Archives for September 2010

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Do You Have an Investment Backup Plan?

Last weekend, I read Larry Swedroe’s latest book The Only Guide You’ll Ever Need for the Right Financial Plan. (Excellent book, by the way, for the intermediate/advanced investor.)

One point Swedroe makes repeatedly throughout the book is that you need a “Plan B” if you’re going to be investing in risky securities like stocks. Specifically, you need to be prepared for a scenario in which:

  1. Stock returns over your retirement are far less than their historical averages (and lower than the returns you were planning on), or
  2. You face an unlucky sequence of returns — namely, a bear market at the beginning of retirement — that leaves your portfolio at just a fraction of its original size while you still (might) have 20+ years of retirement to go.

In other words, you need to have a specific plan for what you will do if it looks like your portfolio is no longer going to be able to sustain the rate of spending that you originally planned on. For example, “If our withdrawal rate gets above X% before age 70, we’ll _____.”

“Plan B” Options

The most likely forms of backup plans are simply ways you can cut your spending or increase your income. For example:

  • Take vacations half as often,
  • Sell your home and move into something less expensive, or
  • Get a part-time job or start a business.

Investment “Plan B”

But what if you don’t want to go back to work or significantly reduce your spending? Is there any way to adjust your portfolio so that it can fund a higher withdrawal rate?

Moving more money into stocks may work — if you get lucky and the market comes roaring back just when you need it to. Or, it could backfire completely if the market continues to perform poorly.

Moving a large portion of your portfolio into TIPS would reduce your risk. But their payout is rather low. An all-TIPS portfolio is unlikely to sustain a withdrawal rate that’s already unsafely high.

In short, if you’re looking at a dangerously high withdrawal rate and you’re absolutely unwilling to cut spending or go back to work, annuitizing your portfolio may be the only way to ensure you don’t outlast your money.

Of course, as we’ve discussed several times here, annuities have their own drawbacks:

Plan B Stinks. What’s My Other Choice?

What if you’re unwilling to cut your spending, unwilling to get a job in retirement, and unwilling to annuitize your portfolio?

If that’s the case, then you probably shouldn’t be taking investment risk at all. I’d say that your best bet is to use a portfolio comprised largely of TIPS and to plan from Day 1 to use a very low withdrawal rate.

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Fee-Only Financial Advisors Can Be Biased Too.

If you’re paid to think something is a good idea, you probably think it’s a good idea. Even if it isn’t.

To use a personal example: I used to be paid to convince people to invest in relatively high-cost, actively managed mutual funds. Now that I’m no longer paid to do that, it’s clear to me that my recommendations were less than ideal. But at the time, I was absolutely convinced that such funds were the best choice.

If you want unbiased advice from your financial advisor, it’s essential to eliminate as many conflicts of interest as possible.

Compensation Based on Account Size

Many people claim that the best advisor is one who is paid as a function of your account size. It ties the advisor’s interests to yours…or so goes the claim.

What it really does is tie the advisor’s interests to your account size, not to your overall financial interests.

For example, imagine that you meet with an advisor who charges 1% of assets each year. You go to see him with a $200,000 portfolio and $50,000 remaining on your mortgage. If he convinces you to invest rather than pay off your mortgage, that’s an extra $500 in his pocket every year–regardless of whether or not that was really the best choice for you.

Or imagine a 70-year-old investor with a $500,000 portfolio, who needs to withdraw $30,000 each year. This investor is looking at a 6.00% withdrawal rate–higher than many people would consider safe, even for a 70-year-old.

In such a scenario, a single premium immediate annuity might make a lot of sense. If the investor buys single premium immediate annuities with $400,000 of his portfolio, he could (currently) get a payout of 6.2%, thereby leaving him with a (somewhat) safer withdrawal rate of 5.2% on the rest of his portfolio.

But if he’s using an advisor who charges even 0.5% of assets, the advisor stands to gain $2,000 each year by convincing the client not to buy the annuity. That’s no small incentive.

In short, how your financial advisor is paid has a lot to do with what advice he or she will give you.

Financial Planner vs. Investment Advisor

It’s useful to draw a distinction between financial planners and investment advisors:

If you want to pay somebody solely to manage your investment portfolio (i.e., you want a low-cost investment advisor), then paying based on the size of your account would make sense. Doing so would align the advisor’s interests to your own.

But if you want somebody to provide you with broader financial planning services, I’d suggest looking for somebody who charges an hourly fee, a flat annual fee, or fixed fees for a given service. This way, you don’t have to worry that your advisor is (even unconsciously) giving you less than ideal advice because it serves his own interests.

Hedge Fund Expenses: They’re Not Cheap

One of the articles submitted this week to my roundup was an interview with a fellow who works as the co-manager of a new micro-cap value hedge fund. After taking a look at the fund, I thought I’d use it as an example of why I suggest that most investors stay away from such investments.

But first, let’s dispel a myth. One of the reasons commonly given for not investing in hedge funds is that they’re high risk. That’s not necessarily true. As with mutual funds, there are many different types of hedge funds. Some invest in high-risk assets; others invest at the low-risk end of the spectrum.

My primary reason for steering investors away from hedge funds is the same as my reason for staying away from any actively-managed fund: High costs. And, with hedge funds, boy can they be high!

“2 and 20”

The typical hedge fund expense structure is the “2 and 20” model, whereby the fund charges an annual fee of 2%, plus 20% of any gains. This is, as you might imagine, quite the hurdle to clear.

Very few investors have shown an ability to consistently outperform their passive benchmark by more than 2% per year, as would be necessary to justify the use of such a fund in place of a low-cost index fund. (In fact, because of the 20% performance fee, they’d have to outperform by well over 2% per year.)

A Low-Cost Hedge Fund?

Interestingly, this particular fund from the interview actually had much lower costs than many hedge funds:

  • It charges no flat annual fee,
  • Its performance fee is only calculated on returns above 6%, though it’s calculated as 25% of those returns, and
  • Its losses are carried forward to offset future gains prior to any fee being paid.

In short, as hedge funds go, this is actually fairly reasonable.

Still, it’s anything but low-cost. By way of illustration, if a small-cap value fund with that expense structure had simply tracked the results of its index over the last ten years, here’s how much it would have charged per year:

  • 2000: 3.72%
  • 2001: 1.76%
  • 2002: No fee.
  • 2003: 3.77%
  • 2004: 4.43%
  • 2005: 0.07%
  • 2006: 3.36%
  • 2007: No fee.
  • 2008: No fee.
  • 2009: No fee.

Even with four years out of ten having no fees at all, such a fund would still have been charging more overall than the typical actively managed small-cap value fund, which in turn would be charging far more than a good, cheap index fund.

Given the usefulness of expenses as a predictor of performance,  I’d suggest that most investors stay away from any investment that promises to take such a large share of your returns.

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