Archives for August 2012

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Checking out an Investment Adviser: Form ADV Part II

Editorial note: We discussed this topic a couple years back, but a few reader emails have made me realize it’s time to cover it again.

When researching a registered investment adviser (RIA), in my opinion the single best first step you can take is to read the RIA’s Form ADV Part 2.

Form ADV is a form that investment advisers have to file with the SEC. Part 2 of the form contains most of the important information that you’d want to know about an investment adviser. For example, you can see:

  • How the adviser charges for his/her services (hourly, fee-for-service, percentage of assets under management, etc.),
  • How much the adviser charges for his/her services (e.g., if it’s hourly, what is the hourly rate?),
  • What services the adviser offers (e.g., if you’re paying 1% per year, are you getting comprehensive financial planning? Or is it just portfolio management, and you would have to pay extra for other financial planning services?), and
  • The adviser’s investment philosophy (i.e., how they pick investments and how they allocate between those investments).

What’s nice about this form is that it’s a way to get the relevant information quickly, without having to filter through a bunch of sales talk (as you would often have to do if you visited the adviser’s website), and without having to give the adviser your contact information.

How to Find an RIA’s Form ADV Part 2

Downloading an RIA’s Form ADV Part 2 is easy:

  1. Go to the SEC’s Investment Adviser Search website.
  2. Look up the adviser by firm name.
  3. Click “get details” then “Part 2 Brochures.”
  4. If necessary, click the link for the most recent brochure filed.

How About an Example?

Let’s say you recently read Allan Roth’s book How a Second Grader Beats Wall Street, you liked it, and you’ve decided to include Allan’s firm Wealth Logic as one of several firms you’re considering. But first you want to find out a bit more about his practice, how much he charges, and so on. So you look up Wealth Logic on the SEC site and download the ADV Part 2 brochure.

With regard to how Allan’s firm charges clients, you find the following plain-English statement:

“All fees are hourly or fixed dollar to minimize any conflicts of interest. No additional profits can be made as a result of the advice rendered. The hourly rate is currently $350. This rate is both negotiable and can be capped for a period of time. All fees are due within 30 days of the billing date and a retainer amount may be requested.”

It’s clear and to the point. And if, for example, Wealth Logic instead charged a fee based on the amount of assets under management, there would be a table showing exactly how that fee is calculated.

With regard to what types of investments Allan’s firm recommends to clients, you’ll find the following statement:

“Minimizing expenses and emotion, and maximizing diversification, are core methods Wealth Logic applies in designing portfolios. Broad index funds of mutual fund and ETF categories are those most often used in the practice, as well as Bank and Credit Union CDs going directly to those institutions insured by the FDIC or NCUA.”

Again, it gets right to the point with very little fluff.

Looking up a registered investment adviser’s Form ADV Part 2 should certainly not be the only research you do on an adviser. But it’s an excellent first step to quickly check for things that would eliminate the adviser from consideration (e.g., an important conflict of interests, fees that you think are too high, a minimum asset level that you don’t meet, or an investment philosophy that’s markedly different from your own).

Self-Insuring for Long-Term Care

A reader writes in, asking:

“As I’ve read about the issues with LTC insurance, one of the topics that consistently pops up is self insuring. I understand the concept of self-insurance, but what I don’t get is how to go about doing it. How would you go about setting up a self insuring plan? How big should the payments be? Where should the money be kept? Should it be invested?”

As a bit of background for those not familiar with the term, to “self-insure” against a certain risk means to save money to be able to pay for the expense out of pocket rather than to buy insurance to cover the expense.

How, exactly, to go about self-insuring for long-term care costs is not something I’ve seen addressed by any authoritative source. What follows are my thoughts on the matter, but I’m very interested to hear what other readers think.

How Much to Save?

As far as the size of the “payments” (which would really just be additional savings contributions), I think a reasonable place to start the assessment would be with an amount equal to the premium you’d have to pay for a new LTC insurance policy. From there, however, you would need to adjust the amount upward to account for the fact that when you’re self-insuring, you don’t get to take advantage of risk pooling.

That is, to self-insure for long-term care, you would have to save as if you will need to pay for long-term care. In comparison, when using insurance, the cost is spread out among multiple people so that the premiums — after paying the insurance company’s operating expenses and profits — only have to cover the average cost per person after accounting for the fact that many people will not end up needing LTC.

Note: This is the reason why the conventional wisdom (which I think is on-target) is that people should buy a long-term care policy sometime between age 50 and 65 if they:

Alternatively, you can approach the question from the opposite direction: Look up the average annual cost for nursing home care in your state, then create a savings plan so that you’re confident you’ll have enough saved for a few years of nursing home care by the time you reach retirement age. (Note: The fact that most people cannot manage such a level of savings is why LTC insurance makes sense for many people.)

 Where Should You Keep the Money?

As far as where the money should be kept, I’m inclined to say that I’d put the additional savings in retirement accounts (if you have room) — with my reasoning being that:

  • In the event you don’t end up needing long-term care, it will generally be better to have funded your retirement accounts than to have saved in a taxable account.
  • There’s a high probability that if you do end up needing long-term care, it won’t be until after age 59.5. (Approximately 90% of long-term care insurance claims start when the policyholder is 70 or older.)

How Should You Invest the Money?

As far as how the money should be invested, I would probably invest it similarly to any other retirement savings during most of one’s working years. However, as you approach retirement age, I’d be inclined to move the money to something more conservative than a typical retirement portfolio — reason being that LTC expenses (while still “long-term”) are likely to cover a much shorter period of time than retirement. And there’s no way to know when they’ll start.

But again, I haven’t read anything authoritative on this topic, and I’m eager to hear what other readers think.

Editorial note: Thanks to my dad, Pat Heffern of AGIS Network, for providing relevant pieces of data for this article. (For those interested, their website has lots of eldercare and long-term care-related information.)

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Social Security Strategies with Different-Age Spouses

A reader writes in, asking:

“Most articles about Social Security assume that the two spouses are the same age or just a few years apart. But my husband is 13 years older than me. How does the conventional wisdom about Social Security change when there’s a big age difference?”

Which Spouse is Older?

As you might expect, the answer is “it depends.” Most importantly, it depends on which spouse (older or younger) has the higher earnings record.

Married couples generally get a better deal from having the spouse with the higher earnings record delay benefits than from having the spouse with the lower earnings record delay benefits. That’s because:

  • Having the spouse with the higher earnings record hold off on taking benefits increases the amount the couple will receive as long as either spouse is alive (because, if the lower-earning spouse outlives the higher-earning spouse, the lower-earning spouse’s widow/widower benefit will be increased by the fact that the higher-earning spouse waited to claim benefits), whereas
  • Having the spouse with the lower earnings record hold off on taking benefits only increases the amount the couple will receive as long as both spouses are alive.

This is generally true whether the spouses are the same age or not. What changes is simply a matter of degree (e.g., how good of a deal is it?).

For example, consider a married couple Amy and Arthur. Amy has a higher earnings record, and she is 15 years older than Arthur.

  • When Amy reaches age 62, having her delay benefits is an especially good deal (better than it is for the higher earner in a same-age couple) because it increases benefits as long as either spouse is alive, and given that her spouse is 15 years younger than she is, it’s likely that that will be a long time.
  • When Arthur reaches age 62, having him delay benefits is a worse deal than it would typically be for the lower earner in a same-age couple, because it only increases benefits as long as both spouses are alive, and, at that point, given that Amy is already age 77, the couple has a shorter first-to-die life expectancy than a couple who are both age 62.

Now let’s switch things around. This time we have Belinda and Bob. Belinda has the higher earnings record, but she is 15 years younger than Bob.

  • When Bob (the lower earner) reaches age 62, having him delay benefits is a better deal than it is for the lower earner in a same-age couple. That’s because, when he reaches age 62, Belinda will only be age 47, meaning that they have a longer first-to-die life expectancy than a couple where both spouses are age 62.
  • When Belinda (the higher earner) reaches age 62, having her delay benefits is not as good of a deal as it typically is for the higher earner in a same-age couple. That’s because, by the time Belinda is 62, Bob will be 77, meaning that their joint life expectancy is less than that of a same-age couple.

Or, to put it differently, for a couple who are very different ages:

  • The older spouse (whether the higher or lower earner) gets a better deal for delaying benefits than he/she would in a same-age couple, and
  • The younger spouse (whether the higher or lower earner) gets a worse deal for delaying benefits than he/she would in a same-age couple.

Fewer Clever Tricks

One other thing that changes for couples who are many years apart is that there’s less room for clever strategies between full retirement age and age 70. For example, in a same-age couple, provided that the lower-earning spouse has filed for his/her own benefit, the higher earner can file a “restricted application” for just a spousal benefit at full retirement age, thereby allowing him/her to collect something while still allowing his/her own retirement benefit to grow until age 70.

If the spouses are more than 8 years apart, that strategy isn’t an option, because by the time the lower earner reaches age 62 (the minimum age to file for retirement benefits, which the lower-earning spouse must do in order for the higher earner to file for spousal benefits), the higher-earning spouse will already be age 70 and collecting his/her own retirement benefit.

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Secondary Market Annuities: A Low-Risk Way to Earn Great Rates?

A reader writes in, asking:

From reading your blog, I know you’re a big fan of lifetime fixed annuities. But I wanted to get your thoughts on secondary market annuities. For example, here are some that I found by googling.

These are backed by some pretty big insurance companies, so why don’t more people invest in these? The returns look better than bond returns. Is the risk that bad?

What’s a Secondary Market Annuity?

Secondary market annuities are fixed annuities that you purchase from somebody other than the insurance company that’s actually behind the annuity.

Example: Don wins a state lottery. His prize is an annuity, backed by MetLife, which will pay $10,000 every month for 10 years (for a total of $1,200,000). Don, however, decides that he wants his money immediately. So he sells his annuity to a receivables factoring company for a lump sum of $400,000. This company then turns around and sells the annuity (at a markup) to other buyers.

Because they are fixed-period annuities, secondary market annuities are quite different from the inflation-adjusted lifetime annuities that I often talk about, because the whole point of lifetime annuities is to provide a guaranteed income for the rest of one’s life, while secondary market annuities provide income over a fixed period.

In other words, secondary market annuities are more comparable to regular bonds or CDs.

How Do They Compare to Bonds?

As I write this, the first item from the page linked to in the reader’s email is a secondary market annuity from MetLife with a 4.25% yield and a 19-year duration. (It appears that they turn over pretty quickly, so this particular annuity might not actually be there by the time you read this.)

If we compare that to current Treasury bond rates, we see that a 20-year Treasury bond (which would have a duration in the same general ballpark as the annuity) would currently have a 2.57% yield.

So that’s a premium of 1.68% (that is, 4.25% minus 2.57%). In exchange, you take on various risks.

First, there’s a slightly higher amount of credit risk with the annuity than with a Treasury bond. But for an annuity from an insurer like MetLife, the credit risk is still quite low.

Second, there’s a degree of legal risk, because these are complex transactions (at least, far more complex than buying a simple Treasury bond). You will want to hire a knowledgeable attorney (one representing you rather than the seller) to look over the documents to be sure that there are no “gotchas.”

Thirdly, there’s liquidity risk due to the fact that it’s nearly impossible to sell what was already a re-sold annuity. (In some cases you might even be legally forbidden from selling it.) So you can expect your money to be tied up for the duration of the annuity. (This is in contrast to a Treasury bond, which is arguably the most liquid investment on earth.)

So is that 1.68% risk premium worth it? For some people it might be — if, for example, a few such annuity purchases would only make up a small portion of the fixed-income side of your portfolio, and you don’t mind spending the time and money to hire an attorney to do the appropriate due diligence regarding the transactions.

For me personally, I don’t want anything to do with them.

How Do RMDs Work with Multiple IRAs?

A reader writes in, asking:

“This is my first year taking an RMD. I know it’s based on my life expectancy and my IRA balance and I’ve read that I need to combine my IRA balances. Does that include Roths? And does it include my wife’s IRAs? (She isn’t yet RMD age…)”

Firstly, your spouse’s accounts are not included for purposes of calculating your own required minimum distributions. Nor are Roth IRAs included, because non-inherited Roth IRAs do not have required minimum distributions.

Combining Different Types of Accounts

RMDs from non-Roth IRAs can all get bundled together. That is, after calculating the RMD for each of your non-Roth IRAs (including traditional IRAs, rollover IRAs, SEP IRAs, and SIMPLE IRAs), you can then add up all of those RMDs and take that total RMD from any combination of those accounts.

Employer-sponsored defined contribution plans — such as a 401(k) — work differently than IRAs. With them, you must calculate your RMD from each plan and take it from that plan. (Exception: If you have multiple 403(b) plans, you can combine the RMDs from those plans and take it from either of the 403(b) plans — much like you can do with IRAs.)

Let’s Look at an Example

Betty is 72 years old and married. She has a traditional IRA and Roth IRA at Vanguard. She also has a rollover IRA at Fidelity and a SEP IRA at Schwab. In addition, she has two 401(k) accounts and two 403(b) accounts from previous employers.

  • When calculating her RMDs, Betty does not take into account her husband’s accounts. (If he’s reached age 70.5, he’ll be calculating and taking his own RMDs, which, in turn, will not be affected by Betty’s account balances.)
  • Betty’s Roth IRA is irrelevant because no RMDs are required from Roth IRAs (unless they’re inherited).
  • Betty will calculate RMDs for her traditional IRA at Vanguard, her rollover IRA at Fidelity, and her SEP IRA at Schwab. These RMDs can be combined and taken from any of the three accounts or from some combination of the three.
  • Betty will calculate an RMD from her first 401(k) account, and she must take that RMD from that account.
  • Betty will calculate an RMD from her second 401(k) account, and she must take that RMD from that account.
  • Betty will calculate RMDs from each of her 403(b) accounts. She can then combine those RMDs and take the total RMD from either account, or split it up however she chooses between the two accounts.

Tax-Gain Harvesting

A few months ago, we discussed saving on taxes via tax-loss harvesting. As a refresher, the idea of tax-loss harvesting is to:

  1. Sell an investment with a current value that’s lower than your cost basis in the investment (so that you can claim the tax loss), and
  2. Buy a similar (though not “substantially identical”) investment at the same time so as to not dramatically throw off your asset allocation.

But sometimes it can make sense to do the opposite: harvest your capital gains.

Specifically, if your current tax rate for capital gains is significantly lower than what you expect it to be in the future, it can sometimes make sense to:

  1. Sell an investment with a market value that’s greater than your cost basis in the investment (and pay any applicable capital gains tax now, at your lower tax rate), and
  2. Use the proceeds to buy a similar investment so you don’t mess up your asset allocation.

Are You in the 10% or 15% Tax Bracket?

For investors in the 10% or 15% tax brackets, the tax rate on long-term capital gains is currently 0%, which can make tax-gain harvesting particularly advantageous.

Example: For this year, Diane is in the 10% income tax bracket. Therefore, under current tax law, her tax rate on long-term capital gains is 0%. Diane expects, however, to move into the 25% tax bracket next year as a result of a job she’ll be starting this fall — meaning that her tax rate on long-term capital gains will be higher than 0% in the future.

Aside from the investments Diane owns in her IRAs, Diane’s only holding is $4,000 in Vanguard Total Stock Market ETF, which she has held for more than one year. Her cost basis in the ETF is $3,000. She can sell the ETF and claim a $1,000 long-term capital gain, on which she’ll pay $0 in taxes. Then she can buy a similar mutual fund or ETF for $4,000. As a result, her cost basis in the new investment will be $4,000 rather than $3,000, meaning her capital gain will be smaller when she eventually sells it in the future.

It’s important to note, however, that if an investor harvested too large of a gain, the gain itself could push her into a higher tax bracket, thereby meaning part of the gain would no longer qualify for the 0% tax rate.

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