Should Financial Advisors Disclose Their Commissions?

One of the complaints often heard about the investment industry is lack of disclosure about compensation.  It is up to clients to ask their financial adviser how they are compensated, and even then it might be difficult to verify if the adviser is telling the truth.  The reality is that compensation has a huge impact on the investment recommendations by advisers.

It would seem that more disclosure is the obvious answer, but according to one study I read, it might not make much of a difference in the actions of clients and might make the advisers even more biased.

My wife is currently reading the book Why We Make Mistakes by Joe Hallinan.  This book is similar to quite a few other books I’ve read that analyze why we make the decisions we do.  Books like Your Money Or Your Brain, Nudge, Sway, Paradox of Choice and many others look at various situations we face and try to figure out why we make consistently irrational decisions and what we can do about it.

She pointed out one section of the book to me that refers to a study done by George Loewenstein from Carnegie Mellon.  He wanted to evaluate the effects of conflict of interests disclosure from advisers, on the decision making of their clients.  The study is call “The Dirt On Coming Clean – Perverse Effects of Disclosing Conflicts of Interest“.

The study

His study used volunteers who played one of two roles – the “Adviser” and the “Estimator“.  Estimators had to estimate how much money was in a glass jar and were rewarded for accuracy.  Advisers were provided with more information than the estimators and were instructed to give advice to the estimator in order to help them estimate more accurately.  Each Adviser provided an estimate to help the Estimators.

The Advisers were divided up into two groups – one set of Advisers were compensated according to how accurate the “client” estimated the amount of money and the second group was compensated according to how high the “client” estimated – accuracy didn’t matter for that second group.

Another test was that the conflict of interest that the second type of Adviser faced was disclosed to some, but not all of the Estimators.

The results

The actual mean jar value was $18.16.

  • Advisers who were compensated on estimator accuracy estimated an average of $16.48.
  • Advisers who were compensated on high Estimator estimates, but conflict of interest was not disclosed estimated an average of $20.16.
  • Advisers who were compensated on high Estimator estimates and disclosed their conflict of interest estimated an average of $24.16.

It’s fairly obvious from the results that compensating the advisers for encouraging a higher estimate influenced their behaviour.  What was more surprising is that disclosing the conflict of interest actually increased the bias even more.

Lowenstein says that “moral licensing” is one of the reasons this happens.  Basically this theory says that an adviser with an undisclosed conflict of interest will feel guilty enough about it that they will try to “do the right thing” to some degree.  By disclosing the conflict of interest, it allows the adviser to do whatever they want since they have admitted the conflict and therefore don’t have to feel guilty about it anymore.

On the Estimator side, Lowenstein showed that although the Estimators did discount the advice from the Adviser when the conflict of interest was disclosed, they underestimated the severity of the conflict and the estimates were less accurate compared to the estimates provided where there was no conflict of interest.


Lowenstein concludes that conflict of interest disclosures may not have much benefit, and can even backfire and produce more distorted estimates as a result.  He concludes that the best way to deal with a conflict of interest is to remove it.

In Britain, financial advisers are not allowed to receive commissions.  This doesn’t mean they don’t get paid – just that they have to charge their clients directly instead of being paid by a third party, such as a mutual fund company.

What do you think?  Should financial advisers be more open about disclosure or should commissions be banned like in Britain?

13 replies on “Should Financial Advisors Disclose Their Commissions?”

Disclosure does nothing when advisors have the trust of their clients. There are GOOD fixed fee advisors out there. If you use one on commission I will light a candle for your deliverance.

This is a tough issue that I’m not sure there’s an easy solution to.

Having commissions disclosed sounds like a great solution, but really isn’t. When somebody goes in to buy mutual funds, they’re already prepared to pay something. People will look at a 1% trailer fee, shrug and say “it’s only 1%.”

When we have such a pitifully low savings rate, wouldn’t forcing someone to pay before they can save via a mutual fund be a bad idea? (Like the British model)

What’s the solution? Personally, I’d like everyone to become a DIY investor and invest in nothing but index funds. Pretty sure that’s not going to happen, but a fella can dream can’t he?

Let me make 2 observations:
1) the adviser who was paid for accuracy – achieved the best results for the estimator.
2) That the honest “high estimate” advisor who told his clients about the conflict of interest achieved worse results than the lying “high estimate” advisor seems irrelevant. In the real world, how many clients would stay with any advisor who was deliberately misleading?

@Jesse – You are right, a lot of client have too much faith in their advisers.

@Fin Uproar – The “1% fee” is another problem. People look at the % amount for 1 year, see that it is small and they don’t worry about it. Meanwhile, over 20 years that 1% can add up to a huge amount of money.

@Weigh House – In the study, the advisers didn’t lie about their compensation, they just didn’t disclose it. Even if they did lie, I’m not sure how the client would know the difference.

FYI – WeighHouse is a company that offers fixed-fee investment advice. Their blog is excellent: http://weighhouseblog

This is a very interesting study. Thanks for sharing it!

I tend to think that disclosure is always a good thing especially when it comes down to conflicts of interest. Unfortunately, this study shows that disclosure gives some a license to steal with less burden on their conscious.

I think this whole issue boils down to one thing. If you hire a financial advisors you want to make sure that you trust the advisor. Some people are very careful whom they trust, others buy snake oil for an inflated price. Unless you institute a thought police, these types of behavior cannot be regulated.

I think that advisors should be allowed to charge a fee for their advisory services, and if someone wants to go through them to implement their suggestions then it’s up to the consumer to ask what that part will cost (expenses in accounts etc.).

No matter what the rules or regulations or laws, the biggest thing is that the advisor has to be someone who will do what is right for the client. EVEN if that means they don’t make any money from that particular transaction. It will pay off 10 fold through referrals to others, as well as maintaining the advisors integrity and building their reputation big time.

@ctreit @John – I agree that disclosure is good even if this study shows that it can be a negative sometimes.

@John – A la carte is a great idea but advisors who offer these services now can’t compete against the “no charge” mutual fund salespersons.

Commissions are not an ideal form of compensation for financial advisers for two other reasons also (in addition to the potential conflict of interest):

1) Commission-based products typically preclude the adviser from recommending a product that doesn’t pay them (ie, their “universe of product choices” is limited… usually significantly)

2) Many financial planning-related issues don’t involve a product at all. In those cases, there is no mechanism by which the adviser can be compensated to work with the client. Example: when should I exercise my stock options? If the adviser is paid solely based on product commission, how would he or she be compensated?

Well I am not a ‘Financial Advisor’ per se, but I work in the financial services industry. Disclosing commissions is only part of it for me, as the main part of the business is passive income.
When someone asks how much I make for selling them insurance, or investments, or any financial plan, I tell them. It’s not a secret, and I really have no reason to keep it secret. Why? Because I know they don’t care, for I am helping them.

If you are selling financial products that are not helping your client, or are confusing, and the client does not know how it benefits them; Than it may be discomforting to hear that you are getting paid $100’s. But I believe if you are able to only sell effective and consumer-friendly products, than you deserve whatever your getting paid.

@John A. Hayner:
You are correct. I teach everything I know to everyone I know. Including people that I have just met. Why share knowledge or financial advice for free? Because everyone needs to know more about money, and If I get a referral from them, I think I deserve it.
Give a little – Get a lot.
Give a lot – Build a reputation.

Thanks for this thoughtful analysis. Actions have pros and cons … and unintended side effects.

Generally speaking, disclosure is good. Knowing the prices may not alter behaviour, though. I get my car serviced at the dealer and the price is what the price is. There are probably cheaper options but there’s satisfaction in dealing with the experts.

There are banks without monthly service charges yet where do most Canadians bank? Similarly, investors may not pay much attention to the compensation their advisor receives even if disclosed plainly.

The reason consumers want commissions disclosed is due to morbid curiosity. It provides no benefit to them. I’m on commission, and required to disclose that I’m on commission, but what I get paid is none of anyone’s business.

I couldn’t tell you what I get paid anyway. I specifically ignore it so that I’m not biased decisions on product or company. I have a general idea by product and that’s enough. So if your rude enough to ask me what I get paid, I can’t even tell you specifically.

Commissioned salespeople in the financial industry aren’t making off like bandits anyway. In my niche (life insurance) the general rule of thumb is that 80% of sales people don’t make it past the first two years. And by ‘don’t make it’, that means they don’t make enough money to earn a living providing advice. It’s not the path to riches people would like to think.

In short, my claim is that consumers want this information, but nor for the reasons they claim that it will prevent bias – it won’t. They actually want it because they think advisors are being paid too much – and that’s likely not accurate either.

I just bought a new furnace and I thought my industry was rough when it came to sales. Sears actually did a hard sell on me (as did the other folks we got quotes on). I knew I was being sold hard, I’m pretty sure it’s a high commission product (10 times the sears points,but only if you sign tonight), but did I feel that I should have a conversation with the sales rep about how much he made from the sale? Clearly not.

Thanks Glenn.

I have a very pragmatic look on commissions: If you want someone to do some work for you, share their experience with you etc – you have to pay them. Call it commissions, fees, whatever you like – nothing comes for free.

I’m a DIYer when it comes to investing – it doesn’t make sense for someone with an advisor to really complain about their fees unless they are planning to go DIY themselves.

In this post, I even put forth the argument that mutual fund DSC fees are a good deal for small investors – if they didn’t exist, it’s likely that the small investors wouldn’t get any advice at all.

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