FIDUCIARY ADVISOR

Custody of Assets

When working with a broker-dealer, that firm actually holds your assets in-house. Their brokers have access to your funds and assets. The recent collapse of MF Global highlights the potential risks broker-dealer clients face.

Independent firms hold client assets with third-party custodians (e.g., Charles Schwab or Fidelity). This model creates a system of checks and balances. The independent advisor has discretion to buy/sell securities on behalf of client but cannot use or transfer monies outside client accounts.

Standard of Care

Brokers are only held to a suitability standard. They can sell their clients investments and banking products even when they know of better options. Registered investments advisors (RIAs) uphold a fiduciary standard. That means they must place their clients' interests ahead of their own.

Affiliations

Broker-dealers often engage in an opaque web of revenue sharing, commissions, and fee arrangements with internal and external product providers. This creates material conflicts of interest; they may be inclined to allocate their wealth management clients' assets to these products based on their kickbacks rather than the merits of the investments.

In general, independence helps avoid conflicting incentives and temptations to exploit clients. Take the case of a loan or other credit product, for example. A broker within a large firm might discuss maximizing fees from a captive client with one of their firm's private bankers. An independent firm like mine will focus on sourcing the best product or rate by making external firms compete for the business.

Motivation

Many brokers focus on transactions to generate commissions. While this naturally creates conflicts of interests with clients, the most dangerous aspect of this model is perhaps its piecemeal nature. A comprehensive financial plan should not be based on a series of flavor-of-the-day transactions. This approach is typically very inefficient both from tax and planning perspectives.

I believe genuine advice and robust planning are critical for financial and investment success (e.g., retirement).  That is why establishing goals and monitoring performance toward those goals are critical elements of my investment process. This helps me deliver peace of mind so my clients can take comfort knowing I manage their affairs with the care and expertise they deserve.

Business Policy

Given the conflicted nature of the broker model, the primary constraints on business strategy often boil down to legality and liability.  A quick search of the Financial Industry Regulatory Authority (FINRA) arbitration and mediation filings can illustrate the frequency and magnitude of issues clients have with these types of investment firms.

As a fiduciary advisor, independent investment advisors must maintain a code of ethics that sets forth their standards of business conduct.  Taking this a step further in an effort to facilitate the highest degree of transparency, I like to formulate investment policy statements dictating guidelines for the investment strategies and types of investments used with each client. This makes my financial planning and investment process fully transparent so my clients can enjoy more peace of mind.

Fees and Performance

Brokers often operate on a minimal-disclosure basis with fees explained in small print. I find it unfortunate and unsurprising that most prospects I meet with are unaware of the magnitude of investment-related fees and how they are levied. Moreover, few if any brokers compare their performance to standard benchmarks or indices.

My fees and performance are fully transparent. I provide my clients quarterly performance reporting and invoices. I also report external fees (e.g., fees charged by ETFs and mutual funds) and calculate their total cost of wealth management. This allows my clients to see both how much they are paying and what they receive for their fees.

Different types of investment professionals

Different investment professionals uphold different standards for the advice and recommendations they provide. For example, brokers are held to a suitability standard. In other words, they only need to have a reasonable basis to believe the products they sell are suitable - even if they know they are not necessarily the best choice. Independent investment advisors uphold a fiduciary standard. This standard of care requires advisors to put the interests of their clients first, act with prudence, and disclose all important facts. I provide an example below to illustrate the difference between standards of care.

Compensation structures are perhaps even more important than required standards of care. For example, brokers typically receive commissions for selling investment products to clients. These monetary incentives may influence their advice and recommendations.

Conflicts of interest

Conflicts of interest may exist at the firm level as well. For example, many large investment firms employ pay-to-play schemes. That is, they make product providers (e.g., mutual fund companies) pay them fees to be included on their platform for distribution to their wealth management clients. This naturally constrains the universe of investments for their advisors to provide to their clients, but it also encourages the firm to favor products from companies who pay them the most fees. While this issue has been flagged by some major financial publications (e.g., Barron's and SSRN), the private nature of these agreements make it difficult for investors to identify let alone understand the potential conflicts and their implications.

Dually registered advisors

Complicating matter further is the overlap between brokers and advisors. Most investment advisors are  dually registered. That is, they are registered both as advisors and brokers. This ambiguity is a contentious issue within the investment world. Indeed, many question the ability of financial professionals to switch broker/advisor hats without misrepresenting themselves, the products they are selling, or their standards of care.

Example: Fiduciary vs Suitability Standard

A securities broker and an advisor both find S&P 500 index funds would make sense for their clients. The market offers several S&P 500 index funds with varying fees and commissions - all of which perform virtually the same before fees. Under the suitability standard, the broker might sell a S&P 500 index fund with higher fees so he can receiver a larger commission (taken out of the client's investment). However, as a fiduciary advisor, I must put my clients' interests first and would opt for a low-fee index fund without commissions.

Financial Planning

Like many other financial advisors, I rely on third-party software packages to help me design, implement, and maintain financial plans for my clients.  However, I find these tools do not adequately model or address many planning issues. So they are only one part of my planning process.

Leveraging my analytical background and experience, I learned how to augment these software packages with my own models and analyses. As a result, I can now easily highlight and address many of the deficiencies I discovered. Some of these involve simple considerations such as beneficiary designations (please contact me to request my tax planning guide for this and other tax-related considerations); others relate to more complex issues around risk simulations and performance modeling.

I find this approach can yield significantly better results. So please get in touch if you would like me to help you make concrete planning decisions that can improve your financial security.

Index Investing

While I generally advocate index investing relative to actively managed strategies for most clients, my research highlights several subtle but significant embedded costs that can far outweigh the low advertised fees. Please read about the cons of passive investing or contact me to request a copy of my more detailed research to learn more about these costly issues. Knowing the difference between well and poorly constructed index products can improve performance by 1-2% per year or more over the long term.

In addition to allowing me to identify and avoid index products with these issues, I can use my experience constructing indices and index products to develop the rules and mechanics for a personalized index to reflect your specific investment goals and risk profile. This provides an unprecedented degree of customization other advisors cannot achieve with off-the-shelf funds and products.

The traditional approach to financial planning

The traditional approach to financial planning involves feeding noisy stock market data into sophisticated statistical models. These models rely on assumptions regarding the future performance of the market in order to achieve various goals for growth, retirement, or income. The statistical assumptions and mechanics behind these strategies are brushed under the rug for investors.

The end result is typically a 60/40 portfolio (i.e., 60% stocks and 40% bonds). This portfolio is periodically rebalanced to maintain those percentage allocations and synthetic income is created by selling principal. This approach results in three significant problems:

• Increased dependence on market performance
• Systematic dampening of performance
• Increased risk of wealth depletion

My research discusses these issues in detail. Please contact me to obtain a copy of or discuss my research on this topic.

My more structured approach to financial planning

I prefer a simpler and more natural approach to provide steady and increasing income. This is especially relevant in the context of retirement. Instead of selling principal to generate synthetic income, I target more reliable income sources to reduce dependence on market performance. The following example illustrates a hypothetical situation

Example couple

Consider a couple with $5,000,000 in liquid assets. Further assume they have $50,000 in annual social security and a current spending budget of $250,000 per year. After social security, this couple requires $200,000 in annual income (including tax payments). This amounts to a required yield of 4% ($200k÷$5m) from their investments. Most advisors would suggest a 60/40 (or similar) portfolio. Then they would sell off a portion of the portfolio each year to generate the required income. Indeed, there is a popular 4% rule of thumb. According to this rule, advisors assume their investors can spend 4% (of the original portfolio value) as a safe withdrawal rate (SWR) each year. In particular, they assume the client will not deplete their principal during retirement. Depending upon subsequent market performance, the principal may grow, erode, or potentially deplete.

My approach does not rely on rules of thumb. Instead, I take a more structural approach that targets the required income as a liability. In this case, I might suggest allocating 30% of the portfolio to a single-premium-immediate-annuity (SPIA). Even with the currently low interest rates, this allocation could generate approximately 8% or $120,000 in annual income. Moreover, this would last as long as either spouse was still alive.

This leaves a residual budget of $80,000 which could then be easily covered by investing the remaining $3,500,000 of the portfolio in the market. Indeed, with a 3% dividend yield or interest rate, this would result in an additional $105,000 of annual income for a total of $275,000 (including social security). Moreover, I would typically suggest investing the bulk of this market portfolio in high-quality, dividend-paying stocks. This would reduce the risk as well as facilitate the growth of the income.

Multiple benefits to this approach:

• Reduced dependence on market performance
  My approach relies first on guaranteed income from insurance companies (generally backed up by the state guaranty funds) and then on dividends which are much more stable than market prices - especially when one targets high-quality dividend payers.
• Reduced fees
  Unlike the more complex annuity products brokers typically push, SPIAs typically embed minimal fees. These are typically far smaller than the fees of maintaining a 40% bond allocation.
• Growth of income
  While the annuity income is typically fixed, dividend-paying stocks tend to grow their dividends over time. This is especially the case for the high-quality companies I target.
• Isolation and growth of principal
  The market allocation within this approach is generally left untouched so it can grow. This directly contrasts the traditional approach whereby the market allocation is regularly rebalanced and sold to generate income.

While this is just one hypothetical example, there are different options and variations. Let me help you optimize my more structured approach to reflect your goals and risk profile.