Tag Archives: CFP

Is There a Way to Discern Whether or Not a Prospective Financial Advisor Will Provide You with Top-Notch Service? Short Answer is Yes.

06 Thursday Mar 2014

Posted by in asset allocation, bonds, business, Consumer Finance, Education, finance, financial advisor fees, financial planning, Individual Investing, investing, investment advice, investment advisory fees, investments, personal finance, portfolio, reasonable fees, reasonable fees for financial advisor, reasonable fees for investment advice, statistics, Suitability

≈ Leave a comment

Tags

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

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.

What is the 800-Pound Gorilla in the Room for Retirees? It is 12.5.

26 Wednesday Feb 2014

Posted by in active investing, active versus passive debate, asset allocation, bonds, business, Education, Fiduciary, finance, financial advisor fees, financial planning, Individual Investing, investing, investing, investments, stocks, bonds, asset allocation, portfolio, investment advisory fees, investments, math, passive investing, personal finance, portfolio, risk, stocks, volatility

≈ 2 Comments

Tags

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

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:

https://latticeworkwealth.com/2013/10/26/are-your-financial-advisors-fees-reasonable-are-you-actually-adding-more-risk-to-your-ability-to-reach-your-long-term-financial-goals-here-is-a-unique-way-to-look-at-what-clients-pay-for/

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:

1)       RIA – http://www.riastandsforyou.com/benefits-of-an-ria.html

 

2)      CFP – http://www.plannersearch.org/why-cfp/Pages/Why-Hire-a-Certified-Financial-Planner.aspx

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.