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Flypaper: Schwab’s Sweet Deal For Advisors

The following is excerpted from a column that appeared in Financial Advisor, a trade magazine, this summer. The author is Mark Hurley, chairman and CEO of a Dallas-based investment firm known as Undiscovered Managers. My comments follow the excerpt.

“’There’s no free lunch’ is a proverb that has stood the test of time. In a capitalistic system, market inefficiencies are quickly arbitraged out of existence and anything of value ultimately costs its end users something. Even the chips at Mexican restaurants eventually stop coming without an order from the menu or the bar.

“The marketing function in the financial advisory business, however, has long been a curious exception to this rule. Accountants, insurance agents and lawyers have referred potential clients to [investment] advisory firms for years. For free. No strings attached. These gifts have inflated the profitability of advisory firms and have fostered a false sense of entitlement — one that has made some advisors delusional when discussing the future cost of client acquisition.

“This ‘silver spoon syndrome’ has become particularly apparent as a result of recent changes in the Schwab Advisor Source Program. Specifically, for each client referred, advisors now will be required to rebate 15 percent of their ongoing revenue across the life of the relationship, regardless of source. Schwab will serve as custodian for the clients’ assets, and shifting to another custodian will trigger an onerously large termination fee, all borne by the advisor. Hence, for all practical purposes, the client referred by Schwab will remain a Schwab client so long as it is a client of the advisor.

“Many advisors have described this new structure as highway robbery and an attack on their sovereignty. Those who are not outraged by the referral fee are incensed by the termination fee. In reality, over the long term, 15 percent will likely turn out to be cheap compared with what referrals will ultimately cost. And the terms will likely be even more restrictive to protect the referring party’s interest. What Schwab is doing is simply part of the normal rationalization of markets.”

I see nothing normal about it. By offering “cheap” referrals, Schwab helps itself while helping the advisor build his or her business. But what happens to the client if, in the long run, Schwab does not offer cost-effective or efficient service? Or if another company acquires Schwab and its “rights” to these clients? Will the investment advisor ante up to buy his client’s freedom?

Hurley starts from the premise that investment advisors, regardless of how they are compensated, are part of the distribution chain for financial products and services. In the world he envisions, it would not matter whether the person you consult for investment advice is a commissioned broker or a fee-only financial planner; either one would be beholden to the firm that “owns” the rights to your business — rights that you never sold.

Unfortunately, when it comes to the mass market, Hurley’s prediction that this is the wave of the future just may be right. There may not be enough revenue to be made from pure, unadulterated “advice” to compensate skilled advisors for dispensing it to small accounts. Average investors may have to take it upon themselves to become knowledgeable enough to pick a suitable strategy and a reasonably priced product. If they cannot, they may have to deal with their “advisors” with the caution they now reserve for telemarketers.

But substantial investors who pay good money for advice have a right to an advisor who has no hidden agenda. If the world Hurley envisions comes to pass, the independent advice business will not merely be changed. It will be dead.

I have never paid nor asked for a referral fee. I do not participate in programs like Schwab’s, even though Palisades Hudson Asset Management, Inc. has more than $100 million in custody at that firm. I would pull that business from Schwab in a heartbeat if it stops giving my clients the service I want them to have.

By the way, lots of professionals are glad to give and receive “free” referrals. I often send prospective clients to attorneys, insurance agents, trust officers and sometimes even other accountants whose work I know and respect. An effective referral is another way of helping a client or prospect, which is my business.

Nearly all of my new clients also come from referrals. I am delighted to have them, and grateful to those who offer them. But never for a quid pro quo. How can a client ever trust me, if he knows I paid someone else he trusted just to get his business?

No, thanks. I’ll find my next client on my own, and keep my independence — and that client’s confidence — in the bargain.

Larry M. Elkin is the founder and president of Palisades Hudson, and is based out of Palisades Hudson’s Fort Lauderdale, Florida headquarters. He wrote several of the chapters in the firm’s recently updated book, The High Achiever’s Guide To Wealth. His contributions include Chapter 1, “Anyone Can Achieve Wealth,” and Chapter 19, “Assisting Aging Parents.” Larry was also among the authors of the firm’s previous book Looking Ahead: Life, Family, Wealth and Business After 55.
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