The Price of Advice

By JASON BRANNING,

Jason K. Branning, CFP® is a fee-based investment adviser and financial planner with Asset Dedication, in Ridgeland. He owns Branning Wealth Management LLC and serves as a board trustee to the College Savings Mississippi 529 plans.

Comparing Two Approaches: Annuity Contract vs. Portfolio Design—There is often a misconception by the Public that they cannot afford a financial advisor. Many times, this leads them to buy products from insurance companies or use a broker to transact trades in a portfolio because it appears to have no cost.

Brokers operate under the principle of disclosure when it comes to their compensation, but many expenses are not visible even if the disclosure protocols are followed. There is no such thing as a free lunch - every investment strategy has costs that consumers pay for whether it is visible to them or not. Brokers are held to a looser standard of care for their clients than are registered investment advisors, though recent changes in the law will hopefully put an end to the worst cases.

Consider the following options:

Option A: Hire a Broker

Brokers usually work for an insurance corporation or stock brokerage company that promises to find a “suitable” variable annuity product.  The laws and regulations that defined the suitability standard were originally designed to protect clients from egregious broker behavior. Advising the elderly to speculate in pork belly options would be an example of such egregious behavior.   The underlying purpose of such recommendations was often to guide (or force) brokers toward financial products that generated the highest profit for the owner of the brokerage and the highest profit to the product provider.

Beginning in 2020, however, brokers will have an obligation to act in the “best interest” of the client. Historically, brokers operated under a suitability standard that had a lower legal threshold in that the broker could ignore the price of the product and was not required to be in the best interest of the client.

Conventional wisdom suggests that consumers want to protect their nest eggs to achieve their desired lifestyle in retirement. Variable annuities are typically offered by insurance companies as the one product that provides a silver bullet to achieve that goal. The claim is that with a variable annuity, the consumer can invest in the markets and have income tax sheltering on the growth until funds are withdrawn, while having floors or protections when the markets decline.

The variable annuity is therefore sold as a way to protect assets if markets are down, sideways, or volatile when consumers want to retire. Guarantees of benefits are often sold with variable annuities to help calm concerns about leaving heirs a specific death benefit, irrevocable future income streams, or principal protections. After the consumer buys the annuity, the insurance company then rebates part of the money collected to pay the broker and invests the rest. In other words, the commission is built into the price the consumer pays for the annuity and thus is hidden (although, technically, it may have been disclosed in the fine print of the contract sold by the broker).

Option B: Hire a Registered Investment Advisor

On the other hand, a Registered Investment Advisor (“RIA”) works directly for the client and is required by law to follow a much stronger “fiduciary” standard. All recommendations must be in the best interest of the client – just as physicians are held to a fiduciary standard that their care must always be in the best interests of their patients. RIA’s must therefore factor in the cost of a product as well as its benefits for a client before making any recommendations.

Furthermore, fees are open and transparent. In this arrangement, the RIA charges the client a direct fee. Fees fall under the same fiduciary standard, meaning the advisor must act in utmost good faith with full and fair disclosure of all material facts regarding any recommendations, fees, or other charges. RIA’s must base their advice on the goals of the client, the client’s time horizon, and total costs of strategies whether seen or unseen by the client. An RIA typically relies on extensive interviews with the client to gather the information needed to make recommendations. Recommendations are typically formed and guided in an open and comprehensive financial planning process that covers the client’s lifetime. The ultimate financial plan usually includes details brokers seldom ask about because they are not required to do so (“Oh! You have two grandchildren you are planning to help get through college? I did not know that.”)

The RIA is free to recommend a variable annuity, of course, and that sometimes happens. But much more often, the RIA will recommend a diversified portfolio of stocks and bonds to accomplish the same long term goal at a lower price. A dedicated ladder of government bonds properly constructed to match income needs over each year for the next five to ten years, for instance, will provide a stream of steady and predictable income while protecting principal if each bond is held to maturity. Because coupon interest and face value redemption of bonds issued by the United States Treasury are guaranteed by the government (they have the right to print the money and give it to you!), the money is secure. A negative sequence of market returns will have no impact on the cash flows coming into the portfolio from interest and redemptions for the time horizon specified in the plan. For example, if the ladder is built to provide eight years of income, then nothing would need to be sold from the stock portfolio for up to eight years. Usually this is more than enough time for markets to recover to the point where they match what is needed to meet retirement goals, based on past bear markets back to 1928. 

In addition, owning a diversified portfolio of stocks has historically been a smart way to grow wealth over the long term. Markets fluctuation randomly over short time periods. But, over the long term, they have gone up three out of every four years, and investors have been rewarded for the price fluctuations (volatility) with investments that earn significant positive returns over the long term, usually defined as 15 years or longer. For instance, the S&P 500 index - stocks from the 500 largest companies listed on public exchanges - has historically averaged between nine and ten percent per year since 1928, and has never lost money if invested for spans longer than 15 years. Investing in mutual funds (or their equivalent ETFs) as considered safer because they own the stocks of hundreds or thousands of companies. This diversity reduces the volatility risk because while an individual company may go bankrupt, a mutual fund could never go bankrupt unless all the companies it owns - hundreds or thousands - would all have to go bankrupt at the same time.

Comparison of Options

While the differing options listed above are not inherently good or bad in and of themselves, consumers should look closer into what the underlying incentives are that may be motivating the advice given.

Consumers should compare costs and returns before settling on a strategy. They should also seek to understand any recommendation, recognize why that particular recommendation makes sense, and know all the costs and benefits before making a decision.

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