“CommonSense InvestSense™”…Account Management

Posted on June 6, 2013 by

“Don’t gamble. Take all your savings and buy some good stock and
hold it ’til it goes up then sell it. If it don’t go up, don’t buy it.
Will Rogers

If only it were that easy. While no one can guarantee how an investment will perform, there are certain precautions an investor should take to protect their financial security.

1.  Always keep copies of all forms and documents that are filled out and/or signed. Documents have been known to disappear or change when questions come up.

2.  Never sign blank documents and leave it to someone else to fill the document in.

3.  Never give anyone discretionary control over investment accounts. Abuse of discretion is one of the leading complaints regarding stockbrokers and investment advisors. The potential risks simply outweigh any alleged benefit. If an investor is asked to sign a trading authorization so that a brokerage firm can accept orders from the investor’s broker or advisor, the investor should write “NO DISCRETION” on the form to avoid any confusion as to the power being authorized.

4.  Read all account statements and correspondence received from a brokerage firm, a broker or an advisor. If wrongdoing is going on in an account and is reflected in the account statements or correspondence, failure to promptly notify the brokerage firm and to object to such questionable activity may prevent an investor from recovering any losses resulting from such activity.

5.  Ask questions. Ask the financial adviser whether they will be serving in a fiduciary cappacity in advisiing you or managing your portfolio.  If they indicate that they will be acting in a fiduciary capacity, ask them if they are willing to put that in writing and sign the document.

Ask why certain investments are being recommended. Ask whether a purchase of a recommended investment product would result in a commission for the broker or the advisor making the recommendation and, if so, what the amount of the commission would be. Ask whether the recommended investment product is a proprietary product of the company that the broker or the advisor is affiliated with and, if so, ask whether the broker or the advisor can recommend similar non-proprietary products.

Ask whether the recommended product has ongoing fees and, if so, how much those fees are. Even if an investor is turning the management of their investment account over to a money manager, the investor should continually ask questions in order to protect against losses due to “black box” asset allocation.

6.  Consider all aspects of an investment. Some investors only look at the historical or projected return of an investment before making an investment decision. Investors should always consider factors such as the risk/volatility of an investment, the fees associated with an investment, and the tax aspects of an investment. This is particularly true when considering the purchase of an annuity. (See “Common Sense InvestSense…Variable Annuities”) Calculate the Active Management Value Ratio on all investment recommendations before you actually investm in order to ensure that your investments are cost efficient.

7.  Be alert to brokers and advisors possibly “working their book.” When business is slow, brokers and advisors may be advised to “work their book.” This may explain unexpected phone calls suggesting that an investor review their investment portfolio and reallocate their assets, switch mutual funds to buy funds from a different fund family, or perform an annuity exchange.

It is illegal for a broker or an investment advisor to make investment recommendations for the purpose of generating commissions. Certain practices should raise red flags for investors. Recommendations that an investor sell funds of one mutual fund company and buy the same or similar type funds of another mutual fund company should be questioned. Recommendations that an investor sell funds of one mutual fund company and buy different types of funds from another mutual fund company should be questioned if the original mutual fund company offers the same or similar type funds as those being recommended, as most mutual fund companies allow an investor to make internal fund exchanges without incurring new commissions.

Recommendations that an investor exchange one annuity for another annuity should always be questioned since the exchange will result in new commissions for the broker or the advisor. Recommending that an annuity owner exchange annuities is especially suspicious when the current annuity is still subject to surrender charges, as the client would lose money as a result of having to pay surrender charges for the exchange. An investor who becomes aware of such practices should promptly notify the appropriate regulatory organizations.

8.  Use breakpoints, when possible, to reduce the commissions on mutual fund purchases. Most mutual fund companies offer investors a discount on front-end sales charges once an investor has invested a certain amount of money in their mutual funds. Most mutual funds begin to offer such discounts once an investor has invested a cumulative total of $50,000 in their funds, with additional discounts for certain levels of additional investments. Recommendations spreading investments among a multitude of asset classes may be cause for questioning, especially when large amounts of money are being invested and/or the recommended amounts are just below breakpoint levels.

9.  Choose appropriate classes of mutual fund shares to reduce expenses. In most cases, A shares and B shares are the only type of mutual fund shares most investors should consider. Many investors immediately lean toward B shares since they do not require the investor to pay front-end sales charges, or commissions. B shares, however, may not be the best choice for the long-term investor due to the higher annual fees associated with B shares.

Generally speaking, A shares are often a better deal for a long term investor due to the fact that annual fees for A shares are typically less than the annual fees charged by B shares. If an investor has a large amount of money to invest, A shares often offer breakpoints to reduce any applicable sales charges. Breakpoints are not generally offered on B shares. B shares are often a better deal for short term investors, since B shares do not impose a front-end sales charge.

While B shares generally carry higher annual fees and often impose deferred sales charges if an investor redeems the shares within a specified period of time, the holding period during which deferred sales charge are applicable is usually relatively short. The investor’s ability to redeem B shares without penalty within a short period of time also allows the investor to minimize the effect of the higher annual fees of the B shares. Some mutual fund companies offer to convert B shares into A shares after a certain period of time has elapsed. Each investor must evaluate their own situation to determine the choice that is best for them.

Investors with managed accounts should always check to see whether their advisor is using A shares or B shares in the management of their account. In most cases, it is generally agreed that advisors should only use A shares in managed accounts due to the lower annual fees charged by A shares and the fact that most mutual funds offer to waive sales charges for A shares held in managed accounts. Another factor favoring the choice of A shares over B shares in managed accounts is the deferred sales charges on B shares. Since managed accounts often involve frequent reallocations of the account’s assets, holding B shares in a managed account may ensure that the value of the investor’s account is reduced by the payment of deferred sales charges.

10.   Don’t be lulled into a false sense of security by an advisor’s credentials or designations. The number of letters after an advisor’s name does not ensure the skill or the integrity of the advisor. The most widely respected and recognized designation in the financial planning industry is the CFP® designation conferred by the CFP Board of Standards. The CFP® designation signifies that an individual has a certain level of experience in financial planning, has completed an extensive examination, and has complied with continuing education requirements.

Always ask for both Parts I and II, and all schedules, especially Schedule F, of an investment advisor’s Form ADV. Take the time to read the material to find out about the planner’s background and qualifications. Although registered investment advisors are allowed to use a disclosure brochure instead of their Form ADV, insist on the investment advisor’s Form ADV. Most disclosure brochures are nothing more than glorified marketing brochures, while the Form ADV contains the information the investment advisor filed with regulatory officials. Also check the planner’s records at the NASD’s web site (www.nasdr.com).

11.   Get more than one opinion. Medical patients are often advised to get a second opinion on major medical decisions. Decisions affecting one’s financial security are equally important. Unsuitable investment advice can drastically affect one’s life. Unfortunately, some people holding themselves out as financial planners and investment advisors may be more interested in selling insurance and investment products than in the quality of the financial advice they are providing.

12.  Avoid the variable annuity trap. Without question, variable annuities are one of the most over-hyped, most oversold, and least understood investment products. The NASD and the SEC are investigating various complaints regarding the sale of these investment products and have already imposed sanctions in some cases. The high fees and expenses associated with variable annuities, along with their lack of liquidity and their negative tax aspects, make them an unwise investment choice for most investors. Annuities can also have devastating effect on an investor’s estate plan, resulting in most of the investor’s money going to the company issuing the annuity rather than the investor’s heirs and loved ones.

13.  Don’t buy life insurance for investment purposes. A popular mantra among insurance agents is that variable life insurance is the “swiss army knife of financial planning.” Anyone who hears such advice should look for another financial adviser. If an investor needs life insurance, then they should buy life insurance that guarantees the amount of protection they need, which is the intended purpose of insurance.

Life insurance is neither intended for or appropriate for investment purposes. The high fees and expenses associated with insurance are totally inconsistent with one of the basic tenets of investing, namely to minimize loss of principal so as to maximize the amount of money working for the investor. While it is illegal for an insurance agent to misrepresent the nature of an insurance product, recent cases involving the alleged misrepresentation of life insurance as retirement/ investment programs demonstrate the need for investors to get advice from more than one investment advisor to better protect their interests.

© 2013 InvestSense, LLC. All rights reserved.

This article is not designed or intended to provide legal, investment, or other professional advice since such advice always requires consideration of individual circumstances. If legal, investment, or other professional assistance is needed, the services of an attorney or other professional advisor should be sought.

Posted in Asset Protection, Investment Advice, Investment Advisors, Investment Portfolios, Investor Protection, Portfolio Construction, Retirement, Retirement Planning, Wealth Accumulation, Wealth Management, Wealth Preservation | Tagged , , , , , , , , , , , , , , , , , , ,

Special Investor Alert-Questions About New “Barron’s Advisors”

Posted on May 29, 2013 by

In February, 2012 I wrote a post regarding the value of Barron’s “Top 1000 Advisers List,” citing the questionable criteria used and lack of transparency on the calculation process used in preparing the list. Barron’s has just published a new list of designated “Barron’s Advisors.”

In the preface to the list, Barron’s states that the publication ranks financial advisors “with the goal of shining a spotlight on the best people in the business.” The preface goes on to claim that the advisors ranked by their publication represents the top 1 percent of their profession.

As a securities attorney, an RIA consultant and a former RIA compliance director, I always view such “best” lists with skepticism. The people on Barron’s new list may be the best financial advisors in the country. However, the criteria that Barron’s claims is not client-centric and therefore is highly questionable in evaluating the skills or performance of the advisors on the list.

Barron’s justifies its list “based on hard numbers: an advisor’s assets under management and annual revenue generated, as well as the length of time in the business, client retention,  and philanthropic work.  None of these criteria translate into truly reliable indicators of a financial advisors skill as a financial advisor.

  • Assets under management and annual revenues may indicate marketing skill, but simply does not necessarily reflect the skills or abilities of a financial advisor. Furthermore, has Barron;’s actually verified an advisor’s representations regarding assets under management and annual revenue.  Recent FINRA notices have addressed the problem of misrepresentation of assets under management;
  • Length of time in the business addresses longevity, but longevity does not necessarily reflect the skills or abilities of a financial advisor, as evidenced by the recent conviction of industry leader Matthew Hutcheson for securities violations;
  • Client retention could be based on client satisfaction, or based on my legal experience, it could also be based on a client not really understanding or being aware of a financial advisor’s actual activity. I use a proprietary metric, the Active Management Value Ratio, to assess the cost effectiveness of an investment and a financial advisor’ recommendations.  Approximately 75 percent of my analyses indicate investments and/or advice that is not cost effective for the investor. In many cases I find situations where the relative cost of the investment or recommendation greatly exceeds the relative benefit by as much as 300-400 percent;
  • Philanthropic work simply makes no sense as a criteria for the skills and abilities of a financial advisor.

The new Barron’s list does include a new disclosure – that advisors must pay a fee to be included on the list. Barron’s assures the public “that the fee has no effect on [an advisor's] in ranking or continued placement on the list.” Right. Hopefully Barron’s will understand those who view such statement with skepticism, as it sounds like something we have heard repeatedly coming out of Washington.

I have been reading Barron’s for almost forty years and consider it a valuable resource. At the same, as an attorney and RIA compliance consultant, these lists are extremely troubling, as they are arguably based more on marketing skills rather than client-centric criteria, as well a new “pay-for-play” requirement that, despite Barron’s claim to the contrary, raises valid questions as to the legitimacy and value of the list.

While Barron’s criticizes other stories as providing “little benefit” to the public, legitimate questions regarding the evaluation criteria and the “pay-for-play” requirement raises the question is actually unintentionally doing the public a disservice by creating both false representations and a false sense of security, either of which could potentially result in unnecessary financial losses due to advisors who prove undeserving of their designation as a “Barron’s Advisor.”

Posted in Asset Protection, Investment Advice, Investment Advisors, Investment Portfolios, Investor Protection, portfolio planning, Portfolio Planning, Retirement, Retirement Plan Participants, Uncategorized, Wealth Preservation | Tagged , , , , , , , , , , , , , | 2 Comments

“Humble Arithmetic,” Prudence, and Successful Investing

Posted on May 22, 2013 by

Facts do not cease to exist because they are ignored. – Aldous Huxley

In 2005, John Bogle, of Vanguard fame, spoke at the 60th anniversary conference of the Financial Analysts Journal. Mr. Bogle’s presentation, entitled “The Relentless Rules of Humble Arithmetic,” suggested that the argument over the EMH, the efficient market hypothesis, was essentially meaningless and that time would be better spent examining the CMH, the Cost Matters Hypothesis.(1)

In support of the CMH, Bogle referenced a quote from Louis Brandeis, one of America’s great legal jurists. Brandeis, in addressing issues within the investment industry and the rampant investment speculation at that time, commented on the “relentless rules of humble arithmetic.”(2) Bogle noted that “the relentless rules of humble arithmetic” devastate the long-term returns of investors.”(3)

In addressing “the relentless rules of humble arithmetic,” Bogle stated that

No matter how efficient or inefficient markets may be, the returns earned by investors as a group must fall short of the market returns by precisely the amount of the aggregate costs they incur. It is the central fact of investing.(4)

Costs matter, period. Far too many investors see a 1 percent annual fee for a mutual fund and dismiss it as only 1 percent. Throw in an additional 1 percent advisory fee and now the investor is looking at a cumulative fee of 2 percent.  If the investment is a variable annuity, throw in an additional 1-1.5 percent, for a cumulative 3-3.5 cumulative fee.

Some investors will still believe that it is only 3 percent without calculating the actual dollars and costs involved. If we assume no taxes and a tax-deferred account, a starting principal of $50,000, an annual return of 7 percent, and an investment period of twenty years, our end wealth would be approximately $193,484.22. Increasing the fees by 1 percent (reducing the annual return to 6 percent) would reduce the investor’s end wealth to $160,356.77, or a reduction of 17.1 percent.

Add another 1 percent of fees (reducing the annual return to 5 percent) and the investor’s end return is reduced to $132,664.89, or a reduction of 31.4 percent. And finally, add yet another 1 percent of fees (reducing the annual return to 4 percent) and the investor’s end return is reduced to $109,556.16, or a reduction of 43.4 percent.

Costs matter.

Charles Ellis, noted industry leader, has recently suggested that the value of active management should be evaluated based upon the investment’s fees as a percentage of incremental return rather than as fees as a percentage of assets under management.(5) Ellis correctly points out that investors already own the assets in their accounts, so such assets should not be evaluated in terms of an advisor’s services or in computing advisory fees.

Ellis also suggests that evaluating fees based on the incremental return investors receive from an advisor’s services can also prevent misleading representations. As an example, Ellis points out that a stated fee of 1 percent,based on assets under management, can actually be considered as an effective fee of 12.5 percent if the incremental return to the client is only 8 percent, since the real contribution of active management would only be the incremental return.

The investment industry often counters with the argument that the additional fees allow for professional money management and improved returns for investors. And yet, the evidence on historical performance seems to indicate otherwise. Standard and Poor’s publishes various reports comparing the performance of indices and actively managed funds. The reports, known as the SPIVA reports, have consistently shown that the majority of actively managed funds do not outperform their relative indices.

The SPIVA end-year 2012 reports found that

Performance lagged behind the benchmark indices for 63.25% of large-cap funds, 80.45% of mid-cap funds and 66.5% of small cap funds.

The performance figures are equally unfavorable for active funds when viewed over three-and five-year horizons. Managers across all domestic equity categories lagged behind the benchmarks over the three-year horizon. The five-year horizon yielded similar results, with large-cap value emerging as the only category that maintained performance parity relative to its benchmark.(6)

Other studies have produced similar reports of the underperformance of actively managed mutual funds.  One of the most detailed studies ever conducted reported analyzed the twenty year period ending in 1998. The study found that

  • Over the twenty year period, the average actively managed mutual fund underperformed the Vanguard S&P 500 Index Fund by 2.1 percent a year;
  • Over a fifteen year period, the average actively managed mutual fund underperformed the Vanguard S&P 500 Index Fund by 4.2 percent a year; and
  • Over a ten year period, the average actively managed mutual fund underperformed the Vanguard S&P 500 Index Fund by 3.5 percent a year.(7)

Now go back and look at the previous data on the impact of lower returns. Is paying higher fees for less return than a simple index fund prudent?

The same study examined the pre-tax performance of actively managed mutual funds and found that

  • Over the twenty year period, investors had a 14 percent chance of beating the Vanguard S&P 500 Index Fund, with an average margin of outperformance of only 1.9 percent and an average loss of 3.9 percent.
  • Over the fifteen year period, investors had a 5 percent chance of beating the Vanguard S&P 500 Index Fund, with an average margin of outperformance of only 1.1 percent and an average loss of 3.8 percent.
  • Over the ten year period, investors had a 2 percent chance of beating the Vanguard S&P 500 Index Fund, with an average margin of outperformance of only 1.4 percent and an average loss of 2.6 percent.(8)

Do those numbers present evidence of prudent investment choices? I actually have the report’s findings of performance on an after-tax basis. Rather than list more statistics, let’s just say the results do not improve.

Costs matter, whether such costs are in terms of fees or the opportunity costs that result from a fund’s underperformance. One study estimated that between 1996 and 2002, the underperformance of broker-sold actively managed mutual funds cost investors approximately $9 billion dollars a year, with such funds producing an annual return of 2.9 percent over the time period, as compared to an annual return of 6.6 percent for directly purchased index funds.(9) Another study estimated that for the period 1980-2005, actively managed mutual funds produced an annual return of 7.3 percent, compared to an annual return of 12.3 percent for index funds.(10)

The last example of the value of humble arithmetic is my own proprietary metric, the Active Management Value Ratio (AMVR).  Given the evidence that suggests that even when actively managed equity-based mutual funds do outperform similar index funds they only do so by a slim margin, a logical question is whether the actively managed funds are cost efficient for investors.

Rather than go through the entire calculation process again, I will direct readers to my previous posts and white paper on this blog.  Using simple subtraction and division, an investor can evaluate the cost efficiency of an actively managed mutual fund in approximately one minute. And yet, this humble arithmetic process can result in significant savings for investors.

In one analysis, I used the AMVR to evaluate the performance of twenty-three of the most common  actively managed mutual funds used within pension plans. I calculated the AMVR score for the funds for both a 5-year and 10-year period, setting an AMVR score of 1.5 or lower as the acceptable standard for cost efficiency. An AMVR score of 1.5 or less would indicate that the active portion of a fund’s annual fee was less than 50 percent greater than the portion of the fund’s return attributable to active management

The 5-year AMVR analysis resulted in only nine of the funds qualifying for an AMVR score at all, and only four of the twenty-three funds having an AMVR score of 1.5 or less.  The 10-year AMVR analysis resulted in twelve funds qualifying for an AMVR score, and only four of the twenty-three funds achieving an AMVR score of 1.5 or less.

Costs matter with regard to cost efficiency.

Those who promote actively managed mutual funds will offer various arguments against the evidence presented in this post.  I suggest that investors perform the easy calculations required by the AMVR. Perhaps Upton Sinclair summed up the active management opposition best when he noted that “it is difficult to get a man to understand something when his salary depends on his not understanding it.”

So it is easy to understand the motive behind proponents of actively managed funds promoting such funds. However, in light of the evidence presented herein, what is not so easily understood is the fact that according to the 2013 Investment Company Factbook, 82.6 percent of the money invested in equity-based mutual funds was invested in actively managed mutual funds!

Whether this fact is due to salesmanship skills or lack of information, the disparity between investments in index funds and actively managed fund suggests that investors may be suffering millions of unnecessary financial losses annually due to both the high costs usually associated with actively managed funds and the underperformance often shown by actively managed mutual funds. As David Swensen, the highly respected chief investment officer of Yale University, has pointed out

at the end of 2007, index funds accounted for only slightly more than 5 percent of mutual fund assets, leaving almost 95 percent of assets in the hands of wealth-destroying active managers. In a rational world, the percentages would be reversed.(11)

While the disparity has improved to 17.4 percent of investors’ assets invested in index funds, the statistics indicate that investors are still acting irrationally and fiduciaries using actively managed mutual funds may be violating their fiduciary duty of prudence. 

What I have provided in this post is essentially the same prudence/due diligence strategy that I use in litigating or providing expert witness services in ERISA and breach of fiduciary duty cases.  While the nature of such cases often requires extensive use of statistics, the beauty and strength of the strategy is its simplicity and easy verification using “humble arithmetic.” With an increasing number of actively managed mutual funds having high R-squared numbers and, in essence, acting as “closet index” funds, it is becoming more common to see situations where the active component of the fund’s annual expenses greatly exceeds the benefit derived from such active management, in many cases by 300-400 percent, or more.

Winston Churchill once said “men occasionally stumble over the truth, but most of them pick themselves up and hurry of as if nothing ever happened.” Hopefully, this post will help some investors realize the “truths” discussed herein and the need for a closer evaluation of mutual funds in terms of cost and its impact on returns, opportunity cost, and cost efficiency, by using the resources referenced herein. For those who value their financial security, the relatively small time required for such analysis will prove to be time well spent.

Notes

1. John Bogle speech, “The Relentless Rules of Humble Arithmetic,” available online at https://personal.vanguard.com/bogle_site/sp20060101.htm.
2. Louis D. Brandeis, Other People’s Money, New York:F. A. Stokes (1914).
3. Bogle Speech.
4. Bogle Speech
5. Charles D. Ellis, “Investment Management Fees Are (Much) Higher Than You Think,” Financial Analysts Journal, May/June 2012, Vol. 68, No. 3:4-6
6. http://www.spindices.com/resource-center/thought-leadership/spiva/
7. Robert Arnott, Andrew Berkin and Jia Ye, “How Well Have Taxable Investors Been Served in the 1980s and 1990s?” Journal of Portfolio Management, Summer 2000, Vol 26, No.4.
8. Arnott, Berkin and Ye.
9. John Bogle, The Little Book of Common Sense Investing:The Only Way to Guarantee Your Fair Share of Stock Market Returns,” New York:John Wiley and Sons (2007), 103
10. Bogle, “Common Sense Investing,” 51
11. Charles D. Ellis, Winning the Loser’s Game: Timeless Strategies for Successful Investing, 5th ed., New York:McGraw Hill (2010), xii

Posted in Investment Portfolios, Portfolio Construction, portfolio planning, Retirement Distribution Planning, Wealth Accumulation, Wealth Management, Wealth Preservation | Tagged , , , , , , , , , ,

Wealth Preservation Saboteurs

Posted on April 30, 2013 by

“Get what you can and keep what you have; that’s the way to get rich.”
Scottish Proverb

In a series of earlier posts, I discussed the three planning areas that I believe constitute real wealth management – wealth accumulation, wealth preservation, and wealth distribution. Of those three, I would suggest that wealth preservation is the most important.  As the Scottish saying goes, “make as much as possible and keep as much as possible.  That’s the secret to becoming wealthy.”

Studies are consistently showing that the public wants more information about asset protection and wealth preservation techniques. Estate planning is being replaced by integrated estate planning, which combines estate planning with asset protection strategies.  There are those in the legal community who now suggest that an attorney’s failure to assess a client’s need for asset protection and to discuss asset protection strategies with a client may constitute malpractice.

When I tell people that I am a wealth preservation attorney, I usually get the quizzical look that begs for further explanation.  In my practice, wealth preservation focuses on protecting one’s wealth from loss due to common problems such as unsuitable investments and/or improper portfolio management, taxes and litigation/risk management.

“Don’t confuse brains with a bull market” is a well-known saying on Wall Street. It is very easy to make money in a bull market, as research shows that three out of four stocks follows the general trend of the stock market.  Unfortunately, investors are often lulled into a false sense of security during bull markets, as their advisers point to increased values as evidence of their investment acumen.

A study by the Schwab Institute concluded that 75 percent of the investor portfolios that they studied were unsuitable for the investors based on the investor’s financial goals, need and personal parameters. My experience would suggest that the actual number may be higher than 75 percent, especially when investment fees and adviser fees are considered.

I have written articles and posts on the Active Management Value Ratio (AMVR), a proprietary metric that allows investors to assess the cost efficiency of actively managed mutual funds.  In most cases we find that the cost of the active management component  of actively managed mutual funds far outweighs the incremental return, if any, that the active management component of actively managed mutual funds, often by as much as 300 to 400 percent, or more.

Charles D. Ellis, a highly respected investment professional, has recently suggested that advisory fees are high, very high, in relation to the benefit provided.  Mr. Ellis suggests that the most commonly used fee by investment advisers, a fee based on a client’s assets under management (AUM), is extremely misleading.  By focusing on fees as a percent of actual benefit produced by an adviser, Mr. Ellis suggests that the 1 percent AUM fee is actually more along the lines of 50 percent or more.

Many investors may dismiss a 1 percent AUM fee as trivial, as just 1 percent.  When analyzed in terms of the AMVR and Mr. Ellis’ methodology, the true cost of such fees and expenses becomes clear. The Department of Labor has estimated that over a period of twenty years, each additional 1 percent of investment fees and expenses reduces an investor’s end wealth by 17 percent. Wealth preservation analysis alerts investors to such cost issues and allows them to make changes as needed to prevent loss of wealth due to unnecessarily high investment fees and expenses.

High fees and expenses are not the only wealth preservation issues that investors need to address.  Two common wealth preservation threats are ineffective, or “pseudo,” diversification and a failure to hedge one’s investments against significant losses.  Too many investors think, or are told, that diversification simply involves owning a lot of different types of investments.  That simply is not true.

True, or effective, diversification depends not on the number of investments one owns, but rather how the investments interact with each other in different market conditions.  The idea is to own a combination of investments that react differently in certain circumstances, or, technically speaking, have a low correlation of returns, so that when some investments are down, other investments will help balance out any losses in order to protect against significant losses to the overall investment portfolios.

Effective diversification is one form of hedging, or using techniques to prevent against significant portfolio losses. Other forms of hedging may include the use of options, inverse index funds and other strategies in order to protect against significant losses. Hedging is simply another example of approaching successful wealth management as the management of risk instead of the management of returns.

Taxes are another major issue with regard to wealth preservation.  The Supreme Court has stated that there is nothing legally wrong with arranging one’s affairs so as to minimize the amount of taxes.  Tax planning as it relates to wealth preservation may involve making inter vivos, or living, gifts to others, in order to reduce one’s taxable estate. Other commonly used techniques include creating wills and trusts to address both inter vivos or post-mortem wealth preservation issues.

Litigation/risk management involves proactively addressing potential litigation/risk concerns and planning appropriately, with the stress on proactively. Far too many times I get a call from someone telling me something unfortunate has happened and they need to protect their assets.  Asset protection and wealth preservation cannot be used to defraud others.  Once a potential cause of action has arisen, the courts will strike down and attempt to shelter or hide assets from the injured party.

In some cases, the easiest risk management tool, insurance, may be sufficient to provide the needed protection against losses due to litigation. In some cases, the cost of insurance requires the consideration of other wealth preservation techniques.

Trusts are a common litigation/risk management tool.  The effectiveness of using trusts as a wealth management tool depends on a number of factors, including the proactive establishment of the trust and the extent of control retained by the creator of the trust.

As mentioned before, trusts are basically ineffective as wealth preservation tools if the event creating liability has already occurred.  With regard to retained control over a trust, the rule is basically that the more control that the creator of a trust retains over a trust, the less protection the trust provides. Likewise, the more that the trust provides in terms of personal benefits to the trust creator, the less protection the trust provides.

One common misperception is trusts have to be expensive.  If you want an offshore asset protection trust based in the Cook Islands with all the trust protector provisions and a collapsing bridge trust as an additional level of protection, then yes, that trust is going to be expensive to establish and maintain.  The good news is that most people do not require that level of protection.  In many cases, common trusts such as an intentionally defective grantor trust, an income only trust or family trust provide the needed protection at a much lower initial and annual fee.

Wealth preservation involves a number of interrelated legal areas.  Wealth preservation can provide valuable benefits without being cost prohibitive.  While the benefits of wealth preservation can be significant, it is important that anyone interested in maximizing the potential benefits act proactively by contacting a professional with experience and knowledge in such services.

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Posted in Asset Protection, Investment Fraud, Investment Portfolios, Investor Protection, Portfolio Construction, portfolio planning, Portfolio Planning, Retirement, Retirement Distribution Planning, Retirement Plan Participants, Retirement Planning, Wealth Accumulation, Wealth Management, Wealth Preservation | Tagged , , , , , , , , , , , , , ,

Three Numbers Every Investor and Fiduciary Should Remember

Posted on April 7, 2013 by

The abundance of investment products and investment information available today can be intimidating and confusing to many investors, both novice and professional.  Over my twenty-plus years as an attorney and investment adviser, I have tried to help others focus on some of the critical information in order to avoid unnecessary investment losses, to help level the playing field against some of the ne’er-do-well that continue to defraud the public and plague the financial services industry.

Speaking with a colleague the other day, he commented on the fact that a lot of the important information we get through trade publications such as InvestmentNews rarely seem to get mentioned in the mainstream media and press.  And when we mention such information to clients, they often comment on how useful such information would have been.

After my conversation with my colleague, I started thinking about some of the “inside” information I have shared with my clients that produced the most reaction and appreciation.  In hindsight, I think five numbers and five fats have stood out the most to me and my clients.  In this post, I will discuss the five numbers.  I will discuss the five facts in my next post.  That being said, the five numbers every investor and fiduciary should know are as follows:

1. “75″ – The number “75″ is actually important for two reasons.  First, a study by Schwab Institutional found that approximately 75% of investor portfolios were poorly structured and unsuitable for their investors given the investors’ financial needs and goals.  I believe that this is primarily a result of the fact that (1) stockbrokers are not required to act in a client’s best interests, and (2) investors are often mislead by portfolios that appear to be diversified because they hold a number of different types of investments, but such portfolios are often not truly, effectively diversified.

The second reason that the number “75″ is important is because research and history have shown that approximately two-third, or 75%, of stocks follow the general trend of the market.  This simply supports the popular Wall Street adage, “[don't] confuse brains with a bull market.”

2. “94″ - While there are many firms and individuals in the financial services industry calling themselves wealth managers, a study by CEG Worldwide, a well-respected financial services consulting firm, concluded that 94% of those calling themselves wealth managers or claiming to provide wealth management services failed to meet the criteria used to qualify as wealth managers.  The criteria that CEG used in their study to determine true wealth management was based primarily on advisers who practiced wealth management as a process as compared to those who simply used “wealth management” as a marketing ploy to push product.  This is the same criteria that investors and fiduciaries should use in choosing a financial advisor to work with.

Secondly, one expert has suggested that this number (OK, actually 93.6, which rounded off is 94), and the study that produced it may have caused more damage to investors than any other number/study.  The number comes from the famous 1986 Brinson, Hood and Beebower (BHB) study that stated that 93.6% of the variation of a portfolio’s returns could be explained by the portfolio’s asset allocation.

The study did not say that asset allocation explained 93.6% of the portfolio’s actual returns, but rather the variation of the portfolio’s returns.  Nevertheless, dishonest brokers and advisers misrepresented, and still do misrepresent,  the BHB study’s findings to convince investors to choose an asset allocation and rigidly adhere to it, despite the proven cyclical nature of the markets.  This is the mantra of the” buy and hold” approach to investing, an approach that some have suggested is better described as the “buy, hold and regret” approach to investing.  Just ask investors how well that worked during the 2000-2002 and 2008 bear markets.

Unfortunately, given the current budget issues that exist at the time I write this post, static asset allocators may soon get yet another costly education.  Dr. William Sharpe, a Nobel laureate for his work in the area of investment management, now stresses the need to be proactive and adjust portfolio allocations when changes in the economy and/or the market dictate such moves.

3. Zero – This number represents the number of variable annuities (VA) and equity indexed annuities (EIA) an investor should own.  As a former compliance officer and a current securities attorney I have heard all the convoluted and conniving justifications for these atrocities.  I have written posts and articles warning investors about these products.  While there may be a few limited instances where they may make sense, such as wealth preservation for high net worth investors, the way they are marketed to the masses is extremely questionable.

One Wall Street Journal article reported that variable annuity salesmen were told to treat potential annuity clients as “blind twelve-year-old,” and to “put a pitchfork in their chests,” and provide questionable responses to potential client’s questions.  VA salesmen and VA advertisements often tout that by purchasing a VA the investor will never run out of money.

What is often not made clear that in order to guarantee that lifetime stream of money, you give up all rights to the money invested in the VA.  Once you annuitize your VA, the balance goes to the insurance company once you die, not to your heirs.  In most cases the insurance company offers various choices for payout, such as joint survivor and a guaranteed period, but these options generally result in lower periodic payouts and, in  some cases, additional fees.

One of the most onerous aspects of VAs is the excesssive fees that most VAs charge, especially with regard to the so-called death benefit.  VAs typically guarantee that in the event the VA owner dies with out having annuitized the VA, the owner’s heirs will receive either the accumulated value of the VA at the time of the owner’s death or the amount of the owner’s actual investment in the VA, whichever is greater.  So the VA issuer is only insuring the amount that the VA owner actually puts in the VA.

Meanwhile, the insurance company assesses the VA’s annual death benefit fee not on the basis of their actual legal obligation, which is the amount of the VA owner’s actual investment, but rather on the accumulated value of the VA.  One study estimated that the actual expense of the annual was approximately 0.10-0.12, but that the insurance companies often charged approximately 1.50%, or approximately fifteen times the estimated value, resulting in a nice windfall for the insurance company.  The additional fee also cost a VA investor by reducing this investment return.

EIAs are also problematic.  EIAs are generally sold with the pitch that investors can earn the same return that the stock market does, with the guarantee that even if the market is down, the EIA investor is guaranteed a minimum return.  What many investors are told is that the potential return is usually capped at a relatively low number, say 10%, and then  is reduced even more by a “participation rate,” usually an additional 2-3% reduction.  In short, the EIA investor is looking at annual rate of between 2-7%.  If the market is up 20% or more for the year, just who is getting the benefit of the excess over the investor’s return?

There may be other significant numbers that I have omitted.  However, investors and fiduciaries that remember these numbers and the reasons for their significance will be in a better position to protect both their financial security and/or their clients’ financial  security.

Posted in Asset Protection, Investment Fraud, Investment Portfolios, Investor Protection, Portfolio Construction, portfolio planning, Retirement, Retirement Plan Participants, Retirement Planning, Wealth Accumulation, Wealth Management, Wealth Preservation | Tagged , , , , , , , , , , , , ,

REAL Wealth Management – Wrap-Up

Posted on March 24, 2013 by

Over the past four weeks, I have written posts to discuss what I perceive to be the three true areas of comprehensive wealth management – accumulation, preservation/protection and distribution/transfer. While many financial professionals may claim to be wealth managers, a study by CEG Worldwide concluded that only 6 percent of those who claimed to be wealth managers actually qualified as true wealth managers, with the remaining 94 percent simply being product salesmen.  CEG’s primary criteria focused on “wealth managers” who addressed all aspects of wealth management and those who employed a  “process” approach to wealth management rather than a “product” approach.

Although I have discussed wealth management in terms of three areas, hopefully the posts have shown that there is actually a lot of overlap between the three areas, showing that proper wealth management is an extremely integrated process.  Wealth management is also an ongoing process, as laws and regulations involving wealth management are subject to change.

The key to effective accumulation is to protect against unnecessary and significant losses, in other words risk management. Losses can come from various areas, including changes in the stock market, taxes, liability issues and effective wealth distribution planning.  Each of these areas should be addressed through strategies such as constructing and maintaining an effectively diversified investment portfolio, proper tax planning, insurance, and regular review of one’s estate planning documents and retirement plan beneficiary forms.

The key to effective wealth preservation and protection is to be proactive.  As I mentioned in my earlier post, many of the wealth preservation/protection techniques often used are basically ineffective once the threatening event has occurred. The other factor often overlooked by those expressing an interest in wealth preservation/protection is that the level of protection provided by wealth preservation/protection strategies is directly related to the amount of control given up by the party seek the preservation/protection. In other words, generally speaking, you can’t have your cake, i.e., complete control over your assets, and eat it too, i.e., be able to protect those assets from everyone.

Many people incorrectly think they cannot afford wealth management. Fortunately, some of the most effective wealth management techniques are inexpensive, such as annual gifting and proper completion of retirement plan beneficiary forms.  While there are those who might like to brag about having an off-shore trust in the Cook Islands or the Isle of Man, very few people need that level of wealth preservation and protection.

Again, in most cases the key to effective wealth management is to be proactive and consult with professionals  who are both knowledgeable and experienced in such matters.  Note I said professionals, not professional.  In wealth management, there is truly strength in numbers.  Given the areas that are involved in true wealth management, a good wealth management team will usually include, at a minimum, an estate planning expert, a tax expert, an investment adviser, and a wealth preservation/protection attorney.

Hopefully this series has been of some benefit to readers. I have received a number of complimentary e-mails, which I truly appreciate.

Take care.

Posted in Asset Protection, Investment Fraud, Investment Portfolios, Investor Protection, Portfolio Construction, portfolio planning, Retirement, Retirement Distribution Planning, Retirement Plan Participants, Retirement Planning, Wealth Accumulation, Wealth Management, Wealth Preservation | Tagged , , , , , , , , , , , , , , , , ,

REAL Wealth Management – Wealth Distributions and Transfers

Posted on March 17, 2013 by

This week, we address what I consider to be the third aspect of a genuine wealth management program -distributions and transfers of one’s assets.  Distribution encompasses both transfers made while one is living, inter vivos transfers, and transfers made after one’s death, testamentary or postmortem transfers.

Distribution planning generally focuses on deciding how to allocate one’s assets to achieve one’s personal goals while minimizing the impact of taxes (i.e., income tax, gift tax, estate tax, alternative minimum tax, etc.) and other financial issues, both during one’s lifetime and after one’s death.  I have already written several posts and white papers that cover some of these issues, so I will simply use this post to provide a general overview of some common issues.

As always, the information provided here is general in nature and is not intended to provide advice for any specific individual.  If you need specific advice or assistance, you should contact an attorney or other professional who is experienced and knowledgeable in such matters.

Two of most common distribution mistakes people make is failing to properly complete the beneficiary forms associated with their retirement plans so as to maximize such assets, and failing to review their beneficiary forms to ensure that they still reflect their wishes. By carefully considering who to designate as their beneficiaries and properly completing the beneficiary form to ensure the most effective distribution of the assets in their plan, the plan owner can effectively “stretch” the lifetime of the assets to benefit more than just the beneficiaries they designate.  For those who have a large balance in their pension account, it may be better to have a custom beneficiary form drafted to ensure the maximum benefit and protection for the assets within their personal account.

Another consideration regarding beneficiary forms has to do with the consolidation that has taken place within the banking and investment industries.  It is not uncommon for people to contact a bank or broker-dealer after the death of a loved one and request a distribution of a loved one’s IRA account, only to be told that the bank or broker-dealer cannot find the beneficiary form for the account.  In such instances the bank or broker-dealer will enforce the default distribution provision on the account, which are generally not in the best interests of the deceased’s heirs and usually result in a heavier tax impact and thus, a significant reduction in the amount of assets going to the heirs. Loss of beneficiary forms can also occur in connection with 401(k), 403(b) and 457(b).

Bottom line, owners of retirement plans should review their beneficiary forms regularly in order to verify that the custodian of a plan has the owner’s beneficiary form on file and that it accurately reflects the account owner’s wishes.  There are numerous cases where the retirement account owner has divorced and remarried, but failed to change the beneficiary forms on his retirement account(s). The Supreme Court has ruled that even though it would make sense that the deceased would want to leave his retirement account assets to his current wife, the terms set out in a retirement account beneficiary form control distributions from said retirement account, regardless of what is stated in the deceased’s will.

Inter Vivos Distribution Planning
A common misconception about wealth distribution planning is that it has to be complicated. A common, yet simple, inter vivos wealth transfer strategy is the use of the annual gift tax exclusion amount.  This exclusion allows an individual to give a certain amount each yer to as many recipients as they wish without triggering any federal gift tax. The annual gift tax exclusion amount for 2013 is $14,000. 

Married couples can maximize the benefits of the annual gift tax exclusion by each making a qualifying gift. That means for 2013, a couple with three children could give each child $28.000 annually, effectively reducing the size of a taxable estate if that is a goal. 

Anyone contemplating lifetime transfers of their assets need to carefully review their personal financial situation to make sure that they can truly afford to make such transfer.  People should be careful not to “let the tax tail wag the wealth management dog.”

Another common inter vivos strategy is the use of trusts.  Some of the common inter vivos trusts include family trusts, intentionally defective grantor trust (IDGT), income-only trusts and special needs trusts.

- Family trust are typically drafted in such a way as to remove the trust’s assets from the grantor’s estates (usually a husband and a wife), but provide for ongoing management of the trust’s assets.
- An IDGT trusts are drafted so that the trust’s assets are removed from the grantor’s estate, but drafted in such a way that the grantor, not the trust, is liable for any annual income tax owed by the trust, allowing the grantor to pay such taxes and to allow the trust’s asset to benefit from compound growth.
- Income-only trust are drafted in such as way as to remove the trust’s assets from the grantor’s estate, but to provide income to the grantor on an ongoing basis. These trusts are often used in an attempt to qualify for benefit programs such as Medicaid.
- Special needs trusts (SNTs) are established to provide financial aid to injured or otherwise challenged individuals.  SNTs must be carefully drafted in order to preserve the beneficiary’s right to important government benefits.

As we mentioned in our previous post, the effectiveness of a trust in providing wealth management advantages is based largely on the amount of control retained by the person establishing the trust, the grantor..  The more control the grantor, the less protection provided. 

Testamentary or postmortem distribution planning
Testamentary planning basically refers to estate planning and specific distributions instructions provided in one’s will.  A common tax strategy is to add testamentary trust provisions within a will that will allow one’s heirs’ to possibly have access to such assets in certain circumstances if the trustee assents to such access, yet still provide tax benefits for the deceased’s estate.

A common trust strategy used with married couples is the so-called “A-B Trust” plan. In this strategy, the will directs that the executor fund one trust, the so-called “bypass trust,” with the so-called estate tax exclusion amount and place any remaining assets in a trust that qualifies for the unlimited marital deduction. The applicable estate tax exclusion amount for 2013 is $5,250,000 and is subject to adjustment annual based on inflation. 

Assuming the marital trust is set-up properly, the use of the marital trust defers any potential taxation of the marital trust’s assets until the death of the surviving spouse, with any tax being based on any asset remaining in the trust. The terms of the “bypass trust” usually provide for distribution of the trust’s assets upon the death of the surviving spouse in accordance with whatever terms are provided, with the distribution of the trust’s principal being tax-free.

The “A-B Trust” strategy is just one testamentary distribution strategy that can be used to both achieve one’s goals while minimizing the impact of taxes. The appropriate strategy for an individual will depend on their specific situation, goals and concerns. That is why anyone considering distribution planning should only do so after consulting with an attorney or other appropriate professional who is both experienced and knowledgeable in such matters.

When large estates are involved, postmortem distribution planning may help resolve issues that were not contemplated when the decedent originally drafted their will. Beneficiaries of large estates may find that distributions to them under a will may not be needed or may produce unwanted tax implications.

In such cases, a beneficiary may choose to disclaim the distribution.  If a beneficiary disclaims a distribution under a will, the beneficiary does not get to designate someone to receive the disclaimed distribution. The disclaimed distribution is treated as if it were never made and is distributed in accordance with instructions in the will.

Distributions are often used when the distribution will result in other family members who are also beneficiaries under the will receiving the disclaimed assets.  Disclaimers, when done properly, can be a very effective tax planning and wealth management strategy.

The strategies discussed herein are only a general overview of some common wealth management strategies for wealth distribution and transfers.  Anyone considering engaging in wealth distribution and transfer strategies should only do after consulting with an attorney or other professional experienced and knowledgeable in such matters. This is definitely not an area for do-it-yourselfers!

Notice: To ensure compliance with IRS Circular 230, any U.S. federal tax advice provided in this communication is not intended or written to be used, and it cannot be used by the recipient or any other taxpayer (i) for the purpose of avoiding tax penalties that may be imposed on the recipient or any other taxpayer, or (ii) in promoting, marketing or recommending to another party a partnership or other entity, investment plan, arrangement or other transaction addressed herein.

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