Objective information about financial planning, investments, and retirement plans

7 Tips to Become a 401(k) Millionaire

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According to Fidelity, the average balance of 401(k) plan participants stood at $104,000 at the end of the second quarter of 2018, just shy of the all-time high level of $104,300 at the end of 2017. This data is from plans using the Fidelity platform.

They indicate that about 168,000 participants had a balance of $1 million, which is about 41 percent higher than a year earlier. What is their secret?  Here are 7 tips to become a 401(k) millionaire or to at least maximize the value of your 401(k) account.

Be consistent and persistent 

Investing in your 401(k) plan is more of a marathon than a sprint.  Maintain and increase your salary deferrals in good markets and bad.

Contribute enough 

In an ideal world every 401(k) investor would max out their annual salary deferrals to their plan which are currently $18,500 and $24,500 for those who are 50 or over. These amounts increase to $19,000 and $25,000 for 2019.

If you are just turning 50 this year or if you are older be sure to take advantage of the $6,000 catch-up contribution that is available to you. Even if your plan limits the amount that you can contribute because of testing or other issues, this catch-up amount is not impacted. It is also not automatic so be sure to let your plan administrator know that you want to contribute at that level. 

According to a Fidelity study several years ago, the average contribution rate for those with a $1 million balance was 16 percent. According to their most recent data, the average contribution across all 401(k) investors they surveyed was about 8.6 percent. The 16 percent contribution rate translated to a bit over $21,000 for the millionaire group.

As I’ve said in past 401(k) posts on this site, it is important to contribute as much as you can. If you can only afford to defer 3 percent this year, that’s a start. Next year try to hit 4 percent or more. As a general rule it is a good goal to contribute at least enough to earn the full match if your employer offers one.

Take appropriate risks 

As with any sort of investment account be sure that you are investing in accordance with your financial plan, your age and your risk tolerance.  I can’t tell you how many times I’ve seen lists of plan participants and see participants in their 20s with all or a large percentage of their account in the plan’s money market or stable value option.

Your account can’t grow if you don’t take some risk.  

Don’t assume Target Date Funds are the answer 

Target Date Funds are big business for the mutual fund companies offering them. They also represent a “safe harbor” from liability for your employer. I’m not saying they are a bad option but I’m also not saying they are the best option for you.

I like TDFs for younger investors say those in their 20s who may not have other investments outside of the plan. The TDF offers an instant diversified portfolio for them.

Once you’ve been working for a while you should have some outside investments. By the time you are say in your 40s you should consider a more tailored portfolio that fits you overall situation.

Additionally Target Date Funds all have a glide path into retirement. They are all a bit different, you need to understand if the glide path offered by the TDF family in your plan is right for you. 

Invest during a long bull market 

This is a bit sarcastic but the bull market for stocks that started in March of 2009 is in part why we’ve seen a surge in 401(k) millionaires and in 401(k) balances in general. The equity allocations of 401(k) portfolios have driven the values higher.

The flip side are those who swore off stocks at the depths of the 2008-2009 market downturn have missed one of the better opportunities in history to increase their 401(k) balance and their overall retirement nest egg.

Don’t fumble the ball before crossing the goal line 

We’ve all seen those “hotdogs” running for a sure touchdown only to spike the ball in celebration before crossing the goal line.

The 401(k) equivalent of this is to just let your account run in a bull market like this one and not rebalance it back to your target allocation. If your target is 60 percent in stocks and it’s grown to 80 percent in equities due to the run up of the past few years you might well be a 401(k) millionaire.

It is just as likely that you may become a former 401(k) millionaire if you don’t rebalance.  The stock market has a funny way of punishing investors who are too aggressive or who don’t manage their investments.

Pay attention to those old 401(k) accounts 

Whether becoming a 401(k) millionaire in your current 401(k) account or combined across several accounts, the points mentioned above still apply. In addition it is important to be proactive with your 401(k) account when you leave a job.  Whether you roll the account over to an IRA, leave it in the old plan or roll it to a new employer’s plan if allowed do something, make a decision.  Leaving an old 401(k) account unattended is wasting this money and can be a huge detriment to your retirement savings efforts.

The Bottom Line 

Whether you actually amass $1 million in your 401(k) or not, the goal is to maximize the amount accumulated there for retirement.  The steps outlined above can help you to do this. Are you ready to start down the path of becoming a 401(k) millionaire?

Approaching retirement and want another opinion on where you stand? Not sure if your investments are right for your situation? Need help getting on track? Check out my Financial Review/Second Opinion for Individuals service for detailed guidance and advice about your situation.

NEW SERVICE – Financial Coaching. Check out this new service to see if its right for you. Financial coaching focuses on providing education and mentoring in two areas: the financial transition to retirement or small business financial coaching.

FINANCIAL WRITING. Check out my freelance financial writing services including my ghostwriting services for financial advisors.

Please contact me with any thoughts or suggestions about anything you’ve read here at The Chicago Financial Planner. Don’t miss any future posts, please subscribe via email. Check out our resources page for links to some other great sites and some outstanding products that you might find useful.

6 Investment Expenses You Need to Understand

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Investment expenses reduce your investment returns. While nobody should expect investment managers, financial advisors or other service providers to offer their services for free, investors should understand all costs and fees involved and work to reduce their investment expenses to the greatest extent possible.

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Here are 6 investment expenses you need to understand in order to maximize your returns.

Mutual fund and ETF expense ratios

All mutual fund and ETFs have expense ratios. These fees cover such things as trading costs, compensation for fund managers and support staff and the fund firm’s profit. Expense ratios matter and investors shouldn’t pay more than they need to.

Vanguard’s site, as you might expect, deals with this topic at length. In one example, it shows the impact of differing levels of fees on a hypothetical $100,000 initial account balance over 30 years with a yearly return of 6%. After 30 years the balance in the account would be:

$574,349 with no investment cost

$532,899 with an investment cost of 25 basis points

$438,976 with an investment cost of 90 basis points

These numbers clearly illustrate the impact of fund fees on an investor’s returns and their ability to accumulate assets for financial goals like retirement and funding their children’s college educations.

Mutual fund expense ratios are an example of where paying more doesn’t get you more. Case in point, Vanguard Value Index Adm (VVIAX) has an expense ratio of 0.05%. The Morningstar category average for the large cap value asset class is 1.03%. For the three years ending September 30, 2018 the fund ranked in the top 10% of all funds in the category; for the trailing five years it placed in the top 6% and for the trailing ten years it placed in the top 24% in terms of investment performance.

Sales loads and 12b-1 fees

Front-end sales loads are an upfront payment to a financial advisor or registered rep. Front-end sales loads reduce the amount of your initial investment that actually goes to work for you. For example, if a rep suggests investing in a mutual fund like the American Funds EuroPacific Growth A (AEPGX) for every $10,000 the investor wants to invest, $575 or 5.75% will be deducted from their initial investment balance to cover the sales load. Over time this will reduce the investor’s return versus another version of the same fund with a similar expense ratio that doesn’t charge a sales load.

Some will argue that this load is a one-time payment to the advisor and their firm for their advice. This strikes me as dubious at best, but investors need to decide for themselves whether the advice received in exchange for paying a sales load warrants this drain on their initial and subsequent investments. This share class has an expense ratio of 0.82% which includes a 12b-1 fee of 0.24% (see more on 12b-1 fees below).

Level loads are associated with C shares. The American Funds EuroPacific Growth C (AEPCX) fund has a level load of 1% in the form of a 12b-1 fee and an overall expense ratio of 1.60%. Brokers and registered reps love these as the level load stays in place for ten years until the funds convert to a no-load share class of the fund. There is a 1% surrender charge if the fund is redeemed within the first year of ownership.

12b-1 fees are a part of the mutual fund’s expense ratio and were originally designated to be marketing costs. They are now used as trialing compensation for financial advisors and reps who earn compensation from selling investment products. They can also be used to provide revenue-sharing in a 401(k) plan. While 12b-1 fees don’t increase expenses as they are part of the fund’s expense ratio, typically funds with a 12b-1 fee will have a higher expense ratio than those that don’t in my experience.

401(k) expenses

For many of us our 401(k) plan is our primary retirement savings vehicle. Beyond the expense ratios of the mutual funds or other investments offered, there are costs for an outside investment advisor (or perhaps a registered rep or broker who sold the plan) plus recordkeeping and administration among other things. If your employer has these costs paid by the plan they are coming out of your account and reducing the return on your investment.

Be sure to review the annual fee disclosures provided by your employer for your company’s plan for information on the plan’s expenses.

Financial advice fees

Fees for financial advice will vary depending upon the type of financial advisor you work with.

Fee-only financial advisors will charge fees for their advice only and not tied to any financial products they recommend. Fees might be charged on an hourly basis, on a project basis for a specific task like a financial plan, based on assets under management or a flat retainer fee. The latter two options would generally pertain to an ongoing relationship with the financial advisor.

Fee-based or fee and commission financial advisors will typically charge a fee for and initial financial plan and then sell you financial products from which they earn some sort of commission if you choose to implement their recommendations. Another version of this model might have the advisor charging a fee for investment management services, perhaps via a brokerage wrap account, and receiving commissions for selling any insurance or annuity products. They also would likely receive any trailing 12b-1 fees from the mutual funds used in the wrap account or from the sale of loaded mutual funds.

Commissions arise from the sale of financial and insurance products including mutual funds, annuities, life insurance policies and others. The financial advisor is compensated from the sale of the product and in one way or another you pay for this in the form of higher expenses and/or a lower net return on your investment.

Investors need to understand these fees and what they are getting in return. In fact, a great question to ask any prospective financial advisor is to have them disclose all sources of compensation that they will receive from their relationship with you.

Surrender charges

Surrender charges are common with annuities and some mutual funds. There will be a period of time where if the investor tries to sell the contract or the fund they will be hit with a surrender charge. I’ve seen surrender periods on some annuities that range out to ten years or more. If you decide the annuity is not for you or you find a better annuity, the penalty to leave is onerous and costly.

Taxes 

Taxes are a fact of life and come into play with your investments. Investments held in taxable accounts will be taxed as either long or short-term when capital gains are realized. You may also be subject to taxes from distributions from mutual funds and ETFs for dividends and capital gains as well.

Investments held in a tax-deferred account such as a 401(k) or an IRA will not be taxed while held in the account but will be subject to taxes when distributions are taken.

Tax planning to minimize the impact of taxes on your investment returns can help, but investment decisions should not be made solely for tax reasons.

The Bottom Line

Fees and expenses can take a big bite out of your investment returns and your ability to accumulate an amount sufficient to achieve your financial goals. Investors need to understand all costs and expenses associated with their investments and take steps to minimize these costs.

Approaching retirement and want another opinion on where you stand? Not sure if your investments are right for your situation? Need help getting on track? Check out my Financial Review/Second Opinion for Individuals service for detailed guidance and advice about your situation.

NEW SERVICE – Financial Coaching. Check out this new service to see if its right for you. Financial coaching focuses on providing education and mentoring in two areas: the financial transition to retirement or small business financial coaching.

FINANCIAL WRITING. Check out my freelance financial writing services including my ghostwriting services for financial advisors.

Please contact me with any thoughts or suggestions about anything you’ve read here at The Chicago Financial Planner. Don’t miss any future posts, please subscribe via email. Check out our resources page for links to some other great sites and some outstanding products that you might find useful.

4 Benefits of Portfolio Rebalancing

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Last year was a strong year for the markets, with the S&P 500 Index up almost 22% in 2017. The new year has started out a bit differently, though with the S&P 500 recording a gain of only 2.59% though the first half of 2018. It’s been a bumpy ride at times, with the markets experiencing some wild swings at times this year after peaking in late January.

The Russell 2000 index which tracks small cap stocks has hit new highs recently and many big tech stocks have done well so far in 2018. The uneven performance of the markets may have caused your portfolio to have strayed from its target asset allocation. You may be taking on more or less risk than is appropriate for your situation. If you haven’t done so, this is a good time to consider rebalancing your investments. Here are four benefits of portfolio rebalancing.

4 Benefits of Portfolio Rebalancing

Balancing risk and reward

Asset allocation is about balancing risk and reward. Invariably some asset classes will perform better than others. This can cause your portfolio to be skewed towards an allocation that takes too much risk or too little risk based on your financial objectives.

During robust periods in the stock market equities will outperform asset classes such as fixed income. Perhaps your target allocation was 65% stocks and 35% bonds and cash. A stock market rally might leave your portfolio at 75% stocks and 25% fixed income and cash. This is great if the market continues to rise but you would likely see a more pronounced decline in your portfolio should the market experience a sharp correction.

Portfolio rebalancing enforces a level of discipline

Rebalancing imposes a level of discipline in terms of selling a portion of your winners and putting that money back into asset classes that have underperformed.

This may seem counter intuitive but market leadership rotates over time. During the first decade of this century emerging markets equities were often among the top performing asset classes. Fast forward to today and they coming off of several years of losses.

Rebalancing can help save investors from their own worst instincts. It is often tempting to let top performing holdings and asset classes run when the markets seem to keep going up. Investors heavy in large caps, especially those with heavy tech holdings, found out the risk of this approach when the Dot Com bubble burst in early 2000.

Ideally investors should have a written investment policy that outlines their target asset allocation with upper and lower percentage ranges. Violating these ranges should trigger a review for potential portfolio rebalancing.

A good reason to review your portfolio

When considering portfolio rebalancing investors should also incorporate a full review of their portfolio that includes a review of their individual holdings and the continued validity of their investment strategy. Some questions you should ask yourself:

  • Have individual stock holdings hit my growth target for that stock?
  • How do my mutual funds and ETFs stack up compared to their peers?
    • Relative performance?
    • Expense ratios?
    • Style consistency?
  • Have my mutual funds or ETFs experienced significant inflows or outflows of dollars?
  • Have there been any recent changes in the key personnel managing the fund?

These are some of the factors that financial advisors (hopefully) consider as they review client portfolios.

This type of review should be done at least annually and I generally suggest that investors review their allocation no more often than quarterly.

Helps you stay on track with your financial plan 

Investing success is not a goal unto itself but rather a tool to help ensure that you meet your financial goals and objectives. Regular readers of The Chicago Financial Planner know that I am a big proponent of having a financial plan in place.

A properly constructed financial plan will contain a target asset allocation and an investment strategy tied to your goals, your timeframe for the money and your risk tolerance. Periodic portfolio rebalancing is vital to maintaining an appropriate asset allocation that is in line with your financial plan.

The Bottom Line 

Regular portfolio rebalancing helps reduce downside investment risk and ensures that your investments are allocated in line with your financial plan. It also can help investors impose an important level of discipline on themselves.

Approaching retirement and want another opinion on where you stand? Not sure if your investments are right for your situation? Need help getting on track? Check out my Financial Review/Second Opinion for Individuals service for detailed guidance and advice about your situation.

NEW SERVICE – Financial Coaching. Check out this new service to see if its right for you. Financial coaching focuses on providing education and mentoring in two areas: the financial transition to retirement or small business financial coaching.

FINANCIAL WRITING. Check out my freelance financial writing services including my ghostwriting services for financial advisors.

Please contact me with any thoughts or suggestions about anything you’ve read here at The Chicago Financial Planner. Don’t miss any future posts, please subscribe via email. Check out our resources page for links to some other great sites and some outstanding products that you might find useful.

8 Portfolio Rebalancing Tips

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A previous post here on the blog discussed 4 Benefits of Portfolio Rebalancing. This post continues on the rebalancing theme and looks at some ways to implement a rebalancing strategy. In light of the recent volatility in the stock market, its important to review your asset allocation once the dust settles and consider rebalancing your portfolio if needed.

Here are 8 portfolio rebalancing tips that you can use to help in this process.

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Set a target asset allocation 

Your asset allocation should be an outgrowth of a target asset allocation from your financial plan and/or a written investment policy. This is the target asset allocation that should be used when rebalancing your portfolio. 

Establish a time frame to rebalance 

Ideally you are reviewing your portfolio and your investments on a regular basis. As part of this process you should incorporate a review of your asset allocation at a set interval. This might be semi-annually for example. I generally suggest no more frequently than quarterly. An exception would be after a precipitous move up or down in the markets.

Take a total portfolio view 

When rebalancing your portfolio take a total portfolio view. This includes taxable accounts as well as retirement accounts like an IRA or your 401(k). This approach allows you to be strategic and tax-efficient when rebalancing and ensures that you are not taking too little or too much risk on an overall basis.

Incorporate new money 

If you have new money to invest take a look at your asset allocation first and use these funds to shore up portions of your asset allocation that may be below their target allocation. A twist on this is to direct new 401(k) contributions to one or two funds in order to get your overall asset allocation back in balance. In this case your will need to take any use of your plan’s auto rebalance feature into account as well. 

Use auto pilot 

For those with an employer sponsored retirement plan such as a 401(k), 403(b) or similar defined contribution plan many plans offer an auto-rebalancing feature. This allows you to select a time interval at which your account will be rebalanced back to the allocation that you select.

This serves two purposes. First it saves you from having to remember to do it. Second it takes the emotion and potential hesitation out of the decision to pare back on your winners and redistribute these funds to other holdings in your account.

I generally suggest using a six-month time frame and no more frequently than quarterly and no less than annually. Remember you can opt out or change the interval at any time you wish and you can rebalance your account between the set intervals if needed.

Make charitable contributions with appreciated assets 

If you are charitably inclined consider gifting shares of appreciated holdings in taxable accounts such as individual stocks, mutual funds and ETFs to charity as part of the rebalancing process. This allows you to forgo paying taxes on the capital gains and provides a charitable tax deduction on the market value of the securities donated.

Most major custodians can help facilitate this and many charities are set-up to accept donations on this type. Make sure that you have held the security for at least a year and a day in order to get the maximum benefit. This is often associated with year-end planning but this is something that you can do at any point during the year.

Incorporate tax-loss harvesting

This is another tactic that is often associated with year-end planning but one that can be implemented throughout the year. Tax-loss harvesting involves selling holdings with an unrealized loss in order to realize that loss for tax purposes.

You might periodically look at holdings with an unrealized loss and sell some of them off as part of the rebalancing process. Note I only suggest taking a tax loss if makes sense from an investment standpoint, it is not a good idea to “let the tax tail wag the investment dog.”

Be sure that you are aware of and abide by the wash sale rules that pertain to realizing and deducting tax losses.

Don’t think you are smarter than the market 

It’s tough to sell winners and then invest that money back into portions of your portfolio that haven’t done as well. However, portfolio rebalancing is part of a disciplined investment process.  It can be tempting to let your winners run, but too much of this can skew your allocation too far in the direction of stocks and increase your downside risk.

If you think you can outsmart the market, trust me you can’t. How devastating can the impact of being wrong be? Just ask those who bought into the mantra “…it’s different this time…” before the Dot Com bubble burst or just before the stock market debacle of the last recession.

The Bottom Line 

Portfolio rebalancing is a key strategy to control the risk of your investment portfolio. It is important that you review your portfolio for potential rebalancing at set intervals and that you have the discipline to follow through and execute if needed.

Approaching retirement and want another opinion on where you stand? Not sure if your investments are right for your situation? Need help getting on track? Check out my Financial Review/Second Opinion for Individuals service for detailed guidance and advice about your situation.

NEW SERVICE – Financial Coaching. Check out this new service to see if its right for you. Financial coaching focuses on providing education and mentoring in two areas: the financial transition to retirement or small business financial coaching.

FINANCIAL WRITING. Check out my freelance financial writing services including my ghostwriting services for financial advisors.

Please contact me with any thoughts or suggestions about anything you’ve read here at The Chicago Financial Planner. Don’t miss any future posts, please subscribe via email. Check out our resources page for links to some other great sites and some outstanding products that you might find useful.

The Super Bowl and Your Investments

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Lombardi Trophy - Super Bowl XXXI

It’s Super Bowl time and once again my beloved Packers are not playing for the for the seventh consecutive year. They had a horrible season with Aaron Rodgers going down with an injury and their backup quarterback just not cutting it. The good news is that I was able to attend six regular season games at football’s holy shrine, Lambeau Field.

Every year the Super Bowl Indicator is resurrected as a forecasting tool for the stock market.

The indicator says that a win by a team from the old pre-merger NFL is bullish for the stock market, while a win by a team from the old AFL is a bad sign for the markets. Looking at this year’s game, New England is an original AFL team while Philadelphia is an original NFL team.

How has the Super Bowl Indicator done?

According Market Watch, this indicator failed to predict the direction of the stock market for the second year in row.  Denver won the 2016 game and the market had an up year. The Patriots won last year and 2017 was a stellar year for the markets. Overall the indicator has held true in 40 of the 51 prior Super Bowls.

Quoted in a Wall Street Journal article before the 2016 game, respected Wall Street analyst Robert Stoval said, “There is no intellectual backing for this sort of thing, except that it works.”

Some notable misses for the indicator include:

  • St. Louis (an old NFL team that was formerly and is now again currently the L.A. Rams) won in 2000 and the market dropped.
  • Baltimore (an old NFL team that was formerly the original Cleveland Browns) won in 2001 and the market dropped. Perhaps the markets were confused since the Browns became an AFC team (along with the Steelers and the Colts) as part of the 1970 merger.
  • The New York Giants (an old NFL team) won in 2008 and the market tanked in what was the start of the recent financial crisis.
  • In 1970 the Kansas City Chiefs shocked the Minnesota Vikings and the Dow Jones Average ended the year up, by less than 5 percent.

Is this a valid investment strategy?

As far as your investments, I think you’ll agree that the outcome of the game should not dictate your strategy. Rather I suggest an investment strategy that incorporates some basic blocking and tackling:

  • financial plan should be the basis of your strategy. Any investment strategy that does not incorporate your goals, time horizon, and risk tolerance is flawed.
  • Take stock of where you are. What impact has the bull market of the past eight plus years had on your portfolio? Perhaps it’s time to rebalance and to rethink your ongoing asset allocation.
  • Costs matter.  Low cost index mutual funds and ETFs can be great core holdings. Solid, well-managed active funds can also contribute to a well-diversified portfolio. In all cases make sure you are in the lowest cost share classes available to you.

View all accounts as part of a total portfolio. This means IRAs, your 401(k), taxable accounts, mutual funds, individual stocks and bonds, etc. Each individual holding should serve a purpose in terms of your overall strategy.

The Super Bowl Indicator is another fun piece of Super Bowl hype. Your investment strategy should be guided by your goals, your time horizon for the money and your tolerance for risk, not the outcome of a football game.

Please contact me with any thoughts or suggestions about anything you’ve read here at The Chicago Financial Planner. Don’t miss any future posts, please subscribe via email. Please check out the Hire Me tab to learn more about my freelance financial writing and financial consulting services. Check out our resources page for links to some other great sites and some outstanding products that you might find useful.

Resources to consider

Check out Personal Capital’s retirement planning tools to be sure you are on trackPersonal Capital can help you organize your entire financial picture and provide advice if needed.

Looking to learn more about investing and financial planning? Whether you do it yourself or work with a financial advisor, the Fire Your Financial Advisor online course from the White Coat Investor can help. Make this the year you invest in yourself. Be sure you have the knowledge and the tools to thrive in today’s complex financial environment.

(Note these are affiliate links, I receive a fee if you enroll at no extra cost to you)

My services

Need help getting your investments on track? Approaching retirement and want another opinion on where you stand? Check out my Financial Review/Second Opinion for Individuals service.

Financial advisors are you looking to ramp up your content marketing? Contact me regarding my ghost writing services for advisors.

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Are Best Mutual Fund Lists a Good Investing Tool?

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We all like to read article with lists that rank things. Top colleges, top new cars, best and worst dressed and the like are just a few lists we see periodically. Mutual rankings have been around for a while.  Many top personal finance publications such as Money Magazine, Kiplinger’s, and U.S. News publish such lists that rank mutual funds based upon performance. Are these Best Mutual Fund lists useful to you as an investor?

Money (magazine)

Best compared to what?

In order for any mutual fund ranking tool to be useful the comparison needs to be apples-to-apples. Comparing a large cap domestic stock fund to a fund that invests in gold mining companies is a pretty useless exercise. Make sure that you understand what is being compared and the basis for the rankings.

Past performance is not an indication of future performance 

This is a pretty common disclaimer in the investment industry and it is one that should be heeded. Last year’s top mutual fund might finish on top again this year or it might end up at the bottom of the pack. This is especially true for actively managed mutual funds where results can often depend upon the manager’s investment style and whether or not their style is still in favor. Mutual funds that have a big year often find themselves inundated with new money from investors who chase performance, this influx of new money can make it harder for the manager to replicate their past success.

Who’s in charge? 

It is not uncommon for a top mutual fund manager to be wooed by a rival fund company or for them to go off and start their own mutual fund. This is not such a big deal with index funds, but when looking at any actively managed fund be sure to understand whether or not the manager(s) who compiled the enviable track record are still in place.

What period of time is being used? 

Make sure that you understand the time period used in the rankings. Returns over a single year can vary much more than returns compiled over a three, five, or ten year time period. Understand that one or two outstanding years can skew longer-term rankings. Longer periods of time tend to smooth out these blips in performance.

Why didn’t you tell me about this fund a year ago? 

I recall looking at many of these lists over the years and wondering why the publication didn’t write about how wonderful the fund was a year ago before it chalked up this large gain. Well the answer is that this isn’t the job of the publication and they and most of us can’t really predict this.

Is looking at performance worthless? 

No it isn’t but you need to look at performance in context. Look at performance over varying time periods and always in relation to the fund’s peers. Among the things to look at:

  • Risk adjusted performance
  • Performance in up and down markets
  • Performance over rolling periods of time
  • Adherence to the fund’s stated style
  • Costs and expenses
  • Consistency of relative performance
  • Changes in the level of assets in the fund

In short selecting and monitoring mutual funds is about more than looking for the top performers of the past. Like any other investment vehicle, mutual funds need to be viewed in terms of potential future performance and in terms of how they fit into your overall investment strategy and your financial plan.

Approaching retirement and want another opinion on where you stand? Do you want an independent review of your mutual fund holdings and your overall investment strategy? Check out my Financial Review/Second Opinion for Individuals service.

Please contact me with any thoughts or suggestions about anything you’ve read here at The Chicago Financial Planner. Don’t miss any future posts, please subscribe via email. Please check out the Hire Me tab to learn more about my freelance financial writing and financial consulting services.

Photo credit:  Wikipedia

Reverse Churning Are You a Victim?

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One of the best things about being a freelance financial writer and blogger is that I often learn new things in the course of my writing. A reader left a comment on a post here on the blog and mentioned reverse churning. Until that time, I had never heard this term, but after a bit of research I found that its’s one more thing that clients of stock brokers and registered reps need to be aware of.

The issue of reverse churning is one that will come to the forefront as the initial implementation of the DOL fiduciary rules commences next week. Here’s what you need to know about reverse churning to protect yourself and to make a good decision if your broker proposes a fee-based account.

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What is churning?

Investopedia defines churning as “Excessive trading by a broker in a client’s account largely to generate commissions. Churning is an illegal and unethical practice that violates SEC rules and securities laws.”

Churning conjures images such as the boiler room in the movie Glengarry Glen Ross (actually they sold real estate) or the iconic 2002 ad by Charles Schwab (SCHW) in which a brokerage house manager is depicted as telling the brokers, “Let’s put some lipstick on this pig” in reference to a sub-par stock he wants them to pitch to clients.

What is reverse churning?

A 2014 piece by Daisy Maxey in The Wall Street Journal describes reverse churning as follows:

“The Securities and Exchange Commission says the practice of so-called “reverse churning”–putting investors in accounts that pay a fixed fee but generate little or no activity to justify that fee–is on its radar. Regulators will be watching for signs of double-dipping by advisers who generate significant commissions within a client’s brokerage account, then move that client into an advisory account and collect additional fees.”

This occurs in brokerage accounts that at one point generated significant commissions for the broker from the purchase and sale of individual stocks or other commission generating transactions. If the activity in the account tails off the broker makes little or nothing from this client.

As a way to generate ongoing fees from this type of client, the broker may suggest moving to a fee-based advisory account, often called a wrap account.

Under this arrangement there is an ongoing fee based upon the assets in the account plus often trailing commissions in the form of 12b-1 fees from the mutual funds usually offered in this type of account. These generally include proprietary mutual funds offered by the brokerage firm, or at the very least costly actively managed funds from other fund families in share classes geared to offering broker compensation.

Fee-based is not fee-only

Fee-based is often confused with fee-only. I suspect the brokerage industry likes it this way.

Fee-only compensation means that the financial advisor earns no compensation from the sale of financial products including trailing fees and commissions. Their fees come from their clients. These can be hourly, a flat-fee or as a percentage of the assets under management.

Fee-based compensation, also called fee and commission, is a mix of the two forms of advisor compensation. A common form of the fee-based model entails the client paying the advisor to do a financial plan and then if the client chooses to have the financial advisor implement their recommendations this will often be via the sale of commission-based products.

The version with fee-based advisory accounts associated with reverse churning by brokers and registered reps arose out of a 2007 rule that prohibits the charging of fees in brokerage accounts. Many broker-dealers have a registered investment advisor (RIA) arm which runs these accounts.

The fiduciary rule

The new fiduciary rules make fee-based accounts more desirable for brokers and other fee-based advisors. These types of accounts will become even more prevalent with the disclosures required for retirement accounts under the new rules.

There has been a movement towards fee-based accounts in the brokerage world for several years now, likely in anticipation of the eventual issuance of these rules. This movement should accelerate in IRAs. In some cases, this will be a good thing as clients will fully know what they are paying in terms of fees.

In other cases, clients will find themselves paying 100 basis points or more in wrap fees for accounts where they were formerly trading infrequently on a commissioned basis. Whether the fee-based account will be a better deal will vary.

If all they are getting is an expensive managed account filled with bad to mediocre mutual funds that charge high fees on top of the wrap fee, this is not a good deal. If the advisor does little more than collect a fee, this sounds like the definition of reverse churning based on my understanding of the term. Much will depend upon the level and types of advice clients receive for the fees they will now be paying.

Buyer beware 

If you are working with a stock broker or registered rep and they propose moving to a fee-based or wrap account, you should take a hard look at what you are being offered. What is the wrap fee? What types of investments are used in the account? Are they expensive actively managed mutual funds that throw off 12b-1 fees in addition to wrap fees? What is the track record of the manager of the account that the advisor is proposing? What types of advice and service will you receive for the fees you will paying?

The Bottom Line 

I can’t recall hearing about a case of churning in recent years. Reverse churning is a new term to me, but from the perspective of a broker or registered rep, fee-based advisory accounts make a ton of sense. They provide ongoing fee income and frankly require little attention from them. If your broker proposes a wrap account, make sure you understand how this arrangement benefits you the client.

Approaching retirement and want another opinion on where you stand? Has your broker proposed a fee-based option and you aren’t sure if this is the right option for you? Check out my Financial Review/Second Opinion for Individuals service.

Please contact me with any thoughts or suggestions about anything you’ve read here at The Chicago Financial Planner. Don’t miss any future posts, please subscribe via email. Please check out the Hire Me tab to learn more about my freelance financial writing and financial consulting services. 

 

How is My Financial Advisor Compensated?

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Many investors do not understand how their financial advisor is compensated. With the initial implementation of the  DOL Fiduciary Rules mandating that advisors put their client’s interests first when working with their retirement accounts upon us, the issue of financial advisor compensation will be front and center. It is important that all clients fully understand how their financial advisor is compensated and how much this relationship is truly costing them.

The three basic financial advisor compensation models 

Commissions: The advisor is compensated for the sale of investments, insurance, or other financial products. Compensation is paid by the firm that provides the financial product, usually a mutual fund or an insurance company. This may be in the form of an up-front charge, trailing (ongoing) fees or a combination of both. Other names for commissions include front-end loads (A share mutual funds are an example), 12b-1 fees that serve as trailing commissions on some mutual funds and commissions paid to advisors for the sale of insurance products.

Fee-based: Typically the advisor will charge a fee for putting together a financial plan for you. If you chose to implement the recommendations in the plan, such as the purchase of insurance, an annuity, or investments, the implementation will typically be done via the sale of commissioned products.

How is My Financial Advisor Compensated?

Fee-based has taken on a whole new significance in light of the new DOL fiduciary rules. Many firms have moved clients to fee-based or brokerage wrap accounts. The fee part arises from the wrap fee (typically a percentage of assets) charged to the client. Many of these accounts use mutual funds that throw off 12b-1 fees or other types of revenue sharing to the brokerage firm.

Fee-only: The advisor charges a fee for the services rendered. This can be one-time or ongoing based upon the nature of your relationship and the services rendered. Fees may be hourly, flat or retainer based, or based upon a percentage of the assets under advisement.

Why should you care how your advisor is paid? Because his/her compensation can impact the choice of the products recommended to you and your return from those products.

An advisor who is paid via commissions will likely recommend those products that offer him a commission or sales load. Sales people generally sell what they are compensated to sell. Commissions can therefore result in a huge conflict of interest for your advisor. Does she suggest the very best and lowest cost products or does she suggest those products that pay her the highest commission?

Fee-only advisors do not have this inherent conflict of interest because they are paid by the client, not the financial product provider. They are free to suggest the best investment vehicles and financial products for each client’s individual situation.

Should compensation be the only metric used to select a financial advisor?

Of course not, but the advisor’s compensation should be made crystal clear to you. When interviewing an advisor ask very direct questions.

Ask them to detail ALL sources of compensation. These might include up-front commissions or sales loads; deferred or trailing commissions; surrender charges if you opt out of the mutual fund or annuity too early; a wrap fee on your overall investment account; or a myriad of other fees and charges in various combinations.

This extends to fee-only advisors as well. Be sure to understand how much you will be paying for their advice and what types of investing costs you can expect to incur.

While you will not be writing a check for any commissions or product-based fees, make no mistake you are paying the freight. Excessive commissions or expenses serve to directly reduce your return on investment.

Once the new fiduciary rules go into effect, you may be asked to sign a form called a Best Interest Contract Exemption or BICE. The BICE form is used when the advisor seeks to use commissioned-based products, collect other types of revenue sharing or otherwise work with you in a fashion that is outside of the new fiduciary rules. Be sure to read this agreement carefully and to ask questions before signing it.

Approaching retirement and want another opinion on where you stand? Not sure if your investments are right for your situation? Need help getting on track? Check out my Financial Review/Second Opinion for Individuals service for detailed guidance and advice about your situation.

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Annuities: The Wonder Drug for Your Retirement?

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Annuities: The Wonder Drug for Your Retirement?

Annuities are often touted as the “cure” for all that ails your retirement.  Baby Boomers and retirees are the prime target market for the annuity sales types. You’ve undoubtedly heard many of these pitches in person or as advertisements. The pitches frequently pander to the fears that many investors still feel after the last stock market decline. After all, what’s not to like about guaranteed income?

What is an annuity?

I’ll let the Securities and Exchange Commission (SEC) explain this in a quote from their website:

“An annuity is a contract between you and an insurance company that is designed to meet retirement and other long-range goals, under which you make a lump-sum payment or series of payments. In return, the insurer agrees to make periodic payments to you beginning immediately or at some future date.

Annuities typically offer tax-deferred growth of earnings and may include a death benefit that will pay your beneficiary a specified minimum amount, such as your total purchase payments. While tax is deferred on earnings growth, when withdrawals are taken from the annuity, gains are taxed at ordinary income rates, and not capital gains rates. If you withdraw your money early from an annuity, you may pay substantial surrender charges to the insurance company, as well as tax penalties.

There are generally three types of annuities — fixed, indexed, and variable. In a fixed annuity, the insurance company agrees to pay you no less than a specified rate of interest during the time that your account is growing. The insurance company also agrees that the periodic payments will be a specified amount per dollar in your account. These periodic payments may last for a definite period, such as 20 years, or an indefinite period, such as your lifetime or the lifetime of you and your spouse.

In an indexed annuity, the insurance company credits you with a return that is based on changes in an index, such as the S&P 500 Composite Stock Price Index. Indexed annuity contracts also provide that the contract value will be no less than a specified minimum, regardless of index performance.

In a variable annuity, you can choose to invest your purchase payments from among a range of different investment options, typically mutual funds. The rate of return on your purchase payments, and the amount of the periodic payments you eventually receive, will vary depending on the performance of the investment options you have selected.

Variable annuities are securities regulated by the SEC. An indexed annuity may or may not be a security; however, most indexed annuities are not registered with the SEC. Fixed annuities are not securities and are not regulated by the SEC. You can learn more about variable annuities by reading our publication, Variable Annuities: What You Should Know.”

What’s good about annuities?

In an uncertain world, an annuity can offer a degree of certainty to retirees in terms of receiving a fixed stream of payments over their lifetime or some other specified period of time. Once you annuitize there’s no guesswork about how much you will be receiving, assuming that the insurance company behind the product stays healthy.

Watch out for high and/or hidden fees 

The biggest beef about annuities are the fees, which are often hidden or least difficult to find. Many annuity products carry fees that are pretty darn high, others are much more reasonable. In general, the lack of transparency regarding the fees associated with most annuity contracts is appalling.

There are typically several layers of fees in an annuity:

Fees connected with the underlying investments In a variable annuity there are fees connected with the underlying sub-account (accounts that resemble mutual funds) similar to the expense ratio of a mutual fund. In a fixed annuity the underlying fees are typically the difference between the net interest rate you will receive vs. the gross interest rate earned.  In the case of an indexed annuity product the fees are just plain murky.

Mortality and expense charges are fees charged by the insurance company to cover their costs for guaranteeing a stream of income to you. While I get this and understand it, the wide variance in these and other fees across the universe of annuity contracts and the insurance companies that provide them makes me shake my head.

Surrender charges are fees that are designed to keep you from withdrawing your funds for a period of time.  From my point of view these charges are heinous whether in an annuity, a mutual fund, or anyplace else. If you are considering an annuity and the product has a surrender charge, avoid it. I’m not advocating withdrawing money early from an annuity, but surrender charges also restrict you from exchanging a high cost annuity into one with a lower fee structure. Essentially these fees serve to ensure that the agent or rep who sold you the high fee annuity (and the insurance company) continue to benefit by placing handcuffs on you in terms of sticking with the policy.

Who’s really guaranteeing your annuity? 

When you purchase an annuity, your stream of payments is guaranteed by the “full faith and credit” of the underlying insurance company.  This differs from a pension that is annuitized and backed by the PBGC, a governmental entity, up to certain limits.

Outside of the most notable failure, Executive Life in the early 1990s, there have not been a high number of insurance company failures. In the case of Executive Life, 1,000s of annuity recipients were impacted in the form of greatly reduced annuity payments which in many cases permanently impacted the quality of their retirement.

Insurance companies are regulated at the state level; state insurance departments are generally the backstop in the event of an insurance company failure. In most cases you will receive some portion of the payment amount that you expected, but there is often a delay in receiving these payments.

The point is not to scare anyone from buying an annuity but rather to remind you to perform your own due diligence on the underlying insurance company.

Annuities and the DOL fiduciary rules

The Department of Labor’s fiduciary rules that will govern which financial products financial advisors use for clients in their retirement accounts do not prohibit the use of annuities, but the new rules do require much more disclosure and justification when they are used. The final draft of the rules also cover indexed annuities which is different from drafts of the rules prior to the final version.

Should you buy an annuity? 

Annuities are not a bad product as long as you understand what they can and cannot do for you. Like anything else you need to shop for the right annuity. For example, an insurance agent or registered rep is not going to show you a product from someone like Vanguard that has ultra-low fees and no surrender charges because they receive no commissions.

An annuity can offer diversification in your retirement income stream. Perhaps you have investments in taxable and tax-deferred accounts from which you will withdraw money to fund your retirement. Adding Social Security to the mix provides a government-funded stream of payments. A commercial annuity can also be of value as part of your retirement income stream, again as long as you shop for the appropriate product.

Annuities are generally sold rather than bought by Baby Boomers and others. Be a smart consumer and understand what you are buying, why a particular annuity product (and the insurance company) are right for you, and the benefits that you expect to receive from the annuity. Properly used, an annuity can be a valuable component of your retirement planning efforts. Be sure to read ALL of the fine print and understand ALL of the expenses, terms, conditions and restrictions before writing a check.

Please contact me with any thoughts or suggestions about anything you’ve read here at The Chicago Financial Planner. Don’t miss any future posts, please subscribe via email. Please check out our resources page as well.  

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5 Tips to Manage Taxable Mutual Fund Distributions

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With the end of the year in sight it’s time for year-end mutual fund distributions. If you hold mutual funds in taxable accounts, these distributions will be taxable to you.

taxable mutual fund distributions

Even with the weakness in the stock market to start the year, the Bexit vote in United Kingdom and recent pre-election weakness many mutual funds have gains embedded from a seven-year plus bull market.

Short of selling the funds, which may or may not a good idea, here are 5 tips to manage taxable mutual fund distributions.

Don’t buy the distribution 

During November and December mutual fund companies will publish information about fund distributions on their websites. If you are looking to add to a position or start a new mutual fund position in a taxable account it is important that you know the dates of these distributions and take the anticipated distribution into account. You don’t want to buy a fund shortly before a significant distribution and then owe taxes on the distribution only having owned the fund for a short time.

Even if you reinvest distributions on mutual funds held in a taxable account the distributions are still taxable in the year received. These distributions can be added to your cost basis in fund which can take a bit of the sting out of this.

Consider tax-loss harvesting to offset capital gains distributions 

As you go through your taxable accounts near the end of the year consider selling holdings with a loss to offset some of the capital gains distributions from your funds.

Just as with gains and losses generated from the sale of investments, long-term capital gains are matched against long-term capital losses and likewise with short-term capital gains and losses.

Tax-loss harvesting or any tax strategy should only be used if it makes sense from an investment point of view.

Index funds are not a cure-all for taxable mutual fund distributions

Index funds tracking standard broad-market indexes are generally pretty tax-efficient. That doesn’t mean that this will be the case each and every year. Further index funds and ETFs tracking small and mid-cap indexes may need to make more transactions in order to track their respective indexes.

As smart beta products become more popular they will likely be less tax-efficient than more common market-cap weighted index products. Smart beta funds will likely need to buy and sell more frequently in order to rebalance to the their underlying benchmark than more standard index products, potentially resulting in larger capital gains distributions.

Don’t let the tax tail wag the investment dog 

While it is aggravating to receive large taxable mutual fund distributions, it is rarely a good idea to sell an investment holding solely for tax reasons.

Mutual fund distributions are one of three types:

  • Dividends
  • Short-term capital gains
  • Long-term capital gains

All three have different tax implications.

Ordinary dividends and short-term capital gains are taxed at your highest marginal ordinary income tax rate. Long-term capital gains are taxed at preferential rates ranging from 15% to 20% with higher income tax payers subject to the 3.8% Medicare tax. Qualified dividends are taxed at these same rates as well.

That said it is important to pay attention to the tax efficiency of the mutual funds that you are using in your taxable accounts. 

Consider distributions when looking to rebalance 

Year-end is a good time to look at rebalancing your entire portfolio, both taxable and tax-deferred accounts.  As you look to rebalance your portfolio consider reducing positions in taxable mutual fund holdings that continually throw off large distributions. If the fund is a good holding look for ways to own it in a tax-deferred account if possible.

The decision with regard to the taxable portion of your portfolio always involves taxes to one extent or another. If you were looking to reduce your position in the fund anyway it can make sense to sell it prior to the record date for this year’s capital gains distribution. If selling the fund would result in a capital gain, offsetting the gain against a realized loss on another holding could be a good strategy.

The Bottom Line

With the gains in the stock market over the past few years many investors may find themselves the recipient of large distributions this year in spite of weakness in the markets over the course of the past year. When possible consider tax-efficiency when buying mutual funds in a taxable account.

Please contact me with any thoughts or suggestions about anything you’ve read here at The Chicago Financial Planner. Don’t miss any future posts, please subscribe via email. Please check out our resources page as well.  

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