The Bogleheads' Guide to Retirement Planning (46 page)

Many people find that they really need help with the “everything else” not including ongoing discretionary investment management. Financial planners often help their clients invest by creating an investment plan as part of their overall financial plan. However, planners do not actually implement the investment portion. These investors may not want to pay a money manager to implement their financial plan and simply want the planner’s help in creating their plan. It is also common for an investor to have a financial planner who helps establish an investment plan and an unaffiliated money manager who implements that plan.

Many advisers do both financial planning and money management. Since the purpose of this book is retirement planning, this chapter will discuss finding a financial planner who only does planning rather than manage money. Most investors need good financial planning to help with that aspect before they decide if they need professional money management. Finding a good money manager is covered in
The Bogleheads’ Guide to Investing
and is the subject of many conversations on the Bogleheads’ forums.

Two distinct trends have driven developments in financial planning: increased life expectancy and replacement of traditional defined benefit plans with defined contribution (DC) plans. Future retirees can expect to spend 20 or 30 years in retirement and will need substantial assets to support themselves. Many DC plans such as a 401(k) shift the responsibility for accumulating a retirement nest egg from the employer to the employee, and all DC plans shift the responsibility for distributing the retirement nest egg from the employer to the employee. Unfortunately, many individuals do not have the knowledge or ability to successfully manage their own retirement assets. See Chapter 6 for more information on DC plans.

The field of financial planning is relatively new, compared with accounting, engineering, medicine, and law. The first book approximating a textbook on financial planning was
The New Money Dynamics
, written by Venita VanCaspel in 1978. An organization of fee-only financial advisers, the National Association of Personal Finance Advisers (NAPFA), was established in 1983. The certified financial planner (CFP) designation came into existence in 1985. College degree programs in financial planning were finally offered on a widespread basis in the 1990s, and at least one college now offers a doctoral program in financial planning.

Many of the breakthrough findings in financial planning have occurred in the last 20 years. Monte Carlo analysis was first applied to the problem of determining a maximum safe withdrawal rate from retirement savings in 1997, when Bengen published his seminal study on 4 percent safe withdrawal rates in retirement. In 2002, Daniel Kahneman was awarded the Nobel Prize in Economics (The Sveriges Riskbank Prize in Economic Science in Memory of Alfred Nobel) for his pioneering work in behavioral finance that had important implications for financial planners in the area of risk control. Eugene Fama and Ken French introduced the three-factor model of investing in 1993, which is used by a growing number of planners in forming retirement portfolios.

Technology also opened up the field of financial planning in new and exciting ways. The Internet, e-mail, and phone calls make it possible to work with an adviser across town, across the state, or even across the country. Perhaps it is pleasant to meet face-to-face with an adviser, but that does not change your financial situation, and time spent face-to-face with an adviser costs you money in higher fees. It may be more practical and less costly to forgo the formality and instead seek a truly competent adviser wherever they are.

More than 78 million baby boomers in the United States will be entering retirement over the next couple of decades. Growing numbers of impending retirees who are depending increasingly on their own investment wits will drive many changes and improvements in the financial planning field in the coming years. Financial planning will expand in clients and scope to keep up with the growing demand and complexity faced by America’s largest graying generation ever.

Financial advisers are paid for their advice and services. There are many different types of fee structures, and no fee structure is right for every person and every situation. This section covers the three major ways financial advisers are paid.

The oldest fee structure is commission sales. An adviser (or broker) is paid a commission or fee from a company whose financial product they sell to a customer. Some commissions are easily recognized in the sales literature, and those costs are supposed to be explained by the adviser. However, not all product literature provides adequate disclosure about commissions, and not all advisers are forthcoming about these expenses. Some commissions are cleverly disguised as high expense ratios, back-end and level loads, or some combination of the two. The purchaser of these products definitely pays a commission, even though it is not called one.

One of your primary goals as an investor is to minimize expenses. Each dollar you save in expenses is a dollar that goes into your pocket. You should select investments that have no loads, minimum trading expenses, and low annual expenses (expense ratios). Your adviser should also be paid a reasonable amount for services rendered. Unfortunately, the incentives driving the commissioned salesperson are often directly opposed to your interests as an investor. Salespeople are rewarded if they can convince you to buy high-commission investments and trade them often. That is exactly the opposite of what you should be doing.

To further confound this obvious conflict, many commissioned advisers have no fiduciary responsibility to you. That means an adviser who is paid from commissions is not
obligated
to act in your best interest, although securities laws do prohibit them from recommending unsuitable investments. This comes as a shock to many investors. Most investors do not realize that the financial adviser on commission does not have a fiduciary responsibility to them. Once investors understand the extent of the conflict, they generally decide they want no part of it.

The conflict of interest between offering advice and getting paid commissions has been a problem for a long time. It probably began when the U.S. stock exchange was started under the buttonwood tree in 1792. The first book to chronicle such conflicts of interest was Fred Schwed’s 1940 classic
Where Are the Customer’s Yachts?
The foreword of that book has a great story:

There are many other books on the subject of brokers and commissions. Thomas Saler documented many adviser conflicts of interest in his 1989 book,
Lies Your Broker Tells You
. For a more humorous recounting of this age-old conflict of interest, read Michael Lewis’s 1990 classic,
Liar’s Poker
.

You should know that the highest commissions are typically paid on the worst investment products. That gives the adviser incentive to sell them. Limited partnerships, variable annuities, equity-indexed annuities, and loaded stock and bond funds all will cost you dearly in commissions and fees. Investments that are good for brokers are usually very poor choices for investors.

The heyday of limited partnerships was in the early 1980s. Commissions between 6 and 10 percent drove salespeople to heavily market these investments. Sales personnel promoted these risky partnerships as a safe way to invest. These partnerships relied on rising oil prices, rising real estate prices, and the federal tax code. The main attraction for investors was generous tax deductions. The Tax Reform Act of 1986 wiped out the federal tax advantages. Declining oil and real estate prices put the final nail into the coffin. Thousands of investors were left with worthless investments that couldn’t be sold. It’s interesting to note that Wall Street has recently attempted to resurrect limited partnerships, calling them direct participation programs this time around.

The complexity of variable annuities plus sales commissions around 5 percent often lead to abusive, high-pressure sales tactics. The
Wall Street Journal
ran an interesting article in 2002: “Annuities 101: How to Sell to Senior Citizens.” It described how advisers and insurance salespeople were trained to use abusive and high-pressure sales tactics. These abuses became so flagrant that the Financial Industry Regulatory Authority (FINRA) had to issue an investor alert in 2003: “Variable Annuities: Beyond the Hard Sell.” Visit
www.FINRA.org
to read the entire article.

Equity-indexed annuities are another onerous form of variable annuities. They offer juicy commissions to sales personnel and marginal returns to investors. Equity-indexed annuities are promoted as investments that achieve some of the higher return of stocks but with limited losses. These are extremely complex investments that most people cannot begin to understand. In general, equity-linked annuities have high commissions, high annual expenses, and steep surrender charges. Because of abusive sales practices involving senior citizens, FINRA issued another investor alert in 2008: “Equity Indexed Annuities: A Complex Choice.” The SEC is considering improved regulation of equity-indexed annuities to rein in the abuses. The SEC proposal is to switch from state insurance regulation to federal securities regulation of equity-indexed annuities.

Let’s look at a hypothetical example that illustrates a potential conflict of interest between a salesperson/adviser and client. Robert and Rita are a 65-year-old recently retired couple who fortunately have all their retirement living expenses covered by two generous defined benefit pension plans (see Chapter 5). They assume at least one of them will live to age 95. In addition to their pensions, they have accumulated $600,000 in a taxable account and $400,000 in a tax-deferred retirement account that they hope to pass on to their children as an inheritance.

Robert and Rita are seeking financial advice on investments. They first receive advice from an adviser at a major Wall Street firm. The broker recommends investing the $600,000 of taxable funds in a variable annuity, which in turn goes into stock funds. The broker also recommends that the couple invest the $400,000 of tax-advantaged money into an actively managed bond fund. How much will the brokerage firm get if Robert and Rita bite? The brokerage firm would receive a commission of $30,000 for selling the variable annuity (5 percent of $600,000) and $18,000 for selling the bond fund (4.5 percent load on the $400,000). In total, the firm would receive a commission of $48,000. The brokerage firm would split that amount with the broker who sold the products.

Regardless of how long Robert and Rita own the investments, they are guaranteed to pay $48,000 in commissions. But that is not the end of it. Assume that the variable annuity has an annual expense ratio of 2 percent per year for as long as they own it and the bond fund has an expense ratio of 1 percent for as long as they own it.

Ignoring taxes, the couple would receive a net return on the variable annuity of 8 percent (the long-term stock market average of 10 percent minus a 2 percent expense ratio). Ignoring taxes, the couple would receive a net return on the bond fund of 5 percent (the long-term bond market average of 6 percent minus a 1 percent expense ratio).

We’ll assume our couple’s portfolio compounds at these rates over their 30-year retirement period. At the end of 30 years, their heirs would inherit $7,386,696. We can assume the salesperson spent 10 hours selling this couple the variable annuity and the bond fund. The couple paid the salesperson $48,000 or $4,800 per hour for this advice.

Now let’s assume Robert and Rita hired a fee-only financial planner who believes in low-cost index-fund investing. We’ll assume the fee-only financial planner charged $200 per hour. For 10 hours of advice, the fee-only planner’s total bill would have been $2,000. The fee-only planner recommends investing $600,000 in Vanguard’s Total Stock Market Index Fund. This planner also recommends investing $400,000 in Vanguard’s Total Bond Market Index Fund. There are zero sales commissions involved with these investments. Since they’d be investing more than $100,000 into each of these two funds, they’d qualify for Vanguard’s Admiral class shares of the two funds. The Admiral class of the Total Stock Market Index Fund has an expense ratio of 0.07 percent, and the Admiral class of the Total Bond Market Index Fund has an expense ratio of 0.1 percent.

Both funds are passively managed (they’re index funds). Since they’re passively managed, we’ll assume they each return 100 percent of their index averages.

Ignoring taxes, the couple would receive a net return on the Vanguard Total Stock Market Index Fund (VTSAX) of 9.93 percent (100 percent of the long-term stock market average of 10 percent minus the 0.07 percent expense ratio). Ignoring taxes, the couple would receive a net return on the Vanguard Total Bond Fund (VBTLX) of 5.9 percent (100 percent of the long-term bond market average of 6 percent minus the 0.1 percent expense ratio).

We’ll assume Robert and Rita’s portfolio would compound at these rates over their 30-year retirement period. After 30 years, their heirs would inherit $12,504,857. The benefits of following the advice of the fee-only planner versus that of the commissioned salesperson are significant. It would result in this couple leaving $5,118,161 more to their children.

These two cases vividly illustrate the inherent conflict of interest present in the commission-based model.