Kickback or Revenue Sharing?

Kickback: a percentage of income given to a person in a position of power or influence as payment for having made the income possible: usually considered improper or unethical.

Recently, I was reviewing a retirement plan for a potential business client and started digging into the costs of the plan. The plan administrator didn't know how much they were paying for the SIMPLE IRA so I called the mutual fund company to ask general questions about a retirement plan with them. What I found was another example of a sweet deal between brokers and mutual funds. 

One of the top 5 mutual fund companies by assets managed has a deal to pay brokers 1% annually for retirement plans with $1,000,000 or more. This is a subsidy to the business with the SIMPLE IRA because they don't have to pay commissions to the broker when buying the mutual fund. The client had no idea this is going on and maybe if they did they would question if the broker put them in the best fund company.

The next question to ask is where is that 1% subsidy coming from? It's coming from high commissions charged to investors with less than $1,000,000 and from higher than necessary mutual fund expenses. These types of "revenue sharing" agreements unjustly raises the costs for many investors, lowers client returns, and creates conflicts between the broker and the client. 

I have seen and heard how broker incentives and mutual fund companies entice brokers to sell products that benefit them and not always the client. A broker sells annuities to earn an 8% commission. A broker sells an exotic product, has no idea how it works but does know he receives an extra 2% commission along with the normal annual fee of 1% and doesn't have to tell the client. A broker has a short list of nine mutual fund companies she is allowed to sell primarily because of revenue sharing agreements. A broker who meets sales quotas receives free trips to Africa or Hawaii. 

It irritates me that brokers get away with receiving money from dual sources and are not required to disclose that information directly to the client. Instead, they bury their compensation in the fine print of thick prospectuses with legal jargon.

It is important to reiterate previous blog posts I have written. Please don't confuse or interchange financial advisor with a broker. Financial Advisors are held to a higher standard, a fiduciary standard, and can only receive compensation from fees paid by their clients. On the other hand, brokers are product salespeople who earn commissions and revenue from the companies they sell products for. The problem is brokers have found a way, through lobbying politicians and regulators, to take fees and commissions from clients and mutual fund companies. They don't have to disclose important information to their clients, don't have to work in the clients best interest and have conflicts of interest. I believe there is only one way to provide objective, independent advice that is in the clients best interest and that's as a fee-only, fiduciary financial advisor.

Value Added: Examples of Building and Protecting Wealth

How does a financial planner/advisor make and save you money?

Last year, Vanguard released a study showing that financial advisors can add about 3% in net returns annually. I have a great recent example of a client who is now going to save about $3,000 a year.

The client inherited a couple of annuity contracts from her parents. After digging deep to uncover all of the fees I tabulated their annual costs to be over $6,000 per year. Because I am an independent financial planner I can work with any number of companies that offer more appropriate investment products for my clients at lower costs. Although I do not place annuities in high regard it made the most sense for the client to exchange their existing contract for another annuity company that didn't charge a commission. By doing a 1035 exchange to a low-cost, flat fee annuity company the client will receive more service, be more diversified, use low-cost index funds with better historical performance and have their fees cut in half.

Asset location is another overlooked area to help save in taxes and increase returns. I have done many reviews for prospects where the other company had their money in all the wrong places. Investments that pay out a lot in interest, capital gains, and dividends were in taxable accounts.  But stock funds that were tax efficient were in IRAs. A better option would have been to own income investments in the IRA to protect it from being taxed at the highest income tax rate. It is important to combine all your assets, determine an appropriate asset allocation, and then place the pieces in the right account for the best tax treatment. Depending on your tax bracket, Vanguard figures the value added from an advisor providing proper Asset Location can be up to 0.75%.

These are just two examples of how an independent Certified Financial Planner, like myself, can help clients build and protect their wealth. There are complex matters that need to be considered from many different angles. Having an expert that is working in your best interest, is trustworthy and has the right skills, knowledge, and tools to do the job gives you a much better opportunity of accomplishing your goals.

Recap and 2015 Outlook

Hello & Happy 2015!

I am having a hard time finding a starting point for this recap of 2014 and outlook for 2015. My first thought is to write about financial planning and how all the pieces work together to build and support the other pieces. I am afraid that most people think that is boring and the only way to keep their attention is to talk about stock and bond returns in 2014. But that is not who I am. From the start of my company in 2008 I have always strived to provide advice and a perspective that is different from financial sales people. The focus of my business is to be a trusted financial professional who gives purpose to personal finances.

I can list a bunch of numbers and figures but what does it really mean to you and did we have control over it? The S&P 500 was up 11% in 2014. Great! Did we have any control over it? No. What we did control is whether or not we added money to our retirement account to take advantage of those gains and accomplish our long-term goals.

What if you had been consistently contributing $10,000 to your retirement accounts over the past 5 years? We rerun your Money Guide Pro financial plan and find that you can potentially retire two years earlier than you planned. Now that means something!

Most people thought bonds were going to crater in 2014 and the Federal Reserve would raise interest rates. Instead the U.S. aggregate bond fund (symbol: BND) was up +5.87% and has had positive returns in 6 out of the last 7 years. Did we control the bond market? No. Maybe we let fear overwhelm us and we kept too much money in a savings account that earned next to nothing. Or maybe, we controlled our fear and invested in stocks and bonds helping us earn a decent return.

Over the past 5 years, would you have rather earned 11% a year by investing in a balanced fund of 60% stocks and 40% bonds or 0.04% from a savings account? Would you have rather bought $10,000 worth of stuff you didn’t need or have earned an extra $7,000 to use towards a great family vacation? That has meaning and a purpose.

Having a financial plan and a budget is something else we control. They help us focus on what is important over the short-term and long-term. What we didn’t control was an Ebola outbreak, that the stock market would be a roller coaster, that oil prices would plummet at the end of the year, or that international stocks would be down -4.6% in 2014.

As we get started in 2015 I am refocusing my thoughts and actions on what I can control. Forget about the daily movements of the market, Wall Street forecasts and what the government is doing. Focus on what you spend, what you save, and what you invest.  How you control these three things will have a great impact on your life, your family, and your wealth.

Tax Loss Harvesting - What is it?

Who likes to pay lower taxes? Most do and one way to accomplish it is through Tax Loss Harvesting. 

When you use a taxable account to invest there is the added advantage to use the losses that may occur to lower your tax bill. There are three benefits to Tax Loss Harvesting:

1. Tax losses represent an interest-free loan that defers capital gains taxes you would otherwise owe into the distant future, and can even eliminate them entirely when you die.
2. After offsetting realized gains, you can use any remaining tax losses to deduct up to $3,000 from your regular income taxes each year.
3. Any remaining losses are rolled over into the subsequent years, so each year until your losses are used up, you can defer your capital gains and apply up to $3,000 against your income.

Suppose you had invested $10,000 into an ETF in a taxable account and later that year it fell to $7,000. Using tax loss harvesting strategy, the ETF is sold to lock in the $3,000 capital loss. Since you are a long-term investor you probably want to do one of two things:

  1. Buy a similar but not the exact same investment after the selling the ETF for a loss.

    OR

  2. Wait at least 30 days to buy the same ETF again.

If you buy the same investment within 30 days the "wash-sale" rule applies and you will lose the benefits of having a capital loss.

The capital loss is valuable in several ways. Before you pay any capital gains taxes each year, you use your capital losses to offset any capital gains, and pay taxes only if you have more gains than losses. If you have more losses than gains, you can apply up to $3,000 of your remaining capital losses against your regular income. And whatever capital losses are still left over can be carried forward indefinitely into future years. Each year, you get to first apply the carried forward losses against capital gains, and then use any remainder (up to $3,000) to reduce your ordinary income.

Using tax loss harvesting to offset capital gains doesn't actually eliminate the capital gains taxes you would have paid. Instead, it defers those taxes into the future. However, future money is worth less than money today.

Using tax loss harvesting to defer capital gains taxes is like receiving an interest-free loan from the IRS. Also, if you still own the shares when you die, your heirs will receive a stepped-up basis, and you will have gotten the up-front benefit from tax loss harvesting while avoiding the taxes on the back end entirely. Finally, the capital gains you owe in the future will be at the potentially lower capital gains rate, while the benefit you receive today of the $3,000 deduction is at your potentially marginal income tax rate. Remember, tax loss harvesting does not work in 401(k), IRA and other retirement accounts. Only taxable accounts.

Bonds - What are they?

Bonds

By definition:  A debt investment in which an investor loans money to an entity (corporate or governmental) that borrows the funds for a defined period of time at a fixed interest rate.

What this means…

A bond is a loan. It's that simple. Instead of you borrowing money from a bank, a company or government is borrowing money from you.

How do bonds work?

Bonds are an important part of an investor's portfolio, typically providing low but relatively stable returns. A bond can be considered a type of "loan". When a government or a corporation needs money, they can either borrow it from the bank, or they can borrow it from willing investors. When borrowing from investors the company will issue a bond in exchange for the money. The amount of money that is borrowed is called the "face value" or the "principal". The bond will promise the investor periodic interest payments (or coupon payments) over a certain time period. Most bonds are considered "fixed income securities" because the coupon payments are a fixed amount. Bonds typically pay these coupon payments annually, semi-annually or quarterly. At the end of the time period (called the maturity date), the investor is paid back the amount that was borrowed (the principal).

What about the Federal Reserve and interest rates?

Like stocks, bonds can be traded in a secondary market. In the secondary market, bonds will have a "price" that is often higher or lower that the principal amount. A major factor that affects the price of a bond is the market interest rate. The US Federal Reserve has a big influence over the market interest rate in the US. When market interest rates rise, the price of the bond falls, and vice versa. However, this only affects investors that actively trade bonds. On the other hand, investors that hold onto bonds until the maturity date are promised the principal amount, and aren't affected by the price of the bond. Unless a company goes bankrupt, no matter what happens with interest rates, an investor will receive that principal amount at the maturity date.

Why do people invest in bonds?

People invest in bonds because they are less risky than stocks, and still provides a relatively stable return. Keep in mind, while stock returns tend to outpace inflation, bond returns are eroded by inflation. Because the coupon payments of the bond tend to be fixed, the payments lose purchasing power as prices rise due to inflation. However, the advantage of bond returns is that they are less risky than stock returns. A company must make their debt payments, before they can declare a profit. Additionally, government bonds are generally considered safer than corporate bonds, since governments are less likely to default on their payments. Hence the coupon payments on your bonds are generally more secure than your stock returns.

Make Your Own Annuity

Strong opinions from consumers and financial planners are levied on annuities. People either love them or hate them. Some see annuities as valuable products with "guaranteed" income and a way to limit losses. Others see the guarantee as worthless and fees to be exorbitant. Personally, I find very very narrow uses for annuities and I believe there are too many sales people swindling consumers out their money with these products.

What exactly is an annuity? It is a contract between an individual and an insurance company. Some allow investing in stocks and bonds (Variable) while others start paying immediate monthly income (SPIA). All are indirect investments where the insurance company uses your money to invest, pay you back principal plus a portion of any returns, and earn a profit.

Here are some of the problems with annuities and ideas on how to create your own strategies to mimic insurance company's.

Variable Annuity: High fund fees, mortality fees, administrative fees, guaranteed income fees, surrender fees, rider fees. These are common costs associated with variable annuities and they can add up to 4% a year. Don't forget about the big up front commission of around 8% you have to pay. Variables also lack liquidity locking in your money for, say, 10 years. Before that time period is over you are only allowed to take out minimal amounts of principal each year. Amounts above what they deem acceptable will face stiff penalties. This limits your flexibility in case of an emergency and if your financial life changes.

Indexed Annuity: These are marketed as providing market returns without risk. The issue is state regulators have strict rules for how insurance companies can invest money forcing them to be conservative. This lowers the potential returns to them and the customer. Returns are usually tied to an index like the S&P 500 but with caps. For instance, the insurance company can stipulate that the return can be capped at 4% a year. So, if the S&P 500 goes up 9% you still only get 4%. But if it goes down 10% you have a 0% return. For this special privilege you will pay a large upfront commission and a large penalty, say 10%, if you want your money back early.

Income Annuity: A SPIA (Single Premium Immediate Annuity) and deferred life annuity fall in this category. They provide monthly paychecks to the annuitant for their lifetime. The issue here is most of the money coming in those monthly payments is returning your principal or what you put into it. I recently reviewed a fixed term SPIA for a client and it is paying 1.6% interest for 10 years. Take out taxes and inflation and they have negative total returns.

Annuity-like Strategies Without the Costs

First, don't forget everyone has annuity already. It is called Social Security. To maximize the income from that wait until full retirement or delay benefits until age 70. Every year you wait past full retirement to the maximum age of 70 you increase your benefit 8%. In contrast, taking Social Security at age 62 permanently decreases the benefit by about 30%.

Variable Annuity: Build a low-cost conservative portfolio using index funds of stocks, bonds and inflation protected bonds. Forty percent or less in stocks is a good place to start.

Indexed Annuity: With this strategy you go to each end of risk spectrum.  On one end you use ultra safe CDs and on the other side you use a stock fund. The majority of the money goes into the CD to protect principal but also earn some income. What is left goes into a total stock index fund that may provide an extra kick to your returns. You will have more control over your money and the potential for better returns than the annuity.

Income Annuity: Delaying Social Security is an easy and cost effective way to replace an income annuity. It will cost you a lot less than the annuity and Social Security annually adjusts for inflation with no additional cost to you. Inflation increases in an annuity takes a separate rider with additional fees. If you believe you need more retirement income look at building a bond ladder using inflation protected bonds.

With the help of a trusted Certified Financial Planner™ you can create your own annuity-like investment using the same principles and strategies as an insurance company but at a much lower cost.

Inspire, Educate, & Plan

If someone asks me what I do or what I am trying to accomplish I say this:

I am about three things: Inspiring, Educating and Planning.

I want people to unearth what is important, what they want and what will bring them happiness. Communicating with real life experiences, plain-spoken financial language, and a deep knowledge of personal finances builds trust and reassures them that they are taking the right path. Having the right financial planner will help put you in a different frame of mind and make the complex understandable so you are PLANNING WITH A PURPOSE.  Give it a try and see where it takes you!

10 Things You Need To Know: Hiring a Financial Planner

Here are the 10 things you need to know before hiring a financial planner:

1. What Do You Need: Depending on the complexity of your finances, you may need a one time review or ongoing support. Do you need help with one specific area of your finances like investment management? A one time review of your retirement plan or budget? Or someone who will tie your taxes, investments, insurance, estate, and retirement parts together? Make sure they offer all the services you need.

2. Your Best Interests, ALL THE TIME: Only some financial professionals have pledged to act in the client's best interests at all times. These types of advisors are called "fiduciaries." Advisors working for Registered Investment Advisor firms have a fiduciary standard all the time. 

Brokers have a lessor, more vague, standard where they are able to sell "suitable" products for your situation. Big brokers like Merrill Lynch, Morgan Stanley, and Edward Jones, and advisors at local banks go back and forth between the two standards to benefit their bottom line and not the clients. 

It comes down to loyalty. A fiduciary advisor is loyal to clients where a broker is loyal to the company its shareholders.

3. Background Check: Do your due diligence to avoid the "bad eggs" in the financial services industry. There are resources to see if disciplinary action has been taken against an advisor or broker. If you are considering a Registered Investment Advisor they must provide a brochure (Form ADV Part 2 A&B) disclosing information about the company and its representatives.

• Registered Investment Advisors: SEC Advisor Search
• Brokers: FINRA Broker Check

4. Some Are Pros, Some are Amateurs: Unlike other professions like a doctor or lawyer, anyone can say they are a financial planner. But, that doesn't mean they have any experience or credentials to provide you with quality financial planning. 

Again, check the person and or company at the SEC or FINRA websites. Credentials like the Certified Financial Planner (CFP®) are not easy to attain and show further expertise. Certified Financial Planners have years of experience; extensive knowledge and skill in all areas of financial planning; completed a background check; ongoing continuing education; and they adhere to ethical standards set by the governing body.

• CFP Lookup: CFP Certification

I attained my Certified Financial Planner designation after three years of working as an advisor, studied and passed six pre-tests and then a two-day 10 hour comprehensive exam. This rigorous testing prepared me and sharpened my knowledge to advise client's appropriately for many financial situations.

5. Avoid Fraud: To protect your money you should only work with someone who uses a Third Party Custodian. Companies like Charles Schwab, Scottrade, and Fidelity are examples of Third Party Custodians. They act as a check and balance for clients by keeping your money separate from the advisor and they provide independent statements to verify account balances.

6. A Financial Planner is NOT a Broker: This repeats some of the information above but it is important to emphasize the difference between the two. A true financial planner will provide unbiased advice that is in your best interest. They will look at all of your financial matters, understand what your goals are, work with you to create a plan to accomplish them and be by your side every step of the way. They will not sell you products or move you in and out of investments every month. 

Brokers are all about selling, selling, selling. They have corporate sales quotas, focus on gathering assets, earn big commissions on insurance products and other investments, don't disclose their compensation, and do not work in the clients best interests at all times.

7. How Are They Paid: There are three standard ways financial professionals are paid:

• Fee-Only: The only composition earned is directly from the client. It can be a flat dollar amount or a percentage of assets/net worth, or on an hourly basis. A Registered Investment Advisor firm has to disclose how they are paid, the amount or percentage and any conflicts up front. They can not receive commissions or kickbacks. This eliminates any incentive to sell products that are unnecessary or inappropriate for the client. Fee-only is the easiest to monitor and understand how much you are paying for the services you are receiving. Fee-only advisors adhere to the fiduciary standard.

• Commissions: This is a percentage charged on the amount of product sold. They more you sell the more you make. Variable annuities are notorious for high fees with up front commissions of  6% -7% and trailing annual fees of 3%. Load mutual funds like American Funds sold at Edward Jones can charge 5.75% commissions up front plus fees to the manager. That means you have to earn 7% or more to get back to even. And you don't receive any advice on other financial matters. They do not have to disclose any kick backs or revenue sharing agreements which provide incentive to sell one product over the other.

• Fee-Based: The term was deliberately created to seem better than the reality and it has become a great money maker for brokers. In truth, "fee-based" means brokers can charge you commissions and fees at the same time. They hide behind both broker and registered investment advisor labels and use them to benefit themselves. Brokers are able to sell a product with an upfront commission and then place it in an account that charges an annual fee on that same asset. Again, they do not have to disclose any kick backs or revenue sharing agreements which provide incentive to sell one product over the other.  

8. What Tools Do They Use: Is the advisor able to use the best industry tools or are they tied to only what their company allows? Are they technologically savvy so you can communicate or get information when and where you want? Because I am an independent financial planner I am able to evaluate and implement the technology tools I believe provide high value, are easy to use and relevant to my clients. Are they set up for video conferencing, sharing documents through Dropbox or another cloud based service, computer sharing, financial planning software?

9. How Do They Invest: History, research and studies show it is almost impossible to consistently beat the market. So why pay an actively managed fund more for something that doesn't perform better? Instead, look for an advisor that uses index funds. They are more tax efficient, have transparent investment holdings and have very low costs. It is also important that the advisor is focused on long-term investing (5 or more years), uses a diversified asset allocation strategy and rebalances.

10. What Advice Can They Give: Brokers can not give advice, only general "guidance", on investments inside 401(k) and other employee benefit plans. They won't give advice on these plans because they have to take on a fiduciary responsibility and that limits how and what brokers sell. 

RIA firms and their advisors can and will provide advice on all of your accounts and assets regardless of where they are. This gives clients a cohesive strategy across all their accounts so they are working to achieve their goals.

Social Security Benefits - What You Need to Know

How to maximize your Social Security benefits can be one the most important financial decisions in retirement. Navigating through the maze of Social Security rules can be one of the most difficult aspects of your retirement. Below is a summary of Social Security information that I think everyone needs to know.

• Determine Your Benefits: In 2011, Social Security stopped mailing annual estimated benefit statements as a cost savings measure. Recently, they revised this change so everyone will receive a statement every 5 years. I recommend that everyone should track their benefits more frequently by creating an account at: http://www.ssa.gov/myaccount/

• Earliest Start Date: Age 62 is the earliest that a person can start taking Social Security. The drawback to starting early benefits is the amount is permanently reduced. Depending on your full retirement, benefits can be reduced up to 35%. Everyone should make an estimate of the break even date for taking benefits early versus your full retirement age versus age 70 bonus benefits. The difficult part is guessing the date of death. To calculate your reduction of benefits use this calculator: http://www.ssa.gov/oact/quickcalc/early_late.html                                                                                                                     

• Full Retirement Age: This depends on the year you were born. 

          1943 to 1954: age 66

          Every year starting at 1955 to 1959 add 2 months

          1960 and later: age 67

• When to Apply: You must be at least 61 years and 9 months old to apply for Social Security benefits. You should not apply for benefits more than 4 months before you want to begin benefits. Benefits are paid the month after they are due. Remember to sign up for Medicare 3 months before age 65.

• Spousal Benefits: If you are married, you or your spouse, but not both can receive spousal benefits. To qualify, the spouse applying for spousal benefits needs to be at least 62 years of age and the other spouse has to currently be eligible or receiving Social Security. Again, benefits will be reduced if the spouse is younger than their full retirement age. In some cases the benefit can be reduced to 35% of the spouses benefit. On the other hand, taking spousal benefits can allow the other spouse to delay benefits thereby increasing the benefits in the future (see file and suspend below).

• Income Limits: If you start benefits before full retirement and still work, your social security can be reduced. In the 2014, if you are younger than your full retirement age for the entire year the maximum amount you can earn is $15,480. For every $2 earned above the maximum amount, $1 will be deducted from your Social Security benefit. If you reach your full retirement age in 2014 your benefits will reduced $1 for every $3 over $41,400 until the month you reach full retirement age. At your full retirement age, there is no reduction of benefits on any amount of income you earn.

• File and Suspend: Do you want to increase your benefit 8% per year? If you file and suspend at full retirement age, Social Security will increase your benefit 8% for every year you wait up to age 70. This could increase your total benefit by as much as 76% over starting Social Security at age 62. One catch. Make sure you pay Medicare part B out of your own pocket. Otherwise Social Security will not increase your delayed benefit.

• Divorced: After full retirement age, ex-spouses can collect spousal benefits on each others work histories and delay their individual full retirement benefits. To qualify you must be unmarried, marriage had to be 10 years or longer, be at least age 62, if ex-spouse is deceased you have to be 60 or older. If the divorced is filing for spousal benefits between 62 and full retirement age you must have been divorced for at least 2 or more years and benefits will be reduced. 

• Taxes: At full retirement age, the percentage of your social security benefits that are taxed depends on your income. Some sources like Traditional IRAs, SEPs, 401(k) withdrawals count towards your taxable income and can determine how much of your Social Security is taxed. On the other hand, ROTH IRA withdrawals do not count. Just another reason to consider contributing to a ROTH. The percentage of benefits that are taxable ranges from 0% to 85%.  In 2014, joint filed taxes: Less than $32,000: 0% of benefits are taxed; Between $32,000 and $44,000: up to 50% of benefits are taxed; Over $44,000: up to 85% of benefits are taxed                                                                                                                                                                            

• Self-Employed: If you are self-employed you can receive full benefits for any month in which Social Security considers you retired. "Retired" means you must not have earned more than the current income limit ($15,480 in 2014) and you must not have performed substantial services. The substantial services test is whether you worked in your business more than 45 hours during the month. If the work is considered "highly skilled" and you worked between 15 and 45 hours in a month then benefits could be denied. If you are under full retirement age for all of 2014 your earnings have to be less than $1,290 per month and did not perform substantial services. View this resource: NOLO