An advisor's compensation is a relevant fact in the client-advisor relationship. Moreover, companies have used this lever to create certain behavior in their advisors. In this post, we will discuss the compensation structure of advisors, how it affects them, the client and the advisor's employer. We will also cite the study that caused large brokerage firms to change from commissions to fees.
As our initial point of reference, we will use the insurance industry. he compensation of a life insurance agent is based on the annualized premium, but also on the type of policy sold and whether the agent works for a company or is independent. In addition, cash value policies tend to pay a lower commission while term policies tend to pay a higher commission. While the specific percentages are not important to our discussion, the structure is highly relevant.
For example, a life insurance commission may be as small as 40% or as high as 120% of the first year's premium. Moreover, the commission on a term policy usually ends after the first year, while a cash value policy may pay a small renewal commission of 5.0% for a few years after the first. The important point is that life insurance commissions are typically "front-loaded." Insurance companies pay a high first-year commission, in part, to motivate the agent to continue selling. In contrast, auto insurance policies usually pay a level commission over the life of the policy. High first-year commissions are a disincentive to future service, since the advisor has received all of their pay upfront. Level commissions provide an incentive for future service, as the agent desires to retain the business.
In the financial services industry, especially in the larger brokerage firms, sales commissions were the dominant method of compensation up to the mid-1990s, when the Tully report was published in 1995 (named after the chairman and CEO of Merrill Lynch at the time, Daniel Tully, who chaired the SEC panel which released the report).
