Today’s inspiration comes courtesy of All Financial Matters (a solid blog with good hard numbers data) who notes that a Money Magazine article called “The Mole” discusses how just because a financial advisor says he puts his clients first doesn’t mean he does. Really? Did I miss something? If it says “I put my clients first” on an attorney’s website does that mean that he does, or does it depend on the attorney? Are there doctors who over bill your insurance company to boost their income? Does a waiter ever suggest a more expensive wine to increase his tip? I’m shocked, shocked, to find out there is gambling going on in here!
All of this, of course, is why you need a good trusted financial advisor in the first place, but that is not why we come here today. I want to show you something from “behind the scenes” as the Mole says.
Financial Advisors and Commissions
Let’s make up a fake client with a $500,000 account to be invested. Let’s ignore all taxes and legal implications for the sake of simplicity and concentrate on commissions. We’ll also assume that the account value stays the same over the years for simplicity. Do realize though that as your account value changes the fees would change too. (These are only the fees from the advisor side. He doesn’t get any of the other fees that you might pay; they go to someone else.)
Option 1: Wrap Account or Fee Account
The standard wrap account charges the client a 1% annual fee to manage their funds. The firm or advisor eats all the trading costs.
One Year Fee = $5,000
Continuing Fee Each Year = $5,000
Fee over 10 years = $50,000
Option 2: Front-Load Mutual Funds (All one fund family)
Loaded mutual funds take a big knock because of their highest fee (usually around 5.75%) but that fee goes down the more you invest. The average mutual fund family charges around 2% for amounts over $500,000. Your advisor usually also receives a 0.25% fee called a trail to the “insiders”. You’ll see it on your prospectus as a 12b-1 fee.
One Year Fee = $10,000 (Load)
Continuing Fee Each Year = $1,250
Fee over 10 years = $22,500
Option 3: Variable Annuity Suze Orman (and everyone financial writer) Nightmare
Variable annuities are always said to have the highest commissions. That is only sort of true. Most variable annuities offer different payout options including all the payout in one year or a smaller first year payout with an ongoing payout. The financial press always talks about the HUGE COMMISSIONS these products have, so we’ll play their game and go with the big up front payout. The up-front varies, but on regular products from the big companies it is around 7% to 8%. You’ll hear about higher ones, but they aren’t the usual products and may not even be approved to sell by lots of firms.
One Year Fee = $40,000
Fee over 10 years = $40,000
Payouts
There are other options, but we’ll stick with these to make things easy. Now, before you get excited, keep in mind that your advisor doesn’t get to keep all of this money. Every financial advisor gets a little bit different deal, usually depending on who he or she works for, and how much they produce (sell). But, this gives you a ballpark idea.
A financial advisor who works for a company that pays for expenses like rent, utilities, staff, and so on generally gets something between a 40% payout and a 60% payout. A payout is how much the advisor gets from the commission he generates. So, for easy math let’s say the advisor gets a 50% payout which means if he generates $10,000 in commissions, then he gets paid $5,000 and his firm keeps $5,000. With me so far? Good.
An independent advisor gets a higher payout but has to pay all of his expenses including staff benefits and so on. We’ll stick with the “house” guy for now.
So in our above examples, our advisor makes $2,500 the first year and $2,500 every year after that off of Option 1. He makes $11,250 the first year and $1,250 every year after for Option 2, and he makes $40,000 the first year and nothing after that on Option 3. Notice how Option 1 and Option 3 actually make the advisor around the same amount of money over the long run. This isn’t actually true. If your advisor is making you even 8% return on your investment then the Option 1 numbers go up and up. After 5 years the account would be worth over $700,000 (now getting $7,000 per year in fees) and after 10 years it is over a $1 million ($10,000 per year in fees!)
That is why a financial advisor who “screws” you into a variable annuity may not only not be a good advisor for you, but may not be good at his own money either. Of course, this would help the advisor meet short term goals, but he has basically agreed to service your account for free over the life of your annuity.
In fact, the advisor selling you those loaded mutual funds is probably giving you the cheapest long-term option (he isn’t lying when he says that.)
Do It Yourself
As with everything, everywhere, it is cheaper to do it by yourself. Remodeling your kitchen? Save thousands doing it yourself. Oil Change? Cheaper if you do it yourself. Brain surgery? Good luck, but probably way cheaper if you do it yourself.
Your investments are no different. Of course, if you don’t know anything about tools and electricity and so on, maybe it is still best for you to hire someone to remodel your kitchen. He will make money when you do. If you don’t know anything about investing and managing your money maybe you should hire someone to do it. He will make money when you do.
Annuities and Insurance Usually Suck as Investments
Don’t get me wrong, I’m not looking to defend annuities as investments. The vast majority of them are terrible investments for most people and whole life insurance is even worse. However, there are people for whom they make perfect sense. I deal everyday with people who are retiring from a company where they spent 30 or 40 years. They have a 401(k) balance (thanks to matching) of around $300,000 and a pension where they can get a one-time payout of $400,000 or a certain number of dollars per year for life. But, that number goes down if your spouse gets paid for life after you die. Also, your kids get nothing if you and your spouse die after just two years! On the other hand, you don’t want to run out of money before you die. These are tough questions when it is your money, and your whole life, and not just an exercise on paper.
For these people, annuities sometimes make sense because they can get more per month than they could with including their spouse on the pension, and their heirs will get the remaining balance if they die early, and if they live a long time, the annuity will pay for life. Yes, I will get a commission for selling them that product, but I ask you, whole has the colder heart here? Me, who sells them a product that meets all their needs and keeps them from ever having to stare at the T.V. and worry if they will run out of money because of the economy, or the person who says do it yourself, you big baby. Look at these numbers in black in white. What’s wrong with you? Don’t you know you are paying for that help?
Rip-Off Cliche
Seriously, is there no other way to rip off financial planning clients than to sell them a variable annuity? It seems that every time a financial “insider” or “investigator” runs out of ideas they write a column about variable annuities and trot out the famed widowed-orphaned-school teacher who was sold variable annuities with her tiny pension. There are TONS of ways you can get ripped off including plenty of do it yourself ways. Don’t be lulled into security because you aren’t getting an annuity.