Understanding Conflicts & Incentives in Financial Services

As we’re going through the process of hiring another wealth planning analyst, I recently took the opportunity to read a book on the process of recruiting. Not because I had any concerns with our process, but because I’m a lifelong student of the craft of financial planning and the business thereof, and I spotted a book on the subject for sale on Amazon; after all, you can always learn something new! Unfortunately, the book didn’t teach me anything about recruiting, but it did provide a salient reminder of just how bad recruiting in the financial services industry is.

Perhaps more importantly, it prompted me to think about the value proposition we offer our wealth planners, and to compare and contrast how it differs from the norms of the financial services industry. So this week, we’re talking about what recruitment looks like in the financial services industry, the rampant problems that it causes, and why we’ve chosen to differ from the norm. For those interested in a financial planning career, I’ll imagine it will be illuminating, but even for those clients and consumers of financial planning services, it will likely be educational in just how much the problems can affect you and your community.

The Traditional Recruiting Model in Financial Services

The traditional recruiting model for financial services looks something like this:

1. Meet with as many potential candidates as possible.
2. Present a glowing picture of the potential career of being a financial advisor.
3. Ask the candidate to provide a large contact list of anywhere from 100 to 300 friends, family members, ex-coworkers, etc. This will ostensibly be used as “a list of people to talk to about your new career,” but it is really just a lead generation list.
4. In varying degrees, have candidates complete one or several insurance and/or investment license exams; sometimes at their own expense.
5. Onboard the newly licensed financial advisor and hold meetings with the people on their list from step 3 to sell them the company’s proprietary investment and/or insurance products, or otherwise try to engage them in a discovery process to ascertain what other products can be sold to them.

I am familiar with this model not only because the business of financial planning is a core area of my academic research, but also because I personally experienced this process when I first entered the industry. Interviewing with several dozen firms, all of which you’d recognize the names of, this was the universal structure. Sometimes the order would vary, e.g., swapping step 4 and step 3, or even moving step 5 up above step 4 and having someone already licensed at the firm do sales conversations with the leads list (gotta strike while it’s hot!)

But ultimately, the recruiting process serves largely as a business development activity for the parent firm, not as a process of vetting the best candidates and offering them high quality opportunities, but instead of validating whether the candidate has enough of a “natural market” to sell to on day one, and then trying to rush them through the onboarding and licensing process so that they can start selling ASAP.

The Typical Compensation Structure in Financial Services

Once someone is licensed to sell insurance or investment products, the majority of the industry then places them on a 100% commission compensation plan; and in saying 100% commission, we don’t mean that they’ll receive 100% of the revenue from their sales, but that their compensation will be entirely based upon their revenue generation. Some firms will offer a temporary salary to ease the transition into the role, but often these salaries evaporate rapidly if sales goals aren’t met, or otherwise are treated as “draws on future commissions,” where the new advisor does not earn additional income until their commissions recoup the earlier draw and then exceed their ongoing stipend.

Within this structure, it’s then important to also understand the concept of “the grid.” The grid is typically a chart that explains what percentage of revenue an advisor will be paid from their sales of investments or insurance products, which will typically reflect the company’s own revenue goals and incentives. An example is shown below, using the hypothetical example of a mutual life insurance company:

When reviewing this structure, what stands out to you? Let me highlight some of the obvious incentives:

• Because the company pays substantially higher commission rates on proprietary life insurance products, advisors will be incentivized to recommend the company’s policies over the policies of other companies, even if they are equal or otherwise superior in cost or quality.
• Transactional investment business pays better than fees, not only because up-front commissions are higher (e.g., 5%+ on the first dollar of an investment in many cases) but also because the payout rate is higher.
• Note that ongoing investment fees only begin to pay out better when the advisor’s ongoing revenue exceeds half a million. This incentivizes “reverse churning,” a practice in which the advisor recommends and sells transactional investment products on commission early on in their business for the higher income it produces, and then later “re-sells” the same investment dollars away from a commission-based account into a fee-based account in order to generate higher ongoing revenue than the transactional revenue produced earlier.
• Financial planning is paid for, but notice that it does not escalate or reach the same level of payout as noted for proprietary life sales or ongoing fee revenue. Why? Because it’s a time-intensive process that does not lend itself to other sources of revenue to the firm itself, such as recurring 12b1 commissions, insurance trails, revenue sharing from investment product companies, or recurring fees from investments under management.

While every product-based, commission-only, or fee-based financial services company will immediately tell you that, despite not being regulated as fiduciaries at all times, they will always put their clients’ best interest first, let’s look at the human incentives at work here, particularly for a new financial advisor.

You’re starting a new job in a new career field. You have no base salary. Your company is telling you to do what’s best for your clients every time, but some options will result in you being paid more, and other options will result in you being paid less. For example, your first client might need life insurance and to invest some money. In the case of life insurance, selling them a permanent life policy instead of a term policy is going to generate 5x-10x the up-front commission, but further, your company will let you keep 30% more of the commission if you sell their life insurance rather than another company’s. This could be the difference between getting $375 instead of $225 on your first term policy, or $3,750 instead of $2,250 on your first whole life policy. If the client needs to invest $25,000, you could put them into a Class A mutual fund and generate a 5.75% up front commission on that, which will get you paid $862.50, or you could recommend they invest in a fee-based account at 1% a year and get paid $125… over the next four quarters, or $31.25 sometime in the next 3 months. So what are you going to do, and how is that going to affect your recommendations? How important is it that you generate income to live on now instead of doing what’s best for your client, particularly when you have no salary or savings to live on as a new college grad, a single parent or spouse getting back into the work force, or a career changer?

Quantity Has a Quality of Its Own

Credit to Stalin for that particular insight. But let’s combine the recruitment and compensation structures we’ve discussed: The typical financial services firm is heavily incentivized to hire as many people as possible because it costs them little to nothing in a relative sense. Some defenders of the typical model will exclaim that it costs them the wages of dedicated recruiters, dedicated internal business coaches, real estate, and so on. Fair enough, but a firm at a large enough scale would likely have all of those costs anyway, but would focus on the quality of their candidates and their productivity rather than the volume of candidates were it in the interest of their business model to do so; and when we then say that the hire-everyone model costs them little-to-nothing, we do so in the context that most of these firms do not pay any sort of wages, payroll taxes, or for any sort of benefits for their statutory employees (who are typically 1099 contractors and seldom W2s), and only pay them if they generate revenue that then funds their pay.

Through that framework of incentives, their new recruits are then heavily incentivized not only for their personal take home pay but also their financial survival to favor the products and services that are both stickiest to the company (proprietary insurance and investment products that cannot leave the company or otherwise move easily) and also that generate the most revenue immediately, thus helping offset the company’s up-front recruiting costs. Then, if the candidates fail, their sold policies and investment accounts still stay with the company, generating ongoing revenue; and if the candidates succeed, then they’ve demonstrated strong sales skills, and they’ll continue to generate more and more revenue for the company. It’s a classic “you win, we win, you lose, we win” business model. Very profitable, but not so great for new advisors and their clients.

So if the choice for many of these financial services firms boils down to hiring as many people as they can, spending little on them, and making money whether they succeed or fail, or whether they should instead invest money into new employees and not use them as a source of business development, what is the logical answer?

How We Choose to Differ

If you came to the conclusion that the companies we’ve been discussing should do exactly what they already do, I can’t blame you. It’s the natural and logical conclusion of the incentives at work. You might then naturally wonder if MY Wealth Planners differs, and if so, why?

One of the first factors is that MY Wealth Planners has no direct financial incentives to recommend any particular suite of investments, insurance, or other financial products over any other. As a fee-only firm, we don’t have any proprietary investment or insurance products or otherwise receive any sort of commissions, trails, or revenue sharing from the companies we place clients’ money with or otherwise advise them to purchase products from. This is beneficial in reducing our conflicts of interest with respect to the options we recommend to clients, but also means we do not have any services or products that generate immediate revenue to the firm in the way that bringing in insurance premiums or investment dollars into structured commissionable financial products can. This means that it’s both not in the firm’s interest to recommend such expensive or proprietary products, but also that the absence of such revenue-generating products makes the survival probability of a new hire on 100% commission-based compensation all but certain to fall to zero, in light that they’ll likely not be able to break-even on their cost of living for months or even years.

Consequently, we pay not just market rate, but above market rate for wages and benefits for new hires. Not solely because we’re generous, but because we want to be both a premium quality employer for new entrants into the financial planning field, and also to do so in a manner that makes it a very safe place to start a career. When the industry-wide survival rate is only 30% over 5 years, and the 100% commission starting jobs’ survival rate hovers around 12%, this presents a remarkably beneficial difference from the industry norm, but one that does come at a cost.

In fact, based on our current business model, it’s anticipated that any new hire will likely take between 24-30 months to be responsible for enough revenue that they actually offset their cost in wages, benefits, taxes, and technology, and up to 75 months to then generate enough excess revenue to actually replace what they cost in the first 74 months. None of that is to say that their work and value aren’t evident in the time that they spend with the firm prior to these key dates, but that the burden of wages, benefits, taxes, and technology tilt heavily against the firm’s favor for the first several years of their time in the practice. Effectively, the firm is making an enormous investment in its staff and at its expense and risk, rather than using new advisors as a source of sales leads.

Why We Choose to Differ

You might be a bit gobsmacked by all of that. After all, if you read through the first half of this blog, it seems to make all the sense in the world to simply hire at volume and to try to make a profit on every new staff member who walks through the door. It would make sense to offer proprietary and more profitable products and services for our team members to recommend to their clients. It would make sense to financially incentivize them to sell those products above other available options. So why not?

Because there is an immutable conflict of interest between a client’s best interest and a firm’s financial interest. This is not eliminated by being a fee-only financial planning firm or being a fiduciary to our clients; even fiduciaries have conflicts of interest. Rather, our obligation is to do everything within our ability to ethically and carefully mitigate as many conflicts as we can, moderate those conflicts we can’t, and to disclose those conflicts to clients so they can make well-informed decisions about whether they believe we can serve their unique and individualized best interests.

Doing so comes at a cost. Today, 42.6% of the firm’s revenue goes to paying staff wages, benefits, and taxes, which could be reduced or otherwise entirely self-funded by simply running the business on a 100% commission compensation model. 23.42% of revenue goes to paying for our newly expanded office space and preparing for future expansion, which we could more rapidly fill by simply offering people “eat what you kill” roles like a typical financial services firm. It would certainly be a fast way to grow revenue to offer financial products on a commission basis and forego our fiduciary obligations in favor of doing things the way a typical firm does.

But what can we say? We have a conscience and an ethical code.

Being an Atypical Financial Services Firm

When we launched MY Wealth Planners in 2019, we did so with a vision: We were going to be the first CFP® Professional financial planning firm in Longmont, the first planning-first firm in Longmont, and the first fee-only firm in Longmont. We accomplished that, along with other plaudits such as being the first Certified B Corp in Longmont. Today, we still occupy a key, differentiated role within the community of financial services firms in Longmont by offering fiduciary-always, fee-only financial planning services.

There are 130+ offices and firms in Longmont you can go to for help with your finances. 99% of them make their money by selling financial products. 99% of them are required to be fiduciaries only some of the time, or even none of the time. 99% of them are affiliated with large national firms that make hundreds of millions of dollars annually in incentive and revenue-sharing payments, and billions in commissions for the sale of their financial products; and those incentives clearly flow down to the incentives of their representatives, agents, brokers, and advisors. That makes it easy for 99% of them to bring on anyone able to fog a mirror to sell products to their family members, because it’s a business development strategy that pays for itself in both the short and long term

We choose the harder path. We choose not to engage in such conflicts of interest or hire new staff members as purely salespeople. Not because it does us any favors, makes us more money, or is going to pay off in the long run; unfortunately, it will probably do none of those things! But because it’s the right thing to do. Not only for the people who join our team, but more importantly, for our clients and community.

Fortunately, we’re not alone. The fee-only financial planning movement has been growing for decades. The proportion of new financial planners who are seeking fee-only financial planning firms is growing. And the appetite to survive on “eating what you kill” in a sales job seems to be declining year over year. It will still likely take decades for the industry to finally turn the page on the practice of using new recruits as a sales funnel, but in the meantime, we’ll sleep well at night knowing we’re choosing to be the change we want to see in the world. We appreciate your support in doing so.