“Before helping others, put your own oxygen mask first.” That’s what they say on airplanes when instructing passengers on what to do in an emergency. It makes a lot of sense: If you can’t breathe, you can’t help others. Unfortunately, an alarming number of financial advisors suffer from personal financial “issues” that can interfere with their ability to help their clients. Personal financial problems can indeed cloud advisors’ judgment and can prevent FAs from making much needed investments in the practice.
Personal financial issues occur in every channel of the industry and affect advisors of every size of practice – from the owners of very large wealth management firms to small independent practitioners. They are not the result of negligence or extravagance but are driven by advisors being caught by surprise while handling life’s natural events. Advisors are parents, and many are supporting college age children. Advisors are sons and daughters, and many are helping fund their parents’ retirements. Advisors are homeowners, and many bought and improved homes in the last five years. In short, advisors are people too. Advisors project current income into the future, just like clients do, and design a lifestyle around those assumptions. Unfortunately, too many advisors, like their clients, were rudely reminded that grand lifestyles are not always sustainable.
Few predicted the ferocity of the recent crisis. You can’t always live under the assumption that Armageddon is around the corner. (Usually, it isn’t.) Still, many mistakes could have been avoided. There were many decisions that advisors made that contributed to their troubles. Having met literally hundreds and hundreds of advisors over the last couple of years, here are the 10 most common mistakes:
1. Creating an unsustainable lifestyle. Years of high earnings lead some advisors to believe that the outsized income would continue forever. When designing their lifestyles, many, naively, took the record income of 2007 and added 10 percent to come up with their 2008 income estimates. Now, we know that was overly optimistic. Advisors need to react to such a problem quickly; the more time they live with a negative cash flow, the harder the problem is to solve. Unfortunately, the only solution is to cut down personal expenses to a more sustainable level. Sustainability can be tough to define, but I would propose that advisors annualize their year-to-date income and calculate a projected income for 2009 from there. Then I would set aside 20 percent as a cushion to absorb the working capital needs of the business and treat the remaining 80 percent as personal income. And set aside some of the income for taxes (this will vary a lot by individual circumstances) so you are not scrambling to pay the tax man next year.
For example, if an advisor has generated $180,000 in income as of September 30th, after paying all expenses in the practice, this means that he is trending towards $240,000 in income for the year (4/3 times $180,000 – since this is three out of four quarters in the year). Of the $240,000, $48,000 should be set aside for the business needs leaving $192,000 in personal income. Let’s say that your CPA advised you that your estimated taxes will be $52,000 at that level of income; that leaves you with personal, “sustainable,” disposable income of $140,000. Note a couple of very important points. One, the tax amount should be estimated by your CPA and will vary a lot from one advisor to another. The second is that the sustainable, disposable income is not nearly as high as you would think for someone making quarter of a million in income.
The discrepancy between the high income but the much lower sustainable income is due to the fact that advisors will absolutely need to leave that 20 percent cushion in the practice. Without it they are risking that even small fluctuations in the business revenue will throw their personal finances in disarray. Which brings us to our second point.
2. Not enough working capital in the business. Most planners tell their clients that they need to have six months of living expenses in cash (or other liquid account) as protection against loss of income. Most planners do not have six months of business expenses in their business accounts. They would be wise to follow their own advice. At a minimum, practices should have three months of operating expenses in their business account to absorb the quarterly cash flow patterns. Of course, we are assuming that every practice has a good handle on its expenses every month, which unfortunately is not always the case.
3. Not managing their business finances. As shocking as it may sound, many, if not most advisors, do not know how much profit their practice generates. What is worse, many have inflated and have built an unrealistic view of their profitability. While it may seem a very simple task to keep track of the expenses, there are two issues that cloud the picture. One is the presence of personal perks that are run through the business and paid for by the business. Examples include, cars and even spouses’ cars, cell phones, travel and entertainment, etc. Mentally, advisors do not consider those “real” expenses, because they are run through the business. But the reality is that they are quite real on the credit card statement, and there is a tendency to overspend in these categories just because the expenses are run through the business. The second issue is various arrangements with staff, referral sources or partners, where advisors pay a percent of some income or an expense or both. Sometimes advisors are not aware of how much is paid out in this area.
4. Not creating a financial plan. Remember the story of the cobbler’s kids—they have no shoes? It’s the same with advisors. It is surprising that many have not properly funded their children’s’ education; many are depending upon a homerun payout—selling the practice in order to generate retirement funds. (Of course, I have met advisors with the opposite problem: They are living like paupers now for a king’s retirement or Ivy tuition payment.)
5. Overinvesting in inflexible vehicles, such as defined benefit plans or whole life insurance. There are many tax advantages to using certain investment vehicles for retirement and/or accumulation of wealth. But there is something to be said about flexibility. Firms that had such plans and had committed to funding them in 2008 had a very hard time at the end of the year. If such a plan is present, there should be a cash budget to accumulate for the contribution throughout the year. Flexibility is of high value in a crisis and perhaps the least flexible is real estate.
6. Owning too much real estate. Advisors have a fatal attraction to real estate—they just can’t have enough of it. Many advisors own the building where their office is—or dream of owning it. Besides the tyranny of the mortgage, the problem with the real estate is the concentration of risk. If you have a mortgage on the house and a mortgage on the office, this means your fixed cost is higher that if you were just renting. I have heard the “why-pay-somebody-else’s mortgage” argument many times. Let’s be realistic: The rent is usually half the mortgage payment (sometimes less), and you also have the flexibility of renegotiating it or changing offices. Rents right now are very cheap and office space availability is high. If you own the building, though, you can’t take advantage of that. The other issue with owning the building is concentration of risk: If the practice is not doing well and other tenants’ business are in the dumps, you may take a double hit.
Strangely enough, owning the building encourages another problem: Hiring too many people just because you have the space to put them in. This is not a problem limited to those who own a building.
7. Overstaffing the practice. The staff is the firm. Staffers are critically important for the future of the firm, and their skills and talents define the advisory firm. At the same time, when the firm can’t pay for the continued employment of its staff, it has to make changes, sooner rather than later. It is painful and no advisor likes laying off valued people. But if you can’t afford to pay for them, something has to give. Waiting another month only makes the financial hole deeper. I have seen advisors go into personal debt in order to meet payroll. That may be an admirable dedication to employees, but it is not sustainable. If the firm is in the red for more than three months, something has to give. People who go into the advisory profession by definition have a high level of sympathy and empathy for others and that can create other problems too.
8. Helping too much. Many advisors are in their 40s and 50s and are helping kids through college while simultaneously helping their parents with retirement. While it is a noble thing to do, sometimes the situation requires asking the kids to take a job in college or cutting down their stipend. It is very difficult to admit to your kids that you can’t afford to help anymore but chances are that most will prefer to take on some student loan rather than see dad or mom go into bankruptcy.
9. Taxes. As self employed business owners, advisors have control over their tax withholdings and estimated payments. Making the estimated payments is an absolute must, yet many times I see advisors skipping them. What is worse, many advisors also do not project the cash flow needs and just hope that they have enough money in the bank on April 15. This year, when the money was not there, many had to file for extensions or workouts. A tax plan and conservative estimates for quarterly payments are absolutely necessary.
10. Thinking they can grow out of any problem. Whenever facing financial worries, advisors believe they just need to grow the top line. That’s how they tackled problems in the past. This crisis is different though: The decline was more severe than we have seen in ages, and the recovery will not come fast. Advisors should be realistic on how much growth they can expect next year when setting their budgets. If they find that they need to grow by 20 percent to break even, that means that they need to redo the budget—on a personal and business level.
The financial woes of financial advisors are not just a fine example of irony. Advisors’ personal financial problems can muddy their judgment and the care of their clients. Remember, the personal example that advisors set is important too. Just as you don’t expect your doctor to smoke, you wouldn’t want to see your advisor maxing out his credit card.