Financial advisors like to talk about how they add value; I want to talk about three ways they subtract it.
1. Sell crappy, overpriced products.
A good sign of a huckster masquerading as an advisor is if he hawks any of the following:
closed-end fund initial public offerings
non-traded real estate investment trusts
non-traded business development companies
The common denominator is a fat kickback. Many are sold to small investors. David Lerner Associates' notorious Apple REIT series is a prime example of a crappy, overpriced product. In 2012 FINRA fined the firm $2.3 million and forced it to pay about $12 million in restitution to elderly retail investors it had tricked into buying the non-traded REITs and paying excessive markups on municipal bonds and collateralized mortgage obligations.
Of course, large investors are also sold crappy products. Rather than anything as vulgar as non-traded REITs and BDCs, high-net-worth families are sold access to private-equity and hedge-fund strategies. This is the rich man’s timeshare: a slice of faux luxury bought at a premium, later regretted. The cognoscenti like to talk about how “top-quartile” hedge-fund and private-equity managers generate all the alpha, while the rest lose money. Who keeps plowing money into the losers? My theory: High-net-worth families who are sold the story that their wealth enables them to buy better managers, the same way it enables them to buy big houses and luxury cars. That just ain't so.
I have seen clients gush about advisors who are remorselessly pillaging their assets. This may seem odd, but the financial predators reddest in tooth and claw are often leaders in local charities and the church. In his Bible for would-be wolves, The Million-Dollar Financial Advisor, David Mullen writes, “Many of our top advisors individually donate more than $10,000 to nonprofit organizations that they are involved in. They view these expenditures as retained earnings.” (Tellingly, none of the practicing "top advisors" he interviewed for the book wished to be identified.) It makes perfect sense. The wealthy retired often find purpose by throwing their time and energy into passion projects. Being active in the same causes not only brings you in contact with them, but it signals that you are a good, trustworthy person, even when you're not.
While the crooks seem to be overwhelmingly commission-based brokers governed by the weak suitability standard, fee-only advisors governed by the fiduciary standard also have conflicts with clients that can result in suboptimal advice. The next two apply to both types of advisors.
2. Advise clients to cash out pensions or take Social Security early.
Here’s a common scenario: A company offers to cash out an employee’s pension for a hefty lump sum. Its helpful representatives and brochures make the payout seem more than fair. A savvy employee, observing that the company is not a disinterested party, might go to a financial advisor and ask for his advice.
Here’s what a “bad” advisor would say:
Look at the expected return on the pension. Given your life expectancy, you'll only earn 6% to 7% (or some number thereabouts). We can do better. The stock market has historically returned 10%. Small-cap value stocks have returned several percentage points more than that. Besides, what if the company goes bankrupt? You could end up with nothing.
Here’s what a good advisor would say:
Are you healthy? If yes, you should probably keep the pension. The main reason a company would cash you out is because the lump sum is smaller—sometimes much smaller—than the pension's expected cost. Pensions are valuable not because they offer the highest expected returns, but because they hedge longevity risk (and inflation risk, if you're lucky). Longevity risk is expensive to hedge with private insurance; you cannot buy the same stream of lifetime income with the lump sum. Let’s not forget there is a huge behavioral benefit to having a professionally managed asset that doesn’t have a daily quoted price and that cannot be redeemed on a whim.
This scenario is much more common than you think. Uncle Sam gives all Social Security beneficiaries the option to effectively redeem their pensions early by taking benefits at age 62. For many retirees, particularly married couples, delaying Social Security for at least one spouse until age 70 makes sense. It is often worth drawing down savings to fund the gap before Social Security kicks in. The strategy feels like a money loser because Social Security does not have a visible price, while one’s assets do. Bad financial advisors are happy to encourage clients to claim Social Security early for the same reasons they recommend clients cash out their pensions: they get more money to manage.
The numbers at stake can be surprisingly big. The present value of foregone benefits from taking a pension as a lump sum or claiming Social Security suboptimally can be greater than $100,000. If an advisor put you in a product that instantly lost you $100,000 for no reason other than incompetence, you'd fire him and take him into arbitration. But because we are homo sapiens, not homo economicus, we care less about foregone opportunities than losses caused by direct action—bringing us to our next advisor screwup.
3. Keep cash in money-market accounts and ultra-short-term bond funds.
Warren Buffett, that rational calculator, is unusual in that he treats sins of omission just as seriously as sins of commission. Most of us are not calculators: opportunity cost is simply not as real as losing money to an active decision. This may explain why so many advisors and investors keep their cash in money-market funds and ultra-short-term bond funds when there are FDIC-insured bank products that offer comparable or higher yields for lower risk. By the lights of homo economicus, this is just as bad as lighting up dollar bills.
Consider a retiree who has $1,000,000 in short-duration bond funds. In today’s low-yield environment, he’s earning a yield of around 1%. He would be better off putting his money in an FDIC-insured bank 5-year bank CDs from Synchrony or Barclays, which can yield 2.2% or more. Because the bank CDs are puttable at par, minus a 180-day interest penalty, their effective duration is low. The advisor, for his services, has incurred an opportunity cost of 1% a year on that money in addition to his customary 1% fee. The advisor is destroying $20,000 a year.
There is also self-interest at work. Many advisors would rather stick a client’s cash in a sub-par, low-yielding opportunity they can collect a fee upon than in a superior one they can’t. Hence the proliferation of ultra-short-term bond funds like iShares Short Maturity Bond NEAR and PIMCO Enhanced Short Maturity Active MINT and now Vanguard Ultra-Short-Term Bond VUBFX.
Of course, just because an advisor uses short-duration funds doesn't mean he’s a fool or a crook. Cash-like funds are OK places to park money for a short while. Sometimes it is more practical to keep cash in an investment account rather than shuttling it in and out of bank accounts.