Commissions from suppliers are common in the sales world. Brokers rely on them for a substantial portion of their income, allowing them to charge clients less for their services. But these under-the-table deals between supplier and broker can also leave a sour taste in clients’ mouths. A good product, consumers might think, should be able to sell itself on its own merits without needing the supplier to grease the palm of the broker. Kickbacks hidden from clients seem even more unsavory. To the common consumer, kickbacks seem to game the system. But the reality may be quite the opposite, according to research by Marco Ottaviani, a professor of management and strategy at the Kellogg School of Management, and Roman Inderst, a professor at Frankfurt University in Germany.
While disclosed commissions can certainly affect a buyer’s confidence in a product, undisclosed commissions—also known as kickbacks—do not, precisely because of the lack of disclosure. “In a sense, we’re showing that commissions play a role because they induce the broker—who’s an intermediary in a sense between the sellers and the buyer—to respond to incentives coming on the supply side,” Ottaviani says.
Kickbacks are particularly sensitive to cost. The supplier with the cheapest product should be able to provide the highest kickback because that firm’s costs are lower. “As such, the advisor will have an incentive to push those cheaper products, and to sell it to more people, which is a good thing because that product should be sold because it is cheaper,” he adds.
While disclosed commissions can certainly affect a buyer’s confidence in a product, kickbacks do not—precisely because of the lack of disclosure.
Commissions Under Fire
That kickbacks could be beneficial for consumers challenges the conventional wisdom behind some recently proposed and implemented laws. The United Kingdom, for example, will require in 2012 that financial advisers forgo commissions when recommending investment products. Those fears have been partly exacerbated by the recent mortgage meltdown in the United States and elsewhere. Mortgage brokers hungry for commissions pushed unsuitable products on unsuspecting clients, many of whom defaulted years later when their interest rates reset. In another example, Minnesota now enforces a $50 cap on gifts to doctors from pharmaceutical firms.
For suppliers, kickbacks and commissions play a key role in selling their product, which is why most are hesitant to accept caps on kickbacks or disclosure of commissions. As a supplier, “if I compromise a commission, my product’s not going to be sold,” Ottaviani says.
Disclosure requirements or outright bans on kickbacks can have a chilling effect on cost-efficiency, Ottaviani and Inderst discovered. Together, they developed a model that encapsulated the relationships between buyers, sellers, and brokers, or the middlemen who link a seller with a buyer. Examples of buyers include a wide range of professions, from financial consultants to doctors to insurance agents. Very little research has been done on the role of commissions and kickbacks, but the few models that have primarily approached the issue from a demand-side—or buyer-centric—point of view. Ottaviani and Inderst took a different tack, studying the dynamics of commissions and kickbacks from a supply-side perspective, or how financial incentives affect the companies selling the products.
The buyers in Ottaviani and Inderst’s model have a choice of two products to sell. These two products differ in suitability, and it is up to the broker to match the buyer with the most appropriate one based on private information, or information unknown to the buyer. An unscrupulous broker in these circumstances would be free to make recommendations based solely on the size of commissions, but Ottaviani and Inderst modeled a more realistic scenario where brokers are concerned about meeting the needs of the buyer. Their concern may be for the well-being of the client, they may be acting in the interests of repeat business, or they may be afraid of punishment by regulators or professional associations should they offer bad advice.
Breaking the Tie
Ultimately, commissions still rule. “What really determines the broker’s advice is the difference between the commissions of the competing firms,” Ottaviani says. “So competition in commissions results in a race to the top—an increase in a firm’s commission induces the rival to further increase its commission.” Two companies offering the same commission on a product are given equal consideration by the broker, regardless of whether the commission is $1,000 or $10,000. “To steer the broker’s advice toward its own product, a firm must first undo the bias induced by the commission set by the rival firm,” he adds.
These compensation practices have differing effects on suppliers and buyers. While commissions and kickbacks can lower brokers’ fees for buyers—a positive outcome—they also reduce buyer confidence in a product—a negative outcome. On the supply side, commissions and kickbacks encourage brokers to sell products that have lower costs because the financial incentives associated with those products can be higher than those associated with a more expensive product.
When brokers are required to disclose the commissions they receive, Ottaviani and Inderst found, commissions for all products are reduced. Firms do not want their products to be perceived by consumers as inferior, necessitating incentives to entice brokers. But the commissions on cheaper products—which are typically higher before disclosure—drop more than commissions on more expensive products. Since brokers care more about the difference in two commissions than the actual amount, they do not have as large an incentive to push the cheaper product. Consumers, suppliers, and the market suffer.
When commissions and kickbacks are capped, sales of the more cost-efficient product also suffer more. This is due in part to the fact that commissions provided by the low-cost provider are generally too low relative to those of the high-cost provider. “The difference in commissions is an underestimate of the difference in cost,” Ottaviani says. In other words, the low-cost provider is pocketing some of the difference in commissions as profit.
Reputational Concerns Are Key
Ottaviani and Inderst’s main finding applies in many cases where commissions and kickbacks are involved, but not all. The actions by disreputable mortgage brokers in the run-up to the financial crisis is a good example. They pushed unsuspecting homeowners into arcane mortgages that they could not afford a few years later. Such brokers may have been in the business for a quick buck, and thus were not concerned about their long-term reputation. The paper’s model accounts for such situations, Ottaviani says, and draws a different conclusion for such circumstances. “If there’s a situation where a broker’s future reputation does not matter, then disclosure is actually good policy.”
Yet in most cases, brokers do care about their reputations. Word of mouth, repeat business, and genuine concern for the customer are concerns that influence their decisions in the real world. Doctors, for example, have an interest in the health of their patients, and thus try to refer patients to the specialist who can best treat them. Ottaviani and Inderst’s model works under those assumptions, and as such can inform real-world policy decisions about commissions and kickbacks. “Policies that chill commissions through mandatory disclosure or bans may have unintended consequences,” Ottaviani and Inderst write. The result may seem counterintuitive, but “having supply-side competition through commissions adds efficiency,” Ottaviani concludes.
Related reading on Kellogg Insight