My Own “Jiminy Cricket”

Brett Horowitz

Brett Horowitz, CFP®, AIF® Principal, Wealth Manager

Whether you are working with a doctor, lawyer, or financial professional, you need to be aware of who is watching over you. It’s not enough to simply assume that they are on your side. When someone gives us recommendations, we want them to be like the Jiminy Cricket character in Pinocchio—a trustworthy person who is looking out for us and helping us make good decisions. Let’s look at an example to help frame this discussion.

You go to the doctor’s office complaining of muscle pain, and the doctor offers you a choice of medications. He hands you Medicine A and you walk out the door, feeling comfortable that he gave you the right medication that will make you feel better in no time. Why are you so at ease with the doctor’s recommendations? The short answer is that you trust the doctor. You believe that they will follow the Hippocratic Oath, which says in summary “above all, do no harm.” You have come to expect that they are providing you with advice that is in your, the patient’s, best interest. What if I told you that the financial profession doesn’t work that way? Surprised? Confused? If you’re like most Americans, you’re not alone.

According to a recent study by the RAND Corporation, commissioned by the SEC, most Americans have trouble distinguishing between advisors and brokers. As the study’s authors note, “Our analysis confirmed findings from previous studies and from our interviews with stakeholders: Investors had difficulty distinguishing among industry professionals and perceiving the web of relationships among service providers.” When a financial professional can have dozens of different titles, ranging from investment advisor to wealth manager to financial planner, it’s not hard to see why consumers are confused. One of the major differences comes down to a popular buzzword in the industry that every investor should understand: the term FIDUCIARY.

What is a fiduciary?

Quite frankly, one of the first questions you should ask your investment professional is this: Are you a fiduciary and do you acknowledge this in writing? (If you’re already working with someone and are unsure of their status, it’s a good idea to call them up and ask them.) A financial advisor held to a fiduciary standard occupies a position of special trust and confidence when working with a client. As a fiduciary, the financial advisor is required to act with undivided loyalty to the client. This includes disclosure of how the financial advisor is to be compensated, elimination of any significant conflicts of interest to the extent possible, and full disclosure of any remaining significant conflicts of interest. In other words, the financial advisor must place their client’s interests first.

Our website specifically states, “As a fee-only financial advisor, our revenues derive solely from fees paid directly to us by our clients. We have no potential conflicts associated with commissions or proprietary products.”

Our firm charges fees based on the amount of money that we are managing for our clients (i.e., assets under management). If you are a client of our firm and are interested in paying off a mortgage to free yourself of the debt, we acknowledge the potential conflict of interest that exists in you withdrawing money from the portfolio and the resulting drop in our fees, but we will help you make the right decision. In fact, over the last few years, we have helped many clients pay off their mortgage. It’s with this peace of mind that they can sleep comfortably knowing that we are on their side.

Let’s say that you just found yourself the recipient of an inheritance or a large bonus check and are thinking about possibly investing it in your portfolio. Without this fiduciary relationship, the answer would be simple: invest everything, because the more you invest, the more fees the firm will reap. But that’s not how we answer the question. We would want to know whether you expect to make any significant withdrawals from the portfolio during the next five years. We do not believe any investor should invest money in the market if they expect to need it back within the next five years. If you’re likely to need funds annually to supplement other outside income, we would make sure that you have enough cash set aside in case the markets go down so that you don’t have to sell anything in the next year and you know exactly where your grocery money will come from. Once again, the decision is not how to maximize our short-term profits; instead we are looking to make smart decisions that will benefit our clients.

On the other hand, brokers and other commission-based advisors are held to a “suitability” standard, which states that they must recommend a product that is suitable for the client, but that may not necessarily be the best recommendation for that person. For example, you’ve probably seen situations where a representative from XYZ Company recommends buying the XYZ Bond Fund, the XYZ Large Cap Growth Fund, and the XYZ International Fund. Is it really likely that XYZ Company could have the best mutual fund in every category?

Fees, fees everywhere

Some firms charge an annual rate, some charge based on assets under management, and some build the fees into the stock and bond transactions. None of these are inherently unfair as long as you know exactly how the advisor is getting paid, whether the fees are reasonable, and what their duty is to you (i.e., business standard or fiduciary). There may also be additional fees—such as mutual fund expenses, transaction fees, account opening or closing fees, and such—so it’s important to know how much those fees are and who receives those fees. At our firm, we use no-load mutual funds and exchange-traded funds. As there are no commissions involved, these investments have relatively low expense ratios, and fees are paid directly to the fund companies. There are small transaction fees as well, and these fees are paid directly to the custodian. We are paid only by our clients, who receive a bill each quarter with the calculation and amount of those fees. Performance is calculated net of fees where possible so that it’s in our best interest and the client’s best interest to limit all fees as much as possible.

You should always be aware of conflicts of interest as they pertain to fees. Will buying the mutual fund, annuity, or life insurance contract primarily benefit you or the person selling the product? The type of legalese you might look for is something to the effect of “Your account is a brokerage account and not an advisory account. Our interest may not be the same as yours … We are paid both by you and, sometimes, by people who compensate us based on what you buy. Therefore, our profits, and our salespersons’ compensation, may vary by product and over time.” (Italics are my emphasis.)

For example, a representative at the XYZ firm may recommend a high-yielding bond to their client. What the client doesn’t know is that the firm is trying desperately to sell the bond to everyone it can so that it doesn’t have to keep the bond on its books due to expected losses (I have taken this example from the book Liar’s Poker by Michael Lewis, a nonfiction book describing his experience as a bond salesman in the 1980s). Who is the best prospect to sell the bond to? Their client, of course. They can do this because as long as the client asked for income in their portfolio, this investment would be suitable.

None of this by itself implies that there is anything wrong with compensation by way of commission. The bottom line is that you, as the client, need to understand how the advisor is getting paid, whether they are being held to a fiduciary or suitability standard, and whether these details are in writing. If in doubt, simply ask your advisor if they will sign a statement similar to the following:

  • In our relationship I will always place your interest first.
  • I will act with prudence; that is, with the skill, care, diligence, and good judgment of a professional.
  • I will not mislead and will provide you with conspicuous, full, and fair disclosures of all important facts.
  • I will avoid conflicts of interest.
  • I will fully disclose and fairly manage, in your favor, any unavoidable conflicts.

It’s time that we break down the confusion surrounding investment professionals so that the public understands who their Jiminy Cricket is.

Feel free to contact Brett Horowitz with any questions by phone 305.448.8882 ext. 216 or email: BHorowitz@Evensky.com

For more information on financial planning visit our website at www.Evensky.com

 

 

Important Questions For Advisors

Steve Foldes

Steven Foldes, CFP®, JD, CMFC Vice Chairman

After a lengthy first meeting with a prospective client, whom we will call Beverly, she said to me, “Thanks for all of that information, Steve, but as I mentioned at the outset I want to meet other advisors in the area so I can compare and contrast and make the best possible choice.” I told Beverly that I applauded her decision to interview a number of financial advisors so she could understand what they do, how they do it, whose interests are being served, and how (as well as how much) they are compensated. Beverly then asked me to make a list of questions that I thought would be the most important when selecting the best possible advisor or advisory firm. I thought it would be a helpful exercise for all investors seeking a trusted advisor to ask the questions which would help them make the best possible decision. Below is the list I gave Beverly to help her feel confident in her search to select the very best advisor and advisory firm for her needs. I believe that any investor should ask these questions before entering into an advisory relationship.

Important Questions to ask of any Financial Advisor

1. Are you a fiduciary? In other words, are you legally obligated to put your client’s best interests first, ahead of all other interests? Our industry is rather unique, in that there is more than one standard of care used by the financial services industry. Registered Investment Advisors (RIAs) are required to operate under a fiduciary standard, putting their client’s interests ahead of their own. However, the brokerage world has another standard known as “suitability.” This lower standard holds that as long as the investment is “suitable” for the client’s needs, then that is sufficient. That is to say, the investment may not be the best or the most cost effective, but as long as the advisor deems it to be “suitable,” then the standard is met. In other words, it enables the advisor to be a financial salesperson, as opposed to one who can be trusted to put the client’s best interests first.

2. How do you charge for your services and how much do you charge? In the financial services industry, there are two main methods of compensation. One is a fee for service, typically based upon the assets under management. The other is commission. Since different products carry different commission rates, and human nature being what it is, there is the possibility of a conflict of interest. In this case, it must be asked whether the interests of the client and advisor are aligned, or is there a conflict of interest from the outset of the relationship?

3. What licenses, credentials, or other certifications do you have? How long have you been a financial advisor, and how long have you been with this firm? Personally, how many clients do you work with, and what is the total assets that you manage? Are you an owner of the firm? These questions are critical in assessing the education and experience of the advisor, not to mention how much time the advisor has to work with his or her clients. Finally, being an owner of the firm is important because owners typically stay with a firm longer while employees often leave, and the last thing a client wants is to follow an advisor who is jumping from one firm to another because of better compensation opportunities.

4. Do you provide comprehensive financial planning and retirement planning services, or are you simply an investment advisor that provides advice exclusively on my investments? Will you be looking at my financial situation “holistically” to provide the best kind of financial advice? If you do financial planning, could I see a sample financial plan?

5. What types of clients do you specialize in, such as retirees, professionals, small business owners, corporate executives, younger people who have recently sold their businesses, athletes, those with inherited wealth, et cetera? It is important to know if the advisor has a special expertise serving a specific niche.

6. What is your investment approach? In other words, please outline your methodology for constructing a portfolio consistent with my goals and objectives, risk and return parameters, and cash flow requirements from the portfolio. If you use mutual funds and exchange-traded funds, what would be the expected “expense ratio” of the funds used in my portfolio? Expense ratios relate to the cost of the mutual funds and exchange-traded funds used in the portfolio. If you use individual stocks, what is the methodology of stock selection? Is it something the advisor does, or do selections come from the home office? As to performance, what is the expected return of my portfolio over the longer term, and has the portfolio been stress-tested to show what I would lose during periods of substantial market volatility, such as 2000–2003 and 2007–2009?

7. How much contact do you have with your clients? How often will we be speaking/meeting to get updates on what is happening with my plan and portfolio specifically, as well as with the markets in general?

8. Will I be working only with you, or have you established a team to work with me? What happens to my account if you move to another firm or retire/die?

9. Who holds or maintains custody of my investments? Is there an independent third party to hold the investments, or are checks written to the advisor or advisory firm? No one thought Bernie Madoff was a thief, so having a firewall between the client and the advisory firm is a very good idea.

10. What about reporting? Is there online access to a secure web portal that puts together all the accounts that can be viewed daily? How often is performance reported to the client? Is there a formal structure set up to report the performance and meet with the advisor?

11. Can I get referrals from existing clients? Having these referrals and understanding the client experience from others in the community says a lot about meeting expectations

12. What makes your client experience unique? Are you really the trusted advisor I seek? Do you provide guidance and advice on things other than investments, such as buying vs. renting a home and home financing options, or buying vs. leasing a car and auto financing options? Is insurance part of the offering? If so, is it sold with a commission to the advisor, or is insurance something that the advisor consults on and avoids the product sale? What about guidance in estate planning, taxes, and setting up different kinds of retirement plans (e.g., defined benefit plans, 401(k) plans) and other ways of setting aside more money for retirement? If this is not done in-house, does the advisor assist with these topics? In essence, does the advisor serve as the quarterback of a comprehensive financial team?  

I told Beverly to take notes during her meetings, and have the prospective advisor answer each and every one of these questions in detail. In that way, she could truly make an informed comparison with all the others she would be interviewing. Happily, after Beverly interviewed several other CFP® practitioners and representatives from several brokerage houses, she selected our firm!

I hope that the list of questions above can help investors like Beverly make better and more informed decisions when looking for the right financial advisor based on their particular circumstances.

Feel free to contact Steve Foldes with any questions by phone 305.448.8882 ext. 240 or email: SFoldes@EK-FF.com