Goldman Sachs: Banker or Bookie?

Late last week, the Securities and Exchange Commission charged Goldman Sachs with investor fraud.  It seems that they chose not to disclose all of the terms of one of their own financial products.  After reading the analysis of the events, I have just got to ask:  Are these bankers or bookies?  Goldman Sachs, among other large Wall Street firms, appears to be running a legal bookie operation, catering to clients who wanted to place large bets on the outcome of certain financial events.  You’ve heard the expression, if it walks like a duck and talks like a duck… The real question: was the game rigged?  We’ll have to wait and see.

Last month, in a post about Greed and Delusion on Wall Street, I said

It’s difficult to appreciate the amount of backstabbing, mistrust and cynicism that is endemic at Wall Street firms. “Wall Street doesn’t care what it sells.” Investment banks exploited their institutional customers (pension funds, mutual funds, banks). The same firm that is advising them on what to invest in (the sell side) also has an in-house operation that is trading for its own account. Why is this blatant conflict of interest allowed?

Incredibly, I may have actually understated the problem!  It seems to me that it is patently impossible to be cynical enough, at least about some Wall Street firms.

Why do I say that?  Well, the suit filed by the SEC alleges that Goldman Sachs put together a package of derivatives based on subprime mortgages and did not disclose that the components were selected by the party who wanted to bet against the investment, i.e. sell short.  The claim is that the security was “designed to fail.”  Please take note of the word “alleged,” meaning that they may or may not have done something illegal.  Because it’s a civil lawsuit which may take years to adjudicate, Goldman Sachs will have ample opportunity to present its side of the story.  I have complete confidence that they will hire the best lawyers that megabucks can buy.

Even if Goldman Sachs “wins” that lawsuit, they may have lost something infinitely more valuable – their reputation.  To my mind, this is no small thing, since confidence in your advisor is (or should be) of paramount importance to investment bankers, including Goldman Sachs.  I am compelled to ask one more question, though, did these bankers aim to protect investors’ interests or were they just determined to make a profit at all costs? 

What Is the Public Value of Trading in Synthetic Securities?

But as investors and citizens, it is worth pondering whether all of this trading activity has a social purpose or is it merely gambling in a more refined form.  The topic of synthetic financial derivatives is highly complex and difficult for most ordinary mortals to understand.  But Roger Lowenstein’s column, Gambling With the Economy in the April 20^th edition of The New York Times, offers an excellent summary of the arguments:

Wall Street’s purpose, you will recall, is to raise money for industry: to finance steel mills and technology companies and, yes, even mortgages. But the collateralized debt obligations involved in the Goldman trades, like billions of dollars of similar trades sponsored by most every Wall Street firm, raised nothing for nobody. In essence, they were simply a side bet — like those in a casino — that allowed speculators to increase society’s mortgage wager without financing a single house.

The mortgage investment that is the focus of the S.E.C.’s civil lawsuit against Goldman, Abacus 2007-AC1, didn’t contain any actual mortgage bonds. Rather, it was made up of credit default swaps that “referenced” such bonds. Thus the investors weren’t truly “investing” — they were gambling on the success or failure of the bonds that actually did own mortgages. Some parties bet that the mortgage bonds would pay off; others (notably the hedge fund manager John Paulson) bet that they would fail. But no actual bonds — and no actual mortgages — were created or owned by the parties involved.

The S.E.C. suit charges that the bonds referenced in Goldman’s Abacus deal were hand-picked (by Mr. Paulson) to fail. Goldman says that Abacus merely allowed Mr. Paulson to bet one way and investors to bet the other. But either way, is this the proper function of Wall Street? Is this the sort of activity we want within regulated (and implicitly Federal Reserve-protected) banks like Goldman?

While such investments added nothing of value to the mortgage industry, they weren’t harmless. They were one reason the housing bust turned out to be more destructive than anyone predicted. Initially, remember, the Federal Reserve chairman, Ben Bernanke, and others insisted that the damage would be confined largely to subprime loans, which made up only a small part of the mortgage market. But credit default swaps greatly multiplied the subprime bet. In some cases, a single mortgage bond was referenced in dozens of synthetic securities. The net effect: investments like Abacus raised society’s risk for no productive gain.

Conclusion

I find Lowenstein’s points very convincing, and I totally agree with his recommendations.
“ …the financial bailout has demonstrated that big Wall Street banks … (have) implicit bailout protection. Protected entities should not be using (potentially) public capital to run non-productive gambling tables.
… Congress should take up the question of whether parties with no stake in the underlying instrument should be allowed to buy or sell credit default swaps. If it doesn’t ban the practice, it should at least mandate that regulators set stiff capital requirements on swaps for such parties so that they will not overleverage themselves again to society’s detriment. …”

Proposed reforms by the Obama administration will hopefully rein in the questionable activities of Wall Street bankers, although, Wall Street lobbyists will naturally attempt to defeat any such reform. As I said previously, we’ll have to wait and see, but nearly a week later, no further charges from the SEC have been forthcoming. Of note, however, several European countries have commenced the filing of similar charges against Goldman Sachs.

More About Ric Edelman

When in my last post, I criticized some of Ric Edelman’s practices and fees, I felt a bit queasy.  Was I being unfair?

I reached my conclusions by reading the handout material and by what he said in a seminar.  I also studied his web site, which disclosed his fees.  But I did not have direct access to a client’s portfolio, so I felt somewhat tentative in my judgments.  But today’s post by Allan Roth An Interview with Ric Edelman – Is High Cost Indexing an Oxymoron? confirmed my suspicions.

Roth analyzed an Edeleman client’s portfolio, and he also spoke to Edeleman. Roth reached the same conclusions I had about the high fees, and he also questioned Edelman’s recommendation of not paying off a mortgage.  Finally he confirmed my belief that Edelman was not paying attention to asset location, since he found the same allocations in the IRA accounts as in the client’s taxable accounts.

But enough criticism.  The rest of this post is about Edelman’s book The Lies About Money, which I can recommend.  In the first two chapters he persuasively lays out the case for diversification and for not trying to time the market.  This is a very important message which many investors still do not get.  Then he explains the advantages of mutual funds.

But it in his fourth chapter, The Demise of the Retail Mutual Fund Industry, that he shines.  He essentially demolishes (active) retail mutual funds.  For starters, he discusses the frequent manager changes, the costs of active management, and the dangers of style drift.  And this is just the beginning; he discusses 25 reasons why you should not use a typical (active) retail mutual fund.

Not satisfied with that, Edelman actually put together A Mutual Fund Scandal Timeline outlining the abuses that have been alleged or proven from 2003 to 2007.  It takes him a “mere” 40 pages to summarize the questionnable practices and allegations of abuse.  If that is not enough to make you question whether your mutual fund or stockbroker is actually your friend, then nothing will.  So buy the book or get it out of the library simply for Chapter 4.

Conclusion

The financial services business is fraught with conflicts of interest, high fees, misleading ads, and general confusion for the typical investor.  Sorting through this mess is not easy.  As William Bernstein says, “Both mutual fund companies and brokerage houses know more ways than you can count of fleecing you without your knowing it.”

To be continued.

Brokers May Have to Change

“A report by Rand Corp. last year found that 63% of investors think brokers are legally required to act in the best interest of the client; 70% believe that brokers must disclose any conflicts of interest.  Advisers always have those duties, but brokers often don’t.  The confusion is understandable, because a lot of stock brokers these days call themselves financial planners.” – Jason Zweig.

If you are confused by the difference among these titles: Financial Planner, Stockbroker, and Registered Investment Advisor, you are not alone.  The “Name Game” in the financial services industry is downright confusing.  How does your financial advisor operate?  How does she get paid?  What are the advantages and disadvantages of each arrangement?

Many people believe that they are getting financial planning from a stockbroker, when in fact financial planning is usually only an incidental part of what a stockbroker does.  Similarly, many people are not aware that a stockbroker does not have to act in the client’s best interests.

A June 19th Wall Street Journal article Big Change in Store for Brokers in Obama’s Oversight Overhaul brings home this point.

According to the article, stockbrokers might have to change the way they do business; they might have to act in their client’s best interests, the way a Registered Investment Advisor already does.

Wow!  What a concept.

Here are the relevant quotes:

Buried in President Obama’s proposed regulatory overhaul is a change that could upend Wall Street: Brokers would be held to a higher “fiduciary” standard that would compel them to place their client’s interests ahead of their own.

Currently, brokers are only required to offer investments that are “suitable,” which means they can’t put clients in inappropriate investments, such as a highly risky stock for an 80-year-old grandmother. The move could change the way products are sold and marketed and even how brokers are compensated.

Many investors don’t even know the difference between the two standards, believing their brokers already are acting in their best interests.

But requiring brokers to operate under a fiduciary standard could force them to offer products that are less costly and more tax-efficient. They will have to disclose any potential conflicts of interest, such as any fees they may get for favoring one product over another. That could mean clients will be offered fewer proprietary products if the broker can find a lower-cost option elsewhere.

For example, a broker couldn’t put you in a mutual fund with higher fees — or one he gets a bigger commission for selling — if he could get a comparable fund with lower fees elsewhere, says Tamar Frankel, an expert on fiduciary law at Boston University School of Law. (Emphasis added.)

The article implies that some stockbrokers sometimes put their interests above yours.  Hmm.   This might just be worth investigating.

Luckily, I’ve discussed this topic many times, and in fact I have a series called The Dark Side of Wall Street, which lists all of the relevant posts.  If you start with Choosing a Financial Advisor, Part 1 at the bottom of the page, you can read them in order by following the “To be continued” link at the end of each post.

Avoid Investment Scams, Part 1

“There’s no such thing as a free lunch.” – Milton Friedman.

“Fed up with purported financial advisers preying on unwitting older people, investigators from the Arkansas Securities Department last year staged an undercover sweep of one of the hucksters’ favorite showcases — free lunch seminars.”

That was the lead in today’s Wall Street Journal article Laws Take On Financial Scams Against Seniors.  According to the article, which is about some questionable and possibly illegal practices, “financial scams that target seniors are on the rise, and states are cracking down.”

“Besides Arkansas and Michigan, Idaho also passed a senior-victim law in recent months that will go into effect this year. Six other states, including Maryland, Minnesota, Missouri, New Jersey, Rhode Island and West Virginia, have similar bills pending in their current legislative session.”

Leaving aside whether seniors are in particular need of protection, and whether the site of the crime is only a lunch seminar, let’s take a look at the misleading products offered.  Here are some relevant quotes, with emphasis added.

The Arkansas sweep … uncovered …shady practices — misleading claims, underplayed risk.

The recession has spurred more scams that play off people’s fear of stocks.  Some investments pitched as low-risk could instead be quite complex.

The events are generally pitched as educational events, with a free meal thrown in. But in Arkansas, state agents instead found that the dozens of seminars they attended all featured hard-sell pitches for financial products, many of which weren’t appropriate for elderly investors. Presenters at about half of the seminars made misleading claims about potential investment returns, Arkansas regulators say. And at about a quarter of the events, products being pushed were ill-suited to older people, such as investments heavily exposed to swings in stock prices.

The frequency of scams is increasing in the recession, many financial experts say. Seizing on fear of stock-market turmoil, sales people and fraudsters are hawking investments that claim to be “low-risk,” or a supposedly safe way to invest in the stock market and earn back losses. In fact, the products may be complex and have significant downsides.

Firms that have been cited for violations range from big financial giants to single-person offices.  In October 2007, a unit of Allianz SE, the German financial company, agreed in a settlement with Minnesota’s attorney general to review sales practices and to give refunds to as many as 7,000 Minnesota seniors that the state said may have been sold unsuitable annuities since 2001.  Allianz also agreed to strengthen its process to determine suitability for customers over the age of 65.

There is nothing illegal about financial advisers pitching products at seminars, but under securities and investor-protection laws, there are lines that these salespeople can’t cross.  Brokers must follow “suitability” standards, meaning they can’t sell a product that doesn’t make sense given a person’s age, income, or liquidity needs.  They can’t misrepresent products. S ales materials and oral presentations must show a balanced picture, with both the risks and benefits of investing in the product.  Any statements to investors that an investment is “safe as cash” or that it carries no market or credit risk “would raise serious questions under FINRA’s advertising rules,” according to the regulatory group.

A number of products sold to seniors have triggered investigations in recent months, including reverse mortgages, which can help senior tap equity into the home and be beneficial, but which can also include hidden costs. Also popular are deferred annuities, which promise future payments to the investor but which can lock up money for a decade or more.

Conclusion

I am not surprised that one of the vehicles used by the scam artists are deferred annuities, as I have written about this before. Quite simply, variable annuities pay salespeople very high commissions. Annuities may be suitable for some people, but determining what is best for you should be done by someone who does not gain from the decision. In other words, your best option is to hire a fee-only planner to advise you on whether you really need a deferred annuity. Quite possibly, a fee-only planner will come up with a less expensive solution that achieves the same goals as an annuity.

The article lists several sites which will help you if you think you have been scammed. Of course it may be too late at that point.  Instead, I’d recommend one site that will help you find a fee-only planner, a fiduciary acting in your best interests – the NAPFA website.

As mentioned in the article, salespeople must only follow a “suitability standard” and do not have to tell you about the best option for you.  The difference between a “suitability standard” and a “fiduciary standard” may seem like a technicality, but the effect on your financial wellbeing can be huge.

Read Part 2.

Avoiding Financial Fraud

Ron Lieber’s New York Times column Even Vigilant Investors May Fall Victim to Fraud was quite disturbing and not a little worrying. It recounts how Matthew Weitzman, a founder and principal at AFW Wealth Advisors, a Registered Investment Advisor, and a fee-only firm, is no longer with AFW. The firm informed its clients of “certain irregularities in a limited number of client accounts.”

You can read Lieber’s article for the details. What is not clear, though, is how much money was involved nor how quickly the irregularities were discovered. Though, from my point of view, they are not the most worrying aspects. What concerns me most is that Mr. Weitzman was a member of the National Association of Personal Financial Advisors (NAPFA).

When a member of the advisory community violates the trust that clients place in him, all clients and advisors suffer. What this country does not need right now is any further deterioration in what little confidence we have left in the banking system, the federal government or our financial advisors.

I have been a fee-only planner since 2003, and whenever possible, I recommend that investors seek out financial planners who are compensated directly by their clients, rather than by commissions. In this way, you will avoid obvious conflicts of interest.

Members of NAPFA all practice a fee-only method of compensation and sign a Fiduciary Oath, which means that they swear to act only in their clients’ best interest. So it is with great discomfort that I heard that not one, but two, former members of NAPFA have been accused of bilking their clients.

What to do? As Ronald Reagan once said, “Trust but verify.” And of course, you should never write checks directly to your advisor, but only to an independent custodian. It is the independent custodian who should be providing you with confirmations of all transactions and trades, and a monthly statement. These are sensible precautions in the age of Madoff.

As Lieber says, “Open your mail. Confirm the accuracy of your trades and fund transfers. Read your account statements. Every month. Every number. Every single word.” I am not sure about reading every number, every word, but I get his drift.

Lieber further recommends that you handle all of your stock transactions yourself. I believe most investors will find this “solution” impracticable, inconvenient and unnecessary. I believe a better solution is for you to sign a limited power of attorney, allowing your advisor to enter transactions on your behalf, but which does not allow him to withdraw your funds. Only you should have the ability to withdraw funds from your account. I am not an attorney, but I believe that this provides adequate protection. (Attorneys, please weigh in.)

My mother always said “A promise is a promise.” Unfortunately, there are always people who will promise one thing and do another. It’s disappointing to have your expectations dashed.

I don’t know about you, but I expect firefighters to be brave, judges to be moral and rabbis and priests to comfort the troubled. Yet, there have been judges who, instead of upholding the law, bend it out of shape for personal gain. And there have been priests and rabbis who have preyed upon our young and betrayed our trust.

Lieber says, “I’ve always believed that advisers in the (NAPFA) association were plenty smart and morally upright, but it’s hard to recommend them now without at least including an asterisk.”

In my experience, NAPFA members have the highest standards in the profession. But like every profession, there may be individuals who choose to violate the trust of clients they serve.

It’s not easy to protect yourself against out and out theft, but you can take some small comfort from the fact that if financial advisors break the law, they are subject to prosecution by the regulatory authorities.

In my opinion, a great majority of investors will lose countless dollars because of the continuance of “Standard Operating Procedures” at Wall Street investment firms. Every day these firms peddle ill-conceived, hard-to-understand, expensive investments, because it is profitable for them to do so. Investors will lose more money in the ordinary course of business than they will ever lose due to outright fraud.

Unfortunately, what is legal on Wall Street is bad enough.

And so, I will continue to heartily recommend NAPFA members, because the fiduciary standard is the right way to do business.

And yes, monitor your accounts. Remember, “Trust but verify.”

Questions to Ask When Picking a Financial Adviser

An article in the April 13, 2009 edition of the Wall Street Journal entitled Seven Questions to Ask When Picking a Financial Adviser largely misses the boat. Granted, it is a challenge to find a “reliable” financial advisor; however, the article did a poor job of advising you on how to go about it. Reading it may leave you with the conclusion that it is impossible to find a financial planner you can trust. There can be nothing further from the truth.

I take exception with the emphasis of the article and several of its points.

How does the adviser get paid?

Mentioning that there are different methods of compensation, as the article does, is not sufficient.

As I’ve said in previous posts, the key issue in choosing a financial advisor is finding one who will act in your interests. To determine that, you must know exactly how and who compensates your chosen advisor. If an advisor is fee-only, you’re off to a good start.

Remember that a stockbroker must act in the employer’s best interests, and that you are not his employer. A Registered Investment Advisor, on the other hand, must act in a fiduciary capacity, i.e. in the clients’ best interests.

Stockbrokers are subject only to a “suitability” standard. They are regulated by FINRA, which (despite their rhetoric) is dedicated to protecting stockbrokers and their employers, not necessarily investors.

What do the adviser’s clients say?

This may or may not be relevant or helpful.

Registered Investment Advisors are governed by the 1940 Investment Advisor Act, which expressly prohibits providing “testimonials,” which client references would fall under. Of course, a client recommendation or testimonial could easily be concocted anyway.

What’s the adviser’s track record?

The WSJ article didn’t even come close to getting this issue right. Choosing an advisor based on his/her supposed investing track record is the wrong approach on several counts!

Even if you did find an advisor with a “superior” track record, we know that it is meaningless, because, as has been stated before, “Past Performance is No Guarantee of Future Results.” If you’ll recall, Bernard Madoff had a superior track record, many testimonials and lots of personal references and endorsements. And we all know what he did.

Key Financial Solutions does not try to “beat the market.” We are not active managers, because studies show that the added costs offset any possible gains of active trading.  Market timing and stock selection do not work.

Since we are not mutual fund managers, we do not have one uniform documented track record. Real financial planners take into account their client’s needs, financial objectives and tax situation before investing their money.

Because our clients have different risk tolerances and time horizons, they naturally have different portfolios and, therefore, different investment performance.

Financial Planning versus Investment Performance

Understand that beating an index is not a financial plan. What a good financial planner will do is give clients the best chance to achieve their goals.  Because the financial plan sets the parameters of the portfolio, a portfolio is simply a tool to realize clients’ goals.

Don’t get me wrong, we are quite proud of our portfolio design, because we use low cost, tax-efficient mutual funds to build globally diversified portfolios.  I am personally fascinated by asset allocation and portfolio strategy.  I use automated reports and individual spreadsheets to monitor a portfolio and to make changes, when appropriate.  Certainly all of these necessary tasks contribute something to investment performance, but not as much as having a plan and sticking to it.

Real Life Returns

Since investor behavior is a very large component of investment returns, we act as coaches so that clients do not make big mistakes.  For example, we manage how clients respond to the euphoria near market tops and to the panic and despair around market bottoms.

Behavioral advice – coaching clients to continue to do the right thing and to avoid doing wrong things – will have a greater impact on investment returns than attempting to choose next year’s hot sector or mutual fund.

Believing in full disclosure and transparency, we report results quarterly so that a client can see exactly how well his or her portfolio is doing. This report is net of all fees, which are clearly stated, rather than being hidden. But I do not recommend giving quarterly results much importance.

Conclusion

When considering whether to retain an adviser for a long-term relationship, avoiding conflicts of interest should be the first consideration. A strict fee-only method of compensation is the best approach for most people. Members of the National Association of Personal Financial Advisors are strictly fee-only planners who sign a Fiduciary Oath.

NAPFA has always maintained that an advisor who is compensated solely through commissions faces immense conflicts of interest. This type of advisor is not paid unless a client buys (or sells) a financial product. A commission-based advisor earns money on each transaction—and thus has a great incentive to encourage transactions that might not be in the interest of the client. Indeed, many commission-based advisors are well-trained and well-intentioned. But the inherent potential conflict is great.

Who Will Guard Your Nest Egg?

“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.

Previous posts have discussed the advantages of using a fee-only financial planner and also the possible conflicts of interest that may arise when working with a commission compensated planner.

Certainly, Wall Street investment firms spend a lot of money on advertising, making it seem as though their interests are aligned with yours. So, it is understandable that the majority of consumers are unaware of the difference between a fee-only planner and someone who calls himself/herself a financial planner but who is actually a salesperson.

In Saturday’s Wall Street Journal, Jason Zweig delineates the nature and extent of the confusion.

Brokers must recommend only investments that are “suitable” for clients.

(Registered Investment) Advisers act out of “fiduciary duty,” or the obligation to put their clients’ interests first.

Most investors don’t understand this key distinction. A report by Rand Corp. last year found that 63% of investors think brokers are legally required to act in the best interest of the client; 70% believe that brokers must disclose any conflicts of interest. Advisers always have those duties, but brokers often don’t. The confusion is understandable, because a lot of stock brokers these days call themselves financial planners.

Brokers can sell you any investment they have “reasonable grounds for believing” is suitable for you. Only since 1990 have they been required to base that suitability judgment on your risk tolerance, investing objectives, tax status and financial position.

A key factor still is missing from FINRA’s (Financial Industry Regulatory Authority) suitability requirements: cost. Let’s say you tell your broker that you want to simplify your stock portfolio into an index fund. He then tells you that his firm manages an S&P-500 Index fund that is “suitable’ for you. He is under no obligation to tell you that the annual expenses that his firm charges on the fund are 10 times higher than an essentially identical fund from Vanguard. An adviser acting under fiduciary duty would have to disclose the conflict of interest and tell you that cheaper alternatives are available.

If brokers had to take cost and conflicts of interest into account in order to honor a fiduciary duty to their clients, their firms might hesitate before producing the kind of garbage that has blighted the portfolios of investors over the years. (Emphasis added.)

Conclusion

Panicking and pulling out of the stock market following a steep decline, concentrating your investments within a narrow range of options, and too much trading and too little long term holding are some of the more common mistakes investors make. Any and all of which will likely result in a reduction of your investment returns.

Understand, though, that high costs can absolutely kill your investment returns, whether from the high fees of a variable annuity or 403(b) plan, high (and often hidden) expenses and fees of some mutual funds, or the opaque mark-up on bonds sold to unsuspecting investors. Your best protection is to ask your financial advisor to sign a Fiduciary Oath. To find a fee-only planner near you, view the NAPFA (National Association of Personal Financial Advisors) web site.

It is encouraging that the issue of who is working in your best interests has been brought front and center by Jason Zweig, a respected author and columnist. Now, let’s see if the Securities and Exchange Commission Chairwoman, Mary Schapiro, proposes changes in legislation that will benefit consumers. The stakes are extremely high, as Wall Street firms make billions from unsuspecting customers.

Entrenched interests never give up power or lucrative business practices easily.

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)

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.

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