Sense on Cents

The biggest secret in the money game is the manner in which people are compensated. Why is this compensation process such a secret? Very simply, if the general public understood the compensation process they could then understand the motivations of those managing their money. 

At the institutional level, Wall Street typically pays people on a salary plus bonus format. The salary often would represent only 20% of the overall compensation. The bonus would be tied to individual, group, division, and company performance. The bonus would typically be paid 2/3rds in cash and 1/3rd in stock. That stock component would typically be paid out over a three to five year time frame, thus tying the individual to the firm. That lockup is known as “the golden handcuffs.”

Under this format, people are motivated to maximize profits in order to maximize compensation. In maximizing profits, however, inordinate residual risks have often been left on the banks’ books. Thus, the risk/reward model has been skewed. Expect the Wall Street compensation model to change to address this issue going forward.

How about on the retail end of the business? In dealing with individuals, the compensation structure typically has a few components. Initially, a broker is paid an ongoing fee to bring assets under management. Once the assets are in place, the manager then typically generates more fees via transactions or performance.  However, often that performance is determined not from the perspective of the individual but from the perspective of the broker.  What does that mean? The bank is trying to maximize profitability by selling as many high margin products through the broker to the individual. The embedded conflict is whether those products truly fit the long term goals of the individual or not.

The issues involved in this entire compensation and performance model are truly exacerbated during these challenging markets. Why? Individuals justifiably want to be more conservatively positioned during these markets. In becoming more conservative, they have looked to move out of stocks, structured products, and lower quality bonds into cash, money markets, and short term government bonds. Whether those are the appropriate moves or not obviously depends on one’s individual circumstances. From the standpoint of the broker, however, those shifts are often very, very expensive moves because those cash-like products pay a token of the fees associated with the higher margin products.

Have you ever seen or heard an advisor from a money management firm publicly encourage people to exit the market, move to cash, sell structured products to buy short term government bonds? I don’t know about you, but I do not often see or hear that happen. Why? Those moves do not pay the bills.

As with any relationship, the topic of fees and compensation should be fully explored and discussed prior to moving forward. I am fully supportive of everybody making as much money as possible. However, I am more for eliminating conflicts of interest which lead to underperformance at the same time.    

The WSJ delves deeper into these issues and asks, Should You Fire Your Financial Adviser? 

LD

This entry was posted on Friday, March 13th, 2009 at 3:01 PM and is filed under Business, Economy, Equity Markets, Reputation, Wall Street. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.