Monday, June 20, 2011

Follow the Money

That suggestion is often applied to crime investigations, fictional or real. I suggest it should also apply to understanding the basis of someone’s argument. To judge whether someone’s advice is unbiased and independent it is important to recognize how that person receives compensation.

Here’s an example in which I had personal involvement. In the late 1980s I switched consulting firms from one that took no commissions to one that accepted commissions as payment for some services—mostly involving health care, disability and life insurance. For some clients our total compensation consisted of the commissions paid by the insurance company for placing the business. For others, we offset our normal fees by the commissions we received. Either way, at least annually we disclosed to each client the commissions we received based on their policies.

Except, it turns out, we didn’t. Some insurance carriers paid our company “bonuses” once we reached certain volume targets. That meant that if the premiums by all of our clients paid to XYZ insurance company for a year exceeded (say) a million dollars, the insurance company would pay us a small percentage of the overage. These override commissions were never disclosed to affected clients. Once I became aware of this issue I got our reporting changed so an allocable portion of these override commissions also showed on client statements.

That, however, didn’t end the internal discussion. Remember, I had come from an environment where clients paid for our advice based on time spent plus expenses, not commissions. Consultants who took no commissions claimed that they were totally independent and served only in their client’s best interests. I fully subscribed to that thinking. Now I was working for a company who might be paid more or less for the same work depending on which insurance carrier we recommended because commission rates differed between insurance companies and because of the possibility of additional override payments.

Oh, no, my new colleagues said, we’re totally independent too. Our clients choose whether to pay us in commissions or fees. I might have bought the argument until I discovered that my predecessor maintained monthly totals of business sold by each insurance carrier and at the top of each carrier’s column was the override level trigger for the year. That chart was distributed to the consultants, “for their information.” Oh, and consultants get personal bonuses based on how profitable their clients are. No conflict there.

In fact, many clients (human resources or finance, depending on the company) liked the commission basis of payment because it didn’t come out of “their” budget. Since commissions were included as part of the benefit cost, it was included in that budget line. Consultant fees were in a separate budget line. In fact, all things equal, some clients liked very high commissions because we offset those commissions against our total fees. The higher the commission, the lower the net fee paid for consultants.

But wait—it turns out that if some of my buddies in the fee-only consulting business met “personal targets” set by the various insurance companies, those companies rewarded the consultants with trips to resort locations for beach, golf, tennis and schmoozing with the insurance company’s bigwigs. You betcha—no conflict there!

Throughout my career, wherever I worked, however we were compensated was the right way to provide the best service to clients. It’s not just my field of human resources consulting. Look at how a hospital is compensated, and you need not wonder why they encourage as much testing as possible. The same thing happens when doctors own the testing facilities—the utilization of those tests goes up.

Lawyers prefer to litigate rather than negotiate because litigation pays better.

Investment consultants, who used to be more honestly called brokers, working for Merrill Lynch and their ilk, are only paid commission when you buy or sell a stock or bond. Is it surprising that they recommend frequent changes to your portfolio? Or since they get extra bucks for selling their employer’s mutual funds, who is being best served when they recommend their high expense fund over a competitor’s lower-cost alternative.

Despite politicians’ denial, I am convinced that who contributes to their campaign makes a difference in their votes. If your family makes its living from mining, then I’ll bet you diminish the costs of ecological damage from mining relative to the benefits of “good” jobs. If you are an environmentalist living downstream from an oil shale field involved in fracking, then water pollution is a vital concern, the heck with the gas and oil produced.

None of us likes to live in cognitive dissonance. As a result we tend to see what we believe. It’s human nature. Therefore, to protect ourselves when we are getting advice or weighing arguments, it is important for us to distance ourselves from our own beliefs.

Even if we accomplish that no small task of independent evaluation, we must recognize that no one gives completely unbiased advice, and we must be wary of any claims made by those who have a stake in the proposition.

~ Jim