I’ve had a few requests to clarify my position on financial planning and the use of financial advisors. I want to state, first and foremost, that I have absolutely nothing against professional financial advisors and the service that they offer. Just like with lawyers, accountants, and consultants – there are times when paying for the time and advice of a professional financial advisor makes enormous sense. In fact, I do think that there are advisors who create more value than cost to the client. That being said, my major goal is for clients to get unbiased advice and understand the motivations of the advisors hired to serve them. My other significant concern is with the current model for charging clients in advisory relationships.
In the United States, the primary model for offering financial advisory services is the “assets under management” (or AUM) model. For those unfamiliar with this model, the advisor charges a percentage fee for the assets on which he or she advises. The typical fee is 1% on all assets that are being “managed”. So, as the client grows her wealth, the advisor rakes in a higher and higher fee without having to do any more work. In the AUM model, a client with a $1,000,000 portfolio pays $10,000 in annual fees, while a client with $200,000 pays $2,000 annually for the exact same service. Is that fair? This model further creates a conflict of interest where most advisors are incentivized to go after bigger accounts, often requiring account minimums of $500,000 or $1mn in order to increase their firm’s overall revenue per account (and their own take-home pay).
Why does the current system bother me so much? Besides the fact that this model makes financial advising inaccessible to anyone from the recent college grad to the typical middle class family (the very people who need it most), the AUM fee is charged every year no matter what happens to the investments! Personal Capital recently did a great study on what this fee costs a typical investor over the course of his investing life time. The summary of the study points out that even using the lowest cost advisors (in their study USAA and, of course, their own roboadvisor) the traditional AUM model would cost an investor with a $500,000 starting portfolio more than $503,000 in fees during a 30-year investing time frame. (See the full report here: Personal Capital Study.) It is noteworthy that the Vanguard Group (vanguard.com) was omitted from their study, as this would change their data so the ultimate result would not point back to their own firm as the least expensive advising option. More on Vanguard (and my love for their nonprofit, unbiased product line) to come in future posts…
So back to the $503,000 charged in fees over 30 years under the AUM model – I’m sorry, but there is no advisor out there adding $500,000 worth of value to a portfolio. Keep in mind that the $503k figure is just for a lower-cost firm’s advisory charges and leaves out the underlying transaction costs and mutual fund fees. If we take the average mutual fund cost of 1% and stack that on top of the 1% advisor fee, we are looking at double the annual fees quoted above (i.e. $4,000 on $200k, $10,000 on $500k, and a mind-numbing $20,000 annually on a $1mn portfolio). In a world of 4-5% real returns (i.e. adjusted for inflation) on a fully diversified portfolio of stocks and bonds, an investor simply CANNOT AFFORD to give up 2% of her investment returns on an annual basis.
So what am I proposing? I’m much more comfortable with the hourly consulting model, the monthly/annual retainer plan, or an alternative suggestion of a “split the savings plan”. My ideal business model would be the latter, where an investor engages an advisor who can expose the client’s current excess fees and help transition her assets back under her control. With this accomplished, the investor pays a one-time charge that is a percentage of the fee savings from the first year. For example, if I save a client $10,000 in fees, I bill 25% or $2,500 once. In this model, there are no additional charges, no hidden fees, and no suboptimal products to push for the benefit of the advisor. This model aligns interests because if the advisor cannot generate measurable savings for the client, he does not get paid. It also creates a nearly risk-free engagement model for the investor as she only pays on proven and measurable results.
At this point you may be thinking, “well, Mr. MoneyHappens, that sounds great, but I don’t know anyone who works under that model and I’m looking for help now”. So, how can you judge if an advisor you might engage is truly looking out for your bottom line? Ask him about his personal investments to see if he is buying what he sells. If he is not using A-share mutual funds, private REITs, and whole life insurance (all high upfront-fee products) for his own portfolio, why does he think these are the appropriate investments for you? For full disclosure, 100% of my family’s assets are invested with Vanguard with an average annual expense ratio (i.e. total annual fee) of 0.10% per year (Yes, that is 1/10th of 1% per year). Why put all our eggs in the Vanguard basket? In my 10 years of money management research, their nonprofit firm is absolutely the best solution that I have discovered. Let’s go back to the previous example of the average investor with a $500k portfolio. She could keep paying $10,000 per year to her dubious financial advisor, or she could move her entire portfolio to Vanguard index funds (paying 0% in AUM fees and an average mutual fund expense ratio of 0.10%) and pay only $500 per year in fees! I suspect the average American could find a great use for that annual savings of $9,500–I’m thinking big Caribbean vacation. Our hypothetical investor also gets to pocket the $503,000 she would otherwise be paying over the next 30 years in the AUM model.
I’ve brought up a lot of points in this post. I will work to unpack the various ideas and support them with more figures and details in future posts, but feel free to question any of the assumptions or views by leaving a comment below.