The Financial Advice Industry
Is it just me or does every financial advisor seem like a sleazy used car salesman, but with a fancier suit? I used to admire financial professionals when I was younger because they were smart, well spoken and wore expensive suits. But once the day of reckoning came, a.k.a the financial crisis in 2008, the financial services industry was left completely exposed. Before 2008 most financial advisors would be compensated through commissions on each product they sold. So basically it was in their best interest to sell you as many financial products as possible, whether you needed them or not, which is pretty sketchy. Not to mention that the barriers to entry for becoming a financial advisor are pretty low. These guys aren’t former hedge fund analysts or investment bankers who understand the mechanics of finance. They’re just salesmen. Needless to say, the more I learned about financial advisors the more I didn’t like them.
However, over the past few years the financial advice industry has faced increasing pressure from robo-advisors like Personal Capital, and this forced financial advisors to adapt. Instead of the old Wall Street sales model where advisors would prey on the “Old Betsy’s” of the world, the culture has shifted towards a fiduciary model. This means that a financial advisor has to act in their clients best interest (kind of odd this wasn’t the case before). The industry currently adheres to a “suitability standard” that requires them to sell financial products that meet a client’s needs but allows the advisor to select high-fee options. For example, product A and product B both meet the needs for a particular client, but Product B costs more because the advisor gets paid a sales commission from it. There is a small conflict of interest there if the advisor decides to pick Product B. Although it meets the clients needs, was it really in the clients best interest considering Product A would have been cheaper?
According to the chart below, trust is everything in the financial advice business and the lack of it has lead to the growth of robo-advisors.
This fiduciary concern has lead to a major migration towards a fee-only business model where advisors are paid a flat fee for the services they provide. This model significantly reduces potential conflicts of interest between advisors and their clients. They don’t get a commission or a bonus for selling you something extra. A major step in this direction was the implementation of the DOL rule, which I believe is a great step towards protecting people with retirement accounts (although there’s been some political drama). However, even with these improved developments there are still good reasons to be skeptical as not all financial advisors are pure fiduciaries. But some of these new changes within the financial advice industry got me thinking that maybe my old bias towards financial advisors should also change.
The Value Proposition
As an avid stock-picker and finance enthusiast, I don’t think I will be needing a financial advisor for the foreseeable future. However, my parents inherited a large investment portfolio with a financial advisor at Morgan Stanley after my grandparents assed away. My parents are frugal and prudent with their money, but they aren’t finance junkies by any means. As such, they value the advice that this particular financial advisor has provided them since inheriting the portfolio. I’ve never met this advisor, but my parents have asked me to look through their account statements so that I could verify this advisor wasn’t screwing them over. From what I can tell this advisor seems to be a straight shooter who manages my parents portfolio the way it should be managed (low turnover, low fees, etc.). This lead me to make an attempt at understanding the value proposition financial advisors add and if I would recommend people to hire an advisor. There are a lot of people out there, including my own parents, that could have a lot to gain by having that trusted person guide them along their financial journey.
According to a study performed by the Center for Interuniversity Research and Analysis on Organizations (CIRANO), financial advice has had a significantly positive impact on growing household financial wealth, see below.
The CIRANO study noted that the major contributor to the growth in financial assets was largely attributed to savings discipline. Its just like having a personal fitness trainer who can keep you on track to reach your goals. The benefits of using an advisor actually increased over time due to the compounding effect (read: Miracles of Compound Interest).
There was also a separate study conducted by Vanguard, which found that over a full market cycle investors who used a financial advisor had an average return of 3% a year greater than individuals who didn’t use an advisor. As shown in the chart below, that adds up to a pretty hefty difference over time.
So the research shows that advisors can certainly add value to a persons financial wealth. However, can’t a robo-advisor do the same thing for cheaper?
One of the key differentiators separating human advisors from computer algorithms is in the realm beyond IRAs and taxable investment accounts. Robo-advisors are pretty limited in scope. When you need to have in-depth discussion about estate planning, taxes or managing money in retirement, an algorithm can’t give you that custom tailored advice. That’s where a human advisor can really add value.
The chart above provides an interesting view on the current landscape within the financial advisory space. To keep it simple, the robo-advisors charge the lowest fees when it comes to commoditized services (ie. automate monthly contributions) regardless of wealth status. Financial advisors add the most value when it comes to more complex services like estate and wealth planning, which typically requires a larger asset base (ie. you need to be rich).
The Wrap Up
My take on financial advisors is that they can add value when you have enough money to make the service worthwhile. My parents who now own a significant amount of financial assets could benefit greatly by utilizing a financial advisor who can provide complex wealth and retirement planning. For a young buck like myself who isn’t a millionaire (yet!), a financial advisor wouldn’t be a feasible solution. But as shown from the studies above, I would definitely recommend an advisor who can provide complex advice, assuming you have enough financial assets. Just make sure they are a fee-only advisor and ask about their fiduciary responsibilities.
For the average person I would recommend looking into a robo-advisor like Personal Capital. For services such as automating your investments or setting up financial goals, a service like this would suit those purposes very well and for a very low cost.
What do you think about using a financial advisor? Please leave a comment below!