, , , , , , , , , , , , , , , ,

Most individual investors rely primarily on trust and the ability to develop a long-term relationship primarily to determine whether or not a prospective financial professional is the right choice.  Turning over the management of your investments to someone else is a major decision that has many implications.  Your current lifestyle in retirement or future lifestyle in retirement and meeting your other financial goals along the way are of paramount importance.  The assessment of your personal risk tolerance and understanding of how the financial markets work is inextricably linked.  With so many choices out there in terms of whose investment advice to value, it can be extremely challenging to decide who to pick or what firm offers the best investment, financial planning, and tax/legal advice.  With that being said, there is a critical step that I wanted to share with you that can limit the possibility that you might end up with a financial professional or firm that will not work as hard as you would like to ensure that your financial future is secure.

The answer to this question lies in the compensation to the financial professional as a result of taking on your business.  Now keep in mind that not all financial professionals will fall into this generalized group.  However, financial incentives and time constraints make this a significant factor in the servicing of your account.  The single most important question you can ask a prospective financial advisor, as it relates to this topic, is how much the average value of a client account is.  Why is this so important?  The reason it is so important is that any financial professional has a number of client accounts to service, and time is limited and constrained of course.  From the financial professional’s perspective, the ideal would be to acquire new clients that offer the most potential revenue.  Let’s go over some of the specifics of the financial services industry to illustrate the importance of this average account size bogey.

Most full-service financial services firms will categorize the client accounts of a financial professional in various tiers.  There are normally tier one, tier two, tier three, and other clients.  Tier one clients are those who offer the most revenue potential.  These clients tend to have the largest amount of assets.  Tier two clients are clients that have less assets than tier one but offer the promise of moving into tier one in the near future.  Tier three clients have below average assets in comparison to the other tiers and show no immediate promise for a lucrative revenue opportunity in the coming years.  There are then all other accounts that really should be transitioned to another financial services firm.  When the firm considers all the costs associated with maintaining that client account, it does not make economic sense.  It is far better for the financial professional to recommend that the client picks another financial services firm and professional most always does so via a referral.  Note that different firms have different terms to describe these classifications.  However, the general concept holds across the entire industry.

Here is the key component as it relates to individual investors specifically.  Tier one clients tend to be the top 20% clients in terms of account size for a financial professional.  Typically a certain relationship holds in these cases.  This tier of clients usually will yield roughly 80% of the overall revenue for financial professional.  Oddly enough, it follows very closely with the famed Pareto Principle.  The tier two clients fall below that top tier, but they show promise for the future.  Many times these individuals have investment accounts at other financial firms or will be coming into a good deal of new monies in the future.  They might be converted to tier one status.  These accounts tend to fall into the 21%-50% of clients managed by the financial professional.  The tier three clients are the bottom half of the accounts managed by that financial professional.  There also are “legacy” accounts that really offer little to no revenue and sometimes are unprofitable under certain circumstances.

Now you can look at the financial incentives from the financial professional’s prospective.  Let’s say that the financial professional earns a 1% fee on all assets under management (AUM) which is very common across the industry.  Therefore, if a client has $1,000,000, the annual fee is $10,000 ($1,000,000 * 1%).  A client with $250,000 at the same AUM fee will yield an annual fee of $2,500 ($250,000 * 1%).  Thus, it would take four of the latter clients to equal the revenue from the other single client.  Given that any financial professional has limited time to meet with clients, it makes perfect sense that he/she would prefer to have only one client since the compensation is the same.  The financial professional with the $1,000,000 client can service that account and look for another three clients to increase that revenue (i.e. similar time/effort expended overall).  The general key is to garner the most assets under management with the fewest amount of clients.  That allows the financial professional time manage his/her time most effectively and efficiently.

Here is the most important question you can ask any prospective financial professional:  What is the average account size of your clients?  If the average account size is higher than your investment portfolio, the chances are quite high that your account and relationship will receive much less attention than that financial professional’s larger account.  Now there can be extreme cases where a few large client accounts distort the average account size to the upside, but you can always ask the general range of client account size overall.  Two things will be at play in a situation where your investment account value is less than the average.  First, it makes more sense for the financial professional to spend more time with the tier one clients from a compensation perspective.  Other financial firms are constantly trying to “steal” these accounts to their firms by offering more services and additional financial product offerings.  Second, depending on the amount that your account size strays from the average, you will most likely receive customer service contact from a junior member on the team and/or a “cookie-cutter” investment portfolio recommendation.

I will expand a bit more on the last comments.  Most financial services firms use what is termed a “turn-key approach” for tier three clients.  There are set asset allocation models with a limited amount of components in the recommended portfolio.  The advice can be nearly identical to what you might find by simply going onto the websites of Vanguard, T Rowe Price, Fidelity, or Morningstar for free.  Now please do not infer that I am intimating that the asset allocation models of those websites are not valuable or match your particular risk tolerance and financial plan.  The point is why should you pay a financial professional to get a recommended asset allocation that is virtually identical to these offerings.  You would be better off not paying a fee whatsoever since you can replicate those portfolios for free and follow the ongoing changes to these model portfolios over time.  Note that the underlying investments in these model portfolios are quite transparent and regularly updated on the websites and in many cases come from regulatory filings to the SEC.

While it is true that some financial professionals provide the same level of service without regard to client account size, but these financial professionals predominantly tend to charge a flat-fee or hourly fee for investment advisory and financial planning services.  Financial professionals that are compensated with AUM fees or via commissions have a very tempting incentive to not only spend more time with larger client accounts to retain the client over time but concentrate on obtaining new clients with potential to be in the aforementioned tier one category.

To summarize at this point, the primary question to weed out the vast majority of potential financial professionals to manage your money is to ask “What is your average client account balance?”  If your account would be less than that average, there is a strong probability that the future attention to your account relationship will be less than the other client accounts.  If you have questions in the future, especially during volatile times in the global financial markets or major life changes, you may not be able to get a hold of your financial professional for guidance in a timeframe acceptable to you.  The other options you have are to find a financial professional where you are above the average or find a financial professional that charges a flat-fee or on an hourly basis.  At least in the latter option, you know that the financial profession spends more of an equal amount of time with each client.  Every client account tends to get the same amount of attention, and there is very little distinction in terms of importance.  Think of it this way, it is your hard-earned money and your future is on the line, you deserve to be one of the important clients of your financial professional.  Not just a name and account number.