In “All the President’s Men” – the famous movie about Watergate – Bob Woodward’s source tells him to “follow the money.” By finding out who paid who, the source tells Woodward that he should be able to run down the scandal, and find how high it goes. Incentives and payments matter. They mattered then, and they still matter.

Photo: 401k Calculator. Source: Flikr. CC BY-SA 2.0

Incentives especially matter when it comes to professional services. Professions like law, medicine, accounting, or engineering serve a larger public good. It’s in everyone’s interest to have safe buildings, a healthy population, and a fair legal system. When we know that we can get unbiased legal advice, contracts are honored, and the economy runs more smoothly. The same holds true for medicine, finance, and accounting.

Professionals need to be paid for their services, and clients should know how their lawyers or accountants get paid. Professional fees are typically transparent and straightforward. We run into trouble, though, when clients aren’t told about side deals or special arrangements.

Caribou locking horns. Photo: Jim Winstead. Source: Animal Photos

For example, a real-estate lawyer might suggest an estate attorney to an elderly client. If the referring lawyer receives a finder’s fee or some other consideration, that can be a problem. If I ask my lawyer for a recommendation, I want a recommendation that fits my need, not one that’s made because the lawyer gets an extra payment.

In medicine, if a doctor orders additional tests and earns something extra from this recommendation, the patient needs to know. People should be informed when the advice they’re getting is promoted by incentives. And it can be too easy for people in a position of trust to take advantage of their special position.

This can be especially true in financial services. Finance plays a critical role in modern life. Well-functioning capital markets allow corporations to fund themselves, combine with other firms, spin-off unrelated businesses, and ordinary people can put their money to work. But people need to know if the advice they’re getting is biased. It’s easy, in finance, to mask incentives with obscure references: strategic partnerships, soft dollars, securities lending, fees with SEC rule numbers, and so on. The advice we receive is often colored by conflicts of interest.

Photo: Jan Fidler. Source: Morguefile

For example, if a middle-aged worker asks a financial advisor how to invest their savings of $250,000, many advisors will face a challenge. If the advisor builds a comprehensive plan and manages the assets under a fee-only approach, they’ll earn about $600 in three months. But if the advisor sells a certain type of commission-based product, they might receive a $15,000 commission payment in a few weeks. Generally, financial planning and an ongoing relationship are better, in the long run, for both the client and the advisor. But the incentive structure makes this difficult.

The best disinfectant is sunshine. Clear and complete disclosure makes the cockroaches run for cover, and hopefully stay there.

Things get done in our economy because people want, largely, the same thing: growing businesses that provide efficient, effective service; products that don’t break down or hurt us; more time to pursue our personal interests or spend with our loved ones. If we keep the lights on, maybe the pests will stay away.

When we follow the money, we find out what the incentives are. It’s never rude to ask your advisor how they’re getting paid. When clients know where you stand, they can best decide what they want to do with their business. Where you stand often depends on where you sit, and who’s paying for your chair.

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