[Editor's Note: This is a guest post from Chris who has a blog titled Eat The Financial Elephant. He and his wife blog about do-it-yourself wealth building, financial planning, and investing with a focus on achieving financial independence and retiring at an early age simply by eliminating waste and living efficiently to create a high savings rate, in their case over 50%. I bet he doesn't buy $11K tables or waste money on expensive boats! We have no financial relationship. Enjoy!]
I am very grateful to have this opportunity to guest post on The White Coat Investor. While our blog has a slightly different focus from WCI, we have a clear common mission of creating educated consumers who will not be victimized by the financial industry. I have read WCI's motivation for starting The White Coat Investor after having poor experiences with the financial industry and it was all too familiar to our own experience. When I think about what motivated each of us to become part of the blogging world, I can’t help but think of the great quote from the movie “Rounders” about the world of high stakes poker: “If you can’t spot the sucker in your first half hour at the table, then you ARE the sucker.” As a high income young professional entering the world of investing, you would be wise to enter into any meeting with a financial professional thinking they are looking at you that way. Your only defense is self-education. DO NOT BE THE SUCKER!
When beginning to invest, we elected to use a financial advisor for two reasons. First, investing seemed very intimidating and complicated. There was definitely an element of fear to go it alone and make mistakes. We felt that we needed a professional to guide us in our investing decisions to assure the best outcomes. Second, it just seemed like it would be easier to pay someone else to do these things for us than to learn to do it ourselves. We were busy young professionals and it was worth our time to outsource these duties. I think our thought process was very representative of most young professionals.
DIY Investing is Cheaper and Easier
Since taking a DIY approach to our financial planning and investing, we realize we could not have been more wrong on either front. We are all but guaranteed to do better on our own precisely because of the extreme savings on expenses and the tax advantages we’ve been able to give ourselves by getting rid of our advisor. By decreasing our tax burdens and eliminating expensive financial advice that brought no value, we have dramatically improved our financial situation without any sacrifice or taking on any excess risk. More importantly, after an initial investment of time to develop our financial plan and investing strategy, it is actually easier and less time consuming to simply do things ourselves than to have to deal with an advisor. We hope to demonstrate this to you with an example.
Let’s create two hypothetical married couples that would be typical young readers of this blog. Each couple earns a combined salary of $200,000. Everyone is 30 years old and beginning to save for retirement starting with $0 savings. [If only most doctors could start investing that young AND with a net worth of $0, but the example still works fine-ed] Both couples plan to retire at age 60 giving 30-year investment time frames. They each have equal risk tolerance. They both will commit to saving $30,000 (15%) of their pre-tax income, to invest. They both will invest in the stock market. We’ll assume market returns of 10% annually.
Finally, we are going to attempt to keep the example simplified. First, we’ll eliminate the effect of inflation by discussing everything in terms of 2015 dollars. Therefore we will reduce the market returns to 7%, attributing 3% of the return to inflation annually. We will keep the absolute amounts of everything else (salary, amount invested, etc.) in the examples constant for the 30 years. We are also going to eliminate the effect of all income taxes except for federal, to not overcomplicate the points being made.
The only difference is that one couple uses a financial advisor and is given the same advice we received as young professionals. Let's call them FA. The other couple chooses to educate themselves prior to committing their first dollar to the investments. They employ the strategies we currently employ since managing our own investments. Let’s call them DIY. Can it really be easier for one couple to have far greater results as we claim without taking any greater risk with investments or saving any more money? Let’s run the numbers.
Missing Out On Tax Deferral
The FA couple is advised to invest in products sold by their advisor. This would be the standard advice for anyone starting out without a high net worth, because the primary ways for most advisors to be paid is through the sale of investment products and having assets under their management. Couple DIY knows that for high wage earners, there are great benefits associated with deferring taxes so they invest their full $30,000/year in their employer-sponsored 401(k) plans. Therefore, they are actually investing $30,000 each year while the FA couple is investing only $21,600/year after paying 28% federal income tax on those dollars.
Paying High Expenses
The FA couple would then be subject to expenses charged by the advisor. We have showed in our case that we paid expenses equal to approximately 2% of our assets per year in fees to our advisor. When starting out, one would likely pay more than that, but let’s use 2% fees to be conservative. After accounting for fees, the FA couple would actually earn a return of only 5% annually. The DIY couple would be subject to fees also. We are very focused on limiting fees with our own investments, using Vanguard index funds that average about .1% annually. However, since our DIY couple is using a 401(k) account they may not have access to these exact funds. Let’s assume they have a poor plan to be fair and have to pay 5X the rate of the Vanguard funds, .5% annually. This reduces their annual rate of return to 6.5%.
Because the FA group did not utilize their tax-advantaged accounts, their investments are subject to additional taxation each year on dividends, interest and distribution of capital gains. They would also be taxed on the sale of any investments that went up in value if rebalancing accounts. We showed in this example how this ends up decreasing investment returns by approximately an additional 1% per year, decreasing their annual rate of return to 4%. The DIY couple’s investments would not be subject to taxation annually, because they utilized the tax sheltered accounts, allowing them to keep more money working for them longer.
Therefore, the DIY couple would contribute $30,000 per year at an inflation-adjusted, after-expense return of 6.5% annually. At the end of 30 years they would accumulate $2,759,677. The FA couple would invest only $21,600 per year and their annual return would be 4% annually. They would accumulate $1,259,892. Assuming you could safely withdrawal 4% of your investments annually in retirement, the DIY couple would be able to draw $110,387/year to live in retirement. The FA couple could draw $50,396/ year in retirement. Remember all amounts are in 2015 dollars.
Taxes Upon Withdrawal
To be fair, the DIY couple has only deferred earnings on their accounts and so they would pay approximately $20,000/year in retirement in federal income tax lowering their take home amount to about $90,000/year versus about $50,000/year in retirement for the FA group. Still not too shabby to nearly double your retirement income without taking extra risk by simply minimizing your taxes and investment expenses.
[Editor's Note: Chris actually overstates the tax bill Actual federal income tax on $110K taxable income (not yet taking SS) for a couple with $20K in exemptions/deductions (basically standard deduction/exemptions) is:
- First $20K= $0
- Next $18,450= $1,845
- Next $56,450= $8,468
- Last $15,487= $3,872
- Total = $14,184
Plus, it's not like there is no tax cost for that taxable account. Some of it is basis, of course, but even if just half of that $50K represents earnings and dividends, that's still $3,780 in taxes. So after-tax, the difference would be $96,203 vs $46,616.]
Are Advisors Really This Bad?
-Can you really assume that a DIY investor could obtain equal returns to someone using a financial advisor? It just so happens that the low cost index funds we choose for our investments have a greater than 80% chance of outperforming an actively managed mutual fund investing in the same sector. Knowing that, I think a more accurate way to ask the question would be this: Could someone using a financial advisor, who has every incentive to sell the more expensive funds, possibly assume to be able to equal the returns of a knowledgeable DIYer? I would personally think not.
– Would a financial advisor really sell you investments and advice that costs you 2% or more of your portfolio annually when there are better investment vehicles costing .1% or less? Absolutely. It is how they are paid. This is why if you choose to use an advisor, you should never choose one who is paid through the sale of products or the amount of your assets under management unless you fully understand the conflicts of interest this produces and you are comfortable with accepting these conflicts.
-Would an advisor really advise you to pass on the obvious and tremendous tax advantages shown above? Ours did! This is the second layer to the conflict of interest. Most advisors are paid by selling you products and/or having your assets under their management. Because the greatest tax advantage available to most workers is to use work-related accounts, advisors have a great incentive to steer you away from these accounts and to products they can earn fees on. [I see this more frequently with cash value life insurance-ed.]
I again want to thank WCI for the opportunity to write this post on The White Coat Investor. I would imagine that there are 3 categories of readers on this site reading this post.
Which Type of Reader Are You?
To the first, this post is simply preaching to the choir and primarily reinforces things you already know. Congratulations if you fall into this category. I hope you keep learning and growing your wealth.
For the second, I hope I’ve piqued some interest in the financial independence/early retirement idea where we look at little inefficiencies in the system that allow you to develop a high savings rate and build wealth very quickly with minimal to no sacrifice of things of value. For you, I hope you’ll stop by our blog to read a bit further about our ideas.
Finally, I’m sure there is a third group of WCI readers that despite reading this guest post still feels that you need to hire a financial advisor because investing is too complicated, too scary or takes too much time. You are high wage earners with disposable income that you are willing to put at risk without even knowing the rules of the game you’re playing. To those in this last group, I’d love if you would reach out to me personally. I’m organizing a poker game and you’re exactly the type of person I’d love to invite!
[Editor's Note: Fee-only advisors reading this will correctly point out that Chris has set up a bit of a straw man here that makes advisors look particularly bad. He's taken the worst type of “advisor” (I usually just call them mutual fund or insurance salesmen) and pointed out how detrimental to your portfolio they can be. Of course, to Chris's credit, the vast majority of those who call themselves “financial advisors” are exactly as he describes and many of us have shared his experience in interacting with them. Even when working with a competent, low-cost advisor (and it's amazing how hard it is to find that combination) the effect of advisory costs on your returns is very real when compared to you investing the exact same way on your own. However, in order to gain that advantage, you must be capable of investing the exact same way on your own. If you are not, due to lack of education or temperament, you either need to rapidly become so through Continuing Financial Education, or hire a competent, low-cost, fee-only advisor.]
What do you think? Have you felt like a sucker when interacting with a financial professional? Have you been sold loaded, high ER mutual funds or inappropriate cash value life insurance? Is Chris too hard or too soft on advisors? Comment below!