware of the high cost of ownership and its impact on returns. They can be confused about the annuitization features including forced annuitization, restrictions on withdrawal and general lack of liquidity, and confusion about living and death benefits.
- Structured products including accelerated return notes (ARNs) where the upside is often capped, principle protected vehicles such as MITTS where time premium can often lead to loss of principal if sold before maturity or where the entire principal is placed at risk if backed by a private entity with a weak balance sheet.
- Variations on traditional investments like preferred stocks, for instance certain Trust Preferred Securities (TOPrS) where they appear to behave like traditional preferreds but they don’t always have the tax advantages that the dividends on traditional preferreds do.
- Many alternative investments including hedge funds are characterized by numerous complex features that deliver outcomes unexpected by investors including their tax treatment, profit sharing with the money manager, high management expenses, use of derivatives that fail to deliver expected results due to option premiums and/or the requirement to “roll” underlying investments because there is no perpetual proxy investment.
- The dependence on historical performance to determine and describe risk rather than an educated explanation of the real underlying risks of investments has led to billions of dollars in litigation. Including the liquidity of auction rate preferred securities and the price stability of AAA rated derivative securities.
- Fixed income investments, which are often sold to the elderly and investors with the greatest aversion to risk, are often sold with a misunderstanding. Or with a lack of full disclosure regarding the stability and risk of principal. Investments like UITs are often sold with the misunderstanding that they must be held to maturity to ensure the preservation of principal. Likewise, there is often no disclosure of the fluctuation in prices that can often occur with fixed income investments from the time of purchase until maturity. Also, many fixed income investments are sold as guaranteed and/or insured but the safety of the guarantor and/or insurer may reduce the security of said investments.
- Leverage in financial products has exaggerated losses and/or presented unrealistic and non-repeatable historical returns. This has led to litigation and complaints in the world of master limited partnerships (MLPs) and closed end funds.
As the sophistication and complexity of the financial products produced by the capital markets division of firms’ increases, there is not a commensurate elevation of the education of financial advisors. Efforts to enforce continuing education requirements are made at brokerage firms. However, the truth is that the FA sales force is aging with the majority having little interest in dramatically expanding their knowledge base. For those that do, the delivery of continuing education to thousands of advisors that covers the details of the rapidly expanding catalog of complex financial products is impractical. Therefore, the continuing education tends to be very general and requires very little study.
The bottom line is that there are many excellent advisors that are extremely diligent in applying the requisite intellectual rigor to appropriately sell complex financial products to clients that meet their very specific needs with comprehensive disclosure. In these cases, there are unlikely to be complaints, much less, litigation.
Neither financial advisors nor clients can depend solely on wealth management firms to insure that the advisors are fully educated on the products that are sold. Both advisors and clients have some responsibility in protecting themselves from the potential negative consequences of selling or buying complex financial products.
For advisors, there are a number of appropriate actions that will help them protect their practice and act in the best interest of their clients.
- Proactively research any complex financial product they are considering selling to their clients. This includes examination of the effects of interest rate moves, rapid market declines or increases, declines or freezes of liquidity (both for the product and for any underlying financial instruments), the financial strength of any guarantor, contractual or prospectus components that could adversely affect the owner, taxation status, fees and expenses, and the consequences of early liquidation, among others.
- Examine the appropriateness of the investment for the individual or entity to whom they are considering selling it. This includes the normal suitability issues of risk tolerance, tax status, age, income, net-worth, and time horizon, but should also take into account, in some cases, issues such as the consequences of the client’s death, the capacity for the client to fully grasp the way that the investment works and will behave in various market conditions, and issues relating to any emotional attachment on the part of the client to a particular investment that may be lost or sold based on the investment in the new financial product, among others.
- Document and take notes on important aspects of the investment, detailed reasons for selling the product to the individual or entity, and conversations that are had with the client discussing the investment.
- Regularly monitor the performance of the investment and update the client regularly on its performance and document these conversations.
- Most importantly, if an advisor cannot completely grasp the details of how a financial product or strategy works, how it will perform in adverse conditions or cannot explain the investment and these details in a way that a client cannot fully understand it, they should not attempt to sell it.
For clients, there are also important steps they can take to protect themselves.
- Ask a lot of questions and take notes. Specifically, ask about the impact of the investment from a tax perspective, how the investment will behave under adverse market conditions, how liquid will the investment be, what the consequences of early liquidation would be, what is the financial state of any guarantor, how will fees and expenses impact returns, and what would happen to the investment and to their estate if they were to die while owning the investment.
- Ask for available documentation. Whether it’s a prospectus, a hypothetical, a third party review, or sales literature, it can help the investor to have a clearer picture of how the investment works and may serve to prompt better questions.
- Never invest in a product or strategy that you don’t understand or that your advisor seems to not fully understand.
The bottom line is that, unfortunately, some advisors and clients do not do the due diligence that is required when investing in complex financial products and the firms’ agents. Both the manufacturers of new products and the sales force are often influenced by incentives that fail to incentivize protecting the clients in favor of maximizing profits.
This expert was a financial advisor for seven years and a supervisor of financial advisors for twelve years. As a supervisor he served as a sales manager, office manager, regional sales manager, and complex director. He managed over a thousand different advisors in different capacities over his time at Merrill Lynch. He held series 7, 9, 10, 63, 65 and insurance licenses in his capacity as supervisor.
During his career he has testified in courtroom, deposition, arbitration, and mediation situations. He has dealt with regulators, attorneys, clients, judges, mediators, and advisors in all of these situations.This expert has a BA in Political Science and an MBA with a marketing concentration, both from Vanderbilt University.