When Your Oil Change Costs $10,000+ a Year

Original article posted on "Separating Value From Bias" Substack here: #9 When Your Oil Change Costs $10,000+ a Year

Paying for ongoing financial advice can provide great value--you're just not always getting it

Strong financial planning can have immense value.

Here is just some of the value financial planning can provide:

1) Ensuring that your investment allocations align with your risk tolerance

2) Ensuring that your investment allocations align with your retirement goals

3) Maximizing the use of retirement accounts

4) Minimizing taxation on your portfolio by putting tax-inefficient assets into retirement accounts or life insurance/annuity policies

5) Using life insurance/annuity policies to reduce volatility in the portfolio, get guaranteed returns, and improve after-tax returns

6) Creative gifting strategies with appreciated assets

7) Use of step-up in basis to pass tax-free wealth to heirs

8) Addressing the income tax liabilities of estate plans

9) Maximizing the use of QBI deductions for business owners

10) Qualified Small Business Stock (QSBS), Opportunity Zone, and Solar Tax Credit opportunities

11) Using real estate deductions to reduce W2 income

12) Using leverage against the portfolio to generate tax-free income (and tax-deductions) while investing for the long-term (eg “Buy, Borrow, Die”)

13) Tax-efficient withdrawal strategy in retirement

14) How to utilize the 0% long-term capital gains rate

If financial planning can provide such immense value, then why is there such a negative connotation around financial advisors or advising?

Why are people who could benefit from financial planning choosing not to seek it out and feel more comfortable with doing a “low cost index fund and chill” approach on their own?

That’s because while financial planning can provide immense value for clients (when done correctly) it’s also easy for financial advisors to just charge you an ongoing fee and not provide much value for it.

After all, how can you tell if your financial advisor is actually providing you some of the value provided above or just dumping your assets into the same model as everyone else and checking in with you every once in a while to make sure you feel good about your relationship with him or her?

The purpose of this week’s edition is to help you understand how to think about the value of financial planning so that you understand how to get the maximum value from it relative to your needs.

The Financial Plan: The Engine to Your Investing and Retirement Strategy

The way I like to tell people to think about the value of financial planning is that a financial plan helps to ensure that you are making the best use of the tools at your disposal to help ensure that you’re maximizing the return relative to your risk tolerances, minimizing the taxes relative to your investment choices, and helping you effectively manage your spending relative to your portfolio so that you don’t run out of money now or in retirement.

Most of us don’t know how to do all of this on our own.

There’s a lifetime of learning here that would be required to ensure that we’re optimizing everything properly.

The way to think about is to imagine you’re in an old car that runs and has all the necessary part: you the tires, steering wheel, brakes, doors, engine, etc.

Is it running properly?

You know that runs because it gets you from Point A to Point B.

Maybe you know that it’s old and certain parts can be replaced.

But unless you’re a well trained mechanic, you’re really don’t know what needs to be done in order for the car as a whole to run as efficiently as possible and all of those parts to work in coordination with one another to ensure the best possible outcome.

When a client approaches a financial advisor, they typically dump all the “parts” of their financial and investment plans in the lap of the financial advisor and essentially say “figure it out”.

These “parts” can include multiple investment accounts with overlapping investments, multiple retirement accounts, home equity, etc.

The goal of the financial advisor and the financial plan is to make sure that all these parts work as efficiently as possible.

For example, retirement accounts defer taxes until you’re in a lower tax bracket. Are you making sure to put your most tax-inefficient investments into your retirement account?

Life insurance and annuities can provide guarantees and tax-benefits that you can’t find anywhere else. How are you benefitting from this?

If you need to make a large purchase, did you know that borrowing against your portfolio can be more beneficial than selling assets and having to pay taxes on a large capital gain?

So when a client first comes to a financial advisor there’s a lot of work that the advisor has to do just to understand the client’s individual finances as well as their personality and come up with a plan that is a best fit for who that client is.

As we talked about in one of our earlier posts, two clients can have the same exact financial situation, but if their views on risk and return are different, they’ll need two entirely different plans.

So the upfront work/value proposition is high.

This is essentially like going to the mechanic with a bunch of parts and asking them to build a whole car for you with the parts.

A good financial advisor does this for you via a financial plan.

The financial plan is the engine that all the other pieces are centered around and makes them “go”.

So there is a ton of value that can be provided in the first year in getting you to both think and implement strategies that are in your best interests but which you might not be aware of.

Getting an Oil Change in the Following Years

Well if there is a ton of value to be derived in the first year from financial planning, what about in the second year and going forward?

If the financial advisor already fixed the engine and the car in the first year, what are they really doing going forward?

The answer is that they are doing the equivalent of providing ongoing maintenance.

It's the equivalent of getting an oil change every 5,000 to 7,000 miles. Maybe some unexpected financial event came up in your life (loss of a job, inheritance, etc) and the plan needs to be tweaked to derive the most value given this new change.

Or maybe the markets had a crash and there’s an opportunity to get a tax-break on some of the losses here.

The point here being is that for most people the value proposition for the client of using a financial advisor in the subsequent years is not nearly as high as it is in that first year.

The problem, however, with the financial advisor’s compensation is that as the portfolio grows in value over time their fees are increasing, even though both the value and the work they do in the subsequent years is dramatically less.

Understanding the Financial Advisor’s Compensation Model

As I talked about both here and in my previous post, the financial advisor typically loses money trying to bring clients in the door. They need an office, marketing materials, pay to acquire leads and distribution channels, etc. All of this takes time and money.

They will then do multiple pitches and only close a percentage of those. That’s more time and energy.

Of the few they close, there’s then a huge undertaking of understanding all the clients’ financial background and their personality and onboarding them onto their platform.

More time and energy.

So if a financial advisor is delivering quality advice, it’s really the client that is benefitting from the exchange here in the first year.

It's only in the later years of the relationship where the financial advisor is doing little work here (i.e. only doing the oil change updates) and getting a high compensation for it.

So the dynamic shifts from the client getting the most value from the relationship in the early years, to the advisor getting the most value in the later years.

In the financial advisory space, the holy grail here is for advisors to work hard in the early years of their career to build up a large amount of clients and assets under management (AUM) so that in the later years they can chill and not do a whole lot of work while simultaneously making a lot of money from the client relationships they’ve built over time.

This is what’s known as a “lifestyle” business.

In the later years the advisor is no longer being paid due to the value of the financial advice he or she is providing, but rather because of the trust and level of comfort you have with him or her.

Financial Advisor Revenue per Workload Over Years of Client Relationship

Most advisors charge a fee that is based on a percentage of assets they manage for you.

This is typically around 1%.

So for example if they are managing a $1 million portfolio of yours, they would be earning $10,000 a year.

As your portfolio grows over time, so does their fee.

The obvious problem here is that you’re essentially paying $10,000+ every year for the equivalent of an oil change.

And once you’re with an advisor you’re comfortable with, you’re unlikely to move your money somewhere else and start the process all over again with a bunch of advisors you don’t know and aren’t comfortable with.

Which is kind of what the advisory model is hoping you’ll do. Get in the door and stay out of fear of the unknown as opposed to the value they are providing.

Financial Advisory Models and Value Propositions

So how do we solve this problem of the client getting high value on the front-end, but limited value on the back-end?

Over the last decade or so, two models have emerged to try and address this issue:

1) The hourly model

2) The flat fee model

The hourly model works by charging a client an hourly rate (eg $500/hour) for each hour the financial advisor works.

For example, if the financial advisor works 20 hours in the first year and only 10 hours in year 2, the fee would be $10,000 in the first year and the $5,000 in the second year.

This would seemingly solve the value imbalance problem we described earlier.

A flat fee model charges the individual a flat fee regardless of the hours spent. So in the previous example, maybe they charge $7,500 in both years one and two, or maybe it’s a tiered scale (eg $10,000 in year one, and $5,000 in years 2 and onwards).

The benefit here is that the fee isn’t tied to the value of your portfolio. So if your portfolio is $10 million instead of $1 million your fee is low relative to your portfolio value in combination to if the client was charging a percentage fee that increased with the value of your portfolio.

However, there are a couple of problems with both of these models in comparison with the percentage of AUM model:

1) The fees of the hourly and flat fee model could be more than that of the percentage AUM model

2) The value proposition of the hourly and flat fee model could be less than the percentage AUM model

Let’s look at a following example.

You have a $1M portfolio and are looking at 3 different advisors who have different compensation models.

One has a percentage of AUM model, the other has an hourly model, and the other has a flat fee model.

The advisor with the AUM model says that her fee will be 1% of your assets that she is managing.

The advisor with the hourly model says that her fee will be $400/hour and that the work will take 30 hours per year.

Finally, the advisor with the flat fee model says that she will manage your assets for a fixed fee of $11,000/year.

Which do you choose?

Remember, that all three are providing the same exact level of service.

The table below makes the options clearer:

Comparing Advisory Compensation Models

By looking at the table above we can clearly see that even though all 3 have different compensation models, they are all providing the same service—namely to put you into index funds.

However, the % AUM model ends up actually being the cheapest.

So relative to the other two, the % AUM model provides the best value per cost of the three.

But if you were to ask me which of these three I personally would choose, my answer would be different.

I would choose neither.

And that’s not because of the cost, but because of the low value they are providing.

They are all charging $10,000 or more to “manage” my assets in index funds without providing any of the financial planning benefits I mentioned at the top of my post.

I could put my assets into index funds myself with a couple clicks of a button through Vanguard, Interactive Brokers or any other platform.

I don’t need to pay someone $10k+ per year to do this and then tell me how the account is doing every quarter while smiling and talking to me nicely.

I would want someone who can actually provide me with tangible financial planning that I can implement—or better yet, they can implement for me.

An ideal situation would be someone does a lot of upfront work for a large fee (and large value provided) in the early years and then occasional updates in subsequent years for a significantly lower fee.

This is akin to paying someone to fix your engine and then getting yearly oil change updates going forward in subsequent years.

But this isn’t what most financial advisors are providing—particularly those who want a lifestyle business that involves more making money off the client relationship than actual financial planning.

Differentiating Value From Price

Back in the days—even before my time—it was customary that if your car was having an issue and you didn’t know anything about cars, you would take someone with you to the auto repair shop who did know about cars so that the auto repair shop wouldn’t immediately know that you were car-illiterate and quote you a ridiculously high price.

Of course, you could always go to multiple auto repair shops and compare multiple quotes to keep each party honest.

This difference in compensation models—between % of AUM, flat fee, or hourly—aren’t by definition better than any other—especially if all they’re doing is just giving your finances the equivalent of a nice car wash and handing it back to you for $10,000+ a year instead of actually fixing the car.

What matters is the value you are getting for your fee.

I’d much rather pay $15,000+ a year and get the full gamut of financial planning benefits than pay $10,000 for something I could do myself with a few clicks.

And this is the problem with financial advising.

If you know enough about financial planning, you realize that many financial advisors aren’t in the business of personal finance as much as they are in business of managing how you feel about your finances and your relationship with them.

You’re not paying for strong financial planning and advice as much as you are paying for a coach or therapist.

So this is the dilemma the industry faces.

If you don’t know anything about financial planning or investing, you’re probably better off seeking out a financial advisor and paying the fee instead of doing nothing.

But the more you know about financial planning, the more you’re going to question the value the advisor is actually providing you in relation to your fee and whether you want to actually pay it if you’re going to get so little in return.

Because no one who knows anything about cars wants to pay $10,000 for an oil change.

So clients who understand financial planning, and want someone to execute it for them, are going to have a tougher time finding someone who can provide the value they’re looking for.

On the opposite side of the coin, financial advisors who do provide a lot of value in the context of financial planning are going to have a tough time closing clients who don’t really understand the value of it or can’t distinguish advisors who provide a lot of financial planning value from those who don’t.

In fact, these advisors who do provide a lot of value are going to lose out to other advisors who do a better job of making the client safer trusting their assets with them.

Which means the financial advisors who want a lifestyle business are incentivized to focus on finding the clients who don’t really understand financial planning and are more than happy to pay the $10,000+ fee for a relationship with someone who makes them feel better about their finances—even if the only financial planning value they are providing is the equivalent of an oil change with a nice thank you card that makes you smile. ?