The role of Incentives and what it means for your Retirement

There is this famous skin Doctor in Bangalore whose clinic is thronged by patients all-round the year. Being famous generally also means that one gets expensive but it ain’t so here, the Doctor Consultation fees is lower than what any other specialist anywhere shall charge.

But there is a catch – you need to buy the ointment he prescribes at the Chemist shop next door. The chemist dispenses the prescription which can be split into two parts. One is the actual ointment, an as I have experienced, this is not one easily available elsewhere. Second is a cold cream which is manufactured by a very famous multi-level marketing company.

You buy both and go back to clinic where the Doctor’s assistant mixes the same, labels it and then goes onto provide you with the next appointment date. While the Doctor fees is generally small, the charge for the ointment is extravagant – especially the cold cream.

You by now would have clearly guessed how the Doctor can afford the small fee and yet earn big. Is this Illegal? Of course, not. He doesn’t really compel you to buy at the chemist next door but I have tried and failed at sourcing the ointment elsewhere, so where else would you really go.

Second, once you accept this as part of the fees, you are okay for your main criteria here is not about paying money but getting rid of the disease that afflicts you.

Is this ethically or morally wrong?

What about if the Doctor charged a much bigger amount as his fee but then recommending medicine that is more affordable and not limited to that one store. Would that change the dynamics for his patients?

Or, what if he charges a low fee but prescribes high cost medicine and gets compensated not by the Chemist but by the Pharmaceutical company by way of tickets to seminars in distant countries or just a direct cut from the sales of the said medicine. Would that make any difference?

Let’s move the discussion to the world of Finance

Stock Brokers for long have chased their clients in an attempt to get them to trade more – higher the trading, more the brokerage. This is of course not in the best interest of the client, but targets have to be met, incentives have to be lapped up – so who is really counting.

While brokerage rates have fallen, even today many a stock broker dealer (the guy who places the order on your behalf) is determined not by how faultlessly he handles the transactions but how much brokerage he can generate.

Don’t we all have an Aunty or Uncle who after becoming a LIC agent would pressurize one to buy a policy which while actually not serving our real needs would help the Aunty or Uncle meet his targets and collect his cut of the cake.

Introduction of Unit Linked Policies took this to an extreme and while the trend has reduced a bit thanks to curbing of how much the agency can pay as commission, the highest and the worst form of financial misspelling still lies in the Insurance Field.

In an attempt to incentivize its distributors to sell its funds, Mutual Funds offer two kinds of payments – Upfront Commission and Trailing Commission

Upfront Comission is paid for any funds received – be they lumpsum or SIP. They range from 1.5% at the higher end to 0.25% at lower end with the Median upfront commission being 0.65%.

Trailing Commission is the commission paid on the value of your investment. This is to incentivize the seller for helping the client stay with the fund. It’s also a kind of ransom paid to ensure that the seller doesn’t take his clients money out at the end of the first year to only re-invest & hence obtain the upfront commission.  This commission ranges from 0.75% to 0.25% with the median working out to around 0.50%.

Debt funds, a category of funds that invest only in Debt products with return comparable to Bonds on the other hand has way lower incentives. The incentives themselves depend on the product with Liquid funds which are favoured by corporates getting the least amount while Gilt and other longer duration products commanding a higher fee in recognition of the skills it takes to sell those.

“Show me the incentive and I will show you the outcome.” – Charlie Munger

Incentives aren’t just limited to the ones above. After all, when people complain that Tata Workshops don’t distinguish between the Taxi driver who is driving a Tata Indica and the owner of Tata Safari, Star Distributors cannot be satisfied with financial incentives alone.

A large mutual fund house for example takes its Star Distributors to Omaha to attend the annual pilgrimage that is the Berkshire Hathway Annual General Meeting. While the meeting itself is in recent years broadcasted live, there is a world of difference in attending it live versus attending it from the comfort of your room. Attending at the comfort of your own doesn’t give you the bragging rights compared to what you get when you attend it live.

It’s ironical that they are sent on a trip to Omaha given Warren Buffett’s own views when it comes to Investing. Speaking to CNBC, he said

“Consistently buy an S&P 500 low-cost index fund. I think it’s the thing that makes the most sense practically all of the time.”

How many advisors, whether they visit Omaha or not will dish out this advise to their clients? While its true that in the recent past, active funds have beaten the passive indices, with new changes, do you really think that they will continue to beat forever.

SBI ETF Nifty 50 is the largest fund out there thanks to it being the fund of choice for the Employees Provident Fund Organisation (EPFO). It is also the cheapest fund around and the one with the lowest tracking error.

Over a 3 year look-back, this fund is the 12^th best fund of 68 funds. Most of the 10 above this, the 11^th fund is its cousin – SBI ETF Sensex, we have only Axis Bluechip fund with almost all others ebing passive ETF’s.

Going further, I believe this trend will accelerate with more and more ETF’s and Index funds being in the top decile.

But ETF’s and Index funds have a problem – they are no one’s baby. So, regardless of the returns, barely any advisor will recommend the same to his clients. Over a 10 year period, the best performing large cap fund is Reliance ETF Junior Bees. Its AUM – a measly 515 Crores.

In the United States, this problem has been taken care of my Fee based financial advisors and wealth management firms who have succeeded in breaking the taboo of investing in simple and plain products. In India, you have better luck finding a needle in the haystack than finding a financial advisor who is fee based.

Fiduciary Duty: A legal obligation of one party to act in the best interest of another.

Fiduciary duty of an Investment adviser is similar in thought to the Hippocratic oath that requires a physician to uphold ethical standards. Keeping the objective of the client above oneself is the key trait of the Fiduciary duty.

Time and again, data has shown that Investors exit and enter markets at the worst possible moments. While one cannot time entry to perfection, when one exits in a panic, the reason is not just about loss of money but loss of confidence.

Mutual funds today are being pushed as the answer to all ills with all kinds of numbers floating around on what to expect. Rather than temper expectations which also leads to a better informed client, very long term historical numbers are used to suggest that one can expect to become rich by investing a very small sum today.

The primary reason for disappointment comes from unable to reach or beat estimations that one figured would be reached. When a product is sold with expectations of high returns, any deviation will result in the product being blamed rather than the message.

Recently I saw an advertisement from a fund distributor that saving just Rs.3000 per month could make one a Crorepati in 30 years assuming growth of 12% per year. There is nothing wrong perse with the above statement.

But what is missing and critical is the value of that 1 Crore, 30 years later. Can you buy what is worth 1 Crore today for the same price 30 years later?

In the US, over a 20 year period (1996 – 2016), tution cost went up by 200% even as general inflation itself went up by 55%. Quality education in India is becoming expensive by the day and given our inability to finance, we are ending up with students passing out of colleges without much of the knowledge and experience required by the Industry.

Tution cost for a two year post graduate degree from the Indian Institute of Management currently stands at 22 Lakhs. Add to this cost of living, cost of books, transport among others and we are quickly looking at somewhere in the 30 Lakh benchmark. Even assuming it grows at 6% per year, 30 years later, you shall be looking at something in the range of 1.75 Crores.

In the above advertisement, 12% return is the post expense return. What this actually means is that a regular fund has to generate 14.5% returns to get you 12% returns. Direct fund requires generating 13.5% returns while the ETF needs to generate just 12.10% returns to meet your 12% requirement.

What if instead, we assume that all funds can generate just 12% returns before expense. Assuming you were saving 3000 per month, what would you end up in the 3 different examples?

Even though the savings and the market returns were the same, the difference in returns is staggering. This is the act of “Compounding”. Returns and Fees both compound – one adds a positive flavour to your returns, another negative.

I am a strong believer in Active Investing and while Active Mutual Funds have had an exciting time, the days of strong out-performance vs the benchmark is more or less gone. The culprit may not be the rules as much as their own growth in assets which limits flexibility on what you can buy.

But that doesn’t stop funds from accumulating more and more for higher the AUM, higher the Income for everyone who is in the food chain.

Well, I think I’ve been in the top 5% of my age cohort all my life in understanding the power of incentives, and all my life I’ve underestimated it. And never a year passes but I get some surprise that pushes my limit a little farther – Charlie Munger

At the Intelligent Fanatics website, a case study was recently posted on the site with a lot of real life examples of how human behaviour was moulded by the wrong kind of incentives. From selling more loans to get meet the incentive plan (sell less than 80% of goal & you had no incentives awarded) to classifying orphan children as mentally disabled since the subsidy by the government was $1.25 per day for an orphan versus $2.75 per day for psychiatric patients.

If my reward to sell a particular fund was a free trip to Omaha, would I really be concerned about whether the fund suited the client or not?

If you are saving for retirement which is 20 / 30 years away, the savings from fee alone can make a huge difference. Remember, at 6% inflation, a Crore wouldn’t go a long way 30 years from now – you will need at least 30 Crores to make the nest count.

Market performance is not something you can control, on the other hand the cost you pay to achieve market returns is very much in your control. The question is, Will you Act?