What Are Stock Brokers’ Responsibilities and How do They Get Paid?

The free market brings us so much. From financial mobility to industry innovation, it’s hard to overstate how much our market economy inspires entrepreneurship and provides innumerable forums for people to acquire and grow wealth.

And yet, because money makes some people do crazy things, there’s an area for argument about how free the markets should be. On the one hand, regulations stifle growth; on the other, one person’s freedom can encroach upon another person’s well-being when everyone is looking to get rich. In the world of financial advising, we see far too many examples of professionals abusing their freedom. If the motivation is there, they can indeed take advantage of people and their retirement accounts.

Financial Advisors: Costs and Accountability

In my professional life, I’m a fiduciary just like a lawyer or doctor – among the lesser-known stock broker qualifications, you will find a sense of ethics. I follow rules and standards that ensure I always put my clients’ financial interests above my own. I withhold no information and don’t make trades or work with specific broker-dealers just because I get a kickback. It makes a lot of sense for me to work in this capacity, but some commission-based advisors at larger firms take a different approach.

This is one of the big reasons I don’t like mutual funds: there’s an increased risk that your account is being mismanaged in order to benefit someone else. I also get pretty upset when I hear about brokers working for bonuses, as those have absolutely zero bearing on the health of an investor’s retirement account. How much does a broker make regardless of whether his clients gain or lose? How much bonus money should they be rewarded with for essentially just doing their jobs?

Saving and investing comprise a huge and important industry and that, unfortunately, leads to some bad management techniques designed to take advantage of unsuspecting clients. You need to have a good understanding of what’s being done with your money and why. In order to know this, you have to ask: “How do brokers make money?”. And if you want to figure out why brokerage fee systems matter so much, you need to pull back the curtain and see how the sausage gets made. In some cases, financial advisor costs are structured to reward them from doing their fiduciary duty and acting in their clients’ best interests; in others, less so.

How Much Does a Broker Make in Fees vs Commission?

Commission exists in all sorts of professions, which is part of the reason it doesn’t raise many red flags when someone finds out their advisor has a commission-based income. Real estate and insurance agents, loan officers, and virtually everyone whose position ends with “sales” get by on this system. Based on this fact alone, you might think a fee-based advisor will be the more expensive option.

In fact, a fee-based advisor might be more expensive – on paper, at least. If you’re looking at a flat brokerage fee or a defined percentage of assets that goes directly to your advisor, that number will likely seem larger than an ambiguous commission clause. In reality, a commission-based contract usually leaves out the most crucial details of the strategies that end up making investors pay more.

Again, the specifics of this depend on your advisor and the firm he or she works for. Someone who works on commission can also be a registered investment advisor (RIA) and therefore follow fiduciary rules. In this case, you’re not as vulnerable to excessive trading that inevitably proves to be incompatible with your retirement goals – your financial advisor’s costs won’t eat up your investment returns.

The problem is, advisors playing by commission rules don’t have to follow fiduciary standards. They don’t have to disclose conflicts of interest or let you know how exactly the commission system functions with their broker-dealer. They can talk all day long about volume and returns, but at the end of the day, they’re just putting lipstick on a pig.

Perhaps the biggest contributor to the lack of transparency and eventual wealth mismanagement is another word that doesn’t usually have a negative connotation: bonuses. What are stock brokers’ bonuses doing to harm their clients?, you’re probably wondering.

The Loaned Bonus Scam

Countless horror stories come from the practice of using enormous bonuses to lure advisors to big brokerage firms. Someone managing a few million dollars in assets will receive an offer to go work (on commission) at an established firm, and the move will come with a signing bonus to the tune of $300,000. At face value, it would appear a talented financial mind with exceptional stock broker qualifications is simply being courted by a big company with deep pockets.

Digging deep into the fine print, you learn that the bonus is a trap. I’m not going to look down my nose at $300K, but that’s just a drop in the bucket compared to the incoming assets of the advisor’s existing clients, who move with him to the large company. That number becomes even smaller when you know that advisors who miss their trading quotas are forced to repay thousands of dollars in bonus money. When they don’t make enough moves, they not only lose out on the commission they rely on, they also have to pay back money they’ve likely already spent. What are stock brokers supposed to do when doing their ethical duty and faithfully representing their clients’ interests could cause them to go broke themselves?

This bonus system absolutely ruins people, advisors and investors alike. In 2013, a broker brought his clients along to Wedbush Securities in exchange for a bonus of over $2 million and hundreds of thousands of dollars in sales incentives. Over the next five years, the advisor cost his clients millions in an effort to meet goals and keep bonuses. He was fired in 2018 and the 12 former clients who filed lawsuits are still licking financial wounds.

While it’s hard to feel sympathy for advisors who lose their clients’ money, most of these brokers don’t start with bad intentions. The promise of an upfront bonus and steady commission lures them in, and then the only way to keep up is to trade excessively and work outside the interest of their clients. When all is finally said and done, a lot of these advisors get stripped of their securities licenses and end up filing for bankruptcy. Wells Fargo, Morgan Stanley, and the rest pay out occasional settlement claims, but the individuals (again, both financial advisors and investors) always take the biggest hit.

The point is that these bonuses create a massive conflict of interest and they often end up influencing advisors who have done right by their clients for decades. If your broker tells you he or she is headed to work for a major firm but nothing will change with regard to your investments, ask if there’s a bonus involved. That advisor might truly believe the change won’t affect your assets, but the strings attached to a signing bonus all but guarantee otherwise.

In the end, this comes down to the rules investors choose to play by. For those of us who follow fiduciary guidelines, any questionable trading puts us in deep and hot water, legally speaking. The alternative – suitability rules – leaves a lot of room for sneaky dealing and foul play.

Suitability Vs. Fiduciary: What Are Stock Brokers’ Incentives?

I’ve set the stage for bashing suitability standards, and that’s mostly what I’m going to do. I will say that suitability doesn’t directly equate to evil practices carried out by villainous advisors. Instead, it leaves room for trading and management techniques that aren’t quite above board.

To define suitability, it simply means that advisors have to produce investment options that are suitable for clients. This sounds like a good thing because you certainly don’t want to be presented with a list of positions that aren’t suitable for your goals; that would mean that your broker is simply wasting your time if not also your money. The trouble comes with “suitable” being poorly defined, and the fact that presenting a “suitable” option is not the same as presenting the “best” option.

For example, a non-fiduciary advisor could present you with an interesting investment in the timber industry. Based on your allocations, age, retirement goals and everything else, investing in timber makes perfect sense for your portfolio. This investment suits you. No one will arrest or punish your advisor for presenting such an option.

Meanwhile, the details of the trade tell a story that’s not just all about your personal benefit. This big purchase could be the broker-dealer’s own product, giving the advisor an extra incentive to push it on his or her clients. In addition, timber shares, while entirely suitable, could still be a vastly inferior investment to putting money into bonds, or emerging market funds, or real estate.

Real estate offers one of the best examples of where fiduciary and suitability rules diverge. Even if your advisor is an upstanding person, there’s no monetary incentive to have you pull money from a retirement account and purchase a rental property. As your financial advisor, I will not get a cut of the monthly rent you charge. I will also lose the percentage I’m able to charge on whatever money you put toward that real estate purchase.

And get this – I do it all the time! I’m always telling clients to buy real estate because it’s the smart thing to do. In the short term, I may lose a couple of bucks. In the long term, my clients make more money, have more to invest, and everyone wins. That’s how I see it, at least.

In any case, a fiduciary has to show the real estate option. We have to make the pros and cons of various strategies known and do whatever the numbers suggest will financially benefit our clients. And, since fiduciary rules have legal consequences when broken, you can expect a lot more transparency from an advisor subscribing to these terms. We tend to give a little more detail, have a little more patience, and offer more flexibility with investment strategy.

I’m absolutely biased since this is how I operate, but I’m also not wrong. There’s a reason everyone on the side of investors wants to promote fiduciary terms across the board. If you need any more evidence that suitability standards aren’t focused on the individual investor, look no further than where big broker-dealers spend their money.

What Are Stock Brokers Doing About this Dilemma?

Just last year, a proposed rule to have all retirement accounts fall under fiduciary guidelines got nixed in the Fifth Circuit Court. The Department of Labor had attempted to establish a standard that every financial advisor and broker would adhere to the same rules of protecting investor interests. Instead, with intense lobbying from the companies that benefit most from unreported transactions and hidden commissions, the fiduciary rule – also known as the Conflict of Interest rule, to really hit the nail on the head – was struck down.

If these companies were willing to spend millions upon millions to fight a rule change, how much money do you think gets made off of conflicted trading and excessive portfolio restructuring? I recognize that there’s a legitimate fear of governmental overreach, and that’s something we should always consider with rule changes, but this is about disclosing investment strategy to those who own the investments. I’m well aware of who provides the capital that drives my enterprise; some of these fancy brokers would do well to remind themselves who pays the bills.

Meanwhile, the SEC constantly blows the whistle on companies offering excessive bonuses, and these firms continue winning arbitration cases and seeking reimbursement from failed advisors. Since the Investment Advisors Act of 1940, registered advisors have had a legal precedent to adhere to, whereas brokers have a vaguely defined standard of suitability and put the interest of their bosses ahead of those of their clients. It’s an ongoing game everyone is forced to play, and your financial future could depend on which side of the contest your advisor falls on.

While I don’t mean to sound dramatic, I want to emphasize again that not all financial managers have the same protocol or ethical standards. It comes back to our free market and what people choose to do with that freedom, as there’s clearly opportunity to put your own financial gain ahead of those you supposedly work for. With so many Americans investing somewhat blindly and putting their security at risk, I feel compelled to sound the alarm bells from time to time.

As someone who chooses to play by the fiduciary rules, I don’t feel overregulated. I do right by my clients and see immense benefit from taking my role seriously. Some may feel like conflicts of interest are their own business; however, when you control another person’s retirement plan, any motivation you have to buy and sell assets is that individual’s business as well.

Be in the Know

I’m of the mindset that more people understanding finance is good for all of us, even if it means I pass along information that doesn’t put money directly in my pocket. The more everyone invests and saves and contributes, the more wealth gets generated for us all to enjoy.

If you’re working with a financial advisor who doesn’t want you to know the ins and outs of the services they provide, including how that broker makes money, that seems like cause for concern. Whoever manages your money and advises your decisions should be focused on your success. An advisor who has to bend over backward and please his manager rather than his clients in order to earn a commission, or who loses bonus money when sales drop, is a compromised broker, to say the least.

You have to pay your advisor in any case, whether through fees or commission on transactions. If the money you pay is less important than whatever kickback comes from some fat cat in a fancy office in Manhattan, it’s time to cut and run. Know how your advisor really pays his or her bills, know whether you’re getting the fiduciary or suitability treatment, and don’t settle for anyone who isn’t putting your interests above their own.