Brawl Street: Jon Stewart vs. Jim Cramer

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Jim Cramer Unedited Interview Pt. 1
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I’m not a fan of the financial advice dispensed by CNBC’s talking heads. The “advice” is contradictory, often based on someone’s guess, and certainly not geared to your individual situation.

I find Jim Cramer, of Mad Money, particularly difficult to watch, and it’s not just the bombast. I believe that none of his recommendations make any sense. He is telling viewers which stocks will do well and which will do poorly, which is impossible to do.

Guessing which stocks to buy is not investing; it’s speculating. The public needs to understand that. So I was pleased that Jon Stewart of the Daily Show took Cramer to task. Since I believe that Jim Cramer’s infotainment gives viewers the absolutely wrong framework for successful investing, I think he got off easy.

ABC This Week with George Stephanopoulos had a roundtable discussing, among other things, whether CNBC fell down on the job covering the financial and business world.

Right at the end of the session, George Will nailed the real issue with his general rules in life.

• Don’t play poker with a man named Slim.
• Don’t buy a Rolex from someone who is out of breath.
• Don’t take financial advice from people who are shouting.

Amen.

Don’t Put Your IRA in a Variable Annuity

I recently received an email from a couple in their 60s requesting advice regarding how to invest their IRA funds. They had been to a “financial planner” who recommended a variable annuity. Luckily they had read my posts on the subject and said in their email that they were “skeptical because of the costs and early withdrawal penalties.”

I heartily concur.

Jeffrie Voudrie’s article Don’t Put Your IRA in A Variable Annuity explains why.

Here’s a quick summary.

If you’ve talked to a broker or agent about rolling over your retirement account, there’s a good chance the advisor recommended you invest in a Variable Annuity. Don’t do it! I believe the only reason a variable annuity is recommended for an IRA is so the advisor can earn more money. Let me explain.

One of the main sales ‘hooks’ used in selling a variable annuity is that you don’t have to pay a commission. That can be very compelling when compared to a mutual fund in which you pay the all the commission up-front. Many advisors will even say that they get compensated by the insurance company, not you. Do you really believe that? Insurance companies are not charitable organizations. If they are paying the broker, they’ll recoup those costs from you—the costs are just hidden so you don’t think you’re paying a commission. The second main argument for using a variable annuity for an IRA is the death benefit (not offered with a mutual fund). “That way you’ll never have to worry about your beneficiary getting less than you invested”, the thoughtful advisor says. This feature may seem nice, but you end up paying through the nose for it.

The real reason that you are recommended a variable annuity for your IRA isn’t that it’s better for you. It’s because it’s better for the advisor. If you invest $500,000 in a commission-based mutual fund, the advisor’s gross commission will only be about $10,000. The same investment in a variable annuity would yield gross commission to the advisor of $30,000-$35,000 or more! If an advisor can earn 3 times more by getting you to invest in a variable annuity instead of a mutual fund, which do you think will be recommended? 

Don’t fall for the ‘put your IRA in a VA’ trap.

Conclusion

I am not sure which is more shameful (1) Wall Street titans who took outsized bonuses that turned out to be based on illusory profits or (2) the bad advice given to consumers every day by “financial advisors.” This self-serving advice costs consumers billions of dollars every year.

There is a better way - fee-only financial planners. To find one near you, consult this web site:

National Association of Personal Financial Advisors (NAPFA)

Stockbrokers in the Spotlight

You may recall a series of articles that I wrote not too long ago about the potential perils and pitfalls of working with stockbrokers, also occasionally referred to as “registered representatives.”

An article in the January 13, 2009 edition of The Wall Street Journal, Help Wanted: Wall Street Stockbrokers, No Joking, explains just how well some “high-producing” stockbrokers are compensated. (Note, in this case, the description “high-producing” refers to how much revenue they generate for their employers.)

For a somewhat jaundiced (and funny) post on this particular issue, see Milo Benningfield’s article, Stockbrokering: Who Said Retail Wasn’t Profitable?

Benningfield, by the way, is a fee-only financial advisor located in San Francisco. Here’s a summary of his post.

Now that investment bankers and traders have proven such great disappointments to the large Wall Street houses, they’ve taken renewed interest in their retail brokerage operations. And what lucrative operations they are.

Naturally, Wall Street wants to take care of these golden geese.

As ‘registered representatives’ of the brokerage firm, stockbrokers (as they are informally called) are legally bound to represent the interests of the firm, not the client, in any transaction. (Registered reps/stockbrokers should not be confused with ”registered investment advisers,” who have a statutory duty under the Investment Advisers Act of 1940 to put the client’s interests before their own.)

In other words, stockbrokers are a distribution channel for the brokerage firms, and it makes perfect sense that the firms would want to protect and support that channel by offering brokers huge financial incentives.

But all the largess heaped upon the brokers does raise a question: just how are the Wall Street firms, who apparently need a government bailout just to stay in business, expecting to recoup the “partner awards” and other incentives that they’re currently “doling” out to stockbrokers?

To answer that question, dear customer, all eyes are upon you. Caveat emptor, my friend.

Caveat emptor – buyer beware. As always, that’s very good advice. If you’d like to read more about this subject, read The Four Pillars of Investing: Lessons for Building a Winning Portfolio by William J. Bernstein. Pay particular attention to Chapter 9, entitled “Your Broker Is Not Your Buddy.”

Caveat emptor, indeed.

Lessons from the Bernard L. Madoff Fiasco

“Many aspects of the Madoff affair are depressingly familiar: the lure of high returns with little risk, glowing testimonials from early investors, the sense of membership in a special club for those fortunate enough to be ‘in the know,’ the trust in the promoter due to religious or social affiliation, the vague documentation of investment strategy, the skimpy accounting, and the speed of the ultimate collapse.” – Weston J. Wellington.

There has been much written about Bernard L. Madoff, who is accused of running the largest financial fraud scheme in history, and all of it sordid and sad. The sorry tale raises serious questions and concerns about how well (or how poorly) the Securities and Exchange Commission, the so-called watchdog of the U.S. securities sector, did its job. It also makes you wonder how it was that so many “sophisticated” investors could have been so thoroughly fooled.

A recent New York Times column, Be Smart, but Don’t Think That You’re Special  by Ron Lieber and Tara Siegel Bernard, summarizes the debacle as follows: “When wealthy investors are willing to hand over a sizable sum to a single money manager they heard about at the country club, certain first principles of investing bear repeating.”

Here are some useful quotes from the article:

… scores of people made outsize bets on his prowess without taking the time to fully understand what they were investing in.

All investors, but especially those with a high net worth, need to maintain a healthy sense of humility about their level of ignorance. Alternative investments, whether they are hedge funds or venture capital or private equity, can be complicated. They contain unpredictable levels of risk. But all too often, people are willing to overlook those risks because, well, everyone else is doing it. Or they simply place too much trust in too few hands.

Humility

Investing, in general, requires humility. Few people have enough of it. It is the reason so few people put most of their money in index funds, which track various asset classes rather than trying to pick the winners in each.

One problem with hedge funds is that they appeal to all the wrong instincts. They are for the privileged. Investors need to have a minimum net worth to qualify. In the case of the money managed by Mr. Madoff, many people seemed to have gotten in on it by belonging to the right country club.

“He was dealing with extremely wealthy individuals,” said Harold Evensky, president of Evensky & Katz, a financial planning firm in Coral Gables, Fla. “All too often, they make relatively easy marks because the pitch is, ‘You’re special, you can get something that other people can’t get.’ ”

But you are probably not special. Bill Gates is special, and he is the beneficiary of the best investment opportunities from the smartest people in the business. The Ford Foundation is special. The people who run Harvard and Stanford and Yale’s endowments are special.

You, however, are probably hearing about the second- or third- or fourth-tier ideas in the world of alternative investments. That does not mean the managers pitching them cannot make them work. But be honest with yourself: if you are in on them, how special could they really be, given the enormous demand for truly unique investment opportunities?

Smarts

You may be rich and you may be smart. But smart about this sort of investing? Not so much.

There is no shame in not understanding Mr. Madoff’s split strike conversion strategy. Admit your ignorance, question your investment adviser’s certainty and seek a plain English explanation of the opportunity that is in front of you.

Secrets

One hard part about investing in hedge funds is that some of the most successful ones will not say much about how they work. If they disclose too much about their tactics, others will copy them and their investors will be hurt. (So will the managers’ take-home pay.)

While Mr. Madoff’s supposed returns were fully available to all, investment advisers were less successful in understanding how he did what he did. “I knew that their returns were always good, but I knew that nobody could explain how they made their money,” said Mr. Weinberg. “In our attempts to look under the hood, it was impossible to ascertain what they were doing.”

Conclusion

Let’s review some of the “red flags.”

Madoff had complete control of his clients’ investment funds. This is absolutely contrary to the recommended procedure of having your funds held separately, in custody, at a broker-dealer firm which is regulated by the Financial Industry Regulatory Authority and backed by the Securities Investor Protection Corporation. As an investor, you should be receiving copies of your statements directly from the (independent) custodian, not from your investment manager.

You need to understand the investment strategy that your investment manager is recommending. Avoid the “black box” approach to investing; look for investments that are clear and transparent.

Question any investment record that looks too steady over the long term. All investments have some risk, no investment is a “sure thing.” (Bear in mind that other investment managers could not duplicate Madoff’s investment performance, using similar strategies, so what “magic” did he possess that others did not?)

As the saying goes, “If it seems too good to be true, it probably is.”

Bubbles and Wall Street, Part 2

“From time to time, for reasons that are poorly understood, investors stop pricing businesses rationally. Rising prices take on a life of their own and a bubble ensues.” – William Bernstein.

When a bubble occurs, Wall Street executives may reinforce it through rational self-interest. The previous post included this quote from Henry Blodget:

“In the money-management business, therefore, investment risk is the risk that your bets will cost your clients money. Career or business risk, meanwhile, is the risk that your bets will cost you or your firm money or clients.”

Blodget expands on this notion.

This tension between investment risk and career or business risk comes into play in other areas of Wall Street too. It was at the center of the decisions made in the past few years by half a dozen seemingly brilliant CEOs whose firms no longer exist.

Why did Bear Stearns, Lehman Brothers, Fannie Mae, Freddie Mac, AIG, and the rest of an ever-growing Wall Street hall of shame take so much risk that they ended up blowing their firms to kingdom come? Because in a bull market, when you borrow and bet $30 for every $1 you have in capital, as many firms did, you can do mind-bogglingly well. And when your competitors are betting the same $30 for every $1, and your shareholders are demanding that you do better, and your bonus is tied to how much money your firm makes—not over the long term, but this year, before December 31—the downside to refusing to ride the bull market comes into sharp relief. And when naysayers have been so wrong for so long, and your risk-management people assure you that you’re in good shape unless we have another Great Depression (which we won’t, of course, because it’s different this time), well, you can easily convince yourself that disaster is a possibility so remote that it’s not even worth thinking about.

It’s easy to lay the destruction of Wall Street at the feet of the CEOs and directors, and the bulk of the responsibility does lie with them. But some of it lies with shareholders and the whole model of public ownership. Wall Street never has been—and likely never will be—paid primarily for capital preservation. However, in the days when Wall Street firms were funded primarily by capital contributed by individual partners, preserving that capital in the long run was understandably a higher priority than it is today. Now Wall Street firms are primarily owned not by partners with personal capital at risk but by demanding institutional shareholders examining short-term results. When your fiduciary duty is to manage the firm for the benefit of your shareholders, you can easily persuade yourself that you’re just balancing risk and reward—when what you’re really doing is betting the firm.

As we work our way through the wreckage of this latest colossal bust, our government—at our urging—will go to great lengths to try to make sure such a bust never happens again. We will “fix” the “problems” that we decide caused the debacle; we will create new regulatory requirements and systems; we will throw a lot of people in jail. We will do whatever we must to assure ourselves that it will be different next time. And as long as the searing memory of this disaster is fresh in the public mind, it will be different. But as the bust recedes into the past, our priorities will slowly change, and we will begin to set ourselves up for the next great boom.

A few decades hence, when the Great Crash of 2008 is a distant memory and the economy is humming along again, our government—at our urging—will begin to weaken many of the regulatory requirements and systems we put in place now. Why? To make our economy more competitive and to unleash the power of our free-market system. We will tell ourselves it’s different, and in many ways, it will be. But the cycle will start all over again.

What can we learn from this bubble?

First, bubbles are to free-market capitalism as hurricanes are to weather: regular, natural, and unavoidable. They have happened since the dawn of economic history, and they’ll keep happening for as long as humans walk the Earth, no matter how we try to stop them. We can’t legislate away the business cycle, just as we can’t eliminate the self-interest that makes the whole capitalist system work. We would do ourselves a favor if we stopped pretending we can.

Second, bubbles and their aftermaths aren’t all bad: the tech and Internet bubble, for example, helped fund the development of a global medium that will eventually be as central to society as electricity. Likewise, the latest bust will almost certainly lead to a smaller, poorer financial industry, meaning that many talented workers will go instead into other careers—that’s probably a healthy rebalancing for the economy as a whole. The current bust will also lead to at least some regulatory improvements that endure; the carnage of 1933, for example, gave rise to many of our securities laws and to the SEC, without which this bust would have been worse.

Lastly, we who have had the misfortune of learning firsthand from this experience—and in a bust this big, that group includes just about everyone—can take pains to make sure that we, personally, never make similar mistakes again. Specifically, we can save more, spend less, diversify our investments, and avoid buying things we can’t afford. Most of all, a few decades down the road, we can raise an eyebrow when our children explain that we really should get in on the new new new thing because, yes, it’s different this time.

Conclusion

A number of things must come together to cause a bubble. One of them is an ignorance of history. We forget that markets can be cyclical. During the boom years, many of us conveniently forget (or didn’t even consider) the possibility of a bust.

It typically takes 30 years for a new group of potential believers to arrive.  Inexperienced investors make it possible for price increases (success) to lead to more price increases (excess).

The old adage, “What goes up must come down” is overwhelmed by “it’s different this time.”

Don’t expect your typical Wall Street messenger to warn you about the danger. Wall Street executives are typically concerned about career risk.  Moreover, in the last bubble, they did a very bad job of managing risk for their own firms.

Bubbles and Wall Street, Part 1

“Bubbles occur whenever investors begin buying stocks simply because they have been going up. This process feeds on itself, like a bonfire, until all the fuel is exhausted, and it finally collapses.” – William Bernstein.

Why Wall Street Always Blows It  by Henry Blodget appeared in the December issue of The Atlantic. The article offers interesting observations on how powerful incentives have compelled Wall Street executives to play musical chairs with their clients’ money, until the music finally stopped.

Here’s what Blodget has to say (emphasis added).

But most bubbles are the product of more than just bad faith, or incompetence, or rank stupidity; the interaction of human psychology with a market economy practically ensures that they will form. In this sense, bubbles are perfectly rational—or at least they’re a rational and unavoidable by-product of capitalism (which, as Winston Churchill might have said, is the worst economic system on the planet except for all the others). Technology and circumstances change, but the human animal doesn’t. And markets are ultimately about people.

Everyone …bears some responsibility too. But … it would be hard to say that any of them acted criminally. Or irrationally. Or even irresponsibly. In fact, almost everyone …acted just the way you would expect them to act under the circumstances.

That’s especially true for the professionals on Wall Street, who’ve come in for more criticism than anyone in recent months, and understandably so. It was Wall Street, after all, that chose not only to feed the housing bubble, but ultimately to bet so heavily on it as to put the entire financial system at risk. How did the experts who are paid to obsess about the direction of the market—allegedly the most financially sophisticated among us—get it so badly wrong? The answer is that the typical financial professional is a lot more like our hypothetical home buyer than anyone on Wall Street would care to admit. Given the intersection of experience, uncertainty, and self-interest within the finance industry, it should be no surprise that Wall Street blew it—or that it will do so again.

Since Wall Street replenishes itself with a new crop of fresh faces every year—many of the professionals at the elite firms either flame out or retire by age 40—most of the industry doesn’t usually have experience with both booms and busts. In the 1990s, I and thousands of young Wall Street analysts and investors like me hadn’t seen anything but a 15-year bull market. The only market shocks that we knew much about—the 1987 crash, say, or Mexico’s 1994 financial crisis—had immediately been followed by strong recoveries (and exhortations to “buy the dip”).

By 1996, when Greenspan made his famous “irrational exuberance” remark, the stock market’s valuation was nearing its peak from prior bull markets, making some veteran investors nervous. Over the next few years, however, despite confident predictions of doom, stocks just kept going up. And eventually, inevitably, this led to assertions that no peak was in sight, much less a crash—you see, it was “different this time.”

Those are said to be the most expensive words in the English language, by the way: it’s different this time. You can’t have a bubble without good explanations for why it’s different this time. If everyone knew that this time wasn’t different, the market would stop going up. But the future is always uncertain—and amid uncertainty, all sorts of faith-based theories can flourish, even on Wall Street.

In the 1920s, the “differences” were said to be the miraculous new technologies (phones, cars, planes) that would speed the economy, as well as Prohibition, which was supposed to produce an ultra-efficient, ultra-responsible workforce. (Don’t laugh: one of the most respected economists of the era, Irving Fisher of Yale University, believed that one.) In the tech bubble of the 1990s, the differences were low interest rates, low inflation, a government budget surplus, the Internet revolution, and a Federal Reserve chairman apparently so divinely talented that he had made the business cycle obsolete. In the housing bubble, they were low interest rates, population growth, new mortgage products, a new ownership society, and, of course, the fact that “they aren’t making any more land.”

In hindsight, it’s obvious that all these differences were bogus (they’ve never made any more land—except in Dubai, which now has its own problems). At the time, however, with prices going up every day, things sure seemed different.

In fairness to the thousands of experts who’ve snookered themselves throughout the years, a complicating factor is always at work: the ever-present possibility that it really might have been different. Everything is obvious only after the crash.

Of course, as …was crystal clear to most Wall Street executives at the time—being bullish in a bull market is undeniably good for business. When the market is rising, no one wants to work with a bear.

Which brings us to the last major contributor to booms and busts: self-interest.

When people look back on bubbles, many conclude that the participants must have gone stark raving mad. In most cases, nothing could be further from the truth.

This does not make the participants villains or morons. It does, however, illustrate another critical component of boom-time decision-making: the difference between investment risk and career or business risk.

Professional fund managers are paid to manage money for their clients. Most managers succeed or fail based not on how much money they make or lose but on how much they make or lose relative to the market and other fund managers.

If the market goes up 20 percent and your Fidelity fund goes up only 10 percent, for example, you probably won’t call Fidelity and say, “Thank you.” Instead, you’ll probably call and say, “What am I paying you people for, anyway?” (Or at least that’s what a lot of investors do.) And if this performance continues for a while, you might eventually fire Fidelity and hire a new fund manager.

On the other hand, if your Fidelity fund declines in value but the market drops even more, you’ll probably stick with the fund for a while (“Hey, at least I didn’t lose as much as all those suckers in index funds”). That is, until the market drops so much that you can’t take it anymore and you sell everything, which is what a lot of people did in October, when the Dow plunged below 9,000.

In the money-management business, therefore, investment risk is the risk that your bets will cost your clients money. Career or business risk, meanwhile, is the risk that your bets will cost you or your firm money or clients.

The tension between investment risk and business risk often leads fund managers to make decisions that, to outsiders, seem bizarre. From the fund managers’ perspective, however, they’re perfectly rational.

In the late 1990s, while I was trying to figure out whether it was different this time, some of the most legendary fund managers in the industry were struggling. Since 1995, any fund managers who had been bearish had not been viewed as “wise” or “prudent”; they had been viewed as “wrong.” And because being wrong meant underperforming, many had been shown the door.

It doesn’t take very many of these firings to wake other financial professionals up to the fact that being bearish and wrong is at least as risky as being bullish and wrong. The ultimate judge of who is “right” and “wrong” on Wall Street, moreover, is the market, which posts its verdict day after day, month after month, year after year. So over time, in a long bull market, most of the bears get weeded out, through either attrition or capitulation.

By mid-1999, with mountains of money being made in tech stocks, fund owners were more impatient than ever: their friends were getting rich in Cisco, so their fund manager had better own Cisco—or he or she was an idiot. And if the fund manager thought Cisco was overvalued and was eventually going to crash? Well, in those years, fund managers usually approached this type of problem in of one of three ways: they refused to play; they played and tried to win; or they split the difference.

Conclusion

When stocks (or house prices) are going up, it is very easy to be optimistic or at least go along with the crowd. There are always many reasons to explain why “the sky is the limit.” That’s how the phrase “it’s different this time” gains currency.

If you work on Wall Street, it’s bad business to be prematurely negative, because you may miss out on the “easy money.” And it can be bad for your career to be pessimistic or even doubtful of the new paradigm.

“Everyone was doing it” may not be a defense for a child’s behavior, but it seems to apply to investment managers who are willing to take on additional risk to attempt outperformance.

Instead of reining in over-optimism and greed, Wall Street executives became enablers for their clients. The timing could not have been worse.

Note that a conservative diversified portfolio will underperform in a bubble but will typically avoid a steep decline when the market turns. This approach is not perfect, but it sure beats chasing performance when everyone says, “this time it’s different.”

To be continued …

Variable Annuities, Part 2

“It has always been said that annuities are ‘sold,’ not bought by investors. Over 90% of all annuity sales are through brokers or life agents… Why are so many people sold annuities? The answer is simple…. high commissions and great sounding stories.” – Scott Dauenhauer.

In a previous post, I outlined some of the disadvantages of variable annuities. Today’s post goes into this a bit more deeply.

A colleague of mine, Scott Dauenhauer of Meridian Wealth Management, is a former stockbroker and someone who is quite critical of the “so-called” advantages of variable annuities that are usually touted by salespeople. The following quotes from Secrets of the Wirehouse and How to Protect Your Best Interests emphasize the high (hidden) costs and lack of real benefits.

Annuities, Hazardous to Your Wealth?
Variable annuities performance is based on an underlying “sub-account,” basically a mutual fund. The major benefit to an annuity is the ability to defer taxes until the money is withdrawn. Another highly touted benefit is that an annuity can pay an income stream for life. Let me lay out a case for why variable annuities may be hazardous to your wealth.

The expenses inside an annuity are one of the main problems. There are several expenses involved. Today most annuities do not charge you an upfront commission, the fee is charged as an annual fee (which you don’t see). This fee is deducted daily from your balance, there are five possible costs. The costs are: The policy charge, Mortality & Expense, Rider charges, underlying sub-account expenses, & transaction costs associated with those sub-accounts. Below is a range of what these cost can add up to:

Policy Charges                                   $ 30-50

Mortality & Expense                        1.00 – 2.00%
Riders                                                .25 – 1.25%
Sub-Accounts                                   .25 – 1.50%
Turnover Costs                                 .06 – 1.00%

Total Costs                                     1.56 – 5.75%  Annually

These expenses take a toll on the ability of the portfolio to match, or even beat the market. The annuity has to earn 2.5-5% before it breaks even for the year.

Add the fact that gains in an annuity are taxed as ordinary income when withdrawn and the chances of your annuity beating your taxable account come close to zero. In addition, if you die with an annuity you do not receive any favorable tax consequences. You lose what the tax code refers to as the “step-up” in basis, meaning that if you die with a taxable account the entire account gets passed on to your heirs with no income or capital gains tax, not so with an annuity.

You may ask “what about the guaranteed death benefit?”

It is basically worthless in most circumstance. Annuities are long-term investments, they are not meant for periods of less than 10 years. If you end up being one of those poor unfortunate souls that bought at the top of the stock market and still have less money than you started with 10 years ago (extremely unlikely, but it happens, though usually due to idiot broker advice) then your loss exposure is likely minimal. An amount that will be less than what you probably paid for the insurance over that period. In any event, the death benefit is not a logical reason to purchase an annuity.

Now, of course, if you have loved ones that you want to provide for a death benefit may offer you some peace of mind. Keep in mind what you pay for that peace of mind and the likelihood of it ever being collected on. If you are insurable, purchase insurance; if you are not, perhaps a variable annuity with a death benefit makes sense (though I still highly doubt it). If in the extremely rare circumstance that a death benefit makes sense in a variable annuity my choice would be to purchase a variable annuity from the Vanguard Group, as they offer a low cost account with a death benefit.

Let’s recap the problems with Variable Annuities. High expense, high marketing costs, tax penalties if under 59 ½, loss of capital gains status, loss of step-up, limited choice of investment vehicles, & worthless death benefits. So why do people continue to be sold these products? High commissions and high profitability to the companies involved. Profit is the bottom line, not your interests. Variable annuities have become such a problem that the SEC (regulator) has issued a booklet available online through its website that lists the pros and cons of annuities.

Living Benefits

Variable Annuity providers knew that the death benefit just wasn’t enough to keep the sale of variable annuities going, so they came up with a whole new generation of benefits for variable annuity products dubbed Living Benefits. The four major living benefits that are offered are as follows:

Guaranteed Minimum Withdrawal Benefit (GMWB)

Guaranteed Minimum Withdrawal Benefit For Life

Guaranteed Minimum Income Benefit

Guaranteed Minimum Accumulation Benefit

These living benefits are sold with some really great stories and too good to be true promises. I can’t even begin to get into the inner workings of each of these so called benefits because it would bore you and take up a lot of space. Suffice it to say that these living benefits are expensive (despite what your broker will tell you) and are not all they are cracked up to be. If you are being told that you will be guaranteed 7% on your money, beware and read the small print. If you are being told that regardless of stock market performance you can withdraw 7% of your account annually, beware.

The stories that are used to sell these products are wonderful, they sound like an investors dream, but reality is much different. These products are costly and in most cases fixed against the possibility of a claim being made. Always read the fine print and hire a professional who has nothing to gain to review any variable annuities recommended to you.

The “Bonus” Annuity Scam
If you are an annuity holder, chances are you have been approached by an insurance agent trying to sell you an annuity that pays you an ‘upfront’ bonus. Whatever you do, do not succumb to the sales pitch for the new “bonus” annuities. This is a new and highly aggressive tactic of the industry, to keep investors “imprisoned” in a high cost product, and generate new and even larger commissions for the sales force. Annuity holders with a few years left in their surrender charge period are approached with the following “typical” story:

“I understand that you are unhappy with your current variable annuity because of poor performance, lack of investment choices & a fading death benefit. I also understand that you have a surrender charge left. We are going to “help” by giving you an up-front ‘bonus’ of 3-6% to cover the surrender charge. It will not cost you anything to switch.”

Unfortunately, the only “bonus” is to the salesperson. The new sale starts the surrender period all over again and the salesperson gets another commission. It is a great deal for the agents, they get two commissions from you.

To pay for the bonus and the commission and any extras, the insurance company raises the expenses on your investments. Since these expenses are buried in the prospectus and hidden from you on your statements, you never know that you are being taken advantage of. When all is said and done, everybody is making money except you! I have actually been in meetings and heard brokers laugh at how they duped another person into a “bonus” annuity.

They refer to the extra commission internally as the “Yield to Broker.” It appears that the SEC is coming down hard on this practice. On June 5th, 2000, they issued an “investor alert” and placed a brochure on its website to help investors understand the benefits, costs, and risks of variable annuities, which combine features of mutual funds and insurance.

Insurance companies have been hit with rounds of lawsuits stemming from churning and suitability. It seems that the real “bonus” will be new business for trial lawyers!!!

Conclusion

When someone, specifically a salesperson who is compensated by commissions, recommends a variable annuity or a “bonus” variable annuity, you should seriously question whether the recommendation is in your best interest (or his). Take it from an ex-stock broker; that recommendation may very well be prompted by the promise of a very high commission.

Read about IRAs and Variable Annuities.

photo credit: loop_oh

Variable Annuities, Part 1

“High fees, low flexibility and ‘horrendous’ tax treatment make variable annuities less attractive than ever, except to the people who sell them.” – Liz Pulliam Weston.

Annuities may come in more flavors than Baskin Robbins ice cream, but don’t make the mistake of assuming that they are as simple as choosing between chocolate and vanilla. In truth, they are very complicated products. A variable annuity is an insurance contract that allows you to invest your premium in various mutual fund-like investments. If you are considering buying an annuity, you must do your homework before making a final decision. CNN.com’s annuity guide is a good on-line primer

SmartMoney.com summarizes as follows.

A variable annuity is basically a tax-deferred investment vehicle that comes with an insurance contract, usually designed to protect you from a loss in capital. Thanks to the insurance wrapper, earnings inside the annuity grow tax-deferred, and the account isn’t subject to annual contribution limits like those on other tax-favored vehicles like IRAs and 401(k)s. Typically you can choose from a menu of mutual funds, which in the variable annuity world are known as “subaccounts.” Withdrawals made after age 59 1/2 are taxed as income. Earlier withdrawals are subject to tax and a 10% penalty.

Variable annuities can be immediate or deferred. With a deferred annuity the account grows until you decide it’s time to make withdrawals. And when that time comes (which should be after age 59 1/2, or you owe an early withdrawal penalty) you can either annuitize your payments (which will provide regular payments over a set amount of time) or you can withdraw money as you see fit.

Since the person recommending the annuity will (no doubt) tell you how “great” this product is, this article will temper that by focusing on the disadvantages of a variable annuity.

Sold not Bought

In financial circles, it has often been said that annuities “are sold, not bought.” And sold they certainly have been — there is more than $1 trillion invested in variable annuities, and new sales total well over $100 billion every year.

However, the popularity of an annuity as an investment does not necessarily suggest that it is wise for you to invest your hard-earned money in it.

So are variable annuities good for investors?

Liz Pulliam Weston, who writes a column for MSN Money, gives away the answer in her article’s title The Worst Retirement Investment You Can Make.

Calling it the “worst” investment may, perhaps, be a slight exaggeration. Let’s look at her main points.

Tax treatment. Your gains in an annuity grow tax-deferred, but they are taxed as income when you withdraw the money. That contrasts with other investments such as stocks and mutual funds, which can qualify for lower capital gains treatments.

Penalties for early withdrawal. Variable annuities are designed as retirement savings vehicles. So, you pay a 10% federal-tax penalty if you withdraw money before age 59½. Insurance companies typically levy surrender charges of their own if you withdraw more than 10% of your balance in the first few years. Surrender charges usually start at 7% of your investment and decline to zero over the next six to eight years. They can range, however, up to 16% and last for as long as 15 years.

Death benefit. Variable annuities typically come with a death benefit that ensures your heirs get back at least as much as you invested if you’re unlucky enough to die while your investments are down. Your heirs will have other problems if you die owning an annuity, however. While most other investments get favorable tax treatment — a so-called “step-up in basis” that eliminates or drastically reduces the taxes heirs must pay when they sell — withdrawals from an annuity are taxed at regular income-tax rates.

Living benefits. Death benefits aren’t the only insurance feature you can get with a variable annuity. Increasingly, insurers are pushing so-called “living benefits” or “life benefits,” which guarantee that you can get back at least your original investment, usually compounded by a certain amount, when you withdraw the money in retirement. Investors stung by the bear market are greatly attracted to these guarantees, Carey said. That’s helped fuel annuities’ rise. Living benefits were available on 20 of the 25 top-selling variable-annuity contracts last year.

Costs. The insurance features of an annuity aren’t free, of course. The typical annuity with just a death benefit costs 50% to 100% more in annual fees than comparable mutual funds. Life benefits can add 20% or more to that cost.

Those extra expenses can seriously eat into your returns. Consider what would happen if you invested $5,000 a year in mutual funds with annual expenses of 1.5%, versus the same investment in an annuity with a 2.5% expense ratio.

If the underlying investments returned 8% a year, after 30 years:

Your variable annuity would be worth $362,177.
Your mutual funds would be worth $431,874 — a difference of nearly $70,000, or 14 years’ worth of contributions.

The gap just widens if you consider the tax implications. In both scenarios, you won’t have to pay tax on your original contributions when you withdraw the money. But the mutual fund gains would in most cases qualify for capital gains tax rates, which range from 5% to 15%, while the annuity’s payments would be taxed at income tax rates — currently 10% to 35%.

Are the life benefits worth it?

Meanwhile, the chances of your actually using the insurance benefits are slim. Relatively few people will die with their annuities worth less than what they paid. The living benefits typically come with a 10-year holding period, and there have been few 10-year periods where investors have actually lost money.

Insurers argue that the life benefits serve as “guard rails,” allowing investors to take more risk with the knowledge that their basic investment is protected. Many financial planners respond that a more appropriate response to risk is to construct a balanced, diversified portfolio with bonds and cash to cushion stock market swings.

Of course, most variable annuities aren’t bought — they’re sold. Only about 2% of variable annuities are purchased directly by consumers; the rest are sold through brokers, insurance agents and bank employees who are paid often-hefty commissions on their sales.

The math is lousy

“When you take the commissions out of the equation, the allure of a variable annuity disappears,” said Miami fee-only financial planner Frank Armstrong, a former insurance agent and author of “The Informed Investor: A Hype-Free Guide to Constructing a Sound Financial Portfolio.” “They cost a bundle,” he added. “And the tax treatment (upon withdrawal) is horrendous.”

“Nobody who’s in the fee-only (planning) business is going to recommend them,” said Armstrong. “Why do you think that is? You think we just have a blind spot that we can’t do the math?”

Some of most vociferous critics of variable annuities are those who, like Armstrong, spent some time in the brokerage firms or insurance companies that push them. Before he became a fee-only planner, Rob Pool of Portland, Ore., worked for a major brokerage firm, and the experience made him wary of the way annuities are sold.

“They’d get recommended even if it wasn’t in the client’s best interest all the time,” Pool said. “I can’t say there’s never a place for a variable annuity in a portfolio, but I haven’t found it yet.”

Conclusion

Personally, I do not recommend variable annuities for my clients, because they are not in my clients’ best interest, and there are much better alternatives. Variable annuities have very high expenses, unfavorable tax ramifications, and they lack flexibility. Before buying one you should understand the surrender charges, early withdrawal penalties and the annual fees. It bears repeating, do your homework before you consider buying an annuity.

Larry Swedroe and Jared Kizer in their new book The Only Guide to Alternative Investments You’ll Ever Need say this:

Some investment products are so complex in design that it is very difficult, if not impossible, for the average investor to fully understand the risks entailed and the costs incurred. Make no mistake about it, the complexity is intentional. After all, if the investor fully understood the product, it is likely that he or she would never purchase it. That is why many of such products are truly “tourist traps” – designed to be sold, but never bought.

Education – or a good fee-only adviser who is not influenced by commission-based compensation – can be the armor that protects investors. The overwhelming evidence from academic studies on Variable Annuities is clear: In general, these investments fall into the category of products that are meant to be sold, not bought.

Read Part 2.

The Dark Side of Wall Street, Part 3

“Not infrequently, brokers become disenchanted and leave the business. Occasionally, they will even become fee-only advisors, whose compensation is not tied to trading.” – William J. Bernstein.

In a previous post, I asked the rhetorical question, “Why would you even consider working with a financial advisor who warns you in writing that ‘Our interests may not always be the same as yours’ and ‘Our profits, and our salespersons’ compensation, may vary by product and over time.’”

Friday’s post quoted exclusively from William Bernstein on the subject of stock brokers’ competence and compensation.

Today’s post quotes a former stockbroker on the incentives and pressures he observed. Scott Dauenhauer, of Meridian Wealth Management, is a colleague who spent five years working for the “big three” brokerage firms. He has written a vivid expose called Secrets of the Wirehouse and How to Protect Your Best Interests.

( “Wirehouse” is an industry term for a large national broker/dealer. Merrill Lynch, Morgan Stanley, Lehman Brothers, and Bear Stearns are all examples of wirehouses.)

Scott’s article covers many topics including broker training, compensation, and the various investment products you should avoid. Here is what he says about broker competency, compensation and the conflicts of interest endemic in the financial community.

How much training do brokers actually have in financial planning? Major brokerage firms tout intensive training programs almost as much as the stocks they peddle.  They brag about the high level of education their “consultants” receive. The truth is the only requirements are that individuals pass the Series 7, and a state insurance exam.  The Series 7 is an industry test that requires memorization of facts about the markets and represents a minimum standard of knowledge.

The Series 7 does not teach an individual how to manage personal finances, let alone create a comprehensive financial plan. The Series 7 doesn’t even teach about how to properly diversify a portfolio.  The insurance exam is an even bigger farce. While the Series 7 actually requires a bit of studying the state insurance exams only require minimal memorization.

Anyway, once a “recruit” passes the Series 7, he/she is sent to company headquarters to go through “intensive training.”  The training is definitely intensive, though not in financial planning or investment management.  The programs focus solely on sales & product training and lasts anywhere from 1-4 weeks. I attended one such program and 95% of the training focused on cold-calling sales and learning proprietary product. Proprietary products are ones that are sold directly (and typically only) by the brokerage firm and typically have much higher profit margins, though mainly benefit the firm, not the person they are sold too.  Brokerage firms want “salespeople,” not highly skilled financial planners.

If the firms hired highly skilled financial planners, the firm wouldn’t be able to sell proprietary products.  This is because the planners would know better.  When the firm hires somebody with no previous industry knowledge, or experience, they have the opportunity to fill that person’s mind with fairy tales, not fact.  The firms’ way of doing business is to focus on proprietary products, high & hidden fees, cold calling, and quotas.  The truth is that very few new recruits have any experience in handling another family’s wealth.  You end up paying high fees for a service that puts you directly on a recruit’s learning curve.  Even brokers who have been at the firm for years may not have any training in financial planning; they are stockbrokers, not trusted advisors.

When dealing with brokerage firm, conflicts of interest abound and for the most part are not disclosed.  The following is a few conflicts that you should watch out for.

First, please understand to whom a public company owes their loyalty; it is to their public shareholders.  The people who own stock in a company must have their interests protected.  A public brokerage firm’s loyalty cannot be 100% to you.

Let’s take a further look at where other strings are attached. A broker gets paid a percentage of the revenues that he/she brings to the firm, typically 25-40%.  It is not, however, that simple. Brokerage firms determine the payout percentage for each individual “product.”  They control product flow by paying higher amounts to brokers for product they want sold (typically products with higher margins).  While this makes sense from a business stand point and from a shareholder standpoint (why wouldn’t you want to incentivize your staff to sell the most profitable products?) it doesn’t work out so well for the end user, the client.  Each firm works differently but depending on the product a firm wants to emphasize, they will pay a broker a higher percentage of the revenue to induce him to sell what the company wants him to sell.  For example, if the company wants a broker to sell a Separate Account Platform product (individual money managers, more to come on this), they may tell the broker that they will receive a higher percentage of the fees they generate from that particular product and that product may generate more fees than other products.

Let me give you a real life example so that you understand.

Imagine that you had only two products to choose from to sell your client; one is a mutual fund that costs the client 2.25% annually and pays the firm 1% annually.  Of the 1% paid to the firm the broker collects 35% of it or .35% annually. On a $1,000,000 account the firm generates $10,000 in revenue and pays the broker $3,500 (you the client pay $22,500).  The other product is a Separate Account where you have an individual money manager.  This product is sold as the latest, greatest way to have your money managed and costs 2.5% annually.  However, this product pays the firm 1.5% annually and the firm will pay the broker 40% of that revenue or .60% annually. On the same $1,000,000 account the firm generates $15,000 in revenue and pays the broker $6,000 (you pay $25,000 annually).  Now, in all likelihood both accounts will have similar returns over time and will probably under-perform the market.  You the client in either situation are stuck in a lousy product that is expensive; however the firm has an incentive to sell one over the other, even if the other isn’t in your best interest.  The separate account sale earns the firm 50% more revenue and the broker 70% more revenue – which product do you think will be presented?  Each firm has their own system and they are all different, but the mechanisms are in place to manipulate the broker into selling what makes the firm and/or the broker more money.

In addition to higher revenue on proprietary products, the broker many times is under tremendous pressure from management to sell you the latest mutual fund offering from that brokerage.  Branch manager compensation is determined in part by the amount of proprietary products his branch sells. His interest is in getting the highest bonus possible, so he in turn puts the pressure on the brokers to “pound the phones,” and sell their “latest offering.”  The brokers are enticed by management with trips, dinners, and a host of other items. It goes unspoken that if a broker does not participate in selling the new offering then things will not be easy for him/her.  I know of one broker who was told, “I don’t think this firm is the right place for you,” after the broker refused to sell the new fund offering.  It turned out that he was the only one to not succumb to the pressure, he eventually left that firm.  I can’t begin to tell you how many voice mails & e-mails I received from management to ‘sell’ the “new” offerings, I never succumbed because it was not in my client’s best interest. Be aware that the pressure is on your broker to sell certain products or else he/she risks losing their job.

Conclusion

Brokerage firms (wirehouses) train (brainwash) recruits in sales techniques and product knowledge, not portfolio management and financial planning. They use carrots and sticks to influence brokers to recommend investment products that are profitable to the firm.

According to William Bernstein, brokerage firms target how much they are going to earn from clients’ accounts.

At the end of the day, most wirehouses operate on the “2% rule” – collect 2% in fees and commissions, overt or hidden, on your clients’ assets, or you’re out.

My experience is that the 2% figure is extremely conservative – it is not unusual to see accounts from which as much as 5% annually is extracted.

You will not see these fees and expenses outlined, because they are not easy to discern. Unless you are a detective, they will be hidden from your view.

Is there a better way? Certainly. It is choosing a fee-only financial advisor, who acts in your best interest, as a fiduciary.

To be continued.

The Dark Side of Wall Street, Part 2

“Make no mistake about it, you are engaged in a brutal zero-sum contest with the financial industry — every penny of commissions, fees, and transactional cost they extract is irretrievably lost to you.” – William Bernstein.

Yesterday’s post was about Wall Street’s habit of designing complex financial products that are difficult to understand. They promise high returns with less risk, but often fail to deliver.  They entail high fees, which are profitable for the producer of these instruments, but not for investors.

It is well worth delving into the issue of brokers’ conflicts of interest.  Your success as an investor depends on knowing how Wall Street really works and in not accepting the client-friendly face it portrays on TV.

William Bernstein, the author of The Four Pillars of Investing, has a lot to say about the competency and compensation of brokers in a chapter called Your Broker is not Your Buddy.

There are no educational requirements for brokers (or, as they’re known in the business, registered reps).  No mandatory courses in finance, economics, law, or even a high-school diploma are necessary to enter the field.  Simply pass the pathetically simple Series 7 exam, and you’re on your way to a profitable career.

It is a sad fact that you can pass the Series 7 exam and begin to manage other people’s accumulated life savings faster than you can get a manicurist’s license in most states.

The most shocking aspect of the brokerage business is that brokers almost never actually calculate the investment results of their clients, let alone reflect on methods for improving them.

Brokers are not trained by the brokerage houses to invest – they are trained to sell.

Brokers pay almost no attention to the returns their clients earn.  It is rare to come across one who routinely calculates his clients’ annual returns, let alone considers what these data might mean.

Brokers do undergo rigorous training, sometimes lasting months – in sales techniques.

What do brokers think about almost every minute of the day? Selling. Selling. And Selling.

Because if they do not sell, they’re on the next train home to Peoria.  The focus on sales breeds a curious kind of ethical anesthesia.  Like all human beings placed in morally dubious positions, brokers are capable of rationalizing the damage to their clients’ portfolios in a multitude of ways.  They provide valuable advice and discipline.  They are able to beat the market.  They provide moral comfort and personal advice during difficult times in the market.  Anything but face the awful truth: that their clients would be far better off without them.  This is not to say that honest brokers who can understand and manage the conflicts of interest inherent in the job do not exist.  But in my experience, they are few and far between.  After all, what is best for the client is to keep investment costs and turnover as low as possible, which also minimizes a broker’s income.

Brokers will protest that in order to keep their clients for the long haul, they must do right by them.  This is much less than half true.  It’s a sad fact that in one year a broker can make more money exploiting a client than in ten years of treating them honestly.  The temptation to take the wrong road is more than most can resist.

Conclusion

Under no circumstances should you have anything to do with a “full service” brokerage firm.

You do not want anyone near your money – advisor or broker – whose compensation is tied in any way to his choice of investment vehicles. 

To be continued.

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