Financial Abundance

I am often asked, “What should I do with a 401(k) or 403(b) retirement plan that I had with a former employer?”  Most former employees are allowed to keep their funds in the former employer’s plan or “roll over” their former plan assets into a new employer’s 401(k) plan.  However, for many people, the best option may be to roll over the retirement plan funds into an IRA.

Let’s look at some of the areas where having an Individual Retirement Account may be advantageous to continuing with your former employer’s retirement plan

Diversification – When you roll over your retirement plan assets to an IRA account with a discount broker such as Schwab, Fidelity or TD Ameritrade, your investment options become virtually unlimited.  For a small trading fee (typically under $10 per trade), you can have a well diversified portfolio consisting of Exchange Traded Funds (ETFs) and mutual funds.  Some retirement plans have such limited choices that providing adequate diversification is virtually impossible.  TIAA-CREF is an example of a large sponsor of retirement plans with such limited investment choices that it is difficult to produce a well diversified portfolio.

If your 401(k) has a good selection of mutual funds from Vanguard or Fidelity, you can roll your IRA over to a mutual fund account with Vanguard or Fidelity.  Not only will the funds in your 401(k) be available, the entire family of funds will be at your fingertips.

Fees – Fees are a significant contributor to the success or failure of an investment portfolio.  Every employer must disclose the retirement plan’s annual fees to the plan participants.  If your 401(k) plan is with a large employer, the 401(k) fees are likely fairly low.   If your employer is a small to medium sized companies, annual fees could be over 1%.  Combining this fee with the typical 1%+ annual operating cost for mutual funds in the plan, your plan’s total annual fees could be as high as 2-3%. 

At most discount brokerages, a well diversified, index-based ETF portfolio can be developed for approximately $100 in trading costs. Most index-based ETFs have annual operating costs of 0.25% or less.  Thus, the IRA option could have total annual fees that are over 2% less than the total fees of many 401(k) plans.

Investment Management – Larger employers often provide 401(k) investment advice to their employees.  However, when you leave the employer, you may find that this advice is no longer available.  Smaller employers typically offer both limited investment options and limited investment advice, with no advice available for past employees.

Fee only asset management is available to provide investment management advice to investors that have neither the time nor interest to manage their own portfolio.  Annual fees for fee only asset management may be as little as 0.75% of the assets under management.  If your asset management firm uses indexed based ETFs, the total annual costs of both management and fund operating expenses may be just 1% or less.  With this approach, you can have individualized professional investment management advice with total fees that are less than ½ of many 401(k) plans.

If you have well diversified investment options, a low cost retirement plan and the time and interest to personally manage your plan, there may be no need to roll it over to an IRA.  However, if diversification, fees or the investment management advice supplied by your former employer’s plan are not adequate, you will likely find that the IRA roll over option is the better approach.  

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Your largest single asset is likely to be your ability to generate earned income.  This asset is commonly call “human capital.”  When developing appropriate asset allocations for investment portfolios, it is important to include the human capital asset.  Let’s look at some ways that including human capital could change your approach to allocating assets in your investment portfolio.

There are three major components of human capital.  These include: 1) your annual income from work,  2) the number of years remaining to work, and  3) the variability of your annual earned income.   Variability can be fairly large if your income is based on commissions.  It also can be large if you have a job in which you may be furloughed or laid off when economic conditions deteriorate.

There are studies that correlate various occupations with stocks, bonds and treasuries/cash.  We will look at only three occupations to demonstrate how human capital can be included in asset allocation decisions.

Tenured Professors – There are few professions more secure than that of a tenured professor.  Their annual income has historically been very predictable, with the main variance being additional income generated by consulting, research or publishing.  Thus, a tenured professor’s income is very similar to the yield from a high quality bond. 

Since there is little variance of annual income, younger professors should typically have higher asset allocations in riskier assets, such as equities and alternative investments.  As a professor approaches retirement, with a decreasing number of remaining work years, the amount of riskier assets should also decrease.

Real Estate Brokers – Real estate brokers receive most, if not all of their income from commissions.  While established brokers have some expectations about annual income, their income is highly variable, depending housing market conditions, interest rates etc.  While a realtor can often work for as long as they wish,  the variability of income makes their human capital asset very similar to equities (stock). 

If you are a realtor, you might be better served by having a greater portion of your investible assets in fixed income (bond) investments.  This will make your investment portfolio more stable as your income varies.  Stable investment income can be very beneficial in lower earning years, which often occur when the stock market is also in decline.

Entrepreneurs –  If you work for an entrepreneurial company, both your income and the number of years that your income will continue are variable.  In down years, entrepreneurial companies are typically the first to cut salaries and benefits as well as to have layoffs.  Having worked most of my life as a “high tech” entrepreneur, I am very familiar with the “bipolar” nature of many entrepreneurial companies.  As an entrepreneur, your human capital is similar to microcap stocks and commodities, either going up dramatically or dropping to $0. 

Not only should an entrepreneur have higher than normal fixed income positions in their investment portfolio, they should only buy equities in relatively risk free companies.  Entrepreneurs have their human capital linked to the success of their companies, which are typically small and highly vulnerable.  It is important that they take less risk in their investment portfolios to offset the high risk of their human capital.

While you may not work in one of these three occupations, your human capital will likely have characteristics of one these.  When you and/or your financial adviser are developing your asset allocations, be sure to consider your human capital as an asset that can compliment your other financial assets.

Regardless of your type of human capital, it can always be terminated by death or disability.  Life and disability insurance need to be a central component of any financial plan.  Properly constructed, they will provide the funds required for you and your family, if you are no longer able to contribute the expected human capital.

Human capital is an asset that should not be ignored.  Including your human capital when allocating your investments portfolio can help you choose the amount of risk that is most appropriate for you and your family. 

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Did you know that many financial advisors are not required to act in the role of a fiduciary?  Many financial advisors are instead subject to a business standard that only requires that the recommended investments be “suitable” for their clients.  Other financial advisors are subject to a more strict fiduciary standard which means the advisor has “a duty to act in the best interests of their client.”

To understand the difference, we must look at the current regulatory environment.  Commissioned based brokers or a broker-dealers are regulated by the Financial Industry Regulatory Authority (FINRA).  Brokers are often called “registered representatives” and work for such firms as Merrill Lynch, Smith Barney, Edward Jones, Wachovia, UBS or Wells Fargo.  Insurance agents, who offer investment products, are also almost always brokers.

FINRA only requires registered representatives and broker-dealers to provide a “suitable” investment to their clients, based on the client’s financial situation and their other holdings.  FINRA does not require for registered representatives and brokers to act in the client’s best interests.  Since FINRA only requires the “suitable” business standard, the registered representative or broker-dealer does not need to disclose any potential conflicts of interests that their investment advice might include.  This often leads to a broker recommending a product with a commission fee (load) when the same product is available as a “no-load” product.

Investment advisors, often called registered investment advisors or RIAs, are a different type of financial advisor.  RIAs are regulated by either the SEC or their state securities regulator.  RIAs are subject to the Investment Advisory Act of 1940, which requires that they have a “fiduciary duty to act in the best interests of their client”.  Investment advisors are paid through a fee structure, either on an hourly basis or as a percentage of assets under management (AUM).  RIAs are typically “fee only” advisors that do not receive any commissions and are always held to a fiduciary standard.

Some financial advisors present themselves as “fee based” advisors.  These advisors will be acting in the fiduciary capacity of an RIA when providing financial planning advice and typically charge a fee for this advice.  However, when these same advisors implement the proposed plan, they sell commissioned-based products.  When they sell commission-based products, they are operating as a registered representative/broker and are regulated by FINRA.  When these products are sold, the advisors are no longer acting as a fiduciary and need only to meet the “suitable” standard for the product that they sell..

If this seems confusing, you are not alone.  New government regulatory proposals are intended to undo this morass.  However, it is unclear how a broker can maintain a fiduciary relationship with their client while selling a commissioned based product, when a similar (or even the same) non-commissioned product is available.  

Since major banks, brokerages and insurance companies are dependent upon the revenues from their commissioned based products, it is doubtful that registered representatives who sell these products will ever be required to have a fiduciary duty when selling products to their clients.   Hopefully the new regulations will require the up-front disclosure of the commissions being paid to the sales person for each product sold, before it is sold, as well as any other potential conflicts of interest.  With this disclosure, the consumer will know how much of the total cost of the products is being used for compensating the broker-dealer and the sales person.

I believe that every financial advisor should have a fiduciary duty to put their client’s interest before their own.  However, until government regulations require this, consumers should be aware of the difference between commissioned based sales people with only a “suitability” standard and fee only planners who have a fiduciary duty to their clients.

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Since March 9^th, the S&P 500 has increased by almost 35%. In normal times, this increase would signal a major bull market rally. However, these are not “normal times.”

As an asset manager, I must continually consider whether I should be increasing, decreasing or maintaining my clients’ equity (stock market) allocations. My decision has been to use the market rally to lower my clients’ equity positions. While my crystal ball is no better than yours, here are a few of the factors that that I believe could negatively impact the market.

1) Valuation – Most economist are predicting that the S&P 500 will end 2009 with operating earning per share (before write-offs) of between $45 and $55. With the S&P 500 index at approximately 900, these earnings provide (pre-write off) P/E (price earnings) ratios of between 16 and 20. In a healthy, growing economy, those P/E values would signify a fully valued market. Can these P/Es be justified in our current environment?

2) Federal Debt – Many ‘bulls” argue that low interest rates justify paying a higher P/E on equities. In normal times, they would be correct. However, with the $700 billion stimulus package, a $1.8 trillion 2010 federal deficit and over $1 trillion dollars committed to federal bail outs, our federal debt will likely increase by well over $2 trillion in the next 18 months. (Remember, a trillion is 1,000 billions)

At some point, China, Japan and other “saving” countries will only buy our federal debt if it is offered at much higher interest rates. When interest rates increase, debt oriented investments become more attractive and equity investments less so. Higher interest rates will also make corporate borrowing more costly, which could easily damage our economic recovery.

3) Commercial Real Estate – The recent financial crisis, requiring $700 billion in TARP funds (not to mention TALF and PPIP), was mainly created by consumer debt. Defaults on mortgages, home equity lines and credit card debt created most of the current “toxic assets.” However, the next “shoe to fall” is commercial real estate. Large commercial real estate bankruptcies are beginning to proliferate. As these failures continue, expect to see more toxic assets appear on our bank’s balance sheets.

4) Toxic Assets – Many banks have balance sheets filled with toxic assets, with more likely to come. The Treasury has proposed the PPIP program to help banks remove these toxic assets to a “private/public partnership.” It seems unlikely that these assets are worth the value at which they are carried on the banks’ balance sheets. Assuming these toxic assets are purchased, much of any losses suffered, as reflected in the difference between their final value and the price paid under the PPIP program, will be assumed by the tax payers (you and me). These losses will increase our federal debt, putting even more pressure on interest rates.

5) International Event – Shortly after the election, our new Vice President predicted that the administration would be tested with an international crisis within its first six months. Most recent administrations have been tested during their early phases. Needless to say, there are many candidates to test our will and resolve. If such an incident occurs, the market will react negatively until the situation is resolved.

While “green shoots” may be appearing, along with signs that the recession may be slowing, our economy still faces many daunting problems. Until there are workable solutions to these problems, it will be difficult for the economy to have a significant recovery.

Considering the problems facing our economic recovery, it is hard to see significant stock market upside at current market prices. While it never pays to time the market, practicing “market intelligence” is always wise. If you are a long term investor, it may be prudent to stay at the low end of your investment policy’s equity allocation. In turbulent markets, investors should focus on asset preservation. The goal of asset preservation is to have the maximum assets available to invest when the economy truly begins to recover and grow.

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With the stock market in turmoil and interest rates at all time lows, you might be tempted to purchase a deferred annuity. The deferred annuity sales person will tell you about the tax deferred benefits, the guaranteed return if you were to die and may even provide a product that gives you market related returns when the stock market is up, while guaranteeing that you will not have a loss in value during a down market. If this sounds too good to be true, it probably is.

Since the deferred annuity sales person will be paid a commission as high as 10% on your deferred annuity purchase, let’s take a closer look at what he/she is trying to sell you. Here are some areas that are not always well explained by the deferred annuity sales person.

1) Mortality and Expenses (M&E) Charges – All deferred annuities have M&E charges to pay for the life insurance guarantee, the sales person’s commissions and the administrative expenses of the contract. M&E charges are usually between 1% and 2% of the contract value, paid every year. If your deferred annuity has a value of $100,000, up to $2,000 annually will be used for M&E expenses. Even though you will likely never see these charges, they are being taken from your investment each year.

2) Surrender Charges – Virtually all deferred annuities that are sold through commissioned sales people will carry a surrender charge. Typically, these charges begin at 7% for the first year of the contract and decrease by 1% per year. Seven years after you purchase the contract, you may still have to pay 1% of its total value if you want to cash it in. Sometimes, you are allowed to withdraw up to10% of contract value yearly. However, the surrender charges assure that the insurance company will have your money long enough to pay for the high sales commissions required.

3) Management Fees – If you buy a variable annuity, the subaccounts are very similar to mutual funds. A typical subaccount will have a 1% or higher management fee. This expense is over and above the M&E fees that were previously discussed. While these fees are somewhat consistent with the fees charged for actively managed mutual funds, they are up to 5 times as high as the fees charged for indexed mutual funds and Exchange Traded Funds (ETFs). The subaccount returns will be net of the management fees, but they will not show the M&E fees that are assessed each year.

While it is true that a deferred annuity will be tax deferred until you cash it in or annuitize it, all gains of the deferred annuity will be taxed at your ordinary income rate when you receive your returns. Since the deferred annuity is typically held for 10+ years, this tax advantage may completely disappear when you cash it out.

If you believe that a deferred annuity is right for you, before you buy the product that your sales person is offering, contact Schwab, Fidelity, Vanguard or another discount brokerage house. They will likely have a similar deferred annuity product. Compare M&E expenses, surrender charges and management fees of the non-commissioned product with the one you are being sold. You will likely find that the non-commissioned product provides a better total return than the one that you are being sold.

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Last month we examined how the first step in structuring a safe investment portfolio is to develop a personal investment policy that is consistent with your investment goals and the current investment markets.

When you develop an investment policy, you define the asset classes you will consider for investments as well as the minimum and maximum portfolio percentages which may be allocated to each asset class. The asset classes you chose and their allocation ranges depend upon your age, risk tolerance and your total financial resources.

In the previous article, we considered two of the most common investment classes, equities (stocks) and fixed income (bond) investments. This month we will consider three additional asset classes.

Real Estate – The most common methods of investing in real estate are rental properties or Real Estate Investment Trusts (REITs). Owning rental real estate requires active management of the investment properties. Rental real estate is also illiquid, often requiring several months to sell at an acceptable price. If these two drawbacks are acceptable, the next step is to accurately evaluate the rental property’s total investment return.

With the current high foreclosure rate, you may find well priced rental properties. However, before you purchase, do a thorough financial analysis of your expected investment return. A simple way of doing this is to compare rental real estate “yields” to the yields of fixed income investments.

For rental property, annual “yield” is net income divided by your net property value. Net income is the expected annual rental income less all expenses, including mortgage payments, property taxes, insurance, property management fees and a reasonable property repair allowance. Net property value is the appraised property value less mortgage balances and all costs required to sell the property, such as realtor fees, closing costs, etc. Because of the previously described drawbacks, annual rental property “yield” should always exceed the yields available from fairly safe fixed income investments.

REITs can be excellent investments during economic prosperity. From 2003 – 2006, REITs provided high yields and excellent total returns. Currently, REIT funds, such as the Ishares Cohen and Steer ETF (ICF) are at historic lows. While they yield approximately 10%, REIT prices will likely remain depressed until a sustained economic recovery begins.

When considering real estate, always examine your investment policy. Rental properties can require significant capital investments which could exceed your investment policy guidelines for real estate investments.

Commodities – Commodities are typically too risky to be included in a moderately conservative investment portfolio. However, there are times when a small investment in a specific commodity is prudent. Gold is considered a safe haven investment as well as a hedge against inflation. A small gold investment may prove worthwhile, especially if gold prices retreat. Many experts also believe that oil prices will continue to rise when the worldwide economy stabilizes.

If you wish to invest in commodities, I recommend using Exchange Trades Funds. Gold can be purchased with GLD (SPDR Gold Shares) and oil with USO (United States Oil). Commodity investments are extremely speculative and should not exceed 5%-10% of your investment portfolio.

Cash Investments – Cash investments include saving accounts, money market mutual funds and CDs that mature in one year or less. The principal is safe, but the yield is usually low or even negative, when offset by inflation.

Currently, most money market funds are yielding under 0.5% and 1 year CDs are yielding approximately 1%. With these low yields, only funds that may be required in the next 12-24 months should be kept in cash investments.

The key to investment success is a well-balanced portfolio, reflecting current economic and financial conditions. Until economic conditions improve, a conservative investment approach will likely serve you well.

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Being in the financial services industry, I am often asked for my financial forecast. Since my crystal ball is no better than yours, I never predict what the future may hold. However, by paying attention to macro-economic conditions, we can make informed investment decisions that will likely increase our total returns.

For 2009, there are some financial indicators that should be considered when planning investment strategies. Let’s examine how these indicators can be used to increase investment returns in 2009 and beyond.

When evaluating your investment portfolio, always consider economic and market conditions as part of your portfolio allocation process. In late 2007, seeing that future economic conditions were weak and the stock market was at an all time high, I decided to dramatically lower my clients equity (stock) positions and add a small position in gold. This decision has lead to significantly lower losses for my clients in 2008 than if they had stayed with their normal equity allocations.

In 2009, we know that economic conditions remain very weak and will likely show little improvement in the short term. We also know that the federal government is going to provide a huge economic “stimulus” program that will likely take the 2009 and 2010 budget deficits to a trillion dollars or more. Finally, we know that decreasing housing and oil prices have created a deflationary environment.

With this information, it appears that stocks will have a more negative than positive bias in the next few months. Therefore, I am not adding to my client’s equity holdings at this point. When market volatility decreases and company profits stabilize, I will slowly bring equity positions back to normal allocations.

Even though deflationary pressures will likely remain for a while, the Fed and the Treasury are determined to print as much money as necessary to reduce deflationary pressures. As the economy recovers, the additional dollars in circulation, combined with our exploding federal deficit, will provide an ideal environment for inflation.

If high inflation occurs, Treasury Inflation Protected Securities (TIPS) will be an excellent investment. 10 year TIPS are currently priced to reflect inflation of less than .5% per year, over the next ten years. If inflation exceeds this amount, TIPS will provide both inflation adjusted yields and an increase in price.

Another likely beneficiary of future inflation is gold. Gold can also be considered a “safe haven,” if economic conditions further deteriorate or the dollar weakens.  If you decide to add gold to your investments, keep your gold position to no more than 5% -10% of your portfolio.  As gold will likely fluctuate in price over the next few months, if you are patient, you may be able to buy it when the price of an ounce of gold is in the low $700s. The easiest way to own gold is through the SPDR Gold Shares Exchange Traded Fund (GLD).

There are many investment philosophies to choose from. After trying several different investment approaches over the past 25 years, I have found that following macro economic data can provide good insight on asset allocations and investments. Combining this information with a simple, diversified, index fund based portfolio has provided for excellent investment returns over the past seven years.

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In the story of the birth of Christ, the Magi gave Jesus gold, frankincense and myrrh. As many of us celebrate the Christmas season, perhaps we should consider giving ourselves one of these gifts, the gift of gold.

I have never been a gold enthusiast. However, gold can be both a hedge against inflation as well as a “safe haven,” when the investment markets are in turmoil. Even with declining inflation during the later part of 2008, November CPI was still up 1% over November of 2007. In the short term we could see deflation. However, with historically low Fed rates and a trillion dollar “stimulus package” on the horizon, long term inflation is a very real potential. In the 1970’s, gold was an excellent investment during that period of extended “stagflation.”

If the markets continue in turmoil, gold may also be a good investment, serving as a “safe haven” investment while other financial markets recede. In 2008, with the S&P 500 down 37%, the bond market down over 20% and most other commodities down, gold is virtually the same price as it was on January 2, 2008.

Since the beginning of 2005, the price of gold has doubled and is now at approximately $850/ ounce. Until 2008, the all time high for gold was reached in 1980 with a price of 850/oz. Based on this, it might appear that there is very little upside in a gold investment. However, in inflation adjusted dollars, the $850/oz in 1980 is almost $2200/oz. in 2008 dollars. Thus, on an inflation adjusted basis, gold is now trading approximately $300/oz. in 1980 dollars.

While gold should never represent a large portion of an investors portfolio, when we are considering a prudent asset allocation, we must consider the current financial turmoil. If inflation does increase as the economy recovers or if the economy deteriorates even more than is expected, the price of gold could increase. Thus, all of my clients have approximately 5% of their liquid assets in gold, which will remain in their portfolio until economic conditions change.

If you decide to add gold to your portfolio, one of the easiest ways of owning gold is through an Exchange Traded Fund (ETF). The most popular gold ETF is the streetTRACKS Gold Shares ETF, with the call symbol GLD. ETFs are traded like stocks and are easy and inexpensive to buy and sell through a discount brokerage house.

While a gold investment is not for everyone, adding the “Magi’s Gift” to your portfolio may increase your future portfolio returns.

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A recent Wall Street Journal article quoted a survey from Prince & Associates showing that “81% of investors, with $1 million or more in investible assets, plan to take money away from their current financial adviser.” Regardless of the amount of your investible assets, you may be considering whether you need a financial adviser or, if you already have a financial adviser, whether you should fire your current adviser and find a new one.

If you have an interest in finances and are willing to invest the time to learn how to comprehensively mange your personal finances, you may require no professional help. If this describes you, learn about the full spectrum of financial planning including tax minimization, risk management, retirement planning, estate planning and of course, investing. I wrote Financial Abundance Guide to help this you identify detailed strategies on how to comprehensively manage your financial resources and secure a prosperous future.

However, when markets are down and the economy is in turmoil, many people begin to question their capability of managing their personal finances. If you have recently felt that you have no idea whether to sell everything or to completely ignore the market and hope that in ten years you will be financially OK, you probably could use professional financial support. If you have concluded that you have neither the time nor interest to manage your personal finances, what kind of financial adviser should you choose?

The first question to consider is what type of financial advice is required. If you only need help in managing your investments, an investment broker or an asset manager may fit your needs. Be sure to determine exactly how the adviser will be compensated before you entrust them with any funds. The following are three types of investment advisers:

1. Commissioned based advisers typically sell both insurance based financial products and load mutual funds. They will often state that their financial planning services are “free” and that you will pay no commissions, as long as you hold the products sold for a period of five years or more.

2. With “fee based” brokerage advisors you pay an annual fee, based on a percentage of the assets in your account. For this fee, you usually may make unlimited trades without paying any brokerage commissions. However, these brokers often collect commissions on mutual funds (such as the 12-b1 annual load) and on other proprietary products as part of their compensation.

3. Fee only asset managers provide professional asset management and offer only products and services with no commissions. Their compensation is based entirely on an annual percentage of the assets that you place with them to manage.

Most investment management firms will offer some financial planning services. However, since they are compensated through the assets that they are managing, they are often not interested in providing comprehensive financial advice to their clients.

Many people require more financial support than just investment management. These clients require comprehensive financial planning to help plan for their children’s educational expenses, prepare for retirement, identify methods of minimizing taxes and financial risks while maximizing their cash flow and their investment income.

If you need more comprehensive help in planning your personal finances, find a fee only, Certified Financial Planner (CFP®) who provides comprehensive financial planning services. A CFP® will have completed extensive financial planning educational training and met both the experience and ethics requirements of the CFP Board of Standards.

Whether you only need investment advice or require a complete analysis of your current financial situation, be sure that your adviser can provide financial strategies that meet your risk profile. Also, be sure that their compensation offers no conflict with your best interests.

If you currently have a financial adviser who is not actively advising you on how to meet your financial goals, you may want to join the 81% of wealthy investors that plan to take money away from their present advisers. If your investment adviser or financial planner is not treating your financial future in the same manner in which they are treating their own, find a financial adviser who will!

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