Unlike the relationship with a product-driven planner (fee-based or commission-based), the costs of working with a fee-only planner are presented up front simply because that charge represents your entire outlay. While this cost may initially appear to be high in comparison, this is typically because the client is not privy to the layer of commissions and/or trailing fees that flow from the sales of insurance or investment products. Many times there are hidden commissions and compensation fees which are not transparent to the client. In that capacity, by law, fee-based and commissioned advisors are required to work in their firm’s best interest, not the client’s. Usually, in these situations, the individuals that represent these firms have an incentive to recommend high cost products, such as whole life and/or universal life insurance, variable annuities, and A, B, & C shares of mutual funds. The following pages illustrate a few of the potential types of compensation that may be the result of dealing with a fee-based advisor.
12b-1 Fees
Rule 12b-1 of the Securities and Exchange Commission allows mutual funds, under specified conditions, to use fund assets (make no mistake about it…this is your money!) to pay for distribution expenses. Since the adoption of the rule in 1980, funds have used 12b-1 fees, often in combination with contingent-deferred sales charges (see below), as an alternative to front-end sales loads for compensating sales professionals for assistance provided to purchasers of fund shares. Other uses of 12b-1 fees have included advertising, sales materials, and other activities involving the marketing of fund shares to prospective investors. Eventually, mutual funds have used 12b-1 fees to pay for administrative services provided by third parties to existing shareholders. These fees are limited to 1% per year.
While 1% may not seem debilitative, it represents roughly 10% of the potential return to which an investor is entitled for bearing the risk of investing in the stock market. Put another way, lowering your return on a $100,000 investment from 9% to 8% will reduce the eventual outcome by over $100,000 ($600,915 vs. $492,680) over a 20 year period! 12b-1 fees are entirely separate and apart from the operating expenses charged by the fund managers. According to regulation, a .25% fee may be assessed while still allowing the fund to call itself “no-load”.
Operating Expenses and Deferred Sales Charges
Some funds impose no front-end load, but charge higher operating expenses to make up for commissions paid to salespeople in the distribution channel. These fees are imposed annually cutting into the potential reward that an investor may realize as a result of his investment. Should the investor liquidate his holdings in the fund prior to a specified number of years, a contingent deferred sales charge may be imposed in lieu of the fund’s ability to recoup its commission expenses.
Annual operating expenses may range from as low as .2% for a passively managed index fund to well over 5% for actively managed funds. In fairness, international investing and certain sector concentrations impose additional logistical costs, but the sad fact is that over 70% of fund managers fail to beat their corresponding index annually. Put another way, many fund managers fail to add enough additional value via their stock-picking expertise to cover the expenses that they impose.
Regardless of whether a fund’s fees are charged as front-end, back-end or annually, the higher they are, the more difficult it becomes to maintain average investment return in comparison to an appropriate benchmark.
Life Insurance
The insurance industry has done little to educate consumers as to the range of product availability or its appropriateness. In many to most cases, the need is to protect against the untimely demise of an income-producing or service providing member of a family. Risk can be transferred (as in the case of insurance), avoided (rather difficult as it pertains to death!), retained (as in self-insurance), or shared (for example, among several businesses). Life insurance is a simple transfer of risk to an insurance company. The appropriate amount is nothing more than the present value of the insured’s family needs to replace the potential lost future earnings.
Pure risk transfer is available only in the form of term insurance. The myriad of other products available, from whole life to variable universal life, combine pure risk transfer with some sort of savings vehicle. Unfortunately, what often results due to the increased cost is a mediocre level of insurance coverage combined with a relatively poor return on the savings component. Pre-sale illustrations often represent a variety of very positive assumptions in excess of the underlying guarantee of the contract. As the cash value of the policy grows, less of the risk remains transferred to the insurer. “Buy term and invest the difference” will, in most cases, be the appropriate axiom. The reason that cash values build as slowly as they do in the early years of a policy is simply because sales commissions are as lucrative as they are!