Advisers' earnings: How do those you trust with your finances make their own living?

December 1, 2009

The entire financial world was turned upside down during the years 2008 and 2009. Investors, executives, employees and the general public are left wondering, "Whom can I trust?" and "How will all these changes affect me?"

Key Points

The entire financial world was turned upside down during the years 2008 and 2009. Investors, executives, employees and the general public are left wondering, "Whom can I trust?" and "How will all these changes affect me?"

The disturbing realities may have a serious impact on the economy for years to come. For example, did you ever think that:

You wouldn't be human if you didn't take notice of these events and wonder how safe your investments were. If executives, stock analysts and the board of directors of each of the firms impacted by the financial crisis couldn't see the problems looming right in front of them, how could you possibly be aware of the risks you face?

Surprisingly, most physicians have not done this. If you had, you would understand the differences between an adviser's "fiduciary duty" and an adviser's "suitability standard" and what these differences might mean for you.

There are many types of financial advisers at a variety of firms. For now, let's discuss three very different compensation models that are used by financial advisers.

Compensation models

1. Actively managed portfolio of mutual funds:

An actively managed portfolio of mutual funds generally includes the use of a financial adviser who does the research for you and selects a group of mutual funds for you to purchase (through the adviser). The idea is that you would select mutual funds with a strong history in each of their respective areas. For this type of arrangement, there are two common fee models. In both of these arrangements, you have to pay the fees associated with the mutual funds. You will also have to pay the adviser for his or her time advising you. More specifically, the models are either:

A. The mutual fund commission model - in this model, you pay the mutual fund load and additional fees called "12(b)(1) fees." The adviser receives a commission from the load collected and an ongoing fee from the 12(b)(1) fees. The average mutual fund load on this type of fund is approximately 1.1 percent, and 12(b)(1) fees range from 0.5 percent to 1 percent. Thus, those of you using this type of fund typically pay 1.6 percent to 2.1 percent in total compensation.

B. The wrap fee model - in this model, you pay the mutual fund fee (can be purchased without a load or with a load), the 12(b)(1) fees, AND you pay the financial adviser a fee for managing the mutual fund choices for you. As the financial adviser takes a significant fee on top of the 2.1 percent above, this is a VERY expensive structure for the client.

What is so interesting about both of these mutual fund models is how little customization the investor gets with this model. Specifically, there is only one-way communication - from the fund to its financial advisers and their clients (you). There is no opportunity for you to meet with the fund managers and have them understand how this fund is part of your overall wealth portfolio. In fact, the vast majority of financial advisers will never meet a mutual fund portfolio manager. If you want a two-way dialogue to make sure the portfolio is integrated with your asset protection, tax, retirement and estate planning, you need to hire an individual investment manager (discussed below). What is intriguing is that a more customized portfolio with an individual manager may be even less expensive than either of the mutual fund-based plans above.

A very disturbing characteristic of mutual fund-based plans is the tax treatment you may suffer. When preparing 2009 tax returns, most U.S. taxpayers who invest in mutual funds will receive 1099 tax statements based on the performance of their mutual funds. Though the fact that you have to pay taxes on investments is not surprising, it is shocking to many when they find out that they owe taxes on any capital gains or dividends the fund may have realized during the year - even if the fund's total value is down 20 percent to 40 percent. This may seem preposterous, but this is the reality for mutual fund investors, who have no control of their fund tax treatment. Given that investors in mutual funds have lost between 16 percent and 44 percent of their gains to taxes over the past 20 years (according to fund tracker Lipper), one would expect smart investors (such as doctors?) to limit their use of these vehicles. Unfortunately, this has not been the case. The mutual fund industry must have very effective advertising.

2. Stockbroker who charges commissions on trades:

This should be self-explanatory. Some physicians rely on stockbrokers (although they may call themselves something different). The title of the adviser is not important - what is crucial is how these advisers are compensated. The business model we will describe here is based on a percentage of the "trades" the adviser places for the purchases and sales of securities in your portfolio.

The drawbacks in this model include the following:

A. This model gives the adviser a significant financial incentive to recommend frequent trades, including the firm's next "best idea." There is no incentive for the adviser to help you build, protect or integrate your portfolio with the rest of your plan. Whether or not your portfolio does well, the adviser does well so long as there are enough trades.

B. These business models exist typically at the largest financial firms. As such, these advisers may be given "inventory" of trades from their home office that they are encouraged to "pitch" to their clients. Many of these firms have morning calls to discuss what the firm would like them to promote on that day.

C. Advisers in this type of business model are generally not subject to a "fiduciary duty" (described below) to their customers. Instead, they simply need to show that any recommended trades are "suitable" - a much less stringent standard.

Despite these conflicts and drawbacks, many investors continue to use advisers in this model - even though it often costs them more in commissions than other models where the fees are much more straightforward.

3. Investment adviser charging fees on assets under management (AUM):

In the past 10 years, this type of financial model has become much more popular and has gained significant market share. This growth has been fueled by its transparency to investors, higher standard of care for the client (a fiduciary duty to clients), and its aligning of the goals of the adviser and the client. The more the adviser helps the client grow the investment assets, the more the adviser earns. Any reduction in the assets under management will cause the adviser to take a lower fee.

While many physicians do utilize fee-based investment managers on their investments, they still fail on two important counts:

A. Tax management on investments. Taxes are typically a much greater drag on investment returns than fees, yet few physicians ask their advisers how they deal with tax planning, preferring to question fees regularly. This doesn't make much sense. At our firm, as an example, we have two CPAs who help clients manage the taxes on their investments - one of whom sits on our investment committee. Ask your advisers how they plan against the tax drag on investments. You may be surprised at what you hear.

B. Along with tax planning, the coordination of your investments with retirement, asset protection, cash flow and other goals is also crucial. This may seem obvious, but often it is overlooked by both the doctor and the investment adviser. Why let your investments sit vulnerable to lawsuits, if these funds are important to you? Why shouldn't investment decisions tie into cash flow and retirement planning? Isn't that the point of getting professional management in the first place? At OJM, we have a multi-disciplinary team that integrates investment planning in all planning areas. If the integration of your planning is important to you, you should make sure you work with an advisory team that is properly trained, experienced and equipped to help you. Otherwise, it would be similar to you performing surgery without an anesthesiologist.

Conclusion

Beyond your career earnings, your long-term retirement and financial well-being is tied to your investments. Given this importance, shouldn't you spend some time investigating how the financial advisers you might work with are compensated, and the incentives these arrangements create? The more you know about the situation, the better equipped you are to make the right decisions for you and for your family. We wish you the best of luck as you navigate these investment waters and would be honored to speak to you about how we may be able to help you.

This column was authored by David Mandell, J.D., M.B.A., an attorney, author of five books for doctors, and principal of the financial consulting firm O'Dell Jarvis Mandell LLC, and by Jason O'Dell, C.W.M., a member of their investment team.

Jason O'Dell is a financial consultant, lecturer and author of two books for physicians. Christopher Jarvis is a financial services professional who specializes in working with business owners, physicians and other professionals. David Mandell is an attorney, lecturer and author of five books for physicians. All are principals of the OJM Group and can be reached at (877) 656-4362, http://www.ojmgroup.com/.