I began writing about personal finance to create a positive outlet for the anger, regret, and pain I experienced because of investing mistakes I made as a young professional. I became a consumer advocate to help others avoid repeating my mistakes.
My mistakes were the result of blindly following the advice of a financial adviser without performing due diligence. I later discovered this advice led me to pay thousands of dollars in unnecessary fees and taxes every year. Compound the effects of these mistakes over decades, and this was literally a million-dollar mistake.
I don’t suggest that all financial advisers are bad people or that you should not seek professional financial advice. But I strongly recommend that you understand that financial advice comes with inherent conflicts of interest.
As a consumer, you must understand what these conflicts are, so you can make good decisions and protect your interests.
How are you paying for advice?
To understand conflicts of interest inherent in the financial advice you receive, it’s vital to know how you are paying for that advice. There are essentially three models to compensate advisers.
You can pay for financial advice through commissions on products you buy. You can pay as a percentage of assets under management. Or you can pay a direct fee for financial advice. Each comes with unique upsides, downsides and conflicts.
Unfortunately for me, I paid all three simultaneously …. the perfect storm. This allows an examination of the conflicts inherent in each model and what it looks like when an adviser chooses his interests over yours. My mistakes could be your good fortune if you take the time to learn from them.
The commission-based model
In the commissions-based model of paying for financial advice, you pay an adviser through a commission on financial products purchased. This is the most common method of obtaining financial advice for those with a low net worth.
The conflicts of interest are obvious. A financial adviser paid by commissions is really a salesman of investment products. Each recommendation creates a conflict of interest. Does the adviser recommend the product most likely to be in the client’s best interests or the product with higher fees that allow the adviser to be paid more?
Statistics suggest consumers beware. Consumer Reports says “term life (insurance) is a better deal for most families.” The same article stated that whole life insurance premiums result in larger commissions for insurance salespeople. So what products are most common? According to the American Council of Life Insurers, in 2016 40% of life insurance policies sold were term policies, while 60% were whole life policies.
Vanguard founder John Bogle said, “It’s amazing how difficult it is for a man to understand something if he’s paid a small fortune not to understand it.” This is consistent with our experience with commissions-based sales.
We paid commissions when buying front-loaded mutual funds. We agreed to this, and fees were listed on every account statement we received. In our last year using the adviser, we paid $1,660 in commission on the investments we bought.
Much later, we determined that our total fees for that year were $7,680. The commissions we were aware of represented only 22% of the total fees we incurred. Most fees were hidden in expensive investment products that were not in our best interest.
Getting sold
The most egregious example of being sold a product not in our best interest occurred when my wife rolled over a 403(b) account when changing jobs. The adviser recommended putting the money into a variable annuity.
We later learned these complex financial products are rarely a good fit for investors, but nonetheless are often sold. They create large commissions for those that sell them. Variable annuities have high expenses, averaging around 3% annually according to the American Association of Individual Investors.
One key feature that makes variable annuities attractive to some investors is the ability to use them as a tax shelter. My wife already had this benefit with the retirement account, without the unnecessary cost or complexity of a variable annuity.
Another example of conflicted advice was being sold proprietary financial products. Proprietary financial products, like mutual funds, are produced by financial institutions. They are analogous to store-brand products available in any grocery chain. But this analogy breaks down quickly.
Grocery stores save on product development, branding, and marketing to sell store brands customers can buy for less. Savings from proprietary financial products could be passed on to consumers, as is done by consumer-friendly companies like Vanguard. But when you’re buying products sold through a commission, proprietary products are vehicles for institutions to maximize profit for themselves.
We worked with an Ameriprise representative. We were sold all Columbia mutual funds and a variable annuity through Riversource, both Ameriprise subsidiaries. The portfolio we owned had fees of about 2% a year, approximately 20 times more expensive than the portfolio I built as a DIY investor.
Unfortunately, our experience is common for those obtaining advice from an adviser (i.e. salesman) in a commission-based model. Buyer beware.
The assets-under-management model
The next model for charging for financial advice is collecting a percentage of assets under management (AUM). Proponents claim this eliminates conflicts of interest inherent in the commissions-based model. Because advisers are paid a percentage of the wealth you accumulate, they claim an adviser’s interests are aligned with the investor’s, because both a client and adviser benefit when wealth grows.
I disagree.
An adviser is paid to accumulate assets under management, not to give the best advice. There are many instances when an investor’s money would be better used elsewhere.
What if a client is debating using extra funds to pay off a mortgage early vs. investing more? There are legitimate arguments either way, but only investing more money benefits the adviser.
How about a person contemplating withdrawing from investment accounts to invest in a personal business? Either decision could be correct for the investor, but only one would benefit the adviser.
Risk is another issue. An adviser could add value by coaching a client to take an appropriate amount of risk.
A conservative investor may need to take more risk to reach their goals. But what if the move backfired and the investor lost money? On the flip side, an overly aggressive investor may benefit by dialing risk down. But what if they lost performance? In either case, the investor could get upset and fire the adviser.
There is incentive for the adviser not to rock the boat. Remember, they get paid for having assets under management, not for giving good advice.
AUM in practice
We knew we were paying commissions for the investments we were sold. We ended up paying AUM fees as well.
The mutual funds we owned had a weighted average expense ratio of 1.14%. Part of the expense ratio was a 12b-1 fee. This annual fee, which was 0.25% of AUM, was in effect a kickback to the adviser, incentivizing him to keep us in a fund he had already been paid to sell us. This allowed the adviser to continue collecting a de facto AUM fee as long as we held the investments.
We were advised to bypass our work retirement accounts and instead invest those funds with our adviser. I contributed 5% of my salary to my 401(k) because I was automatically enrolled by my employer to receive a company match. My wife received employer contributions regardless of whether she contributed. She was advised to completely bypass any additional contribution to her retirement account.
This resulted in us missing out on over $30,000 of tax- deferred savings every year. At a marginal tax rate of 25%, this meant we paid over $7,500 in unnecessary income taxes each year as a result of this advice.
Read: All the ways you can mess up your 401(k) — even if you max out your contributions
The combination of not using this deduction, along with income generated by holding our investments in taxable accounts, elevated our recognized income annually. This poor tax planning disqualified us from contributing to a Roth IRA.
We may have been given this advice so the adviser could sell us funds to collect commissions or to charge fees for assets under management. In either model, the conflicts are the same. An adviser collects fees only when they control your money, creating massive conflicts of interest.
The fee-only model
The third model for paying for financial advice is paying a fee only for advice you receive. This is the most transparent model. You agree to pay the adviser directly for advice. This eliminates many, but not all, conflicts of interest.
Simple is often better with finances. This is especially true when it comes to investing. The problem with paying for investing advice is the incentive it creates to make things complicated.
If an adviser would have shown me we could save $7,000 in income taxes by maxing out work retirement accounts, I would have been ecstatic. If he would have told me index funds were likely to outperform actively managed funds we owned while costing much less, that would have added tremendous value. I would have gladly paid for that advice.
Of course, once I knew this, there would be little else for the adviser to do for me. Investments could be placed on autopilot. There would be no reason for me to get my checkbook back out the next year.
Allan Roth cites the need to justify fees as one of 10 reasons advisers struggle to keep client portfolios simple. Roth is a rare breed in the financial industry. He became financially independent, then became an educator, consumer advocate, and fee-only financial adviser. Most advisers wouldn’t share this information because, unlike Roth, they’re dependent on those fees to feed their families.
Unnecessary complexity
On top of commissions and hidden fees we paid our adviser and his firm, we also paid a $450 annual advisory fee, rounding out the “perfect storm.” We didn’t get good tax advice and we consistently underperformed investment benchmarks, but we did get our money’s worth in one area. We got an abundance of complexity.
We owned 15 mutual funds in the name of diversification. Adding to the complexity, some of the funds were held inside the variable annuity.
When we finally took time to decipher our investments, we realized that we only owned three asset classes: large-cap domestic stocks, small-cap domestic stocks and domestic bonds.
Unnecessary complexity is common in the financial industry. Making investing complex is a way for the financial industry to justify their existence.
Since we began managing our own investments, we have added international developed and emerging markets, real-estate investment trusts (REITs), and Treasury inflation-protected securities (TIPS) to our portfolio. We cut the number of funds we hold from 15 to eight and cut our expenses by over 90%, decreasing cost and complexity while adding diversification.
All financial advice is conflicted
Not all financial advisers are bad people, and not all financial advice is bad. Even in our “perfect storm” scenario, we received some good advice.
We were advised to automate our investments and contribute regularly, to stay invested during the 2008 financial crisis, and to select an asset-allocation in alignment with our risk tolerance. In each case, our best interests were aligned with our adviser’s interests.
But all financial advice comes with inherent conflicts of interest. In our case there were many conflicts. At nearly every turn, our interests lost out. We were sold unnecessarily expensive products, paid unnecessary taxes, and had an unnecessarily complex portfolio to our detriment.
If you plan to seek investment help, you need to understand how your financial adviser is paid and the conflicts this can create. Go in with your eyes wide open or your vision may soon be further obscured when storm clouds start forming.
Chris Mamula used principles of traditional retirement planning, combined with creative lifestyle design, to retire from a career as a physical therapist at age 41. This was first published on the blog site Can I Retire Yet?