By: Reed C. Fraasa, CFP®, AIF®, RLP®
Join Reed Fraasa from Highland Financial Advisors as he demystifies the world of financial advisor fees in this comprehensive video series. Learn about transaction costs, product-related expenses, and advisor fees to make the best decisions for your financial future.
Introduction
Hi, I'm Reed Fraasa from Highland. Thank you for joining us on this video series. You can click the link below to subscribe at any time. We hope this video series helps you, the consumer, learn more about the financial services world and how it works.
Making an Important Decision
This is one of the most important decisions you may make in your life. You can choose to do this on your own, but if you decide to work with a financial advisor, there's going to be a cost associated with that. You want to make sure that you're making the right decision, and that's what I'm going to talk to you about today: all the costs that you need to be aware of when you decide to work with a financial advisor. Some of these costs are relative to you working on your own.
Previous Video Overview
In my previous video, I talked about questions you should ask about how the financial advisor is unique, what services they provide, and what their purpose is. I suggest you go back and watch that if you haven't. But today, I'm going to talk about three things around cost.
Evaluating Cost and Value
First, I love this quote from Warren Buffett: "Cost is what you pay; value is what you receive." So, in any kind of transaction, you always need to evaluate cost and value, cost and benefit. When I plan a vacation, the first thing I do when I'm looking at hotels is go straight to the booking page to see what it's going to cost me for the room. If it's outside my budget, I don't care what the amenities are or the location; I'm not going to book it. So, cost is always in the back of our minds.
Client Concerns About Costs
I know when a new prospective client comes into our office and we start talking to them about what relationship they're looking to have, in the back of their mind, they're always thinking, "What's the cost? What's the cost? What's the cost for this?" If you look at our website, HighlandPlanning.com, you'll see at the very top of the homepage the very first thing you see is a full transparent disclosure of our fees. We don't want people going through our website, getting all excited, and then realizing there's a cost for this. So, it should be very transparent. I challenge you to go to other advisors' websites and see if they have such clear, transparent disclosure of their fees.
Types of Costs
Transaction Costs
There are three types of costs that you could incur. The first one is the cost of transactions. What potential costs could you incur as a consumer if you buy or sell things?
When it comes to securities, you can't buy or sell a security—that would be a stock, a bond, a mutual fund, or an ETF—without incurring a transaction cost, and that must be done through a broker-dealer. Now, a broker-dealer could be a Wall Street firm, an independent broker-dealer, or an insurance-based company. If I want to sell something and you want to buy something, the broker-dealer is going to facilitate those trades, matching up our orders. That's called a broker trade. If they have their own municipal bonds that they're holding in their portfolio at the company, and I want to buy one of those and they sell that bond to me, they're acting as a dealer, and that's where the term broker-dealer came from.
Typically, in most broker-dealers today, if you buy or sell a stock, bond, or ETF, there's no transaction fee to you directly. A mutual fund could have no transaction fee, or there could be a cost for it, but typically, the costs are not more than $10, $20, $30, or $40 to buy or sell something, and you're not buying or selling a lot.
Internal Product Costs
The second area of cost that you should be aware of is the internal cost of the product you're buying. If you buy a mutual fund or an ETF—these are two different types of mutual fund investment companies—there is going to be what's called an expense ratio. That's the operating cost for these investment managers to be able to pay their salaries, their building rent, and everything else to operate. ETFs are typically less expensive than mutual funds. But there are other products out there that you may own or be pitched to you, like annuities or life insurance, which can have much higher costs. You must understand what you are getting for that cost. You may be paying for a feature or a service on that product that you don't need and didn't even know you were paying for it. So, it's important to understand all the costs. You must ask questions and make sure you understand what those costs are related to the products you're buying.
If you're looking at the total cost of an investment portfolio, you really want to understand the average total weighted cost of all the positions you have and what their associated costs are.
Advisor Fees
The third cost is the advisor's fees. What do you pay the advisor, and how do you know if that's a good price for the value you're receiving? If you're receiving investment management and financial planning, typically, people will package that as wealth management under an ongoing fee based on the assets that they are advising on. This is where a lot of people get confused because they don't understand how much of that fee is for picking and managing their investment portfolio and how much of that fee is for the financial planning advice. That's a great question to ask to understand that. You should ask an advisor how much of this fee goes for investment picking and how much of this fee goes to providing ongoing advice and monitoring financial planning.
We know from our experience that about 75% of our fee is for financial planning advice and ongoing monitoring, and only about 25% of our fee goes towards ongoing investment management costs. If you look at the industry, the average cost out there with independent investment advisors is about 1% up to $1 million, sometimes $2 million. So that 1%, how did that come about? Where did 1% come from? Most people think it originally came from the mutual fund industry back in the '60s and '70s. The mutual fund industry primarily had three types of share classes to buy a mutual fund.
One was A shares, where you pay an upfront commission to buy shares in a mutual fund, and then the more you put with that company, you would get breakpoints.
The second was B shares, where the mutual fund companies needed to start competing with the low-cost index no-load providers. To do that, they came up with the idea of a B share where you put your money into the investment, paid no upfront cost, so 100% of your money got invested. As long as you held it for at least five years, you didn't pay a charge if you left, but if you sold it within the first five years, there was typically a declining sales charge.
The third class was C shares, where there was no back-end charge and no front-end charge. Instead, the mutual fund company charged a 1% fee. The person thought they were getting something with no front-end cost and no back-end cost, but there was an ongoing cost. That 1% that the mutual fund companies came up with, when brokers started to leave their employers and form their independent companies, really translated to become the fee that everyone started charging. Did they pull it out of a hat? No, but not far from it, because again, what's the value of the services they're providing for that?
In our opinion, if all you're receiving is investment selection and picking investments for you, 1% is probably overpaying in today's market. If someone has a proactive financial planning service, you will realize the value of paying that 1% and then managing your investments. If they're not and are only providing investment picking for you and perhaps reporting on that, if you're paying much more than a quarter of 1%, you're probably overpaying.
Evaluating Your Advisor's Value
So, in any relationship with a financial advisor, you need to evaluate what you are receiving for that fee. What I've just been talking about is the most common fee structure for an independent advisor, which is an ongoing fee. Now, you could also pay that at a broker-dealer because they can be dually registered. They could have a registered investment advisory operation and a brokerage operation. They may have you in some accounts where you're paying a fee and other accounts where you pay a commission. You may be told that by having some fee-based accounts and some commission-based accounts, they're diversifying you, but that's not what they're doing. They're actually diversifying the revenue sources for the broker-dealer. There is no diversification concept on paying fees of one kind or another. When we talk to people about diversification, it's a very different concept. It's about diversifying for risk, not about sources of income for the company.
Typically, the asset-based fee is the most common form, but you may also find a financial advisor or financial planner who's willing to work with you on an hourly basis. I suggest that if you have a pretty simple situation or you're just starting out, you're going to be better off paying someone by the hour for a few hours a year to help you make better decisions to get started. Later on, you might transition to something else, but it might be in your best interest to just pay someone for a few hours. Other planners will have a project-based fee, so they'll charge you a fee for delivering a financial plan start to finish. Or they may charge you an annual fee where they provide financial planning advice to you with no investment management for the year at a cost based on a quarterly payment. There are any number of ways, and you need to ask the
Questions: In what ways do you charge fees? How do you offer services? What are my options?
Adding Value Beyond Fees
There are things that we do that add value, such as helping people with decisions on their estate documents, insurance products, tax planning decisions around their portfolio, rebalancing, tax-loss harvesting, and all the different things we do for our clients on an ongoing basis, year after year. We believe that adds value above and beyond our fees. I can tell you this: for most relationships, the fee that you're going to pay an advisor over the life of the relationship is not the thing that's going to keep you from reaching your goals. More often than not, it's your behavior and decision-making around things that can be most costly, assuming you have a good advisor who puts your interests ahead of themselves.
Conclusion
Well, that wraps it up. I really thank you for watching. If you'd like to schedule a call with one of our advisors, please click the link below or go to our website at HighlandPlanning.com, and you'll have an opportunity through a calendar link to block out a 15-minute phone call with one of our advisors. We offer a free initial consultation to anyone whom we feel we may be a good fit for, so please don't hesitate to reach out. We want to make sure that everybody understands the decision they're making and that we can help you get with an advisor who would put your interests first.
Have a great day. Thank you.
Reed C. Fraasa is a CERTIFIED FINANCIAL PLANNER™ and founder of HIGHLAND Financial Advisors, a Fee-Only financial planning firm that offers comprehensive financial planning, retirement planning, and investment management. Reed has 30 years of experience as a fiduciary advisor and is the author of The Person is the Plan®, a unique financial planning process. Reed was a frequent guest contributor on PBS Nightly Business Report and has been featured in the New York Times, Wall Street Journal, and Star Ledger newspapers.