Saturday, October 10, 2009

Beware of Financial Advisers!

Financial Advisers - the next big rip-off

A few years ago, Republicans proposed "privatizing" Social Security. It sounded nice, in theory, but it is probably a good thing the idea died a quick and silent death.

In the next 10 years we will see the first wave of retirements for the Baby Boomer generation, and the first effects of the 401(k) generation. And we will see a number of stories, I predict, about rip-offs from financial advisers and institutions.

I live on an island where the average age is 74. It is interesting to see how retirement works out for some people, and not for others. For those with government jobs or secure pensions, retirement is no big deal. They live large, with money in the bank and a secure retirement with no worries. They travel, buy new cars every few years, and relax and enjoy life. But for others, having to manage their own funds, well, it can be more stressful worrying about money. And for some, retirement can be a real nightmare.

Back in the 1980's and 1990's some folks took cash incentives to retire early. They were "bought out" and given lump sums in lieu of retirement pensions. In effect, this converted their traditional fixed benefit pension plans to a 401(k) type self-funded retirement. For many, it did not work out very well. And this experience is a precursor to the millions who will retire shortly under the 401(k), IRA, SEP and related plans.

Those "early out" people illustrate one problem and one fallacy with the 401(k) or Social Security privatization theories - most people simply don't know how to handle money, particularly huge chunks of money.

Think about it. Your average "salary slave" in America receives his income in little drips and drabs, in the form of a weekly or bi-weekly paycheck - sort of like an allowance from Dad. And Uncle Sugar already took out his taxes (because God forbid, if we waited until the end of the year to collect, no one would every pay!). We are coddled and we are treated like children, because if were indeed handed a huge paycheck in one lump sum, most of us, like children in a candy store, would squander it in short order.

Many folks taking "early out" do just that - investing in schemes and businesses that don't quite pan out. A lifetime of work can end up on the trash heap in short order. Others entrust these large sums of money to financial advisers, often with similar, although less tragic results. Huge sums of money invested over the years, often at great risk, ends up yielding a rate of return not much higher than a safe bond or even an FDIC-insured savings account at the local bank. Fees and "loads" and other charges are never clearly disclosed to the consumer.

A big part of the problem is that people simply do not know how to manage money - as they are not trained how to do so. Respect for money is not taught in school, and is not a cultural value for most folks. So in part, yes, it is the "fault" of the consumer for making bad choices. But financial advisers are supposed to be there to help us make better choices. Unfortunately, in many cases, they are simply salesmen selling products on commission - and the great "financial advice" they want to give us is based on what product generates the best commission for them.

Don't act so shocked. This is America, after all.

It seems everyone is getting in the financial advice game these days. Banks, insurance companies, everyone it seems - even the local donut shop - posits itself as a "financial network". My Dad, when he lost his job, became a "financial adviser" for a brief time. Anyone can do it. Why not? It is a booming business. The generation of defined-pension benefits is dying off, and a new generation of 401(k) boomers is coming up, with billions of dollars to invest and no idea how to invest it. It is a goldmine of opportunity for smart people with no scruples. All those mortgage brokers need to find work somewhere, right?

We are already starting to hear stories on the wire about crooked financial advisers. These are just the initial tremors precursing the shockwaves to come. For example, in one recent published incident, a financial adviser sold an annuity to an elderly gentleman suffering from the early stages of dementia. Nothing wrong with annuities, per se, but this one tied up his money for 20 years before paying anything out. When you're 70 years old and looking at assisted living, an annuity like that is not a sound or wise investment. Thanks to all the bad publicity involved in that case, the company in question quickly refunded the money. But how many other cases like that are there out there that we don't hear about?

Another typical example that pops up with all-too-frequent regularity is the "churning broker". The broker is given trading authority by the client (bad idea) and he starts trading the client's stocks - buying and selling several times a day. Oftentimes he ends up selling and buying back the same stocks. Each trade is a commission for the broker (and this is not a "discount commission" firm, either) and pretty soon, the value of the client's account starts to drop. By "churning" the account, a broker can convert hundreds of thousands of dollars in equities into commission fees for himself, and leave the client destitute.

Again, in both examples, the temptation is to blame the client - the investor - for making bad decisions by letting the financial adviser talk him into bad ideas. But for many folks unsophisticated in the market, they have no way of discerning good ideas from bad. They trust their financial advisers to give them good advice. And that level of trust is a very bad idea.

But those are egregious examples of crooked financial advisers - the ones that are just plain crooks. There are many others (perhaps most of them) who merely give bad advice or squander a large portion of the client's money on their own fees and commissions.

For example, the other day I went to my local Insurance Agent (who is now a "certified financial adviser" which is a crock, because there is little or no regulation, training or certification required to become a financial adviser). I had a question about a whole life policy I had. Fresh out of her adviser training and hoping to make "President's Club" in sales, she offered to do a financial analysis of my portfolio for me. I said "Sure, why not?"

The "advice" she had to give me was simple: Cash in all my investments, including life insurance policies, and invest them with her - often in the same funds. The reason given? "Convenience," she said. The cost? 5% of my portfolio. I said "no thanks" although perhaps in stronger language than that. (I believe what I actually said was, "How do you sleep at night?").

The problem is, a lot of folks I know think their financial advisers are their friends. They think they really do get paid to give out good financial advice. They don't understand the commission structure, which encourages even the most scrupulous adviser to steer clients toward certain products.

For example, a good friend of mine always speaks so highly of "that nice young man at (brokerage house)". "He always has such good advice for me, and he calls me up several times a year!". During the recent downturn in the economy, my friend lost nearly half of their portfolio in stocks. At my friend's age, they should not have been so heavily weighted in stocks in the first place and should not have lost so much.

One rule of thumb bandied about these days is that your age should reflect the percentage of money you have in low-yield safe investments (such as a CD or money market in an FDIC insured account at the local bank). At age 30, this should be 30%. At age 50, 50%. At age 75, 75% of your investments should be in "safe" accounts such as banks or bonds.

My friend, unfortunately, had 75% of their money in stocks - the reverse of most good financial advice - and as a result took a big loss - a big loss they could ill afford. Why were they in such a risky porfolio at their age? Their adviser told them to invest this way. Everyone is making money in stocks, right? Might as well jump on the bandwagon. And so long as everyone is making money, everyone is happy and won't notice the commissions and fees eating away at their rate of return.

And unfortunately, in response to such losses, many folks panic and do two of the exact wrong things. Some of my friends on "retirement island" decided that after losing huge chunks of their portfolios, to sell off their stocks and get into bonds. They sold their stocks at a low point and bought bonds when they were at a high point. Sell low, buy high, the sure recipe for disaster.

Others, such as my friend, did an even worse thing: they doubled-down their bet. "I want to see my money increase in value, I don't care what it takes" my friend told their financial adviser, who was all-too-happy to hear that. My friend didn't understand that you can't dictate to the market what your rate of return will be. The broker sold the risky stocks and put the money into even more risky higher-yield stocks. If it works out, great for my friend. But if those stocks tank (and they do!) they will end up with nothing. Either way, the "nice young man" at the brokerage house gets a commission. Did he explain the risks to her? Did he really try to steer her to a safer harbor? Maybe. Or maybe he didn't try all that hard.

You see, that's how these things work. You make money, they make money. You lose money, they make money. Yes some funds reward the fund managers for high profits. But to some extant, that's even worse, as it encourages the fund managers to take huge risks with other people's money, hoping to win big. If they lose, however, they still take home a nice salary. Ask anyone who invested in a hedge fund in the last decade how that worked out. It was a "heads we win, tails you lose" situation. The real winners were the hedge fund operators, in many cases.

So what is the answer for us "little people" out there? I really wish I had one. Investing money is really a crap shoot these days. Brokerage houses and funds advertise heavily to promote brand awareness. Many folks invest with a particular brokerage house or mutual fund based on such brand awareness. But the reality is, we have little or no way of monitoring what goes on behind the scenes. Even with a degree in Accounting, it is difficult to discern from the annual statements what is going on.

The financial products we are being sold are a pig-in-a-poke. You can look at rates of return for years past, but as the prospectus always disclaims, "past performance is no guarantee of future returns".

You can take the bull by the horns and start a self-directed IRA, but even that is fraught with peril. I recently decided to roll over a small IRA with Fidelity into an eTrade account (we had too much with Fidelity for my comfort level). Rather than trust a number of different fund managers to manage our funds, I thought it would be an interesting experiment to invest my money myself in stocks of my own choosing. It was an interesting experiment, with mixed results. While my Fidelity account dropped in value by nearly 1/3 last year, my self-directed account pretty much stayed the same, mostly because I put a big chunk of it into an FDIC insured money market account (good thing it was FDIC insured, too, because it was with WaMu. WaMu went bust, I didn't lose a cent).

The problem with stock investing, as with mutual fund investing, is that the average investor does not have sufficient time or energy to fully investigate stocks to buy. What was "blue chip" material just a few years ago (GM for example) became worthless penny stocks (GM liquidation corp) in a real hurry. Unless you really have your hand on the pulse of a company and know what is going on (which would be insider information and thus illegal) you really can't make an informed decision.

And, unfortunately, that's the nature of the stock investment game. It's fixed. The insiders get the best deals (regulations notwithstanding). The big players even get to trade faster and sooner and before the market even opens (although the government is trying to shut that down as well). The little people (and there are a lot of us out there with our 401(k)s) are left to feast on the crumbs.

The only practical advice I have is as follows:

1. DIVERSIFY: Don't put all your eggs in one basket. The really heartbreaking stories out there usually involve someone who invested all their money in Enron, or put all their money with one brokerage house, or with one financial adviser. While it may be "convenient" to use one source for your investments, if that one source turns sour, you are really in a bad place. Invest in a number of different places, both in terms of brands, as well as types of investments. Putting everything into a single mutual fund through a single brokerage is not a good idea.

2. TAKE ADVICE WITH A GRAIN OF SALT: When your broker or insurance agent or investment adviser calls you, bear in mind they probably want to sell you something. Rarely, if ever, will they tell you what they are making out of the deal (I am not aware of any law requiring them to disclose this information, either). My insurance agent, for example, calls me once a year trying to sell me a new insurance policy (nursing home insurance, lately). When I told him I was not interested, he stopped calling. When I call him for advice on my existing policies, he either doesn't return my calls or refers me to an untrained assistance. No, he is not (and was not) my "friend" but merely a salesman. Salesman will act friendly, but don't confuse their salesman skills with real empathy for your situation. Their commission is their bottom line. And never, ever take the verbal promises of any salesman at face value. Read the actual documents or papers you are signing.

3. TAKE CHARGE OF YOUR FINANCES: By this, I don't mean churn your account, or invest in dubious get-rich-quick schemes. But what it does mean is to read all your statements carefully and think about what you are invested in and whether that investment is appropriate for your age and stage in life. Do the research. Unfortunately, this may mean having to read all those financial statements more carefully rather than just stuffing them in a drawer. And it may also mean you have to go to the library and learn more about finances.

4. FIND SAFE HARBORS: Once you reach a certain age, don't be shy about cashing in those stocks an putting the money into a CD or money market account at your local FDIC insured bank. Your financial adviser will tell you not to, of course, as that works against their interests. But at age 70 onward, playing the market is not necessarily a swell idea, no matter what the folks at the Motley Fool (remember them?) say. At any age, you should have money invested in a safe place that you have direct control over.

The marketplace is a battlefield, and getting more so every day. You cannot trust anyone. People who fall for schemes and scams and get sold a bill of goods always fall victim to trusting someone who is selling them something. This may sound harsh, but it is a basic truth. You can whine and complain about the unfairness of it all, or strap on your armor and go in and do battle. Take charge of your life, be proactive. Don't let these people walk all over you.