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.

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