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"So Many Hidden Numbers": How Advisors Give Their Clients the Vampire Treatment

Ed Latka was never schooled in the finer points of investing, so the 58-year-old did what tens of thousands of Americans do every year: He entrusted his financial future to a professional.

It's been a disastrous decision. After a bank CD matured, he gave the cash to his financial advisor and, at her suggestion, sunk it into a mutual fund. 

He'd used a financial advisor for nearly three decades, but unlike in years past, Latka decided to read the fine print of the fund his advisor chose and noticed a hefty up-front sales charge. He was floored.

"I just spent a whole year's interest from a CD to invest in this mutual fund," Latka said. "What have I been doing for the past 30 years?"

The vampire treatment
Latka, who is on disability after a lifelong struggle with diabetes, now faces a bleak retirement outlook, despite conscientiously saving throughout his career.

"I've read about compounding interest and if my money was kept in one place -- even the most conservative one -- I'd be OK today. But she was moving stuff around constantly," he said. "What's so scary about this when I look back is there are so many hidden numbers."

Latka is hardly an isolated example. His story speaks to the misaligned incentive schemes of many advisors, the general lack of transparency in the broker-client relationship, and the importance of being an active and engaged client -- even if you're a novice.

University of California, Berkeley behavioral finance expert Terrance Odean urges clients to simply open their mouths. "Don't be afraid to talk about fees, and don't hesitate to ask, 'Why are you charging me this much?'" He paused, and then reiterated: "You should always know how much you're paying."

Latka was never quite clear how he was paying for the services of the advisor. "I never got a bill, just the prospectuses," he said. By chipping away at clients' savings each year, fees are portfolio killers, as Latka's story demonstrates. It's worth understanding them in full.

There are three primary ways a broker or advisor gets paid:

1. Commissions

2. Asset-based fees

3. Hourly/project-based fees



Some of these fee structures are inherently better than others. But they all cost you money, and as New York Times columnist and financial advisor Carl Richards told us, "Any time there's an exchange of money for services, there's a conflict." The key is for customers to understand the potential conflicts and to choose a model that's right for them.

The most painful fee structure for clients' portfolios, and the one that comes with the potential for the most perverse incentives, is the commission-based model.

Latka learned this the hard way. His advisor had plenty of ideas for his portfolio. Seemingly every time they met, she had a new place for Latka to move his money -- Internet funds, foreign-stock funds, oil and gas funds, you name it.

It was only much later that Ed learned that how he was paying his advisor and her glut of ideas were intimately linked. For a broker or advisor who's paid by commissions, every time a stock, option, fund, insurance product, or other asset is bought or sold in your account, it probably means income for your triggerman (or woman).

I asked one key question of all the brokers, advisors, clients, academics, and regulators I interviewed: "Does the commission model ever work out for the client?"

Josh Brown, a financial advisor, blogger, and author of the scathing new book Backstage Wall Street, responded bluntly: "No. No qualifiers."

The closest to an affirmative response were a few mumbled replies about how a commission up-front can be advantageous if the client only trades rarely (as if a broker would let a client get away with that).

In Backstage Wall Street, Brown rips into the model further: "If you sat down with a team of economists, engineers, psychologists, and business ethics professors, you simply couldn't create a worse structure, no matter how hard you tried."

Why is this model so terrible? For one, the fees tend to be egregious. Many broker-sold funds include front-end fees of as much as 5.75%. With fees like that, trading even a single time per year can seriously hobble a retirement portfolio. Looking back at the past 20 years, a low-cost S&P 500 index fund would have turned an initial $100,000 investment into more than $300,000. But if you paid a 5.75% load once every year, you would've ended up with just $88,000 -- turning what should've been a big gain into a loss.

As awful as the fees are by themselves, the incentives that they set up can be downright laughable. While a client may be hoping for wise counsel from their broker, if that broker is compensated based on commissions, then that broker may be more focused on selling the product that pays them the most, and not the one that's best for the client's long-term financial health. Imagine a doctor that gets $5 for every Lipitor pill he prescribes -- how many prescriptions do you think he'll write for a competing cholesterol drug, no matter how good it is?

Jim Betzig, the chief operating officer of the $1.5 billion Beirne Wealth group that broke away from Bank of America's (NYSE: BAC  ) Merrill Lynch unit, said that a big part of the split was the fact that the group "[didn't] want to be product pushers." And even though they tried to avoid commission products while at Merrill, the group "wanted to get away from conflicts of interest" that are inherent in the commission-based model.

And because many of the fees are triggered by trading activity -- buys and sells -- the commission model encourages trading. Classic behavioral finance research from Odean and UC Davis' Brad Barber titled "Trading Is Hazardous to Your Wealth" boils down to this: Trading is hazardous to your wealth. The pair of academics showed that the more investors tended to trade, the worse their accounts performed. Or, as they put it, "investors ... pay a tremendous performance penalty for active trading."

A better way
Moving from commission-based brokers and advisors to those that charge asset-based fees is a gigantic step forward. Carl Richards called it "the best model I've seen."

This model can be head-slappingly straightforward. Each year, the advisor charges a percentage fee based on the total value of the client's account assets. If a client has $100,000 in her account and the advisor's fee is 1%, the client ends up paying $1,000 for the services.

A former engineer, David Shucavage came into the financial advisory business from the outside. Now a fee-based financial advisor with Carolina Estate Planners, Shucavage recounts that he just couldn't make sense of what he calls the "fundamentally flawed" commission-based model. Shucavage swiftly shifted his practice toward asset-based fees. As he describes it:

There is a bias if I'm paid by the fund that I'm putting you in, so I switched to an asset-based fee model. My goal now is to make the pot bigger and I'm free to move it to anything that will achieve that goal. If, for example, I'm looking for a product for you, I'm going to look for an ETF with the lowest fees -- in this model fees not only hurt you, but my profit is hurt as well!

That the incentives of the advisor and the client are aligned is a big selling point of this setup.

But this system isn't without its potentially confusing gray areas. Josh Brown, who uses the asset-based fee model in his own practice, told me that "fee-only is the only way to go." But keep in mind: Fee-based is not fee-only.

"Fee-based" leads to different meanings for different advisors. For instance, many advisors have adopted fee-based practices that let them charge a fee based on the amount of your assets and collect commissions from certain products they sell you.

This isn't to say that customers should avoid advisors that are fee-based, but an extra level of diligence is necessary to determine exactly what fees are charged outside of the overall account fee. An advisor that hits a client's account with both account fees and transaction fees has the potential to do even more damage to that portfolio than the commission-based cavemen derided above.

Is this the best there is?
For brokers and advisors, there is some magic to both of the compensation schemes above. Both allow practitioners to charge clients reasonably high fees without those clients really feeling how much they're actually paying.

In a 2005 paper, Odean and Barber, along with Lu Zheng from the University of Michigan, show that investors do the most to avoid mutual fund fees that are the most obvious to them, not necessarily the most costly. That's why so few advisors use hourly or project-based fees. While commissions and asset-based fees simply get taken directly from investment accounts, an hourly fee model requires that investors pull out their checkbook for the services they're purchasing.

For anyone who's ever hired a lawyer, accountant, gardener, or personal trainer, this idea won't seem novel. Yet because it competes against models that doesn't make customers write a check, hourly fees have yet to catch on in any meaningful way -- even though they're completely transparent and give advisors incentives to provide a good experience.

Still, it's not without potential hiccups, such as padding hours or executing tasks slowly. Also, Richards pointed out that with this model investors may refrain from calling their advisor at important times simply because they don't want to write another check. But overall, this really is a great system -- as long as clients stay involved and are interested in what's going on.

Beyond fee structures
Though many advisory clients can end up feeling intimidated by their advisors, it's vital that they remember that, in the end, the advisor is working for them. Berkeley professor Odean's advice is that advisory clients should "always know how much [they're] paying" and should not hesitate to ask, "Why are you charging me this much?"

Jim Weddle, the managing partner of Edward Jones -- a perennial favorite of JD Power's investment firm rankings -- recognizes the importance of being clear about fees and compensation. "A better-informed client is a better client at the end of the day," he told us. Weddle says that Edward Jones trains its advisors to "show clearly how they're compensated."

A good broker or advisor should be able to walk a client through exactly what the client is paying and how that advisor is getting compensated in a way that the client understands. Current or prospective customers will want to think twice about any advisor that is unable or unwilling to do this.

When not to trip over fees
Len Hayduchok, the principal at New-Jersey-based Dedicated Senior Advisors, points out, "It's not about fee versus commission, it's about value." That is, as long as investors have a transparent picture of what they're paying -- a precondition Hayduchok concedes is still often sorely lacking -- clients should be most concerned with the value of the services they get compared to their cost. For instance, commission-based brokers may fall at the bottom of the list of ideal compensation structures, but that doesn't mean that reputable brokers can't create honest, valuable relationships that are worth keeping.

This is a theme that also rings true for Professor Andreas Hackethal. Hackethal is the dean of Goethe University's business school in Frankfurt and has not only written extensively on the subject of financial advice, but has helped advise the German government on the issue. In an interview, Hackethal emphasized that the form that compensation takes shouldn't necessarily be the focus:

We could discuss what the best incentive scheme and investment scheme is, but that's not necessary ... pay schemes are an input -- what you want to look at is the output. With greater transparency, we could have a competition of advisory models based on which produces the best results.

Get educated
If only Latka had known to look out for all of this sooner. After years of his portfolio getting the vampire treatment from an assortment of fees, he now faces an uncertain financial future.

What's worse is that most of Latka's money had been invested in annuities -- an insurance product that typically carries a monster commission for the salesperson. The investment was made a few years before Ed had any idea what an annuity was, let alone that the product locked up his money for seven years.

Even after all of this, he's not interested in throwing anyone under the bus -- he asked specifically that we not mention his advisor's name or even her company. He says, "It's my own fault for not really studying this stuff."

His horror story provides a valuable lesson: When someone else manages your finances, what you don't know can hurt you.

It's essential that you understand the basics of how the financial advice business works. What you don't understand, get your prospective advisor to explain to you. I cannot emphasize this enough: If they can't or won't explain that to you, then it's not the right relationship.

Latka now believes anyone can learn this stuff. Despite a complete lack of interest or schooling in the subject, he told us that he started reading online "with the most basic investing 101." By the time we talked to him, it was hard to picture the clueless Ed Latka he told us about.

There are myriad reasons that an advisor relationship can benefit an investor. But as the experience of Ed Latka -- and, sadly, countless other investors -- shows, if you don't take the time to understand the basics of how this business works, you may end up in the wrong relationship. And that will cost you for years to come.

Fool contributor Matt Koppenheffer owns shares of Bank of America, but does not have a financial interest in any of the other companies mentioned. You can follow Matt on Twitter @KoppTheFool or Facebook. The Motley Fool owns shares of Bank of America. The Fool's disclosure policy prefers dividends over a sharp stick in the eye. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.

Read/Post Comments (11) | Recommend This Article (41)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On May 12, 2012, at 1:37 PM, sucker2wiseman wrote:

    Timely article. At the moment, I'm addressing these very issues with a life long friend - with whom I've trusted my portfolio.

    Eight years ago, he put my girlfriend into a life insurance annuity within an IRA and never told her it was life insurance and that the only way she could "benefit" from the "income" was to die. She didn't understand what she had been sold, and I couldn't understand it either every time we asked him to explain the account to us. Finally, I pinned him down to get him to explain it was a death benefit only! Now she's down from her principal. And, it has taken since mid-March to get the account transferred to another adviser, and is still not completed. One excuse after another about paperwork not being complete, etc...

    She has also been called by his office, (by his boss and him) at least twice over the past two months trying to get her to change her mind about the transfer.

    I decided to move some mutual funds and a cash balance out of my IRA with "my friend" into an online trading account. The wire transfer was seamless, but the cash transfer has been held up for almost a month now because "the transfer paperwork didn't specify an exact dollar and cents amount". Then he slapped my account with a 3% Qtly "management fee" on top of the commissions!!!

    Needless to say, I'll be closing out my entire account with this "friend".

    Lies and deceptive practices, not vetting for suitability, and delaying tactics for transfers.

    Did someone say criminal???

  • Report this Comment On May 13, 2012, at 12:35 PM, TMFTomGardner wrote:

    I hope those that read this article will forward it on to their family and friends. This is one of the primary ways that hundreds of thousands of dollars leak out of the portfolio of someone getting conventional financial "advice".

  • Report this Comment On May 13, 2012, at 4:45 PM, michaelborger wrote:

    Why people feel compelled to keep their lifelong investments in the market without educating themselves on other lucrative yet safer and more efficient investment vehicle baffles me. The handcuffs tying one to stocks are not as strong as they might appear to be.

  • Report this Comment On May 14, 2012, at 11:14 AM, DCUDFlyer wrote:

    Valuable article. Just tweeted it.

    Thanks MF!

  • Report this Comment On May 14, 2012, at 11:29 AM, DMCSween wrote:

    I'm not one for over regulation; however, I just can not believe that advisors are not required to disclose their annual fees they take out of each investor's account. It is amazing to me that they can take money from you and you never see! Anyone know if this is something that can be accomplished? Is there a standard form that you can request of your broker/advisor that has to disclose this info?

  • Report this Comment On May 14, 2012, at 12:34 PM, WikiCPA wrote:

    ^yeah it should be on your 1099-B, talk to your accountant, I'm sure they use the info found on the 1099 to deduct your advisor fees.

  • Report this Comment On May 14, 2012, at 1:22 PM, DMCSween wrote:

    @WikiCPA - I don't get a 1099 for these accounts as they are IRAs. Any other suggestions?

  • Report this Comment On May 18, 2012, at 12:38 PM, MrBill wrote:

    Once when I was considering placing some savings with a financial advisor I asked why they didn't charge a fee based on percentage of _gains_ each fiscal year, say 10%. Advisory fees would at minimum be zero for the year if the client's account posted no gains or a loss.

    I was told this was illegal, yet I cannot see how this would be a perverse incentive. If it is illegal, I suspect the financial lobby had their hand in that to reduce competition from advisors willing to work hard on behalf of their clients.

    With an asset-based fee model, the advisor has little incentive to invest in anything beyond the most basic CDs, bond and index funds that most clients could do on their own.

  • Report this Comment On May 27, 2012, at 2:11 PM, crjr wrote:

    Please explain what ETF means.

  • Report this Comment On May 27, 2012, at 2:28 PM, crjr wrote:

    Great article. It has me questioning my own account and the financial advisor handling it. His fee is derived on the asset-based scenario however I receive statements from Chas. Schwab regarding trade transactions that indicate fees associated with the trade. The Advisor has stated that I do not pay any fees for the transactions but I question that statement. Also, when I receive prospectus information on the trade most of the time the bar graphs of the past years returns are in the negative side of the ledger. Why would they be purchasing stock shares in companies or funds that did poorly last year?

  • Report this Comment On May 31, 2012, at 1:47 AM, Gemini846 wrote:

    While this particular investor (and perhaps many like him) were taken for a ride there are plenty of good reasons for those products.

    Charging a 5% load on an index fund is a joke. Charging that on a fund you aren't going to touch very often that earns avg 12% because its packed full of international companies you can't get on the open market easily isn't so bad as long as it fits your client.

    Then there is the CD example. He's paying a 3% load for a fund that should be returning 3-5% vs his CD that pays what? 0.2% at my bank right now on 1 yrs. Who's getting taken in that one? Not the guy buying bond funds.

    I sell annuities too. They serve a very valuable purpose for the average investor who is retiring in this day and age with too few dollars. They ensure a paycheck for life. The fees are high, but if you don't move your money because you need a paycheck for LIFE then they don't matter too much do they?

    Common sense tells you that you need an emergency fund so you don't have to tap the annuity and pay the surrender charge.

    This article is about awareness but not every product listed is bad. An advisor who is moving your money every year is really borderline churning. You might have a case against them.

    Most fee based accounts I've come across are limited to investors with $1M+ in liquid assets. Strangely enough those studies cited about people doing worse when they move thier money a lot were done without counting fees, so moving a lot still may not be the best plan.

    Fee based accounts are best used when you have an investment company trying to represent a diverse portfolio in a managed account (similar to a mutual fund but not as slow moving). Those accounts do trade a lot like an institution would and the fees would eat you if they were commission based. I'm sure nobody here is advocating managed money.

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