Chapter 20: Important Questions

If you are concerned about how your financial matters are being handled, or you just want assurance that you are on the right track, you should seek a second opinion of your portfolio and an analysis of the arrangement you have with your financial advisor. You should consult a Fee-Only investment advisor—a full-time fiduciary who is not compensated by commissions.

Resources for finding a Fee-Only advisor are The National Association of Personal Financial Advisors (www.napfa.org), Vanguard Group (www.vanguard.com), The Garrett Planning Network (www.garrettplannning network.com), and ClientFirst Wealth Management (www.clientfirstwealthmanagement.com).

What if you already own a variable annuity?

You may be better off to surrender your policy and pay the surrender charge. Compare the surrender charge to the annual expenses to obtain a break even point. For example, if the surrender charge is 7.0 percent and annual expenses are 3.5 percent, you would break even in a little over two years,
provided that you reinvest in an ETF with 0.20 percent annual expenses. If you also pay an advisory fee of 0.50 percent, your break even point would be approximately 2.5 years. Surrender charges may be tax-deductible, which could significantly shorten the break even period. There is a 10 percent penalty for surrendering the annuity before age 59½.

Earnings are taxed as ordinary income. If your variable annuity has significant earnings, instead of reinvesting directly in an index fund(s), consider a tax-free exchange for another more efficient annuity. This is known as a 1035 Exchange. Vanguard offers low-cost variable annuities featuring annual expenses of approximately 0.25 percent. The menu of the Vanguard annuity will consist of many low-cost, passive investment options that aim to match the performance of a certain index. As previously indicated, red flags should appear whenever a financial advisor recommends a 1035 exchange for another variable annuity which generates additional commissions. Vanguard annuities do not pay commissions, so there is no financial incentive to recommend a 1035 exchange for a Vanguard annuity.

What if you already own equity or stock mutual funds?

Identify the annual expenses you are paying and compare them to the expenses of holding a no-load index fund or ETF. If your fund has had some unrealized gains, you may want to hold on to it, or exchange it for a more cost-effective class of shares (such as advisor-class shares, if available). An exchange of share classes is typically not a taxable event. Take the same approach as you would when evaluating whether to hold a variable annuity. Identify your break even point after all surrender charges and annual operating expenses.

If you sell your mutual fund, you can purchase a no-load index fund or ETF in an advisory account. If you pay your financial advisor a 0.50 percent annual advisory fee (versus paying 2.0 percent in annual expenses for the mutual fund), your savings will be quite significant over time.

If you are unfortunate enough to have been sold B class or back-end load shares of a mutual fund, you will face multi-year surrender charges, just like an annuity.

What if I already own bond mutual funds?

Ideally, you can find an advisor who can design and manage a portfolio of individual bonds. This will allow you to replace your costly bond funds.

If you have owned the fund long enough to eliminate all surrender charges, you have a couple of alternatives. The first alternative is to see whether the mutual fund company offers advisor-class shares of the same bond fund. These shares will be less costly to own, because they do not impose embedded sales charges. The only reason to consider this option is if you happen to have a significant capital gain and have no way to shelter the gain from taxation,
such as a loss carry-forward. Otherwise, sell the fund and reinvest in a no-load index fund, fixed-income ETF, or individual bonds. There are many low-cost alternatives using passive management that track U.S. Treasuries, investment-grade corporate bonds, high-yield corporate bonds, and municipal bonds. If you own municipal bond funds, determine the amount of your bond income that is subject to the federal alternative minimum tax (AMT). Municipal bonds with coupon interest that is subject to the AMT are found in many municipal bond funds. They offer higher yields than similar bonds not subject to the AMT, but of course that extra income is “lost” to the investor at tax time. If you have an AMT problem and own a municipal bond fund with AMT bonds in its portfolio, you can sell the fund.

It can be difficult to find no-load index funds, or an ETF for municipal bonds comprised solely of bonds issued in your state of residence. If you are a resident of a state that imposes a state income tax, you can avoid that tax on the coupon interest if the bond is issued by an issuer located within the state. Certainly, if you own a high concentration of bonds in any state, it is even more critical that you know exactly what you own. Paying some state income tax can be a small price to pay for diversification. On the other hand, with state income taxes of 6.0 percent and higher, bonds that allow you to avoid this tax are well worth a look.

What if you already own Separately-Managed Accounts (SMAs) through a brokerage firm?

As with variable annuities and mutual funds, first conduct a break even analysis—comparing the annual expenses of the SMAs to those of no-load index funds and ETFs benchmarking the same index. SMAs can have very high annual expenses (up to 3.0 percent). Unlike annuities and certain share classes of mutual funds, SMAs have no surrender charges.

When exiting SMAs, your main concern is tax liability. For example, you may have four equity managers: large-cap, mid-cap, small-cap, and international. Identify your tax liability in each category. To the extent that you have gains, you can instruct the managers to offset them by taking losses where available. You can also request that any positions with net unrealized gains be delivered to your brokerage or advisory account “in-kind” so your gains are protected from taxation. However, you or your financial advisor will have to manage these positions in the future, which can be a time-consuming and complex task. Unrealized capital losses can be carried forward indefinitely, to offset future gains, or to be used against ordinary income up to $3,000 each year. You can redeploy the proceeds into cost-effective index funds or ETFs. If the SMA is comprised of bonds, you can take the entire account in-kind. Just be sure that you are working with an advisor that has experience managing a bond portfolio.

What if my account balance is less than $100,000?

If you have less than $100,000 to invest, you should consider using Vanguard or some other low-cost provider of comprehensive wealth management. If you work with a financial advisor compensated by commissions, you may be sold an annuity or a mutual fund with sales loads (load fund), high annual expenses, and surrender charges. If you establish an advisory account, the advisory fees may be too high to be efficient for a small account.

Where should I hold my account?

The victims of Bernie Madoff wish that they had paid more attention to who had custody of their assets. Be sure that your account and your assets are held at a well-known custodian. Never allow a money manager, wealth manager, or financial planner to have custody of your assets.

What if I like my present financial advisor, but prefer an advisory account?

Insist that your financial advisor obtain the necessary license (Series 65 or Series 66) to provide advisory services through an advisory account and act as a fiduciary. Many financial advisors are already licensed.

What if I already have a fee-based (as opposed to a Fee-Only) advisory account, but my advisor is partially compensated by commissions, and I do not want recommendations influenced by commissions?

You will need to search for an independent Fee-Only investment advisor. To find one in your area, go to www.napfa.org or www.garrettplanningnetwork.com, www.vanguard.com and clientfirstwm.com.

How do I know if the advisory fees that I am paying are fair?
Generally, any fee over 1.0 percent should be avoided. Advisory fees that include a comprehensive financial plan and periodic updates will typically be higher than those that do not.

How can I reduce advisory fees?
If you feel that advisory fees are too high, request a reduction. There is no law against negotiating. Request a proposal from competitors to use as a comparison. You may realize significant savings with another financial advisor.

If I terminate the client agreement, what fees am I entitled to recover?

Many fee-based advisory agreements charge fees quarterly, in advance. Others charge in arrears, after the work is done. If you have paid in advance, you are generally entitled to receive a pro rata refund for the remaining days in the quarter.

What if I am a trust beneficiary and wish to change trust companies?

It depends upon the language in the trust document. Some documents give the trust department or trust company a virtual lock on managing the assets. Trust departments, known more for their unremarkable money management than anything else, can relax knowing that they have no competition. It may be possible to move the assets to another trust company, and to have the financial advisor of your choice manage the investments. Studies reveal that one of the most common complaints from trust beneficiaries is discovering that trust assets are deployed in poorly-performing investments—often the bank’s proprietary investment products that have high fees.

What if I already own a whole-life insurance policy?

If you already own a whole-life insurance policy, such as a traditional whole-life policy, a universal-life policy, or a variable-life policy, you should consider buying term-life and cashing out of your existing policy. You may be able to save a significant amount of money.

There may be extenuating circumstances under which you may not be able to achieve significant savings, and under which you have little choice but to hold onto your existing policy. If, for instance, you are not in good health, a new policy could be prohibitively expensive or unavailable altogether.

Where can I purchase cost-effective life insurance?
For online quotes from multiple insurance carriers, try www.selectquote.com or www.eterm.com.

What if I already own a target-date fund?

You need to read the prospectus carefully to be sure that asset allocation is not too aggressive. You can always contact the fund company, your financial advisor, or your 401(k) plan sponsor to get the answers you need.

What if I like working with my financial advisor, but I just learned that he has been disciplined or fined by a regulator?

In one word, leave! Find another financial advisor. You should periodically check your financial advisor’s record at the appropriate regulator by visiting either www.sec.gov or www.finra.org.

What if I convert a variable annuity balance to a fixed annuity?

In this instance, the fixed annuity is a sum certain paid periodically for a period certain, such as 10 years or life, depending upon your needs. Once you “annuitize” your variable annuity balance, you will have credit exposure to the insurance company, just like any other fixed annuity. You should check to see what yields are available in the bond market before annuitizing. Chances are, if it is a good deal for the insurance company, it may not be such a good deal for you.

What if my 529 college savings plan is registered in my former state of residence?

Consider a rollover to another provider—one that offers a 529 in your new state of residence. This should enable you to avoid state income taxation. Be sure to compare investment alternatives and fees.

How do I re-title bank accounts or brokerage accounts so that they escape probate?

Just request Payable-on-Death paperwork from your brokerage firm,
and Transferrable-on-Death paperwork from your bank or other depository institution.

What if I own a variable annuity in my IRA?

Fire your financial advisor! A large part of the value associated with a variable annuity is the tax-deferral feature, and you pay dearly for this feature, but your IRA is already tax-deferred.

What if my only life insurance coverage is group term-life, offered through my employer?

This situation is not uncommon. Depending upon the terms of the coverage, you may be able to maintain the coverage after you retire, but at much higher premiums. So, even if you do have employer-based coverage, you might consider buying an individual term-life policy as a supplement. Although the premiums may be higher, you will have portability if you change jobs and will avoid the need to shop for life insurance at retirement, when your life will be more costly to insure. By the time you retire, you may have health issues, making coverage unaffordable or unavailable.

What if an insurance agent is suggesting that I purchase one insurance product to help pay the premiums for another?

For instance, what if you need long-term care insurance and the agent suggests buying an annuity to generate income to pay the premiums on the long-term care policy? Request a written cost-benefit analysis and as always, make sure you are working with a fiduciary.

The next chapter provides a list of questions to ask your financial advisor.

“It’s not how much money you make,
but how much money you keep,
how hard it works for you,
and how many generations you keep it for.”
~Robert Kiyosaki

Have a question? Contact Ed Mahaffy.

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