While it’s only one of several factors when evaluating how to choose a financial advisor, understanding how we’re compensated is crucial for aligning incentives with yours.
Here are five reasons to work with a flat fee, advice-centric financial advisor:
There’s very little conflict to try and “gather your assets”.
Why is this important? If you’re working with an advisor who charges based on the amount of assets under management, there will always be an inherent incentive to try and “gather” your assets since the more money that’s managed, the higher the fee the advisor can receive. This can cause conflicts of interest in certain situations. For example, leaving money in an employer-sponsored retirement plan can be advantageous to keep pre-tax money out of a Traditional IRA and minimize taxes for backdoor Roth contributions. The assets under management (aum) fee model is not close to being the worse compensation model (for fee-only financial advisors) and many great advisors use this model.
However, you cannot deny the conflicts it creates.
There’s no more work involved managing a $100,000 portfolio versus a $10,000,000 portfolio.
Technology has leveled the playing field when it comes to managing investments. There’s still tremendous value in getting people invested appropriately for their needs, goals, time horizon, etc.. However, when it comes to the logistics of managing investments, it’s literally the click of a button. Even less if the advisor uses a third-party manager. There is an argument to be made that higher dollar decisions justify higher fees, but paying (potentially) 100x for a similar service doesn’t make sense to me.
Financial Planning is the main focus.
Regardless of the compensation model, advisors that are advice-centric, planning focused are the most beneficial. Why? As mentioned, since technology has provided us with so many great, low-cost investment options, the most value an advisor can provide you is by taking advantage of the resources available to you. This means putting you in a position to succeed based on your short and long term goals. Planning for tax diversification, understanding how much of your income you need to save to achieve your goals, and how to transfer (or mitigate) risk are a few essential parts of financial planning that have very little to do with investment selection. An advisor that charges solely for advice will always be accountable to provide continuous value.
Percentage fees can have a massive impact on long term growth.
If we’re being conservative and making realistic long term assumptions about investment returns — even a percentage (1%) can have a large impact on the end value of an investment portfolio.
For example, if we assume long term returns of a “diversified investment” portfolio to be 7% and inflation to be 2.5%, that leaves you with a “real” 4.5% growth. Even at a 1% asset management fee, that’s (potentially) eating away at 20-25% of your real return.
Food for thought.
You always know exactly how much you’re paying and what you receive in return.
It’s just like paying for any other professional who provides a service. You make a conscious decision about how much you’re willing to pay and what you receive in return.
Incentive Stock Options (ISOs) are one of the most complicated forms of employer stock compensation.
In this podcast episode, I discuss the basics of ISOs, how they function from a tax perspective and some major pitfalls to be aware of. One of the most common pitfalls people neglect is looking into potential alternative minimum tax (AMT) exposure when they exercise lucrative ISOs.
This happens when you are attempting to hold two years from the grant date and one year from the exercise date to benefit from long term capital gains. This can be a good strategy if you believe the share price will continue to rise and you want to reduce your tax liability.
However, the difference between the strike price and the fair market value of the stock on the day the option is exercised (known as the bargain element) is a tax preference item for calculating AMT.
Depending on how large your ‘bargain element’ is, you could be opening yourself up to a large AMT liability. You must be aware of this so that you’re not stuck with a massive tax bill come tax filing time (and have to find the cash on hand to pay it).
There’s a balancing act when it comes to divesting from concentrated stock positions via an ISO while being mindful of the tax implications.
In this episode, I also discuss the fear of missing out (FOMO) as it relates to owning employer stock (or any concentrated position for that matter), and why I’m a fan of regret minimization.
Anytime you’re selling off a concentrated position, there is an opportunity cost (which I like to refer to as investing FOMO). There’s always the chance that your stock (in this case employer stock) takes off and vastly outperforms the broader market.
However, you have to consider the downside as well, and that the individual security can massively UNDERPERFORM the overall market. You must have a long term financial plan that factors in your complete financial picture to determine whether you should (or need) to be taking on concentration risk.
ISO compensation is one of the most common windfalls I see. Especially, when you’re compensated from a private company that goes public, there’s the potential to become an ‘overnight millionaire’.
If you’ve experienced that ‘pop’, I discuss different ways to approach diversifying depending on your short and long term goals.
At what point in your business’s lifecycle are you? Are you at the point where reinvesting in your business (increasing employees, equipment, etc.) provides diminishing profit returns? If so, consider creating a financial fortress outside of your business so that you are NOT dependent on your business to supplement your lifestyle.
When you create a business, it’s your baby (I get it). It’s easy to get sucked into your business and reinvest 100% of every dollar you generate to grow your business. And if you’re creating a scalable product or service, maybe that’s the right decision (personal finance rules don’t apply to entrepreneurs). However, if you hit a wall (cannot scale further) or are at a point where you are paying yourself an amount that you’re happy with, consider fortifying your personal finances.
In this podcast episode, I discuss some of the pitfalls of becoming overly dependent on your primary business. Especially businesses where there may be little (or no) market value if you were to sell the business, why it’s important to fortify your personal finances sooner rather than later.
How susceptible is your business to changes in the health of the economy? What would happen if your business suddenly came to a halt? These will vary depending on your type of business but are important questions to ask yourself.
One of the first steps in creating a fortress around your business is creating a separate business entity that protects your personal assets from any potential financial and liability claims. The type of business entity you select (such as an LLC, S-Corp, or Partnership) will depend on the number of owners (and employees) you have, and how you want your business to be taxed (flow-through, dividend, etc.).
Once you’ve fully separated your personal assets from your business assets, you must pay yourself an appropriate amount from the business. You want to make sure that you’re keeping the cash flow of the business separate so that you can accurately keep track of tax liability and not compromise your liability benefits of having a separate entity.
As a business owner, you should be paying yourself for the risk you take on and the hard work you put in. Even if the business is self-sufficient, you should be reviewing the amount you are paid so that you can build financial independence outside of your business.
While it’s not uncommon for successful business owners to be dependent on their business to supplement their lifestyle, there may come a time when they’d rather not carry that burden. Depending on the revenues of your business and how transactional they are, you may or may not have as much equity in your business as you believe (if you were to sell). This is another reason why fortifying your personal finances sooner rather than later is a smart move.
“Give me six hours to chop down a tree and I will spend the first four sharpening the axe.”
― Abraham Lincoln
If you’re looking to set yourself up for long term financial success, you must take the time to put systems in place to quickly grow your net worth. Preparation is essential so that you can take advantage of your hard-earned money! To make the process easier, here are 5 steps to prepare for financial success:
1: Automate Your Financial Life
Take the time to establish a high yield savings account separate from your everyday checking. Look into establishing retirement accounts such as Roth, Traditional, and SEP( if self-employed) IRAs, even if you’re not quite ready to start utilizing them. Keep in mind you can still utilize IRAs in addition to your employer-sponsored retirement plan.
Long term you should strive to take advantage of all tax-deferred accounts (individual goals permitting) before moving on to taxable investing. By having the appropriate accounts in place (with bank links etc.) you can make it easy on yourself to make investment contributions in an efficient and timely manner. You can also work on simultaneously building up your cash reserve (anywhere from 3-12 months living expenses depending on the individual) so that you can invest with confidence later. Logistics is half the battle with taking action, so make it easy on yourself!
2: Pay Down Debt Strategically
In line with automating your financial life, take the time to review your debt (such as student loans). As a crucial no brainer, make sure you are allocating your debt repayment to the highest interest debt first. There are different ways to approach paying down debt, such as the debt snowball repayment method. While the specific strategy can vary depending on the individual, the most important thing is you have SOME kind of a plan and are making a conscious effort. The worst thing you can do is avoid looking at it because of the temporary stress involved.
3: Use a Credit Card Like you Would a Debit Card and Build Credit
Credit cards are useful as an intermediary between you and the vendor, especially in cases of fraudulent activity. It’s easier to correct fraudulent charges with a credit card versus a debit card (since it’s technically not your money), which is why you should not use your debit card for daily purchases. You can also earn rewards for purchases you would otherwise make anyways, so it makes sense to take advantage of credit cards! Credit cards are also a secondary cash reserve (hopefully to your actual cash reserve) which can be used for TRUE EMERGENCIES.
Paying off your credit cards on time along with having larger lines of credit (and not utilizing greater than 30% of them) will help build your credit score (fairly quickly too). Having a good credit score is especially useful when you are looking to qualify for a mortgage. With all of this being said, you should treat your credit card like your debit card. This means not spending more money than you’ve budgeted (or have in the bank, circumstance permitting). If you’re paying off your credit card monthly (which you should to avoid the outrageous interest rates), then it’s essentially a debit card with added benefits.
4: Budgeting: Start With Your Necessary Fixed Expenses and Figure out how Much you Have Left
It’s crucial that you at least KNOW what you’re spending. Consider using an online aggregation tool to track your total outflow. You cannot modify your budget if you don’t know what you’re spending. When building out your budget, start by looking at unavoidable fixed expenses you have to pay. From there you can determine what your variable discretionary expenses are. When you have a realistic analysis with yourself of what you are taking home for income (on an after-tax basis) less your outflow, you can figure out what your wiggle room looks like. If this is an area you struggle with, consider working with a financial coach such as Savings Academy.
5: Always Take Advantage of Free Money Even if you Have Limited Cash Flow
Does your employer offer a match on your 401(k) if you contribute a certain percentage of your salary? If so, you should contribute enough to at least receive the full match (even if your cash flow is tight). Free money is the best money. An employer match is essentially a 100% risk-free return (dependent on the match amount). That is hard to find!
Additional free money can come in the form of stock purchase plans where your company allows you to buy its stock at a substantial discount (and then immediately sell at the end of the purchasing period). Taking advantage of a stock purchase plan is not as straight forward as a 401(k) match, but cash flow permitting it can be a great source of “free money”.