Objective information about financial planning, investments, and retirement plans

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.

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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. 

 

Understanding Your Bond Fund’s Duration

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Interest Rates

For most of the past 30 years bonds and bond mutual funds have had the proverbial wind in their sails. Interest rates have steadily headed downwards. Bond prices and interest rates have an inverse relationship.

Last week, however, the Fed increased interest rates by 25 basis points (0.25%). They also indicated that they would continue to raise rates this year as, in their view, our economy has reached a new phase. This is part of an overall tightening of the money supply to keep the economy from overheating, including an effort to keep inflation in check.

Many investors may be wondering what this means for their bond mutual funds ETFs. A key number that all holders of bond funds and ETFs must know and understand is the fund’s duration.

What is duration? 

Bond mutual funds and ETFs are a portfolio of individual bonds.

According to Morningstar, “Duration is a time measure of a bond’s interest-rate sensitivity, based on the weighted average of the time periods over which a bond’s cash flows accrue to the bondholder.” A bond’s cash flows include the value received at maturity, generally $1,000 per bond, and the periodic interest payments received by the holder of the bond. A bond’s duration is expressed in years and is generally shorter than its maturity.

All things being equal, a bond with a longer time to maturity will have a higher duration meaning its price is more sensitive to changes in interest rates. Likewise, the higher the bond’s coupon rate (the stated interest rate paid by the bond) the lower the bond’s duration. Bonds with a shorter time to maturity and a higher coupon rate will have a lower duration and their price will be less sensitive to changes in interest rates.

The duration of a bond fund or ETF can be found on the fund’s fact sheet usually posted on the fund company’s site, or the portfolio tab on the fund’s listing on Morningstar.com.

What does bond fund duration tell us? 

The largest bond fund, Vanguard Total Bond Market Index (ticker VBMFX), has an effective duration of 6.05 years according to Morningstar. This tells us that if interest rates rise by 1% the value of the underlying bonds held by the fund would likely decline by around 6.05%.  Note this number is an approximation and bond prices are impacted by factors other than changes in interest rates. This fund roughly tracks the aggregate U.S. bond market.

By comparison Vanguard Long-Term Investment Grade (ticker VWESX) has longer duration of 13.31 years and would see a greater impact from rising interest rates.

The Vanguard Short-Term Bond Index ETF (ticker BSV) has a duration of 2.76 years.

The actively managed Double Line Total Return Bond Fund I (ticker DBLTX), managed by Jeffrey Gundlach who many call the “bond king,” has a duration of 3.98 years.

What should I do now?

As mentioned above, duration is a good indicator of the potential impact of a change in interest rates upon the value of your bond fund, but other factors also come into play. In 2008, many bond funds saw outsized losses and investors moved their money into Treasuries as a safe haven during the financial meltdown.

Many high-quality bond funds suffered major losses that year based only upon this flight to quality by investors.

Longer term the total return of a bond fund or ETF is driven by income payments as well as the direction of interest rates. Lower coupon bonds will be replaced by bonds with higher coupon rates over time.

Bonds are traded on the secondary market and prices are a function of supply and demand much like with stocks.

Bond mutual funds and ETFs offer the advantage of a managed portfolio.  On the flip side unlike an individual bond, bond mutual funds and ETFs never mature.

Is it time to get out of bond funds?  The point of this article is not to advocate that you do anything differently, but rather that you understand the potential duration risk in any bond mutual funds or ETFs that you currently hold or may be considering for purchase.

Bond funds and ETFs still have a place in diversified portfolios, but for many investors the characteristics of the fixed income portion of their portfolios may need an adjustment. This might mean shortening up on bond fund duration and looking at other, non-core types of bond funds.

The landscape of the financial markets is continually evolving and interest rates are a part of this evolution. As investors we need to understand the potential implications on our portfolios and adjust as needed.

Approaching retirement and want another opinion on where you stand? Not sure if you are invested properly for your situation? 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.  

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Investing Seminars – Should You Attend?

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It must be the season for investing and retirement dinner seminars. I’ve received a number of these invitations in the mail recently.

Typical was one from a local investment firm “___ Cordially Invites You to Attend an EXCLUSIVE Dinner Gathering!” Wow, me invited to anything that was exclusive?  The only brokerage sponsored investment “seminar” that I have ever attended featured legendary market guru Joseph Granville who among other things played the piano in his boxer shorts. It was in a movie theater in Milwaukee back in grad school, no food was involved.

Opening the invitation, it was from a well-known brokerage firm. The topic of the seminar is “Strategies for helping build a stronger portfolio.” The areas to be covered include:

  • Outlook for Domestic/International Stock & Bond Markets
  • Focus on distributions:  strategies for managing your retirement income
  • Developing a systematic process to help GET and STAY on the right financial track
  • Strategies to help take advantage of upside market potential while planning for a possible downside

So far this all sounds great. Reading on I noticed that while the session is sponsored by two brokers from the firm, the featured speakers were from a mutual fund company that offers funds that are often sold by commissioned reps while the other speaker was from an insurance company who is big in the world of annuities.

Should you attend? 

Clearly the objective is to sell financial products to the attendees, this is reinforced by the choice of speakers. That said there might be some good information available, the topics are certainly timely especially for Baby Boomers and retirees.

Consider attending one of these seminars only if you feel that you can resist a sales pitch. In the case of this session, the restaurant is a pretty good one that is close to my home. I am often tempted to check out one of these seminars out of professional curiosity, a free meal at a good restaurant would be an added bonus.

What are you hoping to gain from attending? The brokers are likely spending a fair amount of money on this session and expect a return on their investment. There will be a good deal of sales pressure at the very least to schedule a follow-up session with them.

Think about your real objective 

If you want a good meal and perhaps a little bit of knowledge, go ahead and attend.

If you are serious about finding a financial advisor to guide you to and through retirement, perhaps you should forego the meal and try to find someone who is a good fit for you. I strongly urge that you seek a fee-only advisor who sells only their knowledge and advice. NAPFA (a professional organization for fee-only advisors) has published this excellent guide to finding a financial advisor.

A free meal is great, but in the end as they say, there are no free lunches.

Approaching retirement and want another opinion on where you stand? Not sure if you are invested properly for your situation? 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.  

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. They had a good season and beat the Giants and the top-seeded Cowboys in the playoffs. I attended the game against the Giants at football’s holy shrine, Lambeau Field, my first time attending a playoff game.

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 Atlanta is an original NFL team.

How has the Super Bowl Indicator done?

According the Wall Street Journal, the seven-year win streak for this indicator was broken last year when Denver won and the market had an up year in 2016. The article said that the indicator has held true in 40 of the 50 Super Bowls that have been played.

Quoted in a Wall Street Journal article before last year’s 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.
  • 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 seven 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.  

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Small Business Retirement Plans – SEP-IRA vs. Solo 401(k)

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One of the best tax deductions for a small business owner is funding a retirement plan.  Beyond any tax deduction you are saving for your own retirement.  As a fellow small business person, I know how hard you work.  You deserve a comfortable retirement.  If you don’t plan for your own retirement who will? Two popular small business retirement plans are the SEP-IRA and Solo 401(k).

Small Business Retirement Plans – SEP-IRA vs. Solo 401(k)

SEP-IRA vs. Solo 401(k)

SEP-IRA Solo 401(k)
Who can contribute? Employer contributions only. Employer contributions and employee deferrals.
Employer contribution limits For 2016, up to 25% of the participant’s compensation or $53,000 whichever is less. The maximum for 2017 is $54,000 Contributions are deductible as a business expense and are not required every year. For 2016, employer plus employee combined contribution limit is a maximum of 25% of compensation up to $53,000 ($59,000 if the employee is age 50 or older).  For 2017 the maximums are $54,000 and $60,000, respectively. Employer contributions are deductible as a business expense and are not required every year.
Employee contribution limits A SEP-IRA only allows employer contributions. Employees can contribute to an IRA (Traditional, Roth, or Non-Deductible based upon their individual circumstances). $18,000 for 2016. An additional $6,000 for participants 50 and over. In no case can this exceed 100% of their compensation. The limits are unchanged for 2017.
Eligibility Typically, employees must be allowed to participate if they are over age 21, earn at least $600 annually, and have worked for the same employer in at least three of the past five years. No age or income restrictions. Business owners, partners and spouses working in the business. Common-law employees are not eligible.

Note the Solo 401(k) is also referred to as an Individual 401(k).

  • While a SEP-IRA can be used with employees in reality this can become an expensive proposition as you will need to contribute the same percentage for your employees as you defer for yourself.  I generally consider this a plan for the self-employed.
  • Both plans allow for contributions up your tax filing date, including extensions for the prior tax year. Consult with your tax professional to determine when your employee contributions must be made. The Solo 401(k) plan must be established by the end of the calendar year.
  • The SEP-IRA contribution is calculated as a percentage of compensation.  If your compensation is variable the amount that you can contribute year-to year will vary as well. Even if you have the cash to do so, your contribution will be limited by your income for a given year.
  • By contrast you can defer the lesser of $18,000 ($24,000 if 50 or over) or 100% of your income for 2016 and 2017 into a Solo 401(k) plus the profit sharing contribution. This might be the better alternative for those with plenty of cash and a variable income.
  • Loans are possible from Solo 401(k)s, but not with SEP-IRAs.
  • Roth feature is available for a Solo 401(k) if allowed by your plan document. There is no Roth feature for a SEP-IRA.
  • Both plans require minimal administrative work, though once the balance in your Solo 401(k) account tops $250,000, the level of annual government paperwork increases a bit.
  • Both plans can be opened at custodians such as Charles Schwab, Fidelity, Vanguard, T. Rowe Price, and others. For the Solo 401(k) you will generally use a prototype plan. If you want to contribute to a Roth account, for example, ensure that this is possible through the custodian you choose.
  • Investment options for both plans generally run the full gamut of typical investment options available at your custodian such as mutual funds, individual stocks, ETFs, bonds, closed-end funds, etc. There are some statutory restrictions so check with your custodian.

Both plans can offer a great way for you to save for retirement and to realize some tax savings in the process.  Whether you go this route or with some other option I urge to start saving for your retirement today 

Approaching retirement and want another opinion on where you stand? Not sure if you are invested properly for your situation? 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.  

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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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3 Financial Products to Consider Avoiding

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Before buying ANY financial product make sure that this product is right for you in terms of your unique, personal financial situation.  Financial products are tools and just like your projects around the house you should use the right tool for the job, not the tool that the financial rep wants to sell to you.

Here are three financial products that you should consider avoiding.

Equity-Indexed Annuities 

Equity-Indexed Annuities are an insurance-based product where the returns are tied to some portion of the performance of an underlying market index such as the S&P 500.  They are also called fixed-index insurance products and indexed annuities. Your gains are limited to a portion of what the index gains and there is generally some sort of minimum return to limit (or eliminate) your risk of loss.  As you can imagine these were pitched heavily to Baby Boomers and retirees after the last market downturn and are still being sold based upon fear today.

Two problems here are generally high internal expenses and surrender charges that keep you locked in the product for years. Worse yet, these internal expenses can be hard to isolate. If you decide to go ahead with the purchase of an Equity-Indexed Annuity be sure that you understand all of the details including the level of index participation, expenses, surrender charges, and the health of the underlying insurance company. Check out FINRA’s Investor Alert regarding Equity-Indexed Annuities for more cautionary information.

Proprietary Mutual Funds

It is not uncommon for registered reps and brokers to suggest mutual funds from the family run by their employer. In many cases they are incentivized or even required to do so. While some of these funds are perfectly fine, all too often in my experience they are not.  Whether via high fees and/or low performance these are often investments to be avoided.

A lawsuit against Ameriprise Financial brought by a group of participants in the company’s retirement plan alleged the company breached its Fiduciary duty by offering a number of the firm’s own funds in the plan and that these funds then paid fees back to Ameriprise and some of its subsidiaries as revenue sharing. The suit was ultimately settled.

JP Morgan also settled a suit by some retail investors over the bank steering clients into their more expensive proprietary funds over those of other families.

Load Mutual Funds

It is important that you understand the ABCs of mutual fund share classes.  In the commissioned/fee-based world reps often sell mutual funds that offer compensation to them and to their broker-dealers.  A shares charge an up-front commission plus a trailing fee (often a 12b-1) of somewhere in the neighborhood of 0.25% or more.

B shares charge no up-front commissions, but carry an additional back-end load as part of the ongoing expense ratio.  This can amount to an addition 0.75% or more added to the fund’s annual expenses.  In addition these shares also contain a surrender charge that typically starts at 5% if your sell the fund before the end of the surrender period.  B shares have been largely phased out by most fund providers.

C shares typically have a permanent 1% level load added to the fund’s expense ratio and carry a one year surrender period.

These sales loads ultimately reduce the amount of your investment and are an expensive form of advice. Nobody expects financial advisors or any other professional to provide financial advice for free. Unless the person to whom you are paying these pricey loads is providing extraordinary advice, this is a very expensive way to go.

The DOL fiduciary rules

The fiduciary rules introduced by the DOL (Department of Labor) in April of 2016 impose a far greater level  of disclosure on financial advisors. The rules require financial advisors to act as fiduciaries when providing advice to clients on their retirement accounts such as IRAs.

The fiduciary rules require advisors to have their client sign a disclosure document for many financial products with sales charges and trailing commissions if used in a retirement account. Load mutual funds and proprietary mutual funds will most likely require a BICE (Best Interest Contract Exemption) disclosure. Additionally Equity-Indexed Annuities were not exempted from these disclosures in the final draft of the rules as they had been in earlier drafts.

It will remain to be seen how the fiduciary rules will impact these three products, both within retirement accounts and overall. As an example, broker Edward Jones recently announced that mutual funds and ETFs will no longer be offered to clients in retirement accounts where commissions are charged.

Before making any financial or investment decision review your specific situation. Consult a fee-only financial advisor if you feel that you need financial advice.

Approaching retirement and want another opinion on where you stand? Not sure if you are invested properly for your situation? 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.  

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4 Benefits of Portfolio Rebalancing

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The past year has been volatile for investors. Between a dip in the markets last year, a shaky start to the current year and the Brexit vote in the U.K. it has been quite a roller coaster ride for investors. In spite of all of this, major market indexes stand at or near record levels. In the course of all of this, your portfolio may have strayed from your target allocation and it might be time to rebalance.  Here are 4 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.

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. 

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