The High Cost of Advice

A teenage driver ran a red light and smashed into the small pickup my father drove. Dad ended up lying on the asphalt with the truck on its side just beyond his feet. The emergency workers took Dad to one of the two trauma hospitals in Portland. My wife and I brought him home on Christmas Day 1991.

This bruising event required several responses that involved issues of personal finance. My brother took responsibility for the damaged property: pickup truck, trailer, and tools. I managed the insurance, both auto and medical.

After the settlement with the insurance company of the teenage driver, my father had $50,000 to invest. Dad called an acquaintance who advised him to put the money in mutual funds. Only after the account was opened and funded did I begin to learn what had happened in the transaction.

The funds had a 5.75 percent load, meaning that Dad paid $2,875 in commissions. In spite of the fact that Dad gave the man $50,000, his beginning balance in the investment was $47,125 after the commission was subtracted. This is like buying a new car where the value drops the moment you drive off the dealer’s lot.

Dad had this investment until his death 17 years later. One of the mutual funds in this transaction has returned more than 12 percent over the life of the fund. The difference between the investment gains on $50,000 and $47,125 over seventeen years at twelve percent is $19,740. So the investment Dad made cost him about $22,615—$2,875 in the commissions and $19,740 in lost investment returns.

Let’s put this in perspective to Dad’s financial situation. My father served small- to mid-sized congregations and never earned more than $165 per week as a pastor. The financial cost on this investment would be the equivalent of two-and-a-half years of compensation. When he retired after 31 years of pastoral ministry, his pension provided $195 per month. The financial cost of this investment would be the equivalent of nine-and-a-half years of pension payments.

Financial Advisors

My father’s advisor recommended a suitable investment. Suitability is one of the measures used to assess the conduct of a financial advisor. A financial product is deemed suitable after consideration of the holistic picture of a person’s situation: income, age, net worth, financial goals, and other issues. I have no quibble with my father’s advisor about the suitability of his recommendation.

This experience failed, however, at a higher level of accountability—fiduciary responsibility. The financial advisor served as an agent of the company providing the financial product, mutual funds in this case. The advisor received a commission for this suitable investment, but the advisor did not have a fiduciary relationship with my father in which he would be accountable for the long-term financial well-being of my father. In a fiduciary relationship, the advisor must seek the best for the client even if it results in lower compensation for the advisor. The client always comes first in a fiduciary relationship. But that was not the case with my father. The advisor only had to be sure his counsel was suitable in the moment he made the recommendation.

My father’s experience, unfortunately, was not unique. In March 2012, the National Bureau of Economic Research released a report in which they stated that evidence indicates the self-interest of advisors “plays an important role in providing advice that is not in the best interests of their clients.” A 2011 study of persons with brokerage and bank accounts in Germany described the conflict of interest with financial services providers: “Our findings imply that many financial advisors end up collecting more in fees and commissions than any monetary value they add to the account.”

Informed Decisions

In my father’s case and in the situations of the many people with whom I’ve talked about these matters, financial decisions made without a clear understanding of the transaction can have high costs. Exorbitant commissions for the sale of financial products, even suitable products, reduce the value for the client. High annual fees decrease the annual return on the investment. A person would be well-served to understand these costs prior to signing the contract with an agent selling a financial product.

Two questions could be asked of the agent. First, are you a fiduciary? An agent working in any aspect of personal finance will understand the nuance in this question and the legal ramifications of such a relationship. If the agent responds “no,” then you know that the financial product may be suitable in the moment, but not necessarily in your best interest in the long-term. Greg Smith, in an article in the June 22, 2015, issue of Time magazine, suggests asking a financial advisor to sign this statement: “I, ___, as your adviser, will act as a fiduciary and only give you advice that is in your best interest.” If the advisor will not sign the statement, Smith says, “run as fast as you can in the other direction.”

There is a second question to be asked of a financial advisor: How are you compensated for advising me? The answer should include both information on a commission for a transaction (if any), and ongoing fees. Some financial products, like life insurance policies, are notoriously difficult to understand the fee structure, but informed financial decisions require a persistent effort to fully understand the costs.

The attempt to understand my father’s experience became the first part of my education about investments. The tuition was high, at Dad’s expense, but prompted a journey that over time has increased investment returns as I learned more about personal financial issues. I have discovered that a thorough understanding of compensation issues is necessary in making key financial decisions. I am the one, it turns out, who has the best perspective on the long-term financial stability for my family.

Originally published by Pensions & Benefits USA.