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May 07, 2008

Financial Advisor Red Flags

I've been talking with a number of our prospects the last couple of weeks, and the stories they tell of being ripped off by various financial advisors and investment schemes are amazing. The chutzpah of some of these advisors is incredible - I don't see how they can sleep at night when they sell so many investments that are clearly designed to benefit the advisor more than the client.

I thought it would be useful to jot down some of the things to look out for when dealing with a financial advisor or broker. We'll call these Financial Advisor Red Flags. Here they are, in no particular order:

1. Invoking a dead relative in an effort to keep your account.

I met with someone the other day - I'll call her Ann - who gave this egregious example. Her husband was a rapidly climbing young executive before he died unexpectedly. Fortunately, he had life insurance.

Ann said she didn't know anything about investing, so she contacted the salesman who sold her husband the policy. The insurance guy sold her all sorts of insurance products like variable annuities. He convinced her that all these products were in her best interest. But after a couple of years, Ann looked at her investments and realized that they didn't meet all her objectives, so she called up the insurance guy and told him she wanted to pull money out.

Instead of defending the investments he sold her on their merits, he tried to shame her in to staying put. "Your husband trusted me," he said, "and he would be so disappointed in you."

I wish I could say that surprised me, but I've heard stories like this from lots of people. Some of them inherited their parents' financial advisor when they inherited money, and were guilt-tripped when they tried to move the investments somewhere else. Others said their advisor invoked the "but we're friends!" card: "But we've been in Rotary together for 20 years! I thought you trusted me!"

Any time a financial advisor uses a guilt-trip or an emotional plea to try to keep your account, that should be a big red flag.

2. Recommending variable annuities when they're not appropriate - such as in an IRA.

I've written a lot about the problems with variable annuities. They cost too much, they rely on terrible mutual funds that underperform the market, the list goes on. (You can read up on the problems with variable annuities here.) But my primary objection is that they're appropriate for only a small portion of investors. Most of us would be better off in something else.

I get particularly mad when I hear about an advisor selling someone a variable annuity inside their IRA. An IRA is already a tax-advantaged vehicle. A variable annuity is tax-advantaged, too - it makes absolutely no sense to have one tax-advantaged investment inside of another.

3. Recommending you move money out of your 401(k) or stop contributing.

This is financial malpractice at its worst. Sure, 401(k) and similar plans have their faults, but for most of us they form the cornerstone of our retirement plan.  Until you leave your employer and are eligible to roll over the money into an IRA, you probably should stick with your 401(k) plan. And if your employer matches part of your contributions, that's free money you'd be leaving on the table by shifting your savings elsewhere.

It's also a red flag when an advisor recommends you borrow from your 401(k). Treat your retirement funds as sacred. If you need cash to deal with an emergency, pretend that 401(k) money doesn't exist. If you borrow from your 401(k), you're robbing yourself of the power of compounding and exposing yourself to penalties if you leave your job before the loan is paid off.  Read more about 401(k)s here.

4. Constructing a portfolio for you with an expected annual return of less than 10%.

Many advisors still ascribe to the old way of thinking, that the best way to ensure your money lasts as long as you do is with a typical 60/40 portfolio (60% stocks, 40% bonds). But this construction is too conservative, and its expected annual return is only 8%. That 8% may give you a high probability you won't run out of money, but it almost assures you won't be able to buy anything with the money you have left.  In other words, the 60/40 portfolio doesn't take into account inflation and taxes.

To pay yourself 4% of your portfolio each year in retirement (the generally accepted "safe" withdrawal percentage), keep up with the historical rate of inflation and pay Uncle Sam at a marginal tax rate of 25%, you have to earn a 10% return. The formula is your withdrawal rate plus inflation divided by one minus your marginal tax rate, or (4 + 3.5)/(1-0.25). If you want to withdraw more or if your tax rate is higher, you'll have to earn an even higher return.

So a double-digit annual return is your goal. If your advisor builds a portfolio for you that is designed to return less than that, you should look for another advisor.

5. Recommending only mutual funds, especially those that are only available through his/her company.

I don't like mutual funds as a rule. I really don't like actively managed mutual funds because their high fees virtually guarantee over time that you will underperform the market itself. So mutual funds are bad enough - but conflict-of-interest from your broker or financial advisor makes it even worse.

A groundbreaking study by Daniel Bergstresser and Peter Tufano of the Harvard Business School and John Chalmers of the University of Oregon found that mutual funds sold by financial advisors badly underperformed the funds selected by investors on their own. The study is titled "Assessing the Costs and Benefits of Brokers in the Mutual Fund Industry," and you can read more about it here. You can also listen to my interview with one of the authors here.

A lot of financial advisors will try to steer you toward proprietary funds that are only available through their company. For example, an Ameriprise advisor may try to steer you toward RiverSource mutual funds, which are only available through Ameriprise. It's not because these funds are the best performing. It's because the financial advisor's employer pays him or her to sell the firm's product. It's another example of conflict-of-interest and is a reason to avoid commission-based advisors. For that matter, let's make accepting commissions its own flag:

6. Accepting a commission from products they sell

Any advisor who takes a commission off the products they sell you has a conflict of interest. You can't tell whether the product he recommends is really in your best interest or if he is recommending the product because it pays him well.

If you do use a financial advisor, your best bet is to go with a "fee-only" advisor, one who doesn't get paid commission on the products they recommend. That's the only way you can be sure to avoid the conflict-of-interest.

This post is getting pretty long, so let's stop there for now. I have lots of other red flags to watch out for, and I'll post those later on. If you have a suggestion for a red flag, send me an email. I will compile your suggestions for a future post.

Tags: 401(k), annual return, annuities, commissions, financial advisors, guilt trip, mutual funds

Posted by Kim Snider on May 07, 2008 | Permalink