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SJan 27, 2010

It Helps to Understand Brokerage Economics

Scott Burns

Q. How does one go about setting up an IRA consisting of the Couch Potato funds or another low-expense portfolio? Most financial advisers are at least as interested in their own revenue as they are their clients’. They are not particularly interested in holding an account that isn't generating them "decent" revenue. —G. E., by email from Georgetown, TX

A. It’s pretty easy. Open an account with a low-cost firm. Arrange for them to transfer your assets from your expensive account to your new account. This may require some asset sales, depending on what’s in your account. But you can’t make an omelet without breaking eggs, and the “payback” in lower expenses should be very fast.

Lots of people in financial services send me angry notes, asking whether I expect them to work for nothing. I don’t. You shouldn’t either. So don’t expect a broker or other commissioned salesperson to build a portfolio for you out of Vanguard funds or low-cost ETFs.

The reality is that typical brokers get a payout of 40 to 50 percent of the commissions they generate. Worse, the major firms penalize “underproductive” brokers by reducing their payouts well below that. So brokers are under enormous pressure, and it’s all going to be applied to YOUR money.

Some well-established brokers— those with a “big book” of business— may have enough assets in accounts that they can generate less revenue per dollar invested, but they are rare. More important, they have to choose to generate less income when they are surrounded by a tough competitive culture where all the bragging rights are about “production” and take-home pay.

That leaves you and me with a simple choice. We can accept what comes with their world— high expenses, Wall Street hazards, and trading urgency— or we can choose the calmer, simpler, and low-cost path of index investing. It also means that we’ll never have a top-performing mutual fund or stock. We’ll also never have a complete bomb. We’ll simply have to accept an “average” return.

But don’t be misled about “average return”— it is a return that the vast majority of investors never achieve, whether they are advised by a broker or haplessly choosing hot stocks or hot funds for themselves.

Q. Your recent article concerning the need for life insurance made me start thinking about my situation. My age is 69, and I am paying on three insurance policies. One for $20,000 with a cash value of $5,500, another for $35,000 with a cash value of $8,500 and one for $10,000 with a cash value of $3.000.

I currently pay a total of $90 a month, of which $81 goes to the premium and $9 to the cash value. The interest paid on the cash value is 4.5 percent. The problem is that as I age, the premiums increase. And at age 70, my cash value will start decreasing. It will be wiped out by age 83.

I realize the odds are that I will not live to the age of 83, and my grandkids will benefit if I continue to pay the premiums. After reading a recent column, however, I thought maybe I am looking at this the wrong way. Maybe I should cash out and invest the money in some ETFs and deposit the $90 a month into my TDAmeritrade account instead of the insurance companies. Am I missing something? —C.S. by email from Irving, TX

A. The most important question here is whether someone you care about will suffer financially if you die without $65,000 in life insurance. If someone depends on you for day to day financial help, you need to keep the policies. Indeed, you should be contributing more premium money so you can avoid large policy expenses when you are much older.

But if there isn’t a need for $65,000 of death benefits at some time in the future, you could invest $17,000 for the future and use the monthly premium dollars for something that was fun, like trying margaritas with strange names.

The important thing to remember is that the cash value in your policies is, in effect, a trust fund for your insurance company. The cash value assures the insurance company that the rising premium costs will be paid for years— 13, according to your reckoning. It’s only reasonable to do that if you have a permanent need to provide a particular sum of money to a beneficiary upon your death.

Filed Under: Income Investing, Q&A (from print)