Didja’ ever notice that how you measure something sometimes changes the outcome?

In the 1980’s CEO’s compensation changed from a salary-and-bonus plan to being directly tied to the stock price, and voila, stock prices rose. The companies weren’t necessarily managed any better, but since stock price was suddenly the important metric, it improved.

A similar effect can be seen in Massachusetts schools which are ranked by statewide tests (MCAS). An increase in the scores, doesn’t necessarily mean that the students are any smarter, but they are doing better at passing the exams, leading to much discussion about “teaching-to-the-test.”

Likewise, many financial advisors are paid by a percentage of assets under management. The rate is typically 0.5-2.0% per year, where the low end of that range is for account values north of $1M. If you have $200,000 in an advised account that charges 1.5%, you pay $3,000 per year for that advice.

Not only do I think that’s an awful lot of money, it isn’t judging the right metric. Sure, I want my investments to grow, but what I really want is my net worth to grow. Designing the advisory fee around just one aspect of your net worth focuses their activity around just your investment — typically brokerage — accounts.

Why real estate is sometimes overlooked.

Suppose a client inherits $100,000. One investment that should be considered is to purchase real estate for rental income. Alternatively, the advisor could reccomend a few mutual funds. Keeping the money in the brokerage account enables the advisor to collect the additional $1,500 per year. If the advisor recommends real estate, he will be paid nothing. I’m sure there are many honest advisors out there who truly honor their fiduciary responsbility to their clients, but you’re asking a lot of a person to forgo personal income.

Real estate is an important component of your balance sheet, although it is not given nearly the media bandwidth as the stock market. Well, maybe it has been the last couple of years with the bursting of the housing market bubble. When I look around my immediate family (and uncles, cousins, grandparents…), those who had comfortable retirements had either pensions or rental income (or both). I don’t know a person working today who expects to receive a pension, except for government employees. The rest of us are moving our nest eggs around like chess pieces, trying to gain some level of confidence that we will someday be able to retire.

Here in Massachusetts, you can buy a two-unit duplex for $500,000 that rents for 2 x $1200/month. After $5,000 in property taxes, that nets about $23,800/year. A 4.8% return may not be terribly sexy, but remember that both the property value and the rental income rise over time giving you a cushion against inflation. There are many other considerations to make (property management fees, maintenance, tenant relations, depreciation tax breaks, insurance…), so my quick calculation is extremely oversimplified. Nevertheless, a rental income or two can be a great supplement during retirement.

Other ways to pay a financial advisor.

Some advisors work exclusively by hourly rates,* and my inclination is to believe that they will offer you the most unbiased opinion.

Some advisors who typically work by percentage-of-assets also offer an hourly fee, but people are scared off by the high rates — perhaps $200/hour. But let’s revisit the hypothetical investor who’s paying $3,000/year — that works out to 15 hours per year. The first year your account is with an advisor, he might spend that much time working for you — setting up the accounts, making the investments, and fielding your calls / visits. But by year 2 or 3, it’s all on cruise control. If you pay by the hour, you break even the first year, and then save then next few years. There will come the year when you really need advice due to a divorce, medical problems, an accident, or such and that year’s advice bill will be higher. Paying by the hour enables you to control how much is spent, when, and for what services.

Some advisors charge by a percentage of net worth — not just what they manage but everything you own. While I agree that this is measuring the thing you really want to track, it seems that many clients balk at the idea. I believe that this is because they are accustomed to the idea of “assets under management.” If an advisor suggests a fee structure based upon net worth, the percentage charged should be less than an “assets under management” approach. The fee should work out to approximately the same amount either way.

Commisions. Crikeys. Let’s not even go there. Someone who recomends stuff because they get paid a percentage belongs on QVC.

The bottom line.

If you choose to use a financial advisor, the most important criteria is your trust in their honesty and ability. The type of fee structure they offer is part of the package and can tell you a lot about their priorities.

* I follow Jim Blankenship’s well-written and informative blog, and I know that he does some work by the hour, but I don’t know that this is his exclusive practice. I should really get involved with the local NAFPA and meet more CFP’s.

Photo credit: Flickr

By day, Helen engineers new materials to make computer chips cheaper, better, and faster. When the son goes down (pun intended), she writes about personal finance at Affine Financial Services.