Variable Annuities: Estate Planning Saboteurs

As a wealth preservation attorney, my practice involves various areas of the law including investment portfolio analysis, asset protection, risk management and estate planning. Three primary wealth saboteurs are investment portfolio mismanagement, tax erosion, and personal liability exposure.

I recently read a story indicating that sales of variable annuities have significantly increased. As I wrote in an earlier post, a key question that every investor should always ask before making any investment is “why?”

That question certainly applies with variable annuities. Variable annuities usually involve two of the three risk saboteurs-portfolio mismanagement and tax erosion. Variable annuities can completely destroy an investor’s estate plan.

Variable Annuities and Tax-Deferred Growth
People usually say that they invested in a variable annuity for opportunity for tax-deferred growth. What they fail to realize is that there are other less destructive means of obtaining tax-deferred growth.

Individual retirement accounts (IRAs) are one source of tax-deferred growth without the excessive costs and restrictions associated with variable annuities. IRAs also allow investors to choose their own cost-efficient investment options, allowing investors to avoid the overpriced and poorly performing investment options usually selected for variable annuities.

With most variable annuities typically have a minimum combined cost of 3 percent or more annually, investors should remember that each additional 1 percent of annual fees and costs of an investment reduces an investor’s end-return by approximately 17 percent over twenty years. That could result in an investor losing more than half of their end-return due to a variable annuity’s fees and costs alone, especially if the annuity owner invests in one of the so-called “living benefit” riders often pitched to prospective variable annuity purchasers.

Variable Annuities and Tax-Erosion
Investors often fail to recognize the difference between tax-deferred and tax-free. Tax-deferred means that at some point, somebody is going to be required to pay taxes on an investment. Tax-free means just that, no tax will ever be required to be paid.

When taxes are paid on gains in a variable annuity, those gain are generally taxed as ordinary income. Tax rates on ordinary income gains are always higher that tax rates on so-called “capital gains.” Explaining capital gains is beyond the scope of this article. Capital gains are generally based on the nature of the investment and/or the length of time an investment has been held by an investor. The takeaway here-capital gains are generally preferred over ordinary income due to lower tax rates.

Two mistakes I constantly see are people putting investments that are already tax-advantaged into tax-advantaged accounts. 401(k)/403(b) accounts and IRAs already provide tax-deferral to investors. So why would anyone buy a variable annuity and put the annuity inside a 401(k)/403(b or IRA account?

The same goes for investing in investments that may qualify for capital gains treatment or pay out capital gains income, e.g., stock and equity mutual funds, inside a variable annuity. All that does is convert capital gains into ordinary income for tax purposes, resulting in higher taxes. A general rule of thumb is to place tax-inefficient investments, into tax-deferred account, thereby deferring taxation of otherwise immediately taxable income.

Another general rule of thumb is to place tax-efficient investment in regular investment accounts to take advantage of any favorable tax options, i.e., capital gains and qualify for a stepped-up basis once the investment owner dies. Variable annuities do not generally qualify for a stepped-up basis once the owner of the annuity dies. This is why variable annuities can effectively destroy an estate plan.

Variable Annuities and Loss of Life Savings
Variable annuities are often pitched with the line that investor will never lose their original investment. Furthermore, a variable annuity owner will never run out of money because they can always annuitize their variable annuity and receive payments based on their original investment and the method they chose when they bought the annuity.

What annuity ads do not mention is that if you annuitize a variable annuity, you lose total control over the value of the annuity. Upon the death of the variable annuity owner or designated annuitant, the balance remaining in the variable annuity goes to the company that issued the variable annuity, typically an insurance company not to the variable annuity owner’s family of other designated beneficiaries.

I doubt very few people would say that they worked all their life just so they can benefit an insurance company. But that’s essentially what variable annuity are, a bet by variable annuity issuer that the annuity owner will annuitize and die before depleting the value within the variable annuity, the sooner the better so they receive greater value.

The Beloved Death Benefit Scam
Anyone being pitched a variable annuity will undoubtedly hear that variable annuities offer a death benefit which ensures that when they die, assuming that they have not annuitized the variable annuity, their designated beneficiaries will receive no less that their invested principle.

Moshe Milevsky, a well-respected expert on variable annuities, exposed the death benefit scam by disclosing that variable annuity issuers were generally charging variable annuity owners an annual expense fee that was ten times the actual inherent value of the annuity’s death benefit. While fees naturally vary between variable annuities, the excessive overcharge issue remains. Google “Moshe Milevsky The Titanic Option” to read the article online.

Due to the historic patterns of the stock market, it is extremely unlikely that a variable annuity owner would ever need to available themselves of the death benefit, leading one of colleagues to utter the best analysis of the death benefit in variable annuities:

A variable annuity owner needs the death benefit like a duck needs a canoe paddle.

Selah.

Conclusion
Two takeaways that anyone considering purchasing a variable annuity should remember. The first is a well-known saying in the investment industry-“annuities are sold, not purchased.” The second comes from an article I recently reading read at a web site entitled “The Balance” (thebalance.com)-

Annuities are a form of insurance, and insurance is a risk management tool—not an investment… For investing purposes, index funds are often a better choice than a variable annuity. For the purpose of a guaranteed outcome, other types of annuities are better. That doesn’t leave many situations where a variable annuity is a smart choice.

Variable annuities can easily destroy a well-done estate plan. As the referenced quote points out, there are other viable and more sensible options for achieving the same goals without destroying one’s estate plan and possibly providing nothing for one’s family and heirs.

For those interested in an analysis of the sales pitches variable annuity salesmen often use, click here.

Copyright © 2018 The Watkins Law Firm. All rights reserved.

This article is neither designed nor intended to provide legal, investment, or other professional advice as 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.

To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. federal tax advice contained in this document is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code, or (ii) promoting, marketing, or recommending to another party any transaction or matter that is contained in this document.

Posted in Estate Planning, Fiduciary, Integrated Estate Planning, Investment Advice, Investor Protection, Portfolio Construction, portfolio planning, Retirement Distribution Planning, Variable Annuities, Variable Annuity Abuse, Wealth Preservation | Tagged , , , , , , , , , , ,

Setting the Record Straight on Asset Allocation

One of the “dirty little secrets” of the investment industry is to deliberately misrepresent the findings of a study on the importance of asset allocation. The study, commonly referred to as the BHB study after the three gentleman who conducted the study, found that asset allocation explained 93.6% of the variation in an investment portfolio’s returns. The study made no representations about the determinants of an a portfolio’s returns, only the variations in a portfolio’s returns.

The study examined three general types of investments – stocks, bonds and cash. Stocks are generally acknowledged as riskier than bonds, and bonds are generally acknowledged as being riskier than cash. So the BHB study should not come as a surprise to anyone. higher allocations to stocks, as compared to bonds and  cash, can be expected to increase a portfolio’s overall volatility, or variation in returns.

Investors who understand the true findings of the BHB study and that fact that it made no representations as to the determinants of a portfolio’s actual returns and better protect their financial security by detecting misrepresentations regard the value of investment recommendations.

For an excellent analysis of the true meaning of the BHB study, click here.

Posted in Absolute Returns, Asset Protection, Consumer Protection, Fiduciary, Fiduciary Standard, Investment Advice, Investment Advisors, Investment Fraud, Investment Portfolios, Investor Protection, Portfolio Construction, portfolio planning, Portfolio Planning, Retirement, Wealth Management, Wealth Preservation | Tagged , , , , , , , , , , , , , , ,

InvestSense’s Comments on SEC “Best Interest” Proposal

The Securities and Exchange Commission is currently seeking public comments on its “Best Interest” (BI) proposal. The proposal would reportedly provide a standard of conduct for anyone providing financial services to the public.  The standard would supposedly protect investors from the abusive marketing practices of the investment industry that led to the Department of Labor’s fiduciary standard in the first place.

While I appreciate the fact that the SEC recognizes the need to address the fiduciary issue, I have concerns about whether the SEC is sincere about adopting a meaningful fiduciary standard that will provide the protection that investors need, or just putting on a show that will result in a watered down version of FINRA’s “suitability” standard.

The SEC’s mission statement clearly indicates that protection of investors is a primary purpose. Judicial decisions involving the agency have clearly stated that it is the SEC’s duty to protect investors, not the investment industry.

In Norris & Hirshberg v. SEC (177 F.2d 228), the court rejected the defendant’s suggestion that the securities laws were intended to protect the investment industry, stating that

“[t]o accept it would be to adopt the fallacious theory that Congress enacted existing securities legislation for the protection of the broker-dealer rather than for the protection of the public. On the contrary, it has long been recognized by the federal courts that the investing and usually naive public need special protection in this specialized field.” (at 233)

In Archer v. SEC (133 F.2d 795), the court echoed those same concerns, stating that

“[t]he business of trading in securities is one in which opportunities for dishonesty are of constant recurrence and ever present….The Congress has seen fit to regulate this business.”

Any suggestion that a “suitability,” or “just OK,” standard provides the same protection that a true fiduciary, or “best interest at all times,” standard is disingenuous and a blatant violation of the agency’s mission statement and the very purpose for which the agency was formed.

The need for a meaningful fiduciary standard for anyone financial services to the public can also be seen in the investment firms retreating from being held to any fiduciary duties in connection with 401(k) plans, arguably in order to engage in the same abusive marketing strategies that led to the DOL’s fiduciary standard in the first place.

In FINRA Regulatory Notice 12-25, FINRA stated that the suitability standard and the best interest standard are “inextricably intertwined.” If one accepts that as true, then the SEC should have no objection to clearly defining the legal duty owed to investors as a “fiduciary” duty and defining the duty using the term fiduciary and the terms set out in the ’40 Act, since the best interest standard requires a higher standard of conduct(fiduciary)than the suitability standard just OK).

he late General Norman Schwarzkopf once stated that “the truth is, we all know the right thing to do. The hard part is doing it.” For the sake of American investors, follow the court’s admonition in Norris & Hirshberg and do the right thing and properly protect American investors, instead of the investment industry. by adopting a meaningful fiduciary standard.

The public comment period is open until August 1, 2018. Comments can be submitted at https://www.sec.gov/comments/s7-07-18/s70718.htm

Posted in Best Interest Proposal, Best Interests, Consumer Protection, Consumer Rights, Fiduciary, Fiduciary Standard, Investment Advice, Investor Protection | Tagged , , , , , , , , , ,

1+1=33%, or the Myth of the 1% Annual Investment Fee

This post is going to be short and sweet, as I keep getting calls and emails from people who wonder why their portfolios are not performing as well as they think they should. In most cases, their portfolios are the victims of what I call the “It’s Only 1 Percent” curse.

Many financial and investment advisers “only” charge an annual management fee of 1 percent of the amount of your account. Same for most actively managed mutual funds. What most investors do not understand is the impact of compounding on the “only 1 percent” annual fee.

As an attorney, I put a lot of emphasis on verifiable evidence. Some simple calculations will help explain how over time a seemingly low 1 percent fee can sabotage your investment portfolio.

First, let’s look at the impact of a 1 percent over 10 years. We’ll use a starting account of $100,000, but the impact is the same regardless of the numbers you use.

10% over 10 years=$259,374
9% over 10 years =$236,736

The difference is $22,638, or a loss of 8.72 percent

Over a 20 year period, the numbers would be:

10% over 20 years=$672,750
9% over 20 years =$560441

The difference is $112,309, or a loss of 16.69 percent.

For those of you who want to confirm the numbers, the Excel formula for 10% for 20 years is simply “=1.10^20.” You then take that number and multiple it by your base/starting amount. Here, it would be “=6.72750*100,000”, resulting in $672,750.

According to the Morningstar Research Center, as of July 6, 2018, the average stated annual expense ratio of domestic large cap growth mutual funds is 1.10 percent. Once an investor factors in a fund’s R-squared number to avoid cost-inefficient “closet index” funds, an actively managed mutual fund’s effective annual expense is often 4-5 times higher than the fund’s stated expense ratio.

The next step is to factor in an actively managed fund’s trading costs. Since fund’s are not required to disclose their actual trading costs, InvestSense uses a metric created by Vanguard founder John Bogle as a proxy for a fund’s actual costs. Bogle’s metric is simple – double a fund’s turnover ratio and multiply that number by 0.60. According to Morningstar, as of July 6, 2018, the average turnover ratio for domestic large cap growth funds is 56 percent, resulting in a trading cost of .67 basis points. (a basis point is .01 percent of 1)

The final step is to simply combine a fund’s stated annual expense ratio and its Bogle trading costs number, and multiply that number by the conversion number from your earlier calculations, e.g., 16.69 % or 8.72%. Here, using the Morningstar data, the numbers would project a 29.54 percent reduction in their end-return over a twenty year period. Variable annuities generally have costs of 2.5-3.0 annually. Using our Morningstar data, over a 20 year period, a VA owner could see a reduction of 50 percent or more in their twenty year end-returns.

Conclusion

The incremental fees for an actively managed mutual fund relative to its incremental returns should always be compared to the fees of a comparable index fund relative to its returns When you do this, you’ll quickly see that the incremental fees for active management are really, really high-on average, over 100% of incremental returns. – Charles D. Ellis

Past performance is not helpful in predicting future returns. The two variables that do the best job in predicting future performance of [mutual funds] are expense ratios and turnover. – Burton G. Malkiel

The next time you see a stated investment fee of 1 percent, know that that representation may not properly reflect the true impact of annual expense fees and other costs on your investment return. I highly recommend that investors and investment fiduciaries do a more comprehensive cost-efficiency analysis using InvestSense’s proprietary metric, the Active Management Value Ratio™ 3.0 (AMVR). For more information about the AMVR and the simple calculation process, click here.

Copyright © 2018 The Watkins Law Firm. All rights reserved.

This article is neither designed nor intended to provide legal, investment, or other professional advice as 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 Active Management Value Ratio, AMVR, Asset Protection, Closet Index Funds, Fiduciary, Investment Advice, Investment Advisors, Investment Fraud, Investment Portfolios, Investor Protection, IRA, pension plans, Portfolio Construction, portfolio planning, Retirement, Retirement Plan Participants, Retirement Planning, Uncategorized, Variable Annuities, Variable Annuity Abuse, Wealth Accumulation, Wealth Management, Wealth Preservation | Tagged , , , , , , , , , , , , , , , , , ,

The Active Management Value Ratio™ 3.0: Investment Returns and Wealth Preservation for Investors and Fiduciaries

Studies have consistently shown that people are more likely to understand and retain information that is conveyed visually rather than verbally or in print. I regularly receive requests for copies of the Powerpoint slides. So for those of you that have never seen one of my presentations on the value of InvestSense’s proprietary metric, the Active Management Value Metric (AMVR) 3.0, here is a simple explanation of how the AMVR can help you detect cost-inefficient actively managed mutual funds in your personal portfolios and 401(k) plan accounts and better protect your financial security.

The Active Management Value Metric (AMVR) 3.0
Active Management Value Metric (AMVR) 3.0 is based on combining the findings of two prominent investment experts, Charles Ellis and Burton Malkiel, with the prudent investment standards set out in the Restatement (Third) Trusts’ “Prudent Investor Rule.”

[R]ational investors should consider the true cost of fees charged by active managers not as a percentage of total returns but as the incremental fee as a percentage of the risk-adjusted incremental returns above the market index.” – Charles Ellis

Past performance is not helpful in predicting future returns. The two variables that do the best job in predicting future performance [of mutual funds] are expense ratios and turnover. – Burton Malkiel

Active strategies, however, entail investigation and analysis expenses and tend to increase general transaction costs,…If the extra costs and risks of an investment program are substantial, those added costs and risks must be justified by realistically evaluated return expectations. Accordingly, a decision to proceed with such a program involves judgments by the [fiduciary] that: (a) gains from the course of action in question can reasonably be expected to compensate for its additional costs and risks;… – Restatement (Third) Trusts [Section 90 cmt h(2)]

The following slides are based on the returns and risk data, 2017of a popular actively managed mutual fund over the five-year period January 1, 2013 to December 31, 2017, compared to the returns and risk data of a comparable Vanguard index fund. The fund charges a front-end load, or purchase fee, of 5.75 percent. The Vanguard index fund does not charge a front-end load.

Nominal Returns
Mutual funds ads and brokerage accounts often provide a fund’s returns in terms of its nominal, or unadjusted returns. In our example, the actively managed fund’s incremental, or extra, costs exceed the fund’s incremental returns. This would result in a net loss for an investor, making the fund cost-inefficient and a poor investment choice. Furthermore, 67 percent of the actively managed fund’s fee is only producing 1 percent of the actively managed fund’s overall return. Yet another way of looking at the analysis – would you rather pay $31 for 15.92% return or $94 for an additional 0.16% of return?

Load-Adjusted Returns
However, Investors who invest in funds that charge a front-end load do not receive a fund’s nominal return since funds immediately deduct the cost of the front-end load at the time of an investor’s purchase of the fund. Since there is less money in the account to start with, an investor naturally receives less cumulative growth in their account when compared to a no-load fund with the same returns. This lag in cumulative growth will continue for as long as they own the mutual fund.

The calculation of a fund’s load-adjusted returns can be somewhat confusing. Several online sites provide load-adjusted return data, including marketwatch.com and the fidelity.com site.

In our example, once the impact of the front-end load is factored into the fund’s returns, the investor not only charges higher fees, but also suffers an opportunity cost, as the fund underperforms the benchmark, the comparable Vanguard index fund. This double loss clearly makes the fund cost-inefficient and a poor investment choice.

Risk-Adjusted Returns
A final factor that should be considered is the risk-adjusted return of a fund. When comparing funds, it is obviously important to know if a fund incurred a higher level of risk to achieve its returns relative to another fund since investors may not be comfortable with such risk. As the quote from the Restatement points out, at the very least, investors would expect a higher return that would compensate them for a higher level of risk.

In our example, the actively managed fund assumed slightly less risk than the Vanguard index fund. As a result, the actively managed fund’s returned improved slightly, but not enough to avoid the same double loss suffered in the load-adjusted scenario. Once again, this double loss clearly makes the fund cost-inefficient and a poor investment choice.


The investment industry will often downplay unfavorable risk-adjusted results, saying that “investors cannot eat risk-adjusted returns.” However, the combined impact of additional fees and under-performance should not be ignored by an investor. Each additional 1 percent in fees results in approximately a 17 percent loss in end return for an investor over a twenty-year period. Historical under=performance can be considered an additional cost in evaluating a fund’s cost-efficiency since investor’s invest to make positive returns and enjoy the benefits of compounding of returns.

Interestingly enough, funds that may criticize risk-adjusted performance numbers have no problem touting favorable “star” ratings from Morningstar, which bases its “star” rating on, you guessed it, a fund’s risk-adjusted returns. Risk-adjusted return data for a fund can be found on the “Taxes” tab, which factors load-adjusted returns into their calculation

In my legal and consulting practices, we add two additional screens. The first screen is designed to eliminate “closet index” funds. Closet index funds are actively managed mutual funds that essentially track a market index or comparable index fund, but charge fees significantly higher, often 300-400 percent or higher, than a comparable index fund. Conseqently, closet index funds are never cost-efficient.

The second screen InvestSense runs is a proprietary metric known as the InvestSense Fiduciary Rating (IFR). The IFR evaluates an actively managed mutual fund’s efficiency, both in terms of cost and risk management, and consistency of performance.

Conclusion
The Active Management Value Ratio™ 3.0 (AMVR) is a simple, yet very effective, tool that investors and investment fiduciaries can use to identify cost-inefficient actively managed mutual funds and thus better protect their financial security. All of the information needed to perform the AMVR calculations is freely available online at sites such as morningstar.com, fidelity.com, and marketwatch.com.

For those willing to take the time to do the research and the calculations, the rewards can be significant. For fiduciaries, the time spent can be especially helpful in avoiding unwanted personal liability, as plaintiff’s securities and ERISA attorneys are becoming increasingly aware of the forensic value AMVR analysis provides in quantifying fiduciary prudence and investment losses. As a result, more securities and ERISA attorneys are incorporating AMVR analysis into their practices.

Posted in Closet Index Funds, Consumer Protection, DOL fiduciary rule, ERISA, Fiduciary, Investment Advice, Investment Advisors, Investment Fraud, Investment Portfolios, Investor Protection, pension plans, Portfolio Construction, portfolio planning, Retirement Plan Participants, Uncategorized, Wealth Accumulation, Wealth Management, Wealth Preservation | Tagged , , , , , , , , , , , , , , , , , , , , | 1 Comment

Transparency Is the Best Disinfectant: Four Key Questions Every Investor and 401(k) Plan Participant Should Ask

Sunlight is the best disinfectant. – Justice Louis Brandeis

The ongoing attempts by the Department of Labor (DOL) and Congress to delay or completely reverse the DOL’s fiduciary rule sends a clear message to pension plan sponsors and plan participants – we care more about Wall Street and the overall investment industry than we do about you.

The arguments put forth by Wall Street and the investment industry thus far have been nothing more than self-serving rhetoric and speculation, totally devoid of any legally admissible evidence. And yet, both the DOL and Congress have gone out of their way to agree to any requests for further delays in full implementation of the DOL’s new fiduciary rule.

The DOL recently agreed to delay the effectiveness of the full DOL rule for eighteen months, even though a private foundation estimated that the delay would result in an $11 billion loss to pension plan participants. The DOL agreed to the additional delay even though CEOs for some of the nation’s leading broker-dealers have publicly stated that no delay is necessary, that they were completely prepared for a full and immediate implementation of the DOL’s rule.

So what does this all mean for plans, plan sponsors and plan participants, the primary beneficiaries of the DOL’s fiduciary rule? It means that they need to become more proactive in order to protect their financial security or, in the case of plan fiduciaries, to protect against any unwanted potential personal liability.

In my legal and fiduciary consulting practices, I use five core questions to establish the failure of a meaningful due diligence process by a financial adviser and resulting unsuitable/imprudent advice, in both ERISA and non-ERISA situations. The five core questions that I use in my practices analyze the true nature of the effective returns that investors receive once certain factors are considered. The four factors that I consider in my forensics analyses are: nominal, or stated, annualized returns;  load-adjusted annualized returns; risk-adjusted annualized returns, and potential “closet index” returns, using both Ross Miller’s Active Expense Ratio metric and my Active Management Value Ratio™ 3.0 metric.

Nominal, or Stated, Returns
These are essentially a fund’s absolute returns, based on the difference between a fund’s beginning and ending value over a certain period of time, with no consideration of any other factors. A fund that started the year with a balance of $10,000 and a balance of $10,000 at the end of the year would have earned a return of 10 percent for the year. [(11,000-10,000)/10,000=1,000/10,000, or 10 percent.

Load-Adjusted Returns
The problem with using nominal returns in analyzing a fund’s performance is that it overstates a fund’s effective annualized returns if an investor paid a front-end fee, or load, when they purchased the fund. Front-end loads are immediately subtracted from a fund at the time they are purchased, putting an investor who pays a front-end load behind investors who do not pay a front-end load when they purchase their mutual fund shares.

All things being equal, a front-end load will always cause an investor paying same to lag behind an investor who did not pay any type of load. And the difference in cumulative returns grows larger over time. As a result, mutual funds often use various marketing techniques in an attempt to conceal the negative impact of front-end loads on returns.

Mutual funds are required by law to disclose a fund’s load-adjusted return in a fund’s prospectus. However, it is common knowledge that most investors do not read a fund’s prospectus. One common marketing technique that fund companies use in advertising to hide the negative impact of front-end loads on returns is to use a fund’s nominal returns rather than its lower load-adjusted returns in their ads.

Then, in an attempt to avoid any potential charges of violations of the Exchange Act or the Advisors Act, the fund will ad a footnote, in much smaller print, at the end of the article stating that they did not use the fund’s load-adjusted returns and that, had they done so, the fund’s return numbers would have been lower. They never say how much lower or provide the actual load-adjusted returns numbers. In my opinion, the use of such tactics by a fund or financial adviser is a clear indication of their business ethics and respect for investors, or their complete lack thereof.

Risk Adjusted Returns
Studies have suggested a direct relationship between the level of investment risk assumed and investment return. As the Restatement (Third) Trusts (Restatement) points out, the natural inclination of investors and the duty of investment fiduciaries is to seek the highest level of return for a given level of risk and cost.

The investment industry often downplays the evaluation of a fund’s risk-related returns, with the familiar quote, “investors cannot eat risk-related returns.” However, mutual funds certainly have no problem referencing the number of Morningstar “stars” one of their funds earned if the rating is favorable, even though Morningstar has publicly acknowledged that it bases a fund’s “star” rating on the fund’s relative risk-related returns.

“Closet Index” Returns
“Closet index” funds, also known as “index huggers,” have become an increasing issue with regard to wealth management. Closet indexing refers to situations where a mutual fund holds itself out as an actively managed mutual fund, and charging higher fees for such active management, but whose actual performance closely tracks that of a comparable, but less expensive, index fund. Therefore, such funds are not cost-efficient and violate a fiduciary’s duty of prudence.

One of the best ways to identify a closet index is by using a statistic called R-squared (or R2), which measures the percentage of a fund’s movements that can be explained by fluctuations in a benchmark index. The higher a fund’s R-squared number, the greater the likelihood that the funds can be designated as a closet index fund. R-squared  ratings for funds are available for free on various public internet sites, such as Morningstar, Yahoo!Finance and MarketWatch.

One commonly method commonly used to evaluate a fund’s potential closet index status is to use a fund’s R-squared number to compute a fund’s Active Expense Ratio (AER). A fund’s AER number provides investors and investment fiduciaries with a fund’s effective annual expense ratio given the fund’s reduced active management component. In my practice, I take a fund’s AER and use it in my proprietary metric the Active Management Value Ratio™ 3.o (AMVR). The AMVR allows investors and investment fiduciaries to quantify the cost-efficiency of an actively managed mutual fund.

The impact of such returns on the performance of a fund can be seen in the following example. Capital Group’s American Funds mutual funds are among the most commonly recommended funds to both ERISA and non-ERISA accounts. Financial advisors like the fact that American Funds pay one of the highest commission rates of any fund group, based largely on the 5.75 percent front-end load that American charges non-ERISA accounts. ERISA accounts typically do not charge investors a front-end load on their purchases.

In our example, we will compare the ten-performance of two of American Fund’s most popular funds, Growth Fund of America (retail AGTHX, retirement RGAGX) and Washington Mutual (retail AWSHX, retirement RWMGX) to their comparable fund at Vanguard. Morningstar classifies AGTHX/RGAGX as a large cap growth fund and AWSHX/RWMGX as a large cap value fund. We will use the Vanguard Growth Index Fund and the Vanguard Value Index Fund as benchmarks to evaluate the AGTHX/RGAGX and AWSHX/ RWMGX, respectively. Unless otherwise indicated, the return numbers reflect the ten-year period ending June 30, 2017

AGTHX VIGRX
Nominal 7.24 8.65
Load-Adj 6.93 8.65
Risk-Adj 7.05 8.65
AER 4.19

*AGTHX 10-year cumulative returns – $197,636
*VIGRX 10-year cumulative returns – $229,243

Here, AGTHX lags VIGRX both in terms of nominal and load-adjusted return. AGTHX has a high R-squared number, 93, which results in a significantly higher effective annual expense ratio of 4.19, versus its stated annual expense ratio of 0.66 percent, as compared to VIGRX’s annual expense ratio of 0.18. Based on these numbers, it would be hard to justify AGTHX as a suitable/ prudent investment choice over VIGRX.

A similar comparison on the retirement shares of both funds produces the following results.

RGAGX VIGAX
Nominal 7.54 8.80
Load-Adj 7.54 8.80
Risk-Adj 7.67 8.80
AER 4.07

*RGAGX 10-year cumulative returns – $209,385
*VIGAX 10-year cumulative returns – $232,428

Once again, RGAGX lags VIGAX both in terms of nominal and load-adjusted return. RGAGX has a high R-squared number, 93, which results in a significantly higher effective annual expense ratio of 4.07, versus its stated annual expense ratio of 0.33 percent, as compared to VIGAX’s annual expense ratio of 0.06. Based on these numbers, it would hard to justify RGAGX as a suitable/ prudent investment choice over VIGAX.

It should be noted that when using the AMVR, a fund that fails to provide any incremental return for an investor, or a fund whose incremental costs exceed a fund’s incremental return, is clearly unsuitable and imprudent since an investment in the fund would provide no positive benefit for an investor.

Turning to AWHSX and VIVAX, we find the following results.

 

AWSHX VIVAX
Nominal 6.42 5.69
Load-Adj 5.79 5.69
Risk-Adj 6.48 5.69
AER 4.24

*AWSHX 10-year cumulative returns – $187,361
*VIVAX 10- years cumulative returns – $173,915

Here, AWSHX has a better performance than VIVAX both in terms of nominal and load-adjusted return. AWSHX has a high R-squared number, 97, which results in a significantly higher effective annual expense ratio of 4.24, versus its stated annual expense ratio of 0.58 percent, as compared to VIVAX’s annual expense ratio of 0.18. Even with AWSHX’s higher incremental return (0.79), the incremental costs (4.06), based on AWSHX’s AER number, greatly exceeds AWSHX’s incremental return. Based on these numbers, it would hard to justify AWSHX as a suitable/ prudent investment choice over VIVAX.

Finally, a comparison of the retirement shares for each fund produces the following results.

RWMGX VVIAX
Nominal 6.68 5.83
Load-Adj 6.68 5.83
Risk-Adj 7.46 5.83
AER 1.76

*RWMGX 10-year cumulative returns – $205,337
*VVIAX 10-year cumulative returns – $176,233

RWMGX clearly has significantly higher returns than VVIAX. WMGX has a high R-squared number, 97, which results in a higher effective annual expense ratio of 1.76, versus its stated annual expense ratio of 0.30 percent, as compared to VVIAX’s annual expense ratio of 0.06. RWMGX’s higher incremental return (1.63) exceeds its  incremental costs (1.48). Based on these numbers, RWMGX could be considered a suitable and prudent investment choice for the period analyzed.

Conclusion
Based upon my experience, far too many investors and investment fiduciaries simply take a quick glance at a fund’s nominal return numbers and a fund’s standard deviation and make their decisions based on those numbers alone. Those numbers, alone, simply do not constitute an acceptable due diligence process or a meaningful analysis of a mutual fund.

Based upon my experience, four definite patterns emerge in analyzing mutual funds:

(1) All things being equal, no-load funds typically outperform funds that charge a front-end load and/or excessively high annual expense ratios, especially over the long-term. A front-end load simply puts an investor in a position that is difficult to overcome over the long-term.

(2) Actively managed mutual funds often have lower standard deviation numbers that index funds, showing one potential benefit of active management. However, the difference in standard deviation numbers is rarely enough to make up for the impact of a front-end load.

(3) Both fiduciary and non-fiduciary investors should look for cost efficient funds, funds whose incremental returns exceed a fund’s incremental costs, in order to maximize the benefit of compound returns. Losses, whether due to poor returns and/or excessive costs, deny an investor the benefits of compounds returns.

(4) Closet index funds are never cost-efficient, and therefore are never suitable or prudent investments. Funds with a high R-squared number and/or high incremental cost relative to a comparable index fund should always be avoided, as they are typically the prime candidates for closet index status.

It really is that simple. Investors and fiduciaries should always ask their financial advisors the four questions discussed herein. If an advisor cannot or will not supply all such information, it should raise a red flag as to the professionalism of your advisor, or lack thereof, and how he determined that the advice he has provided to you is suitable and prudent for you – based on your best interests or on the compensation he could receive.

When it comes to the question of suitability/prudence of actively managed mutual funds, the Restatement (Third) Trusts provides investors and investment fiduciaries with a simple test which incorporates the forensic standards discussed herein. After noting the additional costs and risks generally associated with actively managed funds, the Restatement simply states that

These added costs and risks must be justified by realistically evaluated return expectations. Accordingly, a decision to proceed with such a program involves decisions by the trustee that gains from the course of action in question can reasonably be expected to compensate for its additional costs and risks;…

I would strongly suggest the use of the four questions by both plan fiduciaries and plan participants, in fact investors in general, as the cornerstone of their own due diligence process. .  The questions can provide the transparency needed to properly evaluate a plan’s available investment options

As noted ERISA attorney Fred Reish likes to say, forewarned is forearmed.

Posted in Best Interests, Closet Index Funds, Common Sense, Consumer Protection, Consumer Rights, DOL fiduciary rule, ERISA, Fiduciary, Investment Advisors, Investment Fraud, Investment Portfolios, Investor Protection, Portfolio Construction, portfolio planning, Retirement, Retirement Plan Participants, Wealth Management, Wealth Preservation | Tagged , , , , , , , , , , , , , ,

Wealth Preservation and Retirement Accounts

When I tell people that I am a wealth preservation attorney, they often respond by saying that they do not have enough money to need such services. Then I ask them whether they have a 401(k) account, an IRA or some other type of retirement account. At that point we usually find a place to sit and discuss various wealth preservation issues that people overlook, issues that often reduce the effectiveness of such plans.

“Retirement readiness” is a popular buzzword today in the financial planning and 401(k) industries. Unfortunately, the increased attention to the subject has also highlighted some of the common problems that are preventing people from accumulating sufficient assets in their retirement accounts to achieve the level of “retirement readiness” they desire or need for their retirement.

Two of the wealth preservation concerns associated with retirement plans include investment options/selections with a plan and poor management of the account. Unfortunately, numerous legal action involving 401(k) plans has shown that the investment options with such plans are often less than optimal due to cost efficiency issues such as excessive fees and consistently poor performance.

Cost Efficiency Analysis
I created a metric a couple of years ago, the Active Management Value Ratio™ 3.0 (AMVR), that allows investors and investment fiduciaries such as 401(k) plan sponsors to easily evaluate the cost efficiency of a mutual fund. Anyone who can perform simple math calculations such as addition, subtraction, multiplication and division can use the AMVR. For more information about the AMVR, click here.

Another quick method of analyzing mutual funds in a pension plan is to check the fund’s R-squared rating. R-squared is a statistic that indicates to what extent a mutual fund tracks an appropriate stock market index or investment. Funds with a high R-squared rating are often referred to as “closet index” funds.

“Closet index” funds present a serious wealth preservation problem since they provide essentially the same performance of an index fund, but charge fees that are often 300-400 percent higher than those charged by a regular index fund. Avoiding unnecessary investment fees is crucial to working toward “retirement readiness” since each additional 1 percent in investment fees reduces an investor’s end return by 17 percent over a period of twenty years.

While there is no universally accepted threshold R-squared rating to designate a “closet index” fund, InvestSense uses a R-squared rating of 90 as an indication of “closet index” status. An R-squared rating of 90 would indicate that 90 percent of the fund’s performance is attributable to the performance of an appropriate stock market index instead of the fund’s management team. Other entities and analysts, including mutual fund analyst Morningstar, use lower R-squared ratings. Mutual fund R-squared ratings are available for free at several online investment sites such as morningstar.com. marketwatch.com, and the fund family’s web site.

Excessive fees are even more inequitable when a mutual fund consistently under-performs a less expensive index fund. InvestSense recommends that investors and fiduciaries analyze a fund’s historical performance over both a five and ten year period to assess both the fund’s absolute performance and consistency of performance. Funds are legally required to provide this information in their prospectuses. Morningstar also provides such information on its web site under their “Performance” tab.

Retirement Account Management
Another common wealth preservation issue involving retirement accounts has to do with proper management of the account, specifically with regard to risk management. Many “advisers” preach a buy-and-hold approach to investing, with the warning that you cannot “time” the market.

There are several problems with the “buy-forget-and regret” approach to investing.  As the Restatement (Third) Trust and investment icons such as Benjamin Graham and Charles Ellis have pointed out, risk management is the real key to successful investing.

One of the integral concepts of investment risk management is the avoidance of significant, and unnecessary, losses. Legendary investor Warren Buffett has two well-known rulesRule

Rule No. 1 – Never lose money.
Rule No. 2 – Never forget Rule No. 1.

History has proven that the stock market is cyclical, alternating between “bull” and “bear” markets. To ignore such evidence and fail to proactively manage their retirement accounts in such as way as to avoid significant losses simply makes no sense, especially since making changes in investments within a tax-deferred retirement account has no adverse tax consequences.

People often object to such an approach to investing, quoting the familiar mantra that “you cannot time the market,” and I totally agree. However, the classic definition of “market timing” is an all-or-nothing approach to investing, shifting assets so that an investor is either 100 percent in the stock market or 100 percent in cash. The folly, and danger, of such an approach to investing is obvious in terms of both risk and cost.

In his classic, “The Intelligent Investor,” Ben Graham advocated creating an initial investment portfolio divided equally between stocks and bonds. He then suggested reallocating the portfolio when market conditions or the economy suggested such a reallocation, but always maintaining no less than 25 percent in both stocks and bond and never more than 75 percent in either asset class. History has shown the wisdom in following such a simple, practical and prudent approach to investing.

I always find it interesting when strict buy-and-holders criticize a proactive approach to risk management such as Graham’s model portfolio as market timing. These are usually the same people who are proponents of rebalancing a portfolio to restore the portfolio’s original allocations based on a perception that market conditions justify the reallocations. An investor would surely not shift assets out of a successful sector in order to fund a sector not expected to perform as well…would they? If, as many strict buy-and-holders suggest, any reallocation or changes in an investment portfolio constitutes “timing,” then re-balancing would technically be “timing” as well.

Rather than dispute the merits of labels, wealth preservation properly focuses on using a sound, practical and proactive approach to risk management.  Simply put, principal lost in a market downturn cannot fully participate in the market’s recovery. Since an investor will have less money than before the market downturn, they will have to achieve a higher rate return during the market’s recovery than the percentage los they sustained, as shown below:

  • 11% return required to recover from a 10% loss
  • 25% return required to recover from a 20% loss
  • 42% return required to recover from a 30% loss
  • 67% return required to recover from a 40% loss
  • 100% return required to recover from a 50% loss.

Bottom line, you can never get ahead if you have to spend all of your time catching up!

Conclusion 
Contrary to popular belief, wealth preservation is not simply for high net worth individuals. Wealth preservation can provide valuable benefits by protecting and maximizing the value of retirement accounts such as 401(k) accounts and IRAs, including inherited 401(k) and IRAs. Wealth preservation strategies can also help investors create and maintain effective retirement accounts toward increased accumulation within such accounts.

Posted in Best Interests, Closet Index Funds, Consumer Protection, Estate Planning, Integrated Estate Planning, Investment Portfolios, Investor Protection, IRA, pension plans, Portfolio Construction, portfolio planning, Portfolio Planning, Retirement, Retirement Plan Participants, Retirement Planning, Uncategorized, Wealth Accumulation, Wealth Management, Wealth Preservation | Tagged , , , , , , , , , , , , , , , , , , ,