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“So many hidden numbers”: how advisors give their clients the vampire treatment

Ed Latka was never schooled in the finer points of investing, so the 58-year-old did what tens of thousands of people do every year: He entrusted his financial future to a professional.

It’s been a disastrous decision. After a term deposit matured, he gave the cash to his financial advisor and, at her suggestion, sunk it into a managed fund.

He’d used a financial advisor for nearly three decades, but unlike in years past, Latka decided to read the fine print of the fund his advisor chose and noticed a hefty up-front sales charge. He was floored.

“I just spent a whole year’s interest from a term deposit to invest in this managed fund,” Latka said. “What have I been doing for the past 30 years?”

The vampire treatment
Latka, who is on disability after a lifelong struggle with diabetes, now faces a bleak retirement outlook, despite conscientiously saving throughout his career.

“I’ve read about compounding interest and if my money was kept in one place — even the most conservative one — I’d be OK today. But she was moving stuff around constantly,” he said. “What’s so scary about this when I look back is there are so many hidden numbers.”

Latka is hardly an isolated example. His story speaks to the misaligned incentive schemes of many advisors, the general lack of transparency in the broker-client relationship, and the importance of being an active and engaged client — even if you’re a novice.

University of California, Berkeley behavioral finance expert Terrance Odean urges clients to simply open their mouths. “Don’t be afraid to talk about fees, and don’t hesitate to ask, ‘Why are you charging me this much?’” He paused, and then reiterated: “You should always know how much you’re paying.”

Latka was never quite clear how he was paying for the services of the advisor. “I never got a bill, just the prospectuses,” he said. By chipping away at clients’ savings each year, fees are portfolio killers, as Latka’s story demonstrates. It’s worth understanding them in full.

There are three primary ways a broker or advisor gets paid:

1. Commissions

2. Asset-based fees

3. Hourly/project-based fees

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Some of these fee structures are inherently better than others. But they all cost you money, and as New York Times columnist and financial advisor Carl Richards told us, “Any time there’s an exchange of money for services, there’s a conflict.” The key is for customers to understand the potential conflicts and to choose a model that’s right for them.

Commissions
The most painful fee structure for clients’ portfolios, and the one that comes with the potential for the most perverse incentives, is the commission-based model.

Latka learned this the hard way. His advisor had plenty of ideas for his portfolio. Seemingly every time they met, she had a new place for Latka to move his money — Internet funds, foreign-stock funds, oil and gas funds, you name it.

It was only much later that Ed learned that how he was paying his advisor and her glut of ideas were intimately linked. For a broker or advisor who’s paid by commissions, every time a stock, option, fund, insurance product, or other asset is bought or sold in your account, it probably means income for your triggerman (or woman).

I asked one key question of all the brokers, advisors, clients, academics, and regulators I interviewed: “Does the commission model ever work out for the client?”

Josh Brown, a financial advisor, blogger, and author of the scathing new book Backstage Wall Street, responded bluntly: “No. No qualifiers.”

The closest to an affirmative response were a few mumbled replies about how a commission up-front can be advantageous if the client only trades rarely (as if a broker would let a client get away with that).

In Backstage Wall Street, Brown rips into the model further: “If you sat down with a team of economists, engineers, psychologists, and business ethics professors, you simply couldn’t create a worse structure, no matter how hard you tried.”

Why is this model so terrible? For one, the fees tend to be egregious. Many broker-sold funds include front-end fees of as much as 5.75%. With fees like that, trading even a single time per year can seriously hobble a retirement portfolio. Looking back at the past 20 years, a low-cost S&P 500 index fund would have turned an initial US$100,000 investment into more than US$300,000. But if you paid a 5.75% load once every year, you would’ve ended up with just US$88,000 — turning what should’ve been a big gain into a loss.

As awful as the fees are by themselves, the incentives that they set up can be downright laughable. While a client may be hoping for wise counsel from their broker, if that broker is compensated based on commissions, then that broker may be more focused on selling the product that pays them the most, and not the one that’s best for the client’s long-term financial health. Imagine a doctor that gets US$5 for every Lipitor pill he prescribes — how many prescriptions do you think he’ll write for a competing cholesterol drug, no matter how good it is?

Jim Betzig, the chief operating officer of the US$1.5 billion Beirne Wealth group that broke away from Bank of America‘s (NYSE: BAC) Merrill Lynch unit, said that a big part of the split was the fact that the group “[didn't] want to be product pushers.” And even though they tried to avoid commission products while at Merrill, the group “wanted to get away from conflicts of interest” that are inherent in the commission-based model.

And because many of the fees are triggered by trading activity — buys and sells — the commission model encourages trading. Classic behavioral finance research from Odean and UC Davis’ Brad Barber titled “Trading Is Hazardous to Your Wealth” boils down to this: Trading is hazardous to your wealth. The pair of academics showed that the more investors tended to trade, the worse their accounts performed. Or, as they put it, “investors … pay a tremendous performance penalty for active trading.”

A better way
Moving from commission-based brokers and advisors to those that charge asset-based fees is a gigantic step forward. Carl Richards called it “the best model I’ve seen.”

This model can be head-slappingly straightforward. Each year, the advisor charges a percentage fee based on the total value of the client’s account assets. If a client has US$100,000 in her account and the advisor’s fee is 1%, the client ends up paying US$1,000 for the services.

A former engineer, David Shucavage came into the financial advisory business from the outside. Now a fee-based financial advisor with Carolina Estate Planners, Shucavage recounts that he just couldn’t make sense of what he calls the “fundamentally flawed” commission-based model. Shucavage swiftly shifted his practice toward asset-based fees. As he describes it:

There is a bias if I’m paid by the fund that I’m putting you in, so I switched to an asset-based fee model. My goal now is to make the pot bigger and I’m free to move it to anything that will achieve that goal. If, for example, I’m looking for a product for you, I’m going to look for an ETF with the lowest fees — in this model fees not only hurt you, but my profit is hurt as well!

That the incentives of the advisor and the client are aligned is a big selling point of this setup.

But this system isn’t without its potentially confusing gray areas. Josh Brown, who uses the asset-based fee model in his own practice, told me that “fee-only is the only way to go.” But keep in mind: Fee-based is not fee-only.

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“Fee-based” leads to different meanings for different advisors. For instance, many advisors have adopted fee-based practices that let them charge a fee based on the amount of your assets and collect commissions from certain products they sell you.

This isn’t to say that customers should avoid advisors that are fee-based, but an extra level of diligence is necessary to determine exactly what fees are charged outside of the overall account fee. An advisor that hits a client’s account with both account fees and transaction fees has the potential to do even more damage to that portfolio than the commission-based cavemen derided above.

Is this the best there is?
For brokers and advisors, there is some magic to both of the compensation schemes above. Both allow practitioners to charge clients reasonably high fees without those clients really feeling how much they’re actually paying.

In a 2005 paper, Odean and Barber, along with Lu Zheng from the University of Michigan, show that investors do the most to avoid mutual fund fees that are the most obvious to them, not necessarily the most costly. That’s why so few advisors use hourly or project-based fees. While commissions and asset-based fees simply get taken directly from investment accounts, an hourly fee model requires that investors pull out their cheque book for the services they’re purchasing.

For anyone who’s ever hired a lawyer, accountant, gardener, or personal trainer, this idea won’t seem novel. Yet because it competes against models that doesn’t make customers write a cheque, hourly fees have yet to catch on in any meaningful way — even though they’re completely transparent and give advisors incentives to provide a good experience.

Still, it’s not without potential hiccups, such as padding hours or executing tasks slowly. Also, Richards pointed out that with this model investors may refrain from calling their advisor at important times simply because they don’t want to write another cheque. But overall, this really is a great system — as long as clients stay involved and are interested in what’s going on.

Beyond fee structures
Though many advisory clients can end up feeling intimidated by their advisors, it’s vital that they remember that, in the end, the advisor is working for them. Berkeley professor Odean’s advice is that advisory clients should “always know how much [they're] paying” and should not hesitate to ask, “Why are you charging me this much?”

Jim Weddle, the managing partner of Edward Jones — a perennial favorite of JD Power’s investment firm rankings — recognises the importance of being clear about fees and compensation. “A better-informed client is a better client at the end of the day,” he told us. Weddle says that Edward Jones trains its advisors to “show clearly how they’re compensated.”

A good broker or advisor should be able to walk a client through exactly what the client is paying and how that advisor is getting compensated in a way that the client understands. Current or prospective customers will want to think twice about any advisor that is unable or unwilling to do this.

When not to trip over fees
Len Hayduchok, the principal at New-Jersey-based Dedicated Senior Advisors, points out, “It’s not about fee versus commission, it’s about value.” That is, as long as investors have a transparent picture of what they’re paying — a precondition Hayduchok concedes is still often sorely lacking — clients should be most concerned with the value of the services they get compared to their cost. For instance, commission-based brokers may fall at the bottom of the list of ideal compensation structures, but that doesn’t mean that reputable brokers can’t create honest, valuable relationships that are worth keeping.

This is a theme that also rings true for Professor Andreas Hackethal. Hackethal is the dean of Goethe University’s business school in Frankfurt and has not only written extensively on the subject of financial advice, but has helped advise the German government on the issue. In an interview, Hackethal emphasised that the form that compensation takes shouldn’t necessarily be the focus:

We could discuss what the best incentive scheme and investment scheme is, but that’s not necessary … pay schemes are an input — what you want to look at is the output. With greater transparency, we could have a competition of advisory models based on which produces the best results.

Get educated
If only Latka had known to look out for all of this sooner. After years of his portfolio getting the vampire treatment from an assortment of fees, he now faces an uncertain financial future.

What’s worse is that most of Latka’s money had been invested in annuities – an insurance product that typically carries a monster commission for the salesperson. The investment was made a few years before Ed had any idea what an annuity was, let alone that the product locked up his money for seven years.

Even after all of this, he’s not interested in throwing anyone under the bus — he asked specifically that we not mention his advisor’s name or even her company. He says, “It’s my own fault for not really studying this stuff.”

His horror story provides a valuable lesson: When someone else manages your finances, what you don’t know can hurt you.

It’s essential that you understand the basics of how the financial advice business works. What you don’t understand, get your prospective advisor to explain to you. I cannot emphasise this enough: If they can’t or won’t explain that to you, then it’s not the right relationship.

Latka now believes anyone can learn this stuff. Despite a complete lack of interest or schooling in the subject, he told us that he started reading online “with the most basic investing 101.” By the time we talked to him, it was hard to picture the clueless Ed Latka he told us about.

There are myriad reasons that an advisor relationship can benefit an investor. But as the experience of Ed Latka — and, sadly, countless other investors — shows, if you don’t take the time to understand the basics of how this business works, you may end up in the wrong relationship. And that will cost you for years to come.

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The Motley Fool‘s purpose is to help the world invest, better. Take Stock is The Motley Fool’s free investing newsletter. Packed with stock ideas and investing advice, it is essential reading for anyone looking to build and grow their wealth in the years ahead. Click here now to request your free subscription, whilst it’s still available. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

A version of this article, written by Matt Koppenheffer, originally appeared on fool.com

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