I thought I would share two emails I received in a 24 hour period earlier this year. They are very similar to other emails I get multiple times a week and demonstrate very well why I believe paying commissions is the absolutely worst way to pay for financial advice.
My Least Favorite Way to Pay for Advice — Commissions
Lots of advisors I interact with like to discuss the intricacies of and the possible rare needs for financial products like cash value life insurance. But they don't see the damage being done by financial salesmen masquerading as financial advisors. These emails demonstrate that problem better than anything I could possibly write:
Email # 1
I am a hospitalist; I love your website and have learned A TON from your posts about investing. So my question is regarding a front load SEP-IRA (my wife's) and my Roth IRA (also filled with front-loaded mutual funds) we have through Northwestern Mutual vs. doing stuff on my own through Vanguard. My financial guy (CFP) is telling me that in the end I will make more with front loaded mutual funds (about 4%) vs. a Vanguard fund (he says they charge 1% a year on the fund which I cannot find anywhere on their website). I think he is just trying to stop me from
transferring all my money to Vanguard. What do you think?
Email # 2
First of all I want to thank you for what you do. It's because of you that so many thousands of professionals have a firmer grasp of personal finance and the steps they need to take to ensure fiscal health. I first got turned on to your blog a few months ago by a colleague, and the knowledge I have gained as a result is beyond measure. Here's an example of how I personally have benefited. As many others, I am a victim of unscrupulous financial planners. Toward the end of my residency in Anesthesiology, we were approached by a couple of financial advisors who had arranged to hold a seminar/sales pitch at our hospital after hours.
How they were even allowed to do this is beyond me, but there they were, extolling the virtues of their services as “specialists in physician financial management”. Wanting to get started on retirement planning, but not having a plan in place, I signed on. And there began the pouring of my money into high load mutual funds and life insurance.
The funny thing is, from the beginning, I never fully trusted them, and constantly wondered if their guidance was really in my best interest. But with my complete lack of financial literacy, I wasn't able to validate those suspicions. Worse, I didn't even know how to go about investigating the question! And anytime I did manage to feebly inquire why they had me in these high cost mutual funds with 5% loads at Fidelity, they always had slick (and confusing) answers that I had no power to comprehend, let alone refute.
Then when I had built up enough of a portfolio, they moved me to “cheaper” institutional funds where each fund had an ER in the 1.5-2.5% range AND an additional 1.1% fee for all AUM. But, finally, after reading your blog and some of the selected works you recommend, I gained the confidence I needed to dump those advisors, liquidate my funds and move them to Vanguard, and come up with my own asset allocation and investment plan.
As a result I've already saved hundreds if not thousands in unnecessary fees, and I finally feel like I'm in control of my financial future. Anyway, I know that's a long story but I wanted to illustrate just how helpful you've been to me and I'm sure many others who come out of residency both very competent practitioners and very lousy stewards of their money. NO MORE!
But I do need some advice on one other remaining problem and I'm hoping you're willing to provide it. The other way these guys screwed me is by getting me into an indexed universal life policy. I started paying into it in October 2010. So far, as of this month, I've paid 33,800 in premiums, and my cash value is 31,427. The surrender value is 25,894. So during the last 4.5 years, while we watched the stock market's meteoric rise, I ended up thousands in the negative, and I lost out on a real opportunity for gains that I may never see again.
As perfectly exemplified by the experience of these doctors, the very worst way to pay for your financial advice is through commissions. If you do so, you are likely to be receiving bad advice, and probably at an unfair price. The worst financial products pay the best commissions, so the advisor, even if he were competent, is facing a terrible conflict of interest. However, most of these advisors have had little to no training, and the training they have had is in sales. The bottom line? Don't pay for your financial advice using commissions or you're likely to end up like these docs, paying loads, high expense ratios, and commissions on lousy mutual funds and life insurance policies and maybe even an additional Asset Under Management (AUM) fee.
The worst financial products pay the best commissions, so the advisor, even if he were competent, is facing a terrible conflict of interest.
The Second Worst Way To Pay For Advice — AUM fees
Speaking of AUM fees, I consider this the second worst way to pay for advice. It's not as bad as commissions, since the advisor is being paid directly by you and only for their advice and service. So it is truly fee-only, but there are still five significant problems with this model.
5 Problems With the AUM Fee-Based Model
# 1 Conflicts of Interest
You still have a conflict of interest. The advisor gets paid only for money under his management. So if he's not managing your 401(k), but is managing your IRA, he may advise you to do a 401(k) rollover, even if you're in a great 401(k) or maybe should be doing backdoor Roth IRAs (and thus don't want a tax-deferred IRA.) The advisor is also more likely to recommend against paying down student loans or mortgages. Not to mention investments managed by someone else, like real estate.
# 2 AutoPay
AUM advisors generally withdraw their fees from your account rather than asking you to write a check to them. Being “out of sight and out of mind” has the effect of you being anesthetized a bit to just how much you are paying. If you actually have to consciously pony up the cash every year, you might be more likely to negotiate, move on to a lower cost advisor, or learn to do it yourself.
Paying AUM fees doesn't have to result in higher fees than paying an annual retainer or an hourly rate, but too few investors with advisors ever really add up all the fees to see just how much they're paying. Advisors don't like clients who do that sort of thing. They'd much rather fill their client rolls with nice “price-insensitive” doctors who feel they're too busy to deal with “the little stuff” and love how the advisors tell them how important they are and how valuable their time is. Meanwhile, the advisors are laughing all the way to the bank.
They wouldn't even think about working for the mere $100-300 an hour that the doctor is working for. Doctors think the advisors are the “hired help” when in reality, it's just the opposite. The best-paying jobs, and certainly the jobs with the highest ratio of income to education/training required, are owning a business that manages other people's money. AUM advisors might argue that investors really want their fees out of sight because it is psychologically too painful to pay them up-front, and if they quit paying them, they'll be worse off due to their behavioral mistakes. I find that patronizing, although it may be true for many investors with little knowledge and poor discipline.
So why do advisors try to specialize in doctors? Because doctors have money. But guess what? They don't look at all doctors the same. They would much rather advise an orthopedic surgeon than a pediatrician. The capitalist in me knows why. If I were an advisor, I'd charge AUM fees and find as many highly paid specialists as I could find to advise. The capitalist in me can easily see it is a great business decision. But the consumer in me can't help but cry “Foul,” or at least, “Caveat Emptor.”
# 3 High Minimums
Another issue with AUM advice is that the advisor has very little incentive to help you with your money when you don't have much money, which is precisely when you can benefit most from good advice. Minimums are often as high as $1 Million, but almost always at least $100-500K. If a flat annual fee or an hourly rate is good enough when your assets are under $100K, they should be good enough when you have $10 Million.
# 4 Rates Come Down Too Slowly
It simply doesn't take twice as much time and effort to manage $2 Million as $1 Million. Some advisors seem like they're lowering costs by offering to manage that second million at 0.9% instead of the 1% they charged on the first million. But come on, that means you're charging $19K a year instead of $20K a year. Some discount. If they really wanted to charge a fair price, they'd charge 1% on the first million and 0.1% on everything above that.
Speaking of decreasing rates, you always want to be sure exactly how that advisor is charging for the “second million.” Is the fee 1% of the first million and 0.75% of the second million, or is it 0.75% of EVERYTHING once you have over $1 Million. It's different for every advisor, so be sure you check.
# 5 You're Someone Else's “Great Investment”
I had a fee-only advisor remark to me that “AUM fees are the best kind of passive income.” Well, do you really want to be somebody else's best investment? He's right, of course. The income comes in year after year after year, gradually increasing, while the work required goes down as the years go by. Most investment plans are eventually pretty automatic. Even if the advisor has to do some hand-holding during a bear market every 5 to 10 years, no big deal.
So, while paying AUM fees is far better than paying commissions, I'd much rather see doctors paying an annual retainer for investment management and hourly rates for financial planning. I probably wouldn't pay an AUM fee at all, but I certainly wouldn't do so without adding them up so I could compare them to a flat-fee or hourly advisor.
What do you think? How do you pay an advisor? Do you like that method? Why or why not? Comment below!