Beware of the Leeches
Exactly one year ago as I write this post, we were finalizing the process of discontinuing our relationship with our financial advisor and beginning to manage our own investments. For readers who are considering taking similar actions with their own finances, I want to walk through some of the things that we’ve learned over the first year of managing our own money. More importantly, for those just starting out, I want to demonstrate how costly it is to not fully understand what you are investing in before committing significant sums of money to invest.
The purpose of this post is to illustrate the fact that BEFORE investing, you need to be sure you know the answers to these questions.
1.) Exactly how much do your investments cost (both up front and ongoing charges)?
2.) Do you know all of the ways the person selling you these investments is being paid (and if their incentives are in line with yours)?
3.) What are the tax implications of your investments?
4.) How do I get my money back from this investment and what will this cost me in both fees and taxes?
We thought that we could always learn about investing “some other time”. While it is never too late to learn, waiting can be very costly. It is not as simple as firing your advisor and moving on. Getting rid of a financial advisor and the products they sell is kind of like removing a blood sucking leech. Not removing them will drain your resources. However, getting rid of them brings its own discomfort. Kind of reminds me of this scene from the movie “Stand by Me”:
**Warning: Some NSFW language
Today, we will show you how much money we paid in 2014 alone directly to our former financial advisor and the company he represents, despite the fact that we severed ties with them in November of 2013. Please do not read this as advice to your personal situation. The decisions we made are very specific to the investments that we own(ed) and our personal tax situation. This is meant only to demonstrate what we personally had to deal with and to drive home the importance of understanding the 4 questions above BEFORE committing your money to any investment. If you already have invested money and want to make changes, please consider your options carefully and consult with an appropriate investment and/or tax professional for any needed help.
In our last year working with a financial advisor, we showed that we paid at least $7,680 between advising fees, commissions, annuity fees, administration fees, and internal fund fees. We initially figured we would just stop using our advisor and transfer our funds to another company and save these fees. If only it was that easy. As it turns out, we ended up paying $7,500 to our advisor and his company in this first year that we did not use them and we’re not completely done with them yet. How is this possible? Let us explain.
Approximately a year and a half before we took control of our investments, Mrs. EE switched jobs. She had a retirement plan worth approximately $100,000 that our advisor rolled into a variable annuity. A variable annuity is a very complicated and expensive investment product that combines mutual funds and insurance. We later found that they carry very high fees. The primary reason to use a variable annuity would be to shelter money from taxes. Since this money was already in a rollover IRA it already had all of the tax benefits of the annuity, without the cost. However, because we now had this money in the annuity it had to stay in it for 10 years before we could get it out without paying penalties. After crunching numbers and running spreadsheets for a number of scenarios, we realized that we were in a no win situation. We could pay ongoing fees for 8 more years or take one big hit with a surrender charge. We determined it was better to pay the surrender charge of $5,500 and move on. OUCH!
We were able to roll over our Roth IRA accounts and a very small Simple IRA with no fees and no tax considerations. This left our remaining money, invested in mutual funds held in taxable accounts. This money was ours to cash out and reinvest as we please. However, because this money was invested in taxable accounts, to sell off these investments would have major tax implications making it impossible to just simply walk away without major consequences.
Any gains on our investments purchased in the past 12 months would be taxed at our marginal rates of 25%. Any long term gains would be taxed at 15%. Also, because of the amount of money invested, taking all of these gains at one time could have further consequences such as bumping us to an even higher tax bracket and producing enough income for the year that we couldn’t utilize other tax benefits such as making our annual Roth IRA contribution. After careful consideration, we were able to sell off a portion of these investments with tolerable tax consequences.
Unfortunately, this left us with 5 remaining mutual funds with a value of approximately $160,000. The average weighted expense ratio of these funds was 1.25%. This means that we paid an additional $2,000 back to our advisor and his company in the form of account fees for the funds that they sold us years ago, despite the fact that we no longer have any relationship whatsoever.
Unfortunately, these expenses paid to our former advisor are only the beginning of what we now realize we are and have been paying for bad financial advice we received. Next week we’ll look more at the importance of understanding the tax implications of your investments. But that’s another lesson for another day.
For now, remember this take home message. Committing your money to an investment without knowing the answers to the above four questions is entering some murky water. As we demonstrated in our example and the “Stand by Me” boys learned in the video, when entering murky water: BEWARE OF THE LEECHES!