The Race to Zero

The Race to Zero

Bert Whitehead, M.B.A., J.D. ©2013

The government is printing too much money!

We have all heard the clamor raised by concerns that U.S. monetary policy (called "Quantitative Easing") will trigger inflation by causing 'too many dollars to chase too few goods and services.' The U.S. Treasury is issuing U.S. Government bonds at a faster rate than our economic growth. These surplus bonds are purchased by the Federal Reserve Bank, creating money that can be lent to businesses, etc. and so presumably help the economy expand.

There have been a couple problems with this strategy. First, the banks (and corporations) already have too much cash so they are not borrowing it from the Fed as expected. Next, we are still cleaning up the last mess when mortgages were made to virtually anyone. Since the excess money being issued is not being lent out or circulating, it keeps interest rates low. It also depresses the value of the dollar in the international market, since dollars are so plentiful. The good news is that this helps make our exports cheaper for other countries and keeps Americans working.

Ironically, other countries have caught on to this strategy, although not always as aggressively as the U.S. The European Union has been inflating its money supply as a tactic to avoid collapse of the weaker members (Spain, Italy, Portugal, etc.) and to make their exports cheaper. China has had a bout of inflation triggered by a growing labor movement and skyrocketing urban real estate prices. It has been printing more Yuan to reduce its value and make its exports cheaper. And even though Japan is still largely in a deflationary spiral, they have decided that printing more Yen will make their exports more competitive. Even Switzerland, the bastion of conservative economics with the strongest currency in the world, has started printing more Swiss Francs because no one in other countries can afford to buy Swiss watches.

This bloated international money supply is the result of the battle for increasing exports. Lowering interest rates through global expansion of the money supply is ultimately expanding the next inflation bubble. These low rates may give some countries an export advantage, perhaps for another decade or even longer. How can this bubble persist without creating inflation now? There are three factors which can temper inflationary pressures for awhile:

1. Increasing global trade brings down production costs. Just as water seeks the lowest level, free trade enables producers to move to lower cost environments. It also pushes prices down globally which moderates inflation.

2. Technology has brought unparalleled increases in worker productivity worldwide which keeps prices down. Computers, robots, and other smart technologies lower the costs of production dramatically.

3. Consumer savings has increased significantly worldwide as a result of the economic volatility of the past decade. When people feel vulnerable they react by spending less and saving more. This is particularly evident in Japan where people save 6-9% of their income, spurred by their aging demographics and concern that the government's safety net may not be effective when they retire. This savings takes money out of the consumer economy and reduces the amount of money that chases the available goods and services.

Most economists recognize that eventually inflation will catch up with us. But no one knows when or how. Will a smaller, poorer nation default on its debt, or will large investors be scared away from bond auctions as markets lose faith in governments' ability to repay debt? Whether it will be triggered by a 'black swan' event like a war or a natural disaster or simply the gradual erosion of investor confidence, it will likely ignite a global domino effect of hyper-inflation that could engulf most developed countries.

We know it will happen, but we can’t know when. It is critical to prepare by adhering to the one take-away lesson from the history of inflation: you must emphasize safety in bond investments.

This is not easy to accept when you consider that it is likely that interest rates will remain low or continue to drop for another decade, just as they have been dropping in Japan for over 20 years. While a 2% return now on 10-year U.S. Treasury bonds seems skimpy now, it could well be 1% in a few years (which is the current yield on Japan's 10-year sovereign debt). People are saying that interest rates can't possibly go any lower, but they have insisted on that since 1994 when 10-year Treasury rates were at 7%!

It is tempting to be dissatisfied with today’s apparent race to zero interest rates. It impels many of us to want to grasp for higher returns. But higher returns always entail higher risks and it is folly to try to offset lower yields by taking more risks. High yield bonds offer dramatically higher returns than a safe haven, like treasuries, but the risk cuts both ways: when interest rates begin to rise, the value of high yield bonds drops. This is also true of Treasuries, but at least you can be assured of getting your money back at maturity, unlike junk bonds. In addition, when the music stops, holders of junk bonds face significant risk of default. In Functional Asset Allocation theory, which is the centerpiece of our financial planning theory, the function of bonds and cash in your portfolio is to assure consistent cash flow, so it is critical that this part of the portfolio be absolutely safe.

Before you stretch for a higher yield, keep in mind there is a strong likelihood that we very possibly will see continuing low interest rates for a long time. Meanwhile the "Race to Zero" is the harbinger of the next bubble to burst.

(Cf. My blog dated Sept. 4, 2012: Finding "Real Returns" in the Bond Market.)
Special thanks to those who collaborated on this post: Chip Simon, an ACA colleague from Poughkeepsie, N.Y., and Shari Cohen who was the copy editor.

What's a "Safe Portfolio Withdrawal Rate?"

By: Bert Whitehead, M.B.A., J.D

How much can you withdraw annually from your investment portfolio to be sure you don't outlive your money? If you regularly read investment articles, you know that this issue is often debated. Scenarios are analyzed, and various inflation rates, historical investment rates of return, and life expectancy projections are compared.

While these are key and critical exogenous issues if you are managing billions of dollars in pension investments, if you are a real person it is the endogenous factors that are important when you decide how much money to take from your retirement portfolio. Endogenous factors include living within your means, how much you pay in taxes, and taking appropriate risk for your situation.

Inflation: The Bogey Man. There is no question that the cost of living has risen over the years, and the compounded effect of inflation over time is startling. For real people, however, it is more complex than just measuring the price level across the whole economy. Younger and middle-aged Americans will likely see prices rise substantially over their lifetimes, but while working their wages can also increase, and generally faster than the rate of inflation. And if you consistently save 10% of your earnings, the amount you save increases each year and easily outpaces the inflation rate.

For older retired people, especially those on a 'fixed income,' you would think that inflation would be disastrous. Certainly inflation is a continual struggle for those living at a subsistence level. For the more affluent, however, expenses tend to start dropping when they are in their 70's, and continue dropping more rapidly as they age despite increases in inflation. Older people are less mobile, have 'been there, done that, and have the T-Shirt.' They travel less, are generally less active, and less fashion conscious.

So while the rate of inflation is a big concern for money managers who run gigantic pension plans, in reality it has virtually no impact on personal financial planning.

‘I just want to 'Die Broke!' New clients sometimes say they want to withdraw their retirement portfolio money and spend it all on themselves during their lifetimes. No problem, I say: just let me know your date of death!

The simplest and most effective strategy to make sure you never run out of money is to continually save 10% of your total income. While working, most people do this by contributing to their 401Ks. Even in retirement it is prudent to continue to save 10% of your total income (that is, to live at 90% of your means) which includes pension income, social security, and estimated long-term investment returns. Then you don't have to worry about your life expectancy: if you always save 10% of your income you are by definition always living within your means and you will never run out of money.

True, you could end up spending all of your savings for a catastrophic medical expenses. But in that unlikely event, you will be much better off having saved 10% of your income after retirement than you would be trying to spend down to your life expectancy as a primary investment guide.

Of course there is a selection bias in determining which people hire financial advisors. These people generally have been living within their means and saving the surplus their whole lives. For them, the prospect of saving 10% is more comforting than challenging.

If you are going to worry about returns, make it your tax return! Generally the 'safe withdraw rate' calculated by expert financial analysts today ranges from 3.5% to 4.5% of your investment portfolio annually (depending on inflation and longevity assumptions). For real people, however, the source of the funds is much more critical as this determines how much you will pay in taxes.

After-tax cash savings are obviously preferable to withdrawals from a qualified retirement account and impacts your withdrawal rate significantly. Individuals in their early 60's would likely* have to withdraw $15,000 from an IRA to end up with $10,000 in after-tax dollars to spend. Withdrawals from a Roth IRA aren't taxable, but are generally less advantageous than using after-tax savings because investments inside a Roth compound tax free. Taking capital gains results in 50% less tax than a stream of income from an ordinary annuity with the same basis. Selling high-risk assets with uncertain marketability in an over-leveraged portfolio may be more advisable than blindly taking a 4% withdrawal from ready cash.

These issues are dependent on 'asset location,' which determines how investments are structured to be tax efficient. Clearly this is an endogenous consideration when determining withdrawal rates. The composition of assets is different for everyone.

“Are you leavin’ on a jet plane…?” Finally, hiring a great money manager who develops charts, graphs, and long lists of numbers to demonstrate their investment prowess doesn't recognize the really significant issues you face.

Look at the risk in your portfolio this way. If you are flying from New York to Los Angeles, you could hire a fighter pilot who can demonstrate how fast the jet flies, how quickly he or she can maneuver, their skills are in steeply ascending and descending, and that their record flight is 4.25 hours. However, you also have the option to travel with a trained airline pilot who avoids bad weather systems, knows how to handle the jet streams, and is more concerned about the comfort and safety of your flight. Be aware that the airline pilot will estimate your time of arrival as 5.15 hours, but pads the schedule because the trip usually only takes 4.45 hours. If you can “fly comfortably” by withdrawing dollars from a lower risk portfolio during retirement, doesn’t it make sense to do? Doesn’t a safe withdrawal rate depend in part on having a safe level of risk in your portfolio that is appropriate for you and you alone?

Real people need to evaluate the factors that they can control when considering the optimal safe withdrawal rate. Forget the academic studies and historical reconstructions and pay attention to the factors that really affect your future by living within your means, staying attuned to taxes, and investing with appropriate risk.

*Assumes IRA withdrawals are subject to 28% federal plus 5% state taxes.
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Special thanks to those who collaborated on this post: Chip Simon, an ACA colleague from Poughkeepsie, N.Y., and Shari Cohen who was the copy editor.

Congress Passes "Fiscal Cliff" Legislation - An Update from Bert and Pam

Greetings Cambridge Connection Clients,

As your financial advisors, we  have been following the legislative developments in Washington. At the last moment, on January 1, 2013, Congress managed to avert the so-called Fiscal Cliff by passing the bill known as “The American Taxpayer Relief Act”.  Perhaps the most notable aspect of the legislation is that nearly all of the tax-related provisions are permanent.  This affords us a more reliable framework for your personal financial planning.  We will be addressing the impact of these new provisions on your individual tax situation in our tax preparation and tax planning meetings this year.   A brief overview of the new tax act is provided below:

American Taxpayer Relief Act of 2012

The American Taxpayer Relief Act of 2012 (or "ATRA") extends and makes permanent the majority of tax cuts that were scheduled to expire at the end of 2012, in addition to retroactively reinstating some rules that had expired in 2011. Here is a brief summary of the changes:

2% Payroll Tax Cut NOT Extended - The 2% payroll tax cut that has been in place for the past two years has lapsed. Social Security payroll tax had been 4.2% the past two years, but will rise to its prior 6.2% level going forward. The Social Security tax applies to the first $113,700 in wages or self-employment earnings in 2013.

New Tax Bracket - The top tax bracket rises to 39.6%, and applies to income in excess of $400,000 for individuals and $450,000 for married couples. These thresholds are indexed for inflation (in a similar manner to all the other tax bracket thresholds). Bear in mind that tax brackets are based upon taxable income after all deductions, not Adjusted Gross Income.

The remaining tax brackets are extended at their current levels. This means the 35% tax bracket is still in effect, although it's now one of the smallest tax brackets, applying for only $388,350 to $400,000 (for individuals; or $388,350 to $450,000 for married couples).

The changes to the tax brackets are permanent but, of course Congress could still change the rules in the future!

Phaseout of Itemized Deductions and Personal Exemptions - Phaseout of itemized deductions and personal exemptions returns for 2013. This change was already scheduled to happen with a lapse of the Bush tax cuts, but ATRA applies new thresholds to the rules.

The phaseout for itemized deductions (also known as the Pease limitation) reduces total itemized deductions by 3% of excess income over a threshold. The threshold amounts are now an Adjusted Gross Income of $300,000 for married couples and $250,000 for individuals. These amounts are indexed for inflation.

The personal exemptions phaseout (also known as the PEP), reduces personal exemptions by 2% of the total exemptions for each $2,500 of excess income over a threshold. The threshold for this phaseout will be the same as the threshold for the Pease limitation (AGI of $300,000 for married couples, and $250,000 for individuals, indexed for inflation).

Capital Gains and Dividends - ATRA makes permanent the 0% and 15% long-term capital gains tax rates, but increases the tax rate to 20% for any long-term capital gains that fall in the new 39.6% top tax bracket.

Qualified dividend treatment is also made permanent. Notably, because qualified dividends are tied to the long-term capital gains rate, any qualified dividends that fall in the new 39.6% top tax bracket will also now rise to 20%.

Individuals who are subject to the new 20% top long-term capital gains and qualified dividends tax rate will actually find their capital gains and dividends taxes at 23.8%, due to the onset of the new 3.8% Medicare tax on net investment income that would also apply at this income levels.

AMT Relief - The ongoing series of AMT exemption patches over the past decade are made permanent, and fixed retroactively for 2012. The new AMT exemption amount will be $78,750 for married couples and $50,600 for singles in 2012 and indexed for inflation in the future. In a separate but related provision, the rules that allow nonrefundable tax credits to be used for both regular and AMT purposes (subject to some restrictions) is also retroactively patched for 2012 and made permanent going forward.

Estate Taxes - ATRA makes the current estate tax laws permanent, including the $5,120,000 (in 2012) gift and estate tax exemption (which will rise further to approximately $5.25M with an inflation adjustment for 2013). However, the top estate tax (and gift, and GST) rate is increased from the prior 35% to a new maximum rate of 40%.

The estate portability rules for a deceased spouse's unused estate tax exemption amount are made permanent.

Miscellaneous Extension Provisions:

Made permanent:
1) Coverdell Education Savings Accounts (so-called "Education IRAs"), including both the higher contribution limits ($2,000/year), and the ability to use qualified distributions for eligible K-12 expenses, has been extended and made permanent under the new law.

5 year extension:
1) The American Opportunity Tax Credit (the $2,500 tax credit for college) is extended 5 years - it was scheduled to lapse at the end of 2012, and will now run until 2017.
2) The Child Tax Credit and the Earned Income Tax Credit were also extended over the same 5-year time period – until 2017.

Retroactively patched for 2012 and extended one year through 2013:
1) Deduction for up to $250 expenses for elementary and secondary school teachers
2) Exclusion from income of discharged mortgage debt (necessary to prevent a short sale from triggering income tax consequences for the amount of debt that was discharged)
3) Deduction of mortgage insurance premiums as qualified residence interest
4) Deduction for state and local sales taxes paid (in lieu of state and local income taxes paid, useful in states that have little or no income taxes)
5) Above-the-line deduction for up to $4,000 of higher-education-related expenses
6) Exclusion from income for Qualified Charitable Distributions from an IRA to a charity. Notably, a special rule allows qualified charitable distributions made by February 1, 2013 to be counted retroactively for the 2012 tax year, for those who want to take advantage of the rule for 2012 and 2013.

New Roth Conversion Flexibility - ATRA will now allow individuals to convert their existing 401(k) plan to a Roth 401(k) plan, if the employer offers designated Roth accounts under the plan, regardless of whether the individual is allowed to take a distribution out of the plan. The transaction will be taxed in a similar manner to any other Roth conversion. Previously you could only convert a 401(k) plan if you are eligible to take a distribution from the plan, which meant you had to be 59 1/2, dead, disabled, or separated from service, unless the plan allows in-service withdrawals.


“We are pleased to present this summary which is attributed to Brian Shea, CFP, E.A. who provided this to members of the Alliance of Cambridge Advisors to share with our clients.”


Regards,
Bert Whitehead and Pamela Landy

A Christmas Carol

The Lord Mayor Would Have Spoiled

"A Christmas Carol"

Contributed by John David Marotta

 

        This insightful blog was composed by my colleague David John Marotta. He identifies the characters in Dickens’s The Christmas Carol according to their Money Personality matrix which I developed and is explained in my book ‘Why Smart People Do Stupid Things With Money” (pp.22-40). He uses this personality assessment to demonstrate classic behaviors around the Christmas theme, and pinpoint the impact the Christmas Spirit has on each one of us irrespective of our religious differences. His analysis of how our personality shapes our perceptions about money is a real masterpiece. Have a happy holiday! Bert Whitehead, M.B.A, J.D.



In his book "Why Smart People Do Stupid Things with Money," Bert Whitehead describes eight different financial personalities. For the past seven years I've taken a character from Dickens's A "Christmas Carol" and used them to illustrate one of these personalities.

Driven by fear and hoarding all he earns, Marley is a miser. Scrooge saves just as much, but he's greedier and reinvests his money to grow the business. Bob Crachit, on the opposite end of the spectrum, spends too much. He should be able to live on his income, but in modern terms would be called a shopaholic. These three personalities represent the extremes.

The characters in the middle of the continuum include Fezziwig, Scrooge's former boss. He is a nester, who tends toward savings and does better at balancing the extremes of greed and fear. He keeps his spending close to home, but includes his employees as part of his family. The two portly gentlemen tend toward greed, but they also solicit donations for the poor at Christmastime. They are entrepreneurial philanthropists.

Scrooge's nephew Fred represents a traveler who also balances greed and fear but tends toward spending. Indifferent about amassing wealth, he cares more for experiencing life to the fullest. Scrooge's former fiancée Belle is the bon vivant. She is driven largely by the desire to spend money on herself. She judges success by how it improves her own life.

These seven characters from "A Christmas Carol" represent all but one of the eight financial personalities. The final one is the gambler, motivated by greed and a desire to be associated with great power and wealth.

The character most closely aligned with the gambler personality in the story is the Lord Mayor. As Dickens described him, "The Lord Mayor, in the stronghold of the mighty Mansion House, gave orders to his fifty cooks and butlers to keep Christmas as a Lord Mayor's household should."

Politicians align well with the gambler personality. They tend toward greed and spending. They are incorrigible optimists. They mistakenly believe there are easy answers to financial problems.

Whitehead describes gamblers this way: "Gamblers are frequently embarrassed about the way they handle money. They get so good at lying to themselves and others that they actually believe it. They brag when they win, but seem to ignore and deny their losses. This makes it very hard for them to address their financial issues in a reasonable, logical way. Their warped view of financial logic often results in them viewing the casino or horse races as types of investments."

If that doesn't describe today's politicians, I'm not sure what does.

And when their schemes fail, politicians are susceptible to depression or embezzlement. In fact, studies suggest that both a gambling addiction and success in politics correlate with psychopathic behavior. Politicians tend toward lack of guilt, fearlessness and interpersonal dominance. And it is from this small minority of human beings with literally no conscience that we tend to choose our political leaders. This at least explains even if it does not condone their shameless deceit and manipulation of public opinion to extend their own political power and influence.

In their desire to be rich and powerful, politicians tend toward alcohol and drug abuse and sexual addictions, often despite a sham moral posturing for the voters. They also are generous to a fault with the public's money, all the while avoiding any significant private sacrifice from their own resources. This pomp with little circumstance was epitomized by the Lord Mayor's Show, an annual event that Dickens mocked in "The Public Life of Mr. Tulrumble."

Dickens wisely did not include a gambler personality in his Christmas story. Had he done so, the tale would have had an external villain. In Dickens's writings the gambler politician positions himself as a great benefactor to the city and yet turns out to be the "greatest forger and the greatest thief that ever cheated the gallows." The gambler would have assumed the role of antagonist and detracted from the heart of the story: Scrooge's inner struggle and his awakening conscience. Including the Lord Mayor's character would have made it a completely different story.

Dickens started his writing career as a parliamentary reporter. He found politicians pompous rhetoricians who made promises they never kept. His experience is captured in David Copperfield's description: "I record predictions that never come to pass, professions that are never fulfilled, [and] explanations that are only meant to mystify."

Since Dickens's day, politicians have perfected the sound bite, which in essence is the antithesis of nuanced reasoning. It also makes it increasingly difficult to express the complex unintended consequences of economic systems.

Families can't afford gamblers running their personal financial affairs just as our country can't afford politicians assuming our corporate financial affairs. Ultimately Scrooge did what neither the Lord Mayor nor anyone else in the story could. Ebenezer developed the empathy to truly care about others. And then he gave of himself and his own resources to make a difference in their lives. And that is the true spirit of Christmas.


Attribution to David John Marotta
Posted 12/20/12 Online IndUS Business Journal

Five Ways to Get Poor

Bert Whitehead, M.B.A., J.D ©

 

1)  Stay in a Dysfunctional Relationship.  

I have often described divorce as "mutual impoverishment."  While many different relationships can have detrimental financial consequences, divorce in particular leaves both parties handicapped -- often for their lifetimes.  Our divorce laws are designed to protect the most vulnerable spouse, but seldom can the contribution of a high-earning mate be equalized.  So the dependent spouse who typically embraces the primary parent role at the expense of career development often faces a continuing downward spiral in living standard while the higher earner must start a new financial future from scratch. And while two people living together costs less than living in separate households, the reality is that the costs of living apart after a divorce can be financially devastating if both parties attempt to maintain the marital standard of living.

The lesson here is to be choosy about your mate at the outset! "Till death do us part" states a commitment that embraces the mutual support and teamwork that optimizes the marital relationship. But that is still no guarantee of financial prosperity.

Of course other dysfunctional and financially draining relationships can be non-marital. By definition a dysfunctional relationship is one where maintaining a commitment is detrimental to both parties. This can also include parents and children, abused spouses, and those who continue long-term relationship with an afflicted partner who will not take the steps necessary to achieve recovery.  Often the most committed spouse unwittingly aggravates the dysfunctional relationship through co-dependent support.
 

2)  Develop Some Bad Habits.  

No one is perfect; some are more imperfect than others.  The Seven Deadly Sins (Pride, Anger, Sloth, Greed, Lust, Gluttony, and Envy) are considered by many to be the roots of various addictions (hubris, chronic rage, procrastination, gambling, sexual obsession, compulsive spending, over-indulgence in food and drink, covetousness, etc.).  These bad habits are 'deadly' because they are often considered the origins of many other 'sins' or dysfunctional behaviors that are difficult to change.

My experience is that addiction of one type or other is often at the root of financial distress.  Addictions involve misuse of both personal and material assets, so they are often the harbingers of poverty.  Recovery from financial downfalls due to active addiction is seldom successful unless the addiction is directly addressed and dealt with effectively.

3)  Let Your Skills Atrophy. 

As our global economy grows increasingly complex and competitive, skills we develop in our youth become obsolete much sooner than in earlier cultures and societies.  For example, in the past a journeyman carpenter could be assured of a job for life with very simple tools.  This job today requires considerable computer knowledge and more advanced mathematical capability.  The knowledge of a financial planner and other complex professions is estimated to have a half-life of eighteen months.  Half of our knowledge relating to our profession becomes obsolete in just a year and a half.

It is not only more difficult to get a good job without advanced education, the education that qualified you for a job five years ago is likely to be insufficient in today's labor market.  Paradoxically, the more advanced an education required to get a job, the faster those skills and knowledge become obsolete.  Thus, most advanced professions require more continuing education to maintain licensing.

4)  Put Up a Good Front. 

This is essentially the motive for maintaining consumer debt, such as balances on credit cards.  Typically, someone who lives beyond their means is trying to be someone they're not.  Maintaining this illusion to impress others takes a huge psychological toll, which aggravates the guilt and fear.  Dampening those feelings requires more spending on props to maintain the false facade. The  person is sucked into a vortex of poverty.

There is a distinction between 'good debt' and 'bad debt.'  'Good debt' may include a home mortgage, an education loan, or a car loan for someone starting out.  These can be considered 'good' because they enable a person to get leverage, e.g., get a better job, so they can earn more.  This is relative to their ability to earn, so a $250,000 mortgage, or a $100,000 education loan, or a $50,000 car loan is not appropriate as a 'good debt' for a new college graduate who earns $35,000 per year.

 

5)  Don't Celebrate Thanksgiving. 

Getting poor, or rich, is more of an attitude than a measurement.  Relatively speaking, the poorest 10% in our society are richer than the richest 10% of humans in the world.  "Prosperity depends more on wanting what you have than having what you want." --(Geoffrey Alpert)

 

I appreciate the editorial review contributed by Chip Simon, CFP®, an ACA colleague in Poughkeepsie, NY

Are Financial Planning Fees Worth It?

Bert Whitehead, M.B.A., J.D. ©2012

Pssst. Wanna increase your investment portfolio’s returns by 1.82%?

Then get yourself a good financial planner.

Or so says Morningstar, a consumer-driven investment research firm, in a recent study that measured the value of financial planning to individual investors. Morningstar is considered credible because it isn’t paid by the funds and annuities that it rates. Of course, the end users of Morningstar data are generally investment advisors who earn large asset management fees and they greeted the study with enthusiasm. But the report describes certain factors apart from investment portfolio decisions that add incremental value to financial management -- a major point that lends credibility to the study.

Morningstar Describes the Benefits of Financial Planning

Measured together, these outside factors are called “Gamma” by Morningstar and include: asset allocation, “product allocation” (which seems redundant), tax efficiency, and then withdrawal strategy and “liability-driven investing” (which seems to be akin to withdrawal strategy). So it seems there are really three main factors: asset allocation, tax efficiency (in the portfolio), and withdrawal strategy.

Investment advisors primarily tout their “strategy” for buying and selling individual securities or shifting allocations based on their market timing approach. While they insist that this adds more value to a portfolio than they charge, using this approach alone has been debunked by numerous studies. Simplistic or complex hedged “buy high, sell-low” approaches have lower returns in the long run as taxes, trading costs, idle cash, and emotions undermine performance.

However, many investment advisors feel that the 1.82% Gamma advantage would more than cover the 1.0% fee that they charge. After all, they often consider themselves to be “Financial Planners” who advise clients on their "total" financial situation. Therefore, their services deliver value beyond portfolio management.

“Financial Planners” Usually Limit Their Advice to Investments

It’s my experience that most advisors who hold themselves out as “Financial Planners” are in truth “Investment Advisors.” While they pitch the “total” approach, they focus their marketing and advisory efforts almost exclusively on investments. They charge for “assets under management” (AUM), usually a percentage based on the amount of assets a client gives them to manage.

I find that many AUM clients don't reveal all their accounts (especially retirement accounts) to their advisor to avoid being charged a higher fee. So advisors who claim to manage total assets under this scenario are stretching it a bit. In addition, tax efficiency is a sham if the client’s tax return is never reviewed. And, typically, advisors don't know the important withdrawal details of retirement accounts, even when told about these accounts. As to the withdrawal strategy, it’s problematic when neither client nor advisor knows how much the client spends each month or their other sources of income!

Based on these realities, Gamma is tough to find for most financial planning or investment management clients. And the Morningstar researchers agree. They doubt that most financial plans ever go beyond investment selection to include the Gamma advantage.

Advisors May Understand and Advise Only about Investments

That means that most clients pay too much for AUM advice. A $2,000,000 portfolio brings in a $20,000 fee for the investment advisor who charges 1% of assets under management. And since the business is scalable, it’s pure profit. For that fee the client usually gets asset allocation and rebalancing. But where is the guidance about how much to save, when and how to refinance a mortgage, when to initiate a Roth conversion, insurance needs, and estate planning? Since most investment advisors are not trained or professionally certified to provide comprehensive financial advice, the client is told to obtain mortgage advice or Roth strategies from their tax advisor. The tax advisor however knows nothing about the client's investments or long-term goals so the client gets no advice on the issues that matter the most.

Flat Retainers Are More Cost Effective than AUM Fees

Dalbar, Inc., a leading financial services market research firm, consistently finds that clients want comprehensive financial advice. But how can they find it for a reasonable cost when so much of the industry is geared to “gather assets” for AUM?

It’s my contention that a flat annual retainer fee is the least expensive and best method to obtain unbiased, comprehensive financial advice. In fact, it focuses the relationship on the very same outside success factors cited by Morningstar. There are minimal conflicts of interest and the advisor is motivated to work with the client on a regular basis, handling financial issues as they arise.

Think of it this way…would you rather work with an advisor who is structured to put his arms around your money, or one who is structured to put his arms around your problems? Chances are, it’s the latter.

Many people think that annual retainers are too expensive since they are quoted as an annual dollar amount. In fact, a flat annual retainer fee is nearly always less than an AUM fee….and you know what you are paying for. Clients are generally unaware of AUM fee amounts since they are withdrawn directly from their account and buried in the investment reports.

The right professional advice is worth the price. But the only thing worse than paying an investment advisor 1% of your portfolio annually for investment advice, is paying that fee and expecting to get professional comprehensive advice that is not forthcoming.

Special thanks to those who collaborated on this post: Chip Simon, an ACA colleague from Poughkeepsie, N.Y., and Shari Cohen who was the copy editor.

Bi-Weekly Mortgage Payments

Smart Strategy or a Scam?

Bert Whitehead, M.B.A., J.D. © 2012

Most homeowners have been solicited by their mortgage company or another financial institution with an offer to convert to biweekly mortgage payments instead of monthly payments. The advantage touted for this strategy is saving a heap of interest over the years and reducing the time required to pay off your mortgage by several years. Clients often ask us whether this is a good idea or not. No, it is not smart; it is a scam.

If that is all you need to know, you're done: go on and read something else. If you want to understand why it's not smart, read on!

The math does work: paying half your monthly mortgage every two weeks does pay off your mortgage much faster and does save a substantial amount of interest. It may also be viewed as very convenient since most people are paid biweekly.

Investment Earnings Exceed Benefit of Interest Savings

It is not financially advantageous because it doesn't take into account the foregone investment earnings, which is more than the mortgage interest saved. The reason biweekly mortgage payments reduce interest and the length of the mortgage is that you end up paying an additional month's mortgage payments each year (26 payments divided by 2 = 13 Months). The correct comparison is not between biweekly mortgage payments and monthly mortgage payments. The correct comparison is between the interest expense you could save with biweekly payments and the amount of interest earned if you invest the additional amount you otherwise would be paying on your mortgage.

A Sample Mortgage Situation (or A Case Study)

Consider a 30-year, 4% fixed -rate mortgage taken out 5 years ago by a taxpayer in a 33% federal tax bracket. The taxpayer is offered a deal to switch to biweekly payments which would require a $500 “set up” fee plus half of a month's mortgage payment to start. The interest rate (4.0%) remains the same, but instead of a monthly payment of $763.86, the home owner would pay $381.93 biweekly. This would enable the homeowner to pay off the mortgage in 21 more years (instead of 25) and save the homeowner $42,572 in interest expense. This is the ”pitch.”

To correctly analyze this problem, there are five factors to consider:

1. Normally (but not always) the mortgage company charges a fee of about $500 to set this up for you. This is ridiculous because most mortgages permit prepayments with no additional fee or penalty. If you were to invest this $500 fee at 6.00% for the 21-year mortgage period, it would grow to about $815.

2. The terms of the biweekly arrangement actually require that the payments be made at the beginning of the period, whereas typical mortgages charge the €payments at month-end. If the homeowner invested only one month’s payment at 6% for 21 years, it would earn about $480 in interest.

3. Paying half of the monthly payment every two weeks is comparable to paying 13 monthly house payments a year. If the extra $764 was invested each year instead of being used to pay off the mortgage, it would grow to $30,548.

4. Since home mortgage interest is deductible, choosing to reduce interest by $42,572 over the next 21 years would increase federal income taxes by $12,024, plus the taxes saved would earn $ 7,575 over the 21 years.

5. In total, the $ 51,442 in additional investment earnings generated by investing the money instead of paying down the mortgage is sufficient to pay off the balance of the original 30- year mortgage in full in 21 years and still have $18,262 in cash remaining.

Additional Reasons Why Biweekly Mortgages Are Not Advantageous

In addition, if you were able to invest the surplus mortgage payments in an IRA or other pension each year, you would be able to defer an additional $17,981 in income taxes.

Consider also that mortgage providers generally charge a lower rate for shorter mortgages. So if you wanted to pay off your home in 25 years instead of 30, it would be wiser to arrange that at the outset when applying for a mortgage and take advantage of the lower rate.

In any event I advise clients to keep a longer mortgage on their home because it is your best hedge against inflation. If inflation increases in the next 5 or 10 years back to 5% or 10% as it did during the 70s and 80s, mortgage rates will soar to 9 to14%. You would be pleased to owe the bank a couple hundred thousand dollars at a 4% fixed rate as your money market account is paying 6% or more!

Special thanks to those who collaborated on this blog: Chip Simon, an ACA colleague from Poughkeepsie, N.Y., Al Hoefer, my technical consultant; and Shari Cohen who was the copy editor.