Brent Sheather: Use common sense to assess financial plans

Financial advisers must put clients' interests first. Photo / Thinkstock

A Herald reader emailed me the other day asking for a review of an investment plan prepared by the financial-planning arm of one of the major banks.

The reader is in his 60s, plans to retire in five years and has a superannuation scheme that will provide most of his retirement income, so the money he has to invest is "something extra that I have worked hard for and don't want to put at too much risk.

I don't need income but some growth is desirable. I am risk-averse and don't mind paying a little more to ensure I am managing the downside risk, but am I paying too much?"

He was looking to invest $200,000 and, after assessing him as having a moderate risk profile, the "highly trained" authorised financial adviser employed by the "private bank" came up with an asset allocation as set out in the table.

We have also detailed the prospective return from each asset class using actual yields in the marketplace today and, for international and Australasian shares, forecasts of London Business School professors Dimson, Marsh and Staunton writing in the Global Investment Returns Yearbook and the opinion of Barclays Capital in the 2011 Equity Gilt Study.

The asset allocation was 50 per cent in bonds, 5 per cent in property, 40 per cent in shares and 5 per cent in high-cost hedge funds, commodity funds and venture capital. Apart from the 5 per cent in the specialty fund, this asset allocation looks reasonable for someone with a moderate risk profile, so no real problems there.

The reader's question, however, was whether the fees were reasonable in light of the projected return. The fees were quoted as follows:A $200 initial fee for the plan.

A $2000 initial fee to establish the portfolio.

An annual cost of 1 per cent in management fees on the funds used and a 0.9 per cent monitoring and administration fee give total annual fees of 1.9 per cent.

The client had looked around to ascertain whether these charges were reasonable in light of what is generally on offer locally.

He was unable to find much information about fees on the internet, which is not surprising as most advisers do not to disclose to prospective clients what their fees are until they have met and agreed to the production of a formal plan.

On these numbers, the 1.9 per cent annual fee takes a third of the client's return. So the answer to the reader's question is that the fees don't look reasonable. Other products are available where the total annual fees, including monitoring by an adviser, are about 0.5 per cent per annum (pa), or 8.8 per cent of total returns.

His other question was whether the return projections were realistic. The bank made an overall projected annual return, after expenses, tax at 28 per cent and 2 per cent inflation, of 2.85 per cent. Let's look at the 2.85 per cent pa to see if it is realistic.

From the table, we can see that the return before fees, tax and inflation will be about 5.7 per cent pa. The annual fees are 1.9 per cent, so returns after fees will be 3.8 per cent pa. Income on the portfolio will approximate 4 per cent pa, so tax at 28 per cent will take 1.12 per cent, so the after-tax return will be 3.8 per cent less 1.1 per cent, which is 2.7 per cent. This simplistic tax calculation understates the tax to be paid, as 23 per cent of the portfolio is invested in international shares, where we assume a 2 per cent dividend and 4 per cent growth, but the fair dividend rate of tax regime in New Zealand taxes those shares as if they yield 5 per cent. So the cash return on the international share portfolio will be negative after tax and fees. The specialty funds are probably even worse because, with high fees, they pay no dividend yet are subject to tax as if they paid 5 per cent after fees.

But I digress. The post-fee, post-tax return is 2.7 per cent, so if we knock off 2 per cent for inflation, we get a 0.7 per cent pa return. The bank is projecting a 2.85 per cent pa return, so it looks very much like either it has its numbers wrong or it is investing in bonds, which could default in a depression. Neither scenario looks good for the client. On top of all this, his $200,000 portfolio took an immediate hit of $2000 to kick it off and we haven't factored this into our return calculations.

This is one of the first financial plans I have seen since the widely anticipated "new regime" has come into operation, whereby financial advisers are required to put clients' interests first.

Funnily enough, this post-"new regime" plan looks a lot like the pre-"new regime" plan. In particular, the forecast return projections are, as usual, fundamentally overstated.

Let's have a look at what the Code of Professional Conduct for Authorised Financial Advisers has to say about "placing clients' interests first". On page 7, the code defines that what is required to place a client's interests first "for the purposes of this Code Standard is determined by what is reasonable in the circumstances".

This writer is not an expert on the Code Standard, however he did manage to pass the one-hour ethics exam, and it is his non-expert opinion that grabbing 33 per cent of the client's prospective return in fees is "unreasonable in the circumstances" given that there are other lower-cost investment strategies available.

Bank deposits spring to mind, where there is no leakage to fees, in combination perhaps with low-cost exchange-traded funds to give an equity dimension to the portfolio. There is also the related issue of materially overstating returns, which is, of course, a matter of opinion - but it is curious that the higher the fee structure of the adviser, typically the higher return they forecast.

Returns from the fixed-interest portfolio are easy to determine from the bond market and my analysis uses equity returns from the London Business School professors, who probably have less vested interests than most.

Another way of examining whether this plan "puts clients' interests first" is to consider that not only are 33 per cent of prospective returns going to the advisory firm, but the residual 3.8 per cent pa which goes to the client is risky, whereas the 1.9 per cent pa in annual fees going to the advisory firm is risk-free.

This plan amply illustrates the simple fact that the standard annual fees of the local financial advisory industry are ridiculous in the context of prospective returns, and any sensible person would likely leave the money in the bank, where it is possible to get 5 per cent to 6 per cent on term deposits without any fees.

So what does all this mean for Kiwi mums and dads with money to invest? Fortunately, assessing an investment plan does not require a high degree of specialist knowledge, but common sense is essential.

The two key elements are asset allocation, where the specialist knowledge comes in, and fees. The average pension fund has 40 per cent in bonds and 60 per cent in growth assets, so that's your benchmark - if you are more risk-averse, you will have a higher weighting in bonds.

Investors need to draw on their common sense with a little bit of specialist knowledge. Fees are important, too, and warning bells should ring when fees take more than 10 per cent of forecast returns.

A good rule of thumb is to demand to know from the adviser what your cash income will be from your plan and compare that with the fees you are going to pay. In this case, we can estimate the cash income on the $200,000 would be around $7900 pa, before fees.

A fee structure of 1.9 per cent on $200,000 is $3800 pa, meaning that 48 per cent of the income is going in fees.

Again, this should flag a huge warning to anyone with an ounce of common sense.

One has to have a grudging respect for the persuasive powers of the private banking sector, in that they have been able to sell so many people this sort of ridiculous deal when, in another part of the bank, they are selling bank deposits with 5 per cent to 6 per cent pa returns, after fees and with no risk - provided, of course, that we don't have a depression.