My father told this joke when I was a kid:
A man hires a plumber to clear a clogged drain. The plumber taps the pipe with a wrench. He moves along and taps again, and then he taps in another spot. Then he rears back, pounds the pipe with all his might and the drain clears.
"That will be $100," he tells the man.
"A hundred dollars!" the man objects. "All you did was hit the pipe!"
"You're not paying me to hit the pipe" the plumber replies. "You're paying me to know where to hit the pipe.
Pros can make things look easy, and the rest of us should guard against assuming we can do just as well. But sometimes, the pros make their work look harder than it is to convince us we need them -- kind of like witchdoctors shaking rattles and blowing smoke and chanting in tongues.
In the financial services industry, the chanting can seem pretty mysterious. And most of us don't understand why the stock market goes up or down, so it seems to make sense to rely on the experts.
But the pros' insights don't seem very clear, either. Why did Wall Streeters cheer on the technology-stock bubble in 1999? Why didn't they tell us that the housing market was overheated in 2005? Why didn't they lead us all to the sidelines before the stock market tanked last year?
Probably because the pros follow the herd just like everyone else.
On top of that, they are entangled in all sorts of conflicts of interest - considerations that make many give bad advice even when they do know better. Ratings agencies gave top grades to securities backed by subprime mortgages that collapsed and triggered the financial crisis. The problem: the agencies were paid by the firms that issued the securities.
Conflicts of interest can lead experts like stock brokers to steer customers to in-house products even when competitors' products are better. Consider the scores of mutual funds that invest in the Standard & Poor's 500 index. They all hold exactly the same stocks and use the same buy-and-hold strategy. An investor would therefore do best in one charging rock-bottom fees, such as the Fidelity Spartan 500 Index Investor fund (FSMKX), with an expense ratio of just 0.1 percent, or 10 cents a year per $100 invested.
Yet there are more than two dozen S&P 500 index funds with expense ratios at least 10 times higher, charging more than $1 per $100. Clearly, some financial "pros" are recommending those funds even though the Fidelity fund is obviously better.
Undoubtedly, there are occasions when we need help from professionals. But it pays to keep an eye out for conflicts - opportunities for the pro to make money at your expense. The way the pro gets paid makes a difference.
In the traditional commission-based system, the stock broker or other financial adviser receives a commission each time you buy or sell a stock, bond, mutual fund, insurance policy or other product. That gives the pro an incentive to "churn," or recommend lots of trades, and to steer you to the product with the biggest commission..
With another system, based on assets under management, the pro gets a fee equal to a percentage of your account -- $1 a year for every $100 you have, for instance. While the pro has no financial incentive to churn the account, the fee applies to all holdings, including ones that are simply left alone year after year. It doesn't make sense to pay a fee unless your expert is actually doing something.
Because commission and asset-based compensation is so prone to conflict of interest, I prefer the "fee-only" system, where you pay a flat fee or hourly rate for a pro to devise a long-term strategy you can implement yourself. A good plan will consider everything - not just investments but insurance, taxes, retirement, college costs and estate planning.
This can cost more up front - several thousand dollars in some cases - but can be cheaper in the long run. Most important, with the fee-only approach, the advisor should have no financial incentive to steer you wrong.
A trade group for the fee-only experts, The National Association of Personal Financial Advisors, has a referral service on its site. Be certain that anyone you choose is not a hybrid who will charge commissions or an asset fee on top of the basic fee. Also look at this useful advice from the Securities and Exchange Commission.
Finally, never, ever, under any circumstances should you give a pro the authority to manage your account without requiring your approval for every move. Long-term investors never need to do anything at a moment's notice, and it's a red flag whenever a pro wants to make a move without explaining it.
Jeff Brown is an experienced business journalist and personal finance columnist who has written for The Philadelphia Inquirer, The New York Times, and TheStreet.com. Read his bio to learn more about him.
Blog made possible with support from the Corporation for Public Broadcasting.
Comments
Dear Jeff;
Fee only means more than one way to pay.
You wrote an excellent article on selecting a financial planner based upon the fee structure. I would elaborate that fee-only can mean a retainer, a per hour fee, and assets under management ("AUM") or any combination of the above. I too argue for an hourly fee for the short term when developing a financial plan, for example, and a flat retainer fee for ongoing annual services. That way all of the planning work is paid for equally and investment services paid for by AUM won't get the lion's share of the attention at the expense of neglecting other valuable services such as refinancing a home, or retirement planning.
The argument of having a fiduciary on your side.
What's more important than fee structure? I think it's to focus on a professional fiduciary relationship. That means, in the simplest terms, that the financial planner employs all of his or her skills, knowledge, experiences and training to walk in the client's shoes and make the best possible decisions by always putting the client interests before him or herself in every decision affecting the client's financial well being. It also means disclosing every single instance where any shortcoming exists between fiduciary standards and actual circumstances or actions. You won't find this standard offered in the vast majority of services offered by so called "financial advisors". Then, what would you look for?
Consumers can look for the CERTIFIED FINANCIAL PLANNER, or CFP (R) mark of a professional financial planner as a minimum standard of whom to consider for financial planning services. The consumer can at least rest assured that such a planner has already met and continues to follow, the fiduciary standard. Focus on fiduciary means putting all clients first and foremost - always. Had that been the industry-wide standard in 2008, which among other things, forces financial planners to fully discloses risks, can you honestly convince yourself that we'd be in the global financial nightmare today? No Sir! A fiduciary has the responsibility to steer all clients clear of inappropriate investing. With rare exceptions, the polymorphic, smoky derrivative markets that sparked the financial tailspin in 2008 would have been fallen in that category and they would have been considered far too risky for most client portfolios. In sum, it would mean no Madoffs, no morasses, and no messes. Fiduciary means the client is always first, not the pockets of the financial servicer.
It sounds like another world, and yes, it truly could be if consumers just focused on fiduciary - and of course, fees.
Full Disclosure: Steven Wightman is a NAPFA Registered fee-only financial planner who occasionally writes for the NAPFA ADVISOR, the member's magazine.