Conscientious Financial Planning and Retirement Income Management | 201-741-9528
from Lonier Financial Advisory LLC, Osprey, FL

What Are You Paying Your Advisor For?

What Are You Paying Your Advisor For?

You know that the fees you pay to invest your savings matter, and that these costs, even tiny percentages, can significantly reduce your gains over a lifetime of saving and investing. You are probably also aware of the rise of “robo-advisors,” web-based automated do-it-yourself investment management sites like Wealthfront and Betterment that provide sophisticated, algorithmic portfolio management at a much low cost than most financial advisors.

Financial advisors have traditionally provided investment management services for 1% of assets annually, usually on a sliding scale of some sort. That’s $10,000 a year to manage a $1,000,000 portfolio, plus whatever underlying expenses the funds charge, which may average 1.25% for the “high performing” funds the advisor recommends. Heaven forbid the advisor puts you in A shares with a 5% front-end sales charge right off the top. Sales charges are more common if your advisor is a big bank or institution—some apparently still believe they can do this with impunity.

Independent advisors will likely use no-load funds as part of the value they offer as an alternative to the big guys, though the 1% management fee and 1.25% fund expenses remain. Traditionally, some superficial financial planning is provided “at no cost” to provide a basis for allocating the portfolio between stocks and bonds.

Digital Disruption Points to Free Asset Management
Robo-advisors, on the other hand, charge .15%-.25% for management plus underlying low-cost index fund expenses that run about .10%-.15%. That’s a fraction of the traditional cost for portfolio management and fund expenses—$1,500 to $2,500 a year for a million dollar portfolio instead of $10,000 for management, and a similar reduction for fund expenses.

The digital disruption now impacting financial services is driving the cost of portfolio management rapidly towards…free. It’s becoming free because asset allocation is no longer a “secret” that can be credibly defended as a uniquely valuable service proprietary to an advisory firm. Consider this table of relative costs:

Management Fee Fund Expenses Total Cost
Advisor managed 60/40 stock/bond portfolio

1%

1.25%

2.25%

Robo-advisor algorithmic 60/40 portfolio

.25%

.15%

.40%

Vanguard 60/40 LifeStrategy targeted risk fund*

0%

.16%

.16%

*A managed global portfolio of four Vanguard low-cost stock and bond index funds

The traditional advisor has to beat the indexes by about 2% to cover these cost differences. We know from over a decade of S&P SPIVA (S&P Indices vs Active) Scorecard studies that about 60%-80% of all portfolio managers do not even equal their benchmarks each year, yet alone beat them by 2%. And fewer and fewer can equal the indices year after year. And we don’t know who they will be until the year is over. It is, as Charlie Ellis has called it, a loser’s game.

The message of the robo-advisory onslaught isn’t that robo-advisors are a great deal. The message is that it’s increasingly difficult to justify paying anything more than the low annual expenses—and no management fee—of an indexed targeted-date or targeted-risk fund as the core for a life-long investment portfolio. Even robos charge too much!

What Should You Pay an Advisor For?
The era of paying high fees for investment management is ending. Girding for the robo-battle that is underway, traditional investment managers are recasting their services as “wealth management,” and beginning to move beyond a focus centered on investments.

The question you need to ask of your advisor is has he or she moved far enough? Is wealth management as they practice it just another guise for expensive investment management with a few bolt-on sidebars, or has your advisor fully embraced conscientious financial planning as a valuable service in its own right? Conscientious is a deliberate word choice here instead of the more common comprehensive, since it implies a right-minded or even fiduciary responsibility to the client that comprehensive does not.

What is the value of conscientious financial planning? A recent post by Wade Pfau, a professor at American University, looks at Vanguard and Morningstar studies of this question. Pfau sets the stage by observing that “It’s important to remember and easy to forget that the end goal of comprehensive financial planning goes beyond choosing investments.”

The Vanguard paper focuses on the advisor’s value for improving investment results through asset allocation, asset location, lower costs, rebalancing, and coaching. Vanguard says that more expert investment management, while still challenged to make up the management fee that low-cost indexing avoids, offers about a 3% better annual return than naively doing it yourself with typical mutual funds. Pfau points out this 3% additional return just fills the hole the inexperienced digs for himself. The pro still faces the perennial problem making up the 2% cost drag discussed above, just to match market returns. Focused as it is on the professional’s impact on investment management, the Vanguard paper represents the trailing-edge defense for old school investment management, or at least is a justification for Vanguard’s new low cost planning service.

Morningstar is more in the vanguard of this issue with its fuller consideration of the value of “intelligent” financial planning and its impact on retirement income rather than investment returns.

Pfau summarizes the five key strategies from the Morningstar study and adds a sixth for optimizing Social Security benefits:

  1. Asset allocation based on the full household balance sheet including lifetime human capital (income from work)
  2. Dynamic funding of annual expenses in retirement, not a fixed rule for withdrawals
  3. An allocation to Longevity risk management to provide lifetime income from low-cost annuities
  4. Tax efficiency from managing asset location and withdrawals that minimize tax consequences
  5. Matching goals (expenses) with reliable assets rather than chasing performance
  6. Enhanced social capital on the household balance sheet by optimizing Social Security benefits

The value of the first five from the study is an increase of almost 23% more retirement income annually. With Social Security optimization, the six strategies provide over 30% more annual income each year in retirement!

That’s FIFTEEN TIMES the 2% additional annual returns that traditional investment managers struggle to eke out each year to justify their high management fees.

Pay for a High Value Conscientious Financial Plan not for Traditional Asset Management
The five items in the Morningstar study plus Social Security optimization are clearly worth more to you than specious promises of higher returns made by traditional asset managers. If you can’t do these six things yourself either because you are too busy in your career or because you lack the specialized knowledge necessary for some of the tasks involved, find a conscientious financial planner who can and pay him or her a reasonable fee to provide these valuable professional services. 30% more income in retirement is well worth the expense of conscientious planning.

A conscientious financial plan should be based on your household balance sheet, not investment theories for higher returns. Your balance sheet will show the amounts that your plan should allocate to the different techniques for managing major household risks:

  1. A Floor allocation to manage lifestyle risk by matching safe assets to expenses (Morningstar #5)
  2. A Longevity allocation to manage the risk of outliving your money with lifetime income from deferred income annuities and optimized Social Security benefits (Morningstar #3&6)
  3. A Reserves allocation to cash to manage near-term expenses and risks of chance including long-term care (Morningstar #2)
  4. An Upside allocation that can be safely exposed to market risk for long-term growth without jeopardizing the Floor (Morningstar #1)

The implementation of the plan should look across all your accounts, tax-deferred, tax-free, and taxable (Morningstar #4) for tax efficient asset location and conversion to income. And finally the plan should also include an estate plan that meets your legacy goals (a bonus 7th plan strategy!).

What do you think, is conscientious financial planning worth more than investment management? Is the era of paying advisors high fees for investment management coming to an end?

–Michael Lonier

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