Cliff’s Notes Version: Yes. But not as many as the financial planning industry wants you to think.
I’ve made no bones about the fact that I’m no fan of the assets under management fee based structure. I recently received a phone call from an assets under management firm owner who, once he calmed down after being clearly irate for several minutes, tried to tell me that the reason that he ran an assets under management business model because “software costs money.”
After he had told me that I didn’t know what I was doing (I’ll let you, Gentle Reader, decide that one), he then proceeded to tell me about software.
When I co-founded, ran, built, and sold a…
I really must have been asleep at the wheel during that time period in my life.
This gentleman’s assertion was that he had to charge people under his care 1% of their assets every year because he needed to pay for software which executed trades in four clicks.
Let’s look behind a couple of the assumptions here:
- Software costs money. Indeed it does. It’s usually sold as a one-time package or an annual subscription with unlimited use. There’s the occasional per-seat license; however, those are rare. In most cases, it’s what is known as a fixed cost. If you have 5, 50, or 500 customers, it still costs the same. If it’s too expensive, then there are a TON of software developers out there who can build you a better mousetrap for a one-time investment.
- He needed to be actively trading for these people. We’ve discussed before that actively managed funds underperform the market. Most active investors buy high and sell low. While we both agreed that the efficient market hypothesis doesn’t hold, particularly for bond funds, he asserted that he needed to get in and trade because Ben Bernanke made an announcement. That’s market timing, and just because Helicopter Ben coughs, nobody has a crystal ball into the Monkey Brains of the millions of investors out there who may or may not react to what he says.
As I have said many times before, if someone can, in a statistically significant manner, prove that they are providing consistent, justifiable, replicable above market returns and that they’re not just lucky, then they should be charging fees for that knowledge and performance.
The problem is that you’re almost certainly not going to find someone who can do that.
But, that doesn’t mean that there isn’t a place for financial planners and investment advisers to manage money for people. I’ll get to the cases where I think it’s appropriate in a bit.
First, though, let me dispel this belief that planners should charge a percentage of your net worth to manage money. Even if you find someone who, after 25 years of work, can show, in a statistically significant manner, that he can outperform the market in a consistent manner, you still run two major risks in backing up the truck and dumping money onto him:
- Retirement risk. At some point, this person is going to hang up his boots and go sip umbrella drinks on the beach, enjoying the fruits of his labor. Benjamin Graham is a perfect example of this happening. At that point, your funds will be in the hands of an unproven commodity, and you get to wait another 25 years to see if that person is good or lucky.
- The beer truck risk. You’ve found the Perfect Money Manager™. He is beating the market. You wire all of your money to him. He steps out the door to go to work. The beer truck flattens him. No more Perfect Money Manager™.
I’m a fan of controlling outcomes where possible and not fretting over the outcomes that I can’t control.
Still, beyond my disbelief in believing someone else can beat the markets (or that you, watching a bunch of CNBC, will suddenly have insight that nobody else has), there are other, simpler reasons why the assets under management model of charging you is inefficient and takes money out of your pockets unnecessarily.
- Conflating fixed and variable costs. A fixed cost is one that happens one time or periodically and doesn’t change no matter how much your company grows. Office costs, salaries, insurance, and furniture are examples. Sure, if a company grows big enough, then they’ll have to invest more, but those costs won’t change linearly with the number of customers served. Variable costs are ones that increase with the number of customers served. Examples include shipping, commissions, and credit card fees. A well-run financial planning firm will have relatively more fixed costs than variable costs. Therefore, each new customer should be incrementally more profitable, not costly.
- Doubling your net worth does not mean doubling the amount of work needed to serve you. This is the commonly used excuse justification provided by the industry for why the assets under management model is the right one. It’s simply not true. The aforementioned financial planner who seemed to have nothing better to do on a random Friday afternoon than call someone whom he couldn’t pick out of a lineup informed me that there was complex estate planning, retirement income planning, business consulting, and risk management services that higher net worth people required. I agree. They don’t, however, need twice as much EVERY. SINGLE. YEAR. Life changes, but it changes slowly in almost all cases. Unless you live a life where you have tons of constant change, you’re probably a little different than you were last year and you’ll be a little different than you were a year before. A good, strong financial plan should account for those changes. There will be some up front work to provide all of those items, but once they’re provided, you can either go with the plan or do the occasional check-in. Are you on pace to meet your goals as outlined before? Yes? Carry on. No? OK. Let’s see what changed and make tweaks. Won the lottery? Call me.
But, there are cases where it’s appropriate to have someone else manage your money. I’ll outline five cases. In these cases, it’s appropriate to pay a flat fee to someone else to manage your affairs. You and the planner should evaluate your situation up front to determine how much work is needed to transfer affairs and for the planner to manage your assets, and then determine a) a fee, and b) the conditions which would cause the fee to change.
The right answer is not a percentage of your assets. It’s one number. It will have a $ in it and will not include a % in it.
By the way, an hourly rate approach is perfectly acceptable. If you trust your planner and don’t think that you’re going to get nickel and dimed by unnecessarily extravagant expenses and you think that your planner is efficient and effective, then why pay for services you may not use? A good example of a contractual approach for this is to use an hourly rate with a not to exceed (NTE) limit. If the annual charges reach 80% of the NTE limit, then you’re entitled to a free consultation to discuss why the charges may exceed the limit and for the planner to get your explicit permission to exceed that limit.
It’s also not always going to be cheap. It shouldn’t cost you a percent of your net worth every year, but there is value in financial planning (otherwise, I wouldn’t be in the industry). The right financial planner will create significant value in your life and will be worth what you pay (on a related note, here are four questions you should ask a potential financial planner before hiring him).
There are many ways to skin a cat. The assets under management model is about the most inefficient one out there.
What are the cases where it’s appropriate to have someone else manage assets?
I can think of only a few cases, but I’m open to suggestion. Throw your ideas out in the comments, and I’ll add the good ones in here (and, naturally, give credit where credit is due).
- A combat veteran who is too risk averse. I’ve previously discussed how combat veterans are too risk averse with their portfolios. Whether it’s PTSD, TBI, or some other reason, research confirms that most combat veterans have far more of their assets in fixed income than their non-combat counterparts. If this is you, and counseling isn’t moving the needle for you, then look into getting someone to manage your money. I included a list of combat veteran financial advisers in the aforementioned article.
- Older people suffering cognitive decline. We’ve also previously discussed how, after age 60, people start to suffer from cognitive decline and how mathematical skills are usually the first ones to go. Some of the more sophisticated and slightly more successful safe withdrawal rate models are more mathematically intensive and could be risky for older people with such cognitive declines to try to engage in. The models aren’t exceptionally sophisticated – they look more at how your portfolio is performing compared to an expected withdrawal trendline and how the market performed in the past year compared to a simple percentage rate withdrawal – but they do require some numerate nimbleness that may be difficult for an older person to deal with. In this case, it’s perfectly acceptable, once you reach an age of cognitive decline to evaluate having someone execute a formulaic approach to managing your money.
- Special needs dependents. This is going to be a conservator who is responsible for a special needs dependent upon your passing. That conservator or trust manager is going to be responsible for ensuring that the money designated, through the estate plan, for that special needs dependent’s well-being won’t run out. The special needs dependent almost certainly will not be able to handle that responsibility on his own, so it’s entirely appropriate for a trust department or conservator to manage those affairs.
- Complex tax issues where tax management is a priority in preserving wealth. This is going to be a very, very narrow slice of people who will require some specialized knowledge from providers who understand what acronyms like NUA and UBIT mean and how they can affect the nest egg.
- Someone with a large enough net worth that minor tweaking to passive investments simply isn’t worth the time. Let’s do a very, very rough example here. Take someone who has $20 million in assets and is 50 years old. His life expectancy is another 33 years. He’ll sleep 1/3 of that time, so will have 22 waking years. He has 192,852 waking hours left. Divide net worth by waking hours and each hour is worth $103.71 to him. Maybe it’s worth it to this person to have someone else spend an hour a month rebalancing the portfolio.
Edited to add:
Matt Becker came up with another category: people whose Monkey Brains are too strong and they cannot stick to a plan themselves. Whether it’s timing the market or suffering from loss aversion and trying to hit a seven run home run to make up for some bad months or years, these people cannot stop themselves from pushing the red button. If you think you’re a DIYer, but have proven over the years to be not-so-adept at disciplined investing, then give someone else the keys.
Joseph Schumpeter wrote about creative destruction when he covered business cycles. Horse carriages gave way to the car. Punch cards gave way to personal computers, which are giving way to tablets and smart phones. Movies at the theater gave way to VCRs which gave way to CD players which gave way to Blu Ray which will gave way to something else. The assets under management model bases itself on two incorrect assumptions that will eventually give way to another business model: a) you can’t do it yourself, and b) it costs a sliding scale based on a percentage of your net worth for someone to do it for you.
While there are cases where it’s appropriate for someone else to manage money, it’s not appropriate to pay a percentage of your net worth in order to have someone else manage it. Furthermore, the cases where it is appropriate are far, far, far fewer than the assets under management industry would lead you to believe. If you find yourself or a loved one in a situation where it is appropriate to have someone else manage the investments, then make sure you negotiate a flat rate fee. You’ll save yourself a lot of money getting the same level of service.
Did I miss any cases where it’s appropriate for someone else to manage money? Let’s talk about it in the comments below!