Welcome back to Personal Finance for Professionals Part II – Investing in Stocks & Bonds. Last week, we learned why the stock market “always” goes up. Today, I’ll teach you everything you wanted to know about financial advisors but were afraid to ask. This lesson is a long one, and if you are a regular reader of our blog, you’ll note that this material is repackaged from two previous articles. If you’ve already read them, skip this one. If not, this lesson may literally save you millions of dollars.
Financial Advisors
One of my attendings in residency used to love telling the story of bank robber Willie Sutton, who, when asked why he robbed banks, famously answered, “Because that’s where the money is.” Financial advisors absolutely love doctors. Why? Because that’s where the money is.
Whether or not you hire a financial advisor can be a multi-million dollar decision. Before you make it, you must understand what financial advisors can do, what they can’t, and, most importantly, how they are paid.
What is a Financial Advisor
Broadly speaking, financial advisors offer advice on money management and planning for the future. Since most people lack a basic understanding of personal finance and investing, seeking advice from someone educated in money management would seem to make sense. Unfortunately, what exactly a financial advisor is can be confusing, as there is no legal definition of the profession, no uniform credentialing process, and no governing body to ensure an advisor is adequately educated and acting in their client’s best interest.
What Can a Financial Advisor Do?
There are eight things you can reasonably expect from a financial advisor. Not every advisor performs all these items, and very few will do them all well.
- Cashflow Planning: Think of it as budgeting on steroids.
- Investment Planning: Investment planning encompasses portfolio construction, which includes both asset allocation (the percentage of stocks/bonds/real estate) and asset location (where you hold those assets – pre-tax accounts, Roth accounts, or taxable brokerage accounts), as well as periodic rebalancing.
- Tax Planning: Tax planning involves structuring your financial life to minimize your tax burden. Not all FAs are qualified or comfortable with tax planning; an accountant or lawyer often performs this function instead.
- Education Planning: The cost of an education for you and your children can significantly burden your finances. A financial advisor can help plan these expenses.
- Insurance: Every medical professional needs disability insurance at the beginning of their career, and many will need life insurance. Financial advisors can help you determine how much and what type to buy. Unfortunately, the insurance industry is ripe with commissions, back-door deals, and outright fraud, often perpetrated by the very person you are paying for advice. Buyer beware.
- Estate Planning: Preparation is needed to ensure a smooth transition for your heirs.
- Retirement Planning: Many people exclusively think of this when they imagine a financial advisor.
- Behavioral Counseling: Left to their own devices, humans have an innate tendency to shoot themselves in the foot regarding money. A good financial advisor will help you avoid falling prey to your baser behavioral instincts, such as overconfidence, cognitive biases, herding, and loss aversion.
The odds of you finding a single advisor who can do all of these things at an expert level are pretty low. It may be beneficial to hire more than one professional with specific expertise in a particular area, depending on your needs.
If you plan to manage your own money, you need a plan for all eight of these categories.
What Can’t a Financial Advisor Do?
A financial advisor does not have special knowledge of stock or bond investments. No financial advisor can reliably beat the stock market. A financial advisor can’t create meaningful tax breaks for you as a W-2 or 1099 physician.
A financial advisor cannot do the hard work for you. While they can help you plan, you are the one who must make money, live below your means, save/invest, and stay the course for decades. You are not paying them to make you rich; your hard work, high salary, savings rate, conservative investment strategy, and time will take care of that.
How Are Financial Advisors Paid?
The first thing to accept is that financial advisors do not work for free and deserve compensation for their time, knowledge, and effort. You will either pay them directly or indirectly. I don’t mind paying for the value I receive; I just want to know what it costs ahead of time, so my preference is to choose the most transparent payment method. “Saving” a few thousand dollars upfront may cost you tenfold on the back end.
A financial advisor can be compensated in many ways, divided into three main categories: commission-based, commission & fees, and fee-only.
Commission-Based and Commission & Fees
When you choose a financial advisor, whether or not you allow them to invest on your behalf, you pay for their recommendations. Financial advisors who earn commissions are incentivized to put you into products you may or may not need. These commissions are most commonly generated through loaded mutual funds and insurance sales.
Most advisors (rightly) do not pick individual stocks; instead, they often recommend loaded mutual funds. While all mutual funds have a management fee (expense ratio), some also have other fees called loads, which are commissions paid by the fund to your advisor. Financial advisors justify their actions by claiming that they expect these funds to outperform those without loads. There is no evidence that this is true.
For the vast majority of people, term life insurance is sufficient. It is cheap, plentiful, easy to obtain, and doesn’t carry a hefty commission. Yet financial advisors are notorious for recommending whole life insurance, which provides them with a large commission. I know this firsthand because my first financial advisor convinced me to purchase a type of whole life policy in my first year as an attending.
Whether or not your advisor is exclusively compensated by commission or a mixture of commissions & fees, you must recognize that this arrangement carries an inherent conflict of interest. No matter how moral/religious/ethical, when it comes to money, incentives matter.
Fee-Only
It is getting harder for financial advisors to “justify” putting their clients in loaded mutual funds, as index funds/ETFs have gained widespread acceptance as superior investment vehicles due to their low expense ratios. Additionally, consumers are more informed about their insurance needs. This has led to the rise of the “fee-only” advisors, who promote themselves as a lower-cost, more ethical alternative.
While a “fee only” means no commissions, that label alone doesn’t tell you anything about what types of fees an advisor does charge.
Types of Fees
Upfront Fees
Some advisors will charge a one-time, upfront fee. This fee covers their initial assessment of your financial situation. Reviewing your investment accounts, assets, liabilities, income, etc, takes time. This fee can range from several hundred to several thousand dollars, depending on the complexity of your finances.
Annual Fees
An annual fee is often based on the amount of money being managed and/or the complexity of the client’s finances. These fees can range from a few to tens of thousands of dollars.
Hourly Rate
Pay for the advice and services you need? There’s a novel idea in the world of financial advice. While uncommon, some financial advisors charge by the hour. To make this method economically feasible, the rate is often quite high, we’re talking $300-$1,000 per hour.
A La Carte Services
Another uncommon pricing strategy is the à la carte method, where you pay only for the services you choose. Reviewing your current financial plan may cost $2,000, while a comprehensive retirement plan may cost $5,000. Pricing will vary wildly, but should be upfront and transparent.
Assets Under Management (AUM)
AUM fees are a percentage charge for every dollar the financial advisor manages. Most financial advisors charge from 0.5% to 2%. The fee typically decreases the more money you invest with the advisor. AUM fees can also be called “advisory fees” or other terms, but will always be a percentage of assets managed.
Why I Don’t Like the AUM Model
I have three major issues with the AUM model. First, it simply isn’t a good value proposition for the investor. Basic financial advice, such as how much to save, what accounts to set up, and what to invest in, is extremely valuable to you as you start your career. However, once you have everything set up correctly, the hard work is done. The less you mess with your portfolio during your 20-30-year working career, the better! While it may be worth paying 10k for advice when starting out, it isn’t worth paying that much or more every year to maintain what you’ve already set up.
Next, the AUM model incentivizes investing in securities above all else. Investing more money in stocks and bonds is often, but not always, the best advice. Want to get into real estate investing, pay off your mortgage early, or start a business? Not advised.
Finally, AUM fees, like herpes, are the gift that keeps on giving. $5,000 paid in year 1 could become $50,000 in your account in 30 years at 8% interest. Paying an AUM fee every year eventually turns into an expensive, painful reminder of your mistake.
The Effect of AUM Fees
Warren Buffett stated, “Performance comes, performance goes, fees never falter.” You should aim to keep the fees you pay to an absolute minimum. AUM fees are the most pernicious, as you never have to write a check to your advisor, yet they continue year after year, growing with your net worth, and compounding over time.
The following table illustrates the significant impact of AUM fees on a typical medical professional’s portfolio. This portfolio represents a $50,000 annual investment into a retirement account that earns an 8% yearly return. A 1% fee will cost you $1M over 30 years, or 17% of the total. A 2% fee costs you twice that.
My Results
Is the effect really this dramatic in real life? Unfortunately, I kept my money invested with a financial advisor for many years, so I can prove it. When I graduated from residency, I had no financial knowledge. I simply asked a colleague what I should do with my money, and he gave me his financial advisor’s number.
While my initial mistake was due to ignorance, it later became inertia. Long after I knew that I should move the money, I did nothing. Like many medical professionals, I was “too busy” with life, work, business, and other investments.
Figure 1 compares the actual returns in my SEP IRA, which was professionally managed with AUM fees, with a passive portfolio of 100% VTSAX (a total stock market index fund).
As you can see, the market returned an annualized 10.95% during this period, while my “professionally managed” results were an anemic 4.13%. If I had invested 100% in VTSAX with its low expense ratio (0.04%), I would have been up $813,361 by the time I dropped my advisor in early 2021!
There is a reasonable argument to be made that I am not comparing apples to apples with Figure 1, since a 100% stock portfolio is a very aggressive asset allocation. To account for this, Figure 2 compares my results to a passive portfolio comprising 75% VTSAX and 25% VBTLX (a total bond market fund), which is a more conservative asset allocation.
Even with this more conservative approach, my managed portfolio still underperformed the market by over 5% annually, leaving me down $485,227 by the beginning of 2021. While it is obvious that active management of my portfolio by two financial advisors significantly hurt my returns, what’s less clear is why.
I don’t know what my AUM fees were with my first FA, as I never even thought to ask. The second advisor charged me 1%. So, this wasn’t all about AUM fees. As shown in the chart, even with a 2% AUM fee, my portfolio underperformed the benchmark by a wide margin. There were clearly loads, high expense ratios, frequent trading expenses, and other costly shenanigans occurring.
** Please note that this is only my SEP account. I presented these charts to our ER fellows during a personal finance lecture a couple of years ago, and they began discussing afterward how they thought I would be richer. A SEP IRA is a retirement account with a fixed yearly contribution amount. I have other investments, so please don’t feel too bad for me. **
Warning: Fee-Only May Not Be What It Seems
More and more financial advisors promote themselves as fee-only but still charge high AUM fees. They’re not technically lying. AUM fees are fees. They are using “fee-only” as a buzzword and will explain that they don’t use loaded mutual funds and won’t try to sell you insurance products. While that is undoubtedly a better option than paying commissions, it doesn’t solve the devastating effects of AUM fees.
But what we want – someone who will give us financial advice for a set amount per hour, like a lawyer or an accountant, is as hard to find as ever.
Should You Ever Hire a Financial Advisor?
There are many scenarios in which you may want to pay an hourly advisor. I’m happy to pay for answers to questions I can’t figure out, or just to have someone double-check my decisions. There are far, far fewer scenarios in which you should pay AUM fees.
When to Hire a Fee-Only Advisor Paid Hourly
- You have a specific question you can’t answer on your own.
- You have a logistical problem for which you would like help.
- You want someone to review your plan for your peace of mind.
- You have a complex financial situation (including real estate, private investments, a business with a defined benefit plan, etc.).
When to Hire a Fee-Only Advisor Paid Through AUM Fees
- You have no interest in your finances and are willing to pay someone so you never have to think about it. You are also willing to risk abdicating your financial future to someone else.
- You won’t invest unless someone else pushes you and holds you accountable.
- You won’t be able to withstand the natural ups and downs of the stock market, and you need someone to talk you off the ledge when the market is down.
- You have a complex financial situation (including real estate, private investments, a business with a defined benefit plan, etc.) AND you just don’t want to deal with it and are willing and able to afford AUM fees.
- Your financially minded spouse dies, and you inherit complexity. Be aware that this scenario leaves you vulnerable to being defrauded, so exercise caution.
Ultimately, if an advisor can help you reach the financial goals that you couldn’t achieve alone, the expense is worth it.
Hiring the Right Advisor
Let’s be clear: finding a good advisor will be difficult. According to the U.S. Bureau of Labor Statistics, there are over 330,000 financial advisors in the U.S. Even if they were divided equally among all 50 states, that would be 6,600 per state, all with disparate education, credentials, backgrounds, and experience. The odds of finding a competent, ethical, experienced advisor at a fair price are not in your favor.
While nothing I can tell you will guarantee that you choose the right advisor, given the long odds described above, these tips are a good place to start.
Check Credentials/Certifications
I would begin by finding someone with at least a CFP and/or PFS designation. I believe these designations are most in line with what a typical individual/family requires from a financial planner.
Look Them Up
Do some basic research on anyone you consider entrusting with your money. Start with a Google search. Check references that are not your colleagues. How long have they used the advisor? What have been their results? Check with the Better Business Bureau. Verify any credentials or professional licenses. Get in touch with your inner stalker and peruse their social media accounts. You can also look them up on the following sites.
Ensure Your Financial Advisor is a Fiduciary to You in All Respects
First, examine how they get paid. If they are commission-based, there is an inherent conflict of interest. Remember that all fiduciaries are fee-only advisors, but not all fee-only advisors are fiduciaries.
Next, check credentials/certifications. If the advisor is a CFP, CFA, or is affiliated with the National Association of Personal Financial Advisors (NAPFA), they must be fiduciaries.
Ask them, “Are you a fiduciary to me in all aspects?” Finally, read the advisor’s disclosure documents carefully to understand their code of ethics and any disclosures of conflicts of interest
Interview Potential Advisors
Only interview those who have passed your initial screening process; you’ve verified their credentials, ensured they are fee-only, and done due diligence on their background. During this step, you are looking for disqualifiers.
First, while you should feel comfortable sharing the intimate details of your financial life, please note that your financial advisor isn’t your friend. Being professional, courteous, and friendly are table stakes, not deciding factors. Who cares if you went to the same college or attend the same church? Be objective and don’t fall prey to the “affinity” trap.
Next, listen for any outrageous claims. Does the advisor claim they can beat the market? Do they tell you they can save you a large amount of money on taxes? If it sounds too good to be true, it usually is.
Finally, pay attention to where the advisor’s priorities lie. Are they listening to your concerns, or are they leading the conversation toward their own? Do you suddenly find yourself discussing complex life insurance products or trusts? Does the advisor seem overly interested in your friends, colleagues, or business partners? Do they only want to talk about managing your employer’s retirement accounts? I have no problem with an advisor wanting more business, but if the initial interview isn’t exclusively about your personal finances, there is a problem.
Once you’ve completed your background check, due diligence, and a successful interview, congratulations – you still have no idea if you’ve found a competent and ethical financial advisor or not. But at least you’ve improved your odds.
Why You Probably Don’t Need One
Now that you know what a financial advisor does, let’s discuss why you probably don’t need one. Unless you meet the criteria I outlined above, you will be better off without a financial advisor for the following six reasons.
- The basics of personal finance are available for free.
- The basics are 90% of what most people need.
- It isn’t that complicated.
- It’s so hard to find a good one.
- You are intelligent and capable of figuring this out – you just need the education.
- You are not alone.
By simply reading this series, you will be ahead of 99% of the general population when it comes to understanding personal finance and investing. If reading turns into action and you follow the advice presented, you will have little need for an expensive financial advisor.
Do you use a financial advisor? What have your results been? Let me know in the comments below, and consider subscribing to the blog. I hope you enjoyed this lesson. We’ll continue this series in a few weeks, when we discuss the power of dollar-cost averaging. Stay tuned!