Monday, May 18, 2015

Financial Advisor Selection

Do you have a clear idea of what a financial advisor does?  Should you hire a financial advisor?  What should be your selection criteria?  Are you a high net worth individual?  What is an appropriate fee?  These are the matters that will be addressed in this blog.

This blog is primarily aimed at retirees or pre-retirees with investible assets of $1m or more (high net worth individual, HNWI) but it will also apply to many with $500k+ of investible assets, particularly those with other sources of retirement income beyond social security.  Although the target audience of this article begins with those having investments of $1m, there is no upper limit.

Where am I coming from?  I am a retired international corporate tax attorney and CPA.  I switched from individual planning to corporate planning early in my career.  When it came time to tackle my own retirement planning, I realized I lacked the specialized knowledge to do such planning and began the process of getting educated.  Over the last 10 years I have developed a comprehensive retirement financial plan for my own use, and have continued to study financial planning and the financial planning industry.  I am not a financial advisor and do not aspire to become one.  I have no personal financial interests served by this blog.

This blog deals with the selection of a financial advisor and financial advisor fees.  There are two initial posts.  The first will examine: services provided by FAs; types of clients who will benefit by hiring an FA; and criteria for selecting an FA.  The second post discusses FA fees.  It discusses in detail the nature and problems with current fee arrangements, and suggests how the retiree should deal with such fees.

Part 1: Services and Selection of Financial Advisors

The first and perhaps the most important point relates to something that the FA cannot do -- beat the market.  Many FAs will disagree and claim that beating the market is one of the most important services that they provide.  Investment management is an important service of FAs, but the premise of this article is that the FA cannot pick market-beating stocks or funds.  For those interested in a more detailed analysis comparing passive index funds with actively managed funds, see A Case for Index Fund Portfolios.  

Some claim that they can beat the market, not by stock picking, but by building a better diversified, low-cost investment portfolio.  Helping select a passive portfolio that is appropriate for the client, is an important service provided by the financial planner; however, the tweaks that financial planners make to passive investing in order to “beat the market” are of questionable value.  To the extent there may be some value, such tweaking advice does not involve substantial additional time or skill.  

    Services of the Financial Advisor

Following are two summaries of the services provided by a FA.  The first comes from this article by Allan Roth, a financial planner, How to Choose a Financial Planner.

The second summary is from a study prepared by The Vanguard Group.  The following schedule summarizes how various FA services can increase net returns for their clients.

Defining Financial Goals

Defining goals is an extremely important role of the FA.  All planning is based upon a complete understanding of the client's financial position, his objectives and goals, and his behavioral leanings such as degree of risk aversion.  The FA must synthesize all of this information to generate a realistic estimate of retirement spending both present and future, considering all goals and contingencies.  The FA must obtain a complete understanding of all sources of future after-tax income, and reasonably project when and in what amounts such income will be realized.  This income must then be compared and reconciled with projected needs.  Such analyses must be continually updated.  You will find my approach to such an analysis in my other blog and my article, Retirement Planning with Annual Available Spend.  

Building the Portfolio and Sticking with it
In the financial analysis review discussed above, the FA will estimate the investment mix and expected returns.  Now it will be necessary to fine tune the investments.  The purpose of this is not to propose market beating investments, but to select investments that are compatible with the client's need, ability, and willingness to take risk.  This is the second bullet of the Roth list and Modules I-IV in the Vanguard list.  The investments must be diversified, and this is generally accomplished with a mix of index funds and/or ETFs.  

Module II relates to the low cost portfolio.  It contemplates low cost index funds such as those sold by Vanguard.  Vanguard estimates the savings at about 0.45%.  It is important to understand that the advisor fee is not the only investment-related expense.  When the advisor selects mutual funds or ETFs, there are also expenses incurred by the fund/ETF.  These expenses are often quite small for some index funds, e.g., 0.15%, but some of the more complex active funds have expense ratios in excess of 1%.  For a good discussion of how these fees and expenses can add up, see The Heavy Toll Of Investment Fees.

Modules III and IV relate to "sticking with it".  Rebalancing between fixed and equity investments is done to maintain or update the most desirable risk level as determined above.  Module IV estimates that the greatest value add is from behavioral coaching, 1.5%.  It is simply human nature to buy more equities when the market is soaring, and perhaps sell all when the market tanks (2008).  The FA's job is to maintain sanity and the original risk objectives.

Insurance, Pensions, and Social Security

The FA will work with the client to determine the appropriate amounts of various types of insurance, and, in most cases, should consider the applicability of annuities.  For many HNWIs, their assets will be sufficient to self insure, reducing the need for insurance.  Planning pension distributions, required minimum distributions, Social Security benefits, etc. are also important tasks undertaken by the FA.

Income tax and Estate Planning

The FA will assist with income tax planning relative to investments such as: Module V, planning what assets should be in taxable or tax deferred accounts; and Module VI, planning asset spending in order to minimize taxation.  The FA should be able to deal with these investment related tax issues, but generally, the FA is not a tax preparer, and broader income tax services will be done by the client's CPA or other tax advisor.

Estate planning and preparation of wills is generally done through an estate planning attorney.  The FA will often assist in financial analysis and implementing various approaches to gifting and inheritance.


The FA will often assist with a range of other financial issues:  education or large purchase funding; charitable giving; beneficiary reviews, etc.  

    Selecting a Financial Advisor

Do You Need the Services of a FA?

Many HNWI opt to go it alone and do their own financial planning.  For some, that is the right choice, but for most others, the better choice is to hire a financial advisor.  If you are considering taking on your own financial planning, look closely at the description of FA services above.  Are you prepared to do all of these tasks?  Are you prepared to educate yourself on any matters where you are not prepared?  Will you be able to recognize when you will need outside assistance?  Some people handle DIY very well, but many others do not.

Note the 1.5% value impact of Module IV, behavioral coaching.  A qualified FA will have the interpersonal skills to recognize and work with the client's behavioral propensities, whatever those may be.  How risk averse is the client?  What will he likely do if the market soars or tanks?  Is the client likely to stray from his investment policy statement, and how best can he be kept on course?  Of course, some people have no problem with controlling their own behavior, but several studies show how poorly many do in this regard.

How to Select a Financial Advisor

The basic criteria to consider when selecting a financial advisor include technical knowledge, personal skills, and fees.  Fees will be discussed in Part 2 below.  This article assumes that the retiree will hire a fee-only advisor -- an advisor who is not a stock broker or insurance agent, and who does not receive any commissions or kickbacks of any sort.  

The FA should have all the requisite skills to perform the services outlined above.  At a minimum the FA should be a CFP or CPA/PFS.  The FA must have all the technical skills, but, as importantly, the interpersonal skills to earn the client's trust and respect when dealing with behavioral matters.  Of course, reputation in the community can be valuable information when making the decision.

The websites of financial advisor firms are often not clear in identifying the types of services and specific fees that the advisor and firm will take.  I highly recommend that anyone looking to hire a financial planning firm first check the SEC Investment Adviser Search (after retrieving the firm by name and clicking on “SEC” (or state), scroll down the left hand navigation panel and click on “Part 2 Brochure”.  The Part 2 ADV Brochure will provide most of the details on services provided and fees.


Most HNWIs will benefit from the services of a financial advisor.  Hiring a FA will not help the HNWI beat the market, but the FA will help his client create and maintain an investment portfolio that is appropriate to his specific situation.  The FA will also perform additional services related to various other financial matters.  The FA should have both the necessary technical and interpersonal skills.

Financial Advisor Fees

The first post in this blog examined: services provided by FAs; types of clients who will benefit by hiring an FA; and criteria for selecting an FA.  This second post discusses FA fees.  It discusses in detail the nature and problems with current fee arrangements, and suggests how the retiree should deal with such fees.

Part 2: Financial Advisor Fees

By now you may be asking yourself why the entire second part of this blog is devoted to fees.  The reason is that the most common fee structure used by fee-only advisors is percentage of assets under management (AUM), and the most typical annual percentage charged is 1%.  This fee is often billed quarterly for each year of investment management.  Neither the structure nor the rate is appropriate.  

Why retirees like percentage of AUM fees

Although the percentage of AUM structure and rate are inappropriate, the billing procedure is often painless to the client.  Some of the reasons why percentage of AUM fees have worked so well from the client's perspective include:   

a) most clients have little understanding and appreciation of the services they receive in relation to the cost of those services (1% just seems small and reasonable);

b) many of those who do have an understanding of financial matters will not want the hassle of dealing with hourly-based fees, and vetting each item on a monthly bill;  

c) clients will not have to decide whether or not to decline some needed services in order to save on fees (everything is taken care of); and

d) in some cases the fees are less visible because they are withdrawn quarterly from the assets being managed.  When billed in this manner they can seem less onerous than the "out-of-pocket" monthly billed fees.  However, fees are fees, so when considering or comparing advisor fees, the dollar amount rather than percentages should always be used, e.g., rather than simply thinking in terms of 1% per year, the $5m AUM client should consider he is paying $50,000 per year ($1million+ over 20 years).

Why percentage of AUM is inappropriate

The percentage of AUM structure would indicate that there is a reasonable relationship between the level and skill of the services provided and the amount of assets.  However, the fee has practically no relation to the services rendered.  There are three reasons for this:  

First, despite arguments to the contrary by many advisors, the fee cannot be attributed to superior investment performance.  The same basic planning and choices of investments exist regardless of the amount of AUM.

Second, the services performed in the first year when the plan is established, are substantially greater than in subsequent years, yet the same percentage of AUM is charged each year.  

Third, the time and effort needed to perform the advisor's services are not directly proportional to the amount of AUM.  Of course, it may take more effort to plan for a client with $10m of assets than a client with $1m, but it is unreasonable to expect that the fee differential should be $100,000 versus $10,000 per year.  Often there is some scale back of the percentage at higher net worth levels, but the fees still remain significantly out of proportion in relation to services performed.  

One additional negative aspect of percentage of AUM fees is that it may create a conflict of interest.  A percentage-of-AUM fee structure can potentially cause the advisor to be reluctant to recommend actions that will benefit the client, but that will also reduce the AUM base.  Such actions include paying off a mortgage, and using investment assets to purchase annuities, which may then fall outside of the AUM classification.  In particular, annuities are an excellent alternative for some retirees, and should be fully considered as an option in most cases.

Why 1% of AUM is an excessive rate

Fifteen years ago, Rick Ferri of Portfolio Solutions began charging 0.25%, now 0.375% of AUM, nearly two-thirds less than the industry standard.  He explains his rationale and approach on his website.  Now Vanguard has a new advisory service that charges a 0.3% fee and invests in its own very low cost funds.  The great majority of the FA industry has, however, held fast to the 1% (or greater) amount,  which continues to demonstrate what the traffic will bear.

There are now also the so-called robo advisor firms that charge about 0.25%; Schwab now charges 0%.  These firms invest in a variety of index funds and cash, and rebalance when necessary.  Robo advisors provide none of the behavioral coaching and other personal services described above; their services are often more appropriate for younger clients and those with a smaller net worth.  

CPAs and attorneys provide financial and other services, but charge on an hourly basis.  They do not, for example, charge based upon a percentage of total income tax or estate tax savings.  On the other hand, the FA might point to Vanguard's estimated value added savings of 3%, and claim that this entitles them to 1% or one-third of the total savings.

A Better Approach to Fees

The most logical fee structure is the hourly based fee that applies to most CPA and law firms.  The fee is determined by the number of hours specifically devoted to serving the client, and billed at a rate that is based upon the expertise of the people performing that service.  Fees performed by skilled partners are charged at a higher rate than assistants or clerical staff.  Compare this to a percentage AUM fee that has no direct bearing on hours of services, or on the skill of the various advisors providing the service.

Even though the financial advisor's fees should be based on the same criteria used for hourly based fees, the client often likes the simplicity of fixed quarterly billings, as discussed above.  In this event the client's interests may be better served by converting fees, computed by estimating hourly based fees, to a set fee that is billed quarterly or annually.  The first year's services will involve several hours obtaining information from the client and developing an appropriate plan.  After the initial meetings with the client, the advisor should estimate total first year hours that will be devoted specifically to the client, then the firm should assign an hourly fee,  based upon the skill set of the individuals performing the services.  This should be presented to the client as his total first year fees, billed quarterly or annually.  Fees for succeeding years, where fewer and more routine services will be provided, should be similarly set and billed each year.

This fee structure would substantially benefit retirees.  In many cases the total fees incurred by the client will decline significantly.  The client can expect less reluctance by advisors to recommend desirable actions that reduce AUM, such as paying off a mortgage or acquiring an annuity.  Price competition will increase because fees will be quoted in dollars rather than percentages, and retirees will not be required to disclose their own AUM when discussing or comparing financial advisor pricing with friends and family.  Needless to say, such changes would result in lower fees for many advisors.  However, these advisors would still be able to generate fees comparable to those earned by most CPAs and attorneys -- so how bad can that be?

But will the FA Agree to a Revised Fee Structure?

I don't know; the industry has been extremely resistant to any fee reductions.  HNWIs, the higher the net worth the better, are the prize clients for the FA.  Hopefully the HNWI will be successful if he requests a fee bid using the revised fee structure from three or four qualified competing firms.  If the FA insists on a percentage of AUM fee, he should be willing to justify that fee by comparing it to a detailed summary of what the fee would be if computed on an hourly basis, in both the first and succeeding years.


The typical fee structure and fee of financial advisors is inappropriate and excessive.  FAs perform a valuable and professional service, but, unlike the hourly-based fees of CPAs and attorneys, the typical 1% of AUM fee is not a representative return for services rendered.  HNWIs should insist on a fee more comparable to that of attorneys and CPAs.