Taking Responsibility

Critical Stuff:Picking the right kind of financial advice is critical to your financial health.  The person you like best is probably the worst choice. The one who promises the most is the biggest crook.

In This Chapter:  Fee-based means “I screw you and you pay for it”.  Taxes and advisors. Math exposes bullshit.


If you need to live off 4 percent, how can you pay your advisers 2.5 percent?

When I was running the company my wife and I founded we sold 35 percent of the company to a private capital company for a very substantial amount of money. As is typical with these kinds of investments the bulk of the money came directly to Diane and I–as the founders and primary shareholders. Since I could easily be the poster child for Attention Deficit Disorder I didn’t want to focus on managing this financial windfall, and neither did Diane. So we met with a few “wealth managers”, picked two, and gave them the bulk of the money to manage. My direction was simple and arrogant: “I know how to make money, and I’m going to go on doing that. What I want you folks to do is not lose this.” I cringe at my stupidity today, but I tend to learn more through mistakes than success.

So here’s what I’ve learned from this mistake:

  • Many financial advisors are too expensive, give bad advice, have serious conflicts of interest, and don’t do the work you need them to do anyway. You need to do a lot of due diligence to pick one, and you need to educate yourself on the realities of the investment world before you turn your hard-earned savings over to anyone.
  • The common notion about the financial benefits of  sharp fund managers and financial experts delivering superior results has been proven time and again to be untrue in the long run. You need to understand what a financial manager can and cannot do for you.


The Big Lie

Lets get something clear right away. No financial manager is going to be able to outperform the market for you. No mutual fund manager is really “hot”. Yes, they can have a good year or two, but then they won’t. There is a basic and very important principle in economics and statistics called “Regression to the Mean” that rules performance with an iron hand. In any undertaking that involves some element of chance, performance over time will move to the average. Nothing mystical about it, it’s just math. But it’s the reason the second album from your favorite rock group probably wasn’t as good as the first, and your dad is taller than you (or not). It’s why a high-flying trend line for anything collapses to the average in a surprisingly short period of time. The companies that create mutual funds know all about this. But they lie to you by inferring that some “stellar” manager is the reason one particular fund is so hot, and infer that the “hotness” will continue because of the manager’s skill. Yes, they say “prior history is not an indication of future performance”–but who believes that? You should, because it’s true. In fact prior high performance is an excellent indication that the party is over, and you’ve arrived after the shrimp is gone.

The really sneaky part of this party is that you weren’t invited while the shrimp were still plentiful. Companies that create mutual funds “incubate” a whole flock of them privately, and let them run for a while. Then they shoot the losers and market the heck out of the winners (and charge a big “expense ratio” for the performance). But isn’t that what you want them to do? Don’t you want to buy only winners?

Two factors mean this is a lousy deal: Survivor Bias and Regression to the Mean. Both mean that the performance you’re seeing isn’t the performance you’ll be buying. The high flyers will quickly drop to market-level gains or lower. You bought into a streak that was mostly luck, and it’s over.

We’ve gone deep enough into this. You can accept that what I’m saying is true, or start prowling the web looking at the brazillion articles that discuss this. We’ll cover this in a little more depth later in the book.

Who Do You Choose?

If you elect to use professional advice you certainly need to understand the difference between fee-only and fee-based. Fee-only means what it says. Fee-based is sales speak for “I charge you a fee, and I get paid commissions”. Huge conflict of interest, both from the basis of the fee (assets under management) and from commissions–they’re paid to sell you stuff.  And when you are sitting in a financial advisor’s office you will be sold to–that’s a poor time to be investigating their fee structure.

In theory, you can select a fiduciary advisor who has specific responsibilities to put your interests first, but even then there’s lot of room for concern–they must disclose any conflicts of interest. Disclosure represents wiggle room. Your failure to act on full disclosure is not the advisors fault. Do you really read all that disclosure stuff? Even if you do and you find some conflict that worries you the advisor will waggle his hand and say “oh that’s just a required disclosure, I never let commissions dictate what I recommend for my clients.” Yeah, sure.

Yeah, sure.

Equally importantly is that there’s no guarantee that they will pay the kind of attention to your investments that will keep you out of trouble in the future. Theoretically, the reason you are engaging an advisor is that they can outperform you, or at least have better information than you. In truth, your selection of an advisor will probably be more influenced by how good a sales job they do on you, or how much your friends and family trust the person than any clear understanding of their fee structure, real performance, philosophy, and integrity.

Some financial writers claim that fee-only advisors can help you and have no conflict of interest–they are contractually barred from having any conflict or collecting any commission. That may indeed be true, but having an advisor collect a fixed fee from you is no guarantee that they aren’t simply wrong or incompetent. Eliminating the conflict of interest is certainly important, but you also need a competent adviser. And if you choose to look at fee-only advisors, you should understand their compensation and how it still might create a conflict of interest that will influence their recommendations.  For example, a fixed fee represents less conflict than one based on a percentage of assets under management. An advisor with only your interests in mind might encourage you to invest in real estate, or some investment outside their management if it’s in your best interest. One whose fee is based on assets under management will be less likely to do that. That doesn’t mean they wouldn’t give you optimal advice, but the conflict is present and could influence their actions.

Most traditional financial advisors are fee-based, which means they charge you a fee which is typically between 1 and 1.5% of the assets under their management, Some may charge you an additional fixed fee to provide you with general financial advice and services. But then they may also take some commissions from the kind of investments they select for you–multiple and clear conflicts of interest. The fees they are collecting for pushing you into investment products can be substantial. There is a disturbing article on one such company called Matson Money here. It’s particularly disturbing to me since one of my financial advisers steered a large portion of the my funds under his management into these funds. He was undoubtedly doing very well by doing so, as well as collecting his already excessive fees.

Most financial writers soft-pedal their condemnation of these practices. The perpetrators aren’t doing anything strictly illegal. Their conflicts of interest and hidden compensation is disclosed–somewhere. But the simple truth is that clients pay financial advisors to act in the client’s interest first and foremost, and they give them their trust. They don’t expect to be conned into accepting some overpriced set of funds that will eat up the money they are supposed to be growing for retirement. It may not be fraud at the level of some Madoff-style Ponzi scheme. But it certainly doesn’t represent anything like fiduciary responsibility and it’s harmful to their clients. Not all fee-based advisors treat their clients this way, there are many that put their clients needs first. But the conflict of interest is always present, and ultimately influences the thinking of most advisers.

Advice Costs Too Much

Even if they are not screwing you by double dipping and giving advice with a conflict of interest, an advisor may cost too much for what they do. Paying the typical fee of one to one and a half percent of investments under management to an advisor might seem trivial, but as we’ll discuss in detail later, if you don’t want your nest egg to evaporate before you die, you should live on about 3-4 percent of your investments, and less than that if you can manage it. Giving half of that to an investment advisor suddenly seems pretty expensive. But the reality is that most advisors will be steering you into investments that benefit them at least as much as you, especially if they are receiving commissions that come from the expense ratio of the funds they recommend. Take a look at those expense ratios and you might find that your advisors are costing you between 2.5 and 3 percent. That’s what you are supposed to live on when you are retired. That’s all of it. If you are also taking, say three percent from your nest egg, then you’re pulling out five to six percent. That moves you well into the territory of people who will probably run out of money before they kaack. I hear McDonald’s may be hiring seniors.

From a recent LA Times article (full article here) about a proposed rule to force financial advisors to act as a fiduciary:

NEW YORK — A newly proposed rule to ban retirement planners from creating conflicts of interest with their customers might appear to put an end the years-long policy fight over the issue. Don’t bet your retirement on it. The battle is just beginning, proponents of the rule said.

The regulation requiring advisors to put clients’ interests first is designed to halt planners from, among other things, steering unknowing customers into high-cost, poorly performing investments that pay planners more but cost retirees dearly. The formal language published late Tuesday by the Labor Department triggered a 75-day comment period and eventual public hearing that both promise to turn the issue into one of the hotly contested regulatory fights since the Great Recession.

“This is going to be the biggest battle since Dodd-Frank, hands down,” said Dennis Kelleher, chief executive of financial reform advocacy group Better Markets Inc., referring to the sweeping 2010 financial reform law.

Kelleher said the industry can be expected to redouble its efforts to kill or mute the rule with $17 billion in annual revenue at stake. That’s the amount the Obama administration said is unfairly diverted to Wall Street and other financial intermediaries in fees because of conflicted advice given to customers. The administration said planners are often compensated through backdoor payments from mutual fund companies or other institutions without the knowledge of their customers. So far, major trade groups, which have led the fight against the proposed rule, are offering a restrained response.

17 Billion in revenue from giving advice tainted by conflicts of interest!?! Holy crap!!! Any question that you should take a good hard look at your advisor?

And in fact, the financial industry will probably be successful in killing the effort to reign in investment advisors, claiming that the new rules will hurt investors. Remarkable nonsense. If you had any doubt that the Wall Street Journal is firmly in the hands of the investment industry then take a look at their reporting on this issue. Lying liars, pure and simple. They know better, and they’re lying. Flat out, no questions about it, lying.

The good news is that following a really well-researched path for investment with nearly no fees and very little expense ratio is fairly easy. The bad news is that you have to do some of the work yourself, or at least you should. There are simplified alternative financial advisors like Vanguard’s in-house financial advisers that will help you out for .2 percent per year. But you can also do it yourself and probably use Vanguards free services to do the heavy lifting. You can also use robo investment services, as we will discuss later or you could use specialized fee-only advisors that provide more limited services and minimal handholding. But if you do everything yourself, in the lowest cost way, you could wind up with a total fee and expense percentage of about .09%.  If you had one million dollars with a typical financial advisor, and they were collecting fees and steering you into actively traded funds that they collected commissions for, your total expense for funds under management might be 3 percent, or $30,000 per year. If you managed your own investments using something more like a Boglehead (explanation later) approach, your total expense would be $900 or less (not including taxes).

Here’s the most important issue of all: If your investment advisor was so brilliant that they delivered double the performance of the world market you would just about break even on expense. Except that they would undoubtedly be trading a lot, and generating a lot of transaction fees and capital gains. If your advisor isn’t paying close attention to your tax situation with every trade, then the short-term capital gains tax can eat up a lot of the benefits. And the simple truth is that Regression to the Mean ensures that no one outperforms the market for long. In fact, they very rarely do for more than two or three years.

So in the good years, they won’t do much for you after fees and taxes, and in the not-so-good years they’ll still take their cut, and make everything that much worse.

If you are willing to do your share of the work and apply a disciplined approach to your investments, then you can save a lot of money that will enable your investments to grow much faster, with less drag. That’s a VERY big if though. If you are just an undisciplined dabbler, and you yank your money out every time the market goes low, and buy back in when it goes high, then you will screw yourself right into the ground. In that case, you need handholding. Whether you can do that with a low fee advisor or you have to pay through the nose for full service is largely up to you.

Do They Really Do The Work?

In my experience, the more senior the financial advisor is (you want to be working with the main dude, right?) the less attention they will actually pay to your account. If you observe their actions carefully, you can usually tell that when you sit down together in that fancy conference room, and your guy opens your folder, that’s the first he’s seen of it since the last meeting. For the most part, people you have never met are working on your stuff, and they’re doing one-size-fits-all work on your account if they do anything at all. If they aren’t doing much–that’s the good news. Generally, if they leave your account alone they won’t be actively damaging your savings. But what are you paying all that money for?

If they’re moving money around they will likely generate some taxable event. You might expect them to pay attention to your overall tax situation, and give you the best strategy for moving money from one entity to another, but often it’s a general decision, and your individual needs are considered only peripherally. I’m sure I’ll get comments that say I’m completely off base, but a financial advisor with fifty clients is small spuds–how much of their attention is going to be applied to the long and short term tax consequence of their actions? They have your permission to trade without contacting you. They will do so. It won’t always be good for you.

In the next few chapters, I’ll talk about alternatives. But in the meantime, Google the word Bogleheads and do a bit of your own research.

Here’s an excerpt of a comment from SupCheat–one of the beta readers:

“Many pros are insurance salespeople, or were, and became certified financial planners after fact.  They will stuff you to the gills with whole life insurance and annuities that produce very high commissions for THEM.

I got to know one guy pretty well but not as his client. He actually did a lot of good, because he was in tax planning and was a CPA, and the people he served were generally irresponsible spendthrifts.  Setting up trusts, managing inherited estates, doling out allowances and doing tax planning for those types actually served them well, even if it was a high commission service, because the people were shallow, live for today morons, or families fighting over inheritances. An annuity is actually a good thing for a spendthrift, even if sold at high commission, because it forces them to budget.

However, in his own life, he was always on knife’s edge.  He kept taking out second mortgages to live, tapped retirement plans with paid penalties, and generally had not much in the way of personal savings and spent more than he had.  He just wanted to get a certain number of million dollar plus portfolios to manage at one percent a year to guarantee his income stream, which once acquired, would allow him to go on indefinitely with income even if not retired.  Professions based purely on knowledge can go on forever without necessarily retiring, just dialing back a bit, and I think that was his plan.

A lot of it comes down to the “myth of expertise” that many people wish to rely on and trust. When it comes to finance, there is nobody who can predict the future and basically NOBODY is an expert. If you don’t realize that commissions, expenses and services will eat you alive over time, then you are basically doomed to share your nest egg and not use it for yourself.” 


The Retirement Trap Copyright © by Bill Babcock and Babcock, William. All Rights Reserved.

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