Follow the Money (Part 6)

What can go wrong?

Pecora Commission Hearings, 1934. Source: Sunday Times

There are lots of ways for compensation schemes to get off-track. If they aren’t properly tied to the company’s goals, the wrong types of behaviors are encouraged.

My industry, financial services, is filled with stories of misaligned incentives and workers behaving badly. The most egregious are financial traders who get a cut of their trading desk’s profits. They use their firm’s financial position to go long or short various financial instruments—stocks, bonds, commodities, currencies—and are paid based on how these positions pan out. If the desk does well, the trader scores big. If not, he or she may be out the door.

This asymmetry is what causes rogue traders to pop up again and again. These folks know how to circumvent the system’s limitations to take huge positions. If these go south, their firms can lose billions. Traders will hide losing trades in various ways, or manipulate their mark-to-market systems to inflate their bonuses—especially around the end of the year, when the bonus is calculated.

This same sort of thing happens in more mundane settings. In the late ‘90s I knew of a bank trust department that used to pay bonuses based on whether client portfolios did better than an equity index—irrespective of risk. That scheme just incented their portfolio managers to concentrate their client’s portfolios with high-flying tech shares. One portfolio was loaded with over 60% technology companies. Whoops. Needless to say, those clients didn’t do very well when the internet bubble burst.

Traditional commission-based brokers and agents face incentive conflicts all the time. The temptation can be to elicit trades from a client whether these are needed or not. This is called “churning” an account. And salespeople are also paid varying fees from different instruments. Mutual funds and annuities are particularly prone to abuse. These pay up-front commissions and trailing fees that aren’t always clearly disclosed. In some accounts the investor can pay more than 3% per year, and these fees are largely hidden from view.

Photo: Kevalaer Niederrhein. Source: Pixabay

These types of abuses are what’s behind much of the recent regulatory reform. The Dodd-Frank legislation tries to address trading issues at banks; the fiduciary rule for IRAs is an attempt to rein in the worst problems with commission-based investment products. But like most rules-based compliance, these reforms will only work until someone figures out how to get around the regulations and game the system again.

The problem with the financial services industry is that it sees itself as an industry and not as a profession. It focuses on its finances, and not on customer service. Practitioners are more concerned with profits than they are with their own expertise. There will never be a perfect solution to the principal-agent problem: some people will always take advantage of other people and their own situation. But if professionals’ interests are tied to their clients’ financial well-being—their risk-adjusted long-term objectives—the compensation structure could at least encourage practitioners to do the right thing.

Upton Sinclair once noted that it’s difficult to get someone to understand something, when their pay depends on their not understanding it. If we get the pay right, maybe the understanding will follow.

Douglas R. Tengdin, CFA

Chief Investment Officer

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