Should a Retired Investor Use a Financial Advisor?
People often ask if our emphasis on asset allocation and indexing means that we think they don't need to use the services offered by financial planners. The answer, with a couple of important reservations, is a resounding NO!
The right planner/adviser, used in the right way, can add a lot of value to a person's life, just like the right doctor, dentist, lawyer and accountant can (not to mention the baby sitters, car mechanics, and everyone else who makes modern life possible).
Unfortunately, there are a lot of people out there who call themselves financial advisers, consultants, planners and similar terms. And, of course, there is the obligatory alphabet soup of different qualifications after their names (CFA, CFP, ChFC, CPA, RIA, etc.) So how do you find the one who is right for you?
In our experience, the right planner to use is someone you like, someone you trust (listen to your instincts!), someone who comes recommended by people whose acumen you respect, and someone who is well qualified.
Beyond these criteria, we have a very strong preference for Registered Investment Advisors and Certified Financial Planners who are compensated via an explicit hourly fee for his or her services. We prefer to pay financial advisers the same way we pay lawyers, accountants, doctors, and other professionals. When financial advisers are compensated using other approaches, it potentially creates what are called "agency problems" or, to put it another way, a potential conflict of interest between their short-term incentives and your long term financial goals.
Let's look at three types of compensation arrangements, and the agency problems they can create.
The first situation is one where the financial planner appears to be giving you advice for free. As with other things in life, if something sounds too good to be true, it is.
In fact, advisers in this category are typically (well) compensated via commissions paid to them by the companies whose products they sell to you. As much as they protest that it isn't the case, common sense tells you that this must inevitably create conflicts of interest between you and your supposed "adviser." One of the most common (e.g., it has come up in past mutual fund scandals) is a situation where the prospect for a high commission affects the product an adviser recommends to a client. Another problem is called "churning", and refers to excessive trading in a client's account in order to earn more commissions for the adviser.
If you are thinking about using a commission-based adviser, ask ahead of time for disclosure of the commission arrangements on all the products the adviser has considered in putting together his or her solution for you (including the ones he or she rejected). Also ask for the total amount of commissions the adviser will earn over the next five years (many products have delayed payouts) on the products sold to you. Many people are shocked when they see the size of this number. Finally, think long and hard before giving commission based (or, indeed, any) adviser the discretionary authority to execute buy and sell transactions on your behalf without your explicit permission.
The second type of adviser is one who, instead of commissions, charges you a fee that is equal to a percentage of the total value of the assets the adviser is helping you to manage.
In this case, the key issue is whether or not the work actually performed by the adviser scales linearly with the fees you pay to him or her. A good analogy is to the six percent commission charged by real estate agents when a house is sold. More than a few sellers have questioned whether it takes three times as much work to sell a $600,000 house as it does to sell a $200,000 house. The same is true for financial advice. Think about two clients, one with a $200,000 portfolio, and one with a $500,000 portfolio. If they both go to the same adviser who charges a fee equal to one percent of assets, it is logical to ask what additional benefits the latter client is getting for the additional $3,000 per year in fees that he or she is paying.
This issue of the adviser's value added becomes particularly acute when a portfolio increases in value over time due to returns on an investment portfolio whose asset allocation hasn't changed much over time. In short, if you are going to use an adviser who uses a "percentage of assets under management" fee structure, you should explicitly ask about (and carefully assess) the additional services and benefits that you will receive as your assets rise in value (hint: you might practice ahead of time by asking this question of real estate agents!)
The third type of compensation arrangement is one where the adviser's fees (e.g., those paid to the manager of a fund of hedge funds) are tied (at least in part) to the underlying performance of some or all of your investments. (Actually, a fee tied to the value of assets under management is a variant of this).
Superficially, this usually strikes people as an attractive deal -- the adviser will only earn high returns if you earn high returns. The potential downside, however, lies in what happens if your investments lose money (or have returns below a minimum threshold). If terrible performance only means that the adviser loses his or her job, the agency problem involved may be significant. Years ago, a friend who was then a trader at a large Wall Street investment bank told me he had the greatest job in the world. Why? Because if, by risking the firm's capital, he made the firm a lot of money, he would get a big bonus. But if, in taking risks that could result in those high returns, he instead lost a lot of that capital, he would only lose his job, and could always get another one. Given this mismatch between personal upside and downside potential, do you think the trader had an incentive to take risks with the firm's capital that he wouldn't have with his own money? The moral of the story is this: fees tied to investment performance only make sense if the adviser has a substantial amount of his or her own funds invested alongside yours, and will also feel the same pain and regret if the future returns on them are negative.
But finding the right planner is only half the battle. Going to him or her for the right reasons is also critical.
By now you should be able to guess that we don't believe anybody that has visited www.retiredinvestor.com should choose an adviser based on his or her claim to be a great active investment manager. On the other hand, good financial planning is about a lot more than asset allocation and its implementation. People also need to budget their spending, manage their taxes, hedge their risks (which includes, but isn't limited to buying insurance to cover them), borrow wisely, and plan for the eventual distribution of their estate. They also sometimes need help managing their emotional response to the normal ups and downs experienced by different asset classes in their portfolio.
Helping you with all of these tasks, and integrating them into an effective plan, is the real value added you get from a fee only financial advisor. For that reason, we strongly support their use, while always investing wisely and -- just as you do with your doctor — getting an informed second opinion.
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