No More Mr. Nice Guy

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nice guy

photo by Andrew Caird

 

People often tell me that their financial adviser is a “nice guy”, and I think to myself (or say out loud if I’m feeling bold), “He can’t be too nice if he sold you that.”

Please don’t call me a nice guy. Not if nice guys sell people financial products they don’t need. Not if nice guys spend more time learning sales techniques than gaining financial planning knowledge. And not if nice guys charge too much and deliver too little.

You wouldn’t hire an attorney with a great personality if you knew she wouldn’t represent only your interests. And you wouldn’t trust your charming doctor if you knew she was compensated for prescribing you certain drugs. So why would you hire a financial adviser who isn’t required to represent your best interest and may be incentivized to do otherwise?

When it comes to getting financial advice, I encourage you to evaluate potential advisers based on their qualifications, experience, and compensation method. Make sure that whomever you choose acts as a fiduciary who is required to put your best interest first. If he also happens to be a nice guy, that’s icing on the cake.

Buying Cars and Annuities

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What do buying annuities and buying cars have to do with each other? Not much actually, but I’ve recently responded to questions about each on the new personal finance website, Dimespring.com. Check out my answers at the links below:

How much should I save before buying a car?

Is a variable annuity right for me?

 

Financial Advisor Compensation Models

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Rob Oliver explains how financial advisors get paid and suggests questions to ask advisors about how they are compensated.

Resource links:

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Please note that this blog post and video are for educational purposes only and should not be construed as advice specific to your situation. You should get advice from a legal, accounting, or investment professional before deciding what course of action is appropriate for you.

Pick A Number

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Imagine I gave you the option of picking an envelope from one of two hats. Hat One holds 100 envelopes each containing $920. Hat Two contains 100 envelopes that hold either $751 or $1,016. Which hat would you choose?

Before you pick, you should know how many of the envelopes in Hat Two contain $751 and how many contain $1,016. That way, you can calculate the probability of whether you will come out ahead of the sure $920 in Hat One.

In this case, Hat Two holds 66 envelopes containing $751 and 34 envelopes containing $1,016. Now which hat would you choose? It may be obvious, but let’s do the math:

Hat One: (100 x $920) / 100 = $920
Hat Two: (66 x $751) + (34 x $1,016) / 100 = $841.10

As you can see, you stand to make $841.10 from Hat Two based on probability and should pick the sure $920 from Hat One. Any rational person should pick from Hat One, yet most of us pick from Hat Two when it comes to investing.

Hat One represents an index fund, specifically the Vanguard 500 Index Fund during the years 1984-2009*. Hat Two represents the 136 actively-managed domestic equity funds that were around in 1976 when the Vanguard 500 Index Fund was born and had survived through 2009. The envelopes represent one year’s worth of the average annual compounded return for each group of funds. In the case of the Vanguard 500 Index Fund (Hat One), an investment of $10,000 would have yielded you $920 per year on average over the 25-year time frame.

For the actively-managed funds (Hat Two), two-thirds underperformed the Vanguard 500 Index Fund by an average of 1.69% over the time frame yielding a 7.51% average annual return or $751 per year. The remaining one-third of the actively-managed funds beat the Vanguard 500 Index Fund by 0.96%. That group averaged a 10.16% annual return or $1,016 per year on your $10,000 investment.

As shown above, randomly selecting an actively managed fund would have yielded you an 8.41% annual return versus 9.2% for the Vanguard 500 Index Fund. “But Rob”, you say, “I don’t randomly picks funds. My investment adviser selects them after doing lots of research”. Sorry to bust your bubble, folks, but no one can regularly select the winning one-third of actively-managed funds in advance, and the winners are usually not those that have outperformed in the past.

To make matters worse for the actively-managed funds, the results from this study do not include the actively-managed funds that closed or merged during the 25 years (the vast majority of which were under-performing). The results also do not account for sales loads (commissions). If loads were included, the Vanguard 500 Index would have beaten 88% of the actively-managed funds.

“Fair enough”, you say, “But this is one area of the market and one period of time. Don’t actively managed funds beat index funds in other asset classes like small-cap stocks or corporate bonds?”

Not according to Richard Ferri’s extensively researched book, The Power of Passive Investing. In fact, it shows that about one-third of actively-managed funds outperform their indexes across multiple asset classes and various time periods and that the amount you are compensated on average for randomly selecting a winning actively-managed fund is not enough to compensate you for the higher probability and lower return of selecting an under performing fund.

My advice is to stick to low-cost index funds whenever possible. Choose Hat One.

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*The study used in this post is from The Power of Passive Investing by Richard Ferri.

 

Numbers to Know for 2011

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Happy 2011! Below is a list of the essential numbers and phaseout ranges for this year.

  • Maximum contribution to a Traditional or Roth IRA: $5,000 + $1,000 catch-up if age 50 or over (no change).
  • Maximum contribution to a 401(k) or 403(b) plan: $16,500 + $5,500 catch-up if age 50 or over (no change).
  • Income (modified adjusted gross income) phase out range for deductible Traditional IRA contribution, married filing jointly and covered by employer sponsored retirement plans: $90,000-$110,000.
  • Income phase out range for deductible Traditional IRA contribution, married filing jointly and spouse covered by employer sponsored retirement plan: $169,000-$179,000.
  • Phase out range for deductible Traditional IRA contribution, filing single and covered by employer sponsored retirement plan: $56,000-$66,000 (no change).
  • Phase out range for deductible Traditional IRA contribution, filing single and not covered by employer sponsored retirement plan: no limit.
  • Phase out range for Roth IRA contribution, married filing jointly: $169,000-$179,000.
  • Phase out range for Roth IRA contribution, filing single: $107,000-$122,000.
  • Social Security Cost of Living Adjustment: 0%.
  • Annual gift tax exclusion amount: $13,000 (no change).
  • Marginal income tax rates.
  • Tax changes passed in the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010.
  • Maximum deductible contribution to the Michigan Education Savings Program for Michigan residents: $5,000 single, $10,000 married (no change).

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Please note that this blog post is for educational purposes only and should not be construed as advice specific to your situation. You should get advice from a legal, accounting, or investment professional before deciding what course of action is appropriate for you.

Year End Planning Tips

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With the end of 2010 right around the corner, I offer the following year-end financial planning tips:
  • Contribute to your state’s 529 Plan by the end of the year. Many states, such as Michigan, offer a state income tax deduction if you make contributions to the plan that the state sponsors.
  • Convert your Traditional IRA to a Roth IRA by year end. The IRS created a special election for conversions made in 2010 that will allow you to spread the income from the conversion over 2011 and 2012. You can learn about Roth conversions at Vanguard and use its Roth IRA Conversion Calculator to decide if conversion is right for you.
  • Lock-in capital gains and pay at current capital gains rates. Long-term capital gains rates are scheduled to increase in 2011 unless new laws are enacted. If you have unrealized capital gains in a taxable investment account, consider selling your long-term winners and pay at the 15% rate (or 0% if you are in the 10% or 15% ordinary income tax brackets). You can even sell and immediately re-buy the same security to reset its cost basis. The wash sale rule does not apply to gains. You can learn more about this strategy and whether it is in your best interest by reading this article at Fairmark.com.
  • Avoid buying mutual funds in a taxable account late in the year. Mutual funds are required to distributed realized gains each year, and you should avoid paying taxes on distributions when you were not around to participate in the gain. Many fund companies report their expected distributions prior to year-end. Check for planned distributions before you buy or wait until the new year.
  • Take Required Minimum Distributions (RMD) from your IRAs or employer-sponsored retirement plans if you have reached age 70 1/2. Failure to take a required withdrawal can result in a 50% penalty on the amount not withdrawn.
  • Make annual exclusion gifts before year-end. You can give $13,000 in 2010 to an unlimited number of individuals free of gift tax. You cannot carry over unused exclusions from one year to the next.

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Please note that this blog post is for educational purposes only and should not be construed as advice specific to your situation. You should get advice from a legal, accounting, or investment professional before deciding what course of action is appropriate for you.

Variable Annuity in an IRA

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In my profession as a Certified Financial Planner™, nothing gets my blood boiling faster than blatant acts of self-interest by other financial advisers. One of the most obvious examples of this type of behavior is when advisers invest their clients’ Individual Retirement Arrangements (IRAs) in variable annuities.

In my view, variable annuities are almost always a bad idea as a stand-alone investment. Most are exceedingly expensive, complicated, and illiquid. Occasionally, a low-cost variable annuity can be justified as an additional way to invest on a tax-deferred basis if an investor is already maximizing her other tax-deferred investment options. But this situation is a rare exception to the rule.

Yet I regularly work with new clients whose former advisers recommended they invest their IRAs in variable annuities even though an IRA is already a tax-deferred investment vehicle. In these cases, the investors are stuck (due to many years of high surrender charges) in high-fee products for no good reason and I’m left to help them make the best of a bad situation.

I was recently working with a colleague on a project for a new client, and he asked me why the client had bought a variable annuity in his IRA. I replied that he was asking the wrong question. Investors put their trust in financial advisors to steer them in the right direction. The appropriate question, I said, was why had the so-called advisor sold it to the client. Unfortunately, the answer to that question is all too clear to those of us in the industry – for the large commission.

But don’t take my word for it. The U.S. Securities and Exchange Commission and the Financial Industry Regulatory Authority have written investor alerts on the subject.

If your financial adviser recommends that you invest your IRA in a variable annuity, he almost certainly does not have your best interest in mind. It’s time to find a new adviser.

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Please note that this blog post is for educational purposes only and should not be construed as advice specific to your situation. You should get advice from a legal, accounting, or investment professional before deciding what course of action is appropriate for you. Please note that this blog post is for educational purposes only and should not be construed as advice specific to your situation. You should get advice from a legal, accounting, or investment professional before deciding what course of action is appropriate for you.

Skimmers, Jitters, and Complaints

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Below are the interesting personal finance links I have come across since my last post:

Personal Finance Links

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  1. Visit Dinkytown for free personal finance calculators.
  2. If you invest in TIAA Traditional through your employer’s retirement plan with TIAA-CREF, I suggest you read this
  3. Phased out of making Roth IRA contributions? Try the backdoor.
  4. Check out Susan Beacham’s blog if you are interested in kids and money.
  5. Vanguard recently rolled out new exchanged traded funds and a new index fund.
  6. I see eye to eye with Rick Ferri who encourages Forbes readers to buy, hold, and rebalance.
  7. Educate yourself on personal finance through NAPFA’s consumer series. It’s free but you have to register.
  8. Do bonds confuse you? You’re not alone. Learn about bonds courtesy of Vanguard.
  9. Morningstar’s Natalie Choate provides tips and traps about IRA conversions. Scroll down the page to May 4, 2010.
  10. Get credit report tips from Gerri Detweiler via the Garrett Planning Network.
  11. Rick Ferri writes about a new trend in index funds to keep an eye on.

Are your Emotions Costing you 5%?

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I’m a staunch believer that emotions and investing do not mix. The right approach is to determine an appropriate asset allocation for yourself, let the markets do what they will, and then rebalance your portfolio back to its target allocation at pre-determined intervals. I encourage most of my clients to rebalance on an annual basis.

However, many investors do not take this type of approach and, instead, let their emotions determine their asset allocation. When the going gets tough, they abandon their allocation to stocks and flee to safety. Then they wait until the waters are calm and a sharp recovery has taken place before getting back into stocks.

What’s the big deal? On average, investors are getting a 5% lower return on their stock mutual fund investments than the funds’ reported returns. This is mostly due to investors buying in and out of funds based on emotions.

I encourage you to listen to FundAdvice.com‘s recent, four-minute podcast on the subject.