5 Myths about Low-Cost and Fixed-Fee Financial Advisors
If you have a moment, please perform the following exercise: Make a list of everyone who performed a service for you over the last year and how much you paid them. Now rank them from highest to lowest. If you are like most professionals or entrepreneurs, your financial advisor is at the top of that list with nobody else being even a close second. Why is that?
With historically high market valuations and very low interest rates contributing to lower future investment returns, wise investors do all they can to control investing costs. One of the best ways to do this is to avoid using a financial advisor that annually charges you a percentage of your assets (often 1% or higher). Some advisors will even charge sales commissions on top of a percentage of assets. The common term for this practice is “fee-based” as opposed to “fee-only”. The good news is that you now have a viable alternative to high-cost advisors that requires no sacrifice in the level of service received. However, if you were to broach this topic with a financial advisor, you may hear one or more of the following objections or rather, myths.
Myth #1: The best way to compensate a financial advisor is a percentage of the assets managed because it means that you and the advisor are "sitting on the same side of the table" and the advisor will be incentivized to grow your assets.
Response: While asset-based compensation is usually preferable to a commission model that encourages unnecessary transactions, it is still problematic because the primary incentive it creates is for the advisor to gather as much of your assets as possible to collect higher fees. For example, it may make sense for you to pay down your mortgage or purchase a longevity annuity, but your advisor could discourage it because it would reduce the assets on which he can charge fees. As for growing assets via investment returns, your advisor has no control over what the financial markets will deliver. While recommending and implementing an appropriate asset allocation is certainly a valuable service, it need not cost you a high percentage of your assets year after year.
Myth #2: An advisor who charges you lower fees automatically must be providing you a lower level of service.
Response: This statement is reminiscent of the criticisms that were leveled against John Bogle and Charles Schwab when they introduced index funds and low-cost trading for retail investors back in the 1970s. Smart investors quickly learned that when it comes to investing, delivery at a lower cost is inherently a higher level of service, all else being equal. While it is true that some advisors provide more services than others, investors must carefully consider their total costs and determine if they are paying an appropriate amount. Two commonly provided value-added services are tax preparation and estate planning. Both, however, are easily valued in straight dollar terms, and most high-net-worth investors will find that they are worth nowhere near 1% of assets year after year.
Myth #3: Even though an advisor charges 1% of assets, he more than pays for himself because he prevents his clients from making catastrophic behavioral errors.
Response: One of the most commonly cited justifications for this argument is the DALBAR study which purports to show that the average equity investor massively underperformed the S&P 500 over the last 20 years due to poor timing decisions. However, Wade Pfau, a highly respected researcher in Finance, has shown that the math behind the DALBAR study is wrong. Even if this were true, again, you don’t need to pay a percentage of your assets to have someone help you refrain from self-destructive behavior.
Myth #4: Low-Cost advisors lack the credentials and/or education possessed by high-cost advisors.
Response: Credentials and education are certainly an important part of determining the qualifications of an advisor, especially since anyone can call himself a financial advisor. There are now advisors who have legitimate college degrees and respected credentials such as the CFA® and CFP® who charge a fair fee for their services.
Myth #5: One percent of assets is a fair price to pay for developing and implementing a comprehensive financial plan.
Response: A good financial plan is extremely valuable, and yes, the planner should be appropriately compensated. However, should the advisor’s compensation dwarf all the other professionals who provide you a service? This question deserves special consideration by professionals and entrepreneurs who are close to or in retirement because a 1% (or even a 0.5%) fee is a substantial percentage of the annual portfolio distribution (usually about 3-4%). An alternative way to compensate an advisor/planner is through an annual fixed, flat fee. With the advent of software tools like MoneyGuidePro, financial planning has become much more automated and a 1% of assets fee much less justifiable.
All investors would do well to remember the sage advice of John Bogle that investing is the one endeavor where you get exactly what you don’t pay for. Even if your financial advisor is wise enough to steer clear of high cost actively managed funds, a high fee can destroy the advantage gained from using low-cost funds.