Can You Trust Your Broker?

As a young, eager stockbroker in West Barnstable, Mass., in the mid-1980s, Caleb T. Warren spent hours charting companies' performance on yellow pads to find the best picks for his clients. One day, as he sat at his desk at Prudential-Bache Securities Inc., a manager grabbed a pencil out of Warren's hands and broke it. "That's for our research department," the manager barked before stalking off. "Your job is to sell."

Warren tried to take it in stride. But after stints at two other national brokerages, he just couldn't put up with the firms' unrelenting pressure to produce commissions, even though the investments often didn't benefit customers. In 1991, he formed his own money-management firm. He no longer collects commissions, instead charging his 70 clients a flat management fee. "I'm getting paid to make money for my clients, not to sell a product," he says.

Warren's views are part of a rising wave of criticism, both inside and outside the industry, of how stockbrokers and the firms they work for operate. For years, securities regulators have been concerned about shady penny-stock firms and so-called rogue brokers at larger firms. But now, critics are focusing on widely accepted ways of doing business at the biggest and most prestigious firms that they say systematically tend to put investors at a disadvantage. "There is a growing cynicism and suspicion among investors about the industry and its practices," says Arthur Levitt Jr., chairman of the Securities & Exchange Commission.

"UNSUITABLE PRODUCTS." This investor backlash stems in part from the limited-partnership scandals of the 1980s, especially at what is now called Prudential Securities Inc. Investor losses there exceeded $1 billion. The abuses at Prudential Securities stemmed directly from sales practices and compensation systems that induced brokers to put clients into high-risk partnerships originated by the firm. Prudential Securities declined to be interviewed about their current practices.

Today, products of major firms are generally less hazardous to customers' wealth. But ingrained commission compensation policies, which are at the very core of the way Wall Street does business, still tend to encourage brokers, who work almost entirely for commissions, to put their own interests ahead of their customers'. "Prudential showed us how sales contests and paying higher commissions for in-house products led brokers to sell customers unsuitable products," says Idaho State Securities Commissioner Wayne Klein. "These sales techniques are still a serious problem that put the integrity of the industry at risk."

Many brokerage executives are increasingly worried that the industry is hurting itself. Commission incentives have been crucial to the industry's often lush profits and its broad, high-cost array of investor services. But they are also undermining Wall Street's competitiveness. As the reputation of mainstream brokers plummets--one public-opinion poll found that only politicians and lawyers ranked lower--customers are leaving. So are disenchanted brokers such as Warren.

The beneficiaries of this trend are discount brokers, direct-marketing mutual-fund groups, financial planners, and banks, whose employees mainly work on a fee or salary basis. The national full-service brokerage firms' share of securities industry revenues fell from 39% in 1992 to 35% in 1994, while discount brokers' share grew from 3% to 4%. "There is a lot at stake, and everybody in the industry knows it," says Samuel L. Hayes III, a professor at Harvard business school. Big firms "know they must clean up their acts to salvage their niche."

Among the practices under scrutiny:

-- Commission incentives dominate and distort compensation. The more commissions brokers generate, the larger a share of the commissions they can keep. That can encourage "churning," excessive trading of customer accounts. Sales contests and "product of the month" campaigns are common. Many firms recruit top-producing brokers from other firms with huge up-front bonuses, like star athletes. "How can that be in the interest of investors? It's a bad practice and should be eliminated," says Levitt.

-- Firms give little regard to whether customers benefit from investments. Brokers, for instance, receive financial incentives to push in-house products, such as mutual funds, instead of funds originated by outside groups. The reason: In-house investments produce higher profit margins. But these investments may be unsuitable er have worse performance records than products from outside vendors. "Customers are being told `this is the best thing for you,' when the real reason is that the broker gets more money for it," says Alan Bromberg, securities-law professor at Southern Methodist University.

-- Most firms provide little useful information to customers on how their investments are faring. Brokerage statements don't show an account's performance. And there is no disclosure of the aggregate commissions that a customer has paid over a quarter or a year. "If they started including performance and the cost of commissions on brokerage statements, the industry would disintegrate," says Howard G. Berg, a financial consultant and 30-year industry veteran.

Nothing is inherently wrong with commissions. Salespeople get paid on commission for selling everything from suits to cars. In these cases, customers understand the salesperson's job is to sell a product. In the brokerage industry, too many naive customers forget this and trust their broker to do what's best for them. "Firms are deliberately trying to hide the fact" that most brokers are simply salesmen, not financial consultants, says former broker Robert F. Mewshaw, now an investment adviser.

Brokerage executives dispute that the commission system induces brokers to work against clients. "You have to be stupid to make a trade purely because of what the commission is. If it's not in the customer's best interest, you're out of business," says John L. Steffens, who heads Merrill Lynch & Co.'s brokerage unit. Industry leaders say investors face far greater risks from penny-stock firms, inexperienced bank-based brokers, and unregulated advisers. Brokers, they note, are the most highly regulated financial-services providers.

No one disputes, further, that there are many good brokers who rise above the system. These brokers report rates of return to their clients and recommend the best investments. "I sell some PaineWebber products that are good products, and if they are not good, I don't sell them," says Howard Kramer, a veteran PaineWebber broker.

MORAL SUASION. Brokerages, however, are coming to understand that they have to change their ways. "People have to believe that the industry has its clients' interests at heart," says Steffens. "If they don't and a new entrant does, it won't be good for the industry." He concedes that such reforms as eliminating sales contests and extra commissions could cost revenues in the short run. "But in the long run, the impact will be positive in raising client confidence."

Last December, the industry launched a "trust and confidence campaign" to improve brokers' image. It has set up a new, continuing broker education program. Some firms are moving toward fee-based compensation and have stopped making brokers favor house brands. The most offensive contests have been toned down.

Levitt, a former broker, is spearheading the reform. He is relying on moral suasion, admittedly a tall order. Levitt has set up a high-level group to examine broker compensation practices, led by Merrill Chief Executive Daniel P. Tully, Warren E. Buffett, General Electric CEO John F. Welch Jr., and Harvard's Hayes. A report is expected within weeks.

It won't be easy to change the system, which is fundamentally skewed toward selling, not dispensing disinterested financial advice. Recruiters rank sales skill much higher than a college degree as a requirement for new brokers. Most training programs tend to impart little more than superficial financial knowledge. Florida investor James Leavengood says he has heard brokers admit they have no time to read the financial press. "Brokers are the nicest but most shallow people," he says.

The system richly rewards big producers. For example, in 1994 at Smith Barney Inc., a broker generating $149,000 in commissions for the firm earns $49,170, or a 33% "payout." But a broker with $1 million in commissions earns $425,000, a 42.5% payout. Managers encourage performance in other ways. One war story, in a National Endowment for Financial Education study, related how a branch manager asked a rookie broker for his shoes. He would only get them back if he sold 10,000 shares of an automobile stock.

The incentive for brokers to produce is relentless. Young brokers with few clients are especially vulnerable. Most brokers are ranked daily by commissions. At many firms, veterans who do not consistently bring in at least $150,000 in annual commissions are quietly asked to leave. About 75% of new brokers don't make it in five years, which is why the big firms must train hundreds of new ones a year.

Firms sustain the sales culture by doling out recognition and perks. Fledgling brokers start out in a bullpen area and only graduate to an office if their sales increase sufficiently. The biggest producers get secretaries and sales assistants. If they open enough new accounts or generate big sales of certain products, brokers get to pick prizes, such as golf clubs and cameras, from glossy catalogs. A 1992 PaineWebber "premium producers" catalog explains how brokers can earn credits for selling life-insurance products. Producers could earn a Rolex watch and a trip to Quebec, where "gala PaineWebber receptions and dinners fill the evenings in the grand style to which we have become accustomed." PaineWebber says it no longer has prize catalogs.

FANCY WEEKENDS. Most firms have chairman's and president's clubs, which reward the firm's top-producing brokers. They are often feted annually by top management at luxury resorts. In 1994, members of PaineWebber's Pacesetter's club--brokers who made at least $350,000 in gross commissions--spent a weekend at the Phoenician in Phoenix serenaded by disco queen Donna Summer. "The firms hold carrots in front of brokers. The brokers get on the phone and hold carrots in front of the clients," says former Lehman Brothers Inc. broker Paul Warehall. Joseph J. Grano Jr., president of PaineWebber Inc., says the trips reward gross sales, not sales of particular products, and that brokers attend daily training sessions.

There are special enticements for certain high-margin products. One former PaineWebber broker won a trip to La Costa, Calif., in 1993 for selling $1 million worth of PaineWebber's infamous U.S. Short-Term Government Fund, which subsequently lost as much as 9.3% of its value because of bad derivatives investments. PaineWebber says brokers could earn the trip for selling $1 million in any mutual fund.

Or consider a memo to Dean Witter Reynolds Inc. brokers in the Southeast region in October, 1994, announcing that brokers who sold $50,000 in the Trust Company of the West/Dean Witter Global Convertible Trust would qualify for a drawing for a weekend in Bermuda. James Higgins, president of Dean Witter's brokerage unit, first denied the firm held single-product contests. When presented with a contest brochure, he conceded that the firm may have regional contests but insisted it had no national single-product sales contests. The fund is down 2.2% since October.

But the greatest incentives are usually for selling investments created by the firm. The reason for favoring its own products, especially mutual funds, is simple: much higher profit margins. The firm reaps a fee for managing its own funds. It gets no management fee for an outside fund. "The firm's product should sell because it is competitive, not because the firm gets a higher fee," says Idaho's Klein.

The firm that's most vulnerable on this issue is Dean Witter. It says that more than 75% of the mutual funds it sells are the house brand, probably the highest ratio in the industry. Customers who invest in Dean Witter funds pay a sales load that ostensibly compensates the broker for unbiased advice in helping them pick the best fund. Yet three times out of four, clients are simply ushered into Dean Witter funds. One reason: Brokers receive 5% to 15% more for selling Dean Witter funds than for outside funds. "It's like calling yourself a car consultant when you sell Fords," says Don Phillips, publisher of Morningstar Mutual Funds.

If the performance of Dean Witter's funds was top-notch, such a bias might be justified. But Dean Witter's mutual-fund family, like most other brokerage-firm funds, is nothing special. The largest independent mutual-fund groups, such as Fidelity, Vanguard, American, Putnam, and Franklin, in general have better-performing funds (table, pages 72-73).

"PRETTY MEDIOCRE." The average Morningstar rating for a Dean Witter fund is 2.72 stars out of 5 stars, placing it ninth out of the 10 largest independent and brokerage-fund families. According to Morningstar, the annual return of Dean Witter's U.S. equity funds going back to 1980 is just 8.9%, trailing the Standard & Poor's 500-stock index by 51/2 percentage points. Except for a few, "the Dean Witter funds are pretty mediocre," says Morningstar analyst Eileen Makoff.

Dean Witter, whose advertising tagline is "we measure success one investor at a time," responds that having control over the funds it sells allows it to ensure the funds' quality. Its efforts to educate its brokers about the virtues of its own funds are what boost sales, not higher commissions, insists Dean Witter's Higgins. "All things being equal, we would like our customers and brokers to have a Dean Witter-first approach when it comes to Dean Witter products."

Smith Barney also favors its own funds in several ways. It doesn't pay brokers extra commissions for selling Smith Barney funds. But it does give them an extra bonus. Smith Barney says the bonus is modest and deferred for five years. Branch managers, who are paid a percentage of the profits of their branches, must forfeit 21% of these profits unless more than half of the funds sold are proprietary. One former executive says he knows of one manager who had to forfeit $60,000 in pay for not meeting this goal. The firm confirms that branch managers are paid partly on in-house mutual-fund sales, but the method of calculation has changed.

At the other extreme is St. Louis-based A.G. Edwards & Sons Inc., which has no in-house mutual funds. It believes brokers should be free to pick what's best for the client. Otherwise, says Chairman Benjamin F. Edwards III, "the brokers feel prostituted. They have the promise of a higher payout and the threat of disloyalty if they don't go the company way."

MOVING EXPENSES. Concerns such as these don't always bother Wall Street's top salespeople, who actively market themselves on the basis of their production. Nearly all the major securities firms pay hefty up-front bonuses to recruit top-producing brokers. The lure is not only their sales ability but their customers' assets, which they bring along with them. In essence, the broker uses client assets as a bargaining chip for himself. Brokers typically persuade clients to come along by saying the new firm is somehow superior to the old one. They rarely tell clients the whole truth--that they are leaving for cold hard cash.

Big producers are also paid a higher commission percentage when they join a new firm. The rationale is that these rewards make up for the costs that brokers incur by moving. The effect, however, is the broker has an even greater incentive to trade his accounts because of the higher commissions he will earn. Customers who follow their broker to another firm may lose in other ways. Moving their accounts can incur fees and penalties, especially if a customer has to liquidate one in-house fund and buy into a new one.

PaineWebber and Prudential offer the highest up-front payments, say brokers and recruiters. Consider Pru's hiring of Bruce Kramer, Smith Barney's Seattle branch manager, in 1994. According to former associates, Kramer in turn hired more than 25 Smith Barney brokers from his old office, paying as much as "70-50-50" for the best brokers. This means a million-dollar producer would get a $700,000 cash payment to move to the new firm, plus 50% of gross commissions earned for the next 50 months. Kramer denies Pru paid that much. Grano says PaineWebber pays average up-front payments.

The big New York firms say that they dislike up-front bonuses. But the practice is likely to grow as firms scramble to build up assets. Merrill Lynch spent $21 million in the fourth quarter of 1994 alone on signing bonuses paid to brokers hired in that quarter. Merrill says this was the most it had ever paid in a quarter and stemmed from an effort to hire Kidder, Peabody & Co. and Lehman Brothers brokers.

Customers are oblivious to this high-stakes competition. They are also often oblivious to whether their brokers are doing a good job for them. Brokerage statements at major firms don't show rate of return on a percentage basis. Nor do statements report the total amount of commissions paid per year, even though brokers have a running tally on their computer screens. Commissions, if they are disclosed at all, are reported only on a per-trade basis.

The public's disenchantment with stockbrokers, coupled with intensifying rivalry among firms to be more customer-friendly, is producing some reforms. Chicago-based William Blair & Co. is in the final stages of giving its brokers separate customer statements with rate-of-return information, which brokers can pass on to clients. "We think there are customers who want that," says a Blair official. Merrill is several months away from rolling out a new statement to some customers that will include rate-of-return data for stocks, bonds, and cash. No firm interviewed by BUSINESS WEEK has plans to report aggregate commissions, however.

Merrill Lynch, Smith Barney, and PaineWebber say they no longer pay brokers a higher commission for selling house-brand funds. "I know my proprietary sales went down when we removed the differential," says PaineWebber's Grano. "That tells you there was a bias." These firms also deny they have sales contests for specific products.

While commissions still dominate, a small but growing part of big firms' business is fee-based, removing the broker's incentive to churn accounts. Brokers can earn a quarterly fee for referring customers to an outside money manager, called a wrap account. But this is not a panacea. The charges are high, with the customer paying annual fees as large as 3%.

Levitt is determined to make sure the industry keeps moving in the right direction. Under the auspices of the Tully commission, he has been meeting with the heads of the major brokerages. At least publicly, industry honchos praise his efforts. "I came away feeling good. The industry should always work at improving itself," says James Dimon, Smith Barney's chief operating officer. The Tully commission report is expected to implicitly criticize certain practices by lauding firms for not engaging in them, including contests for specific products, high payments to recruit brokers, and differential payments for in-house vs. outside products. If the industry doesn't curb the most egregious practices, the SEC may step in and require firms to inform customers of brokers' incentives. "Full disclosure is the most likely remedy we'll see implemented," says Harvard's Hayes.

In weighing whether to maintain commission incentives, big firms are between a rock and a hard place. If they keep the current system, they could lose market share. But if they move toward a fee system, they might lose major revenues since brokers would be less production-oriented. Whether executives can transform "commission junkies," as former broker Mewshaw calls them, into trusted financial advisers could determine whether the industry prospers or slips into a slow decline.

The Case Against The Brokerage Industry

PRESSURE The compensation system at brokerage firms creates intense pressure on brokers to generate a high volume of commissions.

INCENTIVES Brokers are given extra incentives, such as Rolex watches and all-expense-paid vacations, to sell special high-profit-margin products with little regard to their suitability for customers.

BAD ADVICE Firms push brokers to recommend in-house mutual funds, where the firm earns management fees, instead of funds run by outside managers. Most in-house funds have mediocre performance records.

BONUSES Many firms recruit top "producers" from other firms with huge up-front bonuses and extra-high commissions. That gives the producers an added incentive to

promote excess trading.

POOR INFORMATION Firms don't provide customers information on the overall return on their investments and aggregate commissions they've been charged.


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