By: Gary Droz
The U.S. Department of Labor (“DOL”) has endeavored to address the problem of conflicts of interest in retirement advice with its new fiduciary rule, which focuses primarily on brokers because of their compensation practices that often include 12b-1 fees and commission on proprietary or platform products. Unless the final DOL fiduciary rule is amended or abandoned, any financial professional who works with retirement plans or provides retirement planning advice will be automatically elevated to the level of a fiduciary under ERISA. This means they will be required to meet the standards of this elevated status as well as meet an exemption in order to receive certain compensation, which creates conflicts of interest, and clearly disclose this information to clients.
Here at MainLine Private Wealth, we applaud the DOL for its efforts, but we believe there is a significant conflict of interest these exemptions and the DOL fiduciary rule will not address including the ways in which fund companies end up with their investment products on your broker’s platform. Right now, in order for funds to be included on your broker’s platform, many fund companies or money management firms are often required to pay the brokerage firm a hefty access fee. This means that an investment product that your broker offers as a recommendation may have bought and paid for that spot on the platform instead of earning it. The question becomes are the funds who pay to play really the best investment options available or just those with the most cash?
These practices became a headline this year when Morgan Stanley, one of the largest brokerage firms in the world, removed Vanguard’s mutual funds from its broker offerings. Why would such a dominant broker network remove one of the most popular fund families available and also refuse to pay brokers on assets invested in Vanguard investments? It’s simple. In a recent Wall Street Journal article, Bill McNabb, Vanguard Chairman and Chief Executive, explained that “[t]hey have a model where they want to be compensated for being on their platform in one form or another and that’s just something we won’t do. We think it raises inherent conflict.” The article goes on to say that “by excluding Vanguard funds from its compensation structure Morgan would effectively be giving advisers a disincentive to keep clients in the funds.” Morgan Stanley isn’t the only big bank to ax Vanguard. Another earlier article in the Wall Street Journal noted that Merrill Lynch“already doesn’t allow new clients to purchase new share of Vanguards mutual funds.”
Again, we point to some obvious and important questions. Why remove Vanguard? What separates them from the rest of the pack? And why would Vanguard refuse to pay? Among other things, by refusing to pay access fees, Vanguard is able to keep their fund expenses at the lowest possible level, yet those low fees may be exactly what makes them solid performers. In fact, Morningstar discusses this very topic – the link between fees and performance – concluding that the correlation between low fees and good performance is almost unassailable, stating that “[l]ow fee funds give investors the best chance of success over the long run.”
This creates a conflict for investors, as some of the lowest fee options, like Vanguard, are removed from certain platforms because they are unwilling to “pay to play.” Therefore, it seems likely that other big banks and brokerage firms may follow in the footsteps of Morgan Stanley and Merrill Lynch, which would keep Vanguard (and other great products) out of the investment line up and out of reach for many investors. And, while the DOL fiduciary rule conceptually is good for investors, even it won’t prevent fund companies from buying their way on to certain platforms.
By: Gary Droz
There’s little doubt among industry experts that the equities markets have soared in the first half of 2017. This analysis is hard to miss, given that all the “talking heads” are being asked, and are answering, the same question, now that the third quarter is underway: “what’s in store for the markets in the second half of 2017?”
After flipping through various news channels and reading countless online and print articles a day, a common theme emerges from the market “experts” that are currently in the public’s eye: are the gains that equities enjoyed in the first half of 2017 over and will stocks cool down in the second half of the year?
While this is a valid question, and one that might be important to investors in the short-term, the answer to what lies ahead is actually a pretty simple one to figure out, despite what you might be hearing on your television or reading in your daily news mash-up. In our view, total market value (as reflected by the S&P 500) will likely remain strong in the second half of 2017 for two reasons: (1) because of the historical data for the S&P and (2) based on simple arithmetic.
First, let’s examine the data. By June 30, 2017 the S&P 500 was up 9% year to date. At that point, we were all saying what a great year it has been thus far, but how will the year finish? The better question might be, do the next six months matter as much as the first half did? If you go all the way back to the inception of the S&P 500 in 1957, there have been twenty-five years where the index was up 9% or more. How many of those years finished in the negative? None. While we know that historical data cannot predict future returns, the data does present a very persuasive perspective. In my opinion, it seems highly unlikely that the year will finish in the red. While there are always factors that might create totally unforeseen anomalies, the data still strongly supports the likelihood of a positive year overall.
Now, let’s focus on a more important question, which we aren’t seeing the industry “experts” cover more broadly: if it’s going to be positive, how high can it go? In our view, of the 25 years that have provided returns of 9% or higher, most ended with a year-end return in the mid-teens to mid-twenties. Of those 25 years, there was only one year that ended in a single digit positive return. It’s especially relevant because that was the crash of 1987.
Here are the surprising stats:
First half of the year: ↑ 27.4%
Crash (10/19/87): ↓ 23%
Second half of the year: ↓ 17.4%
Year End: ↑ 5.3%
Finally, outside of the 1987 crash, the S&P 500 has only had two other years where the second half has been negative after a first half with returns above 9%. How did those years end up? In 1975 it finished at 37.5% and in 1986 at 19.7%.
So, our conclusion is pretty simple – historical data and arithmetic show us that the first half of the year creates a “cushion” to allow a drawdown to occur without wiping out the return for the year. Based on this it seems likely that the year will be a good one, even if a drawdown does occur. Let’s hope that the historical data prevails.
All investors should understand that even though historical performance is often used as a measure to model return expectations, past performance is never a guarantee of future results. Investing in securities involves risk, including the possible loss of principal. Projections regarding the likelihood of market outcomes are hypothetical in nature, and do not reflect actual investment results. You cannot invest directly in an index, like the S&P 500. S&P returns are reflective of the reinvestment of dividends and earnings.
By: Gary Droz
In the kind of bull market we’re experiencing, I get the same question from nearly every client: when do you think we can expect a draw down? While I cannot see the future, as an advisor I have the tools and team to provide you with my best assessment.
The market has been in a perpetual upswing for several months, which makes a draw down likely in the near future. While a correction is a normal element of the market cycle, it nevertheless creates a sense of unease in many investors. Drawdowns of approximately 5-10% are common in any market cycle, often times occurring multiple times within the same calendar year. It might surprise you to know that since 2009 the S&P 500 has had 24 drawdowns of more than 5%, which makes it easy to believe that a draw down is likely inevitable, especially considering the S&P 500 has climbed higher for nearly 244 trading days without a 5% or higher pullback.
The last drawdown of more than 5% occurred on June 27, 2016. If one occurred today, it would be the longest duration without one since 2009. If one doesn’t occur until August, it would be the longest period in 20 years. Based on these numbers, it’s impossible to think that a drop in the market is anything but imminent. But as an investor how should that change your behavior? Provided you have crafted a diversified investment strategy that takes into account your personal objectives, goals and risk tolerance – it shouldn’t change your behavior at all.
It is important to understand that the likelihood of a drawdown should not alter your basic investment approach or asset allocation. Provided you are comfortable with the volatility of your portfolio, it is important to be consistent. If you refer to this 20 Year Rolling Chart, you can see that the 24 drawdowns have not altered the basic upward trajectory of the market (as measured by the S&P 500), which has demonstrated performance of approximately 8-9% over the last 28 years – including the meltdown of 2008. Time has a remarkable way of “smoothing out” these periods. Whatever your allocation, whether it be conservative or aggressive, it probably makes sense to stick with it and let the allocation work for you.
By: Gary Droz
As previously published on abcnews.com/money
Many middle-class Americans—and even some with high incomes—feel that no matter what they do, they can’t build wealth because the obstacles are too great.
The good news is that you can accumulate wealth much faster than you think by making sound investments that lead to compounded investment returns—essentially, returns on your investment returns, and returns on these returns, and so on. With compounded returns, it’s astonishing how fast your wealth can grow.
The key to sustaining good returns is to avoid investing mistakes that prevent returns from growing at a compounded rate. In this regular column I will show you how to ensure that compounding is sustainable, enabling you to build wealth over time by avoiding preventable errors.
All too often, people make investing mistakes in their 401(k) plans. This is easy to do because, although these plans can be highly beneficial tools, many are deeply flawed and saddle the average investor with burdensome costs. What’s more, the typical 401(k) plan contains no offerings beyond mutual funds that may deliver poor performance. Often, the result for workers is poor net returns — what they’re left with after paying fees and expenses. This is truly unfortunate, because these plans are the main way that most Americans invest for retirement; many have no other retirement aside from meager Social Security benefits.
However, there are steps you can take to make the best use of your plan to get far better results. If you take these steps to manage your plan investments optimally, you can keep your compounding train rolling. For example, under current rules, a 30-year-old earning $55,000 a year, getting a raise each year of 3 percent and contributing 6 percent annually (pre-tax) to his or her 401(k) — with an employer match of 50 percent, an annual return on investment of 6 percent and making accelerated contributions allowable beginning at age 50 — could accumulate $1,067,716 by the age of 65 (assuming no withdrawals are made from the account).
These are the kind of results that Congress envisioned in 1974 when it passed legislation enabling 401(k) plans. This legislation, the Employee Retirement Income Security Act (ERISA), was intended to make investing for retirement easier and more profitable for the average person.
ERISA allows individuals to defer taxes on certain retirement plans, including 401(k) plans, until they take the money out during retirement, when their tax rate is expected to be significantly lower. These plans discourage participants from dipping into their accounts before retirement by imposing penalties for early withdrawal that apply until they are 59½. Section 401(k) of the act enabled employer-sponsored plans that workers may contribute to through payroll deduction, as well as employer matching contributions up to a point.
This was a great idea for various reasons, including the following:
Because people contribute to their plan accounts from their paychecks, they never see this money, so they can’t spend it. Out of sight and out of mind, this money goes into investment products chosen from the plan’s offerings.
Contributions are tax-deferred, so they lower employees’ tax bills. Tax on these contributions and the returns generated by investment isn’t due until money is taken out of accounts. The idea is to make these withdrawals during retirement, when most people are likely to be in a far lower tax bracket than when they’re working.
Matching money from employers who offer it (many don’t) gives employees a strong incentive to enroll in their companies’ plans—and contribute more to them. After all, this is free money and additional tax-deferred compensation that allows the participant’s account to grow and compound to a much higher level.
This all sounds good, right? Well, it was good in 1974 and can still be today. But unfortunately, the intent of ERISA—to give people a powerful retirement vehicle that easily helps them grow wealth—isn’t being widely realized. Immediately after ERISA was enacted, the financial services industry, seeing tremendous potential, dove into the opportunity-rich waters created by the act. The interests of investors have since been trumped by those of the large insurance and financial services companies that bundled 401(k) plans and the investment companies that provide products to them.
The result today is a 401(k) industry replete with conflicts of interest and sky-high fees. Many plans offer publicly traded mutual funds, many of which perform poorly. Some of the large brokerages and insurance companies that package these plans and provide them to employers often charge outrageous fees — often between 1 and 2 percent per year. Therefore, if your company’s employees’ contributions to a plan total $100 million, these plan providers would get at least $1 million per year for doing little more, in many cases, than selling your company its services and showing up once or twice a year to take someone to lunch.
These bundlers, known as plan providers, decide which investment companies can offer investments on their platforms. Instead of limiting these participating companies to those with the best-performing products, many plan providers select them in a process governed by self-interest: They charge mutual fund companies for shelf space in a pay-to-play arrangement that’s been documented for years. Many plan providers offer 401(k) investors their own proprietary funds. Yet even if your company rids your plan of all such conflicts and arranged to have the “best” mutual funds for you to choose from, you probably still wouldn’t get good returns because of the high fees endemic to this industry.
Atop these fees come those charged by 401(k) plan advisors, many of whom traditionally have had business relationships with the plan providers or investment companies with products in these plans. All this amounts to a 401(k) conga line of conflicted companies and individuals with their hands out for payments that siphon off substantial amounts from workers’ retirement resources.
Also missing from many plans are two key things that ERISA requires: One is financial education for employees to help them get the most out of their plans. The other is the services of a fiduciary advisor — that is, one that has not even the appearance of a conflict of interest — to help workers make thoughtful and informed investment choices to avoid investing mistakes.
None of these issues were supposed to arise from ERISA, which prohibits conflicts and requires employers sponsoring plans to assure plan participants low fees, good service and adequate education. But over time, these priorities have fallen by the wayside, prompting regulators in various presidential administrations to issue rules enforcing and underscoring the act’s original provisions.
The latest round of new rules came last year from the federal Department of Labor, seeking to end conflicts through increased disclosures and to require plan sponsors to ensure that fees are reasonable. But it’s doubtful that this latest attempt to resuscitate ERISA’s original intent will make much difference. For one thing, employers aren’t becoming sufficiently informed of these new rules to change what they’re doing in ways that matter. For another, the powerful legal machinery of the 401(k) plan industry is doing its customary best to neutralize the impact of the new rules.
Regardless of the outcome of the new rules, if you don’t participate in your plan, you’ll be throwing the baby out with the bathwater. You want to take advantage of your plan’s full potential while protecting yourself from disadvantages. Learning how to use your plan is critical, because in these plans you’re essentially your own lifelong financial planner. This is a key step in a broader effort to avoid common investing mistakes that can interrupt your portfolio’s long-term compounding. Remember: Assuring your retirement nest egg is up to you, and you alone.
By: Gary Droz
As previously published on abcnews.com/money.
Try going to the drawer or file cabinet where you keep your 401(k) plan documents and taking a hard look at the list of investments your plan offers. Did you ever wonder how these particular investments came to be included in your plan’s offerings?
The superficial answer likely is that your company, as the plan’s sponsor, accepted an array of investments offered by a large brokerage or insurance company that provides investment platforms to employers. But the real reason is that instead of benefiting you, these investment choices often serve the interests of the firms your company engages as service providers for its 401(k) plan.
Your prospects for a comfortable retirement are probably being significantly lessened by conflicts of interest that often drive the inclusion in 401(k) platforms of poorly performing investments for which hardworking investors are charged high fees. This double whammy means that you aren’t getting good investment returns and that plan service providers have their hands in your pocket, taking big chunks of the returns you do get.
The most fundamental conflict involves the nature of investments offered in these platforms. The typical 401(k) plan offers only actively managed mutual funds. This means that investment managers buy and sell stocks in these funds in an attempt to beat the market. These managers typically have poor performance but receive high fees for that performance. This increases costs for investors.
I believe these costs are needless and merely lower net returns — the money investors get to keep. Reams of objective academic research show that the best long-term returns come not from these actively managed funds, but from passively managed, low-cost index funds and exchange-traded funds (ETFs). These funds are called passively managed because, instead of buying and selling stocks in a mutual fund portfolio, they are managed to match independently constructed indexes, such as the S&P 500. This not only increases net returns by reducing costs, but also positions investors to reap the overall returns of the market. With actively managed mutual funds, investors suffer when investment managers guess wrong, and they do much of the time.
While many actively managed mutual funds charge investors between .6 and 1 percent per year, passively managed funds often charge between .05 to .15 percent. This difference has a huge impact on net returns over time.
Why don’t all plan providers offer passively managed funds in their platforms? The answer is that they wouldn’t trigger much compensation for plan service providers. There’s simply no financial incentive for plan bundlers to include index funds or ETFs.
This fundamental conflict is among many that are costing most 401(k) investors dearly. The most common types fall into one of these categories:
The federal government is seeking to eliminate this conflict by trying to classify all plan advisors, including brokers, as fiduciaries. Current federal rules don’t require brokers to operate under a fiduciary standard – a status meaning that someone is legally liable for putting clients’ interests ahead of their own. The federal government is seeking to eliminate this conflict by trying to classify all plan advisors, including brokers, as fiduciaries.
More broadly, regulators have mounted a major push over the last couple of years to reduce conflicts by requiring increased disclosure of the compensation arrangements from all 401(k) plan service providers. These new rules, adopted by the federal Department of Labor (DOL), require companies sponsoring 401(k) plans to assure that fees are reasonable in the current market. (Many employers, however, aren’t aware of this requirement, despite repeated federal notices.)
To assure low fees, plan sponsors need to know where conflicts lie, and the new compensation disclosure regimen is designed to reveal them. Yet whether this regulatory push will have the intended effect — and whether regulators succeed in classifying brokers as fiduciaries — is doubtful because the industry is fighting these efforts tooth and nail with squads of highly paid lawyers and lobbyists.
What can you do about all this? Perhaps more than you think. Your 401(k) plan may be the only area where the interests of the average employee and top executives are the same. Though executives often have additional retirement savings, many also participate in their companies’ 401(k) plans and naturally want to get the best possible returns.
Consider going to your human resources department and suggesting that plan officials push plan providers to supply low-cost, passively managed investments to improve returns for employees and executives alike. The response will probably be something like: “No changes are possible. They offer what they offer, and there’s nothing we can do about it.”
But there is. While seeking compliance with the DOL requirement to assure reasonable fees, your company can learn about alternative plan providers, perhaps by issuing a request for proposals. In those RFPs, your company could state its interest in passively managed investments. If the current provider can’t offer them, perhaps a new one could. Thus, your company could shop around for a better plan with better investment choices for lower fees.
Most people would be reluctant to take this case to HR. And most people have retirement resources far lower than they would if they had a better 401(k) plan.
Conflicts of interest ultimately result in a significant drain on net returns by escalating fees. The best way to minimize this damage is for employers to include conflict-free, low-cost investment vehicles in their plans.
By: Gary Droz
As previously published on abcnews.com/money.
The current bull market has persisted for about six years now. This is a tale of two types of investors and their behavior in this kind of market.
One is limited by fear and the other is at risk from greed – the two nemeses of successful investing. Both types of investors make mistakes that severely limit their wealth accumulation by limiting their compounded returns.
During bull stock markets, it’s not unusual for some clients to tell me they’re afraid of investing more money in the stock market at prices that they believe are at an all-time high. Those who had this concern two years ago have since watched the market post many subsequent all-time highs.
Then there are the investors who have the opposite problem. During the bull market, they chase returns by putting everything they have into pricey stocks without regard to risk, acting as though the market will never decline. Surprised when bull markets turn bearish, they overreact by selling at low prices.
The folly of both groups lies in their denial of the reality that eventually, everything will go down. That’s right: All types of investments will eventually decline significantly in value — and eventually rise again. History shows that this has always happened, and it will continue to happen with the same certainty that the swallows will return to San Juan Capistrano.
Hyman Minsky, an economist and professor at Washington University, did research that shed light on economic factors indicating why. In his 1976 paper titled “A Theory of Systemic Fragility,” Minsky demonstrated how a stable economy always leads to optimism, to the point where people take more risks, which leads to instability because “success breeds a disregard for the possibility of failure.” He showed how “the absence of serious financial difficulties over a substantial period” results in a “euphoric economy” — where risk-taking gets out of hand.
Caught up in this optimism, banks lend to borrowers who aren’t likely to repay the loans. This and other factors transform a healthy economy into a debt-ridden one, resulting in over-leveraged investment markets that eventually seek equilibrium, bringing on the bear. Thus, Minsky showed the world that in the American economy, health invariably sows the seeds of sickness that is often accompanied by the decline of investment markets. This is in our nature because ours is a culture of excess and consequent austerity, of boom followed by bust.
Minsky’s use of the word “euphoric” preceded economist Robert Shiller’s use of a similar phrase for the title of his book about the 1990s bull market. The title, “Irrational Exuberance,” refers to the wildly inflated values of dot-com stocks in the tech bubble of that market. Irrationally exuberant investors took a big hit when this bubble burst in 2000. The irrationally exuberant have something in common with those who let fear of an inevitable decline prevent them from taking advantage of a bull market: They mistakenly believe that they need to be doing different things with their portfolios when the market is up or down.
As bull markets will always unpredictably turn bearish, the only way to take advantage of the bull while preparing for the bear is to reduce risk by using the same basic diversification strategy regardless of what the market is doing. This way, history shows, investors can get good investment returns in the long run. Rather than acting differently in different markets, investors should establish and maintain a thoughtful investment plan that gets them through up markets and down.
This means setting up a suitable asset allocation — a plan for how much of their money they should have in what investments. The single most important decision in this regard concerns asset classes — the different types of investments and the proportions of each. For most investors, this means nothing more than maintaining an appropriate balance between stocks and bonds. The right balance for you depends on your risk tolerance, which you can determine using any of various questionnaires. Many such questionnaires are available online from reputable financial services companies. If you’re skittish about volatility, you should have more bonds. People who sleep well at night when the stock market is going up and down may be comfortable holding more than half the dollar value of their portfolios in stocks.
Others, especially older investors, may want to have more in bonds, which are extremely likely to return their face value – the amount originally invested — and to pay the interest promised. Thus, bonds guard against fears that the market may trend downward just as they retire and need to take money out to pay expenses. (However, the economic peril of a market drop during retirement is often exaggerated because liquidation is an ongoing process, not a one-time occurrence upon retiring.)
Diversifying portfolios into different types of asset classes is far more of a concern for those who are investing for five or ten years rather than for the truly long term. That’s because even if your entire portfolio is in stocks, you’re virtually certain to get good returns over a period of 20 years or more. In almost every measurable rolling 20-year period, the S&P 500 has returned 8.5 to 9 percent.
For most people, having everything in stocks isn’t enough diversification for them to feel comfortable, especially as they get older. Yet, with people living longer these days, a decision to invest everything in stocks at age 60 or even 70 can still take advantage of the strong likelihood of good market returns over long periods, but these investors are almost certain to be in for a ride that’s too wild for most people their age.
Decisions about what types of stocks to own and how much of each are often less important than asset-class decisions. But these are still important choices, especially for those with stock-heavy investment portfolios. Stock market allocation decisions involve how much to own in large companies versus small; growth versus value stocks; domestic versus international and emerging-market stocks.
These choices tend to matter more in rising markets. In a down market, protection against risk is afforded more by the allocation to different asset classes. That’s because, with increasing globalization, stocks of different types tend to decline together in a sinking market, but bonds may be fine when stocks are sinking.
Setting up an appropriate asset allocation won’t achieve its intended purpose if you continually change the targets, so you must have the self-discipline not to do this. If the stock market is flying high, you shouldn’t be tempted to liquidate half of your bond holdings to buy stocks. And when the stock market tanks, you should resist the self-destructive urge to sell at low prices. You may want to adjust your allocation a bit to reflect market changes, but you should keep it basically the same regardless of what’s happening.
It’s equally important to remember that your asset allocation will shift organically, so you must rebalance your targets to maintain it. In a bull stock market, your stocks will gain value to the point where, instead of your original allocation of 50 percent in stocks, they may grow to 60 or 70 percent. In that case, to maintain your allocation, you must sell 10 or 20 percent of the dollar value of your stock holdings (at gains from the uptrend), and invest this money in bonds. This would restore your original allocation.
Remember: Periodic rebalancing is the key to stock allocation. If large companies have done well, making your portfolio heavier on them than planned, you would sell some of these at a profit and then buy smaller companies, which would be selling at low prices if they haven’t been doing well. It’s a good idea to evaluate your portfolio for rebalancing once or twice a year.
Committing to an asset allocation means accepting somewhat lower returns in bull markets than you might get by investing more heavily in stocks (or in some types of stocks), but being reasonably assured of higher returns in bear markets. The solution of steadfast asset allocation works for both of our prototypical problem investors because it significantly reduces their tendency to be compromised by fear or greed.
Sound asset allocation is an investment strategy for all seasons. It frees investors from worry over what to do when the market shifts, and protects them from their own worst instincts.
MainLine Private Wealth was founded on the ideals of trust and integrity, so you can always count on us to be the advisor who sits on your side of the table.