How Advisors Using Traditional Retirement Models are Costing their Clients Millions

October 01, 2023
Charging a 1% total advisory fee while shifting client assets away from tax-efficient stocks and towards tax-inefficient bonds hurts the same retirement income and wealth goals the advisor is seeking to solve for the client.

The choice to use an advisor in retirement is one that will cost clients and their beneficiaries millions of dollars in both fees and opportunity costs as we’ll show later in this article. If advisors are simply allocating clients to traditional stock-bond investment models without implementing any actual retirement, investment planning or estate planning solutions, clients will never recoup this fee.

The word fiduciary gets utilized a lot by AUM based advisors who claim to be acting in the client’s best interests because their fee model aligns incentives with that of the client. The idea here is that by providing long-term advice, and charging for it on an ongoing basis, the fee-only advisor helps to align interests with the client more-so than an advisor who only sells products that earn a large, one-time upfront commission.

The reality of the situation is that the AUM based advisor has similar conflicts of interest—namely to advocate for solutions that they can charge their AUM fee on

If there is a better fit for the client that doesn’t allow the AUM based advisor to charge a fee on or would result in a reduction in the AUM fee but is ultimately better for the client’s goals, then the AUM advisor has the same conflict of interest as the commission-based advisor.

This conflict is most evident when clients enter retirement. The traditional glidepath for AUM advisors involves increasing the allocation away from stocks towards bonds as clients near retirement in an attempt to reduce the volatility of the portfolio and protect against sequence of return risk so that the client can withdraw a steady stream of income every year in retirement without fear of running out of money.

However, the reality here is that this allocation choice often hurts client retirement goals and long-term wealth—particularly for clients in higher tax-brackets. Furthermore, paying a fee-only retirement advisor an ongoing fee to make and manage this decision for clients adds a heavy drag to long-term wealth.

Putting retirement clients into a similar stock-bond allocation model easily allows advisors the ability to quickly allocate these clients to this type of retirement model and charge their fee on the assets. It’s a business model that is easily scalable.

Unfortunately the business model that may be the best fit for the advisor, may not be the best fit for the client’s retirement goals.

How the stock to bond glide path hurts retirement income goals AND long-term wealth

A typical part of a retirement financial plan includes an asset allocation that provides an expectation of success of meeting a given retirement goal given a desired level of spending in retirement. For example, let’s assume that a client has $5 million in assets at the time of retirement and desires to spend $200,000 per year in retirement (a 4% spending rate). What is the chance of the client meeting that goal in retirement and how much after-tax wealth will the client have left to provide to the client’s beneficiaries at death?

These two retirement goals—retirement income and ending after-tax wealth—are thought to be at odds with one another when we limit asset allocation between stocks and bonds. In order to increase the chance of meeting the retirement goal, the thought is that you need to move away from higher-earning, more volatile stocks towards lower-earning, less volatile bonds. So in order to meet the retirement goal, you are sacrificing long-term wealth—and vice versa. Note that later we’ll see how this no longer applies when we utilize certain insurance products to provide downside protection and yield in place of bonds.

A key step of a financial plan for retirement is to determine the amount of income that client would need in retirement. The next step is to run a Monte Carlo simulation and determine the chance that the client would be able to meet those retirement income goals using a predefined asset allocation (eg 70% stocks/30% bonds or 60% stocks/40% bonds) if the client were to live to a given age (eg 95).

The table below shows the chance of a married couple meeting their retirement goals at various asset allocations if the last spouse were to die at age 95. The couple are both 55 now with $2.8M in assets. They currently live in California with $200k/year in expenses. They plan on needing $200k per year in retirement (marked to inflation) to cover their expenses and lifestyle.

Chance of meeting retirement goals at various asset-allocations

Stock/Bond
Allocation
Chance of
meeting
retirement
income goals
to age 95
Median
After-tax
wealth at
age 95
100%/0%82%$16,705,896
70%/30%80%$8,305,130
60%/40%77%$6,072,735

Meeting retirement goal at different Equity/Bond portfolio allocation:
For HNW clients, large bond allocations actually decrease their chance of meeting their retirement goals due to the low yields and heavy taxation on bond portfolios.

Modeling assumptions
Married, 55 year old couple in California, $2.8M investable assets
Effective Tax Rates: 12% Long-Term Capital Gains, 22% Ordinary Income
Retirement goal: $200k/year for life starting at age 65, increasing by inflation rate of 2% every year
Equity Portfolio: 8.5% mean IRR (including 2% dividends), 15% standard deviation
Bond Portfolio: 4% mean IRR, 4% standard deviation
No correlation between stocks and bonds
Rebalance 1/year
No Advisory Fee

As the above table shows, while the client’s chance of meeting retirement are similar under all three asset allocation strategies, the amount of after-tax wealth created at age 95 by the 100% stock allocation is significantly higher than the other two asset allocation strategies.

Why higher stock-allocations are better for HNW retirement income goals

As evidenced in the previous table, a HNW couple with the above retirement income goals has a better chance of meeting those retirement goals with a higher stock allocation as well as a leaving a larger amount of wealth for their beneficiaries. This is primarily due to the fact that stock gains have higher returns and more tax-efficient than bond gains. So shifting away from higher earning, tax-efficient stock returns towards lower-yielding, tax-inefficient bond returns hurts individuals in a higher tax-bracket over the long-run.

Equity and Bond Returns and Standard Deviations from 1928-2022

ReturnsStandard Deviation
Total
Return
IRR
Price
Return
IRR
Dividend
Return
IRR
Total
Return
Standard
Deviation
Price
Return
Standard
Deviation
Dividend
Return
Standard
Deviation
S&P 5009.64%5.83%3.81%19.49%19.00%1.68%
Baa Corporate
Bond
6.68%-0.11%6.80%7.75%6.65%2.93%

Source: Damodaran, Fed Reserve

Since 1928, the S&P 500 has far exceeded the returns of the bond market. While the S&P 500 has higher volatility than bonds, as measured by the standard deviation, the bulk of the S&P 500 returns come from price return which have numerous tax advantages whereas the bulk of bond returns come from dividends which are taxed at high ordinary income rates.

Many investors might not realize that the bulk of stock returns are due to the price return of the stock, whereas the bulk of bond returns are due to the dividend return of the bond. And bond dividend returns are taxed at significantly higher ordinary income rates than the long-term capital gains rates of price returns. Stock dividends are also often taxed at qualified dividend rates which are significantly lower than the ordinary income taxation rates of bonds.

Furthermore, the price return of an asset is only taxed when that asset is sold. This means stock investments allow these unrealized price return gains to compound tax-free. If the investment is held until death of the owner of the stock investment, then the owner’s beneficiary will be able to inherit that asset without paying any taxes on the gains of the price differential between the share price that the owner purchased it and the share price at the time the original owner passed away through a provision known as step-up in basis (provided that the value of the original owner’s estate is under the current estate tax limits at that time).

This is a huge benefit to buy and hold investors who invest in equity assets like the S&P500 for the long-term. Bond investors won’t benefit through step-up in basis nearly as much over the long-term hold approach since the price return on bond returns over the long-term are small. Note that in the above table the annualized price return of bonds from 1928-2022 was actually -0.11%.

These are important to note because retirees will often live 20 to 30 years post retirement. The shift away from higher-yielding, tax-efficient stocks to lower-yielding, tax-inefficient bonds has a significant impact on the after-tax wealth high net worth individuals leave to their beneficiaries.

This is exactly why in the previous table we saw that choosing a 100% stock portfolio left more than double the after-tax wealth to their beneficiaries than the 70/30 or 60/40 portfolios.

In previous articles I’ve written, I’ve talked about how HNW clients should utilize asset location and place tax-inefficient parts of their portfolio within tax-advantaged wrappers.

For HNW clients that are phased out of contributing to traditional tax-advantaged retirement vehicles to reduce the tax-inefficiency of their portfolio.

The retirement income cost of a fee-only advisor

A financial advisor typically charges a fee that is a percentage of a client’s assets. This fee is generally around 1% of a client’s assets. On top of this, the client also will pay custodian fees and fund management fees which can add an additional 20 to 40 basis points. So, for example, if a client has $1M in assets, the advisor would typically charge a $10,000/annual fee and the client would pay an additional $2,000 to $4,000/year fees for custodian and fund management services. This means the total advisory costs would be 1.2% to 1.4%.

There are two problems with this type of fee structure in retirement:

1) The advisor is typically changing the asset allocation away from higher yielding stocks and towards lower yielding bonds in retirement
This means that the advisor’s fee now makes up a larger portion of the client’s overall return. If the stock portfolio is earning 8% and the bond portfolio is earning 4%, then a 1% fee is only 12.5% (1%/8%=12.5%) of the return of the stock portfolio, but is 25% of the return of the bond portfolio (1%/4%=25%). When we add taxes into this, then the advisor’s percent of the client’s after-tax return is even higher as we’ll see down below.

So the as the advisor increases the client’s allocation to bonds in retirement, the advisor’s fee relative to the client’s return starts to get increasingly high and eats into wealth and retirement income that would have otherwise gone to the client.

2) The advisor’s fee is paid on an after-tax basis
Another problem with the percent of AUM fee in retirement is that the advisor’s fee gets paid after-taxes. This further reduces the retirement income and long-term wealth of the client as the advisor fee relative to the client’s after-tax income is now higher.

As an example, let’s assume a client has a $1M bond portfolio that earns 4%, or $40,000. Let’s assume the client’s effective tax-rate is 25%. That means the client pays $10,000 in taxes and is left with $30,000 after taxes. The client then has to pay the advisor’s 1% fee, or $10,000 which is 33% of the client’s after-tax income. So the after-taxes and the advisor’s fee, the client is left with only $20,000.  So the advisor’s fee is 33% of the client’s after-tax return. Of the total 4% gross return, the client only makes 2% after taxes and advisory fees.

The large drag of the advisor fee on utilizing bonds as a retirement solution

Gross Return
(A)
Tax Rate
(B)
Cost of
Taxes
(C)=(B)*(A)
After-Tax
Return
Before
Advisory
Fees
(D)=(A)-(C)
After-Tax
Cost of
Advisor
(D)
Net After-
Tax Return
to Client
(E)=(D)-(C)
4.00%25.00%1.00%3.00%1.00%2.00%

On a 4% gross return, the client is losing 1% to taxes. Of the 3% after-tax return, the advisor is taking up 1/3 of the client’s return with a 1% fee leaving the client with only 2% after-taxes and after-advisory fees.

In the case above, the advisor is utilizing bonds as a retirement solution and the cost of that retirement solution is 33% of the after-tax return-all of which is due to the cost of the advisor.

There are a number of important questions to ask here:

1) Is shifting the portfolio allocation away from equities and towards bonds a viable retirement solution to begin with relative to other retirement solutions available?

2) What is the impact on the client’s ability to meet their retirement income goals and on ending wealth if the fiduciary advisor they hired to help them takes 33% or more of the client’s after-tax income from the retirement solution they recommended?

When an advisor uses a higher bond allocation in place of a proper retirement solution, this is the actual drag that is taking place due to the advisor’s fee since the taxable bond solution is both lower-yielding and highly taxable.

Is that really a fiduciary retirement solution to recommend a client give up 33% of their returns for the rest of their life with no protection or guarantees that the client will be able to safely withdraw a given amount of income?

And more importantly, are there better solutions out there that actually help improve both retirement income goals and wealth than the traditional stock-bond asset allocation the fee-only advisor is recommending?

We can quantify the impact of this using the same financial planning simulations that we did above. In other words, previously we saw the chance of a client meeting their retirement income goals using different asset allocations. What would these chances look like if we added in the cost of a financial advisor? What would the impact be on wealth at age 95 be?

The financial impact in retirement of a 1% advisory fee for life

No Advisor Fee1% Total Advisory Fee
Stock/Bond
Allocation
Chance of
meeting
retirement
income
goals to
age 95
Median
After-Tax
wealth at
age 95
Mean
After-Tax
IRR at
age 95
Sharpe
Ratio at
age 95
Chance of
meeting
retirement
income
goals to
age 95
Median
After-Tax
wealth at
age 95
Mean
After-Tax
IRR at
age 95
Sharpe
Ratio at
age 95
100%/0%82%$16,705,8966.77%1.0468%$6,706,9895.59%0.61
70%/30%80%$8,305,1305.93%1.1159%$1,800,6984.80%0.51
60%/40%77%$6,072,7355.61%1.1153%$490,4294.50%0.41

Charging a 1% total advisory fee while shifting client assets away from tax-efficient stocks and towards tax-inefficient bonds hurts the same retirement income and wealth goals the advisor is seeking to solve for the client.

As evidenced by the table above, charging an ongoing 1% total advisory fee for shifting HNW clients away from stocks and towards bonds hurts the client’s retirement income and wealth goals. The client would be better off maintaining a 100% stock allocation with no advisor than paying an advisor 1% if the advisor’s sole retirement plan involves shifting asset allocation towards a 70/30 or 60/40 stock-to-bond portfolio allocation without implementing strategies that would benefit the clients’ retirement goals.

Charging a 1% ongoing fee in retirement reduces the client’s chance of meeting their retirement goals and reduces the after-tax wealth they leave to their clients by millions of dollars unless the advisor has specific strategies they can implement to make up for the large cost of the fee.

In fact, in all three scenarios above, using an advisor reduced the client’s chance of meeting their retirement goals by 17%-31%. Using an advisor also reduced the after-tax wealth left to beneficiaries by $5.6 million in the 60/40 portfolio and nearly $10 million dollars in the 100% equity portfolio.

The safer the portfolio the client uses, the larger the impact caused by the use of an advisor. For example, if a client chooses a 60/40 portfolio, their chance of meeting their retirement income goal decreases by 31% (from 77% to 53%). Furthermore, the after wealth income left to their children decreases by 92% from $6,072,735 to just $490,429.

Another way to think about this problem is to focus on the effect on retirement income with and without an advisor. In the above table we focus on the chance of success for the client to meet a retirement income goal of an inflation adjusted $200,000 per year starting in retirement. We can see that the chance of meeting this goal without an advisor is 80% for a 100% stock allocation and 78% for a 70% stock/30% bond allocation. If the client uses an advisor, then the chance of success of meeting that retirement goal drops for each of these allocations. The only way for the chance of success to be the same with an advisor as without an advisor with the same asset allocation is if the client were to decrease their retirement income goal of $200,000.

So how much does the client have to drop their retirement income goal with using an advisor than without? That is essentially the value proposition that the advisor has to make up for just to break even for charging the client an advisory fee of 1% for the life of the client. We can see the answer to those questions below.

The Net Cost of An Advisor on Retirement Income

Stock/Bond
Allocation
Chance of
meeting
retirement
income goals
to age 95
Inflation
Adjusted
Retirement
income
possible
without an
advisor
Inflation
Adjusted
Retirement
income
possible
with an
advisor
Net Cost
of Using an
ongoing AUM
based
advisor
after fee
100%/0%82%$200,000$159,000($41,000)
70%/30%80%$200,000$159,000($41,000)
60%/40%77%$200,000$159,000($41,000)

Charging a 1% total advisory fee on client assets reduces the income that clients can withdraw each year in retirement. In order for the advisor to add value to the client, the advisor has to find other ways of making up this immediate loss of client retirement income.

As the table above shows, paying an ongoing advisory fee hurts the client’s ability to withdraw retirement income on an ongoing basis for a given asset allocation. This means that the advisor has to find a way to add value that makes up for the loss of retirement income due to their ongoing fee. For example, if the client chose a low-cost index fund with a 70% stock allocation/30% bond allocation they would have a 79% chance of meeting their retirement income goal of $200,000/year. However, if they used an advisor who used that same asset allocation, but charged a 1% total advisory fee, in order for the client to have the same chance of meeting their retirement income goal they would have to reduce their retirement goal from $200,000/year to $159,000/year. That’s a loss of $41,000/year (21% lower retirement income) to the client. This means the advisor would have to find other ways to recoup this cost through advanced financial planning strategies just for the client to break-even.

Conclusion

Financial planning in retirement can have immense value. This includes creating tax-efficient investment and withdrawal strategies from a client’s taxable, tax-deferred, and tax-free accounts as detailed in previous Advisor Perspective articles by Pfau and Reichenstein.

However, if clients are paying an ongoing fee in retirement that costs the client and their beneficiaries millions of dollars, then the value of this planning must at the very least offset these costs to make the planning worthwhile.

The wealthier an individual is the more they need complicated estate, tax, investment, and retirement planning solutions that are all integrated together to make sure the pieces all complement each other well.

Many advisors retirement strategy for clients simply involves shifting the allocation from stocks to bonds. This is hardly the sophisticated retirement strategy I’m referring to here.

In fact, shifting the clients away from stocks to bonds actually hurts the majority of clients—particularly those in high tax brackets—as this article showed.

Bonds are lower yielding, and more tax-inefficient than stocks.

In fact, the ability of bonds to provide diversification benefits to portfolios has been shown to be extremely regime dependent. When bonds have negative returns, stocks and bonds tend to have a positive correlation—thereby defeating the purpose of using bonds as a diversifier to offset equity risk in the portfolio. We saw this first hand in 2022 when rising interest rates caused bonds to suffer losses while those same rising interest rates resulted in losses in stock valuations in the equity markets.

Furthermore, the use of bonds as a retirement strategy comes with no protections against interest rate risk and credit risk.

Losing millions of dollars via fees that eat up 20% or more of the clients after-tax return for retirement solutions that don’t actually provide retirement benefits, is a heavy loss for the client and their beneficiaries.

The only one who really benefits from this arrangement is the advisor who gets to easily scale a business by adding the client to same investment model and strategy that all his or her other retirement clients are in while spending minimal time on addressing issues that could add economic value to the client on an individual level.



Rajiv Rebello

Rajiv Rebello

Author

Rajiv Rebello, FSA, CERA is the Principal and Chief Actuary of Colva Insurance Services. Colva helps family offices, RIAs, and high net worth individuals create better after-tax and risk-adjusted portfolio solutions through the use of life insurance vehicles and low-correlation alternative assets. He can be reached at [email protected].

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