Wednesday, August 02, 2006

The cost of financial planning

I have a lot of friends who are smart, knowledgeable, and generally wise in the decisions they make. However, a lot of them have one common characteristic. They don't actively plan their financial future.

Some do nothing at all. They don't budget, don't save, don't invest, and don't even take advantage of the 401k plan offered by their employer. I don't have very many friends in this category, but they are in the worst shape for the long term. Their future security will be at the mercy of Congress as the demographics puts a squeeze on the liquidity of Social Security and Medicare.

Others put away a little bit of money in their 401k. That will help them some, but they have no idea if it will be enough. In addition, they don't usually have a strategy to their investment selections. They could allocate their funds better inside the 401k plan, but they don't really know how. These people are gambling with their future. They may be saving too little, and be forced to work much longer than they wanted to, or to retire at a much reduced standard of living. Alternatively, they may be saving too much, needlessly constricting their budget now so that they can die sitting on a pile of money. They may also be paying a high opportunity cost for failing to more effectively invest their money. Many are taking unnecessary risks by investing in company stock or by not diversifying enough.

There is a third category of people. They recognize the importance of financial planning and don't feel up to the task of doing it themselves, so they hire a professional financial planner. This may help them to avoid some of the pitfalls, but at a very high cost. Unfortunately, the commission-driven world of financial planning brings its own set of pitfalls. There are some "fee only" planners who will provide good advice and sound management at a reasonable cost, but most of the industry is commission-based, and the planner's interests are not at all aligned with the interests of the customer.

These financial managers are not so much "planners" as salesmen, and they want to sell the product which gives them the highest possible commission, not the product which best meets the client's needs. Layer upon layer of fees and expenses eat into the client's principle and stunt the growth of the investments. A typical "financial planner" charges a management fee of 2% of assets under management. Then he invests in mutual funds with a 5% front load and 2% annual expenses. The underlying investment would have to return 10% in the first year for the client to just break even. You could do better with a bank CD.

Over the long term, how much impact does a 2% management fee have on your savings? As an example, consider Steve, a 25-year-old who earns $40k per year. Steve invests 10% of his income in a Roth IRA. Each year he gets a 4% raise, which is just slightly more than inflation. If his investments return 8% annually, by the time he is 65 years old, he will have accumulated $1,846,942. Not bad. However, if Steve had used a financial planner who charged a 2% management fee and invested in front-loaded mutual funds, his account would only be worth $1,122,862. The planner would have gradually transferred 40% of Steve's life savings into the planner's bank account. This is the difference between a secure, comfortable retirement and a job as a Wal-Mart greeter at age 78.

The sad thing is that financial planners don't do much to earn these high fees they charge. Most use outdated and overly simplistic "rules of thumb" to decide how much you need to save and how you should invest. A financial planner's livelihood depends on convincing you that he has a magic crystal ball which lets him pick better investments than you could pick on your own, and that this "value added" will more than make up for his "industry standard" fees. The facts tell a different story. More than 75% of financial planners' accounts underperform the S&P 500 index. About half underperform a "moderate allocation" index consisting of 70% stocks and 30% bonds. In other words, you could randomly select a mutual fund and have a 50/50 chance of doing better than your planner. Better yet, you could buy the Vanguard Total Market Index and have a 75% chance of outperforming your planner.

Right here on this blog I am going to present a plan which for Steve could make the difference between $1,846,942 and $1,122,862. This plan, worth roughly three quarters of a million dollars, is provided free of charge. I have no financial stake in any of the products that I name. I am only a satisfied customer of these companies.

Start off by reading The Four Pillars of Investing by William Bernstein. The $18.87 price at Amazon will make you more effective at managing your finances than many professionals who charge hundreds of dollars a month.

Read Scott Burns column. Read his archives. Read his sections on consumption smoothing, couch potato investing, indexing, Club 401, portfolio survival, and his "Seven Laws of Personal Finances".

Get familiar with, a great source of data on mutual funds.

Know your own risk tolerance and don't exceed it.

Understand the different categories of risk affecting your finances.

Understand some important concepts such as the relationship between risk and reward, compounding interest, dollar cost averaging, diversification, time value of money, and Modern Portfolio Theory.

Make a budget. Any sound financial plan starts with living below your means. Start by tithing to your local Church. Then set aside money for savings. Next pay your fixed expenses. Finally, allocate what is left for other expenses and discretionary spending.

Use ESPlanner to develop a comprehensive financial plan for your family. This powerful tool developed by Laurence Kotlikoff, Professor of Economics at Boston University and Research Associate at the National Bureau of Economic Research, is light-years ahead of what the financial planning industry uses. ESPlanner uses the concept of consumption smoothing combined with dynamic programming to create an optimal lifelong plan, considering all aspects of your finances: current and future earnings, future expenses, housing expenses, home mortgage, taxes, social security, life insurance, and contingency plans for events such as the death of a spouse. Read this paper for a full description of ESPlanner. If you balk at the $150 price tag, compare it to how much you might pay for less reliable help from the financial industry, or to the cost of botching your financial plan.

Use term life insurance to provide the coverage as recommended by ESPlanner.

When you invest, don't chase past performance. Last year's hottest fund is not likely to outperform in the future. Instead, use a consistent asset allocation built with low-cost no-load index funds focusing on total portfolio performance rather than individual funds. Many managed funds charge annual expenses of 1.5% or higher, and you are right back where you started with the financial planner, so mind the expenses. Vanguard offers many funds with expenses below 0.3%. You can get adequate diversification with a fairly small number of funds. Principles from the reading suggested above will help you select an appropriate asset allocation. I like a mix of domestic and international stocks with a tilt towards value and smaller company stocks. The overall risk/return level can be adjusted by combining stock with fixed income investments.

Don't try to time the market. In fact, don't pay too much attention to the day-to-day ups and downs. Reacting to short-term market movements will almost always cause you to make bad decisions. Instead, pick an asset allocation which is appropriate to your goals, and stick with it. If your investments start to drift from that allocation too much, rebalance back to your target allocation, but otherwise keep your hands off. Automatically contribute to your investments on a regular basis, as recommended by ESPlanner.

Ignore any magazine article with a headline such as "Hottest 10 mutual funds" or "Top Stocks to Make You Rich". This is worthless information because past results do not indicate future performance. Professional managers of institutional accounts with hundreds of millions of dollars under their management, an army of analysts, and far greater resources than you have work around the clock to identify and exploit information which will give them an edge. Do you really think that you can beat them at their own game?

If your employer offers a 401k, use it. Contribute at least as much as your employer will match. If a 401k is not an option, consider a Roth IRA or other tax sheltered retirement accounts. Fit the 401k into your overall asset allocation strategy.

If you have kids, open a 529 account to save for their college expenses. A 529 account allows you to contribute up to $10,000 each year to each child. If you start early, this is way more than you need to contribute. Your child is the beneficiary, but you retain ownership of the account. The money grows tax free and can be withdrawn to pay qualified expenses (tuition, books, fees, room and board) tax free. If you withdraw the money for any other purpose you will pay a penalty on the growth. We use the T. Rowe Price College Savings Plan, but Vanguard also offers a good plan.

I didn't say that it was simple. It takes some time and effort to get started. But once you do, you can be a lot better off than you would be otherwise.

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