What Do You Get for $7680 of Financial Advice Fees?
This is the third and final post in a series examining whether you should manage your own money or hire a financial advisor. In the previous posts we explained why we decided to manage our own money and explained how we accumulated $7,680 in fees in a single year for our investments. In this post we’ll examine the quality of advice we received. As in the previous posts, I will attempt to be as fair and objective to our former advisor as possible.
There were positive aspects of using an advisor for two young people starting out. Our advisor helped us set up a plan of making regular automated contributions which is very important in building assets. He helped us to understand, if only on a very superficial level, the concepts of portfolio diversification and asset allocation in alignment with our risk tolerance. He also emphasized removing emotions from investing and sticking to a plan during market downturns, explaining the benefits of not panicking and pulling out of the market. You will notice, however, that all of this advice was also in alignment with his interests. He needed us to keep our money invested and add to it regularly to continue to grow our investments to also charge fees on our money.
When our interests and the interests of the advisor were not in alignment, the results were quite different.
First, he deemphasized the importance of cost on our investment returns. We had no idea of what an expense ratio was, no knowledge of what a 12b-1 fee was, and no knowledge of what expenses were associated with the annuity that we owned until we figured it out on our own.
We compared every fund we owned to their comparable index fund that we now own through Vanguard. The average expense ratio for all of our investments was 1.14%. Index funds tracking a variety of benchmarks available through Vanguard are available without loads for an ER of .05-.1%. None of the more expensive funds significantly outperformed the comparable indexes over the 5 and 10 year periods available to review, and several of the more expensive funds significantly underperformed.
Why would the advisor recommend using funds 10-20 times more expensive that added risk to our investments (to overcome these fees), with no objective reason of expecting any significant consistent superior returns? Every single fund we were in had a .25% 12b-1 fee going back to the advisor, adding to our costs. Therefore, the amount that he collected just in this hidden fee is 2.5 to 5 times more than the total expense of the index funds we currently invest in. He got paid at the expense of our returns. All of the investments we owned as recommended to us were in Columbia Funds mutual funds or a RiverSource variable annuity, though there were many options available with less cost. In the Ameriprise Financial Client Relationship Guide it says in black and white that advisors are paid more for the sale of Columbia Funds and RiverSource products. Shame on us, we never read all of the hundreds of pages of literature and prospectuses provided. We blindly trusted this advisor who had worked with our family for many years. If you’d like to read it yourself, click the link above and go to page 23 of this 37 page document. Under Financial Interest in Products is where this is laid out plainly. I include this link in fairness because as I stated above, we don’t feel that we have any ability to claim any wrongdoing on the part of our advisor. We simply didn’t do our homework.
Second, as stated in the previous post, our former advisor seemed very disinterested in our work retirement accounts even though we were paying a $450 anual fee. Remember that was supposedly for financial planning services. He had access to all of the options for our work plans that we had given him to review, as well as our income and tax information. He advised us to contribute to our work retirement plans up to the level of our employer matches. We followed this advice, while never approaching the contribution limits allowed by the law. As we now understand more about the effects of taxes and expenses on investments, it is clear this turned out to be horrible advice for us. Again, it worked out quite well for him.
Let’s first look at cost again. Every investment option in each of our work plans is purchased without a sales load, meaning we would be investing the full amount of every dollar instead of paying comissions. In each of our work retirement plans, we have bond and index funds available around .3-.4% ER, meaning that a similar portfolio would be much less expensive than what we had.
This advice also cost us considerably by losing the tax advantages of these plans. Last year our last dollar of income was taxed at 28%. Our top tax rate at retirement, when we would pay taxes on this money, would be 15%. We also would miss out on the yearly tax shelter provided by the work related accounts. By investing in taxable accounts with the advisor, we would have to pay taxes on interest, dividends and capital gains yearly thus losing out on the compounding of all of this money.
Translation–it would be virtually impossible for us to do better investing with the advisor than to simply invest in low fee funds in our retirement plans. The investments he put us in would have to outperform our work retirement plans by the 13% difference in tax rates in addition to the 2.5-5.5% we paid up front in commissions on our investments just to get back to where we started. It then would have to overcome the taxes on dividends, interest and capital gains paid every year because we didn’t use the tax deferred plans. Finally we would have to overcome approximately .7% annually in increased expense ratio for the advisor recommended funds.
Adding insult to injury, we were not able to fully fund our Roth IRA last year because our taxable income was too high. The advisor was fully aware of this as the Roth IRA was invested with him. If we maxed out our work retirement plans, we would have easily been under this income limit and been able to contribute a full $11,000 to grow tax free for years and then be taken out tax free in retirement. However, by not maxing out our work plans, we had more overall to invest with the advisor. This means more commissions to him up front and more back end kickbacks through account fees. It made no difference to him if we invested in our Roth IRA or taxable accounts, his commissions were the same.
Remember as in the last post in which we discussed costs, we’re discussing only one year of loss of performance. Imagine our loss with all of this compounded over the next 30+ years if we hadn’t caught it.
Finally, I will return to the variable annuity that the advisor sold us to roll over two work related retirement plans. After considerable research, we see no benefit of rolling over these accounts as he advised. The money was already invested in lower fee funds in tax deferred accounts. After figuring all of this out, we recently asked the advisor why he ever recommended this investment to us. His justification is that we were able to invest from a variety of fund families (outside of Columbia Funds) within the annuity without paying commissions. This is in direct conflict with the advice he gave us to invest with him rather than in our work retirement plans where we had access to these exact same benefits without the costs of the annuity. Even FINRA, the agency that polices advisors, warns investors to be wary with rolling over IRAs. It is big business for advisors to get these rollover assets under their management. (See link)
When reviewing this information now as better informed investors, it is obvious that our advisor chose his own interest over those of his clients. Again, we accept full responsibiltiy for acting on his advice and entering into these investments based on trust, without first educating ourselves. That being said, our case is pretty damning with regards to the financial advice we received at a hefty cost. Unfortunately, we have learned this is common throughout this industry. Our situation is certainly not unique.
There will always be conflicts of interest between what is best for the advisor and what is best for the client. The first of these is cost. Simply stated, your personal investment return equals market return minus investment cost. It is therefore obvious that a choice must be made to either serve the interest of the investor (less cost) or the advisor (more cost). The second is taxes. Investors can benefit by deferring taxes, using tax sheltered accounts and using tax friendly investment vehicles, which makes a huge difference in the returns they actually see. Again there will be conflict. What is best for the investor often requires utilizing work related accounts that are more difficult for advisors to charge fees on. The much cheaper index funds are also much more tax friendly than actively managed mutual funds. Actively managed funds are much more profitable to investment companies and produce kickbacks to advisors. Guess which you’ll be more likely to have recommended for your portfolio. Finally, because advisor’s have to have assets under their management to charge fees, there will also always be a motivation to get you to invest more money with them. This motivation could benefit investors, but this will also always be a potential conflict. Some examples where investors may be better off not investing more would be paying off a mortgage early or investing in their careers by pursuing continuing education or personal business interests. This could also lead you to work longer than needed, saving more than is likely to be necessary to retire.
Some argue that you’ll do better with an advisor who works on an assets under management arrangement. The average fee in this model from what I’ve read is 2%. Despite what we consider very high expenses associated with our investments, our all in costs of our investments came to 1.9%. Advisors working under either compensation model would have many of the same conflicts of interest as they need to have your money under management to earn their fees. I don’t think that we chose the wrong method of paying an advisor. Our mistake was choosing any advisor without fully educating ourselves on how they are paid and not knowing how their incentives were alligned with ours.
We can’t tell you what to do with your own investments. I would strongly advise you to look very closely before investing with an investment professional who is compensated through commissions or a percentage of assets under management without knowing how their compensation aligns with your interests. The potential for conflict of interest is too great. There probably are more (and less) reputable and competent advisors and companies than the ones we used, but you won’t know unless you take the time to do your own homework and research. After doing your own research, if you feel that using a financial advisor is the best decision for you, good luck– and buyer beware!
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