It is my belief that commissions create a moral hazard, as advisers who get paid for placing you in certain products are going to steer you to those products. A commission-based advisor who recommends you go into no load, low expense index funds and low fee term life insurance will starve.
What’s the risk of picking someone who has that track record? Retirement risk! Chances are that this person hasn’t been picking funds straight out of college and is, therefore, in his or her 40s. Instead, this person probably had to work up the ladder and is in his or her 50s or 60s. The manager probably doesn’t have that much longer before retirement, and will be replaced by a new, unproven manager.
Let’s assume that you’re comfortable with someone who has a demonstrated track record. Between 1986 and 2011, this person would have need to beat the market average growth rate of 9.68%. If you have $100,000 to invest, then if you get the market average return of 9.68% over the next 25 years, then you’ll have $1,007,363.11 at the end of 25 years. A planner who takes a 1% fee based on your assets will have received $87,346.92 in fees and you will have $223,814.57 less because of the inability to reinvest those fees.
What does this planner need to get in market return to justify his fees? In this case, he will need to get a 10.79% return just to break even, meaning he will need to consistently beat the market by 11.45% per year.
Naturally, this analysis is somewhat simplified, as I am not taking into account the volatility of returns; for example, you may be more comfortable getting lower returns in exchange for less “wobble” in your portfolio. However, it does show the magnitude of the task that fee-based planners, commission planners, and load-based mutual funds face compared to index funds.
When you look at getting financial planning assistance, make sure that you are taking the full picture of fees into account. Ask how your financial planner is getting paid and how that will affect your long-term planning picture.