posted on: 6/3/2006
revised: 3/9/2010
Jonathan Clements, the personal finance
writer for the Wall Street Journal published an excellent article on
May 31, 2006. While all of his columns are very good, few
articles are formatted in a hard-hitting manner that is needed, in
my opinion, to actually influence personal behavior. This
article is different. It will make advisers turn green and
raise neck hairs of their clients. He has a
fabulous line in the article:
"The problem with our business is
that 98% of investment advisers give the rest of us a bad name."
Funny, but so true. The sad thing
is that 98% may actually be generous to the advisers. I recently
returned from a gathering in Florida of more than 1,000 fee-only
independent investment advisers to learn that I was the only member of the group
who was 100% hourly with no asset charges. That meant that
99.9% were primarily charging asset-based fees1 for managing clients' money!
Now "fee only" advisers are supposed to
be the cream of the crop (or at least they act like this is true).
Most are experienced, successful and are immune from the production
and sales pressure of an account representative at a bank or a
broker at investment wire house. All of these are commendable.
But virtually all of these advisers charge well more than they could
possibly add to a client's net worth so, in that sense, they are
hurting their clients. Fees have such am impact that Clements
makes a good case that the average client of a financial planner
could achieve better results investing in Treasury bonds2.
Clements concedes that most people are
not fit to manage their own money and that most financial planners
are not ill-intended crooks. There is overwhelming data to
support both of these starting points. But that still leaves a
lot of middle ground open for grabs in the financial planning
industry. When choosing a financial adviser, I suspect that
most people are likely to be more impressed by a firm's marketing
brochure or office space than in the actual details of the service
being offered.
Clements advocates that clients should
heed these five principles when choosing a financial adviser:
1) Use only hourly fee advisers.
Avoid advisers who charge commissions or asset-based fees.
This seems obvious to me, yet so few investors actually get the
point. Is it because the commission based people are more
numerous or because they are better marketers? Only one thing
seems clear: the large majority of advisers charge commissions and
asset fees because they make more money doing this than they would
by charging hourly fees. This explains why less than 1 in
1,000 advisers charges only hourly fees. Hourly based
financial planning is not the road to wealth for the adviser, but it
certainly represents the best model for the industry and at least a
fair level of compensation for advisers.
2) Use an adviser with adequate
formal education. The most common designations in
the industry are CFP and CPA-CFS. I am not thrilled with
either of these designations but on the other hand I certainly
understand that it would not be practical to require all advisers to
earn an Master's degree in Business Administration in finance and
accounting, focusing on portfolio management, and then a Master's
degree in Taxation, focusing on compensation planning, combined with
over 20 years as an independent Registered Investment Adviser.
Still, most people do not realize that a CFP and a CPA-CFS can earn
their degree without ever setting foot into a classroom or
participating in teacher or peer-group activities. This may be
my personal bias, but I see far too many advisers who can pass
online tests but not be able to develop "real world" solutions.
I would suggest that clients should look for an adviser with
impressive credentials from an impressive educational institution.
Even a B.S. degree from Wharton (University of Pennsylvania's
business school), for example, combined with adequate work
experience, is better than the average CFP earned through
self-study.
3) Use advisers who act in a
fiduciary capacity. This means that the adviser acts in
your best interest. Pretty basic stuff, right? Not so.
Under the recently passed SEC rule known as the "Merrill Lynch
rule", financial firm representatives are now required to disclose
that they are not required to act in their clients' best interest
but rather that their primary role is to sell investments and that
any advice they provide is only incidental and in support of to
their main role of selling investments. The only legal
requirement for financial planners regarding advice given is that
they not recommend unsuitable investments. This comes as a
shock to clients who actually take the time to understand this
distinction but few actually do. Besides, the technicalities
of this rule make it hard to grasp the issue; I am not sure that Jon
Clements even understands that an adviser does not "choose" to be a
fiduciary but rather this is designated by the factual and legal
climate in which the adviser operates. An Registered
Investment Adviser who operates as an hourly fee is automatically
required to act in a fiduciary capacity.
4) Use an adviser who is well-versed
in other areas besides investments. A good adviser can add
value by saving money on mortgages, taxes, college costs and estate
planning. In fact, over the long term, the value of service
provided in these other areas will clearly outweigh the value added
in providing investment advice.
5) Keep total cost under control.
Whether you are paying a mutual fund fee, a tax preparer's fee, a
commission or a financial planner's charge, all of these add up to
reduce your net results and hinder the long term growth of you net
worth. Set a goal of keeping all of your professional charges
- both the exposed and the hidden charges - to less than 1% of your
total net worth. This might be too difficult a goal for some
at the beginning the financial accumulation stage of life, but it is
a worthy long term goal for every investor.
***
Footnotes:
1 Asset-based fees are
recurring charges that come out of an investment account, usually
ranging from one to two percent of the account value each year.
They may be referred to as "built-in" or "hidden" but financial
firms imply that these fees are more desirable than commissions.
In fact, these fees are considerably more than ordinary investment
brokerage commissions over the long term.
2Clements uses the simple
illustration that is the average balanced investment portfolio of
stocks and bonds returns an average gross rate of 7% per year (in
accordance with historical data) and adviser firms charge 2%
(whether these are built-in fees or the adviser's direct charges),
then the net return of 5% is lower than an investor could have
achieved by buying Treasury bonds without any professional help.
Editorial note added 3/9/2010: In his
final column published before retiring from his position at the Wall
Street Journal, Mr. Clements stated that the only people likely to
remember him ten years after his death are his two children. He
underestimated the impact he made on his readers. I will very likely
remember Jon and appreciate the lessons learned from his column for
the rest of my life and I suspect many other readers feel the same
way.
keywords: choosing a
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Copyright 2010 by Tony Novak. Originally produced and published for the "AskTony" column syndication prior to 2007. Edited and independently republished by the author in March 2010. All rights reserved. |