He left the door ajar by only a foot. It wouldn’t have mattered, except that the opening was in full view of the two-year-olds that were enjoying cupcakes.
It’s a wonderful experience, being two years old. Everything can be real. Hell, everything is real. Your dad is the strongest person on the planet. Santa Clause sits at the mall and listens to your heart’s desires—and then brings them to life on Christmas. Even Spiderman is real. How can he not be real? He was dancing and playing with Baby29 at her friend’s second birthday party in November. It is the age of innocence, when faith is strong and the magic lives on. Not forever, though.
Spiderman failed to latch the door. As he doffed his mask and costume, rather than revealing Peter Parker, the children saw an unkempt teenager in a wife-beater and roomy blue pajama bottoms. At that moment, the magic was gone. The sparkle in the eyes of those two-year-olds dimmed, and a life of cynicism lay ahead.
There is a tendency to exalt the unknown. My team and I serve an internal audit role for one of our clients. Between us, we speak of the external auditor with impeccable adjectives. “(External Auditor) will never let us get away with this! They are far too thorough in their work.” We believe any failure on our part will be found out; we fear them. We believe that they have it together, and that we do not. That all changed for me, though, when person after person started showing up to our interview events that were currently employed by that very same external auditor. I would interview these people kids, and my whole view on the situation changed. “These are the people who are auditing us? Pack it up folks, we’re good.” Of course, some were intelligent people. But, many more were not. We haven’t pulled the trigger on a single applicant coming from the external, out of a half-dozen that have come my team’s way over the last six months.
Such is the case with financial advisors. This $38 Billion industry feeds itself on the fears of the financial layman. I best leave the investing to a professional. I don’t want to mess up and lose a pile of money. We believe there must be something incredibly difficult about managing money, so we fork over a percentage of assets every year in exchange for performance that perpetually underperforms passive index investing.
Don’t take my word for it, though. Let’s bring in an expert on our side. Brother29 (yes, my real brother) works for a state government where he performs validations and background checks for registered financial advisors in his state. If you want to open your own advising office, he’s the gatekeeper. He’s the guy making sure your financial advisor isn’t funneling your management fee back to ISIS. He’s basically a one-man-show in doing this and let me tell you, whatever vaulted opinion he may have once had for financial advisors is long since dead. He tells me, “Eric, half of them have personal bankruptcies, or liens, or criminal records. Seriously, 50%.”
In Retire29’s first ever guest post, Brother29 brings out the same level of snarky sarcasm you’re all used to, except now there’s actually some good information behind it. Let’s welcome Brother29 with a warm round of applause. And, let me tell you, this is some good stuff.
What a Buffet Taught Me about Financial Advisors
A few weeks ago I gave patronage to one of the great American experiences. This is a place where every appetite-fueled desire can be fulfilled and not an empty stomach can be found. There is a selection of B-Grade appetizers and C-Grade desserts as far as the eye can see, and all for the low, low price of $15.95!
What is the slice of heaven?
The All-You-Can-Eat Buffet…God Bless it. And God Bless America.
As I stood there pondering the method in which I want to devour my plate full of guilt and regret crab legs, I began to wonder how this place can make a profit when they seem to only appeal to an audience of wide-waisted individuals. Then faster than the approaching bout of diarrhea, it hit me. Adverse selection! Economics 101 is back.
Students, take your seats.
All-You-Can-Eat Buffets (AYCEB) charge a premium price for all customers in hopes to mitigate the effects that certain customers have on their profit margins. Since they will, at best, break even with the heavier eaters, they will attempt to turn a profit from those gluten free hipsters that decide only to eat a kale salad with lemon water (It’s a dietary restriction, of course). This is essentially a rigged trade, where one group always gets screwed.
This is able to happen due to a concept called informational asymmetry; or the theory that one party (like the high appetite eaters) has better information (the fact that they’re going to tear up that buffet) and hence receives more value within the transaction than the buffet owner. So how does the AYCEB put the transaction back into balance? They simply charge a higher price for everyone.
One could argue that it’s not entirely fair that both parties are paying the same amount even though the amount of food eaten is vastly different. You’d be right too, it isn’t. However, welcome to the second “most American” experience we have to offer, the moral hazard. Nothing gives us more joy then to see someone’s burden fall onto the back of another. This is precisely what the heavy eater does to the slimmer customers of the AYCEB.
So how does this relate to Financial Advisors? I thought you’d never ask.
Think of your Advisor as your favorite local buffet, chalked full of products and services, with some that you otherwise may have never known to exist. Ranging from the staples like financial planning, tax consultation, and brokerage trading all the way to the “next to the men’s room door” items like private placement investing and venture capital formation. It’s great to have an Advisor that can offer such a wide variety of services, and they are undoubtedly well versed and knowledgeable in the areas they offer. But, are they necessary?
Let’s look at an example…
A Man and His Fees
Typically, Investment Advisors are compensated in the form of hourly fees, flat fees from financial planning, trade commissions, and assets under management (AUM) fees. This all depends on what type of contract or service you signed up for. So let’s say you walk into an advisory office for a one-time financial plan, just to get a handle on your entire situation. The Advisors charges you a conservative $500 fee or $125/hour for a half day of work. He offers some basic suggestions about rolling your old 401(k) over, diversifying your portfolio, and setting up a 529 Plan for your child’s education along with giving you a breakdown of your own financial security.
After much talk, you agree to allow him to actively manage your assets for a fee of 1% (common) of your total AUM. Once all the paperwork is processed a few days later your $100,000* nest egg is safely in the hands of a licensed professional. Phew! You can sleep again. Or can you…
Now let’s make a few assumptions: your investment earns 5% a year before any expenses or fees, you make no additional contributions or withdrawals, and you invest only in low-cost mutual funds with a .25% expense ratio. In five years…
- With your Advisor, your net earnings rate would be 3.75% after the 1% annual fee and the .25% expense ratio. After 5 years, your $99,500 (you need to decrement the initial planning fee*) is now worth $119,984.
- Without an Advisor, you net earnings rate would be 4.75% after only the .25% expense ratio. After 5 years, your $100,000 is now worth $126,748. An increase of almost $7,000 compared to the Advisor assisted plan.
But, wait. You say. That’s not fair. How can you use the same return for both accounts, managed and unmanaged? Well, you’re right. We are probably giving too much credit to the advisor, as advisors often fail to meet or outperform investments in low-cost index funds, such as the Vanguard S&P 500 ETF (VOO).
Back to the buffet analogy…
Investment Advisors can make a lot of money off of those folks who have large, complicated portfolios (larger appetites), with complicated tax situations and other needs which may render their services necessary. However, the majority of us have much smaller portfolios and the need for only basic services and advice on markets and personal investing. Hence, a much smaller plate and no need to pay the relative premium for the All-You-Can-Eat type services.
So if you’re thinking about signing on with an Investment Advisor first ask yourself…Is your appetite big enough to cover the cost of the buffet?
Now that you’ve weighed the costs and benefits of paying a Financial Advisor, if you’ve landed on the decision to sign on with one…Great! As I said previously, many Advisors are extremely knowledgeable and can not only help you generate reasonable risk-adjusted returns in investments but save you much more in their understanding of tax sheltered accounts, mutual fund load types, and overall tax and fee avoidance. But before you sign the dotted line, I urge you to do some due diligence on the person or firm you may want to do business with. It goes without saying that not all Advisors are the same, and just because you have or know an Advisor, does not make them right for you.
So often in an industry known for market fluctuations, regulatory changes, and other unknowns, problems exist. However, many are completely avoidable. If you follow these five tips when choosing an Advisor, I cannot promise you positive returns, but I can promise you that you’ll be more confident in your Advisor.
Five Things To Know About Your Financial Advisor
- Disclosure, Disclosure, Disclosure.
In real estate it’s all about location, in finance…disclosure. Financial Advisors come in all shapes and sizes with varying investment objectives, expertise, backgrounds, and even personal agendas. With that said, no matter what the Advisors is offering, it must by both State and Federal law (SEC), be disclosed.
I’ve seen Advisors base their firm’s advice structure on everything from gold and precious metal plays to only investment areas that are backed by biblical verse (not joking). Is one more right than the other? Is it illegal to cite Genesis in your promotional materials? No. But it must be clearly disclosed to current and prospective clients. The financial regulatory industry does not make it illegal for people to invest their money, or for folks to issue securities based on crazy ideas or farfetched theories. Hell some may even pay off, just look at Spanx. But most unfortunately for the investor, do not. Cue up the Beanie Baby.
It is only when a person or entity deliberately misleads, or fails to properly disclose material fact, do they cross the line into illegal territory. So before getting in too deep with a specific Advisor, make sure you see what they are all about first. So how do you do that?
Per SEC rules, each Advisory office must submit a form called the ADV Part II, more commonly known as a Brochure. This documents provides, amongst other things, an overview of the business, their investment strategies, any third party affiliations (i.e. insurance broker), and past disciplinary actions. Moreover, this brochure is public and must be presented to any potential client. So if you want a copy, just ask!
If asking someone directly isn’t your thing, or if you’re trying to maintain a low profile, there is another way to check. This method will provide you an overall snapshot but without all the fine details the brochure would, but it is equally as important and easy to obtain. So without further ado…
The Financial Industry Regulatory Authority (FINRA) created a one-stop shop for those people who want to get a short and sweet background check on pretty much anyone associated to a financial entity. You can search by name or CRD Number (think a financial and public Social Security Number) and even narrow it down by distance from a certain zip code if you want to find someone in your area. Once you’ve found the person of interest, just print off the detailed report and viola, check complete.
These reports will show you any and all financial exams they’ve passed, past and present employment history, and even what no-no’s they have on their record. These can range from previous suspensions from the industry (major red flag), customer complaints, and even personal bankruptcies. Even though you may think you’re accessing some confidential information, trust me, you’re not. All of this information is for public viewing and completely reasonable to question if and when you decide to meet up for a consultation.
Even as the website states right on the homepage, there is really “no reason not to check”. Click on the hyperlink above and start your digging.
- Do they follow a Fiduciary Standard?
This tip is a little bit trickier than a simple search, but may be the most important. Unbeknownst to even financial literate people, currently the law (Investment Advisers Act of 1940) states that all investment advisors must follow a fiduciary standard; however broker dealers are exempt from the definition of “investment adviser” and therefore must only meet a “suitability standard”. This, in a nutshell, means that brokers should not push for investment choices that are not suitable, or appropriate for the given client given their risk tolerance and objectives for instance. An example would be having an 85 year old grandmother in poor health opting into an annuity with a lengthy surrender period. Obviously the broker is just looking to gain the commission off the sale.
The point here is that many Advisors have what the industry calls a “dual affiliation”, meaning they are registered as an Investment Advisor and an agent of a broker dealer. It’s because of this difference that requires advisors who are recommending securities to clearly disclose whether they are brokering a security or advising for a security.
So even though there is at a minimum a suitability standard, which definitely helps avoid egregious issues; there is still some leeway for advisors to subtly push for investments that may present higher commissions rates for them. Although these types of investments may arguably be suitable, they may not necessarily be in the best interest for the client, and hence would violate the fiduciary standard. I would advise you to see whether or not your potential Advisor has language of this sort in their contract, or just ask them to add an addendum if not.
Read this article if you are interested in better understanding this dilemma and what the President and Congress is trying to do to fix it.
- Check the Fee Schedule!
As cited above, fees are the proverbial thorn in the side of almost every investor. The lower you can get them, or avoid altogether, the better. There are two areas that an Advisor must disclose their fee arrangements that are fully available to a potential investor. First, is on the nifty Brochure that I spoke about earlier. Specifically, Item 5 on that document should breakdown how the Advisor plans to withdraw their fees, if they will be paid in arrears, how often they will be deducted, and even disclose if they (or any other associated person to the firm) will be compensated for the sale of a certain security.
Furthermore, the SEC states that this form must be written in “plain English”. Meaning, it should include “…short sentences, definite and concrete words, use active voice, and use tables or bullets points for lengthier or complex topics.” It is the right of every investor to ensure that material being presented to them is clear and complete. Never forget that.
Secondly, knowing that the brochure is a more universal document available to all potential investors, the advisory/investment contracts are usually tailored to a specific clients needs, and hence will provide greater detail on the types of fees you will be accessed. This is the where the rubber meets the road in a sense. This contact will lay out what percentage you will be charged (if you are on an asset-based plan) and should never really deviated from the .25% – 2% range, or 25 to 200 basis points. Normally the more money you have, the lower your fee will be.
Also be aware that not only will your Advisor charge a management fee, but there will be often multiple other fees that you should know about. For example, if you invest in mutual funds there will often be a load, a management fee, and a brokerage trade fee for the initial purchase.
Lastly, you should also know that not all of the fees you will be charged go directly to your Advisor. The managers of mutual funds, custodians of the accounts, brokers and solicitors, and even costs associated to distribution and advertisement (also known as 12b-1 fees) all get a cut. Many of these fees are unavoidable, even if you decided to forgo the services provided by an Advisor and manage your own money.
They say go with your gut, and no truer words have been spoken when talking about entrusting someone with your finances.
Read the details within all of the aforementioned tips and press them on anything you want to clarify. If they seem to skate around the issue, or in any way leave you feeling confused, that might be a sign that are not right for you. Understanding your financial outlook doesn’t have to be complex or hard to understand, but rather the complete opposite. The more confusing it becomes, it is in all likelihood, making it a far riskier environment for you. As my graduate school professor once said, in situations like those just “KISS em’”.
Keep It Simple Stupid.
And, you know what? There’s nothing simpler than low-fee index investing. As Occam’s Razor tells us, “The simplest solution is most often the correct one.”
Here’s to Safe Investing!