Do You Really Know How Much You Pay for Financial Advice?
This is the second in a series of posts in which we look at whether you should manage your own money or hire a financial advisor. In this post, we will break down the amount paid to our investment advisor and the fees associated with the investments in the last calander year (November 1, 2012-November 1, 2013) prior to ending our relationship with him. I will try to give as good of an estimate as possible, but after questioning our advisor repeatedly and spending countless hours trying to read prospectuses, we’re still not sure we’ve been able to account for everything. This is fine, as we want to provide a conservative estimate to not sensationalize and give a fair representation. Therefore, we are sure that we have paid at least the amount that we will show below. The key points are the total amount paid and how this compares to what we were aware we were paying.
First, we paid a $450 “advising fee”. For this fee we had an annual meeting to discuss our goals, review our income, investments and other things that could affect our financial situation. We then received an annual written summary of this meeting and had our accounts reviewed quarterly with rebalancing as needed. We were definitely made aware of this fee and knew we were paying it.
Next we paid commissions on our investments as we purchased them. We were definitely made aware of this and were informed that these were paid up front. We never paid much attention to the impacts of these fees. We assumed that this was simply the cost of doing business. Also, our advisor pointed out that the rate we were paying was progressively decreasing as we reached pricing breakpoints. For example we were informed that our load was decreased from 3.5% to 2.5% when we had accumulated $250,000 in assets. During the last year we were using this advisor, we paid a total in commissions of $1,660.
The total of our advisor’s fee and commissions was $2,110. This was more than we realized we were paying as we never took the time to tally the amount up. It seemed like a lot for what we were getting, which was essentially following a plan of buying regularly and rebalancing to our asset allocation. However, all of this was explained to us up front and agreed upon. What we were really paying and never knew was MUCH more. Let’s continue.
Next we began looking at the expense ratios (ER) of our investments. Every mutual fund and bond fund has some expense associated with running the fund. This makes total sense and may seem obvious to most, but these costs and their impacts on investment return were something we had never thought about until now. A review of our investments revealed the weighted average of the ER of our funds was 1.14% across all of our investments. We had very close to $400,000 invested so at this expense ratio we paid $4,560 in expense for the investments we owned. Each fund’s ER included a 12b-1 fee of .25% annually. This fee, hidden in the expense ratio, goes back to the person who sold the fund incentivizing him to recommend these funds. Thus after already paying the advisor up front commissions we knew about, he received $1,000 in this past year alone in kickbacks for the investments that he placed us in. We never discussed fund internal expenses with our advisor and had never heard of a 12b-1 fee before discovering this on our own.
When reviewing our statements in detail, we noticed that one of our accounts had a surrender charge of $5,500 and didn’t understand why. As we looked at the details, in my wife’s rollover IRA we found that we owned a variable annuity. We didn’t even know what a variable annuity was. We began to do research immediately. As we read up on variable annuities, we learned that they are one of the most complex and expensive investment vehicles you can buy. We also learned that they typically have insurance components included, which we are sure we never discussed and was something we would not have wanted or needed. We learned that one option that may make variable annuities desirable is to provide an investment that allows you to defer taxes. However, they offer no additional tax benefit when already in a tax deferred account such as an IRA, as was our case. Finally, we learned that the reason for the high surrender charges associated is that they produce high commissions to selling agents. We’ll discuss what we learned about variable annuities in detail in a later post. For now, the key point is that owning this annuity cost us an additional $850 dollars for the year for a product that offered no value to us. This $850 is another recurring fee paid annually, based on a percentage of the assets in the annuity.
Finally, each retirement account we owned was assessed a $40 annual fee. This included a Roth IRA for each of us, a simple IRA rolled over from a previous job and the rollover variable annuity, totaling an additional $160 in expenses.
Therefore our total expenses as far as I could determine for one year of advisor fees, commissions, insurance for the annuity, internal fund fees and administrative fees was $7,680. This is compared to the $2,110 that we were made aware of up front. Of the $7,680, the advisor would receive at least the total of the advisor fee, commissions and 12b-1 fees which totaled $3,110. He denied that he had any financial incentive to sell the annuity, and after spending hours reading the 164 page prospectus, we could not figure out how much he was actually paid. We’ll take him at his word and allocate the remaining $4,570 in fees to the costs of the investments chosen by the advisor.
At this point, I think it is important to give some perspective on the cost that we were paying. Since discontinuing our relationship with our advisor, we have elected to manage our own money and are using a Vanguard brokerage account. How much would our investments have cost us if we did this from the beginning? First let’s look at investment costs for one year. A similar portfolio of $400,000 worth of domestic stocks and bonds as we owned could be owned in Vanguard index funds at an expense ratio of only .075% compared to the 1.14% we were paying. While these numbers look small in terms of percentages, in actual dollars this would mean paying $300 for the year for the Vanguard funds versus the $4,560 that we paid. All Vanguard funds are no load. Thus we would have completely eliminated the $2,110 in commissions we paid last year. (We actually would have accumulated CONSIDERABLY MORE than $400, 000 if we hadn’t been paying commissions of as high as 5.5% while buying loaded mutual funds.) We also would not have bought the annuity as recommended by the advisor if we were fully informed, saving the $850 we paid last year. At Vanguard, we pay no custodial fees because they are waived at this level of assets saving us the $160/year we had been paying. By eliminating the advisor, we saved an additional $450 in the advising fee. Therefore the $300 paid in expense ratio with Vanguard would have been our only expense, compared to $7,680 we paid!
Remember, we are talking about only one year. If we would have continued paying only these fees over the next 30 years until normal retirement age, with no increase they would have built to almost a quarter of a million dollars. However, we wouldn’t have been that fortunate. Our true total cost would have to include the commissions and expenses already sunk to build our assets to this level plus increased future costs associated with continued contributions to our investments, growth of the investments and compounding over time. The total cost of using an advisor would have been closer to a million dollars over a lifetime of investing!
We have now established the amount we were truly paying our advisor and the cost of the investments recommended. However, what really matters is value. If an advisor provides knowledge and advice that allows you to cover these costs and still achieve returns greater than you could reasonably expect on your own, he would be worth every penny. In our next post, we’ll examine the quality of service we received. Read on.