Recent AMVR Twitter and LinkedIn post

While the DOL (“fiduciary”) and the SEC (“best interest”) debate their applicable standards, I suggest that cost-efficiency should be a key factor in whatever they decide. Even former SEC chairman Jay Clayton discussed the importance of cost-efficiency re “best interest.”

In my practice, when I meet with a HNW investor or an investment fiduciary such as a plan sponsor, I show them an AMVR analysis of two well- known actively managed mutual funds. They regularly appear in personal accounts and 401(k)/403(b) plans. I then ask them if they would consider the fund to be prudent and/or in their “best interest.”

Then I explain how to use the AMVR using two simple questions:

(1) Does the actively managed fund provide a positive incremental return?

(2)If so, does that positive return exceed the fund’s incremental costs?

If the answer to either question is “no,” then the active fund is not cost-efficient relative to the passive benchmark fund. Can anyone honestly argue that a cost-inefficient mutual fund is either prudent or in an investor’s “best interest?”

Simple and straightforward, John Bogle’s “Humble Arithmetic .”

“Simple is the new sophistication.” – Steve Jobs

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New InvestSense video: “The Active Management Value Ratio 4.0: What Investors and Investment Fiduciaries REALLY Need to Know About Wealth Accumulation and Preservation”

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“‘Why’ – Investor Protection Made Simple”

=One of the most rewarding aspects of writing this blog and my books is when someone contacts you and thanks you for the information and advice that you provide. I recently had someone write and tell me that they have enjoyed my metric, the Active Management Value RatioTM 3.0, so much so that is has become a hobby to do AMVR analyses for their friends. The most commonly used word in emails and conversations has been a feeling of “empowerment..

I enjoy working with both investors, financial advisers and investment fiduciaries, such as plan sponsors. Many people ask me how I can work with groups that have inherent conflicts of interests. My answer is simple. In my practice, I always try to identify and address quality of advice issues and then provide suggestions and solutions that promote a common goal, a win-win situation for all parties.

For over thirty years, I have been involved in quality of financial/investment advice issues in some form or another. I have been a compliance director for both general securities and Registered Investment Adviser divisions, director of financial planning quality assurance for a major international insurance company, and the initial director of the peer review department at the CFP Board of Standards. And now I offer quality of advice services in the form of fiduciary audits for pension plans, trusts and other investment fiduciaries, as well as ERISA litigation support services.

So, I feel qualified to offer advice on my two blogs, this blog and my blog oriented toward ERISA professionals and investment fiduciaries, “The Prudent Investment Fiduciary Rules” ( I truly believe in this blog’s byline – “The Power of the Informed Investor.” As Thomas Jefferson once said, “knowledge is power, knowledge is protection, knowledge is happiness.”

I am a firm believer that the best investor protection strategies are proactive and simple. As Steve Jobs once said, “simple is the new sophisticated.”

Once of my favorite examples of the power of “why” involves a widow who dared to question an asset allocation prepared by a financial adviser. The widow’s husband had carefully created a portfolio that would provide his wife with a portfolio that provided her with the upside potential of capital gains, while at the same time providing her with the incom she would need when he was gone.

When the adviser started to explain the pretty multi-color asset allocation pie charts and calculations, the widow cut the adviser off and simply asked “why.” Unsatisfied with the adviser’s explanation, the widow thanked the adviser for their time and left. The widow left her husband’s work intact and enjoyed a comfortable life thereafter.

In this blog, I want to address three wealth management/asset allocation quality of advice situations that I commonly encounter:

  • quality of advice issues regarding asset allocation recommendations due to the instability of the asset allocation software itself;
  • quality of advice issues due to inconsistency between a financial plan’s recommendations and actual implementation of the advice, what I call recommendation-implementation gaps; and lastly,
  • quality of advice issues due to the recommendation of cost-inefficent investments during implementation of the asset allocation recommendations..

My goal is to help the reader understand and recognize the issues so that they can hopefully avoid the risk management and financial issues involved in each scenario.

Asset Allocation Software Issues
Various financial planning firms offer asset allocation recommendations to the public. The price typically ranges from a couple of hundred dollars to thousands of dollars. What the public is not told and does not realize is that such recommendations may have serious flaws, rendering them virtually worthless.

Many of these asset allocation recommendations are created by asset allocation software programs. Most of such programs are, unfortunately, highly unstable. Like any computer program, the data generated is subject to the the quality of such results depends on the accuracy of the assumptions and other data entered into the software program, the “garbage in, garbage out” syndrome.. Slight errors in the input data can produce significant errors in the recommendations generated.

Asset allocation programs typically suffer from two common problems. First, most of these programs are based upon programs are based upon Microsoft Excel, which, according to software engineers I have worked with, was never intended to handle the numerous interrelated calculations used by most financial planning software.

Secondly, most asset allocation software programs are based on a concept known as “means-variance optimization (MVO). MVO favors investments with high returns relative to volatility/standard deviation. This bias, and the quality of advice issues it creates, has led one expert to characterize MVO-based programs as “estimization-error maximizers.”1

When I am asked to review asset allocation recommendations , the first thing I do is review the data and assumptions that were used in preparing the plan. Any software program is always vulnerable to the “garbage in, garbage out” syndrome. The second thing I do is to reverse engineer the recommendations to see where errors may have been made in the calculations and/or advice provided by the recommendations. After thirty years of dealing with financial/investment quality of advice issues, most errors that investors would miss are readily apparent and easy for me to spot.

Asset allocation recommendations typically assume a constant rate of growth for investments. This simply does not portray reality. Historically, the stock market suffers one down year for every two positive years. Losses suffered during bear markets such as the 2000-2002 and 2008 definitely one’s financial  situation. Financial/asset allocation recommendations typically use either past performance or projected performance, or “guesstimates,” of investments to prepare the financial plan.

The problem with past performance data is that, as the required disclosure for investments states, “past performance is no guarantee or future returns.”  The problem with projected performance, or “guesstimates,” is that they are just that, guesstimates, which can be easily manipulated to convince investors to make decisions that benefit the party that prepared the financial plan.

An investor should always ask the adviser who prepared the asset allocation recommendations to provide the investor with all the data and assumptions that were used in preparing the plan. One common scenario we see is manipulation of the assumptions to ensure that certain investment product are recommended..

One common example of this involves small cap investments. Most people have portfolios that are heavily invested in large cap, blue chip stocks. One reason for this scenario is that blue chip stocks are often stocks that people are familiar with (e.g., AT&T, Coke, McDonald’s). Since most financial planning software favors investments with certain characteristics (e.g., high returns and low risk/standard deviation), a planner can ensure that the plan recommends such products by using assumptions meeting such criteria.  So, if a planner wants to ensure that purchases of small cap products are recommended to produce commissions for the planner, they can manipulate the data to ensure such results without the investor suspecting anything.

Another common scenario I encounter is where the adviser blindly relies purely on the asset allocation software’s output and lacks the knowledge and or experience to identify software mistakes or poor advice, a situation commonly referred to as “black box” advising. As Harold Evensky, one of the nation’s most skilled and respected financial planners has opined,

One of the most frequent criticism of wealth manager optimization is the use of a complex computer program, frequently referred to as a black box. This pejorative description suggests that the wealth manager is implementing an asset allocation policy without understanding how the allocations were determined. The presumption is that the black box, not the wealth manager, is making the decision. Unfortunately, this is often a valid criticism.2

As usual, Mr. Evensky is right on point. Whenever I question advisers about the quality of their recommendations and the advice provided, more often than not the first response is the “deer in the headlights” look, followed with an admission of simply following whatever the software produced and/or a meritless, legally insufficient explanation based on inaccurate interpretations of financial theories such as Modern Portfolio Theory. The quality of advice issues with regard to investment recommendations is so bad that Nobel laureate Dr. William F. Sharpe has deemed the situation to be “fantasyland.”3

If you are an investor who has already had a financial plan prepared, I issue the same challenge to you that I make in my wealth preservation challenges. Review the various spreadsheets and check the accuracy of the calculations of the first ten rows on the spreadsheet. Unfortunately, the other forms of deception used in connection with financial plans are often subtle and difficult for the public to detect without the help of someone experienced in such matters.

For what it’s worth, whenever I point out the calculation errors in a financial plan, the planner and his company often respond by saying that they were simply calculating future value, so the last line of the spreadsheet only needs to be correct. When I ask if the customer, who paid for the plan, was informed that the planner knew that most of the numbers were wrong and were simply to fool the customer into thinking a lot of work went into the plan, I usually get more blank stares

Likewise, when I ask whether the customer was informed of whether past performance or “guesstimates” were used in making the asset allocation recommendations, as well as the inherent issues with either approach, I often get more blank stares or a defense that the asset allocation document disclaimed liability for the asset allocation recommendations. So the adviser asked the customer to pay for the asset allocation recommendations, then basically added a disclaimer to the effect that the adviser and/or his firm were not liable if the recommendations were worthless. So much for developing a relationship of trust.

Recommendation-Implementation Gaps
A serious flaw in asset allocation software is the fact that most asset allocation software is only designed to produce recommendations based on broad, generic asset, not the actual investments eventually chosen during the implementation of the asset allocation recommendations. The performance data and cost data between the generic asset categories and actual investment products is usually very significant, essentially invalidating both the asset allocation program’s input data and the recommendations themselves, “garbage in, garbage out.” This concern is rarely disclosed or discusses with investors.

That is another reason why investors should always ask the adviser for a list of the assumptions used in preparing the asset allocation recommendations. The investor can then use one of the various asset allocation programs online to verify the adviser’s work. Some of the online asset allocation programs may even allow you to perform a limited number of asset allocation calculations based on actual investment products.

Advisers usually have access to advanced asset allocation software programs that allow them to go back and perform an revised asset allocation analysis based on the actual investments recommended during implementation. I know I can. I can even call Vanguard and they will do the analysis for me. Yet, for some reason, advisers do not offer to perform this valuable value-added service for clients. Have to wonder why.

Implementation Cost Concerns
While the recommendation-implementation gaps issue looks at general consistency issues in the transition from recommendations to implementation, an investor should always look at the cost-efficiency of the specific investment products recommended by an adviser. A cost-efficiency analysis is simply a cost-benefit analysis comparing the costs and returns of an actively managed mutual funds to those of a comparable low-cost index funds.

I have written extensively on a simple metric that I created, the Active Management Value RatioTM (AMVR) The AMVR is based on the research and concepts of investment icons such as Charles D. Ellis, Dr. William Sharpe and Burton L. Malkiel. Since studies show that people are more visually oriented, I simply created a visual version of their work.

The AMVR slide below shows how profound the impact of cost-inefficient investments can be on an investor’s end-return. The slide represents the retail class shares of a popular actively managed fund.

A couple of things immediately stand out. First, the impact of a fund’s charging a front-end load to purchase their mutual fund. Most actively managed fund’s charge a front-end load; index funds do not. Secondly, the actively managed fund failed to provide a positive incremental return, or outperform the index fund. And finally, the actively managed fund is clearly cost-inefficient, as its incremental costs (0.47) exceeded it incremental return (-1.12).

So, if an adviser were to this fund during the implementation of their asset allocation recommendations, a prudent investor should immediately ask the adviser to perform an AMVR analysis, or do one themselves. Once the analysis shows results such as those shown above, the investor should immediately ask…”Why?” For more information about the AMVR and the calculation process., click here.

Going Forward
Unfortunately, investors cannot, and should not, blindly accept investment advice from anyone. Yet, the evidence shows that most people do because someone is a “broker” or an “adviser,” a professional trained in such matters. Consider the following:

  • A study by CEG Worldwide concluded trhat 94 percent of those holding themselves out as “wealth managers” were actually nothing more than product salesmen.4
  • A study by Schwab Institutional reported that 75 percent of the transferred investor portfolios inspected were unsuitable given the customer’s financial situation or goals.5

President Ronald Reagan might have expressed it best – “Trust, but verify.” Use the “CommonSense InvestSense” blog and other online resources to educate yourself on common investment concerns, strategies and techniques. Always practice proactive InvestSense and never be afraid to ask “why.”

1. Richard O. Michaud, Efficient Asset Management: A Practical Guide to Stock Portfolio Optimization and Asset Allocation (Boston, MA: Harvard Business School Press, 1998), 36.
2. Harold Evensky, Stephen M. Horan, and Thomas R. Robinson, “The New Wealth Management: The Financial Advisor’s Guide to Managing and Investing Client Assets,” John Wiley and Sons, (Hoboken, NJ: John Wiley and Sons, 2011),187.
3. William F. Sharpe, “Financial Planning in Fantasyland,” available online at
4.Brooke Southall, “Wirehouse accounts don’t match client goals,” InvestmentNews, March 12, 2007, 12.
5. Charles Paikert, “Poll: Few advisers are ‘real’ wealth managers,”; the John Bowen post upon which the article is based is available at

© 2021 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.

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REAL Wealth Management 2021 – Wrap-Up

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

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

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

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

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

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

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

Take care.

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REAL Wealth Management 2021 – Wealth Distributions and Transfers

Today, 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.

One of most common distribution mistakes people make is failing to properly complete the beneficiary forms associated with their retirement plans so as to maximize the benefits such assets by avoiding the impact of taxes. In the past, 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 could effectively “stretch” the lifetime of the assets to benefit more than just the beneficiaries they designate. 

The ability to utilize the “stretch provision has been severely restricted due to recent, and ongoing, legislation in this area. This is an area of the law that is constantly undergoing change. That is why investors should always consult with an experienced attorney and/or CPA on such issues. 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, as the 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 the forms still 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 at least a portion of 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 2021 is $15,000.

Married couples can maximize the benefits of the annual gift tax exclusion by each making a qualifying gift. That means for 2021, a couple with three children could give each child $30.000 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.
– 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, providing a further reduction of the grantor taxable estate 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 attempting 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 potential 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 retains over the assets while in the trust, 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.

The rules in this area have changed dramatically in the past few years, most changes providing potentially significant tax savings for an estate, thereby allowing taxpayers to pass more of their assets to their heirs. For that reason, if you have had any estate planning done in the past, you should definitely have your planning reviewed to see if such plans are still effective and/or whether changes might be advisable that make them even more effective.

A full explanation of all the changes is beyond the scope of this blog and not advisable, since the appropriate estate planning strategy for anyone depends any number or interrelated variables. Overall, the recent changes in the tax code relative to estate taxes have resulted in most people not owing any federal estate taxes upon their death. Again, less taxes means more assets to pass on to one’s heirs.

One such change that has benefited many taxpayers has been the so-called “portability” rules. The portability rules generally allow a surviving spouse to take advantage of the unused portion of her deceased spouse’s unused federal estate tax exemption.

In the past, estate planners would often recommend that a couple equalize their estates to make sure that they maximized the benefits of the federal estate tax exemption. With the new portability rules, estate equalization is no longer necessary.

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 applicable 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 2021 is $11.7 million dollars. That amount is subject to an annual adjustment based on inflation. Another reason to review your estate plan annually.

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 that is not otherwise exempted from taxation. 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, CPA, 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 a distribution. The disclaimed distribution is treated as if it were never made and is distributed in accordance with instructions in the will. Effectively disclaiming a distribution should only be done with the assistance of an experienced estate planning attorney in order to avoid potentially serious tax issues.

Disclaimers 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. However, it is important for anyone considering a disclaimer to understand that if a beneficiary disclaims a distribution under a will, the beneficiary does not get to designate someone to receive the disclaimed distribution.

© 2013-2021 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.

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REAL Wealth Management 2021 – Preservation

“Make as much money as you can and keep what you get. That’s the way to become rich.” – Scottish adage

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 three proprietary metrics, – the Active Management Value Ratio™ 3.0, the Fiduciary Prudence Score, and a proprietary stress test.  Relying on these metrics, we often find situations where clients are paying fees that are often 300-400 percent, or more, higher than necessary to get similar, or better, performance from comparable, less expensive investment options.

At first glance, the slide may appear confusing. However, the reader only has to answer two simple questions to understand the chart:

  1. Did the actively managed fund provide a positive incremental return, i.e., did the actively managed fund outperform the benchmark/index fund?
  2. If so, did the actively managed fund’s incremental return exceed the fund’s incremental costs, i.e., was the actively managed fund cost-efficient.

If the answer to either of the two questions is “no,” then the actively managed fund is not cost-efficient, and therefor is not a prudent investment choice.

In this example, the answer to both questions is “no.” In this example, the data is expressed in terms of basis points, an industry term. A basis point is equal to 1/100 of one percent (.01). Non-financial professionals often say it is easier to “monetize” the AMVR analyses, tothink of basis points in terms of dollar, even though that is not technically correct.

In this case, “monetizing” the analysis, an investor could pay $17 and obtain an annualized return of 14.06 percent, or pay $47 dollars and receive no additional benefit over and above that of the benchmark. In fact, the investor in the actively managed fund would actually be paying to incur a loss due to the actively managed fund’s relative under-performance.

Note the “Load Adjusted” note in the annualized return column for the active fund. Actively managed funds usually imposes a “front-end” load, or commission, at the time that an investor purchases shares in their fund. The “front-end load is often in the range of 6-6.5 percent. The front-end load is immediately deducted from the amount of the investor’s investment. This not only reduces the actual amount of the investor’s investment, but also the investor’s end-return relative to funds that do not impose front-end loads.

Note: Funds in retirement plans such as 401(k) and 403(b) plans should never charge charge loads. IRA investors should never pay front-end loads either and reject any funds that attempt to do so.

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 period 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 under 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 wealth management, tax planning, estate planning, retirement distribution planning and asset protection. The key is to also create a strong team of professionals experienced in these areas and work towards the client’s goals and needs.

© 2013-2021 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 Active Management Value Ratio, AMVR, Asset Protection, Estate Planning, Investment Advice, Portfolio Construction, portfolio planning, Retirement, Retirement Distribution Planning, Uncategorized, Wealth Management, Wealth Preservation, Wealth Recovery | Tagged , , , , , , , , | Leave a comment

REAL Wealth Management 2021 – Accumulation

As promised, over the next few days I will discuss what I believe are the three aspects of real wealth management – accumulation, protection/preservation and distribution.  Most of the posts and white papers on wealth management deal with the accumulation phase.

Rather than repeat such information, I will just recommend that readers review the post and white papers that are relevant to their situation. In particular, I recommend that readers read the white papers on variable annuities, faux financial planning and the Active Management Value Ratio™ 3.0 (AMVR).

Two of the most important factors in the accumulation phase are controlling costs and risk management. The Department of Labor has estimated that each 1 percent of fees and expenses reduces an investor’s end return by approximately 17 percent over a twenty year period.

The late John Bogle, founder of the Vanguard group, was fond of saying “costs matter,” and “you keep what you don’t pay for.” Two of the most effective and easiest ways to avoid unnecessary investment costs is to only invest in cost-efficient mutual funds and avoid closet index funds. For information on selecting cost-efficient mutual funds, click here. For information on  identifying and avoiding “closet” indexing funds, click here

A good example of the damaging impact of unnecessary cost is variable annuities. A common saying in the investment industry is that “annuities are sold, not bought.” There’s a very good reasons for that saying. The average annual M&E expenses, i.e., the death benefit for variable annuities is approximately 2-2.5 percent. Add in another 1 percent for the annual expense fee for the sub-accounts within the annuity, and an investor is looking at a 51 percent reduction in their end return at the end of twenty years.

Add in another 1 percent for a so-called “rider. Projected loss in end-return over twenty years is now at 76 percent or over a three-fourths loss in end-returns. Finally, if a financial adviser is charging another 1 percent for managing the variable annuity, the variable annuity owner is looking at a  projected 93 percent reduction in their end return.  So much for “retirement readiness.” Bet your financial adviser did not explain those numbers to you. For more information about the “secrets” of variable annuities and fixed indexed annuities, click here.

But even smaller fees can have a decided impact on an investor’s return.  When we perform an audit for an investor or a pension plan, we use three proprietary metrics : the Active Management Value Ratio™ (AMVR™) , the Fiduciary Prudence Score™ and a proprietary stress test. All of the metrics focus on the implicit, or effective, impact of the incremental costs and the incremental returns of actively managed mutual funds

We have publicly shared the calculation process for the AMVR™ ratio, which allows an investment fiduciaries, investors and investors to evaluate the cost efficiency of an actively managed investment. Based upon our own experience, very few actively managed investments can justify their fees, as they fail to outperform less expensive passively managed investments.

Investors often overlook the impact of risk on an investment’s performance.  One of the best known risk management formulas is the Sharpe ratio, named after its creator, Nobel Prize winner Dr. William F. Sharpe.  The Sharpe ratio uses an investment’s return and standard deviation numbers to calculate an investment’s risk adjusted performance.

Another area that deserves mention is the use of misleading marketing schemes within the financial services industry.  Ads touting “we’re number 1” are common in financial publications. What investors need to realize is that such claims are generally based on relative returns. Therefore, if Fund A only lost 20 percent while Fund B lost 22%…Fund A is number 1! At the same time, a 20 percent loss is a 20 percent loss, when the original idea was to increase one’s wealth. When the market does recover, an investor suffering the 20 percent loss will have to use some of the recovery to make up for such losses, suffering what another “loss” in the form of an opportunity cost.

Smart investors know that the real secret to successful wealth management is risk management. The most common form of risk management is efficient asset allocation/diversification.  By effectively diversify their investments, creating a portfolio with investments that behave differently in different market environments, an investor can provide upside potential for their investment portfolio while also providing downside protection against market downturns.  While it is true that such an approach often prevents huge annual returns, it also prevents against huge investment losses.  By preventing huge investment losses, an investor’s portfolio can benefit from the magic of compounding returns.

Successful investing does not have to be that hard. History has shown that 75 percent of stocks follow the overall trend of the stock market, whether the trend is up or down.  So despite what your financial adviser may claim about being a market guru, just remember the popular (or unpopular) Wall Street adage – “Don’t confuse brains with a bull market.”

© 2013-2021 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 Absolute Returns, Active Management Value Ratio, AMVR, Closet Index Funds, Consumer Protection, Equity Indexed Annuities, Fixed Indexed Annuities, Investment Advice, Investment Advisors, Investment Fraud, Investment Portfolios, Investor Protection, portfolio planning, Uncategorized, Variable Annuities, Variable Annuity Abuse, Wealth Accumulation, Wealth Management | Tagged , , , , , , , , , , , , , , , , , , , | Leave a comment

REAL Wealth Management-2021

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 only 6 percent of those holding themselves out as “wealth managers” actually qualified as wealth managers, with the remaining 94 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. Further, any product recommended must always be in the client’s “best interest,” both from a financial and goal-based basis.

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 series of posts, 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 Investment Portfolios, Portfolio Construction, portfolio planning, Retirement, Retirement Distribution Planning, Retirement Plan Participants, Retirement Planning, Wealth Accumulation, Wealth Distribution, Wealth Management, Wealth Preservation, Wealth Recovery | Tagged , , , , , , , , , , , , | Leave a comment

Variable Annuities: Reading Between the Marketing Lines

Variable Annuities:
Reading Between the Marketing Lines

James W. Watkins, III, J.D., CFP®, AWMA®
CEO/Managing Member
InvestSense, LLC

“Variable annuities are one of the most overhyped, most oversold, and least understood investment products.” A popular investment industry saying is that “annuities are sold, not bought.”

Variable annuity salesmen use various sales pitches to convince investors to purchase a variable annuity. However, as is often the case, what is unsaid is often as important, if not more important, than what is said. This information gap can have serious financial consequences for investors.

For purposes of this article all references to variable annuities shall only refer to non-qualified variable annuities, those annuities that do not qualify for special treatment under the Internal Revenue Code.

Basic Structure of Annuities
Before analyzing some of the popular sales pitches used by variable annuity salesmen, it is important to understand the basic structure of a variable annuity. A variable annuity can be described as an insurance contract wrapped around mutual fund-like subaccounts. The presence of the insurance “wrapper” allows the variable annuity to provide tax-deferred growth.

Variable annuities typically charge two primary fees, an annual insurance fee and an annual subaccount management fee. The insurance fee usually consists of a mortality and expense (M & E) charge and an administrative fee. The combined typically runs in the range of 2-2.5% of the accumulated value of the variable annuity.

The M & E charge covers the guaranteed death benefit (GDB), which ensures that in the event that the owner of the variable annuity dies before annuitizing the variable annuity, his/her heirs will receive no less than the amount that the owner had invested in the variable annuity. The M & E charge also covers commission payments and general overhead expenses. The administrative fee covers various administrative expenses.

The subaccount management fee is charged for the professional management of a subaccount, much like the annual management fee charged by mutual funds. Subaccount management fees can vary depending on the type of account, with management fees typically falling within the 0.80-1.00% range.

The total annual fee charged on most variable annuities is approximately 3.3.5% of the overall value of the variable annuity. When compared to an average annual fee of 1% for actively managed mutual funds, 0.45% for passively managed mutual funds, and the typically low annual fees for exchange traded funds (ETFs), it is easy to see why the high fees and expenses associated with variable annuities are criticized, especially when their drag on long term performance is factored in.

Annuity Sales Pitches
So why do people continue to invest in variable annuities? Remember, annuities are sold, not bought. An analysis of some of the sales pitches used by variable annuity salesmen, in terms of what is said and what is unsaid, may prove helpful.

What’s said: “Variable annuities offer tax deferred growth.”
What’s unsaid: There are a number of investment accounts (e.g., 401(k) accounts, IRA accounts, Keogh accounts, SIMPLE accounts) that offer tax deferred growth without the high fees and expenses associated with variable annuities. Even investors in stocks, mutual funds, and ETFs can achieve virtual tax-deferred growth as long as they do not actively trade their accounts and they choose investments with low turnover rates (e.g., passively managed funds such as index funds and most ETFs) and low income pay-outs.

The value of the tax-deferred growth offered by variable annuities is reduced by the effect of the high fees and expenses associated with variable annuities. Various studies have been done comparing the cost of investing in variable annuities to the cost of investing in mutual funds. These studies have generally concluded that in most cases it takes a minimum of 15-20 years, in some cases over forty years, for the owner of a variable annuity to break-even from the fees and expenses of variable annuities. In some cases, the owner of the variable annuity may never break-even.

An article by Dr. William Reichenstein of Baylor University provides an excellent in-depth analysis of the effects of fees on the overall return realized by variable annuity and mutual fund investors. Among Dr. Reichenstein’s findings: (1) that costs have a significant effect on the overall effectiveness of an investment, (2) that low cost mutual funds and low cost annuities are the most effective investments for investors, and (3) that the typical variable annuity, with a fee of 2% or more and an annual contract fee of $20-$30, is the least effective investment for investors.1

The value of the tax-deferred growth offered by variable annuities is also reduced by the tax aspects of a variable annuity as compared to a mutual fund. Tax-deferred does not mean tax-free. Sooner or later, the variable annuity owner or his/her beneficiaries will have to pay income tax on the capital appreciation within the variable annuity. Mutual fund owners can often use the capital gains tax rates to reduce the taxes on their mutual funds. Variable annuity owners cannot use the capital gains tax rate, as disbursements from variable annuities are taxed as ordinary income, which usually results in more tax liability and less money for the variable annuity owner or his/her beneficiaries.

What’s said: “You don’t pay sales charges when you purchase a variable annuity, so all of your money goes to work for you, unlike mutual funds that charge front-end sales charges, and stocks and ETFs, which require an investor to pay brokerage commissions.”
What’s Unsaid: There are excellent no-load mutual funds that perform as well as, and often better than, variable annuity subaccounts. These no-load mutual funds usually charge annual management fees far less that those charged for variable annuity subaccounts, especially passively managed mutual funds such as index funds. Investors purchasing stocks and ETFs can use discount brokers to greatly reduce the amount of any brokerage commissions.

The statement that variable annuity owners pay no sales charges, while technically correct, can be somewhat misleading. Variable annuity salesmen do receive a commission for each variable annuity they sell, such commission usually being in the range of 6-7% of the total amount invested in the variable annuity. While a purchaser of a variable annuity is not directly assessed a front-end sales charge or a brokerage commission, the variable annuity owner does reimburse the insurance company for the commission that was paid. The primary source of such reimbursement is through the variable annuity’s various fees and charges, particularly the M & E charge.

To ensure that the cost of commissions paid is recovered, the insurance company typically imposes surrender charges on a variable annuity owner who tries to cash out of the variable annuity before the expiration of a certain period of time. The terms of these surrender charges vary, but a typical surrender charge schedule might provide for an initial surrender charge of 7% for withdrawals during the first year, decreasing 1% each year thereafter until the eighth year, when the surrender charges would end. There are some surrender charge schedules that charge a flat rate, such as 7%, over the entire surrender charge period.

One recent variable annuity innovation that has caused regulators a great deal of concern has been the so-called “bonus” annuities. These products have been marketed in such a way that the public may believe that they receive a free bonus, usually in the range of 3-4% of their investment, upon their purchase of the annuity. In truth, the insurance company sponsoring the bonus annuity simply increases the term and/or the amount of the surrender charges to recover the “bonus.” These bonus annuities continue to be the subject of much scrutiny due to their potential to mislead and deceive the public into thinking that they are receiving something that they really are not receiving.

Prospective annuity purchasers should always study the surrender charge schedule to minimize potential costs. Since surrender charge schedules often reflect the amount of commissions paid to the variable annuity salesman, an investor can compare the commission paid on a variable annuity (typically 6-7%) and the commission charged by front-end load mutual funds (typically 4-5%).

What’s said: “Variable annuities offer a guaranteed death benefit (GDB) that ensures that the variable annuity owner’s heirs will get no less than the amount of money that the variable annuity owner invested in the variable annuity.
What’s unsaid: Most variable annuities discontinue the GDB once the variable annuity owner reaches a certain age. Furthermore, a variable annuity owner also generally loses the GDB if the owner elects to annuitize the variable annuity in order to receive the guaranteed lifetime income benefits.

The value of the GDB itself is questionable. Variable annuities are intended to be long term investments. Given the long term historical performance of the stock market, it is highly unlikely that a variable annuity owner will need to use the GDB since, over the long term, the accumulated value of the variable annuity will probably exceed the amount of the GDB. Thus, the popular saying: ” a variable annuity owner needs the death benefit like a duck needs a paddle.”

In his article, Dr. Reichenstein refers to studies that have estimated that the GDB is worth approximately 0.087% or less2, although insurance companies currently impose M & E charges in the range to 1.25%-1.4% to cover their GDB liability.

Another interesting fact about the M & E charge is that while the GDB in most variable annuities only insures the variable annuity owner’s investment in the variable annuity, the principal, the M & E charge is calculated based upon the accumulated value of the of the variable annuity, which includes both the principal and all capital appreciation within the annuity. This practice, known as “inverse pricing,” seem to be clearly inequitable to the variable annuity owner who is forced to pay a higher amount of M & E charges as the value of the variable annuity increases, with no corresponding increase in the insurance company’s obligation to the variable annuity owner.

For an additional fee, some insurance companies do offer a benefit that steps-up the amount of the GDB to the overall value of the variable annuity on certain anniversary dates. Given the unlikely need to use the GDB, the value of yet another layer of cost is equally questionable.

What’s said: “Variable annuities can provide a lifetime stream of income, guaranteeing that you’ll never run out of money to live on.
What’s unsaid: To get the lifetime stream of income, the variable annuity owner generally has to annuitize the variable annuity. Upon annuitization, the variable annuity owner will receive a monthly payment, with the amount of the payment being based upon the owner’s age and the settlement option that was chosen. The decision to annuitize should only be made after consideration of all of the consequences of such a decision.

Upon annuitization, the variable annuity owner gives up control of the annuity’s assets. Even more important, depending on the settlement options offered by the insurance company and the settlement option chosen by the variable annuity owner, once the variable annuity is annuitized the insurance company, not the owner’s heirs, will receive any money left in the annuity when the owner dies. Some variable annuities may require the owner of a variable annuity to annuitize their annuity upon reaching a certain age. Prospective variable annuity purchasers should always check the terms of a variable annuity being considered to see if the annuity contains such forced annuitization language, as it could frustrate an investor’s estate plans.

Annuitization is, in essence, a gamble. The insurance company is hoping that the variable annuity owner dies before depleting all of the assets in the annuity, in which case the insurance company may receive the balance remaining in the annuity. The annuity owner, on the other hand, is gambling that they will live long enough to deplete the assets in their annuity.

What’s said: “You can roll money over from your 401(k) or other retirement account into an IRA and then purchase a variable annuity for such account. You’ll continue to receive tax deferred growth of your money and you’ll get the safety of the guaranteed death benefit.”
What’s unsaid: Qualified plans and IRAs already offer tax deferred growth. Consequently, purchasing a variable annuity within an IRA simply adds the high fees and expenses of the variable annuity without providing the investor with any meaningful additional benefits.

Many people work hard during their lifetime to accumulate funds not only for their retirement, but also to create an estate to leave to their heirs. Annuitization can result in an insurance company, not one’s heirs, inheriting the results of one’s hard work. While IRA owners must begin to take disbursements from an IRA once they reach a certain age, the balance remaining in the IRA at the owner’s death passes to their designated beneficiaries. There are also various ways to minimize the amount of the required disbursements from an IRA so that the IRA assets can benefit one’s children, grandchildren and beyond.

Placing a variable annuity within an IRA may result in a forced annuitization because of the required disbursements from an IRA at 70½ or because of language in the variable annuity requiring annuitization at a certain age or upon the occurrence of some event. Such a forced annuitization may result in consequences unintended, and undesired, by the IRA owner, including the owner’s heirs’ loss of their inheritance.

The questionable value of the GDB has already been discussed. The GDB is simply insurance. An investor who needs insurance and the GDB it provides should buy insurance, but through more cost effective options, such as term insurance.

What’s said: “You’ll have access to your money at all times since variable annuities typically allow an owner to withdraw up to 10% from their annuity annually, after the first year, without any penalty.”
What’s unsaid: The insurance company’s decision to waive any penalties does not change the fact that all withdrawals from a variable annuity result in tax consequences. Withdrawal of gains from variable annuities are taxed as ordinary income. Variable annuity owners cannot use the capital gains tax rates to reduce their tax liability. In addition, withdrawals made by an owner prior to reaching the age of 59½ are generally subject to a penalty tax equal to 10% of the amount withdrawn.

Many variable annuities allow an owner to withdraw more than 10% in a limited number of circumstances. In the event that unanticipated circumstances arise during the period that the variable annuity’s surrender charges are applicable, and such circumstances are not among those specified for allowing withdrawals beyond the insurance company’s annual allowance, the variable annuity owner may have to pay the applicable surrender charges in addition to the ordinary income and penalty taxes.

What’s said: “If you’re ever dissatisfied with the performance of your variable annuity, you can switch to another variable annuity without paying any taxes.”
What’s unsaid: Tax-free exchanges, known as “1035 exchanges,” present a number of issues. Both the NASD and the SEC have made questionable variable annuity sales tactics, including 1035 exchanges, a priority.

There are reports that 1035 exchanges account for a significant portion of annual variable annuity sales.3 Brokers and advisors like 1035 exchanges since they result in new commissions for the broker or the advisor. Variable annuity owners contemplating such an exchange should note that any 1035 exchange made while the existing variable annuity is subject to surrender charges will result in the owner having to pay such surrender charges. In addition, if the new variable annuity imposes surrender charges, those surrender charges begin anew. Consequently, prior to making a 1035 exchange, a variable annuity owner whose annuity is free of surrender charges should carefully consider the costs and the limitations that new surrender charges may create.

Generally speaking, a variable annuity owner should only consider making a 1035 exchange if (1) the existing annuity is not subject to any surrender charges, and (2) the existing variable annuity is being exchanged for a new annuity that has low or no surrender charges and lower fees and expenses than the existing variable annuity. Owners of variable annuities issues prior to 1982 should consult with a tax expert prior to making a 1035 exchange due to the special tax issues associated with such annuities.

What’s said: “If you’re ever dissatisfied with the performance of a subaccount in your variable annuity, you can switch to another subaccount without having to pay sales loads or taxes.”
What’s unsaid: While a mutual fund investor can choose from the entire universe of mutual funds, the variable annuity owner is limited to those subaccounts that are offered within the variable annuity.

Some variable annuities offer twenty or more subaccounts, while others may offer ten or less. In some cases, the insurance company sponsoring the variable annuity may limit all, or a majority, of the available subaccounts to their proprietary products. Quite often, these proprietary products have less than stellar performance records. It should also be noted that some variable annuities do impose a fee, usually in the range of $20-25 per switch, if the variable annuity owner exceeds a certain number of subaccount switches in a year.

What’s said: “The tax deferred growth offered by a variable annuity will allow you to pass more money on to your heirs.”
What’s unsaid: Variable annuities are terrible estate planning tools. If the variable annuity is ever annuitized, the variable annuity owner loses control of the annuity’s assets and, depending on the settlement options offered and chosen, the insurance company, not the owner’s heirs, may get any money remaining in the annuity when the owner dies.

If the variable annuity owner never annuitizes the annuity, then his/her heirs do receive the value of the variable annuity at the owner’s death. The beneficiaries of a variable annuity must pay income tax on the portion of the proceeds that represent the capital appreciation within the annuity. Such proceeds are taxed as ordinary income instead of capital gains, generally resulting in higher taxes and significantly less money for the owner’s beneficiaries.

Heirs receiving mutual funds, stocks, and ETFs as their inheritance pay no taxes due to the step-up in basis these investment products receive upon an owner’s death. The value of this estate planning benefit cannot be overstated, as it allows heirs to avoid the taxes associated with variable annuities and allows the owner to accomplish his/her goal, namely to pass more of the estate to his/her heirs.

Fixed Indexed/Equity Indexed Annuities
Much has been written about the advantages of investing in index funds. Index funds became even more popular during the bull market of the late 80’s and the 90’s, as indexes regularly reported annual double-digit gains. The annuity industry quickly responded by offering an index-based annuity, commonly referred to as fixed index annuities and/or equity indexed annuities. While equity indexed annuities are technically fixed, rather than variable, annuities, they merit discussion due to the fact that they are tied to an equity market index.

Some might say that the marketing of equity indexed annuities can mislead the public due to the severe restrictions placed on the indexed annuity owner’s ability to fully participate in an index’s gain. Most equity-indexed annuities limit, or “cap,” the owner’s annual gain to 10-12% regardless of the index’s actual gain. The owner’s ability to participate in the index’s gain is further restricted by the imposition of a “participation rate,” typically in the range of 70-80%. For example, if an investor owned an equity indexed annuity that capped the annuity owner’s annual gain at 10%, with a participation rate of 70%, the most that the annuity owner could earn for that year would be 7% (10% x .70), even if the index actually gained 30% that year.

Some equity-indexed annuities do offer downside protection by guaranteeing a minimum annual return, usually related to prevailing interest rates. Nevertheless, when an investor in an index based product is limited to a gain of 7% when the index itself shows a much larger gain, it is easy to understand why some investors may question the inherent value and fairness of the product.

Most annuities offer the owner a variety of additional benefits in exchange for additional fees. These benefits are offered in the form of additional contract provisions, or “riders.” The number of riders is too large to allow a complete discussion here. The prospective investor should analyze each rider offered to determine the true value of the benefit, if any, being offered and the effect of the additional fees.

One rider currently being offered is called an “enhanced death benefit” (EDB). The lack of a stepped-up basis for variable annuities is often an impediment to their purchase. In an effort to counter this disadvantage, the EDB pays an additional amount of money to the heirs in an attempt to mitigate the effect of the ordinary income tax that they must pay. The value of the EDB is very questionable due to the way that it is calculated and the fact that the EDB itself is also taxable. More often than not, the variable annuity owner will determine that the benefit offered by the rider simply does not justify the added cost of the rider.

Do variable annuities ever make sense? One situation where a variable annuity may make sense is where an investor wants tax deferred growth and they have maxed out all other tax-deferred growth options, such as 401(k)s and IRAs. Another situation where variable annuities may make sense is a situation where one’s profession and/or financial situation suggest a need for asset protection and the investor resides in a state that grants annuities protection against creditors.

Even then, an investor should only consider a variable annuity with low annual fees and little or no surrender charges, such as those offered by Vanguard, T. Rowe Price and TIAA-CREF, and only invest money that they can leave invested for a long time. Prospective annuity purchaser should remember Dr. Reichenstein’s findings that the typical variable annuity sold by variable annuity salesmen, with annual fees and expenses of approximately 2% and an annual contract fee, are always a poor investment choice.4 Investors should also look at the number and type of subaccounts offered within the variable annuity, the performance record of each subaccount, and the annual management fee charged by the subaccounts.

What options are available to investors who already own a variable annuity and are either dissatisfied with the performance of their annuity or question whether an annuity was a suitable investment for them? The question of suitability depends on various factors such as the investor’s age, investment objectives, financial needs, risk tolerance level, income, and need for liquidity. Suitability determinations are best handled by a truly objective source such as an attorney or a fee-only financial planner who has a background in annuities or securities compliance.

If a determination is made that the annuity was an unsuitable investment for the investor, the investor may choose to contact the broker and brokerage firm that sold them the annuity, as well as the insurance company that sponsors the annuity, and request that the variable annuity contract be rescinded and that their original investment be refunded in full. Given the current investigations by the NASD and the SEC into questionable annuity sales practices, the sanctions that have already been assessed in some cases, and pending legal actions involving the sale of annuities, investors with suitability questions should consider seeking a professional evaluation and objective advice regarding their situation to ensure that they are not exposing themselves to unnecessary financial losses due to unsuitable investments.

Variable annuity owners whose annuity was suitable, but who are dissatisfied with the costs and/or the performance of their annuity should consider exchanging their annuity for an annuity with lower costs, low or no surrender charges, and/or a better performance record once the surrender charge period on their present annuity expires. Annuity exchanges involving annuities that are still subject to surrender charges are generally discouraged due to the loss that would be created in having to pay the surrender charges.

Ethics and Fiduciary Issues
The marketing and sale of variable annuities continues to be a hot topic with regulators. By law, brokers are only supposed to recommend products that are suitable for an investor given their investment objectives, financial needs and overall investment profile. Investment advisors are required to put a client’s interests first and only recommend actions that are in a client’s best interests. Unfortunately, regulators continue to find far too many cases where the brokers and advisors have failed to honor these obligations and have engaged in predatory sales and marketing practices. In fact, annuity salesmen are sometimes taught to use such predatory tactics to induce an investor to purchase a variable annuity.5

As more and more variable annuity owners figure out the trap of annuitization, fewer variable annuity owners are annuitizing their contracts. This reduction in the annuitization rate has serious implications for the insurance industry, as it means that the amount of money that they receive from annuitized variable annuities could be significantly reduced. To prevent this loss, variable annuity owners should be alert to brokers and advisors urging more of their variable annuity clients to annuitize their variable annuities.

Given the fact that annuitization can frustrate a variable annuity owner’s estate plans and that there are other options available, such as systematic withdrawals, that enable variable annuity owners to tap into their variable annuity without forfeiting control of their annuity, a recommendation to annuitize may not be in a client’s best interests. In such circumstances, a recommendation to annuitize may well raise ethical questions and involve possible violations of securities laws/regulations.

Another example of the variable annuity industry’s seeming indifference to the best interests of the client can be seen in stories and reports prepared or sponsored by the industry comparing investments in annuities to investments in mutual funds. Close analysis of such stories and reports usually reveal that the opinions are based on assumptions heavily favoring the annuities, such as assuming that investors will only invest in mutual funds with high fees and that the fund and/or the investor will generate substantial capital gains by heavily trading the fund/account. Without such assumptions, the chances that the variable annuity will outperform the mutual fund are greatly reduced. Inexperienced investors, however, may not be able to detect such biases.

Rarely, if ever, will you find an industry-prepared or industry-sponsored analysis comparing an investment in a variable annuity to an investment in a low cost mutual fund, particularly an index fund. The low annual fees and passive management associated with index funds virtually guarantee that the variable annuity will always lose out in such comparisons. Long-term owners of stocks and ETFs could also outperform variable annuities as well since the stocks and ETFs would not be burdened by high annual fees and annual capital gains. A failure to disclose such relevant information may also raise ethical questions, particularly if the broker or advisor has a fiduciary relationship with the client.

Such issues, combined with dubious practices such as recommending the purchase of variable annuities within qualified plans and IRAs, recommending unsuitable annuity exchanges, and “bonus” annuities, raise legitimate questions as to whether recommendations to purchase variable annuities are based on the client’s best interests or the fact that commissions paid for variable annuity sales are higher than most other investment options. Unfortunately, FINRA and SEC investigations have proven that far too often the motivating factor is the latter.

Regulators have limited resources to detect and address abusive variable annuity practices. Consequently, investors must assume greater responsibility for their investment decisions and be willing to stand up for their rights when they have been misled or have suffered financial losses due to unsuitable investment advice.

Variable annuities are simply not an effective investment choice for most investors due to the costs, restrictions and adverse tax aspects of the product, particularly when compared to other investment options such as mutual funds and ETFs. Variable annuities are an especially poor choice as estate planning tools, as the implications of annuitization, the lack of a stepped-up basis at the variable annuity owner’s death, and the unavailability of the capital gains tax to minimize taxes may actually prevent a variable annuity owner from effectively passing on his/her estate to his/her heirs.

Variable annuities are investment products that are complex and often misunderstood. The lack of available information and the multitude of options and riders usually offered in connection with variable annuities only serve to increase the confusion. Prospective variable annuity purchasers should carefully consider both what is said and what is unsaid in sales pitches for variable annuities before deciding to invest in such products. Investors who do decide to purchase a variable annuity should only consider those with low annual fees, low or no surrender charges, and an adequate number of quality subaccounts to allow them to realize the highest returns possible. Owners of variable annuities should use systematic withdrawals, rather than annuitization, to withdraw money from the variable annuity in order to ensure that the owner’s heirs, not the insurance company, receive the value of the variable annuity upon the owner’s death.

© 2002, 2013, 2021 InvestSense, LLC. All rights reserved.

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

1. W. Reichenstein, “Who Should Buy A Nonqualified Tax-Deferred Annuity,” Financial Services Review, Vol. 11, No. 1, (Spring 2002), p.30. (with permission)
2. Ibid.
3. J. Opdyke, Shifting Annuities May Help Brokers More Than Investors, Wall St. J., Feb. 16, 2001, at C1.
4. Reichenstein, at 30.
5. E. Schultz and J. Opdyke, Annuities 101: How to Sell to Senior Citizens, Wall St. J., July 2, 2002, at C1.

Recommended Reading

Dr. William Reichenstein, CFA, holds the Pat and Thomas R. Powers Chair in Investment Management at Baylor University. He has written a number of informative papers on the subject of variable annuities and personal investing. His research is available on the Internet at the Baylor University web site at reichenstein/ research.htm.

C.T. Geer, “The Great Annuity Rip-off,” Forbes, February 9, 1998.

J. Kalter, “Annuities: Just Say No,” Worth, July/August 1996.

National Association of Security Dealers, “NASD Investor Alert: Should You Exchange Your Variable Annuity?,” February 15, 2001, available on the Internet at

S. Burns, “Why Variable Annuities Are No Match For Index Funds,” available on the Internet at extra/

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Cost-Efficiency and Common Sense: Simple Factors in Improving the Accumulation and Preservation of Wealth

Section 7 of the Uniform Prudent Investors Act (UPIA) states that “[w]asting beneficiaries’ money is imprudent.” While the UPIA is directed at trustees and the management of trust assets, common sense tells you that the warning is equally applicable to wealth management in general.

Cost-efficiency is a topic that financial advisers and wealth managers try to avoid. Why?Most studies have consistently concluded that the overwhelming majority of actively managed mutual funds are not cost-efficient, with findings such as

  • 99% of actively managed funds do not beat their index fund alternatives over the long term net of fees.1
  • Increasing numbers of clients will realize that in toe-to-toe competition versus near–equal competitors, most active managers will not and cannot recover the costs and fees they charge.2
  • [T]here is strong evidence that the vast majority of active managers are unable to produce excess returns that cover their costs.3
  • [T]he investment costs of expense ratios, transaction costs and load fees all have a direct, negative impact on performance….[The study’s findings] suggest that mutual funds, on average, do not recoup their investment costs through higher returns.4

The late John Bogle, founder of the Vanguard Group, often talked about the importance of investment costs and their impact on investor returns. His “Costs Matter Hypothesis” also addressed the fact that just as returns compound, so do investment costs.

The image below is an example of the forensic analyses we provide to investors, investment fiduciaries and attorneys using our proprietary metric, the Active Management Value Ratio 3.0TM (AMVR). The AMVR allows investors, investment fiduciaries and attorneys to quickly determine the cost-efficiency of an actively managed mutual fund relative to a comparable, but less expensive, index fund.

The chart is an analysis of the retail shares of one of Fidelity’s most well-known and popular mutual funds, Fidelity Contrafund (FCNTX). Will Danoff, the fund’s managers for over 30 years, is one of the most well-known and well-respected mutual fund managers in the industry. However, as the chart shows, the extra costs associated with active management and the fund’s high annual expense ratio result in the fund being cost-inefficient relative to the less expensive Fidelity Large Cap Growth Index Fund (FSPGX).

The bottom line reflects the cost/benefit analysis, or cost-efficiency, of Contrafund in this example. The returns shown here are expressed in basis points, a term commonly used in the investment industry. A basis point is equal to .01 percent of one percent. Therefore, 100 basis point equals one percent. An analogy I often use to help investors understand the importance of the AMVR is to “monetize” the results by asking the following question-“Would you pay $80 to receive only $4 in return?”

The AMVR is simply a version of the familiar cost/benefit methodology. AMVR is simply a fund’s incremental costs (IC) divided by the fund’s incremental return (IR). If a fund’s AMVR is greater than 1.0, it indicates that the fund is not cost-efficient, as its incremental costs are greater than its incremental returns/benefits.

One of the strengths of the AMVR is its simplicity. Once a fund’s AMVR has been calculated the user only has to answer two questions:

  1. Did the actively managed fund provide a positive incremental return relative to the benchmark?
  2. If so, did the actively managed fund’s positive incremental return exceed the fund’s incremental costs?

If the answer to either question is “no,” then the actively managed fund does not meet the standards of cost-efficiency set out in the Restatement (Third) of Trusts’ fiduciary standards. Here, Contrafund’s retail shares would be deeded inefficient under the Restatement’s prudence standards, as the fund’s failed both questions.

Fidelity Contrafund also offers another class of shares, K shares, that are often offered within 401(k) and 403(b) pension plans. The chart below shows the results of a forensic analysis comparing Contrafund’s K shares (FCNKX) and the Fidelity Large Cap Growth Index Fund.

While the K shares data does change, the results do not. Contrafund’s K shares would be deeded inefficient under the Restatement’s prudence standards, as the fund fails to provide a positive incremental return. Furthermore, the fund’s AMVR score of exceeds the AMVR’s 1.0 guideline.

The purpose of this post was not/is not to point solely to Contrafund’s issues. Trust me, they are not alone. As noted before, research has consistently shown that most actively managed funds are cost-inefficient relative to comparable index funds.

The purpose of this post was to alert investors, in both private and 4091(k)/403(b) investment accounts, as to this issue of cost-inefficiency and to inform them about the simple tool, the Active Management Value RatioTM 3.0 that is available for that can be used to calculate the cost-efficiency of actively managed mutual funds.

For benchmarking purposes, I typically use Vanguard’s and/or Fidelity’s low-cost index funds. The returns and costs for both funds are essentially the same, so the AMVR results are usually similar as well. The cost and return data is available on at sites such as,, and

Going Forward
In closing, the Active Management Value RatioTM is based upon the research of investment icons such as Charles D. Ellis, Nobel laureate William F. Sharpe, and Burton M. Malkiel. In analyzing an investment option, Nobel laureate William F. Sharpe has stated that

‘[t]he best way to measure a manager’s performance is to compare his or her return with that of a comparable passive alternative.’ 5

Building on Sharpe’s theory, Ellis has provided further advice on the process used in evaluating the cost-efficiency of an actively managed mutual fund.

So, the incremental fees for an actively managed mutual fund relative to its incremental returns should always be compared to the fees for a comparable index fund relative to its returns. When you do this, you’ll quickly see that that the incremental fees for active management are really, really high—on average, over 100% of incremental returns!6

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

1. Laurent Barras, Olivier Scaillet and Russ Wermers, False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas, 65 J. FINANCE 179, 181 (2010).
2.. Charles D. Ellis, The Death of Active Investing, Financial Times,January 20, 2017, available online at
3. Philip Meyer-Braun, Mutual Fund Performance Through a Five-Factor Lens, Dimensional Fund Advisors, L.P., August 2016.
4. Mark Carhart, On Persistence in Mutual Fund Performance,  Journal of Finance, Vol. 52, No. 1, 57-8 (1997).
5. William F. Sharpe, “The Arithmetic of Active Investing,” available online at
6. Charles D. Ellis, “Letter to the Grandkids: 12 Essential Investing Guidelines,”               available online at

© Copyright 2021 InvestSense, LLC. All rights reserved.

This article is for informational purposes only, and 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.

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