Don't give your broker a free loan

By Michael Brush

Being in the market isn't the only place you can lose money on your investments.

Take your money out of stocks and you're likely to lose as well. That's because many brokerage firms will pay you 1% or less on your idle cash, while they invest that money to earn a 5% return.

Think four percentage points doesn't matter with your spare investment dollars? Think again.

• TD Ameritrade Holding (AMTD, news, msgs) pays just 0.1% on cash balances of up to $5,000 if you don't ask them to give you a better deal. For cash balances up to $25,000 they pay just 0.4%. Up to $100,000 they pay 1.65% -- even though the going return on money market mutual funds is around 4.8%. Ameritrade gathered $185 million in revenues by paying clients so little on their idle cash and then "sweeping" it into an account run by a banking partner, where the money earned Ameritrade a much higher rate. On average, clients held $5.7 billion a day in cash during Ameritrade's last fiscal year, which ended Sept. 30.
• E*Trade Financial (ETFC, news, msgs) pays the same as Ameritrade for the first two tiers, but for cash balances between $25,000 and $100,000 it pays out only 1%. On average, the broker paid just 0.87% on the $10.3 billion-a-day average that clients kept in brokerage accounts in the third quarter of 2006.
• Charles Schwab (SCHW, news, msgs) pays around 1% on cash balances if you have up to $100,000 in assets, unless you ask them to do better. It pays around 2.6% if you have more than that. Overall, Schwab paid clients 2.56% in the third quarter of last year. Schwab earned about 5.1% and pocketed the difference.

The brokers say it's not their fault because they tell customers that they have options. "We really like having this conversation with our clients and educating them on what they can earn on their cash," says Sarah Bulgatz, a Schwab spokeswoman.

The problem is that you actually have to tell your broker that you'd like to earn a higher rate on your cash. And you didn't have to in the past. Before Merrill Lynch (MER, news, msgs) started the sweep account trend by rolling them out in 2000, brokerages typically parked cash in money market mutual funds which paid around 5% in the late 1990s, says Connie Bugbee, managing editor of iMoney.net.

A hard habit to break

So far, regulators haven't said much about sweep accounts. The best any have done is to issue a warning -- in the form of a report called "The Cash Sweep Account: What Deal Are You Getting?" from the New York Stock Exchange. And if regulators don't show their teeth on the issue -- either through investigations or penalties -- don't expect the brokers to change their policies.

That $185 million that Ameritrade earned last year by reinvesting client cash, for example, accounted for 10% of revenue. It contributed 21% of the company's $526.7 million in net income last year, if you adjust the $185 million down by the company's 38.5% tax rate.

"They are paying 1% for the money, and they are lending it out for considerably more. It's a great business," says Bugbee, of iMoney.net. And with competition heating up in the area of cut-rate commissions -- Bank of America (BAC, news, msgs) recently began offering free stock trades to customers with more than $25,000 in deposits -- this source of cheap funds is more important than ever.

Sweep it back

So, no surprise, the brokers are taking advantage of their customers. To help you fight back, here's a quick primer on how to make sure it's not happening to you at some of the larger discount brokers.

Charles Schwab

Schwab clients can elect to sweep excess cash into money market funds which recently paid an annual yield of 4.73%. The initial minimum purchase is $2,500 but after that the minimum is $500. Clients can move cash back out of this instrument after one day without penalty. Customers can also get similar rates with other instruments like certificates of deposit, if they are willing to lock the money up for a few months.

E*Trade

E*Trade customers can sweep brokerage account cash into a bank savings account that currently pays over 5%. There are no minimums and no restrictions on how long the cash has to stay in the savings account. Customers can also choose to have idle cash moved into a money market fund paying 4.2%. The minimum balance you have to keep is $1,000. As with Schwab, though, it's not the default option for idle cash.

Ameritrade

At Ameritrade, if you have $100,000 in assets in your brokerage account, you can earn 4.4% in a money market fund with an initial purchase of $5,000 and a minimum balance of $2,000. The brokerage may relax the $100,000 cutoff in some cases, a customer rep says.

The brokers don't think you're going to do anything about this. Ameritrade told analysts the profits on sweep account cash will reach $515 million or more in fiscal 2007.

At the time of publication, Michael Brush did not own or control shares of companies mentioned in this column.