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Retire Early: How should I select a financial advisor ? What should it cost ?

How should I select a financial advisor ? What should it cost ?


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This article was revised May 6, 1999.

There is probably no surer way to increase your investment returns than to limit what you pay in fees and commissions. The same is true for what you pay an investment advisor. By educating yourself in financial matters and doing much of the work yourself, you can save thousands of dollars per year and, in most cases, out perform professional advisors.

Table 1. shows the effect of investment management fees on your IRA balance. This exhibit assumes you invest $2,000 on January 1st of each year and earn a 10% rate of return before deducting management fees. The table shows your IRA balance after deducting your advisor's fee. Most folks find the results hair raising.

Table 1.
The Effect of Management Fees on your IRA Balance.

Assumes $2,000 yr. contribution,
10% annual return before management fee.
IRA Balance after 5 Years 10 Years 20 Years 30 Years 40 Years
Mgmt. Fee @ 0.02% $13,423 $35,022 $125,696 $360,454 $968,249
Mgmt. Fee @ 0.25% $13,334 $34,556 $122,204 $344,402 $907,762
Mgmt. Fee @ 0.50% $13,238 $34,077 $118,528 $327,816 $846,479
Mgmt. Fee @ 1.00% $13,047 $33,121 $111,529 $297,150 $736,584
Mgmt. Fee @ 2.00% $12,672 $31,291 $98,846 $244,692 $559,562
Mgmt. Fee @ 3.00% $12,307 $29,567 $87,730 $202,146 $427,219

That's not an error. If your advisor is collecting a 3.00% fee, your IRA balance will be some $541,000 lower after 40 years than if you used low-fee investments. Your account will be literally chopped in half, with the larger slice going to your advisor. (See, "How much should I be paying in fees?" ) What you pay in fees and commissions can have a large effect on your retirement.

OMAHA, Neb. May 2, 1999 (AP) -- Multibillionaire investor Warren Buffett on Sunday criticized stockbrokers and investment managers who take high fees for their work.

Investment managers add nothing to the value of the businesses they trade stocks in, yet many demand 2 and 3 percent commissions and fees to help their clients invest, Buffett said.

``The average investment manager adds nothing,' Buffett said. `He subtracts something from your investment performance. It's almost unique among professions that I can think of.'

(Editor's note: Investment management fees have an even bigger effect once you've retired. See, "What is the maximum "safe" withdrawal rate in retirement?")

Even conscientious investors who regularly monitor their portfolios and are alert to changes in tax law may benefit from occasional help. The trick is to find someone competent and honest. Oh, and as our table shows, you don't want to overpay for the advice.

How do you select a financal advisor ?

First, let's start with how not to select a financial advisor. Many financial planners agree that references and recommendations from your friends, neighbors, and relatives may not be of much use. On what basis did they select their financial advisor? What do your friends know about investments? Some of the biggest investment frauds in history were perpetuated by well-meaning people unknowingly recommending crooked advisors to their friends and loved ones.

Since you can't rely on a referral, you'll need to do your own research and evaluation. There are three questions to answer: 1) "Is the financial advisor competent?", 2) "Is he honest? Are his recommendations in your best interest?", and , 3) "Is he overcharging for his services?"

One quick and easy test for competence is offered by California-based financial planner Errold Moody. He calls it the "HP 12C" test. He claims that at least 75% of "financial advisors" cannot operate a financial calculator capable of determining things like the "present value of an annuity." (The "HP 12C" is a financial calculator manufactured by the Hewlett-Packard Company.) This is a good test that will eliminate incompetent advisors from consideration. Unfortunately, it still leaves the dishonest ones in the pool. A dishonest advisor skilled in the use of a financial calculator can cheat you that much faster.

The best way to test the honesty of a financial advisor is to look at the fees and expenses associated with his recommendations. With the wide variety of no-load mutual funds available today, you should never pay a sales load or a 12b-1 marketing fee. If your advisor recommends a fund with any of these fees or charges, he may not have your interests at heart.

Some financial advisors who are actually quite honest will on occasion recommend funds with 12b-1 fees or sales loads. They may argue that the performance of the fund over the last 5 or 10 years more than makes up for the added fees. That may be true, but past performance is no guarantee of future performance. Eliminating from consideration all funds with sales loads or 12b-1 fees may be "throwing the baby out with the bath water", but it's the prudent thing to do. You may miss the 1 in 1000 chance of finding a good "load" fund, but you'll eliminate the likelihood that you'll overpay for a mediocre performer.

Is my financial advisor overcharging me? If you're paying more than 1% of assets, he probably is. It's much cheaper to do the easy stuff yourself, then pay a financial professional by the hour to advise you on the more complicated items. An honest and knowledgable financial advisor who won't try to "pad" his hourly charges might be worth as much as $300 an hour.

The key is to be educated and organized. Read a couple of books on financial planning. Get the hang of using investment tracking software. Read through the web sites listed below. Fill out the budget and client questionaire listed below. Getting your records organized makes it easier to effectively make use of your advisor's time. The meter's running, make sure you get your money's worth.

Perhaps the best approach is to prepare your own financial plan, then hire a financial planner to review it and suggest improvements. It's important to remain fully engaged in your financial affairs. Your retirement depends on it.

How to avoid being taken.

Unfortunately, the investment world attracts more than its share of rouges and thieves. Here's a few suggestions that should lessen the likelihood you'll suffer harm.

  • Use fee only advisors and pay them by the hour. Advisors usually prefer to base their fees as a percentage of "assets under management." This is unlikely to be in your interest.
  • Even when paying by the hour, you need to be careful. One Retire Early reader told me a Big Six accounting firm wanted $600 to perform a "Pre 59-1/2 early withdrawal" calculation for his IRA. This should be about 15 minutes of work for a competent professional. Retire Early even has a JavaScript IRA Withdrawal Calculator that allows you to make the calculation yourself for free. Another was charged $650 by a tax attorney to photocopy a few IRS private letter rulings. This kind of "advice" can quickly lead to the poorhouse. Like I said, you need to be careful.
  • Never give your financial advisor "power of attorney" over your investments. Make sure that the fees and commissions on all investments are reasonable and don't include sales charges or 12b-1 fees. Deal directly with the financial institutions recommended by your planner. Have all statements and correspondence sent directly to you.
  • Avoid buying mutual funds from banks or stock brokers. Mutual funds purchased from these institutions invariably charge sales loads or 12b-1 fees.

Other sites with information on financial advisors.

Note: The sites listed below contain useful information. However, in the spirit of what you've just read above, inclusion here does not constitute a recommendation by Retire Early. Reader's should do their own research and evaluation before selecting an advisor.

Errold F. Moody, Financial Planner - One of the most comprehensive financial planning sites on the Web.

  • Budget - Moody's budget form leaves nothing out.
  • Client Questionaire - Comprehensive. Everything you'll need for your first visit with a financial planner.

Management Account Services, Inc. - Frank Armstrong leads this Florida-based, fee only financial planning firm.

Ernst & Young's Personal Financial Counseling Web Site - Lots of information on taxes, retirement, and investments from a Big Six accounting firm.

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Copyright 1998 John P. Greaney, All rights reserved.

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