How Is My Financial Advisor Compensated? Understanding Broker Fee Arrangements

How are financial advisors compensated? As an investor, you are probably wondering how your broker is compensated for the work they do — recommending securities, executing trades, and ensuring that your portfolio meets your needs. Broker compensation is a complex system and is often cloaked in secrecy — but it doesn’t have to be. Read on to learn about the different fee structures involved in broker compensation.

Commission-Based versus Fee-Based Broker Compensation Arrangements

There are two major types of broker compensation arrangements: commission-based arrangements and fee-based arrangements. Let’s take a look at the significant differences between these two structures.

With a commission-based fee arrangement, a broker receives a percentage of the investment product they sell to the client. Let’s say your broker recommends a variable annuity and you purchase it. What your broker may have failed to disclose to you is that they are receiving a percentage of the value of the annuity as a commission. The commission on a variable annuity can be as high as 10%, which makes you wonder if the broker really has your best interests at heart.

What could be problematic about commission-based broker compensation? When brokers are paid on commission, certain unscrupulous brokers might engage in churning or annuity switching. When a broker churns a customer’s account, it means that they are executing more trades than necessary, creating the illusion that they are trading meaningfully in the account and thus generating more commissions for themselves.

What is annuity switching? Another trick that some unprincipled brokers use when it comes to annuities is “annuity switching.” After placing you in an annuity, a broker might come back to you and recommend a “new and improved” annuity that they claim will better fit your needs. Being unaware of its potentially limited range of new features, you agree, only later realizing that you have incurred considerable fees (including a surrender fee from giving up your original annuity). Meanwhile, your broker has gotten a new commission.

What are fee-based financial advisor compensation arrangements? In this broker compensation structure, brokers do not receive commissions but instead receive a percentage of the assets under management (AUM) in a given client’s portfolio. In an ideal world, this means that broker and client interests are aligned; when the customer makes money, so does the broker. Sometimes, however, this arrangement can be problematic because it could lead to so-called “reverse churning.” What is reverse churning? In reverse churning, a broker sits back and relaxes without doing much trading at all in the portfolio, so you are paying a percentage of AUM but the broker isn’t doing enough work for you.

As you can see, bad things can happen under any broker compensation structure. Thus, it is important to do your due diligence. Research the different compensation structures, research different brokers, investigate a broker’s record on BrokerCheck, and make the best decision for you given your unique needs.

Markups

Commissions and percentages of assets under management (AUM) are not the only ways brokers make money, however. A broker could say they don’t charge commissions, but then go on to charge thousands of dollars worth of markups. What are markups? A markup is the difference between the lowest offering price of a security and what the broker charges the customer. When brokers act as principals, buying and selling securities at their own risk, they often add a markup to generate revenue.

Markdowns

In contrast to a markup, a markdown is the difference between the highest price for a security and the lower price the dealer offers a customer. Why might a broker offer this deal? Sometimes a markdown is offered to stimulate trading. If enough customers are enticed by the markdown to trade, a broker can execute many trades and thus (in a commission-based compensation structure) make up the markdown by generating commissions.

Do Brokerage Firms Need to Disclose Markups and Markdowns?

Historically, broker-dealers were only required to disclose the transaction fee (which is nominal). This lack of transparency meant it was up to the customer to figure out if they were getting a fair deal. This changed in 2018, however, and this is no longer true. According to CNBC, “Starting on May 14, 2018 broker-dealers will need to disclose mark-ups and mark-downs they charge on bonds bought and sold to retail investors on the same trading day.” This disclosure happens after the trade, though most brokers will discuss the markup with their clients.

Can a Broker-Dealer Charge More than a 5% Commission?

FINRA Rule 2121 delineates the guidelines surrounding broker markups. Traditionally, markups should not exceed 5%. Established in 1943, “The 5% Policy” is a guide, not a rule for markups and markdowns. Undisclosed bid-ask spreads of 10% or more are considered fraudulent. (A bid-ask spread is the difference between the highest price a buyer is willing to pay and the lowest price a seller is willing to accept.)

“Handling Fees”

What is my broker-dealer charging handling fees? A handling fee is a fee that a broker may charge you for executing a trade. In the past, some broker-dealers have come under fire for charging exorbitant handling fees that were really commissions in disguise.

For example, in 2011, the Financial Industry Regulatory Authority (FINRA) fined five firms for mischaracterizing commissions as handling fees. Pointe Capital, Inc. (n.k.a. JHS Capital Advisors, Inc.), of Boca Raton, Florida after the self-regulatory agency charged customers a handling fee as high as $95 per trade in addition to a commission. John Thomas Financial charged a handling fee as high as $75 per trade in addition to a commission. First Midwest Securities, Inc., of Bloomington, Illinois charged customers a handling fee as high as $99 per trade in addition to a commission; FINRA also found that the firm charged unreasonable markups and markdowns (a violation of FINRA Rule 2121). A&F Financial Securities, Inc., of Syosset, New York charged a $65 handling fee per trade in addition to a commission. Salomon Whitney LLC, of Babylon Village, New York charged a handling fee as high as $69, plus a commission.

Conclusion

Broker compensation structures can be complex, but your broker should be forthright with you about how they are making money. If your broker charged markups and failed to disclose this, don’t hesitate to contact the securities attorneys of Fitapelli Kurta. Call (877) 238–4175 or email info@fkesq.com for your free case consultation with a securities attorney.