Practitioner #2: Licensed Insurance Agents
Insurance is regulated by each of the 50 states and the District of Columbia; there is no federal regulation or oversight.
The reason: Unlike securities, which are identical (all the shares of IBM stock, for example, are the same no matter who buys them or how many you buy), an insurance policy is custom-designed for each purchaser.
Consequently, you’re not buying a security when you purchase life insurance. Instead, you are entering into a legal agreement with an insurance company. The agreement is executed by a contract — and all contracts are governed by state law, not federal law.
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That’s why insurance is regulated by the states and not by the federal government. Every insurance agent must hold a state insurance license. An agent must hold a license based not on his state of residency, but based on the residency of his clients. Thus, if a New Jersey agent has clients who live in Delaware, he must hold a Delaware license. There are four main types of licenses:
Property/Casualty license. This allows the agent to sell homeowners, automobile, and liability insurance.
Life/Health license. This allows the agent to sell life, health, accident, and disability income insurance, as well as fixed annuity products.
Long-Term Care Insurance license. This allows the agent to sell long-termcare insurance.
Variable Annuity license. This allows the agent to sell variable annuity products, provided that the agent also holds the FINRA Series 6 or Series 7 license described earlier.
Like stockbrokers, insurance agents’ licenses are held with one or more insurance companies. And, like stockbrokers, agents legally represent the insurers, not their customers. And, like stockbrokers, agents earn commissions from the sale of products; they do not give or earn fees for rendering advice.
The most common “investment” product that insurance agents sell is annuities. Annuity commissions range from 1% to 15% of the amount you invest. Sometimes, the agent will earn more in commissions than you’ll earn in interest!
You may not realize this, though, because the product’s commission structure is similar to that of Class B mutual funds.
Consequently, the conflict of interest that can afflict stockbrokers can also afflict insurance agents. As a result, consumers in ever-greater numbers are turning to the next type of practitioner.
Practitioner #3: Investment Adviser Representatives
As we’ve seen, stockbrokers and insurance agents legally serve the best interests of their firms. And they earn commissions when selling products.
Today’s investor wants something more, something better. If you’re like most, you want to work with a true adviser who is not burdened by such conflicts of interest, one who indeed works for you and who is not beholden to some insurance company or Wall Street firm.
You want an Investment Adviser Representative.
Such a person is affiliated (often as an employee) with a Registered Investment Advisor — an advisory firm that is registered with the Securities and Exchange Commission or a state regulatory agency. (Note: Attorneys and accountants are exempt from registration.)
Registered Investment Advisers and their Investment Advisor Representatives are legally obligated to serve your best interests. That obligation is referred to as a fiduciary duty, and it stands in sharp contrast to stockbrokers and insurance agents.
An Investment Advisor Representative must hold one of the following FINRA licenses:
Series 65: Uniform Investment Adviser Law license. Before practicing, the Investment Advisor Representative must also obtain the Series 63 state license.
Series 66: Uniform Combined State Law license. This license combines the Series 65 and Series 63 into one examination.
Perhaps you’ve noticed that the SEC regulates Registered Investment Advisors
and their representatives. Why, then, you might be wondering, does FINRA issue their licenses?
I have no idea.
But I will tell you this: Many Investment Advisor Representatives also hold brokerage licenses and insurance licenses! If you find all this confusing, you’re not alone.
There are two reasons why so many advisors are dually licensed (as it’s called):
First, the complexity of personal finance is a relatively new phenomenon. As recently as 1980, most Americans spent their entire careers working for one employer. Most homeowners only owned one home.
Their employers managed the investments in their pension or 401(k) plans, and nobody had an IRA account (which was not invented until 1974). Money market funds were only 10 years old in 1980, discount brokers didn’t exist until 1975, and the Federal Housing Administration wouldn’t insure adjustable rate mortgages until 1989.
Small wonder, then, that virtually all practitioners were either stockbrokers or insurance agents. (The CFP Board of Standards wasn’t formed until 1985.) In 1980, there were only 564 mutual funds holding a mere $134.8 billion in assets— meaning that stockbrokers were literally brokering stocks (today, they are far more likely to sell mutual funds and annuities, which are easier to sell and pay far higher commissions).
Likewise, insurance agents once sold only life insurance; today, many agents never sell insurance and instead earn a living selling annuities and mutual funds.
As the world of personal finance grew more complex, many brokers and insurance agents began to realize that selling investment and insurance products lacked context. Without considering the customer’s tax rate, risk tolerance, or need for income, it was difficult to say that a given product really was in a given client’s best interests.
For that reason, many brokers and agents migrated to an advisory practice. They continue(d) to recommend products, but now within the framework of a holistic financial planning environment.
If you come upon an Investment Advisor Representative who has been in the field since the 1980s or earlier, chances are good that that person started his or her career as a stockbroker or insurance agent.
And, chances are, he or she still holds his old licenses. (Those new to the field are much more likely to have begun their careers as an advisor; the first college degree in the financial planning field [from Purdue University] wasn’t offered until 1986.)
The second reason many Investment Advisors Representatives also hold brokerage and insurance licenses is because they need to in order to serve their clients.
Even though they are technically serving in an advisory capacity, the vast majority of Investment Advisor Representatives help their clients implement their recommendations. To facilitate the purchase of investments and insurance, the advisor must hold the appropriate FINRA and insurance licenses.
For both these reasons, many practitioners are dually registered. They hold brokerage licenses with a brokerage firm, insurance licenses with one or more insurance companies, and their advisory registrations with a Registered Investment Advisor.
So if the practitioner you’ve hired holds all three types of licenses, in which capacity is he serving you?
There’s an easy way to find out: Just ask him or her.
If your practitioner is acting as a Registered Investment Advisor, he or she must give you a copy of Form ADV. This document is the registration statement that all Registered Investment Advisors are required to file with the SEC (or state regulator).
The ADV explains the services provided by the advisory firm and the fee schedule, as well as the representative’s background. Importantly, the document will state the conditions under which the representative is serving as an advisor vs. a salesperson.
If your financial professional cannot provide you with Form ADV, then he or she is not an Investment Advisor Representative. Period. Never let anyone claim to be serving your best interests unless they can produce that document. You can also check with the SEC at www.adviserinfo.sec.gov. Click “Investment Advisor Search.”
The law requires all those who charge fees for investment advice to register with the SEC or a state agency. Therefore, never work with anyone who has not done so.
Unlike brokers and agents who earn commissions for selling products, an Investment Advisor Representative is paid a fee to give advice. The fee is typically based on time or account value, or a combination of the two.
A fee based on time might be set at an hourly rate or a flat rate based on an annual retainer. A fee based on account value is called an asset management fee; the rate is typically based on the size of the account (usually, the larger the account, the smaller the rate).
Understanding the Difference Between What They Charge and What You Pay
When interviewing prospective advisors, as read in Chapter 83 of The Truth About Money, you should always ask how they are compensated. Unfortunately, if that’s all you ask, you might not be told the whole story.
That’s because there’s often a big difference between what they earn and what you pay. Therefore, instead of asking, “What is your compensation?” you should ask, “What are the total costs I will incur by working with you?”
You see, when your financial advisor provides you with a portfolio of funds, you’ll incur not one cost, but three. So it’s vital that you receive full disclosure — otherwise, you might end up paying far more than you should, and far more than you realize.
First, of course, is the advisor’s fee. Known as an asset-management fee, it is generally expressed as a percentage of assets. At some firms, the asset management fee is as high as 3% per year.
To learn the fees charged by other firms and how those fees are collected, you should ask advisors you are considering hiring for a copy of their Form ADV (Part II & Schedule F), a federal disclosure document that each advisor is required to provide to you.
But the asset-management fee is not the only cost you’ll incur. In addition to paying for your advisor, you must also pay for the funds your advisor has recommended, and this is where you’ll find two other costs: fixed expenses and variable expenses.
Fixed expenses are included in something called the Annual Expense Ratio. Every mutual fund and exchange-traded fund charges this fee — even so-called “no-load” funds. (“No-load” means there are no commissions when you buy or sell shares; it does not mean “no fee.”)
The expense ratio pays for the fund’s recurring operating costs, from the manager’s salary to the toll-free phone number investors call to talk to customer service representatives.
As of December 31, 2009, according to Morningstar, the average expense ratio for all mutual funds is 1.19% per year, although many are more than 2%. The highest in the industry, according to Morningstar as of December 31, 2009, is a staggering 18.4%!
Although the expense ratio is expressed as an annual figure, it’s actually debited on a daily basis. But the charge does not appear on monthly statements, making it hard for investors to notice it. To find it, you must look in the fund’s prospectus, where the expense ratio is expressed as a percentage.
Many investors — and, astonishingly, even many investment advisors — think the annual expense ratio covers all fund expenses. But it doesn’t. The expense ratio covers only perennial fixed costs — salaries, marketing, overhead, and the like. But there are many variable costs to operating a fund, and these are in addition to the expense ratio.
The biggest variable costs are brokerage commissions and trading expenses.
When fund managers buy or sell a security, they pay brokerage commissions — just like you would, if you were to buy or sell a stock or bond. Of course, funds pay lower commission rates than you would pay, thanks to their volume.
Even so, considering that funds trade millions of shares representing billions of dollars, their trading costs are huge — and the more the fund trades, the more it spends on brokerage commissions.
Typically, funds spend tens of millions of dollars in trading costs per year, and these expenses are not included in the Annual Expense Ratio or even disclosed in the prospectus. To find these and other expenses, you must look in the fund’s Statement of Additional Information.
Unlike prospectuses, advisors are not required to provide SAIs to you. As a result, many investors have never even heard of it, let alone ever seen or read one. In fact, after training financial advisors nationwide for years, I can tell you that some advisors have never heard of it either.
Yet, according to Morningstar, the fees described in an SAI can equal or even exceed the Annual Expense Ratio. Until recently, you had to ask fund companies to mail you their SAIs. But thanks to the Internet, you can now find these documents at most fund company websites.
Trading expenses are difficult to determine, but in 2007, an analysis by researchers at Virginia Tech, the University of Virginia, and Boston College found the average fund, based on a sample of 1,706 U.S. equity funds from 1995 to 2005, incurred annual trading expenses of 1.44% per year during that period.
This is in addition to the 1.19% that is the average Annual Expense Ratio according to Morningstar as of December 31, 2009, based on all the mutual funds it tracks.
These two figures put the total cost of the average mutual fund at 2.63% per year. (This calculation is based on historical data; current figures could vary.)
By adding this to a 0.90% advisor’s fee, you can see how ordinary investors can incur a total annual cost of more than 3% per year.
So be careful when asking an advisor what he charges. If the answer is, “My fee is one percent,” he might be omitting the Annual Expense Ratio and trading expenses that you’ll also incur. When you are interviewing potential advisors, make sure they tell you the total costs you’ll pay to work with them.
Practitioner #4: Money Managers
It has long been my contention that I don’t manage money. That might seem to be a strange thing to say, considering that my firm has, at this writing, $5 billion in assets under management. Still, my view is that, rather than managing money, I manage clients.
My colleagues and I at Edelman Financial realized long ago that the key to helping our clients achieve financial success lies not in helping them pick the right investments for their portfolio, but in getting them to invest in that portfolio after we’ve designed it for them.
People often have the best intentions, but distractions, emotions — or downright procrastination (read Chapter 1) — can interfere with our (and their) genuine desire to do what they need to do at the time they need to do it.
This is why my colleagues and I (and pretty much every real advisor in the country) create custom-designed plans and investment programs for each client, and then we focus all our energies on helping the client implement them.
A money manager, by contrast, has no such relationship with clients. His only relationship is with the client’s money.
The most common example is found in mutual funds. Each fund is controlled by a money manager, whose job is to invest the money in accordance with the fund’s objectives. Every person who invests money will be treated identically.
If a manager decides to sell a stock, he or she will sell that stock out of every client’s portfolio, and if he or she buys a stock, every client will own it — and they will all own that stock in the same proportionate amounts.
Thus, every client’s holdings in a mutual fund is identical and their results will be identical. The only differences in results between two investors would be caused by the fact that one might invest or withdraw money on different dates than the other.
Consequently, it is not only possible but quite common for stockbrokers, insurance agents, and Investment Advisor Representatives to recommend that their clients invest with money managers — often via mutual funds, exchange-traded funds, annuities, or wrap accounts.
Put simply, the money manager manages the fund while the investment advisor manages the client’s personal finances.
The material regarding mutual funds is general and is intended solely for informational and educational purposes. Specific details are contained in each fund’s prospectus, which can be obtained from the investment company or your investment advisor.