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Are Your Financial Advisor’s Fees Reasonable? A Unique Perspective – Retirees

14 Tuesday Jan 2020

Posted by in asset allocation, Consumer Finance, Education, financial advice, Financial Advisor, financial advisor fees, financial advisory fees, financial goals, financial markets, financial planning, financial services industry, gross returns, Individual Investing, individual investors, investing, investing advice, investing information, investing tips, investment advice, investment advisory fees, investments, personal finance, portfolio, reasonable fees, reasonable fees for financial advisor, reasonable fees for investment advice, reasonable financial advisor fees, Stock Market Returns

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I started off this examination with a brief introduction to this question.  You can see that discussion by clicking on the following link:

https://latticeworkwealth.com/2020/01/13/are-your-financial-advisor-fees-reasonable-introduction/

As promised, I will start by using retirees as the individual investors.  The hypothetical example is meant to get you thinking about the reasonableness of investing fees and how they affect you reaching your financial goals.  Of course, I will discuss the same topic but using those individual investors who are saving for retirement.  But now, let’s dive into our discussion of this topic by focusing on those individual investors already in retirement.

Example for Retirees:

If you are retired and not independently wealthy, you are in the wealth distribution phase of your life.  There are some retirees that are permanently in the wealth preservation phase.  Wealth preservation simply means that an investor has enough money to live comfortably, but he/she does not need to deplete his/her investment portfolio.  Furthermore, this investor does not really try to increase the value of his or her investment portfolio.  A retiree in the wealth distribution phase of life is the most common example.  This investor is gradually depleting his/her investment portfolio to pay for living expenses on an annual basis.

Since this person is not working anymore, (thus has no income from work, and longevity keeps getting longer), he/she needs have an investment portfolio that is somewhat conservative in nature.  Therefore, it is not reasonable to expect to earn 8.0% per year.  A more common target return might be 5.5-6.0%.  If you are working with a financial professional who charges you 1.0%, you need to earn 6.5-7.0% on a gross basis in order to get to that target net return.  Now the long-term historical average of stocks is about 9.5%, so the higher your AUM fees are, the more weighting you will need to have in stocks and away from bonds and cash.  Well, we have already gone over that, and most individuals that present information will stop there.  I want to take this even further though.

Let’s say you are a current retiree with $1 million that you are living on an additional to Social Security income.  You have a target return of 5.5% to fund your desired retirement lifestyle, and your Financial Advisor charges you a 1.0% AUM fee.  Thus, you will need to earn a 6.5% return gross to reach your bogey.  Now I would like to put in the twist, and I want to do a thought experiment with you.  Your Financial Advisor will sit down with you and assess your risk tolerance and ensure that the investment recommendations made are not too aggressive for you.  If you cannot take too much volatility (fluctuation in asset prices up and down over the short term), your financial professional will reduce your exposure to equities.

Now let’s look at our example through the lens of economic principles.  If you just retired and are 65, you have one option right away.  You can simply invest all your retirement money in 10-year Treasury notes issued by the Department of the Treasury.  Treasury notes are free to buy.  All you need to do is to participate in one of the Treasury auctions and put an indirect bid in.  What is an indirect bid?  An indirect bid is simply saying that you would like to buy a set dollar amount of notes, and you are willing to accept whatever the market interest rate set by the auction is.  What is the yield on the 10-year Treasury Note right now?  The 10-year Treasury closed at 1.85% on January 13, 2020.  When you go to a financial professional, he/she is selecting investments in lieu of you simply purchasing the 10-year Treasury Note.  Keep in mind that US Treasuries are among the safest investments in the world.  They are backed by the full faith and credit of the US government.  Stocks, bonds, real estate, gold, and other investment options all have an added degree of risk.  With the additional risk, there is a possibility for higher returns though.  How does this relate to your 1.0% AUM fee?

Think about it this way:  why are you paying your Financial Advisor?  You are paying him/her to select investments that can earn you more than simply buying a US Treasury Bill, Note, or Bond.  As an investor, you do not want to just settle for that return in most cases.  With that being said though, you can just start out there and forget it.  You do not need to engage a Financial Advisor to simply buy a 10-year US Treasury note.  This means that you are paying the Financial Advisor to get you incremental returns.

In our example above for a retiree, your target investment return is 5.5%.  If you can earn 5.5% during the year, the incremental return is 3.65% (5.50%-1.85%).  Remember that you are paying the Financial Advisor 1.0% in an AUM fee.  Therefore, you are paying the Financial Advisor 1.0% of your assets in order to get you an extra 3.65% in investment returns.  Well, 1.0% is 27.4% of 3.65%.  Thus, you are essentially paying a fee of 27.4% in reality.  Now your financial professional would flip if the information was presented in this way.  He/she would say that it is flawed.  The mathematics cannot be argued with; however, I will admit that many folks in the financial services industry would disagree with this type of presentation.

 Remember that you started out with $1 million.  You could have gone to the bank and gotten cash and hid it in a safe within your residence.  AUM fees are always presented by using your investment portfolio as the denominator.  In our example, your investment fee is 1.0% ($10,000 / $1,000,000).  I urge you to think about this though.  Does that really matter?  Of course, the fee you pay to your Financial Advisor will be calculated in this manner.  But what are you paying for in terms of incremental returns?  If you want to calculate what you are paying for (the value that your Financial Advisor provides), the reference to the starting balance in your brokerage account is moot.  It is yours to begin with.  You have that money at any given time.  Therefore, it should be removed from the equation when trying to quantify the value your Financial Advisor provides in terms of investment returns on your portfolio.

Now remember that I said your target investment return was 5.5%.  The long-term historical average of stocks is approximately 9.5%.  If you choose to simply allocate only enough of your investment portfolio in stocks and the rest in cash to reach that 5.5% target, you will select an allocation of 53.0% stocks and 47.0% cash (5.5% = 53.0% * 9.5% + 47.0% * 1.0%).  Note that I am assuming that cash earns 1.0% and that you can select an ETF or index mutual fund to capture the long-term historical average for stocks.  Now your financial professional is working with you to select an investment portfolio that achieves the 5.5% target return, and their investment recommendations will be different than this hypothetical allocation.

The hypothetical allocation achieves your target return with a simple choice of two assets (an ETF or index mutual fund and a money market).  Keep in mind that you will normally have a portion of your portfolio allocated to fixed income.  The 10-Year US Treasury note is trading around 1.85% as of January 13, 2020.  If you allocate your portfolio to 60% stocks, 30% 10-Year Treasury Note, and 10% cash, your expected return would be 5.5% (5.5% = 49.0% * 9.5% + 41.0% * 1.85% + 10.0% * 1.0%).

Whatever your Financial Advisor is charging you in terms of fees, you need to make that percentage more in your total return on a gross basis such that your net return equals your target return.  In our example above, the assumed AUM fee was 1.0%.  That investment fee means that you must earn 6.5% on a gross basis because you need to pay your Financial Advisor 1.0% for his/her services.  After the fee is paid, the return on your portfolio needs to be 5.5% on a net basis.

So, how much weighting do stocks need to be in your portfolio to ensure that your overall returns are 5.5% after paying your AUM fee?  The answer is 62.5%.  Why?  The expected return of your portfolio is 6.5% (6.5% = 62.5% * 9.5% + 27.5% * 1.85% + 10.0% * 1.0%) before fees.  Given the average retiree’s risk tolerance at age 65 or older, many individual investors do not desire to have a portfolio with 60.0% or larger allocated to stocks.  The more salient observation is that the individual investor had to increase his/her stock allocation by 13.5% in order to pay the 1.0% AUM fee.  This increased allocation to stocks significantly increases the risk of our hypothetical portfolio.  And keep in mind that the historical, long-term average of stocks is just that.  It is an average and rarely is 9.5% in any given year.

But what if we could find a Financial Advisor that only charges 0.5% AUM fee?  How would that change our example above?  So, we now need to earn a gross investment return of 6.0% rather than 6.5%.  The new portfolio allocation is 55.0% * 9.5% + 35.0% * 1.85% + 10.0% * 1.0% = 6.0%.  Our main takeaways here are that the allocation to stocks only increases by 6.0% (55.0% – 49.0%), and this portfolio has a stock allocation less than 60.0%.

Now let’s look at some actual historical data.  The S&P 500 Index did not have a single down year since 2008 if we looked at the subsequent five years of stock returns.  The returns for 2009, 2010, 2011, and 2012 were 26.5%, 15.1%, 2.1%, and 16.0%, respectively.  The average return over that span was 14.9%.  As of December 31, 2019, the S&P 500 Index was up 31.5% for 2019 including the reinvestment of dividends.  Now I am by no means making a prediction for 2020.  However, I wanted to drive home the fact that, if your Financial Advisor sets up your financial plan with the assumption that your stock allocation will earn 9.5% on average, any actual return lower than that estimate will cause you to not reach your target return.  What is the effect?  You will not be able to maintain the lifestyle you had planned on, even more so if there are negative returns experienced in stocks over the coming years.

Essential/Important Lesson:

Let’s look at the next five years starting in 2015.  A five-year period covers 2015-2019.  If you start out with $1,000,000 invested in stocks and plan on earning 9.5% per year, you are expecting to have $1,574,239 at the end of five years.  Let’s say that the return of stocks is only 4.5% per year over the next five years.  You will only have $1,246,182 as of December 31, 2019.  The difference is $328,057 less than you were expecting.  The analysis gets worse at this point though.  How can it get any worse?

Well, if you were planning on 9.5% returns from stocks per year, the next five-year period 2019-2023 needs an excess return to catch up.  Thus, if your starting point on January 1, 2015 is $1,000,000, your financial plan is set up to have $2,478,228 as of December 31, 2023.  If you are starting behind your estimate in 2019, the only way you can make up the difference is to have stocks earn 14.7% over that five-year period which is 5.2% higher than the historical average.  As you can see underperformance can really hurt financial planning.  The extremely important point here is that a 1.0% AUM fee will cause you to be even further behind your goals.  Remember that the illustration above is gross returns.  You only care about net returns and what your terminal value is.  Terminal value is simply a fancy way to say how much money is actually in your brokerage account.

Are Your Investment Fees Higher Than Your Taxes? Probably.

22 Tuesday Oct 2013

Posted by in business, Charity, Consumer Finance, Education, Fed Taper, Federal Income Taxes, finance, financial planning, Income Taxes, Individual Investing, interest rates, investing, investing, investments, stocks, bonds, asset allocation, portfolio, investments, math, NailedIt, personal finance, portfolio, risk, State Income Taxes, statistics, stocks, Uncategorized

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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.