Conflicts of interest in the financial industry
In my recent column in the Edmonton Journal, I highlighted one of the conflicts of interest when it comes to the financial industry giving debt advice vs selling debt products. Some people thought I would really anger the financial industry but I have not heard any comments of the sort.
Here are some other examples of questionable advice coming from the financial industry because of conflicts of interest.
Pay off debt or invest?
Tammy received a $350,000 inheritance and her Aunt who was the executor of the estate suggested she use the money to pay off her mortgage of $210,000. When she went to the bank to pay off the mortgage, they suggested that since there was a penalty to pay off the mortgage, she would be better off investing the $350,000 because the mortgage interest was locked in at a low 2.9% interest rate for the next 19 months. Was this advice really in Tammy’s best interest or was this advice in the banks best interest? That’s where the conflict of interest comes into play again.
Compensation of GICs vs mutual funds
Marie is 68 years old and is tired of the volatility of her balanced fund with Great-West Life. At 68 years of age, she wants something more secure and she does not want to open up her statements and see losses. She goes to her financial advisor to move the money to a GIC.
Unfortunately for Marie, she is talked out of a GIC and convinced to stay put in her balanced fund for a myriad of reasons you have already heard before:
– Don’t panic and sell at a loss
– Hang in there because eventually it will come back
– GIC rates are low and after taxes and inflation you will lose money
Some of these arguments may make sense but does conflict of interest come into question? Did you know the GIC pays one fifth of what the mutual fund pays in commission? It’s possible the advisor sincerely, believed he was doing the right thing for Marie but it may also be fair to bring up the potential conflict of interest that comes from the different commission rates in the products.
Why won’t my advisor sell Exchange Traded Funds?
Jon and Irene have some friends that have decided to move out of their mutual funds and into Exchange Traded Funds (ETFs). ETFs are appealing because they are low cost investment products. Their friends showed them some compelling research showing how higher fees puts investors at a disadvantage.
Why didn’t their advisor suggest ETFs? Most ETFs are lower cost because they either have lower compensation or in most cases, NO compensation built in for the advisor. As a result advisors must either charge a transaction fee to get compensated or they have to charge a discretionary fee directly to the client.
What’s best for Jon and Irene really depends on the value provided by the advisor.
Leverage is sold, not bought
Larry works in the Oil industry and although he makes good money, he also knows how to spend it. The problem is at 39 years of age, he has little to show for his hard work and good income.
Larry meets Ross, a financial advisor and suggests that Larry should get a line of credit and use that line of credit to invest in a portfolio of mutual funds as a way to catch up on his wealth. Larry would borrow $75,000 and make payments of $350 per month to cover the interest and these interest payments would be tax deductible.
Larry’s conservative father-in-law suggested he just invest $350 per month and forgo the line of credit. Ross showed Larry a projection where the investment return was higher than the cost of interest and as a result he would be far better off with the leverage program.
Larry took the advice of the financial advisor and unfortunately, the investments did not perform as well as expected. The conflict of interest comes when we look at Ross’s financial results. Ross made money by selling the line of credit. He also made money on the investment. Ross made $3000 up front plus he makes $300 per year.
If Larry put away $350 per month into a mutual fund, Ross would make $168 per year in commission which is much lower that the $3000 he made up front.
Who’s the real winner in these scenarios?