I have become a personal finance junkie and proponent of do-it yourself (DIY) investing over the past few years. However, this was not always the case. My wife and I used a financial advisor for the first decade of our careers.
In retrospect, we learned that we were paying far more than we realized. In the process, we also received lousy advice. One glaring example that I recently shared was being sold a high-fee variable annuity when rolling over a retirement account after changing jobs. Another was bypassing work-sponsored 401(k) accounts with tremendous tax benefits to invest in products sold by our advisor.
Even after learning how much we were paying and how bad the advice was that we had been receiving, we were still reluctant to become DIY investors. Our initial reaction was to simply find a better advisor.
While trying to find a better advisor, I learned that the advice we were receiving was pretty standard. It was a result of a system loaded with conflicts of interest between what is best for clients and what is best for advisors.
There are several different models for compensating financial advisors. Different models present different conflicts of interest. Each model also has other downsides.
I determined that the only way to eliminate the conflicts of interest inherent in advisor/client relationships was to eliminate the advisor and, you guessed it: be a DIY investor. You need to understand the different compensation models and inherent conflicts of interest associated with each. Then you can make a fully informed decision for yourself.
In the commission-based model, fees are paid to an advisor when he sells a product to a client. The financial industry justifies this model as a way to make financial advice affordable to those without the assets or income to pay for advice with the other models. To quote financial consumer advocate James Dahl: “Bad advice is too expensive at any price.”
The investment industry also claims that they offer this model because clients prefer it. It must also be understood that many clients prefer this model because they have no idea what they are actually paying. Fees can be difficult to decipher and are typically kept out of plain sight.
The first and most obvious conflict of interest in this model is that advisor payment is driven by sales. If an advisor does not make sales, he does not get paid. You may have options to pay down debt, invest in rental real estate, or invest in a 401(k) account with tremendous possible tax advantages that are in your best interest. However, there is no financial incentive for the advisor to guide you down those paths. His financial incentives are tied to selling you products on which he can make a commission.
It may be in your best interest to buy a certain financial product. However, the advisor has no incentive to sell you the simplest, lowest fee products (often the best option for you). Rather, the advisor has every incentive to sell you the most expensive products. These produce high commissions and often result in further, ongoing kickbacks to the salesman. This is why those receiving advice in a commissions-based model are more likely to be sold whole versus term life insurance and actively managed mutual funds, rather than low cost passive index funds.
Advisors operating in the commission-based model generally act under a “suitability standard” rather than a “fiduciary standard.” This enables them to place your investments in complex and expensive investment products with hidden fees. These are often difficult to decipher, such as variable annuities and mutual funds with “12b-1” fees. Due to the low bar set by the “suitability standard,” advisors have little fear of reprimand or reprisal for not acting in a client’s best interests.
Assets Under Management Model
In the Assets Under Management (AUM) model of financial advisor compensation, an advisor is paid as an annual percentage of your assets under their management. Advisors working under this arrangement will point out that they are not incentivized to sell high commission, high fee products. Instead, they are incentivized to place you in the best investment products to meet your needs. The more money you accumulate, the more money they make. Therefore this model is sold as a win-win for both client and advisor.
However, there are some serious conflicts in this model as well. The most obvious is that just as the commission model relies on the sale of products, the AUM model relies on having assets under the advisors’ management for them to be paid. Therefore, they would face the exact same conflicts of interest any time you’d be better served by putting your money outside of their management.
There may also be incentive for advisors to recommend taking inappropriate amounts of risk. There is a significant upside for an advisor to take risks to grow your portfolio. Why? The advisor is paid by a percentage of the portfolio. Advisors can diversify across many clients. Each individual investor has only one portfolio and bears the brunt of any investment losses.
On the flip side, many people are too risk averse. An advisor may be afraid to push an investor to invest in more appropriate, but volatile, assets. If the investor is not invested appropriately to meet his goals, but stays with an advisor, the advisor still gets paid. If the investor gets upset and leaves, even if the advisor gave appropriate advice, the advisor no longer gets paid.
There are other complications to this model, too. A client needs to already have substantial assets accumulated for this model to be viable for the advisor, while charging a reasonable fee. For example, many firms require minimum assets of $500,000-$1,000,000 in order to begin managing your money with an AUM model. While this may be a viable option for some, it leaves many who most need good financial advice completely out in the cold.
Robo-advisors are a subclass of AUM that claim to offer an alternative to this problem. They are quick to point out they can offer a fee structure to all clients that was traditionally available only to clients with a million dollars or more. Their fees range from .25-.5% of AUM.
Podcast: The Pros and Cons of Robo-advisors
Sure, the price of robo-advisors is similar to low-cost traditional AUM advisors. It is a bit disingenuous, though, to assume that robo-advisors offer the same level of value that is provided to millionaire clients receiving individual attention. The potential value of good financial advice worthy of its cost in individualized tax planning and behavioral modification for those that need help in those areas. Instead, robo-advisors are able to offer such relatively low fees by providing cookie-cutter advice and service that is easily scalable with technology. This excellent article from the blog GoCurryCracker provides a detailed analysis of the limitations and fees of robo-advisors.
Finally, while advisors operating in the AUM model may act as fiduciaries, not all do so all of the time. They may still operate under the suitability standard. Or they may operate under different standards with different clients. They maybe even with the same client in different scenarios. In the confusing financial advice world, it is your responsibility as a consumer to find out if your advisor is held to a fiduciary standard.
In a fee-only model, you pay as you go for financial advice. This term is traditionally applied to “fee-only” financial advisors. However, you could also consult with an attorney or accountant for specific legal or tax advice under this model. This is generally seen as the model with the least conflicts of interest. Thus, this offers you the best chance at getting good advice. However, it too is imperfect.
The obvious conflict here, as in any situation where you pay for advice by the hour, is the potential to make things more complicated and thus costly than necessary. For example, a person may be equally served by holding a portfolio with 3 funds as 10 funds, but it is easier to justify fees and ongoing service on a more complex portfolio.
Transparency with fees is the biggest positive of the fee-only model, but it is also a potential drawback. The other models keep fees mostly out of sight and out of mind. You will typically pay much less in a fee-only model over time. However, because you see every fee you pay in the fee-only model, people may be inclined to avoid needed advice to avoid the fees causing underutilization of services.
What Will You Do?
We all must consider many factors when deciding whether or not to seek professional financial advice. If seeking advice, there are many options to go about obtaining it. Unfortunately, none of the options is perfect.
All methods of paying for financial advice present different conflicts of interest as well as other limiting factors. Before choosing an advisor, it is wise to understand the model in which he operates. This will show you the inherent conflicts of interest present, as they will influence the advice you receive.
It doesn’t matter how they are paid. Every financial advisor will face some conflict between what is best for a client and what is best for themselves when giving financial advice. The only way to eliminate all of the conflicts is to educate yourself and become a DIY investor.
Have you tried your hand at DIY investing? What has been your experience, when compared to traditional advisors?