by Archie M. Richards, Jr., CFP^®
October 18, 2004

Be wary of broker conflicts of interest.

Peggy has an IRA of $40,000 and a regular account of $160,000. A review of her investments reveals several problems:

1. Every one of her 15 mutual fund holdings is Class C shares.

   Mutual funds sold by brokers incur selling costs that are deducted from the account. The client can choose the commission arrangement. With Class A shares, the commission is a one-time payment, deducted up front. For investments up to $25,000, the fund in which Peggy has the largest interest charges 5.25 percent. The percentage falls as the amount of investment increases.

   The fund also assesses an annual operating charge of 1.3 percent.

   Let's say Peggy invested $10,000 in Class A shares. After paying the 5.25-percent front end load, $9,475 goes to work. Assume the investments gain at 10 percent a year. This is reduced to 8.7 percent by the annual 1.3-percent operating charges. In 10 years, she'd have $21,821.

   But Peggy bought Class C shares instead. The broker still receives a commission up front. The mutual fund organization pays this with its own money and is reimbursed by annual charges of 1 percent a year from the account. These charges, called "distribution fees," continue indefinitely. The broker can say that no commissions are charged. But he says it with his fingers crossed, because the 1-percent charges are actually commissions under a different name.

   Okay, with Class C, $10,000 goes to work in the fund. The 1-percent distribution charge and the 1.3-percent operating charges total 2.3 percent per year. The net annual gain is 7.7 percent (10 - 2.3). In ten years, Peggy would have $20,997.

   With Class A: $21,821. With Class C: $20,997. She'd end up with $824 less.

   Brokers usually suggest Class C to allow for the possibility of selling the fund and buying another. After two years, the total distribution charges would be only 2 percent, a savings from the 5 percent Class A charge. But when another mutual fund is bought, as is often true, the extra 1-percent Class C charges continue indefinitely.

   In the long run, Peggy would make more if she'd bought Class A and held. If Peggy is elderly and has a good chance of needing the money to spend, Class C might be justified. Otherwise, she should buy Class A and not bounce around.

   Better yet, she should buy no-load funds with no broker and no commissions.

2. Another problem: Peggy holds too many mutual funds that have the same objective. In her regular account, for example, she has three mutual funds of large value stocks. This isn't genuine diversification. But it does raise the broker's income. If Peggy's three large-value mutual funds, for example, had been combined into a single Class A investment, the total would have been big enough to cut the front-end commissions below 5.25 percent, reducing her costs.

3. Peggy told me that when the market weakened and the value of her investments declined, she called her broker. In my opinion, this was a mistake. Brokers know no more about future prices than the rest of us. Calling them after the market has declined simply offers them a chance to recommend changes.

The broker recommended that she sell $50,000 of the mutual funds, half from the IRA and half from the regular account, and invest in a variable annuity. This was a poor recommendation. Here's why:

• Most variable annuities have high commissions and high costs.

• Placing IRA money in a variable annuity is foolhardy. Both IRAs and variable annuities provide tax advantages. Having two sets of tax advantages is unnecessary and increases the costs.

• Variable annuities generally provide a guarantee that if the account is down when the owner dies, the insurance company will refund the loss. This guarantee is unlikely to be used. Two-thirds of the time, the market stays the same or rises. Just because the market had fallen didn't mean it would fall more. Peggy was unlikely to die at the very time the market had gone down further. The money paid to refund the insurance company for the guarantee would probably have been wasted.

Brokers have serious conflicts of interest. Be wary.