Fragmented Financial Advice & Fees

In an earlier post, I mentioned that the term financial adviser lacks any real meaning.  If you want to know the risks and likely biases of a particular financial adviser, you'll need to look behind the business card.  For the retail market, the person identifying as a financial adviser is likely a stockbroker, registered investment adviser, or insurance salesperson, or some combination of the foregoing.  A single financial adviser may even wear all three hats with one customer at the same time, depending on the accounts at issue.  This makes it difficult to track what duties a financial adviser actually owes in a particular context.  Making it more complex, the fragmented regulatory structure means that this single financial adviser may have three different primary regulators, FINRA, the SEC, and state insurance regulators.  

In some circumstances, a self-serving financial adviser may shuffle unwitting clients though these different roles in a series of transactions and arrangements that maximize the financial adviser's compensation.  For example, a financial adviser may begin working with a particular client while wearing a stockbroker hat and receiving compensation tied to inducing transactions.  First, adviser recommends a number of higher-fee mutual funds such as front-loaded A Class mutual fund shares that cost 4% up front and 1% in ongoing fees each year.  While these funds will assuredly underperform the market, they do put immediate cash in the financial adviser's pocket.  After this first conflicted recommendation, a financial adviser may not be able to justify more transactions without irritating the firm's compliance personnel.  After a year or two, the financial adviser may pitch a new account type and move to collecting a fee on the basis of assets under management, say 1.5%, by switching hats and "servicing" the client as a registered investment adviser.  Because it's awkward to badmouth the funds the adviser initially sold, they'll probably sit in the account, bringing the total fees paid to about 2.5% annually.  See what these fees can do to a portfolio after the jump.

High fees ruin returns.  Consider the differences in return for investing a $100,000 inheritance over 20 years.  Vanguard sells an index fund that charges 0.05% to track the S&P 500.  Over 20 years (assuming 10% returns to match average returns since 1970), this would grow to $666,054.   If you buy a mutual fund focused on S&P 500 companies and then layer on an investment advisory fee for a total fee level of 2.5%, you're going to have a different retirement scenario with $405,458 in savings.  You will have paid out over $115,000 in fees.  That is $260,596 less in the end than what you would have if you weren't paying 2.5%.   (If you threw in that extra 4% commission for the first year and only paid 1% in mutual funds fees for the first two years, you come out with $401,309 after twenty years.)  Many mutual funds charge even higher fees, sometimes running to 1.5% or more, making it possible for retail investors to have total fee burdens of over 3%.  It's a great deal for the fund managers and financial advisers.

Maybe those assumptions seem a little far-fetched to you.  Who knows if we'll see 10% returns over the next two decades?  I certainly don't have a crystal ball.  Still, running these numbers isn't hard and low fees should beat high fees over time.  You can use a calculator from Bankrate or FINRA's Fund Analyzer to look at possible futures with different assumptions, such as only 5% annual returns or a shorter number of years.  You can even take the mutual funds in your own portfolio and race them against their benchmarks.  

On the whole, far too many pay far too much in fees because of conflicts of interest and because the market for investment advice isn't particularly competitive.  The White House released a report in February 2015, estimating that Americans pay about $17 billion dollars a year more in fees because of conflicts of interest.  That's a significant amount of money and means that many people will run out of retirement money much sooner than they would have if their savings hadn't been diverted away to financial intermediaries.

This isn't to say that financial advisers don't deserve to be paid.  If they're providing a valuable service, you should pay them a fair amount.  Sadly, many people don't realize how much they're paying or even how they're paying for advice.