What Most Financial Advisors Don't Want You to Know
Updated: May 14, 2020
(Why "Fiduciary" is Often Just a Fancy Word for Marketing)
Part 1: The Most Common Way Financial Advisors Charge Fees Does a Grave Disservice To Their Clients
Financial advisors most commonly charge their clients by using of a fee based on their Assets Under Management (AUM). An AUM fee is calculated by multiplying the dollar amount of a client’s managed portfolio (the “assets” under management) by some percentage that the advisor has chosen as their fee.
So, the more money a client has with the advisor, the higher the fees.
Financial advisors often argue that this fee structure is a good thing, and that AUM fees align their clients’ best interests with their own. “We do better when you do better” is a common refrain. Simple math and common sense tell a different story, however—one that is clearly not in any client’s best interest, but one that is immensely profitable for advisors.
SIMPLE MATH + COMMON SENSE = “YOU’RE CHARGING ME HOW MUCH…AND FOR WHAT, EXACTLY?”
Under an AUM fee model, if a client has $500,000 under the management of an advisor who charges a 1% AUM fee, the client will pay that advisor $5,000 for the year. A client with $1 million will pay $10,000; a client with $3 million will pay $30,000; and so forth.
One “dirty little secret” of the financial services industry is that the time and effort required for a financial advisor to professionally service a $3 million client are not materially more than the time and effort required to professionally service a $500,000 client. In fact, because of the economies of scale that modern technology provide, combined with the advantages of simplified portfolios, the $500,000 and $3 million clients should receive the very same service, the very same investments, the very same performance, the very same statements, and the very same amounts of the advisor’s time and effort.
So why should the $3 million client pay six times the annual fee of the $500,000 client? The answer is simple: There is no good reason.
AUM fees, as they are structured, simply don’t make any sense. They are the equivalent of a dentist charging for a filling based on the patient’s height, or a restaurant charging for its special of the day based on the patron’s weight. Nevertheless, clients pay financial advisors staggering amounts of money, year after year, for work they don’t do and value they don’t provide.
But good luck getting a financial advisor to admit, or even understand, it. As the French philosopher René Descartes said in the 1600s, “A man is incapable of comprehending any argument that interferes with his revenue.” Three hundred years later, author Upton Sinclair affirmed, “It’s amazing how difficult it is for a man to understand something if he’s paid a small fortune not to understand it.”
Remember the “We do better when you do better” claim that AUM fees provide advisors an incentive to grow their clients’ accounts? When advisors say that, they’re implying that they are responsible for the investment returns in client accounts, which is simply not true.
Advisors don’t provide investment returns. Advisors can’t provide investment returns. Markets provide investment returns. Moreover, advisors have absolutely no control over markets—they go up, down, or sideways in reaction to world events, not in reaction to any advisor’s “incentive.” Nor do advisors know which markets will go up, or when. That is because, as common sense tells us, no one can predict the future
When a client account increases in value, it’s because markets increased in value. That’s a good thing! But it’s good luck, not the result of advisor skill. Therefore, the notion that AUM fees give an advisor some incentive to improve investment returns in any given portfolio is deceptive nonsense. The only true incentive AUM fees provide an advisor with is to gather more assets, and to keep those assets from being spent, or invested away, lest the advisor’s fee income go down.
THE FINAL STRAW: THE TYRANNY OF COMPOUNDING COSTS
In persuading clients to invest with them, financial advisors are quick to point out the magic of compound interest, which is a gift that keeps on giving to patient investors. Advisors are much less quick to point out their AUM fees’ tyranny of compounding costs, which is the take that keeps on taking.
Consider that $3 million client who lets their money grow untouched for 30 years. Assume, for simplicity’s sake, that $3 million grows for 30 years at an average of 7% return. That $3 million will turn into around $24 million ($24.058 million, give or take) as a result of the magic of compound interest.
If, however, the client were charged a 1% AUM fee, that same $3 million would grow to only $17.816 million. So they would have supplied 100% of the investment capital, taken 100% of the risk, and received 74% of the reward, as a direct result of the tyranny of compounding costs.
Into whose pocket did the missing 26%, or $6.2 million, go? Almost half of that amount—more than $2.5 million—went to the advisor, while the other portion simply disappeared due to lost compounding of interest. In reality, the outcome is often considerably worse than that for the client, as it is also common for advisors to place clients’ money in funds charging another 1% or more on top of the 1% AUM fee—in other words, clients put up 100% of the money, take 100% of the risk, and receive 50% of the profits.
The cherry on top of this advisory fee scheme is that, in a case like the one above, the advisor would no doubt claim that the 1% AUM fee is “fee-only” for advice, and that because they are not charging commissions, they are therefore, somehow, acting in the client’s best interest.
But, of course, that is doublespeak, and does a grave disservice to the client.
What is the job of an advisor, really? It is to exercise stewardship over the client’s holdings and to offer prudent advice that is in the client’s best interest. It is not to extract exorbitant fees from the client’s accounts. The client’s best interest must always come first, and it is imperative that any fees the financial advisor charges be clear, simple, easy to understand, and fair.
An AUM fee, based as it is on an arbitrary factor, requiring a calculation that changes day-to-day, to determine its cost, and increasing or decreasing based upon dumb luck, is none of those things.
IF NOT AN AUM FEE, THEN WHAT?
What would be better than an AUM fee? A simple, clear, set fee. A flat, fixed annual fee that is a function of the time, energy, and skill required of the advisor, plus a reasonable profit margin, just as fees are priced in all other service businesses. Such a flat, fixed fee would be so much more sensible. It would be simple and clear, requiring no cumbersome calculations to determine its amount. And, if priced reasonably, it would eliminate the conflict of interest of grossly excessive AUM fees. Above all, it would give clients what they deserve: a fair shake.
For example, in the case of the $3 million growing over time, were the client to pay a fee more fair and more in line with the advisor’s actual work done—let's call it $5,000 per year—and not growing, the client’s final tally after 30 years would be $24.048 million, or $6.2 million more than the 1% AUM fee left for them. For those of us who are visual learners, the graph below illustrates the massive difference that a percentage-based fee can have on your savings.
That would also be 99% of the reward, rather than 74%. And the advisor would still be very handsomely paid, just not exceedingly so (actually, 94% less than an AUM fee would have paid). And the client would have gotten every ounce of service deserved.
Part 2: Beware the Self-Proclaimed Fiduciary
Hypothetically, the noun “fiduciary” (“Are you a fiduciary?”) denotes a financial advisor who acts in their client’s best interest. As an adjective, fiduciary means “in the client’s best interest” (for example, “fiduciary advice”). Therefore, many people who seek financial advice rightly want to work with a fiduciary because they want fiduciary advice.
In the real world of financial services, however, “fiduciary” is too often deceptively and manipulatively used. Many advisors claim to be fiduciary who are clearly not. And many people get taken advantage of by them.
You can eliminate that possibility for yourself by asking two questions of your advisor. The first is, “How are you paid?” The second is, “How much, in total fees and investment costs, will I pay?” You cannot ensure that your best interest will be served without having good answers to each question.
There are few things we can be sure of, but we can assure you that if:
The advisor is paid based on what they sell you, meaning by commission or sales load, that advisor cannot serve your best interest.
The advisor is paid as a function of how much money or income you have, and charges fees as some percentage of those, that advisor cannot serve your best interest.
What you pay an advisor in total fees and investment costs is clearly exorbitant, your best interest is not being served.
If having your best interest served is your top priority, find an advisor whose pay structure allows for it. That will be an advisor who is paid a defensible fee for advice, be it hourly, one-time project-based, or a fixed or flat retainer fee.
Two Questions That Shine the Light on “Fiduciary”
Which two questions should you ask your financial advisor?
This one: How are you paid?
And this one: How much, in total advisory fees and investment costs, will I pay?
If you get good answers to both, you are well on your way to identifying a true fiduciary advisor. They will tell you almost everything you need to know. Yes, investment philosophy, planning procedures, tax expertise, and personality also matter and should be understood, but let’s keep this fiduciary consideration simple for now.
If the advisor is paid by commission or sales load for selling you products or investments, that advisor cannot act in your best interest. The simple reason is commissions and sales loads are in the advisor’s best interest, and no one can serve two masters. If it’s in the advisor’s best interest, it cannot be in yours.
If the advisor is paid some percentage of a client’s assets, that advisor cannot truly act in the client’s best interest, for two primary reasons. The first is that the advisor’s clear incentive is to keep the client from doing anything to liquidate the portfolio, thereby reducing the advisor’s fee income (based as it is on a percentage of the assets managed by that advisor), which taints any advice the advisor would offer. The second is that percentage-based fees quickly rise to exorbitant levels, and paying ever-rising, exorbitant fees for the same work is obviously not in any client’s best interest. At some point, fees become unreasonable given the work done on the client’s behalf.
Words That Don’t Matter — Common Advisor Proclamations of Fiduciarity
“I’m a Registered Investment Adviser. I’m legally required to act in your best interest.” That is true to the letter of the law, but too often untrue in the real world. A lot of Registered Investment Advisers are licensed to sell, and do sell, commission-based insurance products, which immediately calls into question their acting in your best interest, even though they may proclaim to.
“I’m fee-only. I cannot accept commissions. Therefore, I only act in your best interest.” Again, this is often not true. A lot of fee-only advisors charge their clients exorbitant percentage-based fees on assets under management. Those fees can produce staggering effective wages of thousands of dollars per hour and more, which is why the money management industry is so notoriously profitable. Yes, being fee-only is better than selling by commission or sales load, but it is not, in and of itself, indicative of “fiduciary.”
“I’m a Certified Financial Planner™ Professional. I’m obligated to act in your best interest by the CFP® Board.” Again, far too often it doesn’t happen. Plenty of CFP® professionals sell commission and sales-load paying products. The great majority charge fees as a percentage of assets under management. And the CFP® Board is notoriously lax in enforcing its code of ethics.
Trust, but Verify
To maintain your dignity, and to ensure the integrity of any advisor with whom you work, heed the Russian proverb made famous by President Reagan: trust, but verify.
Maybe your advisor is truly fiduciary. But if you want to be a savvy financial services consumer, if you want to make sure your best interest is being served, there’s a little more work for you to do.
Don’t rely on any regulation or the federal or state government to protect you, because they won’t. Don’t count on the Certified Financial Planner™ Board’s stamp of approval of an advisor, because you can’t. And don’t rest easy thinking you’re working with a reputable company, because “reputable” really just means “recognizable” most of the time.
It’s a caveat emptor/buyer beware world in financial services. If you want your best interest met, protect yourself. It’s okay to trust, as a start, but always verify. Ask questions. And remember, if an advisor is paid based on what they sell you, or if an advisor is paid as a function of how much money you have, that advisor cannot act in your best interest. It’s simply not possible.