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Sudden Wealth Requires Thoughtful Planning Too

Being the primary medium of exchange for a civilized culture, money can exert strange and sometimes complex influences on people, causing them to exhibit unexpected changes in behavior and attitudes. Nowhere is this more evident than in the case of so-called “sudden wealth” due to inheritance, a large elevation in work income, or in rare circumstances, being the winner in a large lottery. And it’s not only the lucky recipient that’s affected; often it’s the people around the recipient as well.

All of this came to mind last week when a client called to discuss a predicament she was facing due to a rather large inheritance. In this, our client’s wealthy father passed away recently and bequeathed large annual sums to her that will allow her to enjoy a comfortable lifestyle for the rest of her days; a lifestyle that will markedly improve upon her currently modest circumstances.

Her new issue is with certain friends and family members, especially with family members who weren’t included in the inheritance and feel somewhat short-changed. These individuals are treating her differently as well as suggesting “sharing” would be a moral road she should take. And others in her life have approached her for financial assistance for various causes, charities, etc., apparently feeling my client has the means to also share her good fortune with many others and the world-at-large.

Sudden wealth can solve many financial problems, such as debt repayment, bettering one’s lifestyle and spending choices, realizing life-long dreams and even affording the means to help others with their goals, such as sending children to good colleges or relieving parents or others of their financial burdens. It can also bring unwanted and unlooked-for issues such as relationship problems with those who are not as well-off, losing a sense of purpose or direction in day-to-day life, and new financial anxiety of how to preserve this situation for the future in a sensible manner. It also brings new choices perhaps about how and whether to share this wealth, either with those close to them or for favorite causes and charities.

It may sound simplistic, but a sudden, unexpected windfall requires the same type (or more) of forethought, careful consideration and planning expected for those in more modest circumstances. For those who don’t (young superstars in entertainment and sports come to mind), even large amounts of money can be spent unmindfully or given away unchecked until there’s nothing left. There’s nothing wrong with helping others and charitable, but do so in a disciplined and mindful way.It is estimated that hundreds of billions of dollars of inherited money will be passing from the current elderly generation to the so-called Baby Boomer generation over the next decade or so. If you are on the lucky end of this transfer trend, be sure to receive your windfall with a sensible and thoughtful plan in mind. If anything, most recipients will want their new wealth to go toward good (and multiple) uses. Having a plan and goals in place will help ensure this occurs in a sensible and prudent manner.

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Having a Margin of Safety Works for Your Whole Financial Life

Famed investor Warren Buffett once stated that “margin of safety” are the three most important words for investing. By this, Buffett sought to illustrate the idea that If you make your investment too close to the line (or the proverbial edge of the roadway cliff),of succeeding or not, the risk of falling off might be more than you realize. Buffett was naturally referring to margins of safety with investing, but the concept also applies to many areas of personal finance. Having such buffers in your financial plan is prudent and can help avoid that “one thing” in life that sets you back in a big way.

For most people, everyday spending is often the first danger area. Too many consumers are living paycheck to paycheck. The personal finance site “MarketWatch” reported earlier this year that 19% of American households had zero- nothing – nada in emergency savings and 31% of households have less than $500 to pay for things like car repairs, home emergencies, medical co-pays and deductibles, living expenses in case of a job loss, etc. When difficulty strikes in your life, having that cash cushion can be like a warm blanket on a cold winter night, despite the fact that cash doesn’t earn much nowadays.

Similarly, another problem area is credit card debt. Now that we’re three quarters of the way through the year, take a look at your credit card statements for the past 9 months. If your balance(s) are creeping up, you might consider some serious spending changes, especially since we’re not even into the holiday season yet. A steadily increasing credit balance may mean you have no margin of safety in your income versus spending habits.

Retirement planning is another area where retirees and pre-retirees might employ some margin of safety concepts. There are many assumed variables that go into a retirement income analysis, including investment return, inflation and tax rates. I’ve seen some reports where average rates of return seem a little high, (considering market valuations, potential interest rate increases and moderate economic growth for the US). In fact, some of these results haven’t factored in the “What Could Go Wrong?” factor into the analysis. Banking on all being well in the financial world in the next decade or two could be hazardous – if history is any guide. Having your retirement income needs based upon all-is rosy scenarios may not be a wise idea.

Permanent insurance policy projections (for those policies that build cash-value) could be another problem area if the policy owner is expecting to tap the cash value for retirement purposes. Oftentimes, projections of return are a bit optimistic and purchasers forget to look closely at the “non-guaranteed” heading on these projections. Similarly public and private pension overseers could use a bit of margin-of-safety thinking when considering how underfunded their pension plans are and the rate of return they’re using in their assumptions. As many observers have pointed out, overly optimistic return projections are just kicking the can down the road for hard choices that ought to be made to keep the plan whole for the future.

In summary, safety “buffers” are prudent and worth having in all areas of your finances.

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Age-Banding” Concept Is a Beneficial Retirement Planning Tool

According to recent studies by the Insured Retirement Institute and GoBankingRates.com on how the ‘Baby Boomer’ generation (those born in the years 1946 – 1964) is prepared for retirement, 30% of this US demographic have no retirement savings whatsoever, 26% have less than $50,000 saved and a full 74% have insufficient retirement funds to sustain their accustomed lifestyle in retirement to supplement Social Security income. These sobering statistics suggest that retirement income planning will be critical for this generation to attain as much “financial efficiency” as possible from their limited resources.

Over the past two decades, both academics and professionals in the financial planning community have sought to refine retirement income planning methods to help retirees and their advisors better forecast what finances may be required to fulfill retirement goals. Differing research often results in debate about how much in retirement savings may actually be required (answering the proverbial “What’s my retirement number?” question) and unfortunately, with changing paradigms to the retirement income landscape, (including pension underfunding or elimination, rising medical costs, increased average longevity, etc.), finding accurate planning tools seems to be a never-ending moving target.

Over the past years, two findings on retiree spending habits have emerged from statistical research that may help the Baby Boomer retirement dilemma. Since the 1970’s, the prevalent view of retirement was that of stable spending at 70-80% of pre-retirement lifestyle. In fact, much of today’s financial planning software still utilizes this stable spending as a core component. By the 1990’s, the concept of William Bergen’s 4% rule took hold, suggesting that retirees must incorporate inflationary increases into their planning. Thus, the static flat pension payout was not sufficient to carry the retiree through decades of retirement life.

Later, author Michael Stein suggested that most retirees actually go through three general phases of spending; the “Go-Go” years (age 65-75), the “Slow-Go” years (age 75-85) and “No-Go” years (age 85-95). As you can imagine, the early years are generally more active with more spent on travel and leisure, whereas in the late years, spending habits change and often decrease over time. This concept of “age-bands” was further refined by researcher and author, Somnath Basu, who suggested that retirement income analysis should not only include age-band spending, but also break down spending into categories, then assign changes in spending levels through each age band to reflect statistically-supported changes on what a typical retiree spends during each phase of retirement.

As an example, Basu broke down retiree spending into four segments; basic living expenses, taxes, leisure and medical. In the first band (age 65-75), leisure spending may be elevated to 50% more than in the second band (age 75-85) and perhaps 25% in the last band of life. In contrast, during the early retirement years, medical expenses may be much less than in the last third of life, and therefore some adjustment for that category in the spending analysis may reflect more realistic eventual outcomes.

Unfortunately, little of today’s financial planning software utilizing these interesting tweaks, so pre-retirees and their advisors may have to create their own adjustments to incorporate age-banding and spending category changes. For now, it’s worthwhile to still consider such retirement spending changes for your own financial future.

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Be Careful About New College Aid Application Method

In just a couple of weeks on October 1st, families with college-bound students will be able to submit the Free Application for Federal Student Aid (FAFSA) to determine eligibility for college financial aid for the 2018-2019 academic year. For this application, families will be using their financial data from their filed 2016 tax return.

A relatively new feature of the online FAFSA submission process is the Data Retrieval Tool (DRT). This function allows a user to link the FAFSA application with their filed tax return on the IRS database and automatically populate answers for income and tax questions. The DRT also alerts the colleges that the information has been auto-entered by the IRS link, thereby eliminating the need to later “verify” FAFSA data. Last year, however, the DRT was suspended over security problems.

This year, (as a solution to security concerns), the DRT will no longer display the data that is entered onto the FAFSA application. Instead, entries will just read “Data entered by the IRS”. In addition, the Student Aid Report will also not list the submitted data. This may not seem like a problem, but there is actually a potential issue. By not displaying the actual data, parents and students are literally submitting a “blind application” and will be unable to make corrections themselves once the FAFSA is submitted. The only way a change could be made is with the financial aid office of each college where the student has submitted an admissions application. Considering that parental income is often the largest factor in calculating a family’s Estimated Family Contribution (EFC), it is critical to ensure the income information is accurate. Many times, parents are shocked at how high their EFC is. Not knowing what went into the resulting figure can elevate stress levels and add to the work of the financial aid and college process.

To solve this issue, parents should consider filling in the FAFSA application question-by-question and not using the DRT for the initial submission. Of course, this will entail some extra work and understanding of making the correct entries on the application instead of the convenient DRT function. Once done and submitted, parents would receive their initial EFC and should also then print the Student Aid Report (SAR). Then, after the initial submission, parents can turn-on the DRT function and check to be sure their initial submission was accurate. Parents can also wait until the final college choice is made and then re-submit the FAFSA using the DRT so the chosen college can verify the FAFSA information. Of course, differences in the original submission and the DRT version may trigger an amendment to the aid award, but if applicants are careful in their submission, amendments may not happen. Using the DRT may not be a good idea if parents’ present income situation is materially different than in 2016. In this case, completing the FAFSA without the DRT at all and submitting supporting material (copies of tax returns, W-2 forms, etc) may be the best strategy.

For those who are unsure about filling out the FAFSA themselves, the Rhode Island Student Loan Authority’s College Planning Center is a good resource for RI families. Contact them at www.RISLA.com.

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Freezing Your Credit Can be a Good Financial Security Strategy

In today’s cyber-everything world, having your financial identity compromised or stolen can be one of the most frightening and troublesome experiences you’ll have in your lifetime. Although with some prudence, the likelihood of financial ruin is low, as anyone who has lived through it will tell you, even having someone get access to one of your credit card numbers can be a hassle that seems to never end. With recent cyber-hacks to retailers and financial institution consumer databases, the risk of your highly-sensitive information being compromised (such as your birthdate and Social Security number) only seems to loom larger.

While credit card companies and banks can limit the damage to having your debit or credit cards stolen (as long as you quickly report the theft), protecting yourself from thieves who gain access to your Social Security number, address and birthdate could be much more complicated. One preventative strategy is to have your credit reports “frozen”, thereby preventing anyone from opening new credit accounts under your name without your knowledge. Many people wouldn’t realize such accounts are opened under their name until they check their credit report or if they actually applied for a new account and found out their credit rating is compromised.

A credit freeze is accomplished by contacting each of the three credit reporting companies; Equifax, Experian and TransUnion, to request a credit freeze. Based on RI State law, there may be a small fee ($10) to add, lift or remove a credit freeze with any of the credit agencies. Seniors and those who have already been victimized by identity theft generally are not charged for these services though. A security freeze remains on your credit file until you remove it or choose to lift it temporarily when applying for credit or credit-dependent services.

On Friday, September 8th, Equifax disclosed a massive cyber-hack of their database, potentially compromising the sensitive financial information of 143 million Americans. Equifax has provided a link for you to check if your information may have been affected and will also provide one year of free credit monitoring/emergency notification for such consumers. We recommend everyone go this link https://www.equifaxsecurity2017.com/potential-impact to check their own status, utilize the free monitoring offer if they are affected, and consider “freezing” their credit as a further security measure.

To freeze your report, you will need to provide each agency with your name, address, date of birth, Social Security number and other personal information. Once the freeze is in effect, each agency will give you a Personal Identification Number (PIN) which will need to be kept secret and secured by you. If you even need to lift or suspend the credit freeze (again with each of the agencies), you’ll need these PIN’s to unlock your report (such as when you do legitimately apply for credit or open a credit account, apply for a mortgage, etc.). In addition, you’ll need to provide each agency with a dedicated phone number for them to contact you for verification when an inquiry is made about your credit. Some additional tips:

1) Although a credit freeze helps prevent new accounts from being opened, it cannot prevent thieves from stealing using existing accounts. So it pays to continue to monitor your credit report and current credit accounts for fraudulent transactions.

2) The credit freeze does not prevent current creditors from accessing your credit reports. It also does not prevent you from accessing your own credit at any time.

3) Credit freezes are individual, so if you freeze your accounts, your spouse must also freeze theirs.

4) A credit freeze does not impact or hurt your credit score.

For more information, go to the websites of any of three credit reporting agencies above for more information and assistance.

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Another Example Why Diversification Works

The last several years were not great for overseas investments as general indices in Europe, Japan and China underperformed for most investors and mutual funds. When a category struggles in a particular year, the advantage of a diversified strategy (such as the classic 60/40 ratio of stocks and fixed income/cash) often comes into question as there may be years when one or a few asset classes will be average or at the bottom. What is forgotten is the following year or years, the best ones may be the worst or average and the lagging ones of previous year(s) may now be the best. The idea is there should be part of the portfolio that does well each year, even if another part does not. This way, your investment planning remains on track toward your objectives and doesn’t overly suffer in any one year, since losses are harder to recoup.

The “bounce-back” of this idea didn’t really happen for foreign stocks until this year (so far). Foreign stocks, especially those in so-called “emerging markets” have seen resurgence in appreciation and many have outpaced US domestic markets. This includes US stocks; large, mid-sized, and small. In fact, some areas of the US domestic market (small company indices and real estate-related investments come to mind, as well as energy) have been fairly tepid in delivering returns to investors so far this year.

Many investors are second-guessing themselves (or their advisors) and questioning their diversification strategy and may now be thinking that international is “the place to be”. I’ve actually had a few clients question why they’re still invested in real estate or energy when returns have lagged the stellar returns thus far in the global arena. These investors are thinking to abandon real estate and energy and overweight international stocks now. This could be a mistake.

The truth about diversification, and investing in general, is there are bound to be years when one investment category or sector doesn’t work as well as expected. In fact, in a properly diversified portfolio for any one year, there will likely be one to a few sectors that will do well, the majority that might perform on average or as expected, and another one or few that will disappoint, sometimes really disappoint. The key here is that, for the most part, it’s hard to guess, much less know, which sectors will be the stars for the year and which will be the laggards. Research on these questions shows time and time again, that having your portfolio spread out in an asset allocation format tends to produce satisfactory returns over the long haul, (though nothing is guaranteed, of course). In fact, making regular contributions to your portfolio amongst all the different sectors, regardless of how they’re doing in any particular year, is generally considered a smart move, since more shares of the laggards are generally acquired at lower prices and less shares of that year’s winners are purchased at higher prices (that old dollar-cost-averaging idea).

Chasing returns is seldom a sound strategy. Stay disciplined, stay diversified, and continue to save towards your long-term financial goals.

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Early Retirement Brings Big Changes and Many Decisions

According to recent studies, 45-50% of Americans today are forced into unexpected retirement before they planned, whether due to health reasons or being laid off from their employers. Since many such workers are in their late 50’s or early 60’s and in their “peak earning years”, this sudden life event brings many financial changes and decisions that must be made.

First, it’s important to review your severance benefits from your employer, starting with any last salaries to be paid. Many larger companies offer a year’s salary as compensation for being laid-off and this can be an important lifeline. Make sure you’re clear on how the severance will be paid; normal payroll as you’ve been receiving or a lump-sum. Either way, it’s important to consider the income tax to be withheld to avoid nasty surprises at tax-return filing time. If a lump-sum severance is to be paid, make sure you be frugal with how you draw down on that sum. Reviewing your household budget and expenses would also be a prudent undertaking with your family.

Healthcare coverage is the next consideration. If your spouse cannot add you to their employer plan and you don’t have another job lined up with medical benefits, you may have to consider whether to apply for “COBRA” benefits (which usually come with high premium payments) or seek coverage on your own. Since many workers are laid off well before they qualify for Medicare at age 65, it’s important to make sure you have your medical insurance coverage squared away as soon as possible.

Social Security benefits are another consideration. If you lose your job and you’re at least age 62, it’s tempting to go ahead and apply for Social Security income benefits right away to help cover your lost income. That could be a major mistake however, since you could lose between 25-30% of your full retirement age benefit by claiming early. If you have other retirement savings, such as IRA accounts or 401k savings, it may be better to draw on those first (as long as you are over age 59 ½) before claiming SS early.

Decisions also may need to be made on retirement savings and benefits. If you are lucky enough to still qualify for Defined Benefit Pension benefits, there will be choices as to when you take your pension, whether to take a lump-sum benefit and roll it over to an IRA account, and if you select an annuity-style stream of income payment, you might need to decide whether to take a full benefit or a “joint and survivor” payment where your spouse receives a percentage of your benefit if you predecease them. With your 401k/403b and other employer-sponsored retirement savings, you will likely need to consider whether to leave the account with your employer’s plan or take a qualified rollover distribution to an IRA Rollover account. Bear in mind that either choice has benefits and drawbacks to carefully weigh.

Early retirement may also require a re-visit of your financial plan and retirement income analysis to see how all these choices and considerations affect your retirement plans. A review with a qualified financial professional can be helpful to understand these choices and make the best decisions going forward.

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Knowing Human Tendencies Can Help Your Investing

The financial markets are tricky enough to navigate, but at times, investors of all stripes can complicate matters for themselves and are really their own worst enemies. Many investing mistakes can be traced back to what finance psychologists term “behavioral biases”; simple assumptions or habits that are rooted in human nature. Everyone is subject to these tendencies, even the professionals. One key to overcoming these problematic habits when it comes to your investing is to understand them and considering alternative reactions when you catch yourself following these impulses. Here are some common mistakes people make in this manner:

Confirmation Bias: This is the tendency to support a preconceived opinion or theory with data or opinions of others that agree with your opinion and exclude others without fully weighing the merits of opposing viewpoints.

Anchoring: A classic mistake of using a desired starting point to defend an investment strategy or point of view. A good example is the reluctance to sell a losing investment until you (somehow) break even or recover what you’ve lost so far. Same with losses at the gambling table.

Hindsight Bias: A favorite of mine when reading claims by “investment gurus” that past events were clearly foreseeable by them, so you should trust their future forecasts. Basically an assumption that the past was easier to see than it actually was at the time.

Sunk Cost Fallacy: Reluctance to exit a losing strategy based upon the losses already incurred. This is similar to anchoring, but weighs heavily on what has already been lost or spent. People fall into this all the time when considering replacing an older vehicle that is constantly in the repair shop.

Patterning: Seeing patterns and repeatable circumstances where the truth is actually more random chance. This is a biggie with so-called “technical analysis” in the investment world, where investments are made based upon charts and patterns in market activity. There are many believers in this, especially on Wall Street and in the day-trading community. Every religion has its followers and justifications.

Self-Attribution: This is where investors take credit for the wins and ascribe blame to others or other circumstances for the losses. A good investor (or investment advisor) will downplay their skill in the wins (a lot could easily just be plain old good luck) and assume some of the fault for the losses.

Illusion of Control: More and more, especially today, investors need to realize that much of the activity in their investment accounts is far beyond their control. There are literally billions of dollars that transact in the financial markets today and almost no one has any control over the markets or how the investments within their portfolio will change based upon market events or market behavior to those events. To believe one can outsmart or outguess the market is largely illusionary.

Recognizing our natural fallibility to these human traits can be the difference between long-term success with your investment goals or making mistakes that can derail your financial plan. Being self-aware is helpful in most aspects of life and especially so with your participation in the financial markets.

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Retirement Planning: It’s Not Just a Number

Whether it’s clients who meet with us or acquaintances at social gatherings, “How much do you think I’ll need to retire?” is a frequent question we get asked. Unfortunately, the usual answer isn’t all that earth-shattering or helpful; it depends. The notion that all you need is “a number” (popularized by a well-known mutual fund TV commercial a decade ago), just doesn’t explain the difficulty in crafting an effective and workable retirement plan.

Depends on what? On so many factors. Here is the short list: retirement spending needs, interest rates, inflation rates, investment returns, health insurance concerns, charitable intentions, when you plan on retiring, unexpected hiccups in the financial/geopolitical world. All of these are variable and really unpredictable influences on your future, even expected spending levels after you stop working. You may decide to live in another state, you or your spouse may develop health issues, tax rates may increase, who knows?

The myriad of variables can make retirement planning a monumental endeavor and one which most people naturally avoid tackling, especially in fear of making a mistake. In fact, this may be part of the problem – there is a misperception that retirement planning is a ‘One-and-Done’ prospect, when in reality, it is an ongoing process that often requires continual refinement and adjustments as a result of the twists and turns life throws at us.

Just as anyone who has been around several decades knows, things rarely go according to plan, whether it’s raising a family, entering a career, or even just getting through today’s agenda! Why should retirement planning be any different? Let’s use the example of opening a new business. The budding entrepreneur most likely starts out with an idea of what the business will look like, how it will operate, the funding required, where it will exist and how it will grow and prosper. Like a retiree, the new owner will likely have a (written!) plan, secure the finances needed and have defined activities to make the venture a success. All may go well, of course, but more often, many things will not, resulting in set-backs, adjustments, maybe re-doing the financing or spending, changing how revenue (income) is generated and perhaps a whole new approach to the previous vision.

Like starting a business, a career, or even a vacation, corrections and adjustments are part and parcel to the retirement planning process. The keys to success are 1) having a retirement plan (written!) in the first place, 2) carefully considering and coordinating income versus expenses, 3) having a “margin of safety” to the plan in cases investment returns, taxes, inflation, etc. change unexpectedly and 4) having contingencies in place when the big stuff (death, disability, financial calamity) occur. Having a plan is great, being flexible in making adjustments is even better.

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Conflicts of Interest Still an Issue in the Finance Business

The appalling incident involving over 2 million customers of Wells Fargo Bank (where client accounts allegedly were created illegally and money transferred without customer knowledge or approval) over the past weeks illustrates that customer diligence and government regulatory oversight are still sorely needed in the finance world.When the story broke, Wells Fargo fired 5300 employees involved in the scandal, (I wonder how many of these were higher-level executives that turned a blind-eye to the negative aspects of the sales incentive program?), paid $185 million in fines and returned $5 million in customer money, all with a meaningless ‘mea culpa’ from its top executives and a promise to behave better.

On Tuesday, September 13th, Wells also announced they were discontinuing the sales incentive program that encouraged the rogue behavior in the first place.Fine, I suppose, but that horse left the barn a long time ago.(And why: “Effective January 1st”?Why not: “Effective immediately”?) Wells Fargo was actually famous (and lauded in some circles) for the practice of “cross-selling” financial products to their customers; as many as eight different account relationships per customer was their apparent goal. The bank reportedly even had a special title for their program (so-called “Gr-eight Initiative”) and ex-employees are coming forward to discuss the intense management pressure on them to reach sales targets.What makes this particular issue so egregious is the victims of this weren’t even aware their accounts were fodder for Wells Fargo’s profit objectives until the Consumer Financial Protection Bureau investigated and found the massive wrongdoing over the past five years.

The lesson and theme to all of this is simply this: Compensation incentives tied to a financial product sale carry a large conflict of interest risk to the consumer/purchaser.In other words, if the person offering the product doesn’t get paid if you don’t buy or is under pressure to meet a quota target to keep their job, then the potential buyer needs to be doubly-careful that the product is indeed a worthwhile purchase and the salesperson is holding their interests first and foremost. Such sales incentives or even “sales contests” have no place in the financial profession.Interestingly, after years of wrangling with the financial industry, the US Department of Labor is now flexing their oversight muscles to hold financial professionals to a fiduciary standard when working with employees and retirement accounts, meaning putting the client’s interests first.You’d think this ethical standard would be the default code for the financial industry, but apparently it took a non-financial Federal entity to bring the age-old problem to the light of day.

This is not to say that all financial products are bad, that anyone offering a financial product is not worthy of your trust or that those who offer just advice for a fee are above scrutiny and careful consideration.There are rogues in every gallery.What the Wells Fargo affair does is remind all of us that vigilance is always and everywhere needed in your financial dealings and while there are many trustworthy and ethical professionals and institutions out there, longevity, size and brand name are often not enough reassurance that your best interests are the priority.Continued consumer vulnerability in the financial world also shows why having a trusted financial professional to help you understand potential schemes is so valuable.