“There are worse things in life than death. Have you ever spent an evening with an insurance salesman?”
In general, there are three ways that financial planners make money:
- Fee-based (e.g., commissions) – where they get paid when you buy a product (life insurance, brokerages, annuities, etc.)
- Fee-only planners who take a percentage of assets under management – where they get paid based on how much of your assets they manage. They typically take between .5% and 2% of assets as a fee.
- Hourly fee-only planners – where they get paid hourly for the work that they do for you (I am an hourly fee-only planner, in case you did not know).
It is my belief that commissions create a moral hazard, as advisers who get paid for placing you in certain products are going to steer you to those products. A commission-based advisor who recommends you go into no load, low expense index funds, and low fee term life insurance will starve.
What about fee-only planners who charge a percentage of assets under management? Certainly, there are ethical planners who can manage assets and have their clients end up ahead of where they would have been without the planner. There may be some of these planners who are worth their money, but they are few and far between. Remember that most actively managed mutual funds do not beat their index averages and comparables. It generally takes 20-25 years to determine if a mutual fund manager is beating the market because of skill as opposed to getting lucky. As a result, advisers tell you to pick someone who has a 20-25-year track record of delivering market-beating returns.
What’s the risk of picking someone who has that track record? Retirement risk! Chances are that this person hasn’t been picking funds straight out of college and is, therefore, in his or her 40s. Instead, this person probably had to work up the ladder and is in his or her 50s or 60s. The manager probably doesn’t have that much longer before retirement and will be replaced by a new, unproven manager.
Let’s assume that you’re comfortable with someone who has a demonstrated track record. Between 1986 and 2011, this person would have needed to beat the market average growth rate of 9.68%. If you have $100,000 to invest, then if you get the market average return of 9.68% over the next 25 years, then you’ll have $1,007,363.11 at the end of 25 years. A planner who takes a 1% fee based on your assets will have received $87,346.92 in fees and you will have $223,814.57 less because of the inability to reinvest those fees.
What does this planner need to get in market return to justify his fees? In this case, he will need to get a 10.79% return just to break even, meaning he will need to consistently beat the market by 11.45% per year.
Naturally, this analysis is somewhat simplified, as I am not taking into account the volatility of returns; for example, you may be more comfortable getting lower returns in exchange for less “wobble” in your portfolio. However, it does show the magnitude of the task that fee-based planners, commission planners, and load-based mutual funds face compared to index funds.
When you look at getting financial planning assistance, make sure that you are taking the full picture of fees into account. Ask how your financial planner is getting paid and how that will affect your long-term planning picture.