A few weeks ago I met with a financial “advisor” from an insurance company as a favor to my fiance’s friend.

The advisor works on a “referral basis”, which means he gets commissions from the products he sells. I know the game and how he works, so I tweeted about it. A follower tweeted back with a question that pertains to these folks in nice suits with fancy cars.

She asked me how these “advisors” get paid. Her question had to do with the retirement services an advisor in her area offered. Because that advisor represented an insurance company like the one I met with, I knew he was selling loaded mutual funds. Just so we’re clear, these advisors are not advisors, they are merely insurance brokers with a license to sell securities. Here is how I explained how loaded mutual funds work.

Loaded mutual funds are mutual funds that come with some extra fees on top of what you would pay for a “no load” fund. They are broken down into different classes in order to charge different fees appropriately.

A Shares – These shares typically have a front-end load. I’ve seen it as high as 575 basis points or 5.75%. In this case it is 2-3%. If you were to invest $1000 in this fund, you would actually invest $970, with $30 disappearing in fees. The management fee is often the lowest of the three share classes.

B Shares – These shares have no front-end fees. Instead there is a regressive back-end load, or deferred load. That is to say if you sold the fund after 1 year, you might pay 5%, after 3 years 2%, and after 5 years there is no load at all. The fees exist to deter investors from selling too early. Management fees are somewhere between A and C shares. After the period of deferred loads is over, the B-shares often convert to A-shares, to take advantage of the lower management fees. Say you were selling your shares after 3 years, in my example you’d pay $20 for every $1,000 you pull out.

C Shares – These shares often have no or little loads on either end, the buy or sell. If there is a load it is on the back-end, it is level. So if you sell within 5 years at all you’ll pay a 1% fee or something. Instead, the management fee is higher than the A and B shares. C-shares don’t convert to other classes.

Wait there’s a forth one!
There are secret shares as well. They are often hidden in the literature because few people have access to them. You might see them called “Q Shares”, “R Shares”, “Z Shares” or something similar. There are no loads, or fewer loads, and the management fee is less. You don’t often see these because they are for institutional investors, or people with high net worths.

Now let’s see who gets paid where on these. You’ve got two companies that you must pay, the broker (who calls himself an advisor), and the actual advisor (which represents the mutual fund company). For simplicity’s sake we’re assuming (and rightfully so) that the actual people representing the company get a cut of what the company receives.

The intricacies of every broker/advisory relationship will depend on the contract between the two, so I’m just going to make one up.

The broker will get all of the front-end load of A-shares. So when that broker says you don’t pay him anything that’s technically a lie. If you invest $1 million in some A-shares at a 3% front end load, you’re paying him a $30,000 commission (remember he likely just gets a cut of that, but it is a good cut). The actual advisor representing the mutual fund company will make their money with the management fees, which are often way too high for what you get, but that is a digression.

With the B-shares we know advisor will make it’s money on the management fees, but how does the broker pay the bills without a front load? The back end load of course! Once again we’ll assume the broker is getting all of the back end load. But what if they don’t sell early, won’t that mean the broker doesn’t get paid? No. Remember the management fee is higher in B-shares than A-shares. Depending on the contract, the broker will receive a recurring fee, AKA a trailer, for a set number of years after the initial sale.

Since B-shares and C-shares are structured similarly, you can imagine the payout is similar. You’d be right. Once again they would get that level fee if it’s sold early and the trailer from the management fee.

The secret shares with no loads on the front or back will also likely pay a trailer. Since you’re mostly dealing in more zeros and less percentage fees, the payout to the broker is similar to the A, B, and C shares.

Which ones are more profitable? That will always depend on the nature of the agreement between broker

and advisor. I can imagine though the broker probably prefers the A-shares because it’s money now.

In all honesty, anyone who has been investing with these brokers has been duped. These funds aren’t fantastic funds, and only a few gems exist in all of mutual funds that are actually worth any load at all.  Sadly, sometimes these are unavoidable. The brokers have the small business industry on lockdown, and so it’s hard to find other options. If you work for a small company that only offers this type of scheme, tell your HR person and owners about it. If you still have no other choice, pick the funds with the lowest fees and just do enough to get the company match. Put everything else in an IRA.

Non-LOL Cat photo credit: Victoriafee

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  By 		The Weakonomist is the founder of Weakonomics. Clicking the picture of the puppy will tell you more about him. If you like what you're reading consider subscribing to the blog, following him on Twitter, and checking out the related posts below. Please consider a donation if you really enjoy Weakonomics. Also keep in mind that nothing I say can be construed as financial advice.

categories: investing, personal finance