Thursday, June 11, 2009

Sales commissions are bad for consumers

By Dan Danford, MBA, CRSP

Here’s the disclaimer. I hate sales commissions. Not just in the investment industry, but everywhere. I understand that they are a fact of life in certain trades or businesses, and that they aren’t going away anytime soon.

And I also understand why they exist. In its simplest form, a sales commission is capitalism at its purest. Employees who sell the most are rewarded the most.

I’m one of the strongest capitalists you’ll ever meet. I like business and I love entrepreneurs. I’ve started two companies myself, and I serve on the local Chamber of Commerce Board. I earned an MBA and I’m a champion for small business owners everywhere. I like employers and I absolutely love productive employees.

Take a group of employees and assign them widgets to sell. Each widget sells for $10, and each salesperson keeps $1 for each widget sold. At week’s end, the person selling the most gets paid the most.

It’s a simple system, and it works really well for the company. Besides rewarding the most productive employees, it also limits the boss’s salary expense. No sold widgets equals no salary. Similarly, when times are fat, everyone makes money. Who could argue with that?

Well, I can, and I will. None of those arguments work for the consumer. In a lot of ways, sales commissions are actually bad for consumers.

- They align the salesperson’s financial success above the customer’s.
- They add costs to the product. Without the commission, that widget would sell for $9.
- They reward employees primarily for their persuasion skills and charm.
- It’s true that they only get paid when a buyer decides to buy, but that doesn’t mean that the buyer necessarily reached an informed decision. In fact, most of us know that the exact opposite it true in many cases.

In a perfect world, buyers would research a product ahead of time, know exactly what they need, and discover a fair and reasonable price to pay. There would be no need for a costly “information middleman.”

Does anyone buy a new car today without Internet research? We know the accessories, manufacturer's suggested retail price, dealer’s invoice, and even the auto’s safety and other ratings from respected third parties. For a used car, we can easily access the car’s accident and repair history. Truthfully, most of what the salesperson does is accompany us on a test drive and add $1,000 to the price.

The same thing is true with mutual funds and insurance policies. Anyone can look up Morningstar fund ratings or get Internet price quotes. It’s true that a professional can add experience and judgment – even valuable experience and judgment – but throwing a sales commission into the pot can ruin the stew.

Morningstar tracks some 25,000 different mutual funds or share classes. Some feature commissions to salespeople and others don’t. If your investment advisor (agent, broker, representative, or consultant) gets paid through sales commission, then they’ll only be showing you some subset of what’s available. And that subset, however large or small, features higher fees to pay those commissions.

Don’t misunderstand me. I think most investors need professional help. I’m not against hiring a bona fide advisor to help create and monitor an investment plan. What I’m against is paying that person through the sale of certain products or services. Especially if other products and services might to a better job for a lower price. That’s the hidden hazard with most sales commissions.

Information we receive shouldn’t be distorted by the salary scheme. Is the Chevrolet salesperson ever going to tell you that a Ford truck is better value? When you last visited the Verizon wireless store, did they volunteer that Sprint might offer better value for your usage and region? When was the last time a paid salesperson told you “no, that’s not the right product for you.” Wouldn’t we be happier if they did?

Like I said, I hate sales commissions. They are good for the company and bad for the customer. Warren Buffett famously advised, “Never ask a barber if you need a haircut.” Never, never, never, ask a commissioned salesperson what they recommend.

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