Race to the Bottom

According to Wikipedia, today’s title relates to a governmental decision to reduce regulations and taxes in order to attract business to its jurisdiction. Often attributed to Justice Louis Brandeis, the concept has been around since the late 1800’s. For a more current example, Kansas City straddles the Missouri/Kansas line, so each state has regularly offered competing incentives to draw businesses (and their associated tax revenue) to its side. The Hall Family Foundation (founders of Hallmark cards) estimates that between 2011 and 2019, 116 companies received around $335 million in incentives, not for creating new jobs, but for moving one way or the other. Fortunately, the beginnings of a truce began to take shape this past summer.

The investment-oriented website Investopedia notes that the phrase can also be applied to a business which tries to draw more customers by undercutting its competitors’ prices. Presumably the business initiating the price-cutting hopes to be the last one standing when the race is finally over. Those with long memories may remember that this approach didn’t work out so well for the once highly-successful A&P grocery chain.

And how does this relate to financial planning? I have written about this general topic before but this time there’s a new twist. Charles Schwab, the original discount brokerage company, recently dropped its commissions for most trades all the way to zero and most competitors followed suit. What could possibly go wrong? Well, for starters, Schwab’s announcement was greeted with a 20% drop in its stock price, and a similar response echoed through the share prices of the other new ‘zero commission’ brokers.

So why are the firms cutting prices and what does this particular race mean to investors? How is charging nothing for a service that’s had a cost associated with it since 1792 even possible? Remember, Robert Heinlein warned us in his book The Moon is a Harsh Mistress, “There ain’t no such thing as a free lunch”. How will the brokerage companies continue to survive?

Wall Street Journal columnist Jason Zweig recently reported that brokerage firms make a considerable amount of money on the difference between the interest they pay on money market fund balances and what they earn on those deposits. And there are other ways they make money too. One was invented by the investors’ friend, Bernie Madoff. It’s called ‘payment for order flow’. It’s a fee brokerage firms receive for routing their buy & sell orders away from the stock exchanges. The Securities and Exchange Commission requires all brokerage firms to provide best execution for their clients, so each should always be shopping for the best possible deal when a customer wants to sell or buy. Hopefully fees like payment for order flow won’t result in customers ultimately paying more or receiving less.

However, brokerage company profits must come from somewhere and I can’t help but wonder how well Schwab and the others are doing for their customers in this new zero-commission world. Another SEC rule requires that brokerage firms monitor their trade pricing under the National Best Bid Offer rule. WWA uses TDAmeritrade as broker for the assets we manage for our clients. Per the most recent audit, they executed over 98% of orders at a better price than what’s required by the SEC. It might be worth asking your broker if the firm she or he works for is doing as well.

You may be a bit anxious about whether brokerage companies could end up joining A&P in bankruptcy, stranding their customers’ assets. Fortunately, that’s not likely to be a problem. All of the major firms are comfortably solvent and investors are further protected by government-mandated SIPC insurance.

These zero commissions might seem like a big deal but WWA’s clients will not be significantly impacted by the trend. Why? Because we are investors, not traders. While we review all of our clients’ accounts regularly, we react very deliberately to what we learn and try never to respond to a headline bearing either great or terrible news. We believe that broad diversification is an investor’s friend and, combined with thoughtful rebalancing, it will serve most people best.

If brokerage commissions are at zero, can financial planning services be far behind? When I last wrote about this topic, I did a search for ‘Free Financial Planning’ and was rewarded with 410,000,000 links. It appears that the cost of planning services may have fallen too. As I write today’s article, the same search provided 633,000,000 results. Might those services prove to be worth more than their cost? For the providers to remain in business to serve their customers, they have to make a profit at something, often the sale of insurance products. At WWA, we bill our clients clearly for our planning and investment services. That may or may not make us a better choice but hopefully it does make it easier for our clients to determine the value we provide.