Starting a financial planning firm from scratch was an exceedingly daunting decision. After engaging in numerous conversations with others who had embarked on a similar journey, a consistent theme emerged, be prepared to “embrace the suck”. That doesn’t sound all too appealing, I would sometimes think to myself. But these fellow advisors also enthusiastically raved about the many advantages of having their own firm, including increased control over their time, the ability to make independent decisions, greater command over their lives, and the opportunity to cultivate deep long-lasting relationships with clients, just to name a few.
Throughout my entire life, I had never considered myself particularly entrepreneurial, or even considered the idea of starting my own firm. However, after spending a few years in the industry and engaging in thousands of conversations with individuals and families about their finances, closely listening to the concerns expressed by those who chose not to work with a financial advisor, I felt compelled to try to fill a void that I perceived in the industry and provide exceptional value to my clients along the way.
During my college years is when my fascination with personal finance and people’s perspectives and habits on money management truly blossomed. As I delved deeper into researching the financial planning field, a few pivotal books played a significant role in inspiring me to start a career in the field and helping me believe that I could make a big impact improving people’s money management, savings, and investing habits. These books were Nudge by the winner of the Nobel Prize in Economics, Richard H. Thaler, and Cass R. Sunstein, The Psychology of Money by Morgan Housel, and Thinking Fast and Slow by Daniel Kahneman. All of these books do a sensational job of lending insights into why we make decisions the way that we do and how these behaviors affect the way we make decisions based around money. Growing up I had always been interested in business and finances, but after reading these books I developed a profound fascination with personal finance. I became very passionate about helping individuals overcome their behavioral biases and fears, guiding them to align their money with their values, and empowering them with a better understanding of the tools and strategies at their disposal to build wealth.
Finance, like most other career fields, is inherently complex, and achieving optimization demands a certain level of expertise. So, why do so many people attempt to navigate it alone? When people are sick, they promptly seek the aid of a doctor, when faced with legal matters, they readily turn to lawyers for their advice. So, why is it when people recognize their financial challenges, many of them hesitate, or even flat out resist the idea of collaborating with a financial advisor?
As I've accumulated industry experience and engaged in many conversations with individuals and couples, two recurring sticking points often emerge. The discomfort surrounding opening up about the sensitive topic of money with someone they barely know, and the concerns about financial advisors' compensation model.
Regarding the discomfort around discussing money, I completely understand. Unfortunately, our society has fostered toxicity around this topic, exacerbated by the social media age, where people constantly feel judged and compare themselves to idealized online influencers. It's crucial to remember that comparison is the thief of joy. Embracing your unique situation, maximizing your opportunities, and building optimally depending on how you define success for yourself is the best way to reach your personal goals.
The other significant concern revolves around the typical advisor’s compensation model, which charges clients based on a percentage of the assets they manage, usually around 1%. From here on out, I will refer to this compensation model as AUM (assets under management). On the surface, this compensation approach appears to better align advisors' incentives with their clients' interests, when compared to the previously used commission model. However, it still has numerous issues that give potential clients pause and outright prevent many people from being able to work with an advisor.
In devising the structure for my own firm, I identified four key issues with the AUM compensation model that I aimed to address:
Interests not being fully aligned
Advisors who are compensated solely based on the amount of assets under their management often exhibit a preference for clients to continuously add or keep their money in their investment accounts rather than paying off debt or investing in rental properties, among other examples. Additionally, they are incentivized to recommend that you rollover your eligible employer sponsored retirement plans (e.g. 401k, 403b, 457b, TSP) under their stewardship, even if your existing plan is low-cost, has extensive investment options, and provides superior creditor protections.
Another financial planning strategy that AUM advisors often conveniently overlook for their clients pertains to the strategy of backdoor Roth IRA contributions. This strategy could play a monumental role in building up tax-free assets for retirement. Allow me to delve into this strategy and explain why it can be so powerful for a majority of individuals whom it applies.
The Roth IRA is an exceptional savings tool, so much so that the IRS rules restrict individuals with a certain income level from contributing to them directly. This is where the backdoor Roth contribution comes into play. It involves making a non-deductible contribution to a traditional IRA initially and subsequently transferring all that money to a Roth IRA. However, there is a significant caveat associated with this strategy known as the “pro-rate rule”. Essentially, this rule forces you to treat ALL of your non-Roth IRA’s as a single IRA. Let’s examine an example below to better understand it.
For the sake of this example, let’s assume you plan to contribute $6,500 as a non-deductible contribution to your traditional IRA with the intent to convert the entire contribution to a Roth IRA. Let’s also say that you have a $650,000 IRA under the stewardship of an AUM financial advisor. Because of the pro-rata rule, the IRS will inform you that that percentage of after-tax dollars in your non-Roth IRAs is 1% ($6,500/$650,000). So the percentage of your backdoor Roth conversion that will be tax-free is just 1%! That means 99% of that $6,500 conversion will be subject to taxes, even though you already paid taxes on all of it!
Now there is a way to avoid the pro rata rule. This can be accomplished by rolling the Traditional IRA balance to your current employer’s retirement account. Once your Traditional IRA has been zeroed out, you can make your backdoor Roth conversion and the entire non-deductible contribution can be converted tax-free. Unfortunately, for the AUM advisor this could mean a substantial reduction in their compensation, simply because of the method their fees are determined.
This example, though admittedly delving into a somewhat complex planning strategy, is important to understand because it illuminates how your interests may not always be aligned with your advisors. Due to this rule, high-income professionals need to exercise caution when their advisor suggests rolling over their pre-tax employer retirement plan to an IRA while they are still working and earning income. Missing out on these Roth contributions can severely hinder your ability to maximize the longevity of your assets in retirement.
Transparency
With the 1% AUM fee you never even know what you are going to compensate your advisor for the year, until after the fact. I can hardly think of another profession that charges based on a percentage, rather than an actual dollar figure for the work performed. Well, perhaps one…Uncle Sam. And, for the most part, people aren’t overly thrilled with that payment model either. Moreover, the AUM fee is directly tied to and reliant on market returns, a factor that no financial advisor can completely control.
The ability to serve everyone who wants help.
This is the primary issue that I set out to solve when structuring my own firm. One of the core characteristics of the AUM compensation model is that a client must possess a substantial sum of savings for the 1% assets fee to adequately compensate the advisor for their time and make it scalable for their practice. However, even individuals with very high incomes may not have enough accumulated in investment accounts to meet advisor minimums. Young professionals and mid-career professionals in their 20s, 30s, 40s, or 50s, despite earning well, could benefit significantly from a financial advisor's guidance and be financially capable of paying for it. Nevertheless, they could still face rejection because the bulk of their assets might be tied up in a 401k or home equity. Yet, an AUM advisor will have to turn them away if they fail to meet the firm’s investment minimums. This is a demographic I feel strongly about being able to provide advice to. I firmly believe that anyone with the need and the ability to pay for advice should have access to it, irrespective of the amount of assets they have saved in investment accounts.
Place the focus on financial life planning, not investment performance
Basing your compensation solely on one aspect of financial planning inevitably results in a disproportionate focus on that service. Many advisors who charge based on AUM often find themselves dedicating the majority of their time and efforts to defending their investment performance and expertise, overshadowing other critical areas of financial planning. These essential aspects include cash flow management, debt planning, tax planning, and insurance planning, among others. While wise investing is undoubtedly a crucial component of any financial plan, I have personally observed that the time and energy spent trying to "beat the market" could be far more effectively utilized in the other realms of financial planning, where our knowledge and expertise can directly influence the outcomes for our clients.
These experiences and observations served as the motivating force behind establishing my own financial planning firm, designed with a flat-fee compensation model that offers a diverse array of services. This approach enables me to meet individuals wherever they are on their wealth-building journey and provide personalized and timely advice to help them improve their financial situation. The process commences with a complimentary consultation call where we don't immediately discuss money; instead, it's about getting to know each other and exploring how we can collaborate to enhance your financial well-being.
This model affords me the flexibility to work with a broader range of clients, minimizes conflicts of interest, and allows me to adopt a truly holistic approach, focusing on the financial planning areas where I can offer the most value in a person's life.
I firmly believe that the flat-fee model will continue to gain traction and eventually become the standard in the financial planning industry. Flat-fees shift the emphasis towards optimizing your entire financial life, rather than solely focusing on your investment portfolio.
I founded Impact Financial Life Planning with a simple vision in mind: to partner with individuals and couples as their personal CFO, allowing them to dedicate more time and energy to their family and life. Financial planning is intricate, demanding considerable time and effort and constant monitoring, especially when keeping up with the ever-changing legal and regulatory landscape that gives rise to new strategies and the obsolescence of former ones.
Whether you're a recent graduate seeking to start off on the right foot by automating your savings and navigating the intricacies of account types, or a later stage accumulator contemplating the crucial steps to take in your final working years to ensure peace of mind in retirement, I can serve as your trusted navigator through the complex and constantly evolving financial landscape. My aim is to provide impactful financial education and planning to guide you towards a better financial future.
To learn more, visit my website at impactfinanciallifeplanning.com, email me at john@impactfinanciallifeplanning.com or call 410-570-8597.
To schedule a complimentary call, please grab some time on my calendar: https://calendly.com/johnocallaghan/consultation
