Thursday, April 29, 2010

The Fiduciary Standard – Hope Remains

There may yet be hope for consumers of financial products and services. Senators Daniel Akaka (Democrat from Hawaii) and Robert Menendez (Democrat from New Jersey) have offered an amendment to the Financial Reform bill (Restoring America’s Financial Stability Act) that would remove a provision (Section 913) that would provide for a study of the whether the fiduciary standard should be imposed upon broker-dealers. The new language would mirror the House reform bill and authorize the Securities and Exchange Commission to adopt rules requiring broker-dealers who provide advice to comply with the fiduciary standard.

To review, under the current legal structure, most financial advisors, including stock brokers, insurance agents, and financial representatives in banks and credit unions are not required to put their client’s best interest first. Instead, they are required to offer products and services that are “suitable.” This is a lower standard than the fiduciary standard and leaves consumers vulnerable.

According to the web site fi360, there are five core principles to the fiduciary standard:

•Put the client’s best interests first;

•Act with prudence; that is, with the skill, care, diligence and good judgment of a professional;

•Do not mislead clients; provide conspicuous, full and fair disclosure of all important facts;

•Avoid conflicts of interest; and

•Fully disclose and fairly manage, in the client’s favor, any unavoidable conflicts

I strongly support the inclusion of a fiduciary standard in the Financial Reform legislation. I see no point in “studying” this issue. It is rather obvious that financial advisors should be required to act in their client’s best interest.

The banking, securities, and insurance industries are lobbying Congress in an effort to prevent the imposition of the fiduciary standard. Make your voice heard and tell your representatives in the House and Senate that the fiduciary standard is imperative to meaningful financial reform in this country.

Thursday, April 22, 2010

The Moral Abyss on Wall Street

The Securities and Exchange Commission has recently filed charges against one of the most highly regarded firms on Wall Street, Goldman Sachs. The lawsuit claims Goldman defrauded investors by misstating and omitting information about a complex financial product tied to subprime mortgages.

The SEC alleges that Goldman Sachs created the synthetic collateralized debt obligation (CDO) called ABACUS after it was approached by a leading hedge fund, Paulson & Company. John Paulson, the funds manager, asked Goldman Sachs to create a financial product that would allow his firm to essentially bet against it. Paulson’s firm was actively involved in structuring the transaction and paid Goldman Sachs $15 million to put it together.

According to the SEC, Goldman Sachs represented that the residential mortgage backed securities were selected for ABACUS by an independent firm, ACA Management. The debt inside ABACUS soon became non-performing and investors in allegedly lost more than $1 billion. Paulson & Company made billions betting against ABACUS and other similar financial products.

Goldman Sachs has denied the charges and indicated that it will defend itself. The firm claims that it was not required to disclose who provided input into the mortgage-selection process for the transaction or what their intentions were.

When I was a senior at Stanford University, I interviewed for an analyst position at Goldman Sachs. This was in the late 1980s when investment banking was one of the more attractive fields for students graduating in economics from leading universities. I remember studying Goldman Sachs and preparing for my interviews in Palo Alto and in New York. I also remember thinking that Goldman Sachs was clearly the premier firm on Wall Street. Ultimately, I was not hired by Goldman Sachs and I pursued other opportunities.

I am not particularly interested in the nuances of the law and whether Goldman Sachs committed fraud. Based on what I’ve read, Goldman Sachs may be able to defend itself against these accusations. What I find disturbing is Goldman’s failure to adhere to basic standards of fairness, honesty, and integrity. I am left wondering if Wall Street has reached a tipping point and fallen hopelessly into a moral abyss.

Friday, April 16, 2010

Fee Only Advisors Frown Upon Annuities

So, why do most fee only financial planners and investment advisors view annuities with disfavor?

Annuities are expensive products. The internal expenses inside a variable annuity routinely exceed 3% per year. Annuities contain administrative expenses (0.10-0.30%), mortality expenses (0.50-1.5%), investment expenses (0.35-2.00%), and, in many cases, riders (0.25-1.0%). Let’s assume the annuity earns an average of 9% (this would suggest a rather aggressive allocation within the annuities subaccounts). The owner will lose 1/3 of the annuities growth to expenses. It is easy to see why an advisor serving in a client’s best interest, and therefore concerned about fees paid by the client, may discourage the purchase of an annuity.

Annuities are generally not very liquid. The owner cannot readily surrender the annuity and move the money inside the contract without incurring substantial charges. Charges are typically applied for surrenders that occur for 3-15 years from contract inception. These charges typically decline over time, but can start as high as 10%.

Annuities are insurance products sold by licensed insurance agents. These agents earn a commission for selling annuities. Commissions are usually 3-10% of the amount placed in the annuity. So, assuming a 5% commission and a $100,000 deposit, the commission will be $5,000. This strikes most non-commissioned advisors as excessive.

Many advisors also feel that insurance agents sell annuities to people in situations where they are really not appropriate. Annuities with heavy surrender charges over lengthy periods have been sold to retirees in their 80s. Annuities are routinely placed in IRA accounts, which makes little sense from a tax perspective. Insurance agents too often move the vast majority of a person’s investable assets into an annuity instead of spreading the assets across different investment vehicles.

While annuities certainly have many attractive features, they are generally expensive and illiquid. It is no wonder that fee only advisors view them with suspicion.

Thursday, April 8, 2010

Annuities Can Play Role in Retirement Portfolio

I grew up in the insurance industry. My father was a life insurance agent. I learned about insurance products at the dinner table as a kid. After I graduated from college, I entered the financial services industry as an advisor for a major life insurance company. I earned my Chartered Life Underwriter designation in my early 20s. So, I have pretty solid understanding of annuity products.

Over the years I have watched the insurance industry develop a vast array of annuity products. These products have become very sophisticated and, one might argue, too complex. In addition, most of them are very expensive. It is not unusual for an annuity to be loaded with expenses that total 2-3%.

So, while I like some of the features of annuities, I have not been particularly inclined to advise clients to purchase them. [Our firm is fee only. We do not sell any financial products.] Most clients do not understand the newer annuity products and few realize how expensive they are.

However, based on several recent articles and white papers, I am beginning to think there may well be a place for a low cost annuity inside a well structured retirement portfolio. Why? Because a guaranteed, fixed income stream from a highly-rated insurance company can serve to greatly improve the odds that the client will not outlive their resources in retirement.

Our firm has a responsibility to help our clients maintain their lifestyle after they stop working. Given that our clients are routinely living into their 80s and 90s, we need to be diligent about building a portfolio that can withstand the erosion caused by 30-40 years of inflation. We also need to attempt to insulate the portfolio from the impact of cataclysmic market drops as occurred twice in the most recent decade.

So, annuities may serve a valuable role in a retirement portfolio.

Thursday, April 1, 2010

Supreme Court Weighs in on Mutual Fund Fees

The nation’s highest court issued its views on Jones V. Harris Associates, in which investors in Oakmark mutual funds sued the fund manager for allegedly excessive fees. The case reached the Supreme Court after a lower court overturned the “Gartenberg standard.” Under this standard, which was established by a court ruling in 1982, the only way for an investor to prove that a fund’s fees were excessive was to establish that the fees were not properly negotiated with the fund board.

The high court re-established Gartenberg and went further. The ruling accepted the argument that judging whether a fee is excessive requires comparing the charges applied to different types of clients. This brings to light the large discrepancy in fees between individual/retail investors and institutional investors. This new interpretation may require fund managers to inform their boards how much they charge and explain the differences. This may prove very difficult.

Investors should realize that almost all fund companies are profit seeking. It’s pretty obvious that the more they charge you, the more profit they generate. Wise investors look for funds with low fees and high marks for stewardship from Morningstar.

Source: The Wall Street Journal