By Dr. James M. Dahle, WCI Founder
Once more I find myself needing to chart a moderate course. I run into many do-it-yourself investors who are convinced that the financial advisory industry is hosing everyone. I also run into many financial advisors who are convinced their services are so valuable they should be paid millions. In the last couple of years, advisors have taken to pointing toward two studies, one by Vanguard and one by Morningstar, that seem to argue that the services of an advisor provide an incredible amount of value. Let's talk about each of these points of view and why they are both wrong and right.
The Hard-Core Do-It-Yourselfer
DIY investors are fond of adding up all the asset-based fees associated with advice and extrapolating them out for decades. For example, they might use 1% for the financial advisor fees, another 1% for the mutual fund expense ratios and commissions, and another 0.5% for the account fees (such as a 529 or a 401(k)). In total, 2.5%. So if a portfolio has a long-term pre-fee return of 8% per year, and you're paying all those fees, you're really earning 5.5% per year. The difference between 8% and 5.5% over the long run is absolutely monstrous. Consider a physician who invests $50K a year for 30 years.
At 5.5% per year, =FV(5.5%,30,-50000,0,1) = $3.82 Million
At 8% per year, =FV(8%,30,-50000,0,1) = $6.12 Million
$2.3 Million, or 60% more. Think that's huge? Run the numbers out for another 30 years during the distribution phase and you'll really be in awe. If you can withdraw 4% a year from a portfolio safely, but 2.5% goes to the advisor, the advisor gets 63% of what your portfolio produces and you only get 37%, despite doing all the saving and taking all the investment risk. This is a compelling argument that every investor should be aware of. Fees matter, and they matter a lot. Minimizing investment-related fees are a critical aspect of successful investing.
However, this analysis ignores a couple of important concepts. Before we get into those, let's take a look at another point of view.
The Vanguard Study
Vanguard did a study a few years ago, and their conclusion is routinely trotted out by financial advisors trying to convince you to use their services. The conclusion is that an advisor adds “about 3%” to the returns of a typical client. If you're paying 1%, and getting 3%, well obviously you're coming out ahead.
Where does that 3% figure come from? Vanguards says three places:
- Portfolio construction (0-1.15%/year)
- Behavioral coaching (1.5%+/year)
- Wealth management (0-1.45%/year)
Those are pretty wide ranges. I mean, we're really looking at 1.5%-4.1%, even just taking their numbers at face value. We'll come back to how they break those numbers down later.
The Morningstar Study
These are trustworthy institutions doing these studies. Who doesn't trust Vanguard? Who doesn't trust Morningstar? But it's important to not just take the “headline conclusion” and to actually dive into the data a bit. The Morningstar study discusses three greek letters—the well-known “alpha” (beating the market, as attempted by stock pickers and actively-managed mutual fund managers with negative success on average), the equally well-known “beta” (the market return captured by an index fund), and a new, unknown letter, gamma, which they describe as the value added by an advisor.
Morningstar came up with five “Gamma Factors”, i.e. ways an advisor can add value. They include:
- Asset location and withdrawal sourcing (0.23%/year)
- Total wealth asset allocation (0.45%/year)
- Annuity allocation (0.10%/year)
- Dynamic withdrawal strategy (0.70%/year)
- Liability relative optimization (0.12%/year)
They concluded that the advisor added the equivalent of 1.59%/year of value. Which is great if you're only paying 1%, not so great if you're paying 2%.
Criticizing the DIY Financial Advisor Argument
There are three main criticisms of the DIY argument. The first is that it ignores the effects of poor returns on AUM fees. For example, lots of investors think that having an advisor you pay 1% to reduces your safe withdrawal rate from 4% to 3%, or costs you about 25% of your potential retirement spending. Michael Kitces makes a convincing argument that that isn't the case. The reason why is that if a bad sequence of returns shows up, it reduces not only how much you have to spend, but also how much you pay the advisor. Kitces calculates it out that instead of losing 25% (1% of portfolio) of your potential spending, you really only lose 10% (0.4% of portfolio).
The second criticism is that it ignores taxes. That extra return you get from not hiring an advisor should be reduced by the tax cost of that extra return. If the return is LTCG/qualified dividends in a taxable account and you're in the top tax bracket, it should be reduced by 23.6%. So instead of a 1% extra return for the DIY investor, it's really just 0.76% extra. In addition, advisory fees are often paid out of a tax-deferred account. Although technically only a proportion of the fee equal to the proportion of the portfolio that is in a tax-deferred account vs a tax-free or taxable account should come out of the tax-deferred account. I suspect that doesn't always happen, to the advantage of the client and the advisor. If your marginal tax rate is 40%, it's as if your 1% advisory fee really only cost 0.6%. In essence, you're paying your advisory fees with pre-tax dollars. Now it's a little more complicated than that since you lose that tax-protected and asset-protected space forever, but suffice to say you're not losing the full 1% return.
The third criticism of the DIY argument is simply that it ignores value. As Oscar Wilde said, “a cynic is a man who knows the cost of everything and the value of nothing.” I was cynical before I ever went to medical school, and I would be an extremely unusual person if I wasn't more cynical after 7 years of education and training and 12 years of working in an emergency department. We'll discuss value more below, but suffice to say that a good advisor can add value for many people, even knowledgeable, sophisticated investors.
Criticizing the Vanguard Study
Vanguard says advisors can add 3% of value. But let's break it down.
- Portfolio construction (0-1.15%/year)
- Suitable asset allocation using broadly diversified mutual funds/ETFs (> 0%/year)
- Cost-effective implementation/low expense ratio funds (0.4%/year)
- Asset location (0-0.75%/year)
- Total return vs income investing (>0%/year)
- Behavioral coaching (1.5%+/year)
- Advisor guidance (1.5%/year)
- Wealth management (0-1.45%/year)
- Rebalancing (0.35%/year)
- Spending strategy/withdrawal order (0-1.1%/year)
Now that we've gotten into specifics, things don't seem quite so rosy anymore. First, because their estimates are way too high for some of these things. Consider rebalancing. They claim that provides an additional return of 0.35%/year. I call B.S. In general, rebalancing LOWERS returns. It doesn't increase them. What it does is maintain risk at the preset level. Because stocks usually outperform bonds, each time you sell stocks and buy bonds, you're lowering your future expected return. So I have no idea where they come up with a figure like 0.35%/year. There is no rebalancing bonus when one asset class has a much lower expected return than the other.
Another factor they name is asset location. At Vanguard (like with most advisors), that usually means two things:
- Putting higher expected return assets preferentially into tax-free (Roth) accounts, which is bogus because while it does increase expected returns, it does so at the cost of increased risk when accounts are appropriately adjusted for taxes.
- Putting stock preferentially into taxable accounts and bonds preferentially into tax-protected accounts, which is not always optimal because it focuses on tax efficiency only, instead of both tax efficiency AND expected returns.
Next, the study fails to acknowledge that many of these “valuable services” could be provided with some very limited education. How long does it really take to teach/learn the following:
- Use broadly diversified, low-cost index funds to build your portfolio
- Watch your expense ratios, keep them as low as possible
- Preferentially put high-expected return, tax-inefficient asset classes into tax-protected accounts and vice versa
- Don't focus on income, focus on the total return
- Save 20% of your gross income for retirement and don't sell all your stocks in the depths of a bear market
- Rebalance once every 1-3 years
- Spend taxable assets first in retirement, then use tax-deferred assets up to the top of an appropriate tax bracket, and tax-free assets after that
I mean, I can put that on an index card. I can teach it in a one-hour lecture. I just gave it to you for free in this blog post. A good fee-only, hourly rate advisor can probably convince you of it in just a year or two of quarterly meetings for the cost of a few thousand. But you want me to pay you 1% of my net worth every year for the next 60 years (easily a 7 figure amount and possibly an 8 figure amount) for teaching me that? That doesn't pass the sniff test.
Criticizing the Morningstar Study
The precision of this study cracks me up. I mean, it's great to estimate stuff, but reporting it to 1/100th of a decimal point given how vague the assumptions going into the study are? Give me a break. This is financial planning, not physics. Using those levels of precision misleads those reading the study into thinking this data is better than it is. If you just read through the “study” you realize how much hand-waving is going on. The only reason anybody gives this study any credence is that their conclusions are reasonable. Sure, I can believe an advisor could potentially add 1.59% per year of value. But I would have believed it just as much if the answer had been 1.25% or 2%!
Then the study starts throwing out calculations like these:
Do you know what any of that means? No, of course you don't. Neither do I. Neither do 99% of the financial advisors in the country. But it sure looks impressive, doesn't it? I mean, if they use figures like that, it must be accurate.
Yet when you start looking at the assumptions the study is making to get to those conclusions, you lose what respect you had for their mathematical ability. Check out this chart:
Anything there seem weird to you? These are their assumptions for future market returns. Yes, they assume that the future returns on bonds are 4%, never mind that the 10-year treasury was yielding 2% at the time of publication. How about the assumed returns for emerging markets stocks? Yup, 15.2%, 5.5% higher than their assumption for US stocks. Vanguard's emerging markets index fund, started in 1994, has an annualized return since inception of 7.23%, but sure, if you want to use 15.2%, that's fine. Seems reasonable. I mean, how much can you trust the conclusions of someone who makes such stupid assumptions, even if they can solve a dozen indecipherable mathematical formulas?
Making Sense of This Mess
So where does this leave you, dear reader? What is the value of a financial advisor? Well, like many things in personal finance and investing, it depends. And what does it depend on? It depends on the advisor and it depends on the investor.
It should come as no surprise that some advisors are better than others. Not convinced of that? I encourage you to try an experiment I have undertaken over the last half-decade. I've invited financial advisors to apply to be listed on my recommended financial advisors page. The application is not particularly difficult. Most of the questions are pretty leading, such as “Do you believe you can pick stocks well enough to beat an index fund over the long term?” or “Do you believe you can time the market?” Guess what? I disqualify half the people who apply because they didn't get these sorts of questions right. There are tons of incompetent advisors out there, and I'm not talking about the salesmen masquerading as financial advisors that make up the majority of people who call themselves advisors in this country. I'm talking about “real advisors”, people who are fee-only fiduciaries with designations like the CFP and no red flags on their ADV2. Incompetent. I have no doubt in my mind that a significant portion of these folks are not worth their fees. Add in the thousands of brokers and insurance salesmen masquerading as advisors and I fear the percentage of really good financial advisors could be as low as 10%. But guess what? They all think they're in that 10%. And by the time you know enough to distinguish whether an advisor is in that 10% or not, there's a good chance you know enough to do this yourself if you so desire. There's entirely too much luck involved in a needy investor connecting with a competent advisor.
As important as the advisor is to this equation, the investor matters even more. You see, the value of even a good advisor depends a great deal on the investor. Consider a physician who knows nothing about personal finance or investing. An advisor who can get this doc budgeting, saving, maxing out retirement accounts, investing in a reasonable plan, buying appropriate types and amounts of insurance, and staying the course through down markets has likely provided millions of dollars in value over the course of this doc's lifetime. Now consider a physician who is a good saver, understands the nuances of 401(k)s and Roth IRAs, already has a reasonable written investing and insurance plan, and has proven her ability to stay the course by herself in a bear market? How much value is an advisor going to be able to add to this doc's life? Maybe the advisor could tweak the asset allocation a little, but that might end up lowering future performance just as much as increasing it. The advisor could take care of some financial chores. The advisor could perhaps motivate the doc to do some estate planning and toss in a tax-efficiency pearl here and there. But is that going to be worth $10,000, $20,000, or even $30,000 a year? Probably not.
So we see that value is not only relative to the advisor and the investor, but it is also dynamic. Generally, as time goes on and the investor becomes more knowledgeable and disciplined and the plan is put into place, the value goes down. Which is odd, because under the most common payment scheme for fee-only advisors, an asset under management (AUM) fee, the fees generally go UP as time goes on.
At the risk of making this post too long to read, I'd like to throw in a few recommendations, none of which should be new to long-term readers.
#1 It Is Okay to Be a DIY Investor
I figure perhaps 20% of physicians and other high-income professionals have enough interest in this topic to develop the discipline and knowledge required to be their own financial planner and investment manager. If you've found your way to this blog and read it regularly, that percentage is likely far higher than 20%. So if you think this stuff is interesting, or if you just can't stand the thought of paying someone else thousands of dollars a year to do it for you, then go for it. You CAN do this. I've done it and so have thousands of other docs just like you. You can reduce that 3% figure Vanguard uses to less than what most advisors charge without too much time or effort. Managing your own finances is likely the best possible return on your time. It will pay a far higher hourly rate than doctoring, at least after you acquire basic financial literacy.
#2 It Is Okay to Hire an Advisor
Nevertheless, if you are not interested in this stuff, if you are worried you won't do a good job, or if you've proven inadequate to the task in the past, you should not feel “money-shamed” for hiring an advisor. There are so many ways to reduce the cost of advice that if you just put a little effort into it, it shouldn't be that hard for you to get the cost below the value provided to you. That value could be millions of dollars.
#3 Get Good Advice
Good advice comes from a fee-only, fiduciary, experienced advisor with an understanding of the academic literature. If the advice generally gels with what you see when you read good financial blogs or books or spend time on good forums, you're probably fine. If in doubt, get a second opinion! It can be done from the comfort of your own home with little effort at no cost to you.
#4 Make Sure You're Paying a Fair Price
A fair price for financial advice is a four-figure amount each year. You're not going to get good comprehensive advice and service for less than $1,000. But you can certainly get it for less than $10,000. Why pay $30K when you could pay $5K? No reason that I can see other than inertia. A bigger problem is that docs don't know what they're paying. If you think you're getting advice for free, you're likely getting bad advice. If you're not sure what you're paying, add it up. The math works like this: Percentage x assets = total fee. If the percentage is 1% and you have $2 Million in assets, the fee is $20K. If the percentage is 0.8% and you have $600K, the fee is $4,800. Now you can compare that to an advisor who charges an annual retainer or an hourly rate, or simply to the value of your own time.
#5 Don't Be Afraid to Negotiate
Doctors are notoriously bad negotiators. Now you don't need to talk about fees every time you see your advisor, but it's probably a good idea to do so every few years, especially if the amount you're paying is a five-figure amount. Most advisors would rather see their fees cut a bit than watch the entire fee walk out the door and down the street, especially if they've already got your basic plan on auto-pilot and enjoy working with you (that relationship thing goes both ways!)
#6 Try to Minimize the Impact of Fees
Start by selecting an advisor who charges less than average. Give serious consideration to paying for your financial planning via an hourly rate and your investment management via an annual retainer. But given how many AUM advisors charge less than 1%, I see little reason to pay 1%, much less MORE than 1%. Then try to pay as much as possible from tax-deferred accounts. Might as well pay with pre-tax dollars if you can. And realize that you're not losing quite as much as many DIYers would have you believe.
#7 Nothing Is Final
If you are like most, the value of advice likely falls as the years go by. There is absolutely nothing wrong with using fewer services as time goes by or even becoming a DIYer. The vast majority of DIYers hanging out on the WCI forum used an advisor at some point. Once a year, add up what you are paying in fees and consider the value of what you are receiving. If you don't feel you are getting good value for the fees, either renegotiate them, change to a less expensive or less comprehensive advisor, or take over yourself.
What do you think? How would you quantify the value of a financial advisor? How can someone tell if they would benefit from hiring an advisor or not? Comment below!