Compensation and Client Wealth among U.S. Investment Advisors
Dean, Lukas R., Finke, Michael S., Financial Services Review
This study uses disclosure data from 7,043 Registered Investment Advisors (RIAs) in the United States to examine differences in client wealth by type of compensation. Results suggest that firms charging commissions and hourly fees have a higher proportion of low net worth clients. Wealthier clients are more likely to be charged performance-based fees and fees based on assets under management. RIA firms that charge commissions are more likely to provide financial planning services in addition to investment advice. Results suggest that policy restricting compensation may impact the provision of advising services to average investors. © 2012 Academy of Financial Services. All rights reserved.
JEL classification: G20; G28; G29; H31; H32; M52
Keywords: RIA; Compensation; Commission; Conflict; Client; Fiduciary
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The global financial crisis has spurred governments to take a closer look at financial service policy and the regulation of investment advisors (Inderst, 2009). Recently, the Financial Services Authority (FSA) in the United Kingdom banned financial advisors from receiving commissions on retail investment products and volume-based sales beginning in 2013 (FSA, 2010). This was done in an effort to tie charges to "the level of service provided" to the consumer as opposed to the "particular provider or product" being recommended by the financial advisor (FSA, 2010). Australia enacted similar legislation that will take effect in July 2012. The United States took an entirely different approach to the issue of consumer protection and enacted the Dodd-Frank Wall Street Reform and Consumer Protection Act, which gave the Securities and Exchange Commission (SEC) explicit authority to impose a fiduciary duty on all investment advisors and brokers (U.S. Senate Committee on Banking, Housing, and Urban Affairs, 2010).
Opponents of legislation to limit commissions argue that restricting compensation will reduce the amount of financial service professionals in the industry. Because commissions provide greater compensation per initial dollar invested, it is possible that advisors will not cater to low or moderate net worth households. Small investors may also be less willing to seek out and pay for professional advice if its cost is more readily apparent because commission expenses are more opaque than other advising fees.
The purpose of this study is to empirically test whether there is an association between client wealth and investment advisor compensation. Using data from required SEC disclosure from the population of United States investment advisors with at least $25 million in assets, we find that commission and hourly fee compensation is associated with advisors who cater to lower net worth clients. Advisors who cater to higher wealth clients are more likely to charge performance-based fees. Of most importance to policy, our findings suggest that commission compensation is most common among advisors who provide financial planning services, have more employees, and cater to lower-wealth clients.
2. Investment advisor compensation
Commissions and asset fees each involve potential costs and benefits to consumers and firms. Commission compensation provides a strong sales incentive and while this provides operational benefits to the firm (Nisar, 2007), it may emphasize product over advice (Gravelle, 1994). Tying employee compensation to product sales creates an incentive to recommend inferior products that provide a more generous commission (Mantel, 2005). Firms may favor commissions to improve sales force productivity (Holmstrom and Milgrom, 1994). Commissions also allow firms to hire a larger number of new employees because the underproducing employees leave on their own volition when they are not receiving any compensation for their labor. Commissions (like mutual fund loads with breakpoints and 12b-l fees) have also proven to be somewhat shrouded to individual investors (Beshears et al. …