Monthly Archives: October 2021

October

Many of my prospective clients come into my office either not knowing how much they are paying in investment fees or mistakenly thinking that they are receiving their investment counsel for free.  It is no wonder this occurs.  Fees are often embedded in the form of loads (either front-end when the fund is purchased or on the back end when it is sold), commissions, and expense ratios.  These hidden fees make it difficult to ascertain total investment costs for your portfolio. 

Many financial statements appear to have no fees deducted, but just because you can’t see a fee, does not mean it is not present and having an effect on your portfolio.

So how do you determine the fees you are being charged?

How much do you pay for advice? – Fee only versus Fee Based Advisors

First, if you use an advisor, you will somehow be paying for this advice.  There are many ways advisors receive compensation.

A fee “only” advisor charges a fee based on either a percentage of your total assets invested, a retainer, or per project fee based on an hourly rate.   This is the easiest and most transparent way for the client to be charged.  Furthermore, with retainers and hourly fees, large portfolios are not charged egregiously high rates just because they have higher account balances.  Note that true fee-only planners are in the minority in the financial advisory world.   Hourly, fee only advisors are even rarer.

The downside of this approach is that since the client has to write a check for the amount, behaviorally it is less palatable for him, even if the charges are far less. Ironically, this enhanced awareness of the fee, even if it is substantially lower, makes the client more resistant to paying via this method.

Fee “based” advisors are distinctly different from fee only advisors in that they can charge a certain percentage of assets AND may also receive commissions on the products or funds sold to the client.  This could be the case if your advisor who charges you 1% annually on your investment portfolio also gets commissions from the funds or positions in your portfolio or from an insurance product or annuity he or she sells you.

The ABC’s of Investment Fees

Most investors that go to a solely commissioned based brokerage are not charged a fee as a percentage of their assets. So, on the surface, it may appear that the advice they receive is “free.”   Instead, the broker will buy funds that have a built in commission.  These funds are often denoted by a capital letter after the fund.  An “A” fund has a front-end load.  Typically 4-6% of the total amount handed over to the advisor will go straight to him or her as commission.  These fees may decline at certain breakpoints, particularly if you stick within one fund family.  “B” funds have back-end commissions that normally decline over time, so it is best to hold on to these until they have expired.  C funds have level but relatively high annual expenses.  Due to these loads or commissions, load funds tend to have higher expense ratios, as well as potentially 12b-1 fees.

What are expense ratios and 12b-1 fees?

An expense ratio is the most common fee an investor will encounter.    It represents the annual operating costs of the fund.  Every mutual fund or exchange traded fund has this ratio, and, of course, you would ideally like to see these as low as possible.  For example, active funds may have expenses ratios well over 1%, whereas passive index funds may have expense ratios less than .20%.

The 12b-1 fee is also considered an operational expense and, as such, is included in a fund’s expense ratio. It ranges between 0.25-1%, but is more often closer to 0.25%.  It is primarily used as an incentive for the broker or rep to sell the fund and is paid to that broker annually.

Note that although active funds purport to “beat the market,” over two-thirds of these funds fail to beat their benchmark in any one year.   See this related article. As you can imagine, the more of these active funds you add to your portfolio, the chance of you beating the market (as represented by index funds) over many years substantially diminishes.   Thus, the increased expenses many investors pay a fund manager to “market time” or pick “winning funds” are often a waste of money.

Let’s look at an example to bring it all together:

Say I invest $100,000 in a fund with front end loads of 4.75%.  The fund also has an expense ratio of 1.13% inclusive of a 0.25% 12-b1 fee, which goes back to the broker.  At the same time, I decide to invest in a no load passive indexed fund in the same investment category.

After 5 years, assuming that the annualized rate of return for the category index is 10%, the total costs and return of the portfolio would be as follows:

 Even though the expenses for the higher cost fund were perhaps not as transparent, the ending value of the investment shows the dramatic difference.  This is why many investors scratch their head and wonder why their portfolio seems to underperform the market.

The moral of the story is costs matter, especially over long periods of time.  Over just five years, in this example, the low cost investment balance is over 10% higher.

Make sure you fully understand all of your investment costs and how you are being charged.  If future investment returns are expected to be lower than what we have historically experienced, keeping costs low is even more imperative.

If you invest in low cost funds and use a low cost fee only advisor consider yourself well-armed to defend against lower returns in the future.

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Retirement planning can be more complex for women for various reasons.  Women live longer, take time away from work to care for their parents or children, and are often paid less than their male counterparts. 

To compound matters further,  many married men are deciding to retire much earlier than originally anticipated.  A husband’s early retirement can have profound effects on a woman’s ability to fund her retirement throughout her lifetime.  With careful planning, however, these issues can be successfully navigated to provide peace of mind that the couple will have adequate funds.

Many baby boomers are burnt out from working 20+ years in their careers and feel a burning desire to quit and travel the world.  Many men and women are leaving their corporate jobs whether by choice or by design.  Retiring in your 50s, may mean that your spouse will need funds to last 40 or more years.   Unfortunately, women, due to their higher risk of longevity, bear the brunt of a husband’s desire to retire early.   The wife may continue to work after their husband retires to provide additional income, and thus feels increased stress due to suddenly being the sole breadwinner.  Ironically, she may feel as though she needs to retire later to offset the impact of her husband’s early retirement.  Financially, a wife, especially if she has been the lower earner or worked fewer overall years than her husband, will also have lower Social Security spousal and survivor payments, if her husband chooses to take benefits early.

How can women improve planning around her husband’s desire to retire early?

  • Discuss any early retirement decision as a couple and ensure that you are both ready for other emotional, financial, and psychological change.  Be supportive and see how you can make each other’s lives more enjoyable in the interim, to see if retirement can be delayed.  It may mean that you take more time off or even phase into retirement over time.  Most importantly, balance the short term benefits of leaving work with the long term tradeoffs.
  • Try to delay taking Social Security.  If you are both healthy, you should try to delay claiming until at least your full retirement age.  Work with a fee-only financial planner to determine the optimum strategy to maximize your lifetime income based on your age and life expectancy. You can go to livingtoo100.com to get an estimate of your life expectancy.
  • Create a life plan along with your financial plan.  Determine how your lifestyle will change after retirement and make sure to share household responsibilities.  Create an ideal day, week, month, year in retirement.  Write it on paper.  Create a Pinterest board or scrapbook of things you want to do or see in retirement.
  • Realize there are significant tradeoffs.  Early retirement may mean that you can’t gift to the kids as much as you wanted or fund lavish travel plans.  Discuss how that might affect your retirement satisfaction in the long run.
  • Maximize your pension payments through a “pension max” strategy.  If you want to choose a pension benefit that provides maximum yearly income and a small survivor benefit, you need to ensure that your spouse is able to support his or her lifestyle should something happen to you.  A “pension max” strategy using laddered insurance will be necessary to offset the impact of an early death of the person who receives the large pension.
  • Consider long term care insurance—this can ease the burden of taking care of a spouse and help protect assets so that the caregiver spouse can have sufficient funds for the balance of his or her life.

Retirement planning is far more complex than just your investment allocation and selection of funds.

The many moving parts of Social Security claiming strategies, pension strategies, budgeting, withdrawals, and planning for large expenditures all come into play.  Work with a fee only financial planner to ensure that you are making appropriate decisions.  A decision to take early benefits may reduce cash flow stress in the short term, but have longer term negative repercussions.

Sorting it all out with a map of your retirement landscape and how to navigate that map, can help you sleep better at night knowing that important decisions you make about retirement are sound.

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Investors are well aware that financial markets go up and down.  That is the essence of business and economic cycles.  What is difficult for individual investors to master is how to act in the face of market advances and declines.  Unfortunately, most people become very tolerant of risk and increase their exposure to the stock market when the market is advancing.  Similarly, they avoid risk and clip their exposure to stocks when markets are declining, or after a large correction.  It is human nature and “recency bias” that create this visceral response to market perturbations.  Recency bias occurs when investors believe that the most recent performance of their investment portfolios will continue indefinitely in the future.  It is just one factor that results in investors consistently underperforming the stock market.

Brad M. Barber  and Terrance Odean, in their 2011 study “The Behavior of Individual Investors,” conclude that individuals routinely underperform benchmarks through 1) selling winning investments and holding losing investments, 2) being heavy influenced by most recent past returns (repeating investment behavior that coincides with pleasure and avoiding behavior that is painful), and 3) holding undiversified portfolios.

Dalbar studies have also shown that most individual investors typically trail the market rate of return, and they typically do so by a fairly wide margin.

The message from Dalbar since its first study in 1994 is that investment results are more dependent on investor behavior than fund performance and that mutual fund investors who tend to buy and hold are more successful than those who attempt to time the market.

Investors who attempt to time the market are often acting irrationally out of fear of a potential loss.  Stocks and investment funds happen to be the only assets that people buy less of when they become less expensive. Let’s think about buying food at the supermarket, if the price of steak rose considerably, you would be more inclined to reduce your purchase of steak or buy something else, but if the supermarket suddenly reduced the price of the steak by 30%, you would stock up.  However, you do the opposite when it comes to stocks and other investments.  The stock market can foster a gambling mentality.  When you are on a roll you hate to stop, but that is exactly when you should cash some chips in.

So how does an investor counteract the tendency to time the market and invest based on most recent results?  Rebalancing is great way to fight the effects of recency bias.  Rebalancing to your target asset allocation is a mechanistic and unemotional way to fight these counterintuitive emotions.  I sometimes get an odd look from my clients when I suggest that they rebalance after a market run-up.  “Why would I want to do that, the market is hot?” might be a typical comment.  But that is exactly why rebalancing is so important.  It removes the emotions, market noise, and other extraneous factors, and reminds the investor of their original financial plan and goals.

The best value-added proposition a financial advisor provides is to set the target allocation and then monitor and adjust it based on the client’s personal goals and life events.  The asset allocation is set within the investment policy statement and the portfolio is rebalanced yearly, or as needed, after large market advances or declines.  The asset allocation is revisited periodically, at least every 3 years, and is adjusted in response to a client’s retirement goals, change in health or marital status, or market valuations.

Rebalancing in this way, will not only help the client attain rates of return closer to the respective benchmarks for his or her portfolio, it can actually be a source of additional return.  In a recent article in Financial Planning magazine, “Portfolio Rebalancing: Get It Right,” Allan Roth underscores the incremental benefit of rebalancing.  His analysis shows that “over the past 15 years, the portfolio that stuck to its allocation earned 1.54 percentage points more each year than the average portfolio that tried to time asset classes.”

Rebalancing is just one area where advisors add incremental return and why it is essential for our clients to commit to the annual review and rebalance exercise.   Emotions can be hard to control, let your re-balancing take them out of the mix, so you can maximize your long range returns.

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How My 18 year Old Son’s Summer Internship Landed Him in the 25% Tax Bracket

Remember your first paycheck and how shocked you were when you noticed how much was being taken out for taxes?  My son had the shock of his life when he saw his first paystub for his summer internship at Textron, Inc.   Although he instructed his HR department to withhold the minimum amount out of his paycheck due to his small amount of income (he is getting paid $16.50/hr.), his effective Federal tax rate was well over 20%.

It turns out that his housing and relocation subsidy of $2,500 had an automatic withholding of 25%.  Per federal tax law, if you have any supplemental wages, outside of your regular salary, the federal government can withhold taxes at a different rate.  Supplemental wages generally include commissions and bonuses, sick leave payments, reimbursements of nondeductible moving expenses, and taxable fringe benefits.  There are two methods of withholding, but if the supplemental wages are paid separately, they may be taxed at the IRS flat supplemental rate which is 25 percent. Supplemental wages are also subject to Social Security, Medicare, and FUTA taxes.

So in my son’s case, since the company paid him a lump sum of $2,500 for relocation expenses, that amount had 25% automatically deducted from his first paycheck.  Going forward, he will have a lower amount withheld, and then he will get a large refund when files his 2014 tax return.  My son was not happy that he would have to wait for the tax refund, but he will ultimately get most of this money back in the end.  For more info on supplemental wages click here.

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Most people think they’ll be ready to retire when they hit a certain age or accumulate a set amount of assets. Unfortunately, they rarely do the math to determine whether their savings will sustain them after they retire. According to the 2015 Retirement Confidence Survey by the Employee Benefit Research Institute, only 48% of workers reported that they or their spouses have tried to calculate how much money they’ll need to live comfortably in retirement, and people who did attempt this calculation generally ‘guesstimated’ the numbers.

The EBRI found that most Americans spend more time preparing for the holidays than for retirement.

To stay out of financial trouble after you retire, it’s important to start planning well ahead of time. And that involves taking a hard look at the numbers.

Work the problem

Retirement projection is a big math problem, and to get the right answer, you must plug in the right figures. To start, you must have a good grasp of how much income you can expect from retirement income streams such as Social Security and pensions.

The next step is crucial: understanding how much you’re going to spend in retirement. This can be much tougher to predict, but accurate projections can mean the difference between having adequate funds for the rest of your life and outliving your savings. Neglecting this important step before making the decision to retire is unwise; deciding when to retire should be based on your financial capacity.

That’s because once you’re retired, your main source of income ends, and expenses will be covered out of savings, investments and retirement income streams. Spending is perhaps the biggest variable in retirement planning calculations. It’s easy to be complacent during working years, when a steady paycheck is coming in. So it makes sense that a huge paradigm shift occurs when the paychecks stop and cash flow shortages have to be covered from savings. Creating your own paycheck from your savings can be overwhelming.

Set a retirement spending plan

For all of these reasons, establishing a realistic retirement budget is critical. To do this effectively, consider these steps:

1. Envision your life during retirement. Make a list of what you’ll be doing and how you’ll be living. What will a typical day look like? What kinds of hobbies or volunteer work will you participate in? Will you embark on a second career? How much will you travel? Will you move to another location or maintain two residences? How much support will you provide for your kids and grandkids? What is on your bucket list and how much will realizing it cost?

2. Keep track of your current spending for at least three months. Be sure to include expenses that occur less frequently, such as insurance and dues.

3. Review this spending record. My clients are often surprised to see where they’re spending their money. This exercise enables them to align their spending with their goals, values and desires. They’re more committed to a spending plan once they have determined where their money is going because this prompts them to set priorities to ensure that they don’t spend frivolously or on items that aren’t priorities.

4. Make changes in your spending now to reflect the retirement lifestyle you envision. How will your expenses change upon retiring? Does your spending jibe with the goals you identified in the first step? Be sure to revise entries for certain expense categories, such as travel, entertainment and housing, to reflect these goals. Don’t forget to account for uncovered medical expenses and supplemental health insurance premiums, including Medicare Part B.

Watch your withdrawal rates

Once you have put together a spending plan, you can determine how much of your expenses would be covered from your investments. Most financial planners recommend that people who retire at 65 withdraw no more than 4% of savings annually. If you withdraw much more than that, you’re likely to outlive your funds, so you might need to work longer. If you retire earlier than 65, you will likely need to adjust that withdrawal rate downward, as you’ll be making withdrawals longer.

Consider working with a financial planner who specializes in retirement planning. He or she can walk you through the planning process and potentially give you confidence about the capacity of your investment portfolio to provide adequate income after you retire. The planner can also help you realize that you’re not on track and need to make changes.

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