All Financial Advice Is Conflicted

Annuities: Friend or Foe? That headline is not strictly correct. It should read, “Why Most Financial Advice, in Most Cases, Has Conflicts That You May Not Recognize.” But on this day, permit me a bit of exaggeration. Compared with the tale of Santa Claus, my title is a model of truthfulness.

The thought was prompted by Retirement Income Journal's profile of a Canadian financial advisor named Jim Otar, who often recommends fixed annuities to his retired clients. A former engineer turned Certified Financial Planner, Otar has become a fixture on the advisor speaking circuit, outlining the results of his "aftcasting" technique: He says it builds portfolios that, like bridges, can withstand moments of peak stress. He claims that his method avoids the flaws that arise from standard Monte Carlo analyses.

Per Otar's research, those who retire with more money than they require are in the Green Zone and may wish to buy some fixed annuities so that they can take more risk with their other assets (which effectively become house money). Those on the other end of the spectrum are in the Red Zone: They should purchase annuities for protection against longevity risk. Finally, retirees in the middle, the appropriately named Yellow Zone (Goldilocks!), have less need for fixed annuities.

You probably read something different about annuities elsewhere. They don't exactly receive good press. In one of many examples, David John Marotta writes in Forbes that "ever-popular annuities sound too good to be true, which is why you probably should avoid them." (Don't take that literally; you probably should not rule out an investment solely because it looks to be very attractive.) He continues, "Commission-based advisors with insurance licenses sell you whatever form of annuity would have performed well over the past decade … we don't recommend an allocation to annuities to any portion of your portfolio."

Ah. The picture clears. Commission-based advisors recommend fixed annuities because they receive a large, immediate payout on the sale, while fee-based advisors, who are immune from that temptation, can do the right thing for their clients.

Except that process also works in reverse. In thinking through the implications of Otar's counsel, author Kerry Pechter writes, "If you're an advisor, you may find yourself agreeing with Otar's approach but unable to implement it. Your business model may not allow it. Advisors in fee-only practices, for instance, may never be able to recommend an income [that is, fixed] annuity, because it would reduce their assets under management."

I don't see how that can be disputed. Those who are paid by assets are unlikely to recommend actions that reduce the amount of those assets. Revenues motivate behaviors, for the new breed of fee-based advisors as well as the traditionalists who are paid on commissions. Indeed, the revenue motivation is stronger for the reverse case, as the cost of forgoing annual payments on monies that disappear forever into fixed annuities is larger than the gain made from placing a client into a higher-commission rather than lower-commission investment.

By now, you've guessed it: Marotta is paid on assets under management, not on commissions. It could be no other way.

Different Paths Across the financial-services industry, the company's business model affects its investment decisions. The temptations that face commission-based advisors are well-documented: Seek investments that pay higher sales commissions, and trade the portfolio to generate additional revenues. For their part, in addition to the desire to retain the client's monies, advisors who are paid on AUM feel pressure to take action, to justify the ongoing nature of their fees. Thus, the turnover rates on their portfolios tend to be even higher than those of traditional, commission-based advisors. (In that sense, the cure was worse than the disease.)

And then there is the use of in-house funds. Once practiced mostly by the full-service Wall Street brokers, such as Prudential-Bache, Merrill Lynch, or E.F. Hutton (dating myself there), the in-house approach has spread to discount brokers through their telephone and "robo-advisor" platforms. Among 401(k) plans, in-house funds from the recordkeeper are dominant, particularly with target-date funds.

I don't mean to be alarmist. (It is Christmas, after all.) Otar and Marotta might each do splendid jobs for their clients, in their different ways. And there's nothing intrinsically wrong with in-house funds. Go to Vanguard, you get Vanguard. Meet with an advisor who uses DFA funds, you will mostly get DFA. (States one advisor who went through DFA's educational process, "They poured us big glasses of Kool-Aid, we drank it, and we haven't looked back.") Those are good things; Vanguard and DFA do fine jobs.

But … be aware. Those who give financial advice and profess to be conflict-free are probably mistaken. They may give excellent advice, but the informed client will understand why those recommendations were made--and what types of investments will likely be off the table.

By the Way … In a grimly amusing article, Bloomberg's Matt Levine cites the following disclosure language from J.P. Morgan, about its advisors' preference for the company's own mutual funds:

We prefer internally managed strategies because they generally align well with our forward-looking views and our familiarity with the investment processes, as well as the risk and compliance philosophy that comes from being part of the same firm. It is important to note that J.P. Morgan receives more overall fees when internally managed strategies are included.

Levine's response: "The first sentence list the reasons; you can tell because there's a 'because.' The second is just 'important to note." J.P. Morgan gets 'more overall fees' for recommending its own funds, but that's not the reason that it does it. That's just something to note, like an unusual bird or a pretty cloud. It exists absolutely, with no causal connection to anything else."

I wish I had written that. At any rate, the SEC ended up extracting a $307 million settlement from J.P. Morgan for insufficient disclosure. In this case, the sword of the regulator was mightier than the pen.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.