Before You Invest, Ask How Your Adviser Gets Paid

I recently reviewed a prospective client's portfolio and saw something that really made me mad. In an IRA account was a $100,000 variable annuity. What's the big deal, you say?

Well, variable annuities are tax-advantaged investment vehicles, which are generally sold with high, undisclosed commissions and painful surrender charges if you want to switch annuities or take the money out. There's no advantage to owning such an annuity within an IRA account, which is already tax-advantaged.

The client could have obtained the identical insurance-cum-investment by buying an inexpensive term insurance policy (about $500 a year for a 20-year, $1 million policy on a healthy 40-year-old) and invested the IRA in several no-load, no-transaction-fee mutual funds. However, the client's current adviser didn't make that recommendation because he or she wouldn't have gotten a commission of 7% on the $100,000. Now the client is stuck because there would be a substantial surrender charge if he exited the annuity.

As a consumer, you have the right to know what kinds of fees, commissions and expenses are being charged on any financial product you might be considering. And the seller, whether a financial planner, stockbroker, investment adviser, insurance broker or some other type of registered adviser, has an obligation to fully disclose these fees. Failure to get a straight answer on this question should prompt you to walk.

Like other professionals such as doctors and lawyers, financial advisers make their living by offering their expertise. There's nothing wrong with getting paid for offering good advice, but your knowledge of how advisers get paid will help you determine whether their advice to you is appropriate or biased in some way.

Let's go through some of the major financial products and their compensation structures.

Stock Commissions

Full-service brokers such as Merrill Lynch or Salomon Smith Barney typically charge $400 for a 1,000 share transaction, as opposed to a $30 commission at a discount broker such as Schwab or Fidelity, or $5 at a deep discount broker such as Brown & Co. Your full-service commission pays for the research your broker provides to you. By now, though, the conflicts brokerage-house analysts face in rating stocks are well known -- the commissions they make in selling stock to you are trivial compared with the underwriting fees they make from the company whose stock they are selling. That relationship guides how objective the research reports can be.

The other danger of working with a full-service broker is that he or she might push you to overtrade, because there are no commissions to be made if you're a buy-and-hold investor. At the discount brokerages, commissions barely cover operational expenses; their profits come from add-on activities such as margin lending, but at least there you're not being prodded to trade. At unscrupulous brokerages, profits come from directing order flow, meaning you might not have paid an actual commission but you did pay through a wider spread on your transaction, or from "pump-and-dump" (stock price manipulation) strategies.

Mutual Fund Fees

Mutual funds are sold under a variety of commission structures, including some that are "no load," meaning there are no sales charges. "A" shares typically have an upfront charge of up to 5%, "B" shares have a sales charge that declines the longer you hold on to the fund, and "C" shares typically have a level load of around 1% a year indefinitely. Any of these funds may have an additional 12b-1 charge of 0.25% to 1% to cover marketing expenses for the fund. (In other words, you're paying to sell the fund to someone else.)

You're never going to be offered a no-load mutual fund from a commissioned salesperson, so the commission you pay on a load fund should be commensurate with the quality of advice you are receiving. For example, you might be working with a financial planner who helps set you up with a good asset allocation strategy, and then fulfills that strategy with load mutual funds. The commissions received from the funds compensate the planner for the time spent analyzing your situation.

There is also a management fee ranging from 0.50% to 2% annually, which the mutual fund company collects. Mutual funds' performance numbers are reported net of fund management fees, but gross of sales commissions, so be sure to adjust returns when considering fund investments.

Insurance Commissions

Insurance products are sold only by commissioned brokers; the concept of no-load insurance hasn't developed yet. In purchasing insurance for myself, I have found that I get a wider range of cheaper options if I work with at least two insurance brokers. Because it's human nature to offer more expensive policies to try to obtain a higher commission, I let the brokers know they're competing to offer me the lowest-priced policy.

Fee-for-Service Financial Planning

Fee-for-service often applies to financial planners who will develop a plan for you for a set rate or on a per-hour basis. There's no obvious conflict in recommending one type of investment over another. However, it's up to you to follow through on the recommendations.

Fees as Percentage of Assets Under Management

Registered investment advisors, known as RIAs, and, more recently, some of the major brokerage houses, manage your assets in return for a fee computed as a percentage of assets under management. These fees are often set at a sliding scale. For example, at my firm we charge 1% of the first $2 million in equity assets each year and 0.75% of assets over $2 million. Fixed-income asset management might run at half of those levels.

To a large degree, this fee structure aligns the interests of investors with advisers, because the larger your assets grow, the larger the fee your adviser collects. There may be additional fees (for example, RIAs usually hire a custodian to hold your assets who will apply his or her own fees), but generally the adviser will want to minimize costs, including the cost of taxes occurring on realized gains. If you're choosing from among advisers who charge fees as a percentage of assets under management, you'll want to see returns net of fees so you're comparing apples with apples, though gross returns are also available.

Wrap Fees

Major brokerages have introduced wrap fee programs (typically 3% of assets under management) under which the investment of your assets is managed by an outside investment adviser, while reporting and operations are taken care of by the brokerage firm. The wrap fee itself is split between the brokerage firm and the investment adviser. These programs may introduce you to investment advisers whose account minimum is larger than your current assets. If at all feasible, though, you should try to invest directly with the outside adviser and save at least part of the management fee.

Performance Fees

Finally, hedge fund advisers typically charge a management fee of 1% to 3% of assets under management, plus a performance fee of 15% to 25% if the fund's returns exceed certain benchmarks. If the fund suffers a major drawdown, additional performance fees cannot be charged until the previous "high water mark" is exceeded. The fund adviser has a powerful incentive to "stretch" for high returns, usually with the use of leverage, because that's how they achieve the performance bonus.

However, this can lead to what I call the "heads I win, tails you lose" scenario in which the fund adviser draws out high fees when the fund is succeeding, and simply closes the fund after a bad streak because he won't make any money until the fund gets back to the previous high. A classic example is the fund managed by Long Term Capital Management, which quadrupled from 1994 to July 1998, but collapsed to pennies on the dollar by September 1998. Needless to say, the investors didn't get their fees back, let alone their capital. They were, however, offered the "opportunity" to invest in a new LTCM fund at a discounted fee schedule.

The bottom line? My best guess is that the S&P 500 will gain 8% to 10% a year for the next five years. In a slow growth environment, every percent that you save on fees is an extra percent of return in your pocket. Insist on being fully informed.

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David Edwards is a portfolio manager and president of Heron Capital Management, a New York investment management firm. Edwards appreciates your feedback at [e-mail].