The Gradidge Patch

shift happens…

Beware the unconsciously incompetent financial adviser

Investors need to be protected from a number of market participants; expensive product providers, salesmen posing as financial advisers, investment scams, and even themselves sometimes. It is often easy to identify these types of market participants by examining their pricing, their advice processes, or their promises of high guaranteed returns. It requires the investor to simply interrogate the information that they are being given, or ask for help if they are not sure how to interrogate the product, the provider or the adviser.

One of the most difficult things for an investor to do however, is to spot one of the most dangerous species out there; the unconsciously incompetent adviser. An unconsciously incompetent adviser is one that genuinely has his client’s interests at heart, but simply lacks the ability to be a good adviser. The best way to think of this person is to watch Idols during the first few episodes of a new season. Every year you will see contestants that are genuinely shocked when Randall tells them that they cannot sing. This year you would have witnessed one such contestant fainting upon receiving the news. I always blame the parents and the family of those contestants. It is one thing to encourage someone to try their best; it is something completely different to tell the person that they have a talent or ability when they clearly do not.

The unconsciously incompetent adviser is a lot like those tone deaf Idols contestants.
I recently found myself attending a presentation of a product provider that was bringing some innovative investment products to market. There was quite a bit of complexity involved in the products. At no point did the presenter explain the fee structure, nor the all-important terms and conditions. However, I noticed a number of my contemporaries in the audience that seemed impressed with what they were being told. There was a lot of nodding approvals and note taking. How is it that they were somehow able to determine that this was a better option for clients without doing a proper analysis? The job of the adviser is not to simply take the message of the product provider at face value, but rather to interrogate it and ask the difficult questions. This is one area where the duty to act with skill and due care comes in. We are still analysing this new product offering, and we’re being told that the products are “selling like hot cakes”

The real danger of an unconsciously incompetent adviser is that the critical shortcomings in their advice are often hard to detect until the damage has been done. A few years ago I competed against one such adviser for a sizeable retirement investment. The client wanted a fairly high income drawdown from their capital. After completing the analysis we presented our findings to the client, at which point she produced the advice offered by the other adviser. We had offered funds with similar risk characteristics, but our analysis was based on an income drawdown of around 6% at most. Our competition told the client that the funds he offered had delivered a return of over 13% per annum for the 5 years before that, and that she would be fine with a 10% drawdown. The client was keen to go with us as we explained fees clearly, which the other adviser hadn’t, but she was decided on his advice as the income was a lot higher there. It sounds reasonable to draw 10% from a fund that has delivered 13% over the longer term, it takes skill and understanding to ignore those historic returns and understand that the long term return experience of that portfolio will be a lot lower, and understand the impact on a client’s retirement plan.

As with singing some advisers simply lack the required skill to be good advisers. But, they are often really nice people, genuinely nice people. And they genuinely care about their clients and have their interests at heart. Our business is still quite young as we have been in operation for just over 7 years now. Over this time we have taken over a number of clients from other advisers. In some instances it is an easy decision for the client to make; their incumbent adviser has never seen them again since writing up the business, or the product/s they were offered were entirely unsuitable for their needs, etc. However, in other instances it was a fairly traumatic decision for clients to make. The adviser has given good service, done regular reviews, and has dealt with them in a really good manner. But upon closer interrogation it is clear that the advice they have given is just not up to scratch, or the products that they have put their clients into were entirely inappropriate.

How to spot an unconsciously incompetent?

The unconsciously incompetent adviser often starts out as a tied agent for a large organisation such as a bank, a life insurer or an employee benefits company. Here they are taught sales skills and product features. When a client encounters such an adviser they get a sense of comfort from his product understanding, the sales pitch, and the trust inherent in dealing with a large organisation. (It is important to stress here that not all tied agents are incompetent). It is this sales based training, coupled with badly designed and expensive products that contribute to poor outcomes for clients.

They walk among us

I have worked with advisers since May 2000 in various capacities and at various companies, before becoming an adviser myself in December 2008. Since becoming an adviser I have found myself in many situations where I get to listen to fellow advisers, and get their opinions on various issues. The thing about the unconsciously incompetent adviser is that they really do not have anyone that will say to them “dude, you really shouldn’t enter Idols, you cannot sing!”. The product providers that they support are all too happy to get their business and will not jeopardise the relationship. Their clients have come to them for advice and are often unable to tell that this person is really not able to give proper advice. Their fellow advisers are the wrong people to point this out for reasons of professional courtesy and sour grapes, etc. And given that there is a high degree of randomness in fund returns, the unconsciously incompetent could actually do very well for a long time with an inappropriately structured and expensive portfolio.

Admittedly it is getting a lot more difficult for such advisers to join the industry with the introduction of FAIS (Financial Advisory and Intermediary Services) legislation, and the need for advisers to pass regulatory tests. However, this is not completely fool proof. The easiest way for clients to avoid such advisers is to query their academic backgrounds, and look out specifically for mathematical or legal qualifications, depending on the adviser’s area of speciality. The Postgraduate Diploma in Financial Planning is an entirely appropriate qualification, and one held by fewer than 5% of advisers out there. The PDIP Fin Planning qualification is a requirement for the adviser to receive the CERTIFIED FINANCIAL PLANNER® designation from the Financial Planning Institute of Southern Africa. Again, this is not entirely fool proof, but it significantly reduces the probability of ending up with an unconsciously incompetent adviser.

Is financial advice worth it?

Below is a reader’s question sent to Moneyweb which was featured in an article entitled “Is financial advice worth it?” Naturally it got my attention as this is a question I have had to answer to prospective clients.

Q: I will be going on pension at the end of this year at the age of 65. I have no debt and my home is paid for.

I have been involved with four different financial advisors, but cannot get away from the exorbitant costs that are involved. I have my pension and a separate retirement annuity (RA) and about R2 million in cash which they all would love to invest for me. I am left with the impression that they could invest my money to earn about 1.5% per annum more than I could, but since their fees will be 1%, it hardly makes it worth my while.

I now seem to think that my best option is to take my R500 000 tax-free allowance from my pension and draw down the minimum of 2.5% on the rest. If I subsidise myself from my cash reserves, I can survive for the first six years of my retirement while still leaving the rest of my pension to grow. I would not even have touched my RA yet.

However I’m still wondering if I  would be better off investing the cash amount through a financial advisor?

You can read the entire article here:

As expected, the response was sanitised, and designed to offend as few readers as possible. However, after reading the question a few times and pondering on the issues raised, I thought it I’d share my thoughts.

The first thing to note is the reader’s proposed solution to his retirement conundrum. What is clear is that the reader is applying a form of mental accounting. Investopedia defines mental accounting as “the tendency for people to separate their money into separate accounts based on a variety of subjective criteria, like the source of the funds and intent for each account” As a financial planning practitioner, I need to be alert to investor behaviors as those often have the greatest impact on investment success or lack thereof.

What this reader has clearly done is separate the various pools of monies he has, and ‘solved’ his retirement planning conundrum by supposedly taking a low drawdown from one pool, while leaving the other pool/s to grow. This would leave him with much bigger pools of funds after the initial 6 year period. At least he hopes.

What this reader has not seemed to consider is the variables that will impact his retirement over the long term. These include; income growth, portfolio returns in the early years, tax implications of his portfolio structure, portfolio risk and overall portfolio cost.

What he needs to do is maximise after tax income, while protecting capital and generating the required returns net of fees on a consistent basis. Applying mental accounting effectively takes him away from this as he no longer has a consolidated view of his total portfolio. It creates a disjointed approach which effectively derisks the short to medium term in his mind, and does not even consider the real long term risks.

Another observation; he notes that the four advisers / brokers he spoke to would charge an annual advice fee of 1%. That is an extremely high fee. Even if the adviser takes 0% initial fees, a 1% annual fee is guaranteed to place significant strain on an income portfolio. Once administration fees (0.25% to 0.60%) and asset management fees (0.30% to 2.50%) are added, the portfolio could have total fees of maximum 4.10% per annum. So a return assumption of 9% p.a. net required the portfolio to deliver 13.10% p.a. before fees. This is an incredibly high return for a usually conservative income portfolio. By way of benchmark we structure income portfolios for clients with a maximum total annual fee of between 1.40% and 1.60% p.a. (including advice, administration and asset management fees).

Back to the very important question raised by the article; is financial advice worth it? In my biased opinion; it can certainly be. However, the client needs to distinguish between cost and value. It seems that the advisers he spoke to charged commission only. He needed to look for advisers that would offer him the option of a consulting fee instead. This could have reduced the cost significantly. The value of advice, if done properly, would have come through in the form of a sound long term plan with clear and reasonable assumptions about the future, a budget, a cash flow forecast and analysis, a well priced portfolio, a well structured portfolio, tax structuring and proper implementation.

Good luck to him though. I hope he ends up with a proper retirement plan.

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