"So Many Hidden Numbers": How Advisors Give Their Clients the Vampire Treatmenthttp://www.fool.com/investing/general/2012/05/11/so-many-hidden-numbers-how-advisors-give-their-cli.aspx Matt Koppenheffer
May 11, 2012
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
"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:
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.
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
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?
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
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