The Four Kinds of Practitioners You Can Hire
By Ric Edelman
From The Truth About Money, Part XIII – How to Choose a Financial Advisor.
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Financial Advisor. Financial Planner. Financial Consultant. Account Executive. Vice President, Investments.
The industry has conjured up a variety of titles. All are designed to impress, some to obfuscate. But no matter what a person might call him- or herself, there are really just four kinds of advisors.
That might be surprising, considering the vast array of professional designations that now exist in the industry. While conducting research for this book, we found 95! They’re all displayed in Figure 13-1, but the important point to note is that none of them are bestowed by federal or state regulators.
Practitioner #1: Registered Representatives
You know who this is, even if you don’t realize it. Registered Representatives are more commonly known as stockbrokers.
The Crash of 1929 and the Great Depression that followed were caused, in part, by lack of federal rules and oversight. To solve the problem, Congress created the Securities and Exchange Commission in 1934. Then, on the theory that thousands of brokerage firms and hundreds of thousands of stockbrokers were far too numerous for a single regulator to effectively supervise, the industry was permitted to regulate itself.
I know this sounds silly — like asking the fox to guard other foxes — but the idea has been in place for nearly 80 years. The Financial Industry Regulatory Authority, which operates under the auspices of the Securities and Exchange Commission, is called a self-regulatory organization, and is responsible for licensing and supervising the business activities of all brokerage firms and stockbrokers. No company may engage in the business of underwriting securities or executing securities transactions (meaning, it can’t buy or sell investments for consumers) unless it is a FINRA member. To become licensed, your application must be sponsored by a brokerage firm, and you must pass a FINRA-administered examination.
FINRA issues licenses covering every area of the securities industry, including commodities futures, options, municipal securities, and supervisory licenses for those who manage others (such people are known as “principals”).
The most common licenses held by those who work with consumers are:
- Series 6: Limited Representative Securities license. This permits the representative to sell mutual funds. If the representative also holds a Life and Health Insurance license issued by a state regulator, the representative may also sell variable annuity products.
- Series 7: General Securities Representative license. Representatives holding this license can sell stocks, bonds, and municipal securities, as well as options contracts, mutual funds, and ETFs. (Again, the representative may also sell variable annuity products if he also holds a Life and Health Insurance license issued by a state regulator.)
- Series 63: Uniform Securities Agent State Law license. Even though a candidate passes the Series 6 or Series 7 examination, he or she cannot sell products to consumers until he or she also passes the Series 63 examination, which is required to receive a state securities license.
FINRA calls a person who holds these licenses a registered representative because he or she is registered with FINRA and is a representative of the brokerage firm with which he’s affiliated.
Pay particular attention to that last phrase. Stockbrokers legally represent their brokerage firms. Brokers are considered by FINRA and the SEC to be product salespeople whose job is to represent the best interests of their firms. According to the regulators, brokers sell investment products in order to earn commissions; they are not paid to give advice, and any advice they do give is considered “incidental” to the sale of their products.
Don’t believe me? Then read this disclosure, which the SEC requires on the monthly statements that are issued by brokerage firms:
- Your account is a brokerage account and not an advisory account. Our interests may not always be the same as yours … [M]ake sure you understand … the extent of our obligations to disclose conflicts of interest and to act in your best interests … [O]ur salespersons’ compensation may vary by product and over time.
Indeed, registered representatives generate commissions for themselves and their firms through the sale of investment products.
The most common investment product sold by brokers are mutual funds, so let’s examine closely how brokers earn a living.
Mutual fund commissions are set by the fund companies themselves; neither brokers nor brokerage firms can alter them. There are three basic ways you can pay those commissions: when you buy shares, when you sell them, and annually.
Let’s explore them.
Mutual Fund Sales Charge #1: Front-End Load
Also known as Class A shares, or up-front load, you pay at the time you invest. There is no fee for reinvesting dividends or capital gains, and you can withdraw your money at any time without charge (at the then-current value, which may be higher or lower than when you invested).
Although the legal maximum is 8.5%, virtually all stock funds charge 5.75% or less, and almost all bond funds charge 4.75% or less.
Furthermore, front-load funds offer several discounts:
- Breakpoints are essentially volume discounts; the more you invest in one fund family, the lower the load. Discounts often start at $25,000, and the more you invest, the bigger the discount. Breakpoints typically occur when you invest $100,000, $250,000, or $500,000, and most funds waive their loads entirely when you invest $1 million or more.
- Letter of Intent. If you open an account today with a small amount but plan to invest more within the next 13 months, you are entitled to the breakpoint today, thus giving you a discount on today’s investment even though you have not yet invested enough money to actually qualify for it. (If you fail to fulfill your LOI, the fund will retroactively collect the higher fee from your account.)
- Rights of Accumulation give you a discount based on the total amount of money you invest — and not just in that fund, but in any fund in the same fund family. Thus, if you are investing $15,000 in a fund but previously have invested $35,000 in other funds of the same family, you are entitled to the $50,000 discount level on the $15,000 investment you are making today. You also are permitted to add together all the investments made by members of your household for purposes of calculating the biggest ROA discount.
- Free transfers. All fund families allow investors to move money between funds with no additional load, provided the money stays in the same family.
Note that a small transfer fee might apply, and unless it’s a retirement account, the transfer will be considered a taxable event.
Five Common Broker Tricks
Federal rules require all front-end load mutual funds to automatically award the above discounts to investors. However, the higher the load, the higher your broker’s commission — which can tempt some brokers into playing tricks on you:
Trick #1: Splitting Registrations to Avoid Breakpoints
Instead of opening a joint account with husband and wife for $250,000, the broker opens two accounts, one in each name, for $125,000 each. This avoids the $250,000 breakpoint, meaning you pay a higher load and the broker gets a higher commission. It’s illegal.
Trick #2: Failing to Award Rights of Accumulation
An investor who already has a large account in a fund family opens a new, small account for her children, but the broker fails to apply the discount to the new account, which she’s entitled to by virtue of the existence of the larger account. It’s illegal.
Trick #3: Failing to Disclose Letter of Intent Availability
A broker allows a client to open an account with a small amount, knowing that the client intends to add to the account within 13 months, but does not execute the trade with the proper LOI discount. It’s illegal.
Trick #4: Recommending an Investment Amount Slightly Below a Breakpoint Level
A broker tells a client to invest $95,000 into a fund, failing to disclose that if the client were to invest just $5,000 more, the entire investment would receive the $100,000 discount level. (Quite often, due to the discounts, investing $100,000 can cost less than investing $95,000.) It’s illegal.
Trick #5: Churning
This occurs when a broker encourages a client to move money from one fund family to another. A move within the family would not generate a commission, but a move to a new family does. If there’s no economic justification to support the recommendation, the generation of the new commission is called churning. It’s illegal.
If you think any of these tricks have been played on you, inform your broker of the error and your account will be quickly corrected. If your broker is slow to cooperate, notify the branch manager or the fund directly. The law is on your side, and you’ll have no problem getting it fixed. The last thing your broker wants is for you to contact the federal regulators, for any of the above violations could cost your broker his license.
Mutual Fund Sales Charge #2: Back-End Load
Also known as rear-load, reverse load, or Class B shares, this share class is usually available only when investing $50,000 or less. (Because of breakpoints offered on Class A shares, regulators regard Class A shares as more cost effective when investing larger amounts.) Class B funds don’t charge you when you invest. Instead, reverse loads assess a withdrawal fee, also called a surrender fee. The amount is typically 5% or 6% in the first year, declining 1% per year until it vanishes after the 6th or 7th year. Each deposit receives its own “clock.”
Technically called a Contingent Deferred Sales Charge, reverse load funds offer several features to minimize the surrender fee. For example:
- You are permitted to withdraw dividends and capital gains at any time with no charge.
- Many funds allow you to withdraw up to 12% of your investment each year at no charge.
For liquidations beyond these amounts, the fund assumes you are withdrawing the oldest shares first, thus paying the lowest fee possible.
- You may move money between funds with no surrender fees, and without restarting your clock, provided the money stays in the same family. As with Class A transfers, a small transfer fee might apply, and unless the money is held in a retirement account, the transfer will be considered a taxable event.
Mutual Fund Sales Charge #3: Level-Load
Known as Class C shares, these also do not charge a front-end load. Instead, the back-end load is usually 1% on amounts you withdraw during the first 12 months. Regulators have also made it clear that they believe Class C shares are best suited when investing money for relatively short periods of time.
Do Brokers Suffer from a Conflict of Interest?
You can see the potential problem here: Do commission-based brokers suffer from a conflict of interest? After all, they make money only when you buy products from them. Those products often pay high commissions, some higher than others. So when a broker recommends a certain product to you, is that recommendation for your benefit or for the benefit of himself and his firm?
This same question arises when dealing with the next kind of practitioner.
Practitioner #2: Licensed Insurance Agents
Insurance is regulated by each of the 50 states and the District of Columbia; there is no federal regulation or oversight.
The reason: Unlike securities, which are identical (all the shares of IBM stock, for example, are the same no matter who buys them or how many you buy), an insurance policy is custom-designed for each purchaser. Consequently, you’re not buying a security when you purchase life insurance. Instead, you are entering into a legal agreement with an insurance company. The agreement is executed by a contract — and all contracts are governed by state law, not federal law.
That’s why insurance is regulated by the states and not by the federal government. Every insurance agent must hold a state insurance license. An agent must hold a license based not on his state of residency, but based on the residency of his clients. Thus, if a New Jersey agent has clients who live in Delaware, he must hold a Delaware license. There are four main types of licenses:
- Property/Casualty license. This allows the agent to sell homeowners, automobile, and liability insurance.
- Life/Health license. This allows the agent to sell life, health, accident, and disability income insurance, as well as fixed annuity products.
- Long-Term Care Insurance license. This allows the agent to sell long-termcare insurance.
- Variable Annuity license. This allows the agent to sell variable annuity products, provided that the agent also holds the FINRA Series 6 or Series 7 license described earlier.
Like stockbrokers, insurance agents’ licenses are held with one or more insurance companies. And, like stockbrokers, agents legally represent the insurers, not their customers. And, like stockbrokers, agents earn commissions from the sale of products; they do not give or earn fees for rendering advice.
The most common “investment” product that insurance agents sell is annuities. Annuity commissions range from 1% to 15% of the amount you invest. Sometimes, the agent will earn more in commissions than you’ll earn in interest!
You may not realize this, though, because the product’s commission structure is similar to that of Class B mutual funds.
Consequently, the conflict of interest that can afflict stockbrokers can also afflict insurance agents. As a result, consumers in ever-greater numbers are turning to the next type of practitioner.
Practitioner #3: Investment Advisor Representatives
As we’ve seen, stockbrokers and insurance agents legally serve the best interests of their firms. And they earn commissions when selling products.
Today’s investor wants something more, something better. If you’re like most, you want to work with a true advisor who is not burdened by such conflicts of interest, one who indeed works for you and who is not beholden to some insurance company or Wall Street firm.
You want an Investment Advisor Representative.
Such a person is affiliated (often as an employee) with a Registered Investment Advisor — an advisory firm that is registered with the Securities and Exchange Commission or a state regulatory agency. (Note: Attorneys and accountants are exempt from registration.)
Registered Investment Advisors and their Investment Advisor Representatives are legally obligated to serve your best interests. That obligation is referred to as a fiduciary duty, and it stands in sharp contrast to stockbrokers and insurance agents.
An Investment Advisor Representative must hold one of the following FINRA licenses:
- Series 65: Uniform Investment Adviser Law license. Before practicing, the Investment Advisor Representative must also obtain the Series 63 state license.
- Series 66: Uniform Combined State Law license. This license combines the Series 65 and Series 63 into one examination.
Perhaps you’ve noticed that the SEC regulates Registered Investment Advisors
and their representatives. Why, then, you might be wondering, does FINRA issue their licenses?
I have no idea.
But I will tell you this: Many Investment Advisor Representatives also hold brokerage licenses and insurance licenses! If you find all this confusing, you’re not alone.
There are two reasons why so many advisors are dually licensed (as it’s called):
First, the complexity of personal finance is a relatively new phenomenon. As recently as 1980, most Americans spent their entire careers working for one employer. Most homeowners only owned one home. Their employers managed the investments in their pension or 401(k) plans, and nobody had an IRA account (which was not invented until 1974). Money market funds were only 10 years old in 1980, discount brokers didn’t exist until 1975, and the Federal Housing Administration wouldn’t insure adjustable rate mortgages until 1989.
Small wonder, then, that virtually all practitioners were either stockbrokers or insurance agents. (The CFP Board of Standards wasn’t formed until 1985.) In 1980, there were only 564 mutual funds holding a mere $134.8 billion in assets— meaning that stockbrokers were literally brokering stocks (today, they are far more likely to sell mutual funds and annuities, which are easier to sell and pay far higher commissions). Likewise, insurance agents once sold only life insurance; today, many agents never sell insurance and instead earn a living selling annuities and mutual funds.
As the world of personal finance grew more complex, many brokers and insurance agents began to realize that selling investment and insurance products lacked context. Without considering the customer’s tax rate, risk tolerance, or need for income, it was difficult to say that a given product really was in a given client’s best interests.
For that reason, many brokers and agents migrated to an advisory practice. They continue(d) to recommend products, but now within the framework of a holistic financial planning environment.
If you come upon an Investment Advisor Representative who has been in the field since the 1980s or earlier, chances are good that that person started his or her career as a stockbroker or insurance agent. And, chances are, he or she still holds his old licenses. (Those new to the field are much more likely to have begun their careers as an advisor; the first college degree in the financial planning field [from Purdue University] wasn’t offered until 1986.)
The second reason many Investment Advisors Representatives also hold brokerage and insurance licenses is because they need to in order to serve their clients.
Even though they are technically serving in an advisory capacity, the vast majority of Investment Advisor Representatives help their clients implement their recommendations. To facilitate the purchase of investments and insurance, the advisor must hold the appropriate FINRA and insurance licenses.
For both these reasons, many practitioners are dually registered. They hold brokerage licenses with a brokerage firm, insurance licenses with one or more insurance companies, and their advisory registrations with a Registered Investment Advisor.
So if the practitioner you’ve hired holds all three types of licenses, in which capacity is he serving you?
There’s an easy way to find out: Just ask him or her.
If your practitioner is acting as a Registered Investment Advisor, he or she must give you a copy of Form ADV. This document is the registration statement that all Registered Investment Advisors are required to file with the SEC (or state regulator). The ADV explains the services provided by the advisory firm and the fee schedule, as well as the representative’s background. Importantly, the document will state the conditions under which the representative is serving as an advisor vs. a salesperson.
If your financial professional cannot provide you with Form ADV, then he or she is not an Investment Advisor Representative. Period. Never let anyone claim to be serving your best interests unless they can produce that document. You can also check with the SEC at www.adviserinfo.sec.gov. Click “Investment Advisor Search.”
The law requires all those who charge fees for investment advice to register with the SEC or a state agency. Therefore, never work with anyone who has not done so.
Unlike brokers and agents who earn commissions for selling products, an Investment Advisor Representative is paid a fee to give advice. The fee is typically based on time or account value, or a combination of the two. A fee based on time might be set at an hourly rate or a flat rate based on an annual retainer. A fee based on account value is called an asset management fee; the rate is typically based on the size of the account (usually, the larger the account, the smaller the rate).
Understanding the Difference Between What They Charge and What You Pay
When interviewing prospective advisors, as read in Chapter 83 of The Truth About Money, you should always ask how they are compensated. Unfortunately, if that’s all you ask, you might not be told the whole story. That’s because there’s often a big difference between what they earn and what you pay. Therefore, instead of asking, “What is your compensation?” you should ask, “What are the total costs I will incur by working with you?”
You see, when your financial advisor provides you with a portfolio of funds, you’ll incur not one cost, but three. So it’s vital that you receive full disclosure — otherwise, you might end up paying far more than you should, and far more than you realize.
First, of course, is the advisor’s fee. Known as an asset-management fee, it is generally expressed as a percentage of assets. At some firms, the asset management fee is as high as 3% per year. To learn the fees charged by other firms and how those fees are collected, you should ask advisors you are considering hiring for a copy of their Form ADV (Part II & Schedule F), a federal disclosure document that each advisor is required to provide to you.
But the asset-management fee is not the only cost you’ll incur. In addition to paying for your advisor, you must also pay for the funds your advisor has recommended, and this is where you’ll find two other costs: fixed expenses and variable expenses.
Fixed expenses are included in something called the Annual Expense Ratio. Every mutual fund and exchange-traded fund charges this fee — even so-called “no-load” funds. (“No-load” means there are no commissions when you buy or sell shares; it does not mean “no fee.”) The expense ratio pays for the fund’s recurring operating costs, from the manager’s salary to the toll-free phone number investors call to talk to customer service representatives. As of December 31, 2009, according to Morningstar, the average expense ratio for all mutual funds is 1.19% per year, although many are more than 2%. The highest in the industry, according to Morningstar as of December 31, 2009, is a staggering 18.4%! Although the expense ratio is expressed as an annual figure, it’s actually debited on a daily basis. But the charge does not appear on monthly statements, making it hard for investors to notice it. To find it, you must look in the fund’s prospectus, where the expense ratio is expressed as a percentage.
Many investors — and, astonishingly, even many investment advisors — think the annual expense ratio covers all fund expenses. But it doesn’t. The expense ratio covers only perennial fixed costs — salaries, marketing, overhead, and the like. But there are many variable costs to operating a fund, and these are in addition to the expense ratio.
The biggest variable costs are brokerage commissions and trading expenses.
When fund managers buy or sell a security, they pay brokerage commissions — just like you would, if you were to buy or sell a stock or bond. Of course, funds pay lower commission rates than you would pay, thanks to their volume. Even so, considering that funds trade millions of shares representing billions of dollars, their trading costs are huge — and the more the fund trades, the more it spends on brokerage commissions. Typically, funds spend tens of millions of dollars in trading costs per year, and these expenses are not included in the Annual Expense Ratio or even disclosed in the prospectus. To find these and other expenses, you must look in the fund’s Statement of Additional Information.
Unlike prospectuses, advisors are not required to provide SAIs to you. As a result, many investors have never even heard of it, let alone ever seen or read one. In fact, after training financial advisors nationwide for years, I can tell you that some advisors have never heard of it either. Yet, according to Morningstar, the fees described in an SAI can equal or even exceed the Annual Expense Ratio. Until recently, you had to ask fund companies to mail you their SAIs. But thanks to the Internet, you can now find these documents at most fund company websites.
Trading expenses are difficult to determine, but in 2007, an analysis by researchers at Virginia Tech, the University of Virginia, and Boston College found the average fund, based on a sample of 1,706 U.S. equity funds from 1995 to 2005, incurred annual trading expenses of 1.44% per year during that period. This is in addition to the 1.19% that is the average Annual Expense Ratio according to Morningstar as of December 31, 2009, based on all the mutual funds it tracks.
These two figures put the total cost of the average mutual fund at 2.63% per year. (This calculation is based on historical data; current figures could vary.)
By adding this to a 0.90% advisor’s fee, you can see how ordinary investors can incur a total annual cost of more than 3% per year.
So be careful when asking an advisor what he charges. If the answer is, “My fee is one percent,” he might be omitting the Annual Expense Ratio and trading expenses that you’ll also incur. When you are interviewing potential advisors, make sure they tell you the total costs you’ll pay to work with them.
Practitioner #4: Money Managers
It has long been my contention that I don’t manage money. That might seem to be a strange thing to say, considering that my firm has, at this writing, $5 billion in assets under management. Still, my view is that, rather than managing money, I manage clients.
My colleagues and I at Edelman Financial realized long ago that the key to helping our clients achieve financial success lies not in helping them pick the right investments for their portfolio, but in getting them to invest in that portfolio after we’ve designed it for them. People often have the best intentions, but distractions, emotions — or downright procrastination (read Chapter 1) — can interfere with our (and their) genuine desire to do what they need to do at the time they need to do it.
This is why my colleagues and I (and pretty much every real advisor in the country) create custom-designed plans and investment programs for each client, and then we focus all our energies on helping the client implement them.
A money manager, by contrast, has no such relationship with clients. His only relationship is with the client’s money.
The most common example is found in mutual funds. Each fund is controlled by a money manager, whose job is to invest the money in accordance with the fund’s objectives. Every person who invests money will be treated identically. If a manager decides to sell a stock, he or she will sell that stock out of every client’s portfolio, and if he or she buys a stock, every client will own it — and they will all own that stock in the same proportionate amounts. Thus, every client’s holdings in a mutual fund is identical and their results will be identical. The only differences in results between two investors would be caused by the fact that one might invest or withdraw money on different dates than the other.
Consequently, it is not only possible but quite common for stockbrokers, insurance agents, and Investment Advisor Representatives to recommend that their clients invest with money managers — often via mutual funds, exchange-traded funds, annuities, or wrap accounts.
Put simply, the money manager manages the fund while the investment advisor manages the client’s personal finances.