The Risk of Professional Investment Advice

Managing your finances and planning for retirement can be complicated.  As your assets grow, consider retaining a financial advisor to help you with your investments, define your goals and create a plan for achieving them.

There are many benefits to working with a financial professional.  A research paper by Vanguard found that a skilled advisor can add 3% or more in net returns annually. These benefits stem from proper asset allocation, low costs, rebalancing, behavioral coaching, asset location, and a suitable retirement withdrawal strategy.

Given the upside, is trusting your future to a financial advisor a no-brainer?

Unfortunately, it isn’t.  There are downside risks you need to consider.

Here are the major ones.

Fees matter

Fees charged by financial advisors can significantly impact your ability to reachyour retirement goals.

Most advisors charge based on how much money they manage under a structure called “assets under management” or AUM. Financial advisors using an AUM model typically charge about 1% of a total portfolio for the first million. The fee percentage declines as the amount of assets increases.

Because these fees are expressed as a small percentage of your assets (instead of in dollars), you may not appreciate the amount of these fees.

Typically, advisors who charge an AUM-based fee deduct that fee directly from your investment account, reducing the total invested.

The combination of the AUM-based fee and having it deducted from your investment account can be significant.

Assume you invest $1 million without using an advisor, and your investment earns 6%annually.

After20 years, your investment would be worth approximately: $3,207,135.

If you paid a 1% AUM fee deducted from your portfolio every year, your ending value would be reduced to $2,616,822,a difference of $590,312.

Paying the advisor a 1% fee, deducted annually from your portfolio, reduced your earnings by 26%.

How would you respond if your advisor told you that the combination of their fee and how it is paid would equal 26% of your earnings?

Fortunately, there are alternatives.

Some advisors charge a retainer or a set monthly or annual fee regardless of how much money they manage. Others have a fixed hourly rate allowing you to pay only for the time you need.

Retainer fees are about $4,000 annually, while hourly rates usually range from $150 to $350 an hour.

Advisors like Sensible Portfolios cap their fees, so you pay a fraction of the fees most AUM-based advisors charge.

Conflicts matter

It’s impossible to avoid conflicts of interest with advisors who charge an AUM-based fee. Still, there are different levels of conflicts and different legal standards, depending on the advisor you retain.

All registered investment advisors (RIAs) are legally bound to act in a “fiduciary” capacity.  A fiduciary is ethically bound to act in your best interest. This means fiduciary financial advisors must always act in the best interest of their clients (even if they stand to gain less money from it) and must disclose any current and potential conflicts of interest.

Most brokers affiliated with major Wall Street firms are not fiduciaries.  They are often paid through commissions based on the investments they recommend. This creates a fundamental conflict of interest between brokers – who may be interested in selling a product that generates the highest commission—and their clients.

If you want to reduce conflicts of interest with your advisor, consider hiring one who is an RIA.

Qualifications matter

You can be licensed as a financial advisor without graduating high school.  You just need to pass a test administered by FINRA. Passing this exam doesn’t mean you are required to put the interest of your client above your own or to provide competent advice.

You’ll see many acronyms after the names of financial advisors.  Some reflect serious education and training.  Most don’t.

Here are qualifications that reflect meaningful study and expertise:

C.P.A.  Certified Public Accountants must be college graduates, pass a difficult examination and be current on tax law. 

C.F.A. Chartered Financial Analysts must pass a rigorous three-part test covering ethics and professional standards, investment tools, asset classes and portfolio management, and wealth planning.  They must commit to a 4-year program (or more) and 300+ hours of study for each of the three examinations.

M.B.A. A master's degree in business administration from an accredited educational institution is an impressive credential. Holders of an M.B.A. typically went to graduate school for two years of full-time study. They have a background in accounting, finance, and marketing, among other subjects. You can find a list of the top-ranked business schools by U.S. News here.

CFP: Applicants must meet requirements relating to ethics, pass an examination, have considerable experience providing financial planning advice, and meet certain educational requirements.

You can minimize potential issues with your advisor by limiting your search to RIAs with one of these designations.

Trust, but verify

Finding an advisor you trust is critical to a successful relationship.

You can find a fee-only advisor through the National Association of Personal Financial Advisors.  These advisors are only paid by you.  They do not accept commissions, which reduces the possibility of a conflict of interest.

You can avoid significant problems by insisting that an independent third-party custodian hold your funds.  You should be able to access your account on the custodian's website anytime.  This article discusses the role of custodians and lists some of the largest ones.

Finally, do your due diligence:

Read the Form ADV of the advisor.

Review their website to understand their investment philosophy and the background and experience of their advisors.

Research the firm using FINRA’s BrokerCheck website.  It provides information about brokers and brokerage firms and offers easy access to information about advisors.  You can confirm whether a person or firm is registered to sell securities, offer investment advice, or both.  It will also disclose the broker’s employment history, regulatory actions, investment-related licensing information, arbitrations, and complaints.

Hiring a financial advisor is one of the most important decisions about your financial future. By recognizing both the upside and the potential risks, you’ll be well-positioned to select someone who will add value and help you achieve your goals.

Sensible Portfolios is a registered investment advisory firm that provides low-cost, high-value investment and retirement planning services. Its founding partner, Darrell Armuth, is a financial advisor and a certified public accountant.