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Column: Do you know how much your financial planner really costs?

Editor’s Note: In “How To Retire With Enough Money: And How To Know What Enough Is,” economist Teresa Ghilarducci lays out the financial advice you need to retire comfortably in a neat 100 pages. Below, we have an excerpt from the book that offers tips on money managers and investing.

If Jane Austen were alive today, she’d probably say that it is a truth universally acknowledged that a man or woman in possession of a fortune must be in want of a financial manager. In fact, you don’t even need a fortune: If you’re remotely middle class in America, almost inevitably you’ll get hooked up with an investment adviser. Or, as I like to say, a “Guy.”

Your Guy doesn’t have to be a guy; some are women. The result, though, is the same. “Jeff called. He wants me to sell some bonds and buy FROOFROO stock. He suggested $10,000 worth, but I said only $5,000.” Or, “My Guy is pretty good. He always calls, and he doesn’t push me into investments.”

Sounds OK so far, right? But when I ask people how much the Guy costs, they don’t really know. When I ask if he has fiduciary loyalty, they don’t know what that means. When I ask if the investments he puts them in do better than a standard benchmark like the S&P 500 index, again, they don’t know.

The Guy rarely takes into account anyone’s taxes or debt levels or other real issues about their lives. The Guy lives on commissions. In fact, many Guys are essentially in sales, with a working knowledge of financial terms. Many couldn’t pass a basic financial literacy test.

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A definition of terms here: Fiduciary loyalty essentially means an ethical obligation to you, the customer. Helaine Olen, author of “Pound Foolish: Exposing the Dark Side of the Personal Finance Industry,” explains it this way: If you bought a pair of shoes from a store that had fiduciary loyalty, it would be the store’s responsibility to make sure those shoes really fit you before you left. Similarly, a fiduciary money manager can be sued if he or she doesn’t give you financial advice that’s solely in your interest.

The news about money managers isn’t all bad. There are fee-only certified financial planners who are independent and free of conflicts of interest. They don’t sell investment products, and they don’t work on commission. Such a professional will charge you up front to create a financial plan, similar to the way a lawyer would charge you to draw up a will. This service might cost you $1,000 or more, but you’ll save money in the long run.

One caveat here: Fee-only advisers tend to be pretty rare outside cities, so you may have difficulty finding one if you live in a smaller town. However, the good news is that you may not even need a manager. To understand why, you have to understand what passive management and active management are.

A passively managed fund is one in which the manager takes a hands-off approach, usually by following a stock or bond index. One such stock index is the Russell 3000, which contains the stocks of approximately 98 percent of the investable U.S. market. (In other words, when you invest in a fund that follows the Russell 3000, you are investing in 98 percent of U.S. companies at one time.) Smaller, but better known, is the S&P 500. Introduced by Standard & Poor’s in 1957, it follows the 500 largest publicly traded companies. This index is widely used to measure the general level of stock prices (though the Dow — which contains 30 high-profile stocks — steals all the headlines).

A fund that tracks the S&P 500, therefore, will mirror the general performance of the stock market overall. You won’t be protected from the usual fluctuations. It will go up and down. But over time, the market has always gained ground.

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In contrast, an actively managed fund is one whose manager chooses stocks in an effort to outperform the market. Some managers do succeed at this — for a time. But the statistics show that such hot streaks always end. Studies done on actively managed mutual funds have been clear on this point: Past performance is a very unreliable predictor of future returns.

Professor Jeremy Siegel explains this in detail in his book, “Stocks for the Long Run.” Using mutual-fund data provided by the Vanguard Group and Lipper Analytical Services, he found that all actively managed equity mutual funds returned an average of 10.49 percent per year for the period 1971 to 2006, whereas the S&P 500 rose an average of 11.53 percent.

It’s worth noting two things here (as Siegel did). First, the funds benefited from a stellar run for small stocks between 1975 and 1983 (this likely helped actively managed funds — managers find smaller stocks attractive because of their growth potential). Over the period of 1984 to 2006, after the run was finished, actively managed funds returned an average of only 10.8 percent yearly compared with the S&P 500’s 12.26 percent. Second, and more important, the actively managed fund figures don’t reflect the impact of sales and redemption fees.

And now we’ve arrived at a crucial point: It isn’t whether your fund manager can beat the market and for how long; what really chips away at your savings when you invest in an actively managed fund is how much your manager charges. Passive management can be done very cheaply, by virtue of its hands-off approach. Index funds tend to charge about 0.1 percent of the total investment in fees; they pass the savings on to you. Active management, by nature, costs more. These expenses, likewise, are passed along. Usually, the cost is about 2 percent.

To illustrate this, let’s say you have $100,000 to invest in a mutual fund. You have a choice: an index fund or one with a fund manager who chooses stocks in an attempt to beat the market. Once you pick a fund, you stay in it for, let’s say, 10 years.

During those 10 years, the S&P 500 rises by 5 percent a year, and both funds match that in performance. Naturally, the index fund does, because it tracks the S&P. The other fund does it through skilled stock-picking by its manager. (This is statistically unlikely, especially over a 10-year period. In fact, it’s almost certain that an actively managed fund would return less than the S&P 500. But for the sake of argument, we’ll assume that it matches the S&P.) So after 10 years, that $100,000 has grown into $163,000 through the power of compounding.

Let’s pause here and talk about compounding, because it’s that important. Interest compounding in savings works the same way as the runaway growth of your credit-card balance if you only pay the minimum (only now it’s not quite so “runaway,” since market returns, averaged over time, aren’t as high as credit-card interest rates). But the key point is the same: You earn interest on your principal and interest on your returns, meaning the picture just gets better over time. The earlier you start and the longer you can keep your money invested (meaning no early withdrawals), the more the miracle of compounding works for you.

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So in our example, if you invest $100,000 at 5 percent per year, in 10 years, that money will have turned into $163,000. Except that won’t be the balance on the statement you get in year 10, whether you invested in an actively managed or a passively managed account. It’ll be less than $163,000. Why? Because of fees.

If you go with an index fund, you’d end up with $161,000. That’s because index funds charge one-tenth of 1 percent of the assets under management, so instead of earning 5 percent, you’re getting 4.9 percent. Because of the math of compounding interest, a 0.1 percent drop in the rate of return leads to a 2 percent drop in total return. In your case, that means you paid about $2,000 over the 10 years to be in the index fund. Maybe that doesn’t thrill you, but remember, an index fund’s 0.1 percent fee is about the best you can do, short of writing to every single publicly traded company and enclosing a check for individual stock certificates that are then mailed to your house and that you then store in a gigantic filing cabinet . . . Yikes.

But what happens if you chose an actively managed fund? That’s where the math of compounding interest comes home to roost in a big way. Actively managed accounts generally charge up to 2 percent in fees. We’ve seen that in an index fund every 0.1 percent in fees results in a 2 percent reduction in total return over 10 years. So every 1 percent in fees leads to about a 20 percent drop — actually, a bit more, given that we’re dealing with compounding and its snowball effect. With a 2 percent fee structure, you get about 46 percent less in total return from an actively managed account over 10 years. In our example, your $100,000 investment has grown in the actively managed fund to the same $163,000. But the fees charged by your manager over time have eaten up $29,000, so you’re left with $134,000. None of the difference is caused by your fund’s performance; it’s all fees.

So if, in 10 years’ time, you want to fee-shame yourself about your choice, there’s no shortage of ways you can do it.

  1. I earned 46 percent less than I would have in an index fund.
  2. I got a 3 percent return when I could’ve gotten 4.9 percent.
  3. I earned $34,000 instead of $61,000.
  4. I paid $29,000 in fees when I could have paid $2,000.

Clear enough? You should also remember one thing: The above example generously assumes that your fund manager matched the market’s performance, getting a 5 percent return. But history tells us that, minus a few lucky streaks, managed funds almost invariably underperform the market. I’m reminding you of that because a mutual-fund manager is going to tell you his fund’s fees are worth it, because his experts’ picks will outperform the market. But the statistics tell a different story. Are there ever managers who beat the market several years in a row? Sure. But research shows high flyers generally last a few years at most.

Given this, why would you choose an actively managed fund? You shouldn’t. This is one of the biggest mistakes people make. To be absolutely clear: If you’re with a broker or any kind of adviser paid on commissions, you should sever that relationship as soon as possible. Honestly, you would be better off earning the Boy Scouts’ personal finance merit badge and then trusting what you learn from it than using a “Guy.” Simply put: Low-fee index funds are all you need. Vanguard Funds is a one-stop shop in this area. I have no connection to or interest in Vanguard; they just offer an excellent product. You can buy directly from their website.

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You might be asking, “But what if I have a high net worth?” My answer is the same. Multibillion-dollar funds, like the Norwegian sovereign wealth fund, are so big that if they make a move, the world moves with them. They make markets. They need to be buying illiquid assets and private equity, et cetera. You don’t.

If you still feel that you want someone to guide you through the investing process, get a fee-only adviser and pay up front for a personal plan. If you’re part of a couple, make sure that your partner in life and in finances is comfortable with the adviser you choose. Both parties need to feel secure about a decision this big.

Six critical questions to ask your Guy

  1. How are you paid? Fee-only advisers receive no compensation from the sale of investment products. All others do. You can’t count on an adviser who gets a significant portion of their pay in sales commissions. Period. Leave if they are not fee-only.
  2. Do you have any conflicts of interest that influence the advice you provide? Financial advisers who are registered representatives get paid to sell insurance or annuity products promoted by their brokers. Ask how they choose the investments they recommend. Ask them directly how they are paid.
  3. Will my assets be housed with an independent custodian — that is, a bank that is not selling the investment products? “Yes” is the only acceptable answer here. Bernie Madoff’s firm did not use an independent custodian. Enough said.
  4. Are your clients similar to me? If your adviser’s typical client is worth $1 million or more and you aren’t rich, think twice. Your adviser may lean toward advice more suited to his or her richest clients.
  5. What services do you provide? If the adviser’s primary service is investment advice and you want a complete financial plan, this adviser is unlikely to be a good match.
  6. Do you act in a fiduciary capacity toward your clients? Leave fast if the adviser doesn’t say yes. You are asking the broker if he or she is obligated to put your interest first, before that of his or her firm. If there is any other answer but a clear yes, grab your wallet tight, and leave.

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