Advisor Blog

Ameriprise has consistently recommended its own RiverSource (now renamed Columbia - fund companies love to change names when the old name is associated with unpleasantry) funds to its clients despite their high expense ratios and often poor performance while ignoring better alternatives.  This is what happens when an advisor eschews fiduciary duty and operates under the FINRA suitability rule.  Stuffing accounts full of their own proprietary mutual funds is a very effective way of transferring clients' wealth to the owners/shareholders of the firm. 

However, ERISA law requires that the sponsor of an employee retirement plan must act as a fiduciary.  Ameriprise tried to do the same thing with its plan participants and offered them its own funds as investment choices within their 401(k) plan.  The result is a lawsuit by their own employees/plan participants.  Apparently, they resent having to invest in the same funds that Ameriprise recommends to its clients!  According to Barron's "surely thousands of articles have been written on how to pick the best mutual funds and spot the worst. But here's a tip that doesn't often come up: If a fund company's employees are suing for being forced to invest in their own firm's mutual funds, you probably want to steer clear".  We agree.

Many business owners and 401(k) plan sponsors are scrambling to understand and comply with the new Department of Labor mandated fee disclosure regulations that will become effective only a few months from now. The new regulations explained under sections 408(b)(2) and 404(a) of the Employee Retirement Income Security Act of 1974 (ERISA) require additional disclosures to be made to plan sponsors and plan participants, and require all plan service providers to furnish much more information about their services, expenses and fees. ERISA section 408(b)(2), the service provider rules, become effective April 1, 2012, while the new 404(a) participant disclosure rules become effective May 31, 2012.

Yes, that's $2 Billion, with a B.  At least, that is the initial estimate of the loss at UBS as the result of one "rogue trader", now under arrest, in the bank's equity trading division.  UBS claims that no client funds were involved in the loss.  But, according to Forbes, this will result in UBS reporting a net loss for the quarter.  The much larger issue is the serious failure of internal risk controls. According to Reuters, UBS "got caught up in almost every industry mis-step, and one which vies with Citigroup as the firm to come out worst from the 2008-2009 financial crisis, having recorded losses of over $50 billion and having had to be rescued by the Swiss authorities".

This leads us to question why anyone would choose to do business with UBS.  This is the same outfit that facilitated the opening of offshore bank accounts and then turned the list of clients over to the US government so that they could be prosecuted for tax evasion. 

Merrill Lynch is another disaster.  In late 2007-2008, Merrill was hemmorhaging money due to losses sustained from its large and unhedged portfolio of collateralized debt obligations (CDOs) and had fired its CEO, Stanley O'Neal.  Under pressure and facing loss of confidence in its solvency, the firm was sold to Bank of America in September 2008.  Now, there are serious questions about Bank of America's ability to survive.

Of course, everyone is aware of what happened with Lehman Brothers and Bear Stearns.  Smith Barney, another victim of the financial crisis, was spun off by Citigroup to a joint venture with Morgan Stanley.  In the end, Citigroup, Merrill Lynch, UBS, Morgan Stanley, Wachovia, Credit Suisse, Lehman Brothers, Bank of America, Bear Stearns, and JP Morgan Chase all suffered massive losses on write-downs of structured products.  So, why would any reasonable person choose to do business with the survivors (or the "walking wounded") in this group?  In fact, doing so could be considered to be rewarding their bad behavior.

There is a better way.  According to many recent studies, the fastest growing segment of investment advice delivery is the Registered Investment Advisor (RIA) fiduciary model.  According to RIA Database, there are now more than 13,000 Registered Investment Advisors in the US acting as wealth managers with over $1.7 trillion dollars in assets under management.  Why?  Informed clients prefer the RIA fiduciary model over the traditional broker-dealer model.  And why wouldn't they?  Why would anyone choose to do business with a firm that can't manage their own employees, control the risks that they are exposed to, or even remain solvent?  Beyond that, why would anyone choose to do business with an advisor that chooses not to assume the role of a fiduciary to his or her clients? 

Greg Schmitz was meeting with a defined contribution plan record-keeper and third party administrator a few months ago, and during the meeting he came and got me because he wanted me to hear what they were proposing.  As a fiduciary to the plans that we work with, we assume the responsibility for selecting the investments and designing the portfolios that are used in the plan.  The vendor was trying to convince us that they had an automated system that would document investment selection and Greg was utterly shocked that their system looked at performance over only the past three years.  So was I.  When we questioned that methodology, they told us "well, over longer time periods, all you end up with are index funds."  Our point, exactly.  We chose to work with a different company.

There has been a lot of critcism of 401(k) plans over the past few years and, frankly, much of it is well-deserved.  The vast majority of plans, particularly those of small employers with less then $10 million in plan assets, are too expensive and offer terrible investment options.  The market for small plans is dominated by large insurance companies.  The fees are frequently hidden inside a group annuity structure.  But, change is coming.  New Department of Labor rules regarding fiduciary duty and fee disclosure are on the horizon - and it will expose the insurance company plans for what they are.  It will also require plan sponsors who have chosen to use them to explain the excessive fees to the participants.

The New York Times ran an article last weekend on this subject (thanks again, to one of our great NY resident clients for forwarding it) and concluded that there are some very good low-cost options, including working with a Registered Investment Advisor that can select inexpensive funds from Dimensional Fund Advisors for the plan. We've been acting as the investment advisor to 401(k) plans for many years using low-cost funds from Dimensional and Vanguard with full disclosure of all fees.  The plans that we work with won't have a thing to worry about under the new DOL rules.  That won't be the case for the plans that fell for the sales pitch from the big insurance companies. 

Dave Ramsey isn't always right, but once in awhile he hits the proverbial nail directly on the head.  Yesterday's (March 4) edition of his radio show was a great example of this.  At about 43 minutes into the show, you can hear Dave discuss the virtues (or lack thereof) of whole life insurance, particularly expensive whole life policies from companies like Northwestern Mutual and New York Life.

He refers to whole life insurance as "the payday loan of the middle class."  If you don't get that reference, payday loans are a horrible product.  They charge ridiculous interest rates and take advantage of unfortunate people that need money to make it until they receive their next paycheck.  Many states are enacting legislation to help keep the companies that offer these products in check because they are so abusive.

Scott Maxwell and I listened to the segment again today and we ran the numbers to check Dave's math.  He's not dead on, but he's close enough to support the point that he's making.  Of course, a Northwestern Mutual salesman will disagree, and that's the problem.  The investment community points to terrible products like whole life and then uses a broad brush to paint all insurance products as expensive and awful - and all insurance agents as lying salesmen.  Conversely, the insurance industry tries to convince everyone that the capital markets are dangerous and evil and that the typical investor in them is doomed.  Of course, neither of these polarized positions is correct. 

So, the fundamental question is obvious.  Who do you trust?  It's time for some critical thinking.  Should you trust the insurance salesman that works for a particular company and only sells their products?  Is he going to tell you that another company's product is better than the one he sells?  He won't earn a commission that way, so it's unlikely.  Should you trust the advisor that only works with investment products?  Do you think that he will recommend an insurance product if it's right for you?  He can't get paid for it.  Will he place your best interest above his own self-interest?  What about a broker-dealer representative that also has his insurance license?  If he's paid on commission, will he recommend a product that pays him less if it's the right thing for you?  You'd hope so, but it certainly does not always happen.

The bottom line - work with an independent registered investment advisor that clearly discloses the way he is compensated and can offer both investment and insurance products.  In addition to the disclosure, registered investment advisors are required by law to put the client's best interest first.  This is the fiduciary standard that we've talked about before and it is a much higher standard than the suitability standard that applies to insurance salesmen and broker-dealer representatives.  Within our firm, Scott Maxwell, Greg Schmitz, and Bob Lamse are all licensed to work with insurance products under the fiduciary standard.

So, you've decided to work with an advisor that operates under the standard of fiduciary duty and that, consistent with the overwhelming evidence that supports it, chooses to build portfolios based on passive asset class exposure.  So far, so good.

But, even fee-only Registered Investment Advisors offer a bewildering array of services with fee structures that vary widely.  Many appear to offer the same thing for surprisingly low fees that others offer for fees that seem outrageous.

First, decide what type of relationship you want.  Is it bare bones portfolio management - simple asset allocation and rebalancing?  Or, do you want tax management, advanced performance reporting, and complex portfolio design across multiple accounts?  What about wealth management services, like insurance and tax planning, trust administration, or a private banking relationship?  Will the advisor help with your employer's 401(k) and include that in the asset allocation?  Do you need the services of a family office - bill payment, travel arrangement, security services, property management, and/or legal services?

Keep in mind that many small or new advisors may charge fees that are less than the industry average while trying to build their practice.  They may operate out of their home or an executive suite.  They frequently do not have administrative support, in-house compliance programs, sophisticated security systems for the protection of confidential client data, or advanced reporting capabilities.  Are you comfortable with your confidential information residing on someone's home computer or should it be behind a firewall on an encrypted drive in an office that has a monitored security system?  All of these capabilities and safeguards add cost.  But, is it wise to ignore them?

What about the firms that offer a flat retainer fee instead of charging clients based on assets under management?  At first blush, it sounds like a great idea.  But, what is an advisor paid by a flat fee motivated to do?  The only way that that this advisor can increase profitability for his existing account base is to minimize the time spent on each client.  In contrast, the advisor that is paid on assets under management has an incentive to grow each client's portfolio and expand the relationship.  He may be much more willing to spend time with the client in order to do so.

If your primary focus is on portfolio performance, then the yardstick should be the risk adjusted after-fee, after-tax net return of the portfolio.  The advisory fee is actually irrelevant in the comparison of advisors if the risk adjusted net return is higher than that of the competitors.

Many portfolios that provide high expected rates of return are more tilted toward the risk factors that produce return (value and small cap stocks).  But this always comes at the expense of tracking error relative to the common indices (the DJIA, S&P 500, etc) that are talked about on the nightly news or by the CNBC "talking heads" (including clowns like Jim Cramer).  As a result, they require more "hand holding" of clients during the inevitable time periods when the portfolio will underperform the common index that the client uses as a comparison.  These advisors are justified in charging higher fees to compensate them for this activity and for the opportunity cost of lost time developing new clients and growing their practice.

Most prospective clients that engage in "fee shopping" vastly oversimplify the process and tend to choose an advisor for the wrong reason.  Even the fee structures between advisors can be confusing when the services offered are almost identical.  Some advisors that charge based on assets under management use a tiered fee approach and others use breakpoints.  We'll examine the two approaches in the next installment.

Photo by Brian Hillegas

Most potential clients are completely unaware of the bifurcated standard of care that exists between broker-dealers and Registered Investment Advisors.  Most of the so called "advisors" that work for major financial services firms are registered representatives of a broker-dealer.  Broker-dealers and their representatives are regulated by FINRA, the Financial INdustry Regulatory Authority.  FINRA is a self-regulatory organization of broker-dealers.  The standard to which FINRA regulated firms are held is called suitability.  In other words, if a product meets the FINRA definition of "suitable", it can be sold to a client.  This does not mean that it is the best product for the client.  In fact, it frequently is the product that pays the salesman (his card won't say that - he or she will be a "financial advisor" or "wealth manager" or an "asset preservation specialist", etc) the highest commission.  And, that's OK under the FINRA suitability standard.

On the other hand, Registered Investment Advisors (RIAs) are regulated by either the Securities and Exchange Commission (SEC, for larger advisors) or by the state regulatory authorities (for smaller advisors).  RIAs are held to a fiduciary standard.  The fiduciary standard is the highest standard of care under the law and requires that the RIA put the client's best interest first at all times, including putting it ahead of its own interest.

There is a vast difference between the two standards.  Knowing this, you may ask yourself why anyone would ever choose the lesser of the two.  It comes down to ignorance and obfuscation.  Most clients have no idea that the two standards exist.  Most broker-dealer representatives (aka salesmen) don't exactly go out of their way to explain it.  And, since more than 90% of the "advisors" out there are really FINRA regulated salesmen, the voice of the RIAs is often unheard through all the noise.  Nevertheless, this is extremely important and we can't imagine why anyone would choose to do business with an advisor that provides a lower standard of care.