It’s not Peter, Paul, and Mary stealing from you. The 12b-1. Investment advisers secret money machine. 3 proven ways to steal a clients money. Should you learn Chinese? Returning phone calls. Hiding fees behind bonds. Quick. Who says this? “I can steal your money and shine your shoes?”

Welcome to our listener-supported podcast, Money Talk, uncompromised absolute financial truths behind financial perceptions with host, Ed Sutkowski and Chuck LeFebvre. Let’s listen in.

Ed Sutkowski: Welcome, I am Ed.

Chuck LeFebvre: And this is Chuck.

Ed: Today’s topic is in our second stage, the management of the assets, and more specifically, investment advisor and investment fees, costs expenses, both disclosed, and most importantly, non-disclosed. Chuck?

Chuck: Yes. Well, I think a couple of things caused us to decide we wanted to have this conversation today, one of which is this article that was published this morning on wealthmanagement.com that we’ll talk about in a little bit. That reminded me of this analysis that had been done maybe a couple of years ago for a client who had several IRAs with an investment advisor. The investment advisor was charging fees on some of those IRA accounts on a- this would become more the typical approach, on a percentage of the assets under management. There was also one IRA in that batch that had about a $1.5 million in it that was- the investment advisor was saying there’s no fees charged against that. We dug in and did a detailed analysis of this, looking at what was really being paid and discovered that– This followed having multiple requests for the advisor to provide some detailed reporting of the total fees being charged. It turns out that about 40% of the total fees that were being charged in those accounts were not disclosed even when there was a specific request for disclosure.

Ed: Yes. Let’s back that up for just a second. This occurred in 2016, as you’ve suggested. I recall making these requests with authorizations attached in writing, and the investment advisor is domiciled in a major city and with a large organization. This is not a Peter, Paul, and Mary next door, it’s a huge organization. The resistance only caused us to probe even further. Chuck, would you describe the nature of the fees that you picked up?

Chuck: Yes. They came into several different categories, some of which would go directly into the advisor’s pocket and others were just bleeds against the account where you’re not exactly sure how much of that goes into the advisor’s pocket. Starting with, even though we were talking about a platform where there was a fee charged that was based on the value of the assets in the account, there were also trading costs being charged. These are just- it’s another term for traditional commissions; trading costs being charged against the account. Those trading costs were part of the total fee that the client was paying. Part of the fee was for the investments that were held in mutual funds. There’s a particular type of fee that mutual fund shares hold, called the 12b-1 fee, which is– There’s all kinds of commissions that can be charged on mutual fund shares, depending on the share class and so forth but the one that is insidious because it’s not often easy to find in any disclosures is this 12b-1 fee. That is an annual fee that is charged as part of the management expenses of the mutual fund. Effectively, it ends up being a commission to the advisor or the advisory firm.

Ed: In other words, this mutual fund itself has this charge, and then there’s the advisor charge on top of the mutual fund charge, plus the sharing of that 12b-1 fund expense.

Chuck: There can be, yes. With this particular investment advisory firm, I’ve seen that where the investment advisory firm has collected both 12b-1 fee on mutual funds, and on top of that, charged a separate advisory fee. These 12b-1 fees, and this is probably important to note, can be charged on mutual funds even when the fund is described as a “no-load fund”.

Ed: That is disingenuous?

Chuck: Yes. I believe it’s disingenuous. Typically, when you talk about a mutual fund being a no-load fund, that means that the fund shares that you’re talking about have no sales charge associated with them. In other words, it’s not a mutual fund share class, where you pay an upfront sales charge, which is typically what you see in A shares. Class A shares of mutual funds will typically have an upfront sales charge. In other words, when you purchase fund shares, you pay a charge of typically 5%, sometimes more than 5%, for the purchase of those mutual fund shares, or what’s referred to sometimes as a deferred contingent sales charge, which is a sales charge that is paid when you sell the shares of the fund. Typically, what will happen is, if you buy a share class that has this deferred contingent sales charge, you’ll pay, again, it can be up to 5% when you sell the mutual fund shares. The reason that’s referred to as a deferred contingent sales charge is because, the longer you hold the shares, typically, that the percentage of that charge will gradually decrease and will gradually go down to zero.

Ed: Well, to make sure that I understand, this is in an IRA, Individual Retirement Arrangement, often referred to as Individual Retirement Account. We have at least three classes of fees: monthly trading costs, quarterly advisory fees, and the mutual fund 12b-1 fees.

Chuck: Yes, those are the three types of fees that you can pinpoint and say are going directly to either the individual advisor or the individual advisor’s firm in some form; but they’re really not the total of the expenses that are associated with the account.

Ed: That just the one chapter?

Chuck: That’s just chapter one.

Ed: Chapter two are the funds in respect to the mutual fund itself.

Chuck: Right. In this particular case, there were mutual funds that have management fees. This is basically all of the other ongoing charges against the performance of the individual mutual fund shares other than the 12b-1 fees. The truth of the matter is that, even though people are educated to think about those fees as exclusively benefiting the mutual fund company and not the advisor or the advisory firm, even in the case of those so-called management fees that are part of mutual funds, there is often some type of a revenue-sharing arrangement. This is not disclosed as a 12b-1 fee, it’s really not disclosed at all unless you, really– In circumstances where I’ve received disclosures on this, it’s almost required litigation in order to get it.

Ed: What do you mean, almost?

Chuck: Well, it’s a threat of litigation with an ongoing court proceeding and, “Okay, we’ll turn this over rather than forcing you to file a lawsuit.”

Ed: The papers that you receive are written in Chinese almost.

Chuck: Yes, even then, very hard to parse through exactly how much is being shared in these so-called revenue-sharing arrangements, but what it will typically be is the mutual fund company will have an arrangement with an advisory firm, where the mutual fund company pays a portion of what’s disclosed on the prospectus as a pure management fee. A portion of that will still get shared with advisory firms, because they are purportedly assisting the mutual fund company by providing statements to the customers and so forth. Even part of that essentially goes to the advisor in addition to whatever disclosed commissions and charges and so forth, go to the advisory firm. Very often, the individual investment advisor, I’m talking about the human being who you talked to on the phone or sit across the desk from, wouldn’t even know where to look or where to find what that percentage is. It’s just happening behind the scenes because of these kinds of backroom deals that happen between the fund companies and the advisory firms.

Ed: But having said that, Chuck, the bottom line here is, without regard to the nature of the assets and their suitability or acceptability for the IRA in terms of other issues, which we’ll get to in a second, the overall annual charges read about 150 basis points.

Chuck: Yes, and that’s on assets that were a total value of around $4 million. You will typically hear advisors say something like, “We charge a 1% annual fee on the first million or the first $2 million. Then, the next million dollars, the percentage is lower”, and so on and so forth. This particular advisor had disclosed a fee structure similar to that, yet, when you really dug in and looked at all of the different fees and expenses that were really being charged against the account, it ended up being, even on a $4 million account, a much, much higher charge than had been disclosed either at the outset, when the fee was being quoted to the client, or even after the fact when we were making repeated written requests for a disclosure of this whole fees charge.

Ed: Let’s put that in dollar amounts and at very approximate but very close. Total expenses, right at $59,707, or say $60,000 a year, all that took 1.5 thereabouts of the assets, the disclosed fees were about $25,000.

Chuck: Right.

Ed: But the actual fees were like $60,000. There was non disclosed fees of about $35,000. What do you think about that Mr. Advisor? After repeated requests and the expenses incurred in getting that, silence.

Chuck: Absolute silence, yes. Unfortunately, I don’t think that this is an atypical example. This thing, even though we’ve really dove in deep with this one particular client and got exact numbers, I’ve done similar analysis on smaller accounts and larger accounts with different advisors and have found that even though the numbers aren’t always quite as stark as this, it’s a very rare occasion where you have a complete and transparent disclosure of the fees and expenses that are associated with an investment account. Keep in mind, the reason this is important is because every dollar that is part of these fees, costs, and expenses it’s just a direct drag on the performance of the investment. Not only in that particular year, but then that dollar that is spent in the form of fees is not available to continue to grow in the future. Over time, if you’re a long term investor, this can be a very significant drag on total performance. I mean, here we’re talking about one and a half percent of the market value of the assets in total, being dragged out of it in terms of fees, costs, and expenses. That’s like doubling the rate of inflation.

Ed: That’s right.

Chuck: They are trying to compete against that.

Ed: Having said that, now let’s drill down into the nature of the investments, which is a different issue. We’re talking about an IRA at age 70 and a half, we have these required minimum distributions. They’re not subject to the same fiduciary rules that are applicable to advisors with respect to tax-qualified arrangements. Now, there was this what is suitable for the subject, IRA owner. Having said that, but in this instance, there are some series of opportunities or a unit trust or whatever that made no sense but you were bound to purchase series A and then an automatic rollover to B, to C, the same expenses. Which was just– Can you expand that. I’d get a little emotional about this thing, but go ahead.

Chuck: Right. Those unit investment trusts, the particular ones that were involved in this particular account, is an investment that is, first of all, very expensive in terms of the total charges that are embedded in the asset itself. Then second, like you said, it’s a long term time commitment when you’re invested in, at least in these particular ones. You see this often with older clients, where you will find investments being purchased on their behalf or sold to them that have these time commitments associated with them, which is really just astonishing. How often you’ll see something like an annuity that has a seven-year surrender charge on it being sold to somebody who might be upwards of 75 years old, and you just wonder, “Well, now wait a minute, isn’t that person who’s at an age where they ought to be able to access their funds without a charge at any time that they want to?” It probably also bears mentioning that, now, one thing that most people would say is probably an appropriate investment for someone in this age category are bonds and other fixed-income securities. I think that can be an arguable point. But it is literally impossible when you’re buying and selling bonds to know exactly how much sales charges are associated with.

Ed: Why is that Chuck?

Chuck: That’s because what happens is these investment houses will typically sell you a bond that is part of their inventory that they’re holding. The sale price of the bond, in other words, the interest rate that you will earn on that bond in your investment portfolio is already priced in a way where that’s net of whatever fees the investment house has decided that they’re going to collect on it. Just as an example, if you buy a share of stock, let’s say you’re going to buy a share of XYZ Corporation stock, there’s a public listing for the price of that stock. You can go on to Google or Yahoo, you can look up what that listing. Your broker or advisor will execute a trade for you at that public price and then charge, typically some trading cost or commission against that. When you buy a bond, it’s a little bit different because there isn’t really an exchange out there where you can find a public listing of the price of a bond. Instead, you’re just engaged in a transaction with your broker, where the broker already owns the bond. They just simply quote you the price that they- that individual broker or brokerage house is willing to sell you that bond at. You don’t have an opportunity to compare that price with what other sellers of bonds out of the same issuance might be willing to sell it for.

Ed: But, Chuck, in the interest of a fair disclosure on both sides of that, the price of the bond should reflect the interest rate. In other words, if we have changes in the interest rates, the price of the bond will vary according to those changes. Rates go up on the face value of $100,000 bond got with a 4% coupon goes down. The sum of the excess interest and change in face value will equal the 10%. There is a bit of a market especially in the government bond area, but the point is, it is not disclosed.

Chuck: Right, no, that’s exactly right. The other thing is that the counterparty in your transaction, when you’re buying and selling bonds, is not some third party out there in the marketplace, but it’s the person who’s advising you to buy or sell the bond, in many instances. If the goal as an investor is to buy low and sell high, that’s the goal that the advisor is trying to achieve for themselves when they’re coming to these investment recommendations.

Ed: That’s okay, this is the way the world works. But the discussion is centered on the disclosure. If this individual wants to spend 150 basis points for hand-holding and investment advice, for investments that are inappropriate, that’s fine. But the role of the advisor is got to be, should be must be, “Hey, this is what this is costing you. We may unbundle this. We’re talking about this holistic approach. We’re going to be your psychiatrist, your psychologist, we’ll shine your shoes, account to you and your wills and trusts.” “But what’s the charge?” “There’s no charge for that. That’s part of our overall fee.” What’s your view of that, Chuck?

Chuck: Well, I think that there’s a lot of risks associated to the advisor in having a fee structure like that. I don’t think it’s fair for the client either. I’m actually not a fan of that type of fee structure. The reason that’s not good for the client is because, effectively, if you are a client who doesn’t have a lot of tax questions, estate planning questions, et cetera, you’re paying for that service anyway. I would argue that, because every client of that investment advisory firm is paying for that service, whether they use it or not, there’s a bit of a disincentive for the firm to be very good at delivering those services. What I have found is that many, if not virtually all, investment advisory firms are quite low-skilled when it comes to the delivery of these things that are other than investment advice, yet, that’s part of the sales pitch that’s used in order to justify these fees. That’s the perspective from the client side. From the firm side, let’s say that you are an investment advisory firm and you really have built up a portfolio of good people and good expertise and resources that you truly are prepared to deliver on this promise of being able to provide holistic financial planning services and estate planning advice and maybe some light accounting services and that sort of thing. When your clients receive their statements, and assuming that the statements adequately disclose the fees and the fee is based on the percentage of the assets in the account, they will look at that and they’ll say, “Why am I being charged this much for investment management when there weren’t even any trades in my account this month?” I literally had a client of mine, call me up just this month and say, “I just got my statement from XYZ firm, and they charged me X thousand dollars for this quarter. They haven’t done any investment management at all this quarter. Do I have your permission to pull my money out of there?” I said, “Well, you don’t need my permission for anything.” The point is that, this is a client who has been told over and over and over again by the investment advisor in question, that, “All those fees are not really for investment services, they are for all these other services that we provide.” Yet, what the statement says to the client every time they get one is, “You’re being charged for investment services.” During the period of time where no investment changes were made, it appears to the client that they’re simply being robbed of their money.

Ed: Now, having said that, I’ve seen situations where this fee is based upon really passive investments, other than mutual funds, index funds, for example, where there’s no activity yet there is a fee. I’m thinking of trying to summarize some of the observations. The bottom line here is, if you’re going to use an investment advisor, make sure there’s a segregation of the investment fees and the other fees which should be charged on an hourly basis, if at all.

Chuck: Yes, I’m a big fan of advisors unbundling these fees and charging, let’s call it, an investment management fee, even if they aren’t truly managing the investments, that is reflective of the amount of work associated with managing investments, and charging advisory fees for financial advice on either an hourly basis, or let’s say a transactional basis. Just some basis other than, “Well, you have so many assets under our supervision, therefore, we’re just going to take a percentage of that.” Charge a fee that is linked to the service so that the client knows what am I paying and what am I getting? They can link those two and make a determination whether it. fair to the client. These clients, they don’t want to steal service for–

Ed: They want to pay.

Chuck: They want to pay for the services. The idea isn’t to rob anyone of their living but the problem is that this current model, this fee based on assets under management, so-called, these advisors refer to it as AUM. This model allows the less skilled advisory firms, the firms that are less skilled at delivering these holistic type services, to essentially receive money from clients that is unearned and it penalizes the firms that are better at delivering those services. The industry really would be acting as its own best interest if it moved dramatically away from that particular model in my opinion.

Ed: Yes, summarizing it, the ideal portfolio in today’s world, given the 200-year history of the stock market and friction cost and the like, would be, for example, an S&P total return index fund for let’s say 80% of the portfolio and the balance on a dividend growth index fund, passive investments and buy and hold and do nothing. That should be sold by an individual who is salaried, is paid on a salary basis, by the subject organization versus a percentage of the assets brought in or versus a percentage of the assets sold. The incentive is to sell those with the highest commission which will then read down to the benefit of the advisor. In other words, W2 compensation, the organization should be charging for most of its services, at least a part of them, on an hourly basis. But guess what? It’s not going to happen. I’d like to turn to the article that you made reference to just at the beginning of the session about why advisory fees are dropping like a rock.

Chuck: Right. This article came from wealthmanagement.com. It was published this morning. It’s an op-ed.

Ed: That’s October 29th.

Chuck: Yes, you’re right, it’s October 29th. This article– I should probably back up and say this website, wealthmanagement.com, is really a website that caters to investment managers. Any member of the public can go on there and read these articles, but it’s an industry-targeted website. It’s always interesting to look in there to see what types of articles investment advisors are reading? What I find is that an awful lot of what gets posted on this website is not really about estate planning, not really about these other services that are part of a holistic package and really not even a whole lot about investment management but a whole lot about relationship management.

Ed: A pretty another way, the thrust of many of these articles is, get to know the client-

Chuck: Get to know the client.

Ed: – and establish a personal relationship, and be the advisor in lieu of the lawyer, the accountant, the psychiatrist, the psychologist, the dog catcher. Do everything to engender a relationship, position of trust. But the reality is the changes are occurring by virtue of, for example, technology. You can do these comparative analyses, the various rates of return by a click of the button. And the rise of fiduciary information. People are understanding that lawyers, and I’m not defending the legal profession, by the way, they need as much help as anyone else, for the most part, are fiduciaries. The responsibility of the lawyer is to act in the best interest of the client, without regard to the economic benefit or detriment to the lawyer. I’m not sure that that standard is applicable to everyone in the world. Certainly not on many of the investment advisors who purchase investments for you on the basis of whether they’re suitable. Then the knowledge that’s gained, and then logic, and then finally education. People are becoming more and more astute, given this technology and information. Most importantly in my travels is the platform. Let’s use Schwab as an example. Again, the disclaimer, I don’t own shares in Schwab. I doubt that I will ever owns shares at Schwab because they wouldn’t permit me to say what I’m about to say. That is, their platform is out of this world. It has ratings for the mutual funds, there are own rating system for the stocks, press the button, you get rates of return, time-weighted, dollar averaging, and whatever you’d like. There’s reports showing how you’ve performed. The advent of technology has permitted the viewer to see the numbers.

Chuck: There’s this rise in so-called robo-investing, so some of these investment strategies. If you’re talking about just the pure work of selecting investments, so much of that can be done nowadays, through a computer algorithm, in which case, that is part of what should be driving these costs down. Of course, the thrust of this particular op-ed is suggesting to investment advisors that change is underway and that fees are already going down. Now, my own observation is that, that has definitely happened with respect to large platforms like Schwab, Fidelity, robo-type platforms and self-serve type things. I have a very hard time finding an investment firm that has office space where you can go and meet personally with an investment advisor, where clients are really experiencing-

Ed: Value.

Chuck: -fees going down.

Ed: And value.

Chuck: Yes. Yet this article suggests that all of these things that you’ve just mentioned, should be driving costs down for everyone. This idea of having a fee that’s based on 1% of assets under management is just an anachronism of an earlier age. Maybe that’s occurred in the large metropolitan markets, I haven’t seen it near us, but I certainly hope that that becomes the reality everywhere because, people should have the choice right now, no matter where they live, of being able to get a personalized service, and meet face to face with an individual with that the level of service that they want, and not be stuck into a fee structure that is based on the level of technology that existed 40 years ago. That’s literally what they’re stuck with.

Ed: Chuck, two questions. Where is this going, and where should it be going?

Chuck: Where it is going is, I think that what’s happening is- now this is based on my own observations and interactions with people, is that what is happening is that the advisory firms are moving more and more aggressively into territory other than investment advice and investment management. They are, at least as part of the sales pitch, if not in terms of actual delivery, speaking more and more about things like tax, things like estate planning, things like a holistic financial management, things like even light bookkeeping type services and that kind of thing. Conversely, they’re almost becoming mini accounting firms, or at least marketing themselves as such, so no irony in the fact that the accounting firms have done the exact same thing in the opposite direction. I think what we’re seeing is people fiercely defending their fee structure and then justifying them more and more by saying, “We have all these extra things that we’re promising to provide”, with very high degree of difficulty and people actually getting those promised services. Where it should be going is, I think it’s great for these firms to be able to offer those extra services if they are capable of doing that. I certainly don’t want to suggest that everybody has to “stay in their lane and so on.” That could be a real benefit for the clients, but those services need to be earned, and not just automatically charged. In other words, the way it should be going, in my opinion, you may disagree, the way it should be going is that advisors should be charging a rate that is on the downward slope and ever-decreasing for investment management services, and then having add-ons that are charged separately at rates that are readily disclosed to the clients, and the client can comparison-shop, and they can understand “You’re going to do some bookkeeping for me, how much does that cost from you versus having my accountant do it?”

Ed: Right. Having said all that, Chuck, let me suggest where it is going.

Chuck: Please do.

Ed: The wrong way.

Ed: I am saying to you that despite the fact that all these disclosures are made, all these expressions of interest and all terms are made, the clients don’t change.

Chuck: True.

Ed: I had set default to truth, this relationship. It’s this disingenuous establishment of a relationship for economic purposes only is the way it’s going. I see it very difficult, except in the case with a very sophisticated, academically interested individual to make a change. It’s disruptive because this person, you’re acknowledging, the client is acknowledging, that this person has been disingenuous to me over a long period of time.

Chuck: Yes. The regulators I think benefit the industry in the sense that, for instance, this example that we went through in some detail earlier in our discussion here. We didn’t make any report to the regulator to complain about that particular service provider. The reason for that is because I’m just 100% sure that the answer to any complaint would be “Well, the disclosures that were provided were completely in line with what was required under the regulations.”

Ed: I think of the subject. The most famous opportunity of stealing is the guy is now in jail in New York City, remember? One of the gentleman made the disclosures to the SCC that “Look, this is a Ponzi scheme periodically.” Guess what the SCC did, nothing.

Chuck: Nothing, right. You’re talking about the Madoff, the gentleman who was doing this analysis and every year would bring a three-ring binder or a stack of files to the SCC. He is like, “Here’s my analysis that this Bernie Madoff guy is just robbing people”, and they just ignored him?

Ed: Yes. “Well, he’s a member of this society is on this committee”, blah blah. “He’s a nice guy. Our resources are challenged, we can’t do all this.” Point is, you’ve got to be educated, you got to fend for yourself. You got to think. You got to ask questions, “How much is this costing me?” If the advisor has 15 Mercedes Benz’s in their various garages and five homes throughout the country, you might think that you may be overcharged for your services.

Chuck: Yes.

Ed: Okay. That’s it for today.

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