Choosing a financial advisor can be an extremely consequential (and difficult) decision. Finding the right one can make a significant difference to your financial future. Finding the wrong one can have devastating consequences.
Unfortunately, many (most?) of the 300,000 or so financial advisors in the United States are simply financial salesmen with excellent communication skills and just enough knowledge of the financial marketplace to be dangerous. And, sadly, most of them work for the best-known Wall Street firms, banks and insurance companies (the part of the industry that those of us who are independent refer to as “the Dark Side”). Suffice it to say, while it’s very easy to find someone with “financial advisor” on their business card, it can be frustratingly difficult to find someone who can actually dispense objective financial advice at a reasonable price.
Whomever you choose to work with should, at a minimum, meet all of the following criteria:
- Demonstrate integrity and intelligence.
- Operate as an independent Registered Investment Advisor (RIA). This significantly increases the odds that you’ll get objective, non-biased advice.
- Charge an hourly rate or retainer-based fee (you do not want to pay commissions or “percent of assets-under-management” fees).
- Favor a low-cost passive, market-oriented investment strategy.
- Always act as a fiduciary, and commit to doing so in writing.
- Use a large, well-established, third-party custodian (e.g, Schwab, Fidelity, TD Ameritrade).
Conversely, any advisor who tries to sell you a variable annuity, or life insurance as an investment vehicle, or anything that s/he refers to as a “hedge fund” or an “absolute return” fund should be immediately eliminated from your list. Similarly, anyone who claims they can show you how to consistently out-perform the market should be viewed with a great deal of skepticism.
If you do your homework, you are likely to find a relative handful of advisors who meet all of the above criteria, with one exception: There are very few advisors who are willing to charge on a retainer basis. Why? Because they know that most investors don’t understand the negative impact that the typical advisor fee structure has on their portfolios’ returns.
Among independent RIAs, the most common pricing scheme is to charge a percent of “assets under management” (AUM). This fee can vary from 25 basis points (0.25%) to 1.5% or more and probably averages 1% – 1.25%. 1% may seem like a very small fee, but it’s not. Here are just a couple reasons to avoid AUM fees.
1. 1% is really 25%. The bull market of the past several years notwithstanding, the long-term historical return for the stock market is just shy of 10% per year, on average, and the intermediate-term bond market is currently yielding around 2%. This means that the long-term expected return on a balanced portfolio comprised of 50% stocks and 50% bonds is about 6% per year before taxes, mutual fund fees, trading costs and advisor fees. So, before all those other costs, a 1% AUM fee really translates into a 16.7% (1% ÷ 6% = 16.7%) fee on your profits. After all those other costs, a 1% AUM fee is probably taking 20% – 25% of your after-tax returns. No advisor on the planet is worth 20% – 25% of your money.
2. AUM fees penalize affluent investors. Most advisors have a minimum account size that they’ll work with. This, in effect, sets a floor for their fees. And that floor tells us a whole lot about the effort required to manage a portfolio. For example, the floor for a 1% AUM advisor with a $100,000 minimum portfolio size is $1,000. This means that the advisor can profitably manage a $100,000 portfolio for $1,000. What most investors don’t realize is that it takes very little additional effort to manage a $1,000,000 portfolio than it does to manage a $100,000 portfolio. But, under a 1% AUM arrangement, the $1,000,000 client is going to pay ten times as much as the $100,000 client (for a portfolio that is likely very similar in terms of its overall composition). In fact, if you do the math, you’ll find that many affluent investors are paying their advisor thousands-of-dollars per hour of effort (often for very questionable advice).
Even less affluent investors, who are more often subject to pure commissions rather than AUM fees, often end up making their advisor – rather than themselves – rich. With commission rates ranging from 4% – 7%, an investor with $100,000 is going to pay his “advisor” $4,000 to $7,000 in up-front fees; fees that are often poorly disclosed or justified by meaningless historical data or the pretense of “guarantees”.
Professionals – like doctors, CPAs and attorneys – don’t charge commissions (or AUM fees). Your next financial advisor shouldn’t either. $$ Michael L. Gay, MBA, CFP®