Wells Fargo and Unchecked Incentives
Wells Fargo was hit with a $185 million fine Thursday for widespread illegal sales practices that involved opening over 2 million fake accounts without customers’ knowledge. The U.S. Consumer Financial Protection Bureau’s $100 million portion of that fine was the largest ever in the agency’s five-year history.
The CFPB said Wells Fargo “terminated roughly 5,300 employees for engaging in improper sales practices.” That’s not exactly an isolated incident. It’s the result of a systemic problem with Wells Fargo’s incentive policies for those employees. I’m not condoning the actions of these former employees, but when 2% of a company this large is fired for fraud it is clear this is not just a few bad eggs. There are cultural issues that need to be addressed.
I worked for Wells Fargo for seven years as a portfolio manager, and have fond memories of my time there. While I wasn’t in a sales role, the company’s cross-sell culture and long-standing goal to get the average product count per customer to eight were well known by all. Those employees with sales goals are pressured to meet certain incentive-based targets or risk losing their jobs. Although it hasn’t been specified, we’re probably talking about mostly bank tellers and customer service representatives here, not salespeople. Their only job should be servicing your banking needs, not pushing you into products you don’t want or need.
But perhaps one of the most corrupt incentive systems in the financial world is that of the commission-based financial advisor. Whenever you incentivize one behavior over another you are going to get more of it. This is why this type of financial advisor doesn’t often put their clients’ interests first. If they are going to get paid a 7% commission to put you into an annuity, then an annuity is what they are going to try to put you in. If a structured CD offers them more compensation than the traditional CD you wanted, you will be pushed in that direction. For investment accounts they are compensated for generating trading commissions. This often leads to “churning”, or making frequent trades in a portfolio that do nothing to meet the client’s objectives but do quite a good job of lining the pockets of brokers.
Working in the Portfolio Services Group at Wells Fargo, we provided fiduciary investment management for a fee based on a percentage of assets under management. We often tried to get brokers (they were called “financial consultants” at the time) to direct clients to us when they wanted discretionary wealth management, as our services were the best suited to meet those needs. We failed in this endeavor for years because they could get paid more selling their clients other products. It wasn’t until we offered to pay them 120% of the fee to their grid that we started getting any traction. If you want brokers to do the right thing for their clients, they need to be paid the most for doing just that.
Another form of incentive compensation is found in the hedge fund world. Here, the industry standard is 2/20 (that is 2% of assets under management plus 20% of gains). While the overall fees are high, it would seem the 20% on gains would align the manager’s interests with making as much money as possible for their clients — a good thing, right? The problem is this works as a sort of call option. They make extra money for gains, but there is no additional penalty for losses. This can incentivize a manager to take increasingly greater risks if they are at a loss for the year. Additionally, these funds often have high-water marks, meaning their target doesn’t reset every year and they must make gains beyond the highest value the fund has ever hit. This also sounds good, but in practice if the high-water mark is too high a hedge fund will often close the old fund and simply open a new one.
A fiduciary investment advisor, on the other hand, typically charges only s reasonable fee (e.g. 1%) that is based on a percentage of assets under management. If the account grows, they make more money. If it loses value, they make less. It is usually tiered as well, with larger accounts being charged smaller percentages at the margin. This is a fair approach, because while managing a larger account might not necessarily be more complicated than managing a smaller account, the liability the manager takes on and the magnitude of the impact of his decisions certainly are.
Whether you are dealing with a financial advisor, a real estate broker, or even a mattress salesperson, it’s a good idea to understand how they are incentivized and if those incentives align with your best interests. And if you are establishing incentive programs for your employees, take the time to imagine what the unintended consequences of those incentives might be.