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bonds, business, Certified Financial Planners, CFP, finance, Financial Advsiors, financial planning, individual investing, investment advisory fees, investments, personal finance, Registered Investment Advisors, retirement, RIA, stocks, volatility
The 12.5 I am referring to is 12.5%, and it relates to investment advisory fees. I have discussed the effects of investment advisory fees at length in previous posts. In general, most individual investors pay fees to financial services firms that are too high in comparison to the value provided in many cases. For example, the vast majority of individual investors do not need complex, strategic tax planning, estate planning and legal advice, or sophistical financial planning. However, the firms that most people invest with offer those services within the fee structure. There is very little in the way of options to select a larger wealth management firm that will provide only asset allocation advice at a reduced fee because the individual investor does not need the other services when it comes to tax, legal, and sophisticated financial planning. I wrote an article several months ago in regard to how you can look at the value added by your financial professional. It is worth a review in terms of what he/she can do for you that you cannot simply do yourself using a passive investing strategy. Here is the link:
I would like to focus on a different way of looking at investment advisory fees. My primary focus will be on retirees; however, the logic directly applies to those in the wealth accumulation phase of life trying to save for retirement. As I have mentioned previously, the standard fee for investment advisory services is normally 1% of assets under management (AUM). This structure simply means that an individual investor pays $1 in fees for every $100 invested. Another way to look at it is that you will pay $10,000 annually if your account balance is $1,000,000 ($1,000,000 * 1%). I would like to go through an illustration to show what this means in terms of your investment performance, overall risk profile, and the ability to reach your long-term financial goals.
Most individual investors do not write out a check to their financial professional. Rather, they have the investment advisory fees paid out of the investment returns in their portfolios. My example does not make any difference how you pay your fees, but it can be somewhat hidden if you are not writing out a check. The fees just appear as a line item on your daily activity section of your brokerage statement; most investors skim over it. In order to make the mathematics easier to follow, I am going to use a retiree with a $1,000,000 account balance and a 1% AUM fee annually. My entire argument applies no matter what your account balance is or your AUM fee. You just need to insert your personal account balance and AUM fee which may be higher or lower. So let’s get started.
In my hypothetical scenario of a $1,000,000 portfolio subject to a 1% AUM fee, this retiree will have to pay $10,000 to his/her financial professional for investment advisory services rendered. Well, we can look at this fee from the standpoint of the portfolio as a whole in terms of investment performance necessary to pay that fee. The portfolio will need to increase by at least 1% to pay the fee in full. Now most financial professionals will tell clients that they can expect to earn 8% per year by investing in stocks. So using that figure (which is close to the historical average), we can get to the fee by allocating $125,000 of the overall portfolio to stocks in order to increase the portfolio on average by 8% to be able to pay the $10,000 fee ($125,000 * 8% = $10,000).
What does that mean in terms of your overall portfolio allocation to stocks? You can imagine that, whatever your total allocation to stocks is, 12.5% of that amount is invested simply to pay fees. For example, if you are just starting out in retirement at age 65 and have 60% allocated to stocks, 12.5% of the expected return (8%) from stocks in your total portfolio will go to pay your annual investment advisory fees and 47.5% of the expected return (8%) from stocks in your total portfolio will add to your account balance.
The math works out this way: $1,000,000 * 60% = $600,000 // $600,000 (invested in stocks) * 8% (expected return from stocks) = $48,000 // $48,000 – $10,000 (AUM fee at 1%) = $38,000. An alternative way to do the math is to take the total allocation to stocks and subtract the necessary allocation to stocks to pay the AUM fee, and that result is the investment return for the year that remains in your account balance which is $38,000 (So take 60.0% – 12.5% = 47.5% // $1,000,000 * 47.5% * 8% = $38,000).
The paragraph above has major impacts for your portfolio. Firstly, it illustrates how much additional risk you are taking on in your portfolio as a whole. In order to breakeven net of fees, you need to invest 12.5% of your portfolio into stocks. Retirees are in the wealth distribution phase of life, and most are living off the investment account earnings (capital gains, dividends, and interest) and principal. Since retirees have no income from working and will not be making any additional contributions, they are impacted greater than other investors in the way of volatility. Stocks are more volatile investments than bonds but offer the promise of higher returns. It is the simple risk/reward tradeoff. Second, it shows that the higher the fees for retirees the more vulnerable they are to volatility as a whole. Since retirees need to withdraw money on a consistent/systematic basis, a higher allocation of their portfolio to riskier investments are more vulnerable than other investors that have longer timeframes prior to retirement (wealth accumulation phase). If there are major downturns in the stock market, retirees still have to withdraw from their accounts in order to pay living expenses. They do not have the luxury of not selling. Yes, a retiree could sell bonds instead of stocks but then the allocation of stocks has to rise by definition as a percentage of the entire portfolio.
There is a way to rethink the investment strategy for a retiree. In today’s investing environment, there are many more investment offerings that offer financial products at much lower expenses than traditional active mutual fund managers. These include ETFs and index mutual funds. The expenses typically are less than 0.20% (in fact, most are significantly lower than this). Additionally, there has been the proliferation of independent Registered Investment Advisors (RIAs) and Certified Financial Planners (CFPs) over the past 10-15 years who charge fee-only (hourly) or flat fee. Most of these financial professionals charge significantly lower fees than the traditional 1% AUM fee. In fact, it is possible to cut your fees by 50% at least. Now the flipside may be that you might not have the ability to consult with some about certain sophisticated tax, legal/estate, and financial planning strategies. However, most retirees do not need that advice to begin with. The average retiree only needs a sound asset allocation of his/her investment portfolio given his/her risk tolerance and financial goals. To learn more about independent RIAs and CFPs, I have included these links:
The main benefit in terms of reducing fees is not only that the retiree keeps more money, but, more importantly, he/she can reduce the overall risk of the portfolio. Let’s go back to our hypothetical example of a retiree with a $1,000,000 who is charged a 1% AUM fee or $10,000 per year. If the total investment advisory fees are reduced by 50%, the total annual fee is 0.5% or $5,000 per year. What does this mean? In our first example, the retiree had to allocate 12.5% of his/her portfolio of stocks to pay the $10,000 annual AUM fee (assuming an 8% expected return). If the fees are 50% less, the retiree now only has to allocate 6.25% of the portfolio to stocks in order to pay the annual investment advisory fees ($1,000,000 * 6.25% = $62,500 // $62,500 * 8% = $5,000).
Now if we go back to the longer example of a simple 60% stock and 40% bond portfolio, the retiree in this case is able to invest 53.75% in stocks and 46.25% in bonds and still pay the annual investment advisory fees. The math is as follows: ($1,000,000 * 53.75% = $537,500 // $537,500 * 8% = $43,000 // $43,000 – $5,000 new annual fees = $38,000). You will note that the retiree has $38,000 in his/her portfolio after the annual fees are paid out. This dollar amount is equal to the other hypothetical retiree who had to pay a 1% AUM fee. The example illustrates that both investors have the same expected increase to their portfolio but the retiree with the lower fees is able to get to that figure with a portfolio that is less risky because he/she is able to allocate 6.25% less to stocks.
Another way to look at this scenario is that the retiree in the second case with 50% lower fees could have alternatively chosen to reduce his/her stock allocation by 5%. For example, the retiree could have started with a portfolio allocation of 55% instead of using the 53.75% stock allocation. In this example, the retiree would have an expected return after fees that is $1,000 higher than the retiree from the first example and take less risk. The math is as follows: ($1,000,000 * 55% = $550,000 // $550,000 * 8% = $44,000 // $44,000 – $5,000 = $39,000 // $39,000 – $38,000 = $1,000). The retiree in this example would have a higher expected return from his/her entire portfolio of 0.1%. While this figure might not sound like much, the more important point is that this return is achieved with less risk (only 55% allocation to stocks versus a 60% allocation to stocks).
A financial professional might argue that he/she is able to create an asset allocation model for an average retiree that will end up having investment returns higher than that recommended by the independent RIA or CFP. Of course, this might be the case. However, in order to have the retiree be indifferent between the two scenarios, the portfolio recommended by the financial professional charging a 1% AUM fee must be able to return 0.5% more annually at an absolute minimum. Now this does not even consider the riskiness of the retiree’s portfolio. In order to have a portfolio earn an additional 0.5% per year, the client will have to accept investing in riskier asset classes. Therefore, given the additional risk, the retiree should require even more than an additional 0.5% overall return to compensate him/her for the potential for higher volatility.
As you can see, the level of fees makes a big difference. The more you are able to cut the fees on your retirement account (and any account for that matter) the less risky your portfolio can be positioned. In the aforementioned example, the overall reduction in the exposure to stocks can be a maximum of 12.5% to stocks. Now the average retiree will most likely not want to forgo any investment advice from a financial professional. However, in the case of person able to lower his/her investment fees by 50%, he/she was able to reduce his/her investments in stocks by 6.25% (12.5% * 50%). In fact, you can figure out the possible reduction in exposure to stocks by multiplying the 12.5% by the reduction in fees you are able to achieve. For example, let’s say that you are able to reduce your investment fees by 70%. You would be able to reduce your allocation to stocks by 8.7% (12.5% * 70%).
The entire point of this article is to show you how you can be able to reduce the volatility in your portfolio and not sacrifice overall investment returns. If investing in stocks during your retirement years makes you nervous, this methodology can be used to help you sleep better at night because you have less total money of your entire retirement savings allocated to stocks. However, you are not sacrificing investment returns. Always remember that in the world of investment advisory fees, it truly is a “zero sum game”. All this means is that the investment advisory fees are reducing your net investment portfolio gains. The gain in the value of your portfolio either goes to you or your financial professional. The more you learn about how investment advisory fees, the types of financial professionals available to advise you offering different fee schedules, and how the financial markets work, the more gains you will keep in your portfolio.
bonds, business, compensation, education, fiduciary, finance, Financial Advisors, financial services industry, investing, investment expenses, investment fees, investments, personal finance, stocks, suitability
A great debate is raging on in the financial services industry regarding the concept of suitability and fiduciaries. In fact, many firms in the financial services industry are lobbying hard with millions of dollars to keep suitability as the “law of the land”. What is the difference even? Does it make a difference in the investments and asset allocation strategy recommended to you? Well, the financial services industry does not want to change the status quo away from suitability; I can assure you of that. In order to answer that question better, I will provide an analogy below to try to explain the concept more clearly.
Imagine that you have a son or daughter who is finishing up his or her senior year in high school. He or she has done remarkably well academically and has participated in many extracurricular activities. Your child is interesting in pursuing a degree in engineering and is not quite sure what school to go to and if mechanical or biological engineering might be the right path. A sensible and perfectly natural approach would be to consult the high school guidance counselor to get some insight. The guidance counselor may recommend the local university in town. The guidance counselor knows that they offer a degree in engineering. Let’s say your son or daughter report back with excitement at the prospect of going off to college and starting on the path to a career in engineering.
After you have that conversation, you run into a friend who you “brag” to about the news. However, that friend is an engineer and mentions that there is a well-respected engineering program only 75 miles away. That university is known as one of the best in, not only in the state, but in the region. You are still very proud of your son or daughter but cannot understand why the guidance counselor did not mention that option. You decide to go to the guidance counselor and ask what his process was when he talked to your son or daughter. The guidance counselor simply states that your child mentioned that he/she wanted to go into an engineering program. The local university offers an engineering program, and it is accredited as well. When you ask why the other university was not mentioned, the guidance counselor replies that his job was only to find a school that had the degree your son or daughter needed. It was not his job to find the best option. Needless to say, you would be extremely perturbed or worse.
That little story can serve as the backdrop for the issue of suitability and fiduciaries. There are some financial professionals that offer advice based upon suitability. Other financial professionals are considered to be fiduciaries. Suitability is more akin to the way in which the guidance counselor handled the meeting with your son or daughter. The job was only to find a school that fit the needs. Finding a better option was not really thought of or necessary. The friend actually put you on the path to how a fiduciary approaches things. A fiduciary would find the best option given all the information about your son and daughter and his/her future plans.
Now the definition of suitability and how a fiduciary must act are really complex from a legal standpoint and the corresponding requirements needed to follow either. A fiduciary has additional legal responsibilities to you as a client. In order to be a fiduciary, there are strict rules on compensation, products that meet your financial goals, investment expenses, and conflicts of interest. What might a conflict of interest be? Well, a good example is that many financial services firms have proprietary asset management arms and investment products. If that firm manages your recommended portfolio components, additional revenue goes to that firm. Another example might be that many mutual fund offerings provide the financial professional with lucrative 12b-1 fees that are referred to in the industry as trails. A trail simply means that the financial professional receives an annual amount based upon a specified percentage applied to the client accounts that he/she has with the mutual fund company. Another favorite offering is variable annuities. These types of products offer extremely high payouts which are applied to the face value of the insurance policy. It can be very tempting to offer the variable annuity with the highest payout as long as the underlying investments are acceptable (i.e. they invest in large cap stocks that were one portion of your proposed portfolio allocation).
Now I am not saying that anyone who only has to adhere to suitability requirements will automatically place you into investments that have higher fees for you or are better for his/her year-end bonus. My point is that a fiduciary must adhere to higher standards of conduct and act truly independent. A fiduciary runs the risk of additional liability if they breach their duty to you as a client. A financial professional that only has to recommend suitable products has a much lower hurdle to get over. As long as he or she recommends a mix of stocks, bonds, and alternative investments that meets your financial goals, that is all they have to do. Of course, that financial professional may suggest the exact same products that a fiduciary would. However, they are not required to recommend offerings that are the best in terms of investment fees and the best financial product available given your circumstances.
The important thing to remember is to always ask your financial professional whether or not he/she is a fiduciary. If not, you want to ask them how they come up with solutions that are suitable for you. You can even ask them if there are other options available. If you see recommendations that are heavy on the mutual funds of the firm you are dealing with or life insurance products with large amounts of legalize and complicated forms, you should delve deeper into that financial professional’s logic. You definitely should ask what form of compensation and amount he/she will receive and if any revenue goes to the firm from that financial product. Additionally, I would ask them why a more low cost, passive approach might achieve the same objective but be less expensive for you. Some of the responses might surprise you. If the answers seem to sound more like the guidance counselor, I would urge you to seek a second opinion before you choose that financial professional and start an account with that investment portfolio.