Fee-Only Equals Unbiased?
You may have encountered ads that tout fee-only advisors as unbiased because they do not earn commissions. News flash: They are just as susceptible to bias as commissioned advisors! The fee-only model can actually be detrimental to the consumer. Fee-only advisors earn most of their fees from asset management, either personally managing the buy-sell-hold decisions day-to-day or by earning a fee from the money management firm they select for the client’s account. The larger that account, the greater the fee. But what if the client’s best move is to buy a single-pay life or long-term care policy, or what if they might need a fixed/guaranteed annuity to match up to their guaranteed-to-incur expenses? Well, purchasing such lump-pay products would take away major chunks of the assets available for the fee-only advisor to manage, hence the same potential for bias with fee-only advisors as with commissioned ones. Get an individualized analysis that identifies which types of accounts are most prudent for you to own, given your individual needs. You must trust the human being, and not distrust merely on the basis of method of compensation. A secret to finding this is to ask the advisor to show you financial plans in which he or she recommended product purchases and the rationale (with client names removed), or to demonstrate that his or her firm routinely handles both products and fee-based advice.
Now, imagine this: The new regulations decree that the reps are, individually, fiduciaries charged with having your best interest at heart. Yet the employers of these firms produce their own brand products and select a mix of competing products to sell alongside their own. These employers are not held to the standard. Firms use two criteria to select products for sale.
- Maximizing profit margin for the shareholders (the commission a rep gets is just a part of this larger “gross concession to the dealer,” or GDC). Shall we declare that these firms must earn no profit? Is that fiduciary? On the surface, it seems fiduciary, but what of incentive to compete, to innovate and improve? Historically, these two “social goods” have been absent for consumers in command economies and sectors where profits are regulated rather than determined by competition. The harder it is to explain a product, the more skilled the rep must be to explain it, and this is among the factors driving commission level. A limited partnership composed of real estate or oil leases has a higher profit potential for the consumer than most products, but also has a very high GDC.
- The other main factor brokerages use in selecting products to broker is minimization of lawsuits from people claiming that commissions or potential surrender charges are high or hidden (whatever “high” means). So they sell “restricted illiquidity” products, like back-end mutual funds, REITs, and annuities, but ignore some potentially superior ones whose liquidity limitations are above average. Yes, this lawsuit intimidation factor has become that significant to brokerages. Recall the earlier example of annuity carriers having become leery, accepting only about half of what one can invest, so the legal environment restricts consumer choice. The income you get from annuities that have high potential surrender charges is almost always higher than those the large brokerages sell. Why? Because the annuity company can get a higher return if it’s confident that its accounts will not be demanded to liquidate frequently; this enables it to guarantee higher income to the consumer. However, brokerages have become intimidated by lawsuits over high surrender charges, allegedly improperly committed to via bad advice, and so a new industry standard has evolved: None sell annuities with surrender charge schedules longer than six or seven years, nor with starting potential surrender charges higher than five or six percentage points. They instruct their reps to tell consumers that this is a better value because of the lower surrender charge, yet they cannot disclose that the income is very much lower in these than in annuities with greater surrender charge patterns.
“Oh, no problem,” says one consumer. “I’ll just buy Vanguard funds or its no-load in-or-out annuity, or I’ll buy from my mutual insurance company because they don’t make a profit for shareholders. That will maximize my value.” Hmm. A little common sense here: What are the odds that one company, like Vanguard, Fidelity, MFS, or any other you name, has all of the very best-managed funds and annuities—all the best? No such company has ever claimed to the public that they did, for that would be an obvious untruth. Even those who have the best of “whatever” for a few years eventually lose research staff or managers, or have random losses. And does Vanguard offer an annuity that guarantees against market losses, yet pays interest based upon the market? No, that innovation occurs where the profit margin allows innovation and carrier risk-taking; true risk transference is sold to consumers. No one can deny that Vanguard, Knights of Columbus, Thrivent Financial, and Mass Mutual built their brands on serious resources that enable them to stay very competitive. But there is, actually, profit in their products. It just does not go to stockholders; it is split between personnel compensation and consumer dividends of one form or another.
So, what is actionable here? You need not only an advisor who is willing and able to find you the best courses of action as to the planning aspect of your finances, but one—perhaps not the same person—who will find the best product in each category that you need. Let’s focus now on individual professionals and their services and relationship to you.
Types of Professionals
Insurance Agents:
Many insurance agents have become quite sophisticated in their analytical abilities. Most fee-based financial planners are or were licensed insurance agents.
An appropriate sale is one that can be documented to fill a need. The applications even ask questions about need, and they include forms used to document whether a “replacement” or product switch is truly in the client’s best interest. These can be falsified, so always read what you sign, and get a copy—at least after processing of the forms.
Many people see insurance agents as beneath them on the social ladder. Don’t view anyone this way, even if he or she paints your fence or digs your ditches. Humans all have infinite worth, and their work is service to their fellow human beings; a genuine service work has dignity, from art to plumbing to being a politician. For this reason, though, practical fee-advisors and other financial professionals who hold insurance licenses often try to de-emphasize the insurance aspect of their work. This shyness can cause you to think that insurance is some minor issue, a lower priority than seeking investment gain. In the risk management chapter, we will examine the fact that after cash reserves and budgeting-related issues, insurance is the prudent person’s first priority.
Some people mistakenly believe that an insurance license makes the agent a competent generalist—some even believe that there is one type of license for all insurances. There are several, and you need specialists in each area unless you find one or two agents who have broad expertise and licensure. This is because the agent should have access to multiple carriers to shop the market for you in the product categories you need.
Field Marketing Organizations:
Most agents have either very large brokerages that employ them or are independent contractors using FMOs.
Insurance Carriers:
But here is another industry secret (at least one not mentioned at the big stock brokerages): The difference in financial soundness and long-term ability to pay claims of an A– carrier compared to an A+ carrier is inconsequential. While I would not buy B+ unless the trend for reserves and other measures of financial fitness were improving, there is no evidence—and the rating companies have never asserted otherwise—that an A– carrier should be avoided in your buying decision.
Investment Advisor Representatives (IARs):
We have seen that IARs show up as independents or as employees of brokerages, most often in firms that position themselves as financial planning firms. To sell financial advice that includes the buying or selling of any securities, one must become registered as an IAR.
An honest IAR will evaluate whether you can do this yourself or whether you need modular (rather than comprehensive) financial planning. All are obligated to work in your best interest; all are obligated to have a written contract for service; all must disclose fees, background, and specialties accurately (all of this in writing). This makes IARs a bit easier to scrutinize.
Certified Public Accountants (CPA):
Many people incorrectly assume that CPAs and accountants are IARs, or that if they are so registered, they are the best IARs because of expertise in accounting. Not so. CPAs are no ordinary accountants; they are certified by their competency boards in various subdisciplines of personal and corporate accounting, but not in financial planning for individuals.
Yes, you need a CPA—for accounting, not financial planning.
Other important financial professionals for your team: Small to mid-sized banks and credit unions employ, usually without direct employment control, IARs, insurance agents, and investment brokers. The largest ones have huge organizations for these, and they have full compliance control onsite. I have noticed the level of ability and average age and experience to be noticeably less at these smaller institutions. That may make a difference to you because not all planning is by software, and the optimal solution is rarely the first run of a simulation. As with most advisors regardless of industry, experience is valuable.
But I will offer a serious caution:
A banker or lending officer, therefore, is not a financial planner or investment or insurance broker, and again, just because they might have the licenses, I caution against even the temptation to allow influence over your credit use to extend or even be assumed to extend to your investment decisions.
Tax Attorneys, Business Brokers, and Other Consultants:
These experts may have a place on your team of advisors, but typically they are needed at specific points, either to solve a problem like readying a business for sale or to deal with a tax conflict.
Estate planning attorneys are crucial for making sure that your estate-related desires are accommodated. They are essential when a client has either a large estate or any complex challenges, regardless of estate size.
Their services and the considerations these specialists help with are explored in the estate planning chapter, but for now, remember this: They are specialists, and even if they broaden their practices to financial planning, their perspective and predominant training has the natural bias of their predominant training.
Financial planners, especially Certified Financial Planners, are specifically trained to understand these specialists and to efficiently coordinate their paid time for you. The specialists generally do not have this training. The best way to form your team is to have your financial planner coordinate when they must be retained. Allow your financial planner to head the team, to act for you in your best interest. This places the advisor with the broadest experience in a position to efficiently integrate analyses and avoid conflicts. You at least need an estate planning attorney (see last chapter) and a financial planner. But make sure—never assume—that the planner’s main competency is financial planning.
This excerpt is taken from “The Secrets of Successful Financial Planning: Inside Tips From an Expert,” by Dan Gallagher. To read other articles of this book, click here . To buy this book, click here.
