Thursday, October 25, 2007

Why does my financial advisor seem to work for free?

One day at work I saw a sign advertising a free seminar hosted by my employer about investing and retirement savings plans. It just so happened that I was starting to think about putting some money away for retirement, and so I went to the seminar. An energetic guy named Mike gave a slick presentation with lots of graphs that I couldn’t completely follow, but I was left with the impression that Mike and his firm knew what they were doing, and that people could do very well financially by investing. Another plus was that my company’s employees would not be charged the usual yearly fees for Mike’s services.

I approached Mike, and we set a time for my wife and me to meet with him at his office. After some discussion, we agreed that we would invest in a couple of different mutual funds, but as we were getting ready to sign papers and hand over most of our savings, I had a strange feeling that something wasn’t right: we didn’t seem to be paying for Mike and his company’s services. The new accounts had no yearly fees, this meeting was free, we would pay no commissions on the mutual funds, the mutual funds we chose had no front-end loads, and we would only be charged back-end loads if we withdrew the money within 5 years.

When I asked Mike how he got paid for helping us, he managed to give an answer that steered me away without really answering. Slowly over the next few years of reading investment books, I managed to fill in the story. Mike and his firm got an up-front commission of 5% of our investment right away, and they later got a trailer commission of 0.5% of our money each year. These commissions were paid out of the mutual funds’ management fees and back-end loads, making them invisible to my wife and me. The exact percentages may vary from fund to fund, but the basic idea is the same: financial advisors usually get up-front commissions and, in some cases, trailers.

So, financial advisors do not work for free. Most of them just don’t like to talk about how they are paid.

Bonus: A Tax Rate of 93%!

I was going through some old papers belonging to family again and found the following in the 1963 Canadian Federal Tax Guide:

For the portion of income over $400,000, the tax rate is 80%. Add the Quebec provincial rate of 13.2% to this, and you get total tax rate of 93.2%!  The corresponding US tax rate in 1963 on income over $400,000 was close to 90% as well.

This really surprised me. Sure, $400,000 was an enormous income in 1963, but to take away almost all income above that level seems incredible. I used to think that income tax rates had risen steadily over the past century, but apparently, there have been some big bumps along the way.

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