You’re paying for loyalty – make sure you’re getting it.
If you’re paying someone for advice and investment management, his only compensation should be what you pay him, the advisory fee. 0.75 to 1.5 percent per year is fair, depending on account size. Obligations are structured by payments, and his only obligations should be to your interests.
Back when people used full-service stockbrokers, a good broker could offer financial advice and help craft a portfolio to suit your needs. But he was not paid for this service directly, which created a conflict of interest between his bottom line and yours.
In the absence of a management fee a broker must live off commissions and sales fees, and his advice may be compromised. He will be inclined to favor high-fee products and high-turnover strategies, which may not be safe or appropriate. It takes a long-term outlook and strong ethical compass for a broker to avoid such temptation, the more so because until recently there has been scant legal impediment.
Among savvy brokerage clients, there is at least some understanding of buyer beware. Brokers are known to be salesmen. But when you pay an advisor, you should be able to trust that his only obligation is to fulfill the terms of your agreement as set in the compensation structure. This is not the case. Many advisors double dip and compromise their ability to act solely in your interests.
Some advisors are salesman in disguise
The law allows advisors to take sales fees, commonly mutual fund loads or sales charges for other securities or insurance products. He who pays the piper calls the tune, and such an advisor is making side deals with your money.
Advisor and friend Aaron Brask recounts evaluating a financial product that seems to have been designed to fleece investors:
In this case, my client (recently retired) was interested in finding investments with a healthy but safe yield, so the broker suggested an autocallable note advertising a yield of 7%. This note effectively invested in the stock market, but exchanged the investor’s dividends and upside potential in exchange for a potential (but not guaranteed) fixed annual yield of 7%. It would also lock up his money for up to three years during which period he would be 100% exposed to the downside risks.
On the surface, this certainly did not appear safe since it carried all the same downside risks of the market. Moreover, when this note matured, capital gains taxes would eat into the returns (if there were any) since this was for a taxable account. This brought the maximum potential upside closer to 5% per year than 7%. Last but not least, the small print revealed an embedded profit or commission of 2.5 – 4.5%. Suffice to say, this was a clear veto.
The structured notes business is a lucrative business for the banks and brokers selling the products. They start with an investment, use derivatives to re-engineer its risk and return, and subtly reduce the payouts to embed their profits. You invest a dollar, but perhaps only 95 cents might actually get invested on your behalf.
Fees like that would be hard for some advisors to resist. The major banks and brokerages employ financial engineers to design products that appear to fulfill desires (“you want 7 percent? Here you go!”), but really are just compensation structures in disguise.
Don’t allow double-dipping. Check your statements for sales loads, and look up the funds in your account to see what you might have been charged upfront (and what you are paying annually). Ask your advisor if he is earning sales fees or anything else from your account besides the agreed-upon management fee. If he is, see if you can change your agreement (probably not worth the effort) or find another advisor.
Check your fund fees
Advisors can assemble an excellent retirement portfolio without ever incurring a sales charge, and the fund fees in that portfolio should average well under 1%. For traditional buy-and-hold stock and bond portfolios fund fees should be 0.10-0.25%. Some double-dipping advisors put you in funds that not only have sales charges but annual fees of over 1% for strategies that are little different from indexing. Managers of such funds are willing to pay advisors handsomely for new clients. The total of sales, fund, and advisory fees could be as high as 3% per year, fully one third of the long-term return of the stock market!
You want a “fee-only” advisor
The term “fee-only” didn’t come from a marketing genius. When you see it you should actually think “good.” The “fee” in fee-only refers to your direct payment to them, and their only obligation is to help you protect and grow your wealth.