Working with Advisors

Jason writes in to ask:

I met with an investment counselor at my bank. I liked him personally, and he was very respectful of my investment goals.

He came up with a portfolio of five different American Funds offerings–a mix of domestic stock, international stock, and bond funds. The downside is that American Funds requires me to pay an up-front fee equal to 3.5% of my investment.

I’ve read about the advantages of index funds, which I can purchase cheaply through an online brokerage. I am leaning toward that type of strategy, but can online discount brokerages advise me on how to use index funds to put together a portfolio? Or will I be on my own? Or is there somewhere else I should seek advice?

Avoiding Commission-Paid Brokers

American Funds are definitely not the worst thing a person can invest in. That said, I’d generally recommend staying away from sales-loaded mutual funds and the brokers who sell them.

For example, based on Jason’s statement that he’d be paying a 3.5% sales load, it appears that we’re talking about an amount between $100,000 and $250,000. That means that, at a minimum, he’s looking at an up-front cost of $3,500 for this advice. You can get a good financial plan for significantly less than $3,500.

Separating the Advice from the Transaction

Jason raises a good point about discount brokerage firms: They generally don’t offer financial advisor services.

But that’s fine. In fact, even if your brokerage firm does offer such services, I’d generally steer clear. As I’ve mentioned before, brokerage firms have a vested interest in getting you to do what’s profitable for them, rather than what’s profitable for you.

As such, I think it’s usually a good idea to invest with one company (a discount brokerage firm of your choosing) and get your advice from a different company. In my opinion, hourly-fee advice from an independent advisor is the least-biased available.

Exception: Vanguard CFPs

There is one noteworthy exception to my suggestion to avoid advice from your brokerage firm: Vanguard. Vanguard has CFPs on staff who can help with managing your portfolio.

There are two reasons I’d be far more willing to accept investment suggestions from Vanguard than from any other brokerage firm or fund company:

1. As we’ve discussed before, Vanguard is (indirectly) owned by clients, so there’s not much of an incentive for them to recommend anything other than what they believe is best for you.
2. Their funds are always among the cheapest in each category (especially if you request that the CFP stick to index funds).

Also, the price is quite affordable:

• For people with accounts of $500,000 or more, the service is free.
• For people with accounts between $50,000 and $500,000, it costs a flat $250.

For people with less than $50,000, it costs $1,000, though in most cases a portfolio of less than $50,000 shouldn’t be terribly difficult to manage on one’s own.

My understanding is that it’s a relatively basic plan–not as comprehensive as you could get by sitting down with an independent CFP, for instance. Though at $250, that’s still a bargain. At $0, well, that’s even better.

April 4, 2011 5 comments

One thing I’d suggest doing before enlisting the services of a financial advisor is getting a copy of the advisor’s Form ADV.

Form ADV is a document that Registered Investment Advisers (RIAs) are required to file with either their state or with the SEC. It’s broken down into two parts.

ADV Part I includes:

• Identifying information about the firm,
• How many clients they have,
• Total amount of assets they manage,
• Whether or not they’re a broker-dealer or a registered representative of a broker-dealer (That is, are they paid commission to recommend certain investments?), and
• A whole list of other (less interesting) tidbits.

ADV Part II includes (among other things):

• What type of services they offer,
• How they charge their clients (hourly fees, percentage of assets under management, fixed fees, commissions, etc.),
• What type of analysis they perform when selecting securities for a client, and
• The RIA’s education and career background.

Finding an Advisor’s Form ADV

There are two ways to get a copy of an RIA’s Form ADV:

• Look it up online, or
• Ask for it –they’re required to give it to you.

If you look it up online, you can search by name of the firm or by name of the advisor. Unfortunately, RIAs aren’t currently required to submit Part II electronically, so you’ll have to ask the RIA for it.

Note: If a financial advisor doesn’t have a Form ADV, that means that he or she is not a Registered Investment Adviser. It’s likely that this person is either a commission-paid stockbroker or insurance agent, in which case my suggestion would be to look elsewhere for advice.

How About an Example?

It would surely be useful, but I don’t have the heart to make an example of an RIA whose Form ADV sets off all kinds of red flags. Instead, let’s take a look at an RIA whose ADV shows pretty much everything I’d look for.

Dylan Ross is an RIA and CFP who regularly reads and comments on this blog. His ADV Part II is publicly available on his website. From it, we can see that:

• He charges hourly or fixed fees rather than commissions or AUM fees (and if you scroll through to Schedule F, you can see the specific fees for each service),
• He counsels clients on long-term investing rather than short-term trading,
• He provides advice in the areas of cash flow, debt management, risk management, college funding, retirement planning, estate planning, tax planning, asset allocation and investment selection.

And we can see the following about his investment selection process:

“Adviser believes that the appropriate allocation of assets across diverse investment categories (e.g. stock vs. bond, foreign vs. domestic) is the primary determinant of portfolio returns and critical in the long-term success of one’s financial objectives; therefore, Adviser advocates the use of passive, low-cost, broad-market index investments.”

Why Not Just Ask?

Wouldn’t an RIA would be willing to share any of the above pieces of information if you asked? Yes, almost certainly. Still, I’d suggest getting the official documentation for two reasons:

1. It may call your attention to a potential red flag that you would not have thought to ask about, and
2. It doesn’t allow for any wiggle room. Rather than getting a carefully-worded answer that conceals an unpleasant piece of information, you get a check in a box: “yes” or “no.”

September 29, 2010 4 comments

If you’re paid to think something is a good idea, you probably think it’s a good idea. Even if it isn’t.

To use a personal example: I used to be paid to convince people to invest in relatively high-cost, actively managed mutual funds. Now that I’m no longer paid to do that, it’s clear to me that my recommendations were less than ideal. But at the time, I was absolutely convinced that such funds were the best choice.

If you want unbiased advice from your financial advisor, it’s essential to eliminate as many conflicts of interest as possible.

Compensation Based on Account Size

Many people claim that the best advisor is one who is paid as a function of your account size. It ties the advisor’s interests to yours…or so goes the claim.

What it really does is tie the advisor’s interests to your account size, not to your overall financial interests.

For example, imagine that you meet with an advisor who charges 1% of assets each year. You go to see him with a $200,000 portfolio and $50,000 remaining on your mortgage. If he convinces you to invest rather than pay off your mortgage, that’s an extra $500 in his pocket every year–regardless of whether or not that was really the best choice for you.

Or imagine a 70-year-old investor with a $500,000 portfolio, who needs to withdraw $30,000 each year. This investor is looking at a 6.00% withdrawal rate–higher than many people would consider safe, even for a 70-year-old.

In such a scenario, a single premium immediate annuity might make a lot of sense. If the investor buys single premium immediate annuities with $400,000 of his portfolio, he could (currently) get a payout of 6.2%, thereby leaving him with a (somewhat) safer withdrawal rate of 5.2% on the rest of his portfolio.

But if he’s using an advisor who charges even 0.5% of assets, the advisor stands to gain $2,000 each year by convincing the client not to buy the annuity. That’s no small incentive.

In short, how your financial advisor is paid has a lot to do with what advice he or she will give you.

Financial Planner vs. Investment Advisor

It’s useful to draw a distinction between financial planners and investment advisors:

If you want to pay somebody solely to manage your investment portfolio (i.e., you want a low-cost investment advisor), then paying based on the size of your account would make sense. Doing so would align the advisor’s interests to your own.

But if you want somebody to provide you with broader financial planning services, I’d suggest looking for somebody who charges an hourly fee, a flat annual fee, or fixed fees for a given service. This way, you don’t have to worry that your advisor is (even unconsciously) giving you less than ideal advice because it serves his own interests.

September 6, 2010 8 comments

The question of how to pay a financial advisor comes up frequently in personal finance literature. Typically, the discussion focuses on conflicts of interest and goes something like this:

• Commission-paid advisors have very large (perhaps insurmountable) conflicts of interest with their clients,
• Advisors who charge a percentage of assets under management have smaller, though still meaningful, conflicts of interest with their clients, and
• Advisors who charge hourly fees or who use a fee-for-service system have few conflicts of interest with their clients.

That’s all well and good, and I’d agree with such analysis. But I think there’s also something to be said for a simple common sense approach:

Is your advisor’s fee-structure a good match for the type of service he/she provides you?

Financial Advisors as Doctors

By way of analogy: You probably don’t pay your doctor an annual retainer. Nor do you pay an annual fee that’s a function of how much you weigh or how tall you are.

Most likely, you pay per visit. Why is that?

I suspect it has something to do with the nature of the service your doctor provides: an annual checkup, plus consultations when a specific need arises. In other words, most days, you don’t need your doctor to do anything for you.

The same goes for investing. From day-to-day, managing a portfolio requires very little work. And for many of us, that work can be almost completely automated.

That said, an unbiased advisor who can answer the more complicated questions and point out possibilities for planning is surely valuable. For example:

• Should you execute a Roth conversion this year? And if so, how much of your IRA should you convert?
• When should you start taking social security payments?
• Would it be wise to annuitize a portion of your portfolio in order to minimize the risk of running out of money?
• How should you draw down your accounts in retirement? Should you take money out of taxable, tax-deferred, or tax-free accounts first?

But the nuts and bolts of investing and portfolio management is simple:

1. Select an appropriate asset allocation.
2. Minimize costs.
3. Rebalance according to an explicit plan in order to keep your risk level where you want it to be.

Call me crazy, but I don’t see much need for ongoing help with that.

June 16, 2010 18 comments

I usually recommend that investors avoid commission-paid financial advisors.  The conflict of interests created by commissions is too great to overlook.

Of course, that still leaves several options:

• Advisors who charge a fee equal to a percentage of your portfolio,
• Advisors who charge hourly fees,
• Advisors who charge a flat annual (or quarterly) fee,
• Advisors who charge flat fees for specific services,
• Advisors who use various combinations of the above.

So how should you choose between them?

Consider Conflicts of Interest

Asset-based fees: Advisors who charge as a percentage of assets have an interest in keeping as many assets under their care as possible, even when that’s not in your interests (such as when you would be better served by liquidating some assets and paying down debt).

Also, there’s a conflict of interests to the extent that the advisor’s tolerance for income volatility is different from your tolerance for portfolio volatility.

Hourly fees and fee-for-service: Hourly or fee-for-service advisors have an incentive to “over plan,” that is, to sell you services that you don’t really need.

Flat annual fees: Advisors who charge flat annual fees have an incentive to “under plan,” that is, to do the minimum amount of work possible to keep you around.

Personally, I find the conflicts of interests caused by asset-based fees to be the most concerning, though I’d argue that each of the conflicts mentioned above is far less significant than those involved with commission-paid advisors.

Which One Costs the Least?

An advisor might try to convince you that a fee equal to, say, 1% of your assets is a good value because he (or she) will be able to help you improve your returns by more than 1% per year. Such advisors may be correct about their ability to improve returns by helping you avoid mistakes, minimize taxes, and so on.

But that does not necessarily mean that the fee is justified.

If you’re able to find a low-cost advisor, one whose advice is every bit as good and whose fee would only total, say, 0.5% of your portfolio, wouldn’t that be preferable to using the advisor with the 1% fee?

The value of financial advice is not the degree to which it will improve your results. As with every other good/service produced, its value is the lesser of:

1. Its benefit to you, or
2. Its replacement cost–how much you would have to pay another provider for a similar service.

In other words, be sure to shop around!

January 27, 2010 15 comments