The Bogleheads' Guide to Retirement Planning (47 page)

Many financial advisers use an Assets Under Management (AUM) fee model, where clients are charged a percentage of the portfolio being managed. Advisers using the AUM model are usually registered investment advisers (RIA) under the Investment Advisor Act of 1940. RIAs are bound by law as fiduciaries to act in the client’s best interest. Generally, advisers using the AUM model are money managers, although financial planning may also be included under that fee.

Under the AUM model, RIAs typically charge about 1 percent. Some advisers charge more, and some charge much less. Do not assume that you get more services from the ones who charge more. RIAs do not typically include the value of a client’s home or business in the quantity of assets being managed because they are very difficult to value accurately and really cannot be managed in the way that stocks and bonds can be managed.

Let’s assume an investor has $1 million in investable assets. An RIA with a 1 percent AUM fee would charge the investor $10,000 per year for money management. In some cases, financial planning services are included in the AUM fee, and in other cases, they are charged separately. Do not pay a higher AUM fee for an adviser who automatically includes planning services you do not need or need only occasionally. It is better to negotiate those services separately. Why pay for the complete buffet when all you want is a salad?

Many advisers use a tiered approach to the AUM fee. For example, an RIA may charge 1.2 percent on the first $500,000 under management and then drop to 1 percent for the next $500,000. Investors with more would be charged less than 1 percent per year on the assets over $1 million.

Adviser fees should be clearly explained in writing before you enter into an AUM agreement. Investors would do well to shop around for price and compatibility. Many advisers post their fees on their web sites.

When financial advisers first start in business, they’ll often accept any size client. Successful advisers learn that the time required to prepare and implement financial plans turns out to be very similar, regardless of the client’s net worth. If financial advisers want to optimize their time and profits, the AUM model usually drives them to higher net worth clients. Often, a successful adviser will attempt to replace the smaller clients with larger clients. At this stage, advisers may increase their minimum asset level per client they accept or increase the minimum annual fee per client. Some advisers direct their existing lower net worth clients to other options, and some continue working with these customers. It depends on the adviser. If you are a smaller client, that would be a good question to ask.

The AUM model eliminates most conflicts of interest. Advisers who charge a percentage fee can align their interests with the client’s. Both parties want the client’s net worth to increase. Many clients find it comforting that their advisers are actually in the boat with them.

There can be drawbacks to the AUM model. For instance, under a bundled fee approach where the AUM covers financial planning and money management, investors might be paying a lot for planning advice that they use infrequently or not at all. Also, since an adviser is paid based on assets, an unscrupulous investment adviser may recommend investments that are too risky because over the long run, riskier investments would be expected to increase the adviser’s assets under management. Unfortunately, those unethical advisers are exposed only in a bear market, after you take substantial losses.

Some advisers offer hourly or project-based billing. Financial advisers who offer planning and investment services by the hour charge $80 to $400 per hour. The hourly fee depends on the experience of the adviser, the geographic location of the client, and the complexity of the financial planning services provided. Other financial advisers charge by using project-based methods. A project-based fee could be $100 or $10,000, depending on the included services. In general, a simple retirement plan would cost about $500. Advisers using the hourly fee or project model are usually RIAs and must act in the client’s best interest.

People with limited assets and resources may find hourly and project-based advisers an ideal choice. There is a nationwide network of planners who cater to this market. Sheryl Garrett established a financial adviser program that assists working-class and middle-class individuals. The Garrett Planning Network is composed of independent fee-only financial planners who charge either by the hour or by the project. She contends that most middle-class investors do not need comprehensive financial planning. Thus, it is best to break up financial planning into different and specific elements so that everyone can afford help in the specific area they need. If a client needs another element at a later date, they can work with their planner and pay only for the next element.

Charging by the hour or by the project tends to eliminate most conflicts of interest. But there could still be issues. For instance, hourly advisers may try to log as many hours as possible. That can be pretty frustrating, not to mention a waste of money. These investors should probably investigate other types of advisers. Finally, some planners advertise hourly planning but they promote their AUM asset management services when you go for an appointment. That is a conflict of interest.

What you see is how much you pay, no more and no less. That is the flat-fee model. The fee is set in advance and does not change. Some years, you may need more advice and some years less, although this does encourage frequent communication and face-to-face meetings. The annual flat-fee model focuses on long-term relationships rather than pay as you go. This model eliminates incentives for the adviser to recommend riskier investments to increase the quantity of assets under management.

Flat-fee advisers tend to dislike the AUM model because that puts their annual income at the vagaries of the stock market. In addition, they do not want their clients to judge them by the performance of the financial markets. The flat-fee adviser wants to be a client’s long-term financial person regardless of what the markets do.

Just like all the other methods of compensation, the flat-fee model has a few pitfalls. For instance, a flat-fee adviser may try to do as little work for you as possible and still collect the fee. Also, some flat-fee advisers get kickbacks from the referrals they give to money managers and insurance agents. Make sure your adviser has no conflict of interest.

There is a fourth model. Several large mutual fund companies offer limited financial planning services for free or a fee, depending on the amount you have invested with that company. One company that offers this service is the Vanguard Group founded by John Bogle in 1975. This firm is unique among mutual fund companies because the customers own the firm. It is a mutual benefit type of company. Vanguard offers excellent educational materials on their web site and also provides personal portfolio advice.

Vanguard has different customer levels and services, based on the amount each client has with the company. Customers with more than $1 million at Vanguard are called Flagship clients. They receive free portfolio advice, including annual checkups. Customers with $500,000 or more invested at Vanguard are called Voyager Select customers. They get their fee waived for portfolio advice, and annual checkups are included. Voyager customers have $100,000 to $500,000. They pay $250 for portfolio help as needed. All other customers pay $1,000. Free annual checkups are not included for any client with less than $500,000 invested. Even if you do not qualify for free portfolio advice, Vanguard’s prices are still relatively inexpensive. There are no face-to-face meetings. You would be talking with your Vanguard financial adviser over the telephone.

As you can see, there is no one fee structure or set of services that’s right for all investors. By comparing the various fee structures and services you require, it should be easier to select the fee structure that best suits your needs.

Financial advisers’ designations are a smorgasbord of acronyms. In fact, there are so many different designations that the subject is often compared to alphabet soup.

The field is relatively young but vast. Consequently, there is no single financial adviser designation that covers everything. However, of all these designations, Certified Financial Planner (CFP) is the most prominent for people searching for a financial planner. The CFP designation was first awarded in 1972 by the College for Financial Planning in Denver. In 1985, the International Board of Standards and Practices for Certified Financial Planners (IBCFP) assumed responsibility for CFP examinations. The IBCFP also awards CFP licenses. Currently, there are over 23,000 licensed CFPs, some of whom are also CPAs.

The IBCFP maintains a list of registered educational programs. Some are bachelor’s or master’s degree programs at colleges and universities around the country. Many others are certificate programs in financial planning and are designed specifically to prepare applicants for the CFP exam. The best-known certificate program is the CFP professional education program offered by the College for Financial Planning. This is a six-part, self-study program that usually takes two years to complete. It is possible, however, for students to accelerate the program and complete it in one year.

The CFP comprehensive certification exam is a two-day, 10-hour exam that includes multiple-choice questions, matching items, and case problems or problem sets with multiple-choice responses. The exam covers insurance, investment, income tax, retirement, and estate planning. The requirements for acquiring the CFP designation are designed to provide the CFP applicant with the tools needed to provide effective financial planning services.

If you are seeking investment management, the Chartered Financial Analyst (CFA) designation is a high-level money management designation. It is similar to the CPA in accounting. People who seek a career in investment analysis and portfolio management seek the CFA charter rather than the more broadly based CFP. CFA candidates must complete a graduate-level self-study program and pass three extremely rigorous exams. The process generally takes three years, although it can be completed in two and a half. A CFA candidate is tested on financial reporting and analysis, quantitative investment tools, asset classes, wealth planning, and ethics.

There are at least 56 different designations for financial advisers. Except for the CFP and CFA designations just noted, many of these designations are not recognized as meaningful in financial circles. However, they’re often used in an attempt to impress potential clients.

Some advisers also list RIA after their names as if it were a designation. It is not. As you recall, RIA stands for registered investment adviser. The requirements for becoming an RIA are not particularly stringent. Typically 40 hours of study is required to pass a Series 65 exam administered by a state securities regulator. The adviser must also complete Form ADV, which includes the fee structure and a written code of ethics. Because RIA is not a designation, the SEC forbids people from putting the letters RIA on a business card next to their names. Unfortunately, that does not stop some less ethical advisers from doing so in an effort to fool the public.

If you have decided that using a financial adviser is the best decision to help you achieve your financial goals and objectives, then selecting a good one is the next step. You now have the necessary background and understanding of key topics to help make this process easier.

Thoroughly question a potential adviser regarding the various methods of adviser compensation, and get it in writing. For instance, some advisers are hybrids. These hybrid advisers are paid commissions under one business identity and take fees under another identity. It is not possible to overstate the serious conflicts of interest that can arise with this arrangement. Potential advisers should also be questioned thoroughly about any referral arrangements. Many advisers make a business out of referring their clients to friends or family members for other services they recommend. Unfortunately, some advisers practice the old retail trick of bait and switch. They advertise one type of service when they really want you as a client for a completely different service.

You should inquire into your potential adviser’s qualifications. What educational background and professional designations does the adviser have? Ask the adviser for a copy of the ADV Part II, which is filed with either the state or the SEC. The adviser is required by law to provide this document to you before you invest with them. The ADV Part II is genuinely worth reading because it describes in detail the adviser’s business. The best way to get an ADV Part II is to call the adviser and ask for it. Many advisers have links in their web sites.

Some people need help in a specific area. Certain advisers specialize in target markets like small-business owners or employees of large corporations. Investors with large taxable accounts are the most obvious example. Other advisers deal with difficult tax situations, including company stock option programs. If taxes are an issue for you, make sure your adviser has the necessary experience and expertise.

Ask the potential adviser if your relationship will be a fiduciary relationship. In a fiduciary relationship, the adviser puts the interests of the client first. Ask to see the adviser’s written code of conduct. The SEC requires all RIAs to have a written code of conduct that is to be made available to a client or potential client on request. Also contact your state’s securities office and make sure your state officials have no outstanding issues regarding this adviser.