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Fee-Only Financial Advisors Can Be Biased Too.

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.

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Comments

  1. Great post! Sometimes we forget that even with fee-only there can be a conflict of interest. It really is a good idea to always follow the money!

  2. I agree with Miranda – great post. Many people don’t make the financial planning/investment management roles distinction and therefore miss the conflict of interest. More single premium immediate pay annuities should be recommended. In an effort to maximize investment management fees advisors are putting people’s retirements at risk. We know it now but look the other way. Twenty years from now a lot of people will look back and wonder what happened. But we’ve seen it all before in a different guise. The housing crisis unfolded even though many people knew what was happening. Unfortunately short term profits took precedence and many people ended up hurt.

  3. Hi Mike, your email address seems to not be working. Just wanted to give you a heads up of the problem. Feel free to delete this message.

  4. @Mike: “But at the time, I was absolutely convinced that relatively high-cost, actively managed mutual funds were the best choice.”

    What made you “see the light”?

  5. Indeed. Thank you! I switching hosting companies, and apparently as part of the process my email address got nuked. It’s back up now, but it was down all the way from Sunday morning through Monday evening.

  6. Lots of reading. But it all started with Bogle’s Little Book of Common Sense Investing.

  7. Really good point. I’m including this link in a national workshop I’m doing in San Fransiso (in Nov) for Psychologists in the section about deciding whether to use a financial advisor or not!

  8. Thanks for sharing the article. I hope they find it helpful. :)

    Good luck with your workshop!

If you want to discuss this article, I recommend starting a conversation over at the Bogleheads investing forum.
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