Welcome to our listener-supported podcast, Money Talk, unpromised absolute financial truths behind financial perceptions with hosts Ed Sutkowski and Chuck LeFebvre. Let’s listen in.
Chuck: Welcome to Money Talk. I’m Chuck.
Ed: I’m Ed. Today’s topic is conflicts.
Chuck: You say conflict and immediately I think about lawyers. I know we’re going to talk about lawyers, but of course, also we’re talking specifically about conflicts of interest.
Ed: We’re going to be talking conflicts associated with economic interests, money, honey.
Ed: And specifically, the lawyer that manages the estate of an individual and charges a percentage, which is interesting. I mean, a decedent’s estate and does the investing. Any observations about that, Chuck?
Chuck: Yes. Clearly, there’s an absence of independence there. What happens anytime you’re involved in investing, I don’t care who you are, if you’re actually marketing investments for somebody, the financial industry is great at especially one thing and that is providing some means by which revenue from the investment vehicle makes its way back to whoever marketed it. And so, whenever I hear about a lawyer or a CPA or anyone else who holds themselves out as being completely independent making investment decisions, I always wonder: Wait a minute! What types of under the table or in some cases fully disclosed? Yet still, in my opinion, inappropriate financial arrangements are in place whereby they’re being paid by the financial instrument itself for the marketing of the financial instrument.
Ed: You must understand that a lawyer’s role is that of a fiduciary.
Chuck: Yes, and for this reason, I really feel most strongly about this in the case of lawyers, maybe it’s because we are lawyers. I think of that one as one where the clients really ought to expect absolute independence.
Ed: We travel with various levels of sophistication clients and it’s appalling to me. We see some folks that are not sophisticated, but for one reason or another, won a lottery or inherited, are so, so naive and they’re taken advantage of. We had a situation this morning.
Ed: I can’t believe it.
Ed: These representatives, registered investment advisor, sold the client an annuity without disclosing the fees and has in the– how many issues? I saw 300 or 400 issues.
Chuck: Oh, yes, in this investment account. When the client died and then we got into administering the estate, there were, I believe, 238 individual positions in this. When I say positions, what I’m referring to are individual stocks, bonds or mutual fund shares, 238 separate positions. For people who don’t travel in the investment markets very frequently or browse, you might think, “The S&P 500 has 500 stocks. 238 doesn’t seem like that many positions.” That is an enormous number of positions to have in one account. To tell you how vast that net ends up being cast, there were stocks in-
Ed: Russian banks.
Chuck: Russian banks.
Ed: I couldn’t believe it.
Chuck: Bolivian breweries and places you’d never even heard of. And you’re just thinking, “There’s absolutely no way one advisor can possibly understand each of those investments”, especially when you get into so many foreign issues. On top of having to understand what’s going on with that business, you have these geopolitical considerations, you have exchange rate considerations. You have all kinds of things that you if you understand what is good or bad about purchasing stock in some small Russian bank somewhere, you can’t possibly also be an expert on all of these other things that were going on.
Ed: I see that. I think of this registered investment advisor, and we cleaned up a lot of them. The decedent came over from the old country, was gifted, and has a little trouble with the language, and yet– anyway, there’s all kinds of devices these advisors use to make sure that no one understands what the actual fees are.
Chuck: By the way, boy, we really quickly got off the topic of lawyers, but let’s go. What’s going on with this advisor, I’m almost certain, is that this is driven by a commission structure that rewards lots of trades. Let’s say there’s $100,000 of cash that needs to be invested, if you just buy a single stock or a couple of stocks, that doesn’t really generate as much revenue as if you’re trading in 100 different things with that money. By the way, these people who are captive employees of some of the big brokerage houses, they might have their commission structure for their individual trades.
Then there’s also this overlay incentive that has to do with the revenue that the firm generates from their accounts. By that, I mean it’s not directly commissions, but fees and so forth, that the firm gets to charge through its clearing operations. Among those fees have to do with extra fees that have to do with purchasing or even holding foreign securities. It just kind of appalled me to look at this account and see all of these issues that are sitting out there.
Ed: That’s not unusual. I’ve also seen a similar situation with a bank. A local bank with 200 issues. I was like, “What are you talking about?” It was only $4,000,000. You could have six issues, an Apple, a Microsoft, but anyway.
Chuck: You can have one. You can have an S&P 500.
Ed: And forget it.
Chuck: You might be the world’s most boring investor, but you’re probably outperforming 90% of the other traders out there.
Ed: You do the reading, and you’ll find that that is the case. The epitome of conflict is the realtor that represents both sides of the transaction.
Chuck: I see that all the time.
Ed: You get these disclosures that are saying, “Now, you understand that representing–” I understand that I’m being the subject of this– Let me just say being the subject of the absence of independent representation and now I am signing off on it, which makes me complicit. I don’t get that.
Chuck: I know. That happens all the time. And as a society, we’ve come to accept that without giving it much thought. I would encourage anybody listening to actually give that some thought and to think about what does representation actually mean in that context? What on earth is this person doing if the whole point is you’re negotiating a contract with somebody and they’re representing both sides of that negotiation? By definition, what that means is that the service they’re providing is absolutely nothing. You’re on your own.
Ed: That’s right.
Chuck: Here’s the thing. When they do that, they make more money than when they act independently.
Ed: Chuck, to that same, let’s not bury all the realtors. We know of at least one in this location, in our area, that’s very good.
Ed: She happens to be a female. And she is very well staffed, knows what she’s doing, tells you the way it is. This is a market study this way. That’s so refreshing. We know that she represents the seller.
Ed: There is no question about that.
Ed: Anyway, there’s exceptions.
Ed: But there are bad lawyers. There are bad automobile mechanics. They’re on the fringes of the bell curve, but nonetheless, you got to be careful, consider the source.
Ed: I’d like to talk about these accounting firms and what’s going on there. Historically, we had a pyramid. We had some folks up on top that were receiving some benefits of all the lower rung individuals and yet the funding of the retirement benefits for the departing members was crazy. It was funded typically by the income, that profit generated by the organization.
Chuck: Right. We should probably back up a step. Typically, when you have a retirement plan, what my retirement benefits will eventually be are funded by deferring what would otherwise be my current income into a trust where those funds grow and then I draw upon them after I retire. But what these accounting firms do, and it’s astonishing–
Ed: And, law firms, by the way.
Chuck: Law firms do too. But it is almost like an industry-standard in the accounting world for them to have these unfunded retirement plans where there is no trust created, of the type that I’ve described at least. And my retirement is not being funded by deferrals that were made while I was working. They’re actually like a miniature version of Social Security
Chuck: Where the existing workers, their productivity is being– some of the profits they generate are being drawn down in order to pay the current benefits of the current retirees. Which is just an amazingly top-heavy type of system to put in place. They make it worse in a lot of cases by having mandatory retirement ages. They have these guys that want to work and are forced into.
Ed: It’s 62, here’s the door.
Chuck: Right. They’re forced into retirement at age 62, and then they’re retired and they’re living off this unfunded system for 30 years sometimes. it’s really–
Ed: Chuck, I know one that it’s about 35 years.
Chuck: Well, when you think about it’s no wonder some of these very same firms that have those structures in place end up being very predatory about their billing. They end up expanding their businesses into all these little and crannies digging for revenue.
Ed: Now what’s the big one?
Chuck: Now they’re doing both investment advisory services and trust services.
Ed: And investment banking services.
Chuck: That’s right, investment banking services.
Ed: It’s a function of revenue. Now, I must also tell you in my experience with a lot of professionals is as follows, let’s focus on the expenses.
Ed: Wait a minute, focus on the revenue. If you were to create value for your client, you’ll find that you can charge more for it because the client perceives value.
Ed: If you’re a cookie cutter and now you’re looking to invest the money for the client that you know has got all money because due to the tax return
Ed: Are you a fiduciary, or what is your role here?
Ed: I’m always troubled. By the way, the funding of these top-heavy benefits typically occurs with a rabbi trust, which doesn’t change, but they set some money aside. The point is, it’s a pyramid at the inception and it’s then an upside-down pyramid down the road…
Ed: because you have fewer people supporting this larger retirement group.
Ed: So, what you get is a conflict. Let’s see if we can sell you insurance. I may be overstating this, but I can see the revenue issue and we can’t do what we have to do with a mere hourly charge. Well, what’s your hourly rate and should it be more? If you’re doing something more than something that’s routine?
Chuck: The thing that I find troubling in this context is that even though lawyers in some cases are expanding into these situations where they’re getting themselves into financial conflicts, accountants as an industry, they have gone in with both feet. They are fully immersed in the business of having essentially the entire range of financial services, which by definition involves putting themselves into conflict situations.
A lot of people think of accountants as tax preparers. And that’s part of what their function is. But, in the business world, so much of what accounting profession does or is supposed to do beyond preparing tax returns at the heart of the service is supposed to involve professional independence like lawyers. By professional independence, you mean you want to be willing at times not to merely advocate what your client wants but give them the truthful answer to a question.
Ed: Even if they don’t like it.
Chuck: Even if they don’t like it. There are regulatory roles for accountants to play where that’s critical. It’s been a while, but we did have a financial crisis that most people can remember. A big part of what led up to that was people relying on what were supposedly independent valuations being done of financial instruments that turned out to be essentially tailored to what the clients wanted. Why does that happen? It’s because these firms get into situations where they’re so dependent on revenue, they can’t get out from under this voracious appetite for revenue and that forces them to compromise their independence in order to satisfy well-heeled clients.
Ed: I want to be very specific here, Chuck, in this question of funding retirement benefits, self-funded that is without any tax deferral associated with it. I want to give you a little story. We have a client you’re familiar with him in his 80s. Given the structure of his activities, his lawyer has had a little better year than perhaps we all have. There had been a case in the past, had a SEP IRA in place. Now is setting up a profit-sharing 401 (k) plan plus a cash balance plan. At that person’s age, with a comp of about 300,000 can put away right at $200,000 in value. Now, just think about that. That 200,000 it results in a savings tax ever paid of about 25%.
Chuck: Yes. That’s amazing, isn’t it?
Ed: The payroll taxes and the UC tax, all those and Illinois purposes, ours are not taxed.
Ed: Anyway, it’s this very shortsighted nature of these professionals that focus on expenses rather than revenue and deferring self-gratification. What occurs though, is that the licensed professionals given the tenure at schools, tend to have a lot of debt.
Ed: They need the money now, but on the other hand, we’ve represented a fair number of personal injury guys that even when they have paid the debts off, have this lifestyle.
Chuck: Oh, yes!
Ed: Multiple homes that, “Oh, what are you doing?”
Ed: “I just got to spend it.”
Chuck: Well, you know what’s interesting about that is, you see that cycle occur when you’re talking about licensed professionals in general. Not just lawyers, but you’ve got lawyers, you’ve got accountants, you’ve got doctors, you really–
Chuck: The actuary investment advisors.
Chuck: These are folks where they fall into that cycle. And the people who don’t are the ones who are business owners, entrepreneurs. You know what I think of the difference there is, Ed, is that when you’re talking about this one category of what I’ve just referred to as entrepreneurs and business owners, those are people who have a need for capital in order to drive their business. I think that need for capital gives them a very different perspective about the idea of accumulating capital with their earnings.
Ed: You got to do it.
Chuck: You have to do it. It’s critical, their balance sheet is important to them.
Ed: I must tell you, Chuck, the real successful ones have no bank debt.
Ed: They get to the point they had bank debt starting it up.
Ed: Now they get to the point where they don’t need bank debt. They have no bank debt.
Ed: We see this in the loans. As a matter of fact, just this week, we’re talking about individual family that has all kinds of loans they’ve made to their corporation. They’re giving those loans, if you will, to generation-skipping trusts or outright to children and the company will pay off the loan will be the cash to invest. Because giving away a note, is not like giving away cash.
Ed: It’s the same thing, but the company will pay these notes off with cash. The point is, they’re extremely conservative with their non-business investments.
Ed: They’re not going to be in the stock market very much. It’s going to be short-term treasury notes and whatever because their risk is in that business organization.
Ed: Now you get the goofy lawyers and accountants and doctors, they’re trading stocks every three minutes.
Ed: And end up with zero at the end of the day.
Ed: I’ve always thought it was a good idea to have these tax-qualified plans for the licensed professionals and not draw a W-2 till the end of the year.
Chuck: Right. Because it forces them to think about–
Ed: To think, “Wait a minute, I don’t–” The spouse or significant other says, “We need X, Y, Z.” “I’m going to have to borrow to get that.” “What do you mean borrow?” “I don’t get paid until the end of the year.”
Chuck: Right. Exactly.
Ed: Oh, it’s a great cushion. The spouse doesn’t buy a bunch of horses.
Ed: We’ve seen that. Let’s horse around, but they didn’t mean horse around. They mean really buying horses.
Ed: Or a sailboat.
Ed: The hole in the water into which you throw money. But we see these activities and I’m not sure the result. I wish I had a better feel for the psychology of all this. They’ve worked so hard to get to where they are and they dissipate the funds.
Ed: I have trouble–
Chuck: They always figure there’s more where that came from.
Ed: I suppose.
Chuck: My dad had this expression. There’s $1,000,000 in your back. The expression and the idea is as long as you’re capable of working, then you’ve got the ability to make the money that you just spent.
Ed: Right. I don’t get it, but that’s okay. I was interested, I was talking to a colleague just yesterday about what’s occurring. He and his brother both went to the service to get the GI bill. His brother became a nuclear physicist. He’s a PhD and he’s a terrific lawyer. The comment was, “you know Ed, he calls me Eddie, which is the real.” By the way, on my social security application, I show Eddie because I didn’t think Edward was a very good name. But any event, he said, “We’ve lost the passion for an accomplishment that I’ve done myself.”
Ed: The handout. And what has that done to this country? We’re not going to go there.
Ed: The point is the idea of doing something on your own is a huge deal because you gain what’s called respect. Chuck, you can’t buy respect.
Chuck: No, you can’t.
Ed: The other folks we’d like to beat up a little bit here would be the committee members, the executive resource committee members for either the not-for-profit hospitals or profit hospitals and the listed companies. Let’s talk about the listed companies first. You populate the executives, populate the committee with people that are friends or whatever with this promise of X, thousands of dollars, $120,000 to $250,000 in fees. Are the members of this committee going to say, “No, we’re not going to give you a raise.”?
Ed: That is a conflict, I think.
Chuck: Oh yes, absolutely. I think particularly when you’ve got board members who are not who are not heavily invested in the company for which they’re sitting on the board. They really don’t have skin in the game. Their skin in the game is their director’s fees.
Ed: Yes, but those are deferred.
Chuck: I’m talking about the ones who aren’t deferring them.
Ed: Oh, yea.
Chuck: They’re getting cash. They are getting cash in hand. They want to have a seat at the table. They want to have that line on their resume that says that they’re a director of a big company often, a publicly traded company. They don’t want to lose all that privilege that comes with that. Here comes management and they say, “We have to get–” It’s very thinly veiled. You scratch my back, I scratch yours. Maybe the veil’s not there at all.
Ed: I’ll tell you two examples that support what you’re saying. I visited with a client who was on the board of a listed company. I said, “You’ve got this opportunity to buy this stock too as well.” “I’m deferring my fees.” “Why don’t you take the fees out as income and buy the stock and you then can margin the stock and own more?” “Oh no.” I said, “Wait a minute, isn’t that a better result? If you have the stock, you get voting control, you get dividends, you get base to step up at death, all these other things.” “Oh, no, I don’t want any risk.” You’re managing–
Chuck: You’re managing the risk for all the other shareholders.
Ed: Who’s working here? We get the same thing with the for-profit and with the not-for-profit hospitals. It’s, “I want to be on the board.” That’s funny. My view, be on the board so you can elicit on your CV, but on your obituary. Because you’re a big deal when you’re a ghost and you have 50 organizations that you served on board. Wait a minute did you own any stock in those organizations?
Ed: It was- Without skin in the game, you do not get non-conflicted independent advice.
Chuck: Yes, there are no unknown people sitting on those boards. Right?
Chuck: They’re always the hot shots in town.
Ed: The perceived to be hot shots, but you don’t want to look at the balance sheets because I’ve seen some, and I must tell you, you’re going to lease a car.
I think we beat up a lot of people today, Chuck. It’s your fault that we’re beating them.
Chuck: Blame me. I’ll take the blame. Yes.
Ed: But I also will tell you that you put money away, you can access it with good stocks, you become independent and you can have a little more fun.
Chuck: Oh yes! That is actually again, going back to the recommendation for these licensed professionals to involve in these deferred compensation plans, that is also part of the point. They become, I think better professionals because that gives them independence.
Ed: They have to worry about retirement.
Ed: Anyway, we’ve harped on this before, but I keep getting back to it as I see these conflicts, it seems like it’s one a week.
Chuck: Oh yes. It’s happening all the time.
Ed: Heads up, consider the source, and enjoy life.
Chuck: Sounds good.
Ed: Talk to you next time.
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