The culture of commissions and why it's a problem

Bad incentive systems continue to pervade much of financial services, and are the bane of savers and investors

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Last week, I wrote briefly about the annual Buffett and Munger show from Omaha, Nebraska. However, as one would expect in a six-hour Q&A from the two, that was hardly enough to cover the stream of wisdom and fascinating observations that were to be found in the event. One of the parts that I found most relevant to the state of financial products in India was Warren Buffett talking about the power of bad incentives. In fact, that's a topic that Munger also railed against in an interview given at the same time as the shareholders' meet.

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There's probably nothing that damages the personal finances of savers more than encounters with salespeople who have been incentivised to in a certain way. Munger says in the interview: I'm afraid that salesmen do have a wonderful incentive. ... what a salesman will do is just awful, if you give a man a family to support, in the commission system. ...It's disgusting. My dead wife had a relative, her mother's cousin, who was a blind doctor. And he had two adopted children. And after he was blind, and he was living on the savings that he'd made from working very hard ... and this goddamn broker who was married to the adopted daughter, he just churned the old guy until he was broke. He was blind! He was his own father-in-law! They just think if you need it enough, it's OK to do.

That's quite a comment on the culture of commissions: 'They just think if you need it enough, it's OK to do.' From our own experience in India, we know very well that almost all (maybe not almost, but 100%) of the problem in personal finance arises from the malpractices driven directly by the system of selling on commission. Whatever be kind of product that is being sold, if the seller gets a percentage of the amount invested every time there's a transaction, then you can be sure there are going to be a lot of transactions. There's no real way of stopping it, except by changing the model of payments.

At its heart, this incentive problem is one of a severe misalignment of the interests of the customer and those of the salespeople. People will follow their own economic interest: that's a basic, unshakeable rule not just of business but of life itself. In almost every financial product, the customer (or saver or investors) benefits when the product delivers over a long period while the salesperson benefits from the act of selling itself. Even if the salesperson gets paid something over a long period, a big chunk of it is up front, and that's the real problem. Of course, Indian mutual funds are now an honourable exception to this but more on that later.

Map this on to any personal finance service of the kind that Munger talks about. It's in the seller interest that you keep buying and selling repeatedly. Every time you buy a new investment, a commission is generated. In services like stock broking, the same is true of selling. The BEST scenario for the saver is to find a good long-term investment and stay invested in it. This leads to the highest returns and the lowest taxation. However, this is also the WORST scenario for the intermediary because there are minimal transactions. This is a stunning mismatch of economic incentives. In fact, saying 'mismatch' is a huge understatement--this is a completely adversarial model, where the intermediary is necessarily an enemy of his client.

Well, not necessarily, because in theory the seller can be good enough to worry about the long-term well-being and loyalty of the customer. He may say to himself, 'I'll put my own immediate interests on the backburner so that the client has a good experience and becomes a customer for life.' Does anyone do that? In my experience, a certain number of individual advisors do so but institutional ones never do. That's because institutional sellers are bound by the incentives of the organisations themselves, which are inevitably transaction oriented.

The interesting part is that after about a decade of tinkering, SEBI has finally evolved an incentives structure for Indian mutual funds which is immune to these problems. There are no upfront commissions possible and there is no incentives for churning the investors' money. Of course, many sellers will simply divert to other products--like insurance--that haven't been cleaned up by the sector regulators. Still, knowledgeable investors who understand the power of incentives can do enough to save themselves.

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