09.21.07

Paying on Commission

Posted in Finance at 11:14 am by Valentine

Question: What do insurance representatives, financial advisers, mortgage brokers, and car salespeople all have in common?

Answer: They all directly profit if they can talk you into a bad deal.

Congress is in a tizzy over “deceptive practices” by mortgage brokers, but as usual they are missing the larger picture. The mortgage industry is only one of many dominated by commissions based directly on the profit generated from a deal. It is not unreasonable to reward a salesperson for drumming up business; those who are most successful at closing deals ought to benefit from their greater talent and efforts. Would you want to hire a real estate agent on salary, regardless of results? Yet there is a fine distinction between paying a commission based on the value of the deal and paying based on the profit of the deal. The latter encourages the representative to push customers into higher-margin products regardless of what best suits their needs.

Such a commission structure is particularly common (and especially unethical) when dealing with customers who are at a competitive disadvantage in negotiations. A borrower looking to purchase a first home might qualify for an FHA loan, but a “teaser rate” subprime product could generate greater profit for the lending company. Which will the broker offer first? A recent college graduate looking to begin saving for retirement might be best served by a low-cost index fund (or basket of index funds), but the financial adviser has every incentive to push them into a variable annuity product with a total expense ratio that is 20 times higher. These are not “fair” negotiations, since the one party is a professional in the business with privileged knowledge of the profit structure while the other is often inexperienced and naively trusting.

[Update: The Massachusetts Attorney General’s office appears to agree with this assessment. Read more here.]

Unfortunately, I don’t see governmental regulation as an adequate answer to this problem. While revamping the disclosure pages won’t hurt, they are often passed to consumers at the bottom of an inch-thick stack of pamphlets, prospectuses, and application forms. Rather than offering consumers incomplete reassurances, the government should loudly affirm the principle of caveat emptor. Perhaps the disclosure sheets should read:

1. You’re an adult now. If you don’t do your homework, nobody else will do it for you.
2. There ain’t no such thing as a free lunch. If it sounds too good to be true, you’re not reading the fine print.
3. The person in front of you is hoping to pick your pocket. Don’t trust your fortune to their charity.
4. If you want advice that serves your interests, pay for it yourself.

There are usually alternatives to dealing with these sharks. Many mutual fund companies (e.g. Fidelity and Vanguard) sell directly to consumers rather than working through brokers. Have a question? Call their service desk and you’ll get a straight answer. You can buy insurance directly from Amica or SBLI without going through a broker. Research mortgage rates and terms on Bankrate.com (though I would be cautious when dealing with many of the companies listed there).

Doesn’t this make more sense than trusting Uncle Sam to watch out for your interests?

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