Wealth Preservation Saboteurs

Posted on April 30, 2013 by investsense

“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.

© 2013 InvestSense, LLC. All rights reserved.

This article is neither designed nor 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 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 , , , , , , , , , , , , , , | Leave a comment

Three Numbers Every Investor and Fiduciary Should Remember

Posted on April 7, 2013 by investsense

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 three out of every four stocks, 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/fixed 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 , , , , , , , , , , , , , | Leave a comment

REAL Wealth Management – Wealth Distributions and Transfers

Posted on March 17, 2013 by investsense

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.

© 2013-2019 InvestSense, LLC. All rights reserved.

This article is neither designed nor 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.

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.

Posted in Asset Protection, Retirement, Retirement Distribution Planning, Retirement Planning, Wealth Distribution, Wealth Management, Wealth Preservation | Tagged , , , , , , | Leave a comment

REAL Wealth Management 2019- Preservation

Posted on March 9, 2013 by investsense

When I tell people that I am a wealth preservation attorney, I often get the obligatory inquisitive look, followed by “what’s that” question. In my law practice, wealth preservation law covers several areas of the law, primarily wealth management, tax planning, estate planning, and asset protection. The primary focus is to address each of these areas, analyze a client’s current situation, and reduce or eliminate any unnecessary exposure to actual or potential losses

Many people mistakenly believe that wealth preservation is only for high net worth individuals who needs trusts and other expensive asset protection tools and strategies. In truth, the most effective and easiest wealth preservation strategy is to effectively diversify all investment accounts, including 401(k) accounts and IRAs, and avoid unnecessary costs by only selecting cost-efficient investments.

With regard to wealth management, I analyze a clients’ current investment portfolio in overall suitability and efficiency, in terms of both cost and risk management.  I draw heavily on over thirty years of experience in the area of quality of financial advice, including various stints as a compliance director. both for general securities and investment adviser operations.

I use four proprietary metrics, three of which are proprietary – the Active Management Value Ratio, the Active Management Fee Equivalent, the Fiduciary Compliance Ratio, and a proprietary stress test.  Relying on these metrics, we often find situations where clients are paying fees that are often 300-400 higher than necessary to get similar, or better, performance from less expensive investment options

I also analyze a client’s investment and financial situation in terms of the client’s overall financial needs and plans.  As an example, variable annuities can basically destroy a client’s estate plan is the client annuitizes the annuity prior to his/her death by removing the asset from the estate plan.  A variable annuity can also have serious implications for those who need Medicaid later in life.  These are all issues which should really be considered prior to investing, but definitely analyzed at some point in case steps should be considered to minimize any potential damage.

Tax planning is an obvious part of wealth management.  As legendary jurist Judge Learned Hand stated, there is nothing wrong or illegal with arranging one’s affairs so as to minimize taxes.  Losses due to taxes obviously reduce wealth and can significantly reduce one’s estate. Tax laws can impact investment choices, e.g., Traditional IRAs vs Roth IRAs, tax deferred investments options vs. non-tax deferred investment options.  Tax laws can impact estate plans e.g., estate equalization strategies, marital property considerations, disclaimer strategies. With the constant change in tax laws, it is critical that clients utilize all possible resources,  including tax attorneys and CPAs, in order to keep their comprehensive wealth management up-to-date with regard to tax planning.

Estate planning focuses on the efficient distribution of one’s estate.  Efficient distribution focuses on both ensuring that the deceased’s last wishes are honored, but also that the estate is not greatly reduced due to the impact of taxes. We will discuss estate planning more in next week’s post on distribution. For now, let’s just say that there are a number of strategies, including estate equalization, trusts and qualified disclaimers that can be used as part of an effective wealth management process.

Finally, studies consistently show that the public wants to know about asset protection strategies, particularly the use of asset protection trusts.  There are basically two types of asset protection trust – domestic asset protection trust (DAPTs) and foreign asset protection trusts (FAPTs).  The most popular domestic jurisdictions are currently Nevada, Delaware, Alaska and South Dakota.  Popular foreign jurisdictions include the Cook Islands, Nevis, Isle of Man and the Cayman Islands.

In choosing a jurisdiction for an asset protection trust, there are several things to consider. First and foremost, the asset protection laws differ from jurisdiction to jurisdiction.  Two of the most important legal issues to consider are the statute of limitations (SLs)/contestability provisions and the exceptions from protection.  The optimum situation is a jurisdiction with short SL/contestability periods and as few exceptions as possible.  With DAPTs, there is also the issue of whether the DAPT state will honor and enforce a judgement from another state due the “full faith and credit” provision of the U.S. Constitution.

I have a lot of people contact me and say they are going to be sued, so they need an asset protection trust…now!  Then I explain a couple of things of things about asset protection trusts, such as (1) asset protection trusts cannot be used to perpetuate fraud; (2) the earlier an asset protection trust is created, the greater the protection; and (3) the effectiveness of an asset protection trust is inversely related to the amount of rights and powers retained by the trust’s grantor. In many cases, it is too late to create an effective asset protection trust, as the event creating the liability has already occurred.

The key to effective wealth preservation is not to view wealth preservation in isolation, but rather as part of a comprehensive wealth management plan.  Wealth preservation involves various aspects of the law, including tax planning, estate planning, and asset protection. The key is to also create a strong team of professional experienced in these areas and work towards the client’ goals and needs.

I am of Scotch-Irish descent, so naturally I have always been fond of the following Scotch adages – “make as much money as you can and keep what you get. That’s the way to become rich.”

© 2013-2019 InvestSense, LLC. All rights reserved.

This article is neither designed nor 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 Fraud, Investment Portfolios, Investor Protection, Portfolio Construction, portfolio planning, Portfolio Planning, Retirement Planning, Wealth Management, Wealth Preservation | Tagged , , , , , , , , , , , , , | Leave a comment

Dividend Investing vs. Variable Annuities

Posted on March 7, 2013 by investsense

Excellent analysis of problems with variable annuities from the “Seeking Alpha” web site . Only thing missing is discussion of the use of inverse pricing on VA’s annual fees, producing windfall for VA issuer at expense of VA owner.

“Seeking Alpha Retirement Portfolio – Dividend Investing vs. Annuity Purchasing” http://bit.ly/VLswFM

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

CommonSense InvestSense: REAL Wealth Management 2019

Posted on February 22, 2013 by investsense

I originally ran this series back in 2013. The series has proven to be among the blog’s most popular posts. So we are going to update the original posts and re-run the entire series. Today we address the ongoing “wealth manager” versus “asset management” debate. And there is, or should be, a difference.

The “wealth manager” charade is something that the regulators need to address. All God’s children simply are not “wealth managers.” A true wealth management implies a set of comprehensive services that address a client’s entire wealth issues – including portfolio management, risk management, tax planning, retirement planning and retirement distribution planning. An asset management is often limited to just that, portfolio management.

Another important distinction that needs to be made is comprehensive “wealth manager” versus “product pusher.” A study by CEG Worldwide concluded that less than 10 percent of those holding themselves out as “wealth managers” actually qualified as wealth managers, with the remaining 90 percent being nothing more than product pushers. Just to make myself clear, product is not inherently bad. The problem is when the only thing the “wealth manager” has to contribute it selling product, with no knowledge of or no provision of the services involved in the other aspects of comprehensive wealth management.

True wealth management is a process, not a product.  True wealth management is more than just asset allocation or portfolio optimization.  In my opinion, true wealth management involves a number of issues, most notably accumulation, preservation and distribution of wealth. In too many cases you simply have product pushers addressing accumulation, with no services related to the preservation and distribution aspects of wealth management.

Over the rest of the week, I will write a post each addressing a separate stage of the wealth management process: accumulation, preservation, and retirement and distribution planning. In the final installment, I will discuss the proper way to combine each stage into a comprehensive wealth management plan.

Next: REAL Wealth Management – Accumulation

Posted in Investor Protection, Portfolio Construction, portfolio planning, Retirement Plan Participants, Retirement Planning, Wealth Management, Wealth Preservation | Tagged , , , , , , , , , , , , , , , | Leave a comment

3 (and a half) Common IRA Mistakes to Avoid

Posted on November 8, 2012 by investsense

Individual retirement accounts (IRAs) have proven to be a very popular investment option.  When set-up properly, IRAs can provide investors with greater flexibility and overall wealth management opportunities than traditional retirement accounts such as 401(k) and 403(b) accounts.

That said, experience has shown that far too often IRA accounts are not set-up or managed properly, resulting in costly results for investors.  Common mistakes include improperly titled accounts, ineffective use of beneficiary designations, and failing to integrate an investor’s IRA with their overall estate plan.

Improperly titled accounts

The issue of improperly titled accounts arises most often in connection with inherited retirement accounts and inherited IRAs.  Failure to properly title an inherited account may result in immediate taxation of the entire accountand, accordingly, the loss of the benefits of tax-deferral.

The general rule with regard to inherited retirement accounts is that the inherited IRA account must be set up to indicate that it is an inherited account.  This is required to ensure that certain restrictions on inherited accounts are followed. For example, one way of properly titling an inherited IRA would be as follows, “John Doe, deceased IRA f/b/o Jane Doe.” (f/b/o stands for “for benefit of”)

I’ve seen far too many cases where errors have occurred in titling inherited IRAs. I would strongly recommend consulting with an attorney or other professional experienced in such matters to ensure that no mistakes are made.  At the very least, an investor should insist on reviewing the titling paperwork before approving the actual transfer of funds.

Beneficiary Designations

From a wealth management perspective, the choice of beneficiary designations is one of the most important decisions an IRA owner will make.  By carefully considering the choice of beneficiaries, an IRA owner can maximize the tax-deferral benefits available with an IRA and, thus, the potential financial benefits to the beneficiaries.

Back during my securities compliance days, I would see numerous IRA applications with “estate” marked as the IRA’s beneficiary. Choosing “estate” as an IRA’s beneficiary should be the last option for most IRA owners, as it precludes any opportunity to “stretch” the IRA to maximize the benefits of tax-deferral for the IRA beneficiaries.

An IRA owner should obviously choose the beneficiaries that they want to provide for and protect.  That said, there are various ways to accomplish this goal and still maximize the utility of the IRA itself.  The key is to carefully consider one’s choice of beneficiaries and to consult with an attorney or other professional experienced in such matters in order to prevent potentially costly mistakes.

Integrating IRAs With Estate Plans

The distribution of an IRA is governed by the IRA’s beneficiary designation forms, not by the terms of the IRA owner’s will  Let me repeat that. The distribution of an IRA is governed by the IRA’s beneficiary designation forms, not by the terms of the IRA owner’s will.

This is one reason why IRA owners should review their IRA beneficiary forms on a regular basis, at least annually and after significant events, to ensure that the forms reflect their true desires. There are numerous cases where ex-spouses inherited large IRAs instead of current spouses or children simply because the IRA owner never updated the IRA beneficiary forms.

I have been involved in a number of cases involving this issue, where the results were clearly inequitable and not at all what the deceased would have wanted. This is exactly why it is so important for people to have their entire estate plan, including retirement plans, reviewed by an attorney to ensure that their wishes will be carried out. I’ve seen too many cases where people have said that they talked to their accountant or financial adviser and they said everything was proper, only to find out that the advice they received was incorrect.

Failure to properly integrate IRAs and other retirement accounts can result in disastrous results,  in some cases even splitting families apart due to an unintended inequitable division of property. Properly integrating estate plans with retirement accounts and IRAs often involves setting up separate beneficiary accounts within the retirement accounts and IRAs to ensure maximum benefits to the beneficiaries.  Properly integrating estate plans with retirement plans allows a client to provide for each heir and beneficiary in accordance with their true wishes.

One last situation needs to be discussed.  With the increase in the number of mergers within the financial services industry, I have seen an increase in the number of situations where banks and brokerages have been unable to find the beneficiary forms for accounts.  Depending on the firm’s policy, the inability to locate a customer’s beneficiary forms may result in the institution paying the account’s assets to the customer’s estate which, as we mentioned earlier, is the worst option for both the account owner and their beneficiaries.

I tell my clients to always get a copy of the beneficiary forms for their accounts.  In many cases I draft personalized beneficiary forms for my clients to accommodate their particular situations.  In such cases, I always instruct the client to not only get a second original of the executed document, but also to get the financial institution to sign a document acknowledging receipt of the personalized beneficiary form.

I recommend that my clients review their retirement accounts and beneficiary forms on a regular basis, especially after significant events such as births, deaths and divorces and mergers involving their financial institutions. I also review my clients’ retirement accounts with regard to issues such as the account’s default beneficiary designation policy and the flexibility and investment options available to beneficiaries after the account owner’s death.

Retirement accounts are often a person’s largest financial asset. Yet, in too many cases, little or no consideration is given to properly establishing and managing the account. In some case, this is because the account owner is not given sufficient information about the account and the potential impact of their decisions.  In other cases, the account owner is simply overwhelmed and confused and acts quickly to just get the ordeal over with.

Integrating one’s estate plan with their retirement accounts is necessary if one wants to ensure that their final wishes are accomplished. Someone at one of my presentations suggested that this was a subject where an ounce of prevention was truly worth a pound of cure. I quickly pointed out that that was not really accurate, as in most instances, a mistake in this area might not be curable at all since it normally requires the approval of the Internal Revenue Service.

The better option is to take the time to get it right the first time and work with an attorney or someone who is both experienced and knowledgeable in such matters.  While the time and cost should not be prohibitive, the peace of mind in knowing that your affairs have been properly set-up to provide for your heirs and beneficiaries is invaluable.
– Jim Watkins

Posted in Asset Protection, Investor Protection, IRA, Retirement Plan Participants, Retirement Planning, Wealth Management, Wealth Preservation | Tagged , , , , , , , , , , , | Leave a comment

Avoiding the “Missing the Ten Best Days” Ruse

Posted on July 7, 2012 by investsense

Stockbrokers and investment advisors sometimes employ the “missing the best days in the market” ruse to convince investors to stay in the market, even when economic and market indicators suggest a more defensive strategy.  In some cases, advice is simply to preserve annual 12b-1 fee payment to stockbrokers and advisers.

An excellent article in the “Seeking Alpha” blog points out both sides of the story and factors investors should consider.  The referenced Journal of Financial Planning article by Paul J. Gire makes an excellent point, namely that using such presentations without presenting both sides of the story could result in ethical violations for CFP® professionals and other fiduciaries. 

http://seekingalpha.com/article/648391-don-t-let-best-market-days-mantra-derail-your-tactical-investing

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

The Active Management Value Ratio™- Revealing the Undisclosed Cost of Actively Managed Mutual Funds

Posted on June 25, 2012 by investsense

Despite overwhelming evidence that actively managed mutual funds generally underperform passively managed index funds, the evidence indicates that most investors continue to purchase and hold actively managed funds.  Even when an actively managed fund does outperform its relevant index, the margin is usually slim, often measuring less than 1 percent.  That 1 percent advantage may disappear entirely when the actively managed fund’s annual fees are factored in.

In analyzing the prudence of actively managed mutual funds, I use a proprietary formula, the Active Management Value Ratio™ (AMVR), to determine the cost effectiveness of an actively managed mutual fund. In short, most actively managed mutual funds simply are not cost efficient.

Most investors only think of mutual fund fees in terms of the annual expense fee quoted in ads and prospectuses.  What most investors do not realize is that in breaking down an actively managed mutual fund’s annual fee into its active and passive components, the active component usually exceeds the passive component by a wide margin.

Most investors expect to see a reasonable relationship between the fees they pay and the returns they receive. However, that is usually not the case when it comes to actively managed mutual funds, where it is not unusual to see the portion of the annual fee allocatable to active management, often 60-70 percent of the fund’s annual return, providing only 25-30 percent of the fund’s annual return.

When we apply the AMVR, we often find that the fund’s active fee component either significantly reduces or totally removes the active management component’s contribution to the fund’s overall return. In some cases, the active management component of the fund may actually end up costing an investor money.

To understand the AMVR, let’s start with a simple cost-benefit analysis.  Let’s assume that we have two mutual funds.  Fund A is an index fund that tracks the S&P 500 Index.  Fund A does not impose a load, or upfront fee, to purchase the fund and has an annual expense fee of 0.15 percent.  Fund B is a load fund that charges a purchase fee, or load, of 3.5 percent and an annual expense fee of 1.50 percent. Fund B’s purchase fee is immediately deducted from an investor’s initial investment, meaning the investor starts off at a loss.

Fund B has an R-squared rating of 90, meaning that ninety percent of the fund’s performance can be attributed to the performance of the underlying index, in this case the S&P 500 Index, rather than the contributions of the fund’s management.  So an investor could have received ninety percent of Fund B’s performance for essentially ten percent of Fund B’s annual fee.  In other words, an investor is paying ninety percent of the amount of Fund B’s fees for whatever returns Fund B earns in excess of the S&P 500’s return.  If Fund B does not outperform the S&P 500 Index, the investor receives nothing for the excess annual fees they paid for Fund B.

The AMVR provides an even more useful analysis.  For our analysis we will compare two popular actively-managed, domestic equity mutual funds, two funds that are often included in 401(k) plans.  Popularity aside, when we perform an AMVR analysis on these two funds, we get drastically different findings.

Fund #1   
• Fund’s Five-Year Annualized Return – 4.88%
• Fund Expense Ratio – 0.69%
• Index Fund’s Five-Year Annualized Return – 2.29%
• Index Fund’s Expense Ratio – 0.17%

The first step in computing the AMVR is to compute the difference between the funds’ expense ratios and the difference between the funds’ five-year annualized returns.

• Actively-Managed Fund’s Expense Ratio – Index Fund’s Expense Ratio = Active Cost
• Actively-Managed Fund’s Five-Year Annualized Return – Index Fund’s Five-Year Annualized Return =   Active Contribution

In our example, the Active Cost would be 0.52 (0.69 – 0.17) and the Active Contribution would be 2.59 (4.88 – 2.29)

The next step in calculating the AMVR is to compute both the Active Cost and the Active Contribution as a percentage of the actively-managed fund’s expense ratio and five-year annualized return, respectively.

• Active Cost/Actively-Managed Fund’s Expense Ratio = Relative Active Cost
• Active Contribution/Actively-Managed Fund’s Five-Year Annualized Return = Relative Active Contribution

In our example, the Relative Active Cost would be approximately 0.75, or 75% (0.52/0.69), and the Relative Active Contribution would be approximately 0.53, or 53% (2.59/4.88), resulting in an AMVR of 1.41 (.75/.53)

Fund #2 
• Fund’s Five-Year Annualized Return – (3.30%)
• Fund Expense Ratio – 0.52%
• Index Fund’s Five-Year Annualized Return – 3.69%
• Index Fund’s Expense Ratio – 0.17%

Performing the same steps as before for Fund #2 produces a Relative Active Cost of 0.67, or 67 percent (0.35/0.52). Since Fund #2’s annual return is less than the index fund’s return, the actively-managed fund has a negative Relative Active Contribution and, therefore, no AMVR rating.

For our purposes, we have found that it works best to calculate active cost as a percentage of active return, with an AMVR score of 0.75 or lower as a goal. An AMVR score of 1.00 or higher would indicate that an investor did not receive a commensurate return on the additional expense fees incurred on the actively-managed mutual fund.

In our example, Fund #1’s AMVR score of 1.41, indicates that our investor paid 75 percent more in fees than the index mutual fund’s total fee in order to receive the actively-managed portion of the fund, yet only received 53 percent more in returns.  This disparity raises potential questions regarding the prudence of investing in the fund.

These imbalances are also reflected in measurements such as a fund’s active expense ratio (AER).  The AER was developed by Professor Ross Miller of the State University of New York.  Dr. Miller’s study found that due to the fee issues associated with actively managed mutual funds, the effective annual expense ratio for such funds was often significantly higher, often 5-6 times greater, than the fund’s stated annual expense ratio.

Investors often see a stated fee of 1 percent and just dismiss it as being only 1 percent. What investors fail to see is the cumulative impact of fees.  According to a study done by the General Accounting Office, over a twenty year period, each 1 percent of investment fees reduces an investor’s ending return by approximately 17 percent.  So, if you are paying an investment adviser an annual management fee of 1 percent and paying annual 401(k) fees of 1 percent, goodbye 34 percent of your end-return.

This is why variable annuities are such a bad investment decision. If your investment adviser recommends that you purchase a variable annuity (generally imposing an annual fee of 2 percent) and recommends that you retain him to manage the variable annuity for you for an annual fee of 1 percent, goodbye 51 percent of your end-return. Add to that the fact that variable annuity issuers base their annual fee on the accumulated value of the annuity rather than on their actual legal obligation to you, an investor’s best course of action is to just say “no” to variable annuities.  (Please see our white paper under “Variable Annuities” for a more detailed analysis on variable annuities and the questionable and often misleading marketing tricks used to sell them.)

Posted in Investment Portfolios, Investor Protection, Portfolio Construction, portfolio planning, Portfolio Planning, Retirement Plan Participants, Retirement Planning, Wealth Management, Wealth Preservation | Tagged , , , , , , , , , , | Leave a comment

A Simple Step to Better Protect Pension Plan Participants

Posted on April 23, 2012 by investsense

Reviewing the reported trillion dollar losses that investors suffered during the 2000-2002 and 2008 bear markets, I cannot help but wonder how much of those losses were preventable, especially for 401k investors. 401k plans are increasingly opting for participant directed retirement plans that shift the risk and burden of retirement investing on the plan participants. Even though ERISA permits plan sponsors to provide investment education programs for plan participants, there is increasing concern among plan sponsors and others that participants may not be able to effectively manage their retirement accounts.

As you review ERISA and other applicable retirement plan related legislation, you notice three persistent themes, or duties, for fiduciaries: prudence, diversification and the avoidance of large losses. In discussing these duties, modern portfolio theory is constantly mentioned as the standard in assessing compliance with these duties.

Dr. Harry Markowitz introduced the concept of Modern Portfolio Theory (MPT) in 1952. Prior to MPT, most portfolios were constructed based purely on risk and return data. With MPT, Markowitz introduced the concept of including the correlation of returns of available investment options as a factor in constructing investment portfolios. By factoring in the correlation of returns, an investor can combine investments that behave differently in various market conditions, which theoretically reduces the overall volatility of the investment portfolio.

While MPT’s calculations have been the subject of legitimate criticism, the benefit of combining assets with low correlations of return is still valid. Both the Department of Labor and the courts still point to the principles of modern portfolio theory as the applicable standard for assessing the prudence of actions taken by retirement plan fiduciaries.

And yet, based upon my experience, most retirement plans do not provide retirement plan participants with correlation of returns information to help them make informed investment decisions. Participants are generally only provided with information regarding an investment’s annual returns and standard deviation. As a result, plan participants often end up with portfolios that are not effectively diversified, leaving the participant needlessly exposed to investment risk.

Plan participants are often offered various investment options, with funds described as large cap, small cap, growth, value, international, and emerging. Without correlation of returns information, a plan participant often constructs a portfolio seemingly diversified based purely upon the number of funds and the difference in names of their investments. Investors are therefore lulled into a false sense of security by this “pseudo” diversification.

Without correlation of returns information on the plan’s available investment options, plan participants are unaware that many of their investment choices behave similarly in different market conditions, thereby providing little if any protection against downturns in the market. Studies have consistently shown an increase in the correlation of returns of equity based investments of all kinds, including international equity investment products. Furthermore, studies have shown that over the past decade, the correlation of returns among equity based investments has increased even more during periods of volatility in the market, effectively reducing the perceived benefits of diversification.

Most 401k plans have chosen to adopt participant directed plans under Section 404(c) of ERISA. One of the requirements for qualifying under 404(c) is that the plan sponsor provide plan participants with “sufficient information to make an informed decision” regarding the plan’s available investment options.

Given the fact that ERISA, the Department of Labor and the courts have recognized MPT as the applicable standard for prudence with regard to retirement plans, and that the cornerstone of MPT is factoring in the correlation of returns in the portfolio construction process, one can legitimately question whether a retirement plan’s failure to provide plan participants with correlation of returns information for a plan’s investment options allows a plan participant to make an informed decision as required under the law. Furthermore, a question arises as to whether the failure to provide such information constitutes a breach of fiduciary duty by the retirement plan’s named fiduciary.

I believe that these are questions that are soon to be presented given the LaRue decision, which established the right of plan participants to bring personal actions for losses incurred in their retirement accounts, and the investment losses that plan participants are suffering. While many retirement plans offer some sort of investment education programs, my experience has been that such programs are usually provided by companies that are serving as service providers to a plan and are seriously lacking in meaningful content.

I have yet to come across one retirement plan educational program that discloses the correlation of returns data for a plan’s actual investment options or addresses the use of such data in constructing an effectively diversified investment portfolio, even though there is no legal prohibition against providing such information. In fact, Section 404(c) and Department of Labor Interpretive Bulletin 96-1 clearly support disclosure of such information.

The integration of ERISA with the widely accepted principles of modern portfolio theory has resulted in a curious paradox for both retirement plan fiduciaries and investors, one with potentially serious liability implications. Plan participants are legally entitled to information that allows them to make informed decisions, to protect their financial security. Court decisions have indicated that the failure to provide such information to plan participants raises questions as to whether a participant can truly exercise control over their retirement account, which is one of the requirements for a 404(c) plan.

Another factor supporting the disclosure of such information is the relative ease in obtaining such information.  The actual calculation of correlation of returns can be easily done by using the correlation function on Microsoft Excel. A number of sites such as Vanguard’s Advisor site and Blackrock’s iShares site provide programs that compute correlation of returns data.

There have been studies suggesting that only one-third of 404(c) plans are in compliance with the section’s requirements. One prominent ERISA attorney, with over thirty years of experience, has stated that his firm has never found a plan in complete compliance with all of 404(c)’s requirements.

The issue involving correlation of returns information seems easy enough to remedy, since the fiduciary arguably needs such information to prudently select the proper investment options for the plan. Hopefully, plan fiduciaries will begin to provide plan participants with such information in order to protect plan participants against unnecessary risk exposure due to “pseudo” diversification and to protect themselves from unnecessary liability risk exposure.

Posted in Investment Portfolios, Investor Protection, Portfolio Construction, portfolio planning, Portfolio Planning, Retirement Plan Participants, Retirement Planning, Wealth Management | Tagged , , , , , | Leave a comment