Variable Annuities, Part 1

“High fees, low flexibility and ‘horrendous’ tax treatment make variable annuities less attractive than ever, except to the people who sell them.” – Liz Pulliam Weston.

Annuities may come in more flavors than Baskin Robbins ice cream, but don’t make the mistake of assuming that they are as simple as choosing between chocolate and vanilla. In truth, they are very complicated products. A variable annuity is an insurance contract that allows you to invest your premium in various mutual fund-like investments. If you are considering buying an annuity, you must do your homework before making a final decision. CNN.com’s annuity guide is a good on-line primer

SmartMoney.com summarizes as follows.

A variable annuity is basically a tax-deferred investment vehicle that comes with an insurance contract, usually designed to protect you from a loss in capital. Thanks to the insurance wrapper, earnings inside the annuity grow tax-deferred, and the account isn’t subject to annual contribution limits like those on other tax-favored vehicles like IRAs and 401(k)s. Typically you can choose from a menu of mutual funds, which in the variable annuity world are known as “subaccounts.” Withdrawals made after age 59 1/2 are taxed as income. Earlier withdrawals are subject to tax and a 10% penalty.

Variable annuities can be immediate or deferred. With a deferred annuity the account grows until you decide it’s time to make withdrawals. And when that time comes (which should be after age 59 1/2, or you owe an early withdrawal penalty) you can either annuitize your payments (which will provide regular payments over a set amount of time) or you can withdraw money as you see fit.

Since the person recommending the annuity will (no doubt) tell you how “great” this product is, this article will temper that by focusing on the disadvantages of a variable annuity.

Sold not Bought

In financial circles, it has often been said that annuities “are sold, not bought.” And sold they certainly have been — there is more than $1 trillion invested in variable annuities, and new sales total well over $100 billion every year.

However, the popularity of an annuity as an investment does not necessarily suggest that it is wise for you to invest your hard-earned money in it.

So are variable annuities good for investors?

Liz Pulliam Weston, who writes a column for MSN Money, gives away the answer in her article’s title The Worst Retirement Investment You Can Make.

Calling it the “worst” investment may, perhaps, be a slight exaggeration. Let’s look at her main points.

Tax treatment. Your gains in an annuity grow tax-deferred, but they are taxed as income when you withdraw the money. That contrasts with other investments such as stocks and mutual funds, which can qualify for lower capital gains treatments.

Penalties for early withdrawal. Variable annuities are designed as retirement savings vehicles. So, you pay a 10% federal-tax penalty if you withdraw money before age 59½. Insurance companies typically levy surrender charges of their own if you withdraw more than 10% of your balance in the first few years. Surrender charges usually start at 7% of your investment and decline to zero over the next six to eight years. They can range, however, up to 16% and last for as long as 15 years.

Death benefit. Variable annuities typically come with a death benefit that ensures your heirs get back at least as much as you invested if you’re unlucky enough to die while your investments are down. Your heirs will have other problems if you die owning an annuity, however. While most other investments get favorable tax treatment — a so-called “step-up in basis” that eliminates or drastically reduces the taxes heirs must pay when they sell — withdrawals from an annuity are taxed at regular income-tax rates.

Living benefits. Death benefits aren’t the only insurance feature you can get with a variable annuity. Increasingly, insurers are pushing so-called “living benefits” or “life benefits,” which guarantee that you can get back at least your original investment, usually compounded by a certain amount, when you withdraw the money in retirement. Investors stung by the bear market are greatly attracted to these guarantees, Carey said. That’s helped fuel annuities’ rise. Living benefits were available on 20 of the 25 top-selling variable-annuity contracts last year.

Costs. The insurance features of an annuity aren’t free, of course. The typical annuity with just a death benefit costs 50% to 100% more in annual fees than comparable mutual funds. Life benefits can add 20% or more to that cost.

Those extra expenses can seriously eat into your returns. Consider what would happen if you invested $5,000 a year in mutual funds with annual expenses of 1.5%, versus the same investment in an annuity with a 2.5% expense ratio.

If the underlying investments returned 8% a year, after 30 years:

Your variable annuity would be worth $362,177.
Your mutual funds would be worth $431,874 — a difference of nearly $70,000, or 14 years’ worth of contributions.

The gap just widens if you consider the tax implications. In both scenarios, you won’t have to pay tax on your original contributions when you withdraw the money. But the mutual fund gains would in most cases qualify for capital gains tax rates, which range from 5% to 15%, while the annuity’s payments would be taxed at income tax rates — currently 10% to 35%.

Are the life benefits worth it?

Meanwhile, the chances of your actually using the insurance benefits are slim. Relatively few people will die with their annuities worth less than what they paid. The living benefits typically come with a 10-year holding period, and there have been few 10-year periods where investors have actually lost money.

Insurers argue that the life benefits serve as “guard rails,” allowing investors to take more risk with the knowledge that their basic investment is protected. Many financial planners respond that a more appropriate response to risk is to construct a balanced, diversified portfolio with bonds and cash to cushion stock market swings.

Of course, most variable annuities aren’t bought — they’re sold. Only about 2% of variable annuities are purchased directly by consumers; the rest are sold through brokers, insurance agents and bank employees who are paid often-hefty commissions on their sales.

The math is lousy

“When you take the commissions out of the equation, the allure of a variable annuity disappears,” said Miami fee-only financial planner Frank Armstrong, a former insurance agent and author of “The Informed Investor: A Hype-Free Guide to Constructing a Sound Financial Portfolio.” “They cost a bundle,” he added. “And the tax treatment (upon withdrawal) is horrendous.”

“Nobody who’s in the fee-only (planning) business is going to recommend them,” said Armstrong. “Why do you think that is? You think we just have a blind spot that we can’t do the math?”

Some of most vociferous critics of variable annuities are those who, like Armstrong, spent some time in the brokerage firms or insurance companies that push them. Before he became a fee-only planner, Rob Pool of Portland, Ore., worked for a major brokerage firm, and the experience made him wary of the way annuities are sold.

“They’d get recommended even if it wasn’t in the client’s best interest all the time,” Pool said. “I can’t say there’s never a place for a variable annuity in a portfolio, but I haven’t found it yet.”

Conclusion

Personally, I do not recommend variable annuities for my clients, because they are not in my clients’ best interest, and there are much better alternatives. Variable annuities have very high expenses, unfavorable tax ramifications, and they lack flexibility. Before buying one you should understand the surrender charges, early withdrawal penalties and the annual fees. It bears repeating, do your homework before you consider buying an annuity.

Larry Swedroe and Jared Kizer in their new book The Only Guide to Alternative Investments You’ll Ever Need say this:

Some investment products are so complex in design that it is very difficult, if not impossible, for the average investor to fully understand the risks entailed and the costs incurred. Make no mistake about it, the complexity is intentional. After all, if the investor fully understood the product, it is likely that he or she would never purchase it. That is why many of such products are truly “tourist traps” – designed to be sold, but never bought.

Education – or a good fee-only adviser who is not influenced by commission-based compensation – can be the armor that protects investors. The overwhelming evidence from academic studies on Variable Annuities is clear: In general, these investments fall into the category of products that are meant to be sold, not bought.

Read Part 2.

The Dark Side of Wall Street, Part 3

“Not infrequently, brokers become disenchanted and leave the business. Occasionally, they will even become fee-only advisors, whose compensation is not tied to trading.” – William J. Bernstein.

In a previous post, I asked the rhetorical question, “Why would you even consider working with a financial advisor who warns you in writing that ‘Our interests may not always be the same as yours’ and ‘Our profits, and our salespersons’ compensation, may vary by product and over time.’”

Friday’s post quoted exclusively from William Bernstein on the subject of stock brokers’ competence and compensation.

Today’s post quotes a former stockbroker on the incentives and pressures he observed. Scott Dauenhauer, of Meridian Wealth Management, is a colleague who spent five years working for the “big three” brokerage firms. He has written a vivid expose called Secrets of the Wirehouse and How to Protect Your Best Interests.

( “Wirehouse” is an industry term for a large national broker/dealer. Merrill Lynch, Morgan Stanley, Lehman Brothers, and Bear Stearns are all examples of wirehouses.)

Scott’s article covers many topics including broker training, compensation, and the various investment products you should avoid. Here is what he says about broker competency, compensation and the conflicts of interest endemic in the financial community.

How much training do brokers actually have in financial planning? Major brokerage firms tout intensive training programs almost as much as the stocks they peddle.  They brag about the high level of education their “consultants” receive. The truth is the only requirements are that individuals pass the Series 7, and a state insurance exam.  The Series 7 is an industry test that requires memorization of facts about the markets and represents a minimum standard of knowledge.

The Series 7 does not teach an individual how to manage personal finances, let alone create a comprehensive financial plan. The Series 7 doesn’t even teach about how to properly diversify a portfolio.  The insurance exam is an even bigger farce. While the Series 7 actually requires a bit of studying the state insurance exams only require minimal memorization.

Anyway, once a “recruit” passes the Series 7, he/she is sent to company headquarters to go through “intensive training.”  The training is definitely intensive, though not in financial planning or investment management.  The programs focus solely on sales & product training and lasts anywhere from 1-4 weeks. I attended one such program and 95% of the training focused on cold-calling sales and learning proprietary product. Proprietary products are ones that are sold directly (and typically only) by the brokerage firm and typically have much higher profit margins, though mainly benefit the firm, not the person they are sold too.  Brokerage firms want “salespeople,” not highly skilled financial planners.

If the firms hired highly skilled financial planners, the firm wouldn’t be able to sell proprietary products.  This is because the planners would know better.  When the firm hires somebody with no previous industry knowledge, or experience, they have the opportunity to fill that person’s mind with fairy tales, not fact.  The firms’ way of doing business is to focus on proprietary products, high & hidden fees, cold calling, and quotas.  The truth is that very few new recruits have any experience in handling another family’s wealth.  You end up paying high fees for a service that puts you directly on a recruit’s learning curve.  Even brokers who have been at the firm for years may not have any training in financial planning; they are stockbrokers, not trusted advisors.

When dealing with brokerage firm, conflicts of interest abound and for the most part are not disclosed.  The following is a few conflicts that you should watch out for.

First, please understand to whom a public company owes their loyalty; it is to their public shareholders.  The people who own stock in a company must have their interests protected.  A public brokerage firm’s loyalty cannot be 100% to you.

Let’s take a further look at where other strings are attached. A broker gets paid a percentage of the revenues that he/she brings to the firm, typically 25-40%.  It is not, however, that simple. Brokerage firms determine the payout percentage for each individual “product.”  They control product flow by paying higher amounts to brokers for product they want sold (typically products with higher margins).  While this makes sense from a business stand point and from a shareholder standpoint (why wouldn’t you want to incentivize your staff to sell the most profitable products?) it doesn’t work out so well for the end user, the client.  Each firm works differently but depending on the product a firm wants to emphasize, they will pay a broker a higher percentage of the revenue to induce him to sell what the company wants him to sell.  For example, if the company wants a broker to sell a Separate Account Platform product (individual money managers, more to come on this), they may tell the broker that they will receive a higher percentage of the fees they generate from that particular product and that product may generate more fees than other products.

Let me give you a real life example so that you understand.

Imagine that you had only two products to choose from to sell your client; one is a mutual fund that costs the client 2.25% annually and pays the firm 1% annually.  Of the 1% paid to the firm the broker collects 35% of it or .35% annually. On a $1,000,000 account the firm generates $10,000 in revenue and pays the broker $3,500 (you the client pay $22,500).  The other product is a Separate Account where you have an individual money manager.  This product is sold as the latest, greatest way to have your money managed and costs 2.5% annually.  However, this product pays the firm 1.5% annually and the firm will pay the broker 40% of that revenue or .60% annually. On the same $1,000,000 account the firm generates $15,000 in revenue and pays the broker $6,000 (you pay $25,000 annually).  Now, in all likelihood both accounts will have similar returns over time and will probably under-perform the market.  You the client in either situation are stuck in a lousy product that is expensive; however the firm has an incentive to sell one over the other, even if the other isn’t in your best interest.  The separate account sale earns the firm 50% more revenue and the broker 70% more revenue – which product do you think will be presented?  Each firm has their own system and they are all different, but the mechanisms are in place to manipulate the broker into selling what makes the firm and/or the broker more money.

In addition to higher revenue on proprietary products, the broker many times is under tremendous pressure from management to sell you the latest mutual fund offering from that brokerage.  Branch manager compensation is determined in part by the amount of proprietary products his branch sells. His interest is in getting the highest bonus possible, so he in turn puts the pressure on the brokers to “pound the phones,” and sell their “latest offering.”  The brokers are enticed by management with trips, dinners, and a host of other items. It goes unspoken that if a broker does not participate in selling the new offering then things will not be easy for him/her.  I know of one broker who was told, “I don’t think this firm is the right place for you,” after the broker refused to sell the new fund offering.  It turned out that he was the only one to not succumb to the pressure, he eventually left that firm.  I can’t begin to tell you how many voice mails & e-mails I received from management to ‘sell’ the “new” offerings, I never succumbed because it was not in my client’s best interest. Be aware that the pressure is on your broker to sell certain products or else he/she risks losing their job.

Conclusion

Brokerage firms (wirehouses) train (brainwash) recruits in sales techniques and product knowledge, not portfolio management and financial planning. They use carrots and sticks to influence brokers to recommend investment products that are profitable to the firm.

According to William Bernstein, brokerage firms target how much they are going to earn from clients’ accounts.

At the end of the day, most wirehouses operate on the “2% rule” – collect 2% in fees and commissions, overt or hidden, on your clients’ assets, or you’re out.

My experience is that the 2% figure is extremely conservative – it is not unusual to see accounts from which as much as 5% annually is extracted.

You will not see these fees and expenses outlined, because they are not easy to discern. Unless you are a detective, they will be hidden from your view.

Is there a better way? Certainly. It is choosing a fee-only financial advisor, who acts in your best interest, as a fiduciary.

To be continued.

The Dark Side of Wall Street, Part 2

“Make no mistake about it, you are engaged in a brutal zero-sum contest with the financial industry — every penny of commissions, fees, and transactional cost they extract is irretrievably lost to you.” – William Bernstein.

Yesterday’s post was about Wall Street’s habit of designing complex financial products that are difficult to understand. They promise high returns with less risk, but often fail to deliver.  They entail high fees, which are profitable for the producer of these instruments, but not for investors.

It is well worth delving into the issue of brokers’ conflicts of interest.  Your success as an investor depends on knowing how Wall Street really works and in not accepting the client-friendly face it portrays on TV.

William Bernstein, the author of The Four Pillars of Investing, has a lot to say about the competency and compensation of brokers in a chapter called Your Broker is not Your Buddy.

There are no educational requirements for brokers (or, as they’re known in the business, registered reps).  No mandatory courses in finance, economics, law, or even a high-school diploma are necessary to enter the field.  Simply pass the pathetically simple Series 7 exam, and you’re on your way to a profitable career.

It is a sad fact that you can pass the Series 7 exam and begin to manage other people’s accumulated life savings faster than you can get a manicurist’s license in most states.

The most shocking aspect of the brokerage business is that brokers almost never actually calculate the investment results of their clients, let alone reflect on methods for improving them.

Brokers are not trained by the brokerage houses to invest – they are trained to sell.

Brokers pay almost no attention to the returns their clients earn.  It is rare to come across one who routinely calculates his clients’ annual returns, let alone considers what these data might mean.

Brokers do undergo rigorous training, sometimes lasting months – in sales techniques.

What do brokers think about almost every minute of the day? Selling. Selling. And Selling.

Because if they do not sell, they’re on the next train home to Peoria.  The focus on sales breeds a curious kind of ethical anesthesia.  Like all human beings placed in morally dubious positions, brokers are capable of rationalizing the damage to their clients’ portfolios in a multitude of ways.  They provide valuable advice and discipline.  They are able to beat the market.  They provide moral comfort and personal advice during difficult times in the market.  Anything but face the awful truth: that their clients would be far better off without them.  This is not to say that honest brokers who can understand and manage the conflicts of interest inherent in the job do not exist.  But in my experience, they are few and far between.  After all, what is best for the client is to keep investment costs and turnover as low as possible, which also minimizes a broker’s income.

Brokers will protest that in order to keep their clients for the long haul, they must do right by them.  This is much less than half true.  It’s a sad fact that in one year a broker can make more money exploiting a client than in ten years of treating them honestly.  The temptation to take the wrong road is more than most can resist.

Conclusion

Under no circumstances should you have anything to do with a “full service” brokerage firm.

You do not want anyone near your money – advisor or broker – whose compensation is tied in any way to his choice of investment vehicles. 

To be continued.

The Dark Side of Wall Street, Part 1

“Wall Street’s sales and marketing machine is continuously pumping out fairy tales: fanciful fables filled with legendary deeds and winning exploits. The only differences between many of the Street’s product ‘innovations’ and other types of fairy tales are that the stories are designed for adults, and they rarely have happy endings.

Like the apple given to Snow White by the Evil Queen, these products offer enticing features designed to lure investors, but almost all have one thing in common: Despite their seeming appeal, they have attributes that make them more attractive to the seller than the buyer. These products typically fall into the category called structured products. ” – Larry E. Swedroe and Jared Kizer.

Another “Safe” Bet Leaves Many Burned is a good overview article by Eleanor Laise on several “structured products”.  It appeared in the November 11, 2008 edition of The Wall Street Journal.

The gist of the story is that Wall Street firms sold complicated products which promised high returns with little risks. The risks were understated; the returns never materialized.

To see how complicated structures products are, read this article.

How many brokers or investors really understood the mechanics behind such whiz bang inventions such as the following?

• Principal-protected notes
• Reverse convertibles
• Return-enhanced notes

The projections (a.k.a. promises) for these products were based on hypothetical scenarios best viewed through rose-colored glasses. Naturally, disappointment followed when the outcome proved otherwise.

All of this brings to mind the old oft-told advice, “If it sounds too good to be true, it probably is.”

Here are some choice quotes from the article:

In recent years, Wall Street firms raced to sell small investors “structured products” linked to everything from stock indexes to currencies. They were often marketed as a relatively safe way to get a slice of market gains.

Now, in the midst of the market turmoil, many investors holding these complex products are getting burned.

With structured products, which are issued by big Wall Street firms, investors can get exposure to commodities, stocks or other investments without actually owning those assets. The products may promise to give investors a portion of any gains in, say, U.S. stocks or Asian currencies while offering some protection from market losses. They typically behave like packages of bonds and options, but what investors are actually buying with most of these products is the unsecured debt of the issuer.

With Wall Street in turmoil, many of the risks of structured products are now coming to light. “Reverse convertibles,” for example, offer fat yields but leave investors exposed to steep losses if a stock price collapses. “Principal-protected notes” typically are designed to return the principal investment at maturity, along with some portion of the gains in an underlying benchmark, such as the Standard & Poor’s 500-stock index. Yet investors selling before maturity may not recoup their full investment, and the principal protection depends on the issuer’s ability to meet its obligations. Many “return-enhanced notes,” meanwhile, offer some multiple of an index’s gains but provide no protection against stock-market declines.

When an issuer goes belly up, as Lehman Brothers Holdings Inc. did in September, structured-product investors are generally left standing in line with other creditors and may face a long wait to determine how much, if anything, they’ll be able to recover. Some Lehman structured products now are trading for less than 10 cents on the dollar, according to SecondMarket Inc., a marketplace specializing in illiquid assets, which says it has heard from investors holding more than $2 billion worth of Lehman structured products.

The problems are coming at a time when small investors have been on a structured-product buying binge. This year through early November, nearly $34 billion worth of structured products were sold to small U.S. investors, surpassing the $33.5 billion sold in all of 2007, according to StructuredRetailProducts.com, an independent research firm.

The recent upheaval is particularly painful for investors because structured products are often sold to people who are in or near retirement and seek relatively secure or high-yielding investments. Principal-protected notes, which were offered by Lehman and other issuers, were generally designed to at least give investors their original investment back at maturity, and were often touted as safer than direct investments in, say, a stock-market index. The double-digit yields commonly offered by reverse convertibles, meanwhile, may be enticing to people living on a fixed income.

The current problems come on top of longer-standing concerns about these investments. They can be difficult to sell for a decent price before maturity and often carry embedded fees that are tough for individual investors to decipher. Regulators in recent years have raised alarm bells about structured products, voicing concerns about the marketing and sales practices of brokers who sell them.

Conclusion

While it is nice that “regulators in recent years have raised alarm bells about structured products,” that hardly seems enough to protect investors. Transparency is missing for these products, because they “often carry embedded fees that are tough for individual investors to decipher.”

This year has been particularly difficult for all investors, as most strategies have failed, at least in the short term. Even so, in investing, some things are constant. To wit:

• Risk and reward are inextricably related. (There is no such thing as a free lunch.)
• A straightforward approach is usually the best.  Keep it simple: Diversification via low-cost mutual funds.
• Avoid hyped synthetic, “enhanced” products, which typically have high fees and hidden risks. Complex structured products benefit Wall Street much more than they do investors.

Forgive me for being cynical, but it comes from listening to fee-only financial advisors who used to be stockbrokers. They have, in essence, come over from the “dark side.”

One thing I am quite confident of is that the brokers were compensated handsomely for selling these “safe” investments. Rick Ferri (a former stockbroker) is quoted in The Bogleheads’ Guide to Investing, “Wall Street wants you to believe they are there to make money for you, but their true purpose is to make money from you.”

To be continued.

Choosing a Financial Advisor, Part 3

“Fiduciary – A Financial Advisor held to a Fiduciary Standard occupies a position of special trust and confidence when working with a client.  As a fiduciary, the Financial Advisor is required to act with undivided loyalty to the client.  This includes disclosure of how the Financial Advisor is to be compensated and any corresponding conflicts of interest.” – Focus on Fiduciary.

In a previous post, I said that, when looking for a financial advisor, you want someone who puts your interests first, i.e. a fiduciary.  This merits further discussion.  By way of example, lawyers, trustees or doctors are considered fiduciaries. On the other hand, stock brokers, insurance agents and registered representatives are not.

According to the National Association of Personal Financial Advisors (NAPFA) web site, Focus on Fiduciary:

Federal and state law requires that Registered Investment Advisors are held to a Fiduciary Standard.  This law requires that an advisor act solely in the best interest of the client, even if that interest is in conflict with the advisor’s financial interest. Investment Advisors must disclose any conflict, or potential conflict, to the client prior to and throughout a business engagement.  Investment Advisors must adopt a Code of Ethics and fully disclose how they are compensated.

Because broker-dealers are not necessarily acting in your best interest, the SEC requires them to add the following disclosure to your client agreement.  Read this disclosure, and decide if this is the type of relationship you want to dictate your financial security:

“Your account is a brokerage account and not an advisory account.  Our interests may not always be the same as yours.  Please ask us questions to make sure you understand your rights and our obligations to you, including the extent of our obligations to disclose conflicts of interest and to act in your best interest.  We are paid both by you and, sometimes, by people who compensate us based on what you buy. Therefore, our profits, and our salespersons’ compensation, may vary by product and over time.”

If you see this disclaimer in your contract, you have been warned that you are not working with a fiduciary.  My question to you is, “Why would you even consider working with someone who has issued you this warning?”

After all, you engage a financial advisor to look after your interests. In my opinion, having a trusted relationship is not possible after you have read the warning quoted above.  Since commissioned representatives receive incentives for selling one investment over another, how do you ever know why someone recommends one investment product to you over another? How do you know what it is actually costing you?

I wholeheartedly agree with NAPFA’s conclusion:

NAPFA has always maintained that an advisor who is compensated solely through commissions faces immense conflicts of interest.  This type of advisor is not paid unless a client buys (or sells) a financial product.  A commission-based advisor earns money on each transaction—and thus has a great incentive to encourage transactions that might not be in the interest of the client.  Indeed, many commission-based advisors are well-trained and well-intentioned. But the inherent potential conflict is great.

I believe that a strict fee-only approach is the best way of working with clients.  I want my clients to consider me as a trusted advisor and true partner, not a salesperson.

To be continued.

photo credit: Rui Almeida (Portugal)

Choosing a Financial Advisor, Part 2

“A Fee-Only financial advisor charges clients directly for his or her advice and/or ongoing management. No other financial reward is provided, directly or indirectly, by any other institution. Fee-Only financial advisors are selling only one thing: their knowledge.” – National Association of Personal Financial Advisors.

In a previous post, I wrote that a fee-only financial planner might be better choice for you than a financial planner who is compensated by commissions. Here is a continuation of an article by the Consumer Federation of America, an advocacy, research, education, and service organization.

The Financial Planning “Name Game”

If a fee-only financial planner is probably your best bet, what about all those other planners out there? As consumers have started to wake up to the conflicts of interest that result from commission-based compensation, more and more financial planners have adopted confusing terminology designed to obscure how they are compensated. Here are a few of the most common that you should be on the look-out for:

Fee-and-commission. This is the now somewhat out of fashion term for a planner who earns a fee for developing a financial plan, then earns commissions selling the products to implement that plan. For years, planners were able to sell this arrangement as being in their client’s best interests on the grounds that they were more objective than commission-only salespeople and more affordable and convenient than fee-only planners.

Since consumers have become more conscious of the total costs of fee-and-commission planning and the incentives commission-dependent planners have to steer them into costly and possibly inappropriate products, few planners now use this relatively candid terminology, though the majority continue to practice in this fashion.

Fee-based. This is today’s more fashionable terminology for fee-and-commission financial planning. The conflicts are the same, but the candor is gone. Some “fee-based” financial planners will tell clients they can work either on a fee-only basis or on a fee-and-commission basis if the client wants to implement the plan through them. Somehow, however, the bulk of their clients end up as fee-and-commission clients. The term “fee-based” is misleading, so you should be wary of those who use it.

Fee-offset. Under a fee-offset arrangement, a planner imposes a fee for drawing up a strategy, then reduces up to 100 percent of that fee to account for any commissions that may be earned in implementing the plan. The problem of commission bias is less obvious, but it remains. After all, if a financial plan costs $2,000 and the planner earns $10,000 in commissions for selling the needed products, he or she will be able to pocket $8,000 in conflict-producing commissions …even after totally offsetting the cost of the original plan.”

Interpretation

How your financial advisor is compensated should be important to you, because being paid a commission results in the (very distinct) possibility of a conflict of interest. Fee-only means the advisor cannot accept commissions. If the financial advisor’s paycheck comes from a brokerage firm, then the advisor is an employee and owes loyalty to the firm. When the paycheck comes directly from you, your interests come first.

As many consumers have discovered, some brokers regularly rely on obfuscation – confusing them with dozens of “facts,” figures and recommendations until their head is reeling. It’s disingenuous for them to suggest that you are not paying a fee, because the mutual fund (or insurance company) pays it. Certainly, no one would assume that the fees come from the benevolent tooth fairy. I call it obfuscation, but that’s really just a polite way of saying that they’re lying to you.

What you really need is someone who will put your financial interests first. This is a good description of someone who acts as a fiduciary.

Since labels for advisors – fee-based, fee-offset – are often confusing (on purpose, in my opinion) your best defense is to ask very pointed questions and expect very direct answers.

Question #1
You: “How are you compensated?”
Advisor: “I am compensated solely by my clients.” Correct answer.
Advisor: “Oh, you needn’t worry about that! My fees get paid by the insurance company or mutual fund.” Incorrect answer.

Question #2
You: “Do you act as a fiduciary?”
Advisor: “I always act as a fiduciary.” Correct answer.
Advisor: “Sometimes.” Incorrect answer.

Question #3
You: “Will you put that in writing?”
Advisor: “Yes, I will put that in writing.” Correct answer.
Advisor: “My word is my bond.” Incorrect answer.

You should be aware that members of the National Association of Personal Financial Advisors sign a Fiduciary Oath.

I actually give my Fiduciary Oath to prospective clients at the first meeting along with the Privacy Notice.

To be continued.

photo credit: emuphoto

Choosing a Financial Advisor, Part 1

“You don’t need 99.9 percent of what Wall Street is selling. It’s expensive, unsuitable, or stupid. Most investments are designed to profit the brokers, banks, and insurance companies, not you.” – Jane Bryant Quinn.

The quality of the financial advice that you get is dependent upon many things, including the training and academic background of your financial advisor. It also depends, in large measure, on how your advisor is compensated. Researching this issue and understanding what best serves your particular interests is a task well worth pursuing. Reading books on financial planning is one way to arm yourself because, in my opinion, it is nothing short of a war. I hope to do my part by providing you with a series of articles on the subject.

If you take the “easy way out” and merely go with the investment firm that has the best (i.e. most expensive) commercials on TV and the glitziest print ads in the local newspapers, consider this. You may be lining the pockets of your advisor, with your gold.

For one purely objective view on the subject, consider the Consumer Federation of America, an advocacy, research, education, and service organization. In an article on choosing a financial advisor, they argue that using a “fee-only” advisor may be your best choice.

Financial Planners

The way in which a financial planner is compensated can directly affect the advice he or she gives clients. A relatively small percentage of the individuals offering financial advice actually get paid exclusively for giving such advice. The majority earn some or all of their income selling mutual funds, annuities, insurance, and other financial products to implement their recommendations. “Advisers” who are also salespeople, however, inevitably face a conflict of interest and will almost certainly be tempted to steer clients into products in which they have a financial interest. The greater the adviser’s dependence on commission income, the greater the conflict. In the end, that conflict could cost you both in out-of-pocket expenses and in the quality of advice you receive.

Long-Term Cost

One of the chief attractions of commission-based financial planning is that it appears affordable. Typically, commission-based planners charge a relatively low fee or no fee, for the “advice,” expecting to earn the real money on the back end, when they sell the products to implement their recommendations. When you buy a product to implement that plan, however, a percentage of the money you spend goes to pay a commission to the planner. Ultimately, the price you pay includes not just the commission itself, but the money it would have earned over time had it been invested. In assessing the costs of financial planning, therefore, you have to include the cost of implementation.

Quality of Advice

The increase in implementation costs is not the only price you pay for commission-based planning. You may also pay in the form of poor advice. After all, when a financial “adviser” earns most of his or her money as a financial salesperson, the product sales tend to drive the process. In the worst case scenario, the planning becomes nothing more than window dressing to attract clients for the real money-making business of selling products. Clients are offered one-size-fits-all plans that inevitably lead to the purchase of a handful of high-commission products.

Even those commission-based advisers who attempt to offer comprehensive financial advice still can find themselves biased by compensation considerations when it comes time to implement their recommendations. After all, the more the adviser lowers the initial fees to attract business, and the more time he or she spends on the planning process, the more he or she must earn in the implementation phase to make that investment of time pay off.

Under such circumstances, even the best of commission-based planners is unlikely to recommend no-load or low-load products, for example. Other less scrupulous planners may recommend an investment, such as a particular mutual fund or annuity, simply because of the special incentives or higher commissions they receive.

The temptation for planners to recommend higher commission products carries another risk for clients. Product sponsors tend to offer higher commissions on those products that are more difficult to sell, because they are riskier. Thus, in pushing higher commission products, the planner may encourage you to take unnecessary risks with your money.

“Fee-Only” May Be Your Best Choice

So, if you are looking for objective financial advice, a fee-only financial planner is probably your best bet. Fee-only financial planners are compensated solely by fees paid by their clients. They can be paid in a variety of ways—a flat fee or retainer, an hourly fee, a percentage of assets under management, or a percentage of income from investments. The key is that they do not accept commissions or compensation from any other source.

Fee-only financial planning does not necessarily eliminate every conceivable form of conflict-of-interest. When fee-only planners “sell” portfolio management services, for example, they may have a financial incentive to recommend those services to clients. The fee-only approach is, however, subject to fewer conflicts than any other form of financial advice. Furthermore, because fee-only planners are compensated solely by the client, there are no hidden third parties in the relationship and thus, no divided loyalties.

Conclusion

I work strictly on a fee-only basis. That was my choice in setting up my practice, as it is the kind of arrangement I would want if I were the client.

Since everyone’s circumstances are different, you may be the rare individual who can best be served by a financial advisor who is compensated by commission. But, you won’t know that unless you get a second opinion. As Jane Bryant Quinn said, “If you don’t know much about investing yourself, it’s hard to tell good advice from bad.”

The majority of fee-only financial planners are members of the National Association of Personal Financial Advisors (NAPFA), an organization started in 1983. To find a fee-only advisor in your area, call NAPFA at 1-800-FEE-ONLYor visit their homepage at www.feeonly.org

To be continued.

photo credit: Office Now

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