How financial planners earn their fees
There's nothing wrong with paying a financial adviser for her services. But make sure you're getting something for those fees.
NEW YORK (Money) -- Question: Why are you against paying higher fees to planners? Aren't higher returns worth high fees? If someone is providing a superior service, they should be well compensated for that service. How is it any different from other service professions like doctors, lawyers, or even pool cleaners?
The Mole's Answer: I'm asked this question all the time and partially agree with you. There is certainly nothing wrong with being paid to provide services that will benefit the client. That's how I make a living too. But you should know what you're paying for.
What you should be paying for
Let's take a look at what areas we planners can add value, and what areas we can't. A good financial planner can help a client develop an appropriate risk management plan (insurance plan), oversee their estate plan and perhaps even help on tax issues. We can look at the big picture and tell clients whether they are on track to meet their financial objectives, or what they need to change to get there.
When it comes to investing, we can also help, but only in certain areas. We can help the client in selecting an asset allocation and diversification plan to minimize uncompensated risk. We can design the plan so that assets are held in the most tax-efficient way. We can even provide the discipline to be long-term investors and not performance-chasers.
All of this is very similar to the model of other service professions, like the doctor, lawyer, or even the pool cleaner. And I'm with you up until now.
Where our perceptions diverge is in the area of getting what you pay for, or rather, not getting it.
What you shouldn't be paying for
If you're expecting that a high-fee planner is going to beat the market, or generate superior returns, you're likely to be disappointed.
Let's use the example of a doctor. Usually when I hear the doctor argument from a planner it goes something like this:
If you needed heart surgery, you wouldn't go to the cheapest heart surgeon, would you? So why only invest in inexpensive funds rather than utilize the best techniques available? After all, it's total returns that matter, not costs.
This sounds like a very appealing argument but the logic doesn't hold water. The market is nearly all professionally managed. So paying one expert a fee of 1% or 2% annually to outsmart another expert, with the expectation of achieving a return greater than the market, is a game that fewer than 1% of us will win in the long run. I don't feel that lucky, so I don't have my clients make this long-shot bet with their nest egg.
The argument is settled by simple arithmetic. If, for example, the market returns 10% and you pay a 2% fee for this planner's expertise, then the average dollar invested will yield only 8%. And if the market loses 20%, then your average dollar invested will lose 22%, once fees are added to the investment losses.
So that 2% fee may not seem like a lot, but it's adding to your losses and taking away from your gains. As a class, we financial advisers can't add any value here. Put another way, it's a zero-sum game - our gain is your loss.
Our profession may be overrepresented in Lake Woebegone, as I've never met an investment advisor who 'fessed up to being below average. Unfortunately, when I benchmark a professionally-managed portfolio to the broad indexes, the actively-managed portfolios rarely won out, even for short periods of time.
So if you're expecting fee to ensure a better return on your investments, you're playing a losing game.
It's okay to pay a planner for areas where they can add value by helping you reach your financial goals. Just remember that all fee models, including my own hourly model, have some conflicts. You should always understand what's in it for the planner. That's no different than the surgeon who might have an incentive to recommend an operation.