BE AWARE that there are many, many advisers who profess to offer "objective" or "trusted" advice, but who don't operate as fiduciaries. And - due in large part to a weak U.S. Securities and Exchange Commission application of the fiduciary requirements of the Investment Advisers Act - even those who are required to be "fiduciaries" by law often "disclaim away" their fiduciary obligations, or seek client "waivers" of core fiduciary obligations.
In other words, even if your adviser says "I am a fiduciary" and/or "I act in your best interests" - you need to DIG DEEPER!
This article, and checklist, can be utilized by consumers to TEST their current financial or investment adviser. Or, it can be utilized as consumers shop for an adviser. Good luck with your search!
NOT ALL "FIDUCIARY" INVESTMENT ADVISERS, FINANCIAL ADVISORS, WEALTH MANAGERS, AND/OR FINANCIAL PLANNERS PRACTICE AS TRUSTED ADVISORS
Several readers have asked me for a list of questions which consumers can ask, when interviewing a financial or investment adviser. In forming this checklist, I emphasize that the chosen adviser should, at all times:
- function in a fiduciary capacity, AND
- without any waiver or disclaimer of their fiduciary obligations, AND
- possess the requisite knowledge to provide financial planning and/or investment advice as a true expert.
Other advisers "disclaim" away their core fiduciary duties. Fore example, many "fiduciary" advisors state that they don't provide tax advice in any form - even though a tax-efficient investment portfolio is one of the many keys to long-term success for their clients.
Hence, I suggest additional questions consumers can, and should, ask of their current or prospective financial and/or investment adviser.
[Preliminary note: The term “adviser” and “advisor” are used interchangeably. Technically a “registered investment adviser” is spelled that way, while in current United States English the spelling “advisor” is more often seen. Over the last decade the American usage has been migrating to "adviser."]
I believe most individual (and institutional) clients possess a reasonable expectation that the investment strategy which is recommended satisfies the due diligence requirements under the “prudent investor rule.” In this regard, the adviser should submit to the client, upon request, the evidence (either academic research, summarized, or back-testing in an objective manner) which supports the proof that the requirements of the prudent investor rule are met.
- NOTE: The prudent investor rule (PIR) is a very tough standard. It requires the construction of a portfolio that emphasizes diversification in order to minimize idiosyncratic risk (also termed "diversifiable risk" or "non-systemic risk"). The PIR also requires that the investment adviser not waste the client's assets; in general, a lower-cost investment product that achieves the same objectives is required to be chosen over a similar higher-cost investment product. In this author's experience, many financial advisers either do not understand the requirements of the prudent investor rule, or they simply don't undertake the requisite due diligence (on both investment strategies, and investment products) to adhere to it.
- The Department of Labor applies the PIR to ERISA-covered accounts, such as 401(k) and a few 403(b) accounts. Effective April 10, 2017, the PIR also applies (in most instances) to all types of individual retirement accounts (IRAs); however, challenges to such rule exist in both the courts and in Washington, D.C.
- It is possible that a client may desire a more aggressive, or less aggressive, investment strategy be utilized - that does not meet the requirements of the PIR. Or a speculative strategy; perhaps one based upon the adviser's qualitative macro-economic analysis. Investment strategies flowing from qualitative analysis are difficult to "back-test" - and nearly always cannot be supported by quantitative academic research.
Hence, when a strategy is utilized which does not meet the dictates of the prudent investor rule, the additional risks inherent in such strategy should be disclosed to the client, and the potential rewards also explained. Such an explanation should be thorough, in my view, given the importance of this issue.
Don’t take any excuses here. As a consumer, it is very difficult to later prove what is not in writing. Require your (prospective or current) financial adviser to place his or her answers to these questions in writing. If they don’t or won’t, chances are they have something to hide, and don't want to reveal the truth about their practices.
If you cannot obtain the answers to these questions in writing, then just walk away!
- Are you a fiduciary under the law, and will you continue to be my fiduciary at all times during the adviser-client relationship we will enter into, and with respect to all of my accounts with you and all of the advice you provide to me?
If the adviser is unwilling to act as a fiduciary to you – i.e., meeting the standard of due care as an expert adviser, acting with the highest degree of loyalty to you and in your best interests at all time, and with complete candor and truthfulness – this adviser does not deserve your consideration. Period. End of story.
- Fiduciary relationship, in which the adviser acts on your behalf, “stepping into your shoes” and always acting in your best interests; or
- Salesperson/customer relationship - the person before you seeks to use planning, education or advice as a means of selling products to you. In this instance the person is not a fiduciary. While “suitability” applies (“everything recommended to you will be ‘suitable’ for you”), this is a very low standard that does not require that the best investment products are recommended for you (in fact, many very expensive, poor products are recommended under the suitability standard).
Beware cash value life insurance. Yet, cash value life insurance (i.e., "permanent life insurance" should ONLY be sold when a permanent insurance need exists, in this author's view. Whole life, universal life, equity-indexed universal life, and variable universal life are simply too costly to warrant consideration as investment vehicles. In the absence of a permanent estate tax liquidity problem (rare today, given the nearly $6m per person estate tax equivalent exemption, and spousal portability), cash value life insurance should NOT be obtained by consumers. Term life insurance (with a conversion feature) is much more appropriate.
Beware annuities! Another product that is often sold on a commission basis are annuities. Yet, there do exist low-cost variable annuities and low-cost immediate fixed annuities, that pay no commissions. (Equity index annuities, also called fixed index annuities, are nearly always sold on a commission basis; however, as of the time of this writing - Dec. 2016 - this author has not yet encountered any equity index annuity product that meets the author's due diligence test. The problem with equity indexed annuities is not the concept behind the product; rather, the problems include the design of the annuity product that puts far too much control in the insurance company, imbeds too high a cost structure within the annuity, and in many cases the relatively low financial strength of the insurance company).
2. What services will you provide? Can “financial planning” advice be separated out from your “investment advisory” services?
Review that contract carefully – and make certain you understand all of the services you are receiving (or not receiving). Discuss each service with your advisor. Have your advisor revise the written agreement to reflect any detail, as to services provided, which might not yet be in the document.
Yet, more comprehensive financial planning services can usually be "unbundled" or separated from investment advisory services.
More comprehensive financial planning can also be undertaken in a variety of different ways:
- For clients with greater planning needs, realize that the financial planning process, for a new client, can take time. It may be a “comprehensive financial plan” presented all at once, or the financial planning recommendations may be presented and reviewed in a series of meetings in which certain specific issues are addressed at each meeting.
- After an initial financial planning is undertaken, for some clients revisions to that plan may not be required for several years (absent some change in your circumstances). In such a circumstance, expect to pay more for financial planning in the first year, and less in subsequent years.
- For most clients, however, financial planning needs are ongoing. In this sense, financial planning is not an "event" or a "plan" - but rather a "process." Financial life coaching is often provided under these types of arrangements. Ongoing tax advice is also likely to be provided.
True fiduciary advisers know that the mere receipt of material compensation from anyone else, other than the client, could influence them (consciously or unconsciously) when they make a recommendation to you. This means that the adviser may not be acting in your best interests, but rather in the adviser’s interests. And, as explained below, fees and costs matter.
- Should you invest funds you possess, or pay down debt instead?
- Should you make lifetime gifts to others, and if so how much?
- Should you purchase a lifetime immediate annuity?
4. Will you be recommending any “proprietary products” to me? Will you be engaging in any “principal trade” with me?
5. What are the “total fees and costs” I will pay with regard to my investment portfolio – including the fees and costs charged by the products you recommend, as well as your own advisory fees – on an annual basis?
Here’s a suggested maximum amount of the total fees and costs for investment advisory services for different sizes of an investment portfolio. There are many investment advisers who provides investment supervisory services for less than the TOTAL FEES AND COSTS shown below:
Size of the Portfolio
Maximum Total Fees and Costs: Includes the Investment Adviser's Fees, and Product Fees (both the Annual Expense Ratio as well as estimated transaction and opportunity costs that exist within pooled investments such as mutual funds and ETFs)
2.00% or less
$75,000 to $200,000
1.75% or less
$200,000 to $500,000
1.25% or less
$500,000 to $1,000,000
1.20% or less
$1,000,000 to $2,000,000
1.10% or less
$2,000,000 to $3,000,000
0.95% or less
$3,000,000 to $5,000,000
0.80% or less
0.75% or less
NOTE: The following should be included in any "total fees and costs" analysis provided to you:
- The effect of sales loads (commissions) for the holding period of the investment product (or, for a maximum of 10 years);
- The annual expenses, as shown in any disclosure of "annual expense ratio" or similar. For a mutual fund, these might include:
- fund management fees;
- fund administration costs;
- 12b-1 fees;
- The "implementation shortfall" costs of management of any pooled investment fund, which can be estimated by a firm or adviser for each fund the firm/adviser recommends. These might include:
- Market impact costs;
- Bid-ask spreads and/or principal markups/markdowns;
- Opportunity costs due to delayed or canceled trades;
- Brokerage commissions paid for effecting securities transactions within the pooled investment fund;
- Opportunity costs due to maintenance of cash holdings within a fund;
- Offsets to fees occurring due to securities lending ratios;
- Costs of hedging the portfolio, if hedges are utilized; and
- Costs likely to be incurred if redemption fees apply.
Explanation. Fees and costs matter. As the founder of Vanguard Funds and consumer advocate John Bogle recently stated, “the magic of compound returns is overwhelmed by the tyranny of compounding cost. It’s a mathematical fact.” In his article, "The Tyranny of Compounding Costs," John Bogle used the following illustration. If an individual made a $1,000 investment at age 20 and received 8% annualized returns, the account balance would grow to $109,358 by age 80. If a 2.5% annual management fee was added into the equation, the ending account balance would only be $26,206. Over the 60 years, these annual management fees eat up a staggering 76 percent of what the investor would have earned with no management costs.
- The advisor’s separate advisory fee (whether paid as a percentage-of-assets managed fee, as a flat annual retainer, as a project fee, or on an hourly basis);
- The mutual fund’s annual expense ratio – which is the sum of the fund’s management (investment advisory) fee, administrative fees, and 12b-1 fees (which, as I’ve noted above, should be avoided);
- The mutual fund’s brokerage commissions resulting from trading within the fund (these can be discerned and quantified by an expert advisor) - an up-front commission might be divided by 10 to determine the long-term impact of the commission (i.e., in determining the annual impact of the commission); a higher denominator might be utilized if the mutual funds sold are not typically held for 12 years or longer).
- What greater annual rate of return must a 5.75% load fund earn, ali other things being equal, if the benchmark earns a level 10% annually, to break even with the benchmark?
- If the fund is held for only 5 years, the fund must earn 1.20% more, each year, over that period, to "break even."
- If the fund is held for 10 years, the fund must earn 0.59% more, each year, over that period, to "break even."
- If the fund is held for 15 years, the fund must earn 0.43% more, each year, over that period, to "break even."
- If the fund is held for 20 years, the fund must earn 0.32% more, each year, over that period, to "break even."
- If the fund is held for 25 years, the fund must earn 0.26% more, each year, over that period, to "break even."
- Note that the average holding period for stock mutual funds is about 4 years, and for bond mutual funds less than 3 years, according to the Investment Company Institute.
- Since rebalancing of an investment portfolio requires selling asset classes (and funds within them) that go up in value, while purchasing those asset classes that have lagged, even a "buy-and-hold" strategy requires some sales of mutual funds, over time.
- In essence, in this author's view, commission-based product sales are inconsistent with the prudent investor rule, specifically, and inconsistent with Modern Portfolio Theory in general.
- The mutual funds’ transaction and opportunity costs, relating to trading within the fund. Market impact and transaction costs can be estimated by an expert advisor, based upon the level of trading volume actually occurring within the fund and based upon the asset class in which those stocks are located. Opportunity costs due to cash holdings within the fund can likewise be estimated.
I recommend that consumers receive advice from only expert financial advisors and/or investment advisers. How can a consumer judge this? It’s difficult.
- Certified Financial Planner™ (CFP®). This certification indicates a broad base of foundational knowledge in all areas of financial planning. The minimum requirements to attain the certification include a 4-year college degree (in any field), six foundational courses (each a 3-semester-credit hour equivalent) in financial planning and investment topics, the passage of a tough 6-hour national exam, and adherence to the CFP Board's conduct standards. This is the most well-known (from the standpoint of consumers) of the various designations in financial services.
- Certified Public Accountant / Personal Financial Specialist (CPA/PFS). Roughly equivalent to the CFP® certification in terms of the required knowledge of financial planning subjects. But, the designee must also be a Certified Public Accountant. This typically indicates a solid knowledge of finance and individual income taxes - both areas that often propel CPA/PFS holders to be some of the best financial planners out there, on average.
- Chartered Financial Analyst (CFA). This designation is the toughest to obtain. Recently more "wealth management" topics have been embedded into the course of study, which requires significant study over the course of 1.5 to several years and three day-long tests along the way. However, the focus of the course of study remains on investment theory and principles. Nevertheless, for those within the investment advisory industry, this is generally the most respected designation - even though consumer recognition of the designation lags.
However, please note - rely upon these designations ONLY for their indication of competency. Not all holders of these designations practice as "bona fide fiduciaries" in my view.
7. Have you ever been cited by a professional or regulatory governing body for disciplinary reasons?
Disclosures of disciplinary history can be found in Form ADV, Part 2B (the “Biography” disclosure document of an investment adviser), and on the advisor’s Form U-4. Ask for and review both of these documents.
There has existed ongoing controversy over the number of "expungements" of complaint history which are permitted by the broker-dealer self-regulatory organization, FINRA. Hence, the absence of the indication of a complaint in the database does not ensure that no complaint was ever filed against the person. Perhaps one way to counter excessive expungements is to do a Google search of the adviser's name (perhaps with the name of her or his firm, and/or her or his location - such as town or city - of her or his office). However, since many firms have mandatory arbitration agreements, and seek to keep arbitration awards "secret" (i.e., non-disclosed to the public), a Google search is not a guarantee, either.
8. Will you sign this fiduciary oath?
(2) I will act with prudence; that is, with the skill, care, diligence, and good judgment of a professional.
(3) I will not mislead you, and I will provide conspicuous, full and fair disclosure of all important facts.
(4) I will avoid conflicts of interest.
(5) I will fully disclose and fairly manage, in your favor, any unavoidable conflicts.
- How long have you been in business?
- How many clients do you possess?
- Do you engage in any other business activities?
- In what accounts (i.e., with what custodian) will my investments be held? What safeguards exist to ensure my funds are not stolen?
- Who in your firm will be working with me? You? A junior advisor? A team of advisors? Others?
Again, I stress that these answers should be obtained in writing from your financial/investment adviser and/or her or his firm. Far too often in arbitration proceedings verbal statements made by advisers, to their clients, are not admitted into evidence, as the contract (client services agreement) signed by the client contained a "merger" clause. More often than not, in arbitration proceedings verbal statements made by the advisor are also denied. Get it in writing!
Consumers searching for an adviser are much more likely to find advisors who correctly answer all of the questions above by visiting these web sites:
Garrett Investment Advisers (http://garrettinvestmentadvisors.com) - and its "Find An Advisor" search tool. (By way of disclosure, in March 2016 I transitioned by own practice into this firm, which has a few dozen advisers around the U.S. as of March 2016.)
XY Planning Network (http://www.xyplanningnetwork.com) - and its "Find An Advisor" search tool. This organization has grown rapidly, and has over 200 firms as of March 2016.
Alliance of Comprehensive Planners - http://www.acplanners.org/home, and specifically to its "Find an Advisor" search function located at http://www.acplanners.org/findanadvisor. The Alliance has a few hundred advisers, I believe, as members as of March 2016.
What About the CFP Board and the Financial Planning Association? Be aware that being a certificant (with the Certified Financial Planning Board of Standards, Inc.) may guarantee a baseline level of competence, but does not ensure that the advisor follows a bona fide fiduciary standard at all times.
Nor does membership in the Financial Planning Association ensure that the advisor follows a bona fide fiduciary standard at all times.
While both of these organizations provide valuable benefits to their members, and both organizations promote adherence to high professional standards of conduct, in this author's view consumers should not rely upon the "find an advisor" tools of these organizations.
Likewise, several other organizations often tout the "fiduciary status" of their members, or state that their members are required to act "in the best interests" of the member's clients. As indicated earlier in this post, there has been a denigration of the fiduciary standard over time - some would say an evisceration. Hence, it is important to not assume that just because someone calls themself a "fiduciary" or states that they will "act in your best interests" does not necessarily mean that they adhere to the highest standards of prpfoessional conduct. Use the questions above to determine if the person is a true, bona fide fiduciary who avoids (rather than just discloses) conflicts of interest, and who is a true expert, and not a mere "pretender."
I hope that the checklist above, and other information provided, can serve to guide consumers in the right direction - toward true fiduciary advisors who are both experts and keep their clients' best interests paramount at all times.
All consumers should interview several advisers before deciding. Fees and costs are a primary determinant, but not the only one. Expertise should be ascertained. And the adviser's investment philosophy should be aligned with your beliefs and comfort level.
GOOD LUCK WITH YOUR SEARCH!