Fees, Fees, and More Fees – The Death of a Portfolio

How a portfolio X-ray of an affluent, educated, and sophisticated Investor’s retirement account(s) showed how it was being chewed alive by hidden fees and commissions, threatening to end her retirement just as it was getting started.
palmer_portrait“The broker-dealer and its dually registered investment advisor representatives received way more compensation than the mere 0.85% annual amount they stated to Janet. Actual fees and commissions were much closer to 2.5%.”

Editor’s Note: This is a true story. Sadly, it’s not an unusual story. But it is quite unusual for such a bunch of dirty details about systematic, pedestrian investor abuses to surface in public. It took courage for Janet to volunteer these personal details, allowing each of us the opportunity to be better informed.

While helping an ex-Fortune 500 retiree prepare a financial disclosure document, we discovered that the recommendations being made by her broker were likely to cause her to outlive her portfolio.

Having retired from a Fortune 500 company some years back, Janet Stelson (a real person now in her early 60s, and for compliance sake not her real name) was faced with taking a lump sum distribution from her defined benefit plan, to be rolled over into a self-directed IRA. In addition, Janet, who is single, had a 401(k) savings plan that she intended to rollover as well. Taken together with future receipt of Social Security benefits, she seemed to have more than enough to handle her financial needs in retirement — which could last 30 or even 40 years, based on her good health and life expectancy upon her retirement.

Janet did all the right things. She asked around — family and friends — for financial advisors to interview. She interviewed several. In the end, she chose one of the large national wealth management firms and a team of financial advisors with fancy titles, such as “Senior VP — Wealth Management.” She received the firm’s Form ADV Part II (now known as Part 2A), and received a broad variety of investment recommendations.

“How much do I pay in fees?” Janet inquired. The reply: “0.85% each year,” which according to Janet was the answer she received on several different occasions, with no elaboration and no caveats.

Janet was happy in retirement. She was confident and self-assured having acted prudently with her “rollovers,” by selecting a team of “senior investment advisors” obliged to act in her best interest, or so she thought. Despite this self-assurance, however, a gnawing sense of anxiety and concern about out-living her money kept her awake some nights. It seemed that every time the stock market went up – her portfolio didn’t – despite having what she felt was a properly diversified portfolio containing both stocks and bonds. In her mind’s eye the fact that she didn’t seem to be keeping up with the market – especially in recent years – was troubling.

Enter the Expert

Shortly after retiring, Janet was recruited to be the Treasurer of a not-for-profit after-school day care program for disadvantaged youth. Her role as a board member would require her to accept fiduciary responsibility for the finances of the program, and as such, she was required to complete a financialdisclosure document designed to alleviate any potential conflicts-of-interest; more specifically, she needed to disclose her personal assets, their place of custody and any contractual agreements. In the preparation of her disclosures she gathered up all of her bank and investment statements and began entering their content into a spread sheet. Rather soon she recognized just how difficult this was going to be as the description of each individual investment identified in her statements left her increasingly confused as to what she really owned. More ominously, with each entry she grew more fearful that perhaps rather than receiving “financial advice,” she had in fact been sold some very expensive investment products.

That’s where I came in.

Two days of reviewing disclosure documents

Having come to the realization that merely entering her investments into a spread sheet was not going to provide her with a meaningful reflection of what she actually owned and their related costs. That’s when she came to me with the request that I provide her with an independent “X-ray” of her investment portfolio. Her directive was clear – discern for her exactly what she owned, the “total fees and costs” and provide her with a general portfolio review. Janet was cautiously optimistic that her big name advisors had taken care of her appropriately — and that despite her misgivings – her portfolio “X-ray” would in fact reflect that she had chosen advisors, who acting as fiduciaries, unequivocally had her best interests in mind. After my “X-ray” analysis, her attitude changed abruptly.

As I undertook my analysis, I reviewed the large firm’s current Form ADV, Part 2A. I searched the Web (including at times the Securities and Exchange Commission’s Edgar database) and reviewed an additional 40 other disclosure documents, including fund prospectuses, statements of additional information, a variable annuity prospectus and occasional fund annual reports. I also obtained summary data from Morningstar Inc.

In all fairness, it should be noted that I don’t know all of the facts which, if I were Janet’s advisor, I would have needed to know in order to complete my analysis and provide her with appropriate recommendations. I did not sit down with her for hours to explore her lifetime financial goals, values, history of reliance on professionals for advice, and many other aspects of her financial situation. For example, I did not review her personal expenditures, her budget, her personal balance sheet, or any other risks she might be exposed to in other aspects of her financial life. Specifically, I focused on the analysis of her fees and commissions and the brutal effect they have on her portfolio returns and her ability to maintain an income from the same.

Over the course of the two days available to me to undertake the analysis, I pored through the monthly statement that was nearly 60 pages long (not uncommon, given the existence of four separate accounts and a broad range of investments). It included cost basis information, realized gains/losses, unrealized gains/losses, transaction ledger for the month, etc. Most of the documents I reviewed — prospectuses, statements of additional information and annual reports — were between 30 and 150 pages in length. Fortunately, I knew where to look to access the data I needed. Having been at one time an Assistant Professor teaching advanced courses in investment policy, I possess a very good understanding of all of these documents, and the terminology utilized. As a seasoned securities expert, having performed thousands of these portfolio “X-rays” over the years, I instinctively know how to negotiate these documents very well. I was hence able to obtain much of the data I needed from these disclosure documents, in a very rapid manner — relative to most financial advisors (I suspect). And certainly a great deal faster than 99% of individual investors. What was the result of my analysis? Here’s where the tale begins to turn ugly.

The Portfolio X-ray; getting in to the weeds over fees and cost analysis

First, understand that a vast portion of Janet’s portfolio — more than 80% — was in two IRA accounts, both managed under investment advisory programs. (This is where the 0.85% annual investment advisory fee was assessed.) Janet had two other brokerage accounts with this dual registrant firm (i.e., both as a broker-dealer and as an investment advisor), which were also reflected in her consolidated monthly statement.

Second, I found that 24% of Janet’s account was invested in a variable annuity possessing total fees and costs of 3.75% annually. (The investment advisory fee was not applied against this investment). While the variable annuity had a stepped-up death benefit guarantee, and a guaranteed minimum income benefit rider, I concluded that the high costs of the product and the limited nature of the benefits of these riders made the benefits to Janet largely illusory in nature.

Third, the broker-dealer, and its financial advisors, received way more compensation than the 0.85% annual amount they stated to Janet. They received “revenue-sharing payments” in the form of 12(b)-1 fees. Most of the mutual funds in the investment advisory accounts had 12(b)-1 fees in the range of 0.25% to 0.15% annually. One mutual fund in the brokerage account had a 12(b)-1 fee of 1% annually. While I cannot be certain that all of these 12(b)-1 fees were passed on by the funds to the broker- dealer firm, a frequently quoted statistic is that 80% of 12(b)-1 fees are, in fact, paid to broker-dealers.

Other revenue-sharing payments were noted in the funds’ prospectuses, including payments for shelf space, often referred to as “pay-to-play” agreements. These are payments by fund complexes for “preferred marketing opportunities,” often paid by the fund’s manager from a portion of the management fees charged by the fund’s investment advisor. The existence of such payments provides an incentive to a fund manager to establish and maintain higher management fees, even as economies of scale are achieved as the size of the fund increases. Again, it was not possible to discern if revenue-sharing payments were actually made, but Form ADV Part 2A of the dual registrant firm noted that the firm “receives other compensation from certain distributors or advisors of mutual funds” and that “revenue sharing compensation will not be rebated or credited” to its clients.

Additionally, many of the mutual funds in Janet’s portfolio provided “additional compensation to registered representatives of dealers in the form of travel expenses, meals, and lodging associated with training and educational meetings sponsored.” Whether these particular benefits were actually received by these particular “financial advisors” is not known, although such practices remain fairly common in the broker-dealer industry.

Also, for trading of securities within the fund, many of the funds paid brokerage commissions back to the dual registrant firm at which Janet held her investment advisory accounts. The generally high portfolio turnover of these funds resulted in a relatively high amount of brokerage commissions (and other transaction costs within the funds, such as principal mark-ups and mark-downs, bid-asked spreads, market impact costs, and opportunity costs due to delayed or canceled trades). Additionally, the amount of brokerage commissions in many of the funds was higher than would be expected, due to the payment of higher brokerage commissions by the funds in return for research from the broker-dealer firm — a practice known as payment of “soft dollars.”

The dual registrant also had Janet invest in one of its proprietary funds. Of course, this fund had high fees and costs, as well. I could not discern if any of the management or other fees were rebated to the client.

In summary, I found that Janet was paying well above 2% in “total fees and costs.” With another day or two of analysis, to better discern and analyze the data on transaction and opportunity costs (including those relating to cash holdings in the funds, which were above average in many cases), I would likely find that the total fees and costs ranged somewhere between 2.1% and 2.5%, and perhaps even higher.

To provide some context, the average investment advisory fee paid for an overall investment portfolio of this size would be slightly below 1% a year. And, with the fiduciary advisor avoiding additional compensation and utilizing both low-cost and tax- efficient index funds and/ or ETF investments, the additional fees and costs would be quite modest. In essence, Janet was paying about twice what she should have been paying, in total fees and costs; about an extra $20,000 per year – every year. And there are, as I pointed out to Janet, many financial/investment advisors who charge fees well below industry averages, and who also recommend very-low-cost mutual funds or ETFs to their clients.

Contrary to the understanding of many individual investors that “expensive investment products must be good,” the high total fees and costs incurred by Janet were certain to drag down the performance of her portfolio over time, and by a large amount due to the effects of compounding of annual fee payments, and its effect on the resulting terminal values of a retiree’s portfolio.

Tax efficiency: Not present

Other aspects of Janet’s portfolio were troubling. The overall portfolio was not designed in a manner that boded well for long-term tax efficiency. The location of assets, as between taxable and tax-deferred accounts, did not appear to reflect any long-term tax minimization strategy.

By way of explanation, as a general rule taxable accounts should hold assets that will secure long-term capital gain treatment upon their sale, such as tax-efficient, tax- aware or tax-managed stock mutual funds. Also, international stock fund allocations to taxable accounts can result in income tax credits; these tax credits are not available for international funds held in IRA accounts. In tax-deferred accounts, fixed-income investments should initially be allocated. The Roth IRA account, which grows tax free, should be held in the asset class with the greatest long-term expected returns, such as U.S. small-cap value stocks. These are general rules, only, and there are some exceptions to these rules, none of which appeared applicable here.

However, since the bulk of Janet’s overall investment portfolio was in IRA accounts, the effects of this inattentiveness to tax-efficient investing were somewhat ameliorated. If the investor had possessed a somewhat larger percentage of the portfolio in taxable accounts, the concerns expressed herein as to tax-efficiency would be much greater.

Investment strategy: Not sure there even was one?

In the review of the investment portfolio I did not identify an over-reaching investment strategy for managing overall portfolio risk and expected return. With respect to the equities (stocks, stock funds), there didn’t appear to be any obvious strategy for mitigating volatility nor capturing known return premiums. There was no obvious commitment to using investment strategies that have withstood the rigors of academic scrutiny; Modern Portfolio Theory (MPT), Efficient Markets, and the utilization of the value and small-cap tilts (part of the Fama-French three-factor model).

Instead, the portfolio emphasized individual stock selection, or “active management.” As the academic research has shown, active investment strategies underperform, on average, passive investment strategies over long periods of time. (For a good explanation of this issue, without needing a heavy dose of statistics, see “Rick Ferri’s recent article”: http://www.forbes.com/sites/rickferri/2013/04/04/index- fund-returns-get-better-with-age/).

Despite her portfolio having a bunch of differently named mutual funds in it, this did not mean that proper diversification was achieved. (It is possible to achieve a very high level of diversification from a handful of funds, if properly selected.)

Two-thirds of Janet’s portfolio was invested in fixed-income securities of one type or another. While this might sound conservative, the presence of a number of high- yield bonds in multiple funds, a floating-note fund, and a structured fund investment filled with mortgage-backed securities of dubious quality (the fund was the subject of a class action settlement in 2009), presented obvious risks. Sadly, the very portion of Janet’s portfolio that was intended to act as a stabilizing force against the volatility of her equities proved to be just as risky. Despite the attractiveness of the higher yields on her bond holdings, the interest rate risk associated with their long-dated maturities was of real concern. Compounding this concern was the extent to which the low credit quality on her bond holdings exposed her to a higher default risk and a lack of liquidity should she need to sell them.

Janet was withdrawing 3.5% from her investment portfolio annually, and she expected this rate of withdrawal to continue. And why not, she was, after all, well below the “4% threshold” that’s often touted throughout the financial planning industry. Yet, given the high fees and costs associated with her overall investment portfolio, and its present asset allocation, I projected that her portfolio would likely only sustain (with its current asset allocation) a rate of withdrawal of approximately half its current amount, or (1.75%). In other words, Janet was likely to outlive this portfolio, given the inefficient way it was currently structured, and the high fees and costs embedded throughout.

Additionally, since I was provided with only a snapshot of Janet’s portfolio, I could not see the changes to the portfolio made over time. However, based on the purchase dates of many of the investments stretching back years it did not appear that a great deal of changes had been made to her investment portfolio.

Yet, even within these limitations, I was able to discern quite readily that Janet was being harmed, by a high level of fees and costs, a questionable asset allocation, and a somewhat tax-inefficient portfolio. And, while the precise amount of additional compensation paid to the dual registrant firm and its “wealth managers” will likely never be known, it is certain that insidious conflicts of interest were present — which no doubt influenced the quality and type of the “advice” being provided. In other words, there wasn’t any attempt to rebalance her portfolio on a regular basis, automatically lowering her portfolio’s overall volatility while maintaining her stated risk and return profile.

There is substantial academic evidence that investors don’t read the disclosures (due to many behavioral biases, which have long been studied and discerned by academia)? Even those that try to read disclosure statements, like Janet, rarely understand them. What we do know is that “dual registration” (i.e., registration as both a broker-dealer firm and as a registered investment adviser firm) has become increasingly common; with about 88% of investment adviser representatives are also registered representatives of broker-dealer firms.
A day of Reckoning

We agreed to meet at my office wherein we went over the portfolio “X-ray” report together. The “X-ray” report is very straight forward, consisting of a spread sheet that populates into a colorful 30 page PDF report filled with various graphs, charts and tables comparing her individual results to those of industry averages for the same. An independent side-by-side comparison of her portfolio to that of industry averages provided a vivid picture of the negative effects the hidden commissions and fees were having on her ability to build wealth and sustain her monthly distribution.

Despite the fact that Janet is extremely self-confident and articulate, her voice was cracking as she expressed her feelings of disbelief, “I feel … betrayed,” she blurted out. She explained to me that she had often confirmed the fees she was paying when meeting with her “financial advisors;” only to repeatedly be told a figure far less than the figure staring her in the face from my report.

Janet continued, and with saddened eyes and anger welling-up in her voice, she recounted to me that she had “trusted her financial advisors.” They had assured her they were looking out for her best interests. “Boy was I wrong,” she lamented.

When Janet had finished I asked her some impromptu questions. Had she ever received the Form ADV, Part 2 from the firm, and over the years had she received the mutual fund prospectuses and annual reports? Had she read them and did she understand them? At first, Janet was taken aback by my questions. Thinking about it for a minute, she succinctly answered, “yes and no.” Yes, she had received the documents, and despite her above average level of education versus most investors — No she had neither read nor understood them.

Janet continued. “I trusted my financial advisors. They were supposed to be honest with me. I asked them direct questions. At no time did they explain to me that either they or their firm received all of these additional fees.”

An All too Familiar Tale

I then explained to her that her experience was by no means an isolated one. That the financial services industry is full of “financial advisors,” and “global wealth managers,” and “VP portfolio advisors,” and “senior investment consultants,” and “registered financial planners,” and so on, each self-describing title possessing multiple layers of conflicts of interest. That in fact, 95% of “financial advisors” don’t avoid all conflicts of interest, as they should. And that disclosures of conflicts of interest when actually made by dual registrant firms and their employees, are often “casual” in nature, not read by investors, and even if read -seldom understood.

We discussed how this dual registration confusion complicates the “investment advice” rendered during the all-important decision of what to do when rolling out of a 401(k) defined contribution plan upon retirement. We both commented on the sheer amount of advertising and marketing all the large financial services firms direct toward this single life event. Wondering aloud at which point the “financial advisor” takes off his “advising hat” and puts on his “commission sales hat?”

A Roller Coaster of Emotions

By the end of our meeting Janet was both angry — and sad. Angry that her “financial advisors” had been able to hide their exorbitant and devious means of compensation behind a complex set of obscure disclosures; and sad – they had not acted in her best interest; causing her to suffer substantial financial losses. She was further angered knowing, despite an abundance of over-whelming evidence, her investment portfolio had not been managed according to the principles of Modern Portfolio Theory (MPT). And that “actively managing” her portfolio was nothing more than a cover for exhorting exorbitant fees and commissions under the roués of acting in her best interest.


Janet’s “wealth management” firm did in fact possess fiduciary obligations to her, as did the team of “financial advisors” working for that firm. Sadly they designed their disclosures to be casual in nature, hard to understand, and when sought-after and found – hidden away within some long disclosure document in a dark corner of some website needing to be searched out, discovered, read, and comprehended.

Clearly, all of us, as investors, have a responsibility to do our homework when it comes to managing our investments and the relationships that surround them. In short, “trust but verify.”

Copyright © 2014 Wealth Management Partners of MI, LLC