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There are two important ratios that most individuals do not pay enough attention to. In fact, the financial services industry rarely, if ever, makes mention of them. They are as follows:
– The first ratio measures the amount of your investment fees paid versus the total federal, state, and local income taxes you pay.
– The second ratio measures the amount of investment fees paid versus your total income.
Why are these two ratios so important? First, they bring to your attention the absolute dollar amount of investment fees paid to your Financial Advisor, your brokerage firm, and other third parties. Second, you will note that, although you cannot choose to ignore paying your income taxes, you can lower the total amount you spend on financial and investment advice. Lastly, you can think about what other uses you might have for the money you spend currently on investment fees either in whole or in part. Let’s talk briefly about how to calculate these ratios and then delve into their usage in more detail.
The ratios are fairly easy to calculate. The first ratio is investment fees paid versus total federal, state, and local income taxes you pay. Luckily, most people do not pay local income taxes, and several states have no income tax. If you do have one or both of these taxes, you simply add the total taxes due together from all three sources. Note there is a big difference between taxes paid and taxes due. If you received a federal and/or state tax refund, you still paid taxes into the system. A refund is simply an adjustment to ensure that you only pay your fair share according to the tax code. You would add up the taxes due to federal, state, and local agencies on your income tax returns. Your investment fees come directly from your brokerage statement(s). The two most common expenses are asset under management (AUM) fees and commissions. You would add up all the AUM fees and commissions charged to your over the course of the year. The only other number you need is to take your Adjusted Gross Income (AGI) from your federal tax return.
As I have stated in previous posts, the most common AUM fee is 1%. So let’s take a common scenario for retirees today. For illustrative purposes, assume there is a retiree with a $1 million portfolio in a 401(k) account that withdraws $50,000 and is charged a 1% AUM fee. The total AUM fee would be $10,000 for the year. If the retiree also has Social Security income of $20,000, the second ratio would be 14.3% ($10,000 / ($50,000 + $20,000)). What does that percentage mean? The percentage shows you that your investment fees are equivalent to 14.3% of your annual income. Now the total taxes paid by each individual will vary greatly. However, the average taxpayer tends to pay around 10%-15% in federal and state income taxes. In our assumed scenario above, the total income taxes due would be $7,000-$10,500. The first ratio is either 142.9% ($10,000 / $7,000) or 95.2% ($10,000 / $10,500). What does that percentage mean? The percentage shows that in the higher tax situation you are paying essentially the same amount in income taxes as you are in investment fees. The lower tax situation shows that your investment fees are 42.9% higher than your income taxes. No matter which way you slice it, you are in a high “investment fee” bracket. The investment fees you are paying are yet another drag on the net income you end up having for living expenses and for leisure activities. To a great extent, your income taxes are fixed in any given year unless you have an unusual income stream occur. Your investment fees are variable every single year.
Now I am not saying that you should no longer use a Financial Advisor or go to your investment firm. Please do not mistake that as my message. However, I am recommending that you calculate those two ratios to bring the investment fees to your attention. You can then make the choice regarding whether or not you might want to seek out a fee-only or hourly Investment Advisor or Financial Planner. Or you might want to investigate if you have the knowledge or can acquire the knowledge how to manage your own investments. What would be the incentive of those two alternatives? Obviously I am biased, but nothing like these stories inspire me more. My parents are in the grouping that would be charged roughly $10,000 per year in investment fees. They are lucky enough to not require a Financial Advisor to whom they would pay a 1% AUM fee or similar level. I recently found out that they will be taking a two-week cruise in Europe next month for essentially that same amount. My father is fine with the vacation because he knows my mother deserves a relaxing time after her recent (and successful) battle with breast cancer, and he has listened to my logic in terms of the “savings” that they have each year. You might debate the term “savings”. I simply use the term due to the fact that they are taking a cruise rather than paying a Financial Advisor and his/her firm. It is the same choice that you have when it comes to how you would use your money, if you did not have to pay an AUM fee.
For many other people, the monies can be used to help family and charities while you are still alive. For example, you could decide to pay $10,000 toward your grandchild’s college education or add money to your grandchildren’s’ 529 college savings plans. Or, if you have 15 grandchildren, you might choose to buy all of them an iPad for the holidays. Conversely, the charitable uses for the money are almost as endless as your imagination. One particularly interesting idea with Thanksgiving coming around the corner is paying for dinners for disadvantaged families. The average family spends roughly $50 for a Thanksgiving dinner each year. That figure sounds quite low to me. What if you gave 130 families $75 toward their Thanks giving dinner next year? If you wanted to split the monies between your family and charity, you could buy 65 dinners instead. Imagine being able to allow an entire square block of families be able to enjoy a great meal or how many more free Thanksgiving meals a homeless shelter could serve with $5,000. The great thing about this new-found freedom is that you will avoid the $10,000 AUM fee the following year again. You can choose to do the same thing the following year in whole or in part. Why not choose to get to know two local families, sponsor them, and pay for their groceries for the entire year?
Note that there is nothing that says you cannot see a fee-only or hourly Investment Advisor or Financial Planner. You might pay $250 per hour for four hours or a flat fee of $1,000 on an annual basis. In that scenario, you would be saving $9,000 ($10,000 – $1,000). Plus, there is another thing that retirees fail to realize most of the time. There is no rule that says you have to keep all your money at one full service brokerage firm. There are many individuals that maintain an account at a full service brokerage firm and have another account with most of their funds at a discount brokerage firm. The full service brokerage firm will want you to transfer the funds over to them, but I worked for years preparing performance reports for high net worth clients. Many of them had money at other firms, and we simply included that information as data points in a customized report that showed all their assets and returns of their portfolio. If your firm balks at you moving monies from them and tells you they might drop your account, I would seriously consider why you are at that firm anyway. You can ask your Financial Advisor what value he/she provides that necessitates your keeping all your assets there. I would encourage you to show him/her your two ratios and use that to start the discussion.
There may be certain cases where it is difficult to find your investment fees. If you are not paying any commissions or an AUM fee, I certainly assure you that your Financial Advisor is not managing your money for free and he/she a nice person. You should ask what fees you are paying. Did you pay a load to purchase a mutual fund? What is the expense ratio of your mutual funds or variable annuities? There is a multitude of ways to charge fees, and it is in the best interest of a financial services firm to not disclose each of them. Now I will clarify here. You will most certainly get a financial note that says you are charged x percent, but it is quite rare for that percent to be changed into an actual dollar amount for you to view. For the aforementioned scenario above, the firm should say that your AUM fee is 1% which is equal to $10,000. The latter figure is much more impactful.
What are good benchmarks for the ratios discussed above? The first ratio measures your investment fees versus your total income taxes. A ratio of 10%-15% is a great target. The second ratio measures your investment fees versus your total income. A target of 1%-3% is a great target. If you are accustomed to dealing with a Financial Advisor, it is quite unlikely that your ratios will approach those levels. However, as previously mentioned your investment fees are variable and can change. Your Financial Advisor may make the argument that he/she is needed to ensure your income taxes are strategically planned. Well, he/she should have been doing that all along, right? Isn’t that one of the reasons why you are currently working with a Financial Advisor? If you have a tax plan in place and are not expecting an unusual sum or source of income, the additional cost of having a Financial Advisor as a “tax expert” is usually not a good cost/benefit option. Why? Does it make sense to pay a Financial Advisor an extra $9,000 per year over a fee-only Investment Advisor to ensure you do not pay an extra $1,000 in income taxes? The net cash flow for you is a decline of $8,000; remember you can always consult your tax accountant or financial planner for an hourly consultation whenever a tax situation comes up. Furthermore, you can arrange to meet with either party for at least one hour per year to speak only about taxes.
Lastly, I strongly encourage each of you to open a checking account at a bank or credit union that you only use to pay investment fees and income taxes. It is very easy to find a checking account that charges no monthly fee whatsoever, especially at a credit union in your area. There may be cases where it is inadvisable to pay investment fee via a checking account. Why? Well, you would have to withdraw the money, pay federal and state income taxes, and then send the money to your financial services firm. In that case, I would encourage you to pay your investment fee with a check from your home equity line of credit. Most of the time, you will be paying 3-5% in interest on a home equity loan. The tax-equivalent interest rate at today’s levels is approximately 1.95-3.75%. In order to highlight the level of investment fees paid, it is well worth paying an additional $200 or so in interest on your home equity loan.