Has the turbulence of recent years left you feeling like a ship captain trying to read his compass in the middle of the Bermuda Triangle? These days it seems nothing is what it appears to be. Over the last five years, financial advisors have found themselves questioning many of the basic principles of retirement planning, investing, estate planning, stock options-management strategies, that most sacred of sacred cows, modern portfolio theory, and one of the most reviled products of recent years, annuities.
Their problems are compounded by the fact that clients' psychology remains tinged by the sky-is-the-limit, anything-is-possible mentality of the late '90s technology bubble. But many advisors are starting to wrestle with a new reality, one in which the risks of retirement planning and managing money for older clients are rising much faster than most individuals believe.
The new reality is a long way from the environment of the past two decades that many advisors and their clients have come to see as normal. In the 1980s, new retirees were spoiled by high yields on traditional retirement investments like bonds that allowed them to maintain a reasonable living standard despite what for many was a substantial retirement savings shortfall. They became even more spoiled when financial advisors-and the rest of the financial services industry-convinced them that they could earn even higher returns on equities.
Today, the high yields on fixed-income investments are history, and the future returns on equities, while likely to be higher than bonds, are anyone's guess. In late June, Bill Gross, the widely respected fixed-income chief at Pimco Investments, addressed the issue of linkage between equity and bond returns at Morningstar's Mutual Fund Conference, noting that when stocks took off on a 17-year run with 17% annualized returns in 1982, bond yields stood at 14% or 15%. These days, some comparable fixed-income issues are yielding 4%, 5% and 6%, so one can extrapolate that a period of single-digit equity returns is quite probable. Quoting Will Rogers, Gross quipped that these days he wasn't as concerned "with the return on my money as I am with the return of my money."
But it's not simply the shrinking returns from financial assets that are rearranging priorities for advisors. Clients are living much longer, and their attitude toward retirement is changing. One traditional tenet of retirement planning-the assumption that clients would be able to live with substantially less income than when they were working-isn't materializing.
Indeed, one reason many clients are eager to engage in income-producing activities well into their sixties and beyond is that they want to remain vital. But the other reason is that additional income increases their financial security and permits them to enjoy a much higher standard of living without having to dip deep into their life savings.
Don't Defer QP Withdrawals Forever
The implications for qualified-plan investments and withdrawals are radical. Traditionally, advisors counseled retirees that it was wise to withdraw from their taxable assets while continuing to let funds in tax-deferred accounts compound. The reasoning is that if qualified-plan funds are permitted to keep growing, the power of compounding eventually would compensate for the ordinary income tax rates at which withdrawals will be taxed. The assumption underlying this reasoning was that clients would retire in a lower income tax bracket than they faced while working, an assumption that is turning out to be wrong more often than expected.
For high-net-worth clients, an advisor can be creating a huge tax trap, warns Rick Adkins, CEO of The Arkansas Financial Group in Little Rock, Ark. These days, Adkins is urging affluent retirees to tap qualified plans first and leave other assets off the table. If they follow his advice, clients try to direct or "soak up" as much of the withdrawals in the 28% tax bracket as possible. "Then they invest those monies for growth that will ultimately be taxed at only a 20% [capital gains] rate," he explains. "Otherwise, they run the risk that those assets will be taxed at a 40% rate instead of a 20% rate. To just keep deferring it is a sucker's bet."
Like Adkins, Eleanor Blayney of Sullivan, Bruyette, Speros & Blayney in McLean, Va., acknowledges that qualified plans are powerful wealth builders. "Tax deferral is a subset of compound interest," she says. And it's an excellent way for younger clients to start accumulating assets and experience the power of compounding.
The problems come later. Clients who retire with seven-figure amounts in 401(k) plans frequently fail to realize much of that money is Uncle Sam's, not theirs. "I've come to the realization that coming into your retirement with a huge slug of your wealth in qualified plans creates its own set of issues," Blayney continues. "You are taking a lot of risk that the tax laws may change on you."
How Much QP Funds You Need
Another problem confronting advisors is that of clients who want to retire and become volunteers at 50 or 52 years old, but who have most of their assets in qualified plans. In Hackettstown, N.J., Bob Barry of Barry Capital Management is seeing a growing number of professionals in this predicament. "There's only so much you can do with regulation 72(t)," he says, referring to an IRS rule that permits withdrawals from qualified plans before age 591/2. "We're seeing people come in with $4 million, of which 80% is in qualified plans. With tax-managed mutual funds, they don't have to be in that position."
Some advisors are taking dramatic steps. After the capital-gains tax rate was cut from 28% to 20%, Bill Bengen, principal of Bengen Financial Services in El Cajon, Calif., ran some numbers and decided to stand conventional wisdom on its head. He now advises some affluent clients in their late forties and fifties to limit their 401(k) contributions to no more than required to receive the maximum employer match, or free money. He counsels them to invest the rest in a taxable account. "In the long term, they'll have a lot more money, a lot less taxes and a lot more flexibility," Bengen says. "Also, qualified-plan money can be an estate-tax time bomb."
Ross Levin of Accredited Investors in Minneapolis won't go quite as far as Bengen. But he often advises clients who are eligible to divert those monies into a Roth IRA. Once the money is out of a qualified plan, clients face many more options. The money can be invested for growth or income. It also can be gifted to clients' children.
Rethinking Estate Planning
When it comes to estate planning, perspectives there are changing as well. Not so long ago, most advisors assumed their clients' objectives were simple and straightforward-to leave as much money to their heirs as possible. In reality, clients' attitudes on the subject are not nearly so uniform.
This is particularly true among individuals who either have accumulated substantial wealth at a young age or amassed a fortune of sorts at a later age. Clients in their thirties and forties often worry about establishing a will that leaves millions to children who are "barely out of diapers," Blayney says. "You need to explore these issues with them." Clients who are older, have amassed smaller amounts of wealth and have older children who are established in their careers may be more likely to leave the bulk of their assets to their offspring.
Among the very affluent, advisors report that most clients are less interested in exotic vehicles like dynasty trusts than they might have been a decade ago. "They want to leave enough so the children are comfortable, but they don't want to create trust-fund babies," one advisor says.
Advisors are becoming appreciative of clients who don't conform to the mainstream. "More clients are saying to me, 'If I leave my kids with $2.9 million, that will be $2.89 million more than I started out with," Barry says.
The new tax law has created more confusion about estate taxes than most advisors would care to admit. More than a few folks in country clubs are chortling about the repeal of the estate tax, but whether it really will be abolished is questionable. But increasingly, there is a growing consensus that the law will be changed long before then.
Meanwhile, some advisors to the very affluent are questioning the notion that these clients should make substantial gifts to their children and pay gift taxes. "We don't do that anymore," says Roy Ballentine, an advisor in Wolfeboro, N.H., who serves 50 clients with an average of $75 million in assets. "We're waiting to see what happens."
Be Selective About Clients
Despite the market downturn of the past 18 months, many leading advisors have found the business climate much more conducive to growing their practices than the previous few years were. One of the sadder, unwritten stories recently is the number of advisors who, hectored by bubble-crazed clients, reluctantly succumbed to pressure, threw in the towel with regard to long-held principles and hopped on the tech-investing bandwagon late in the game. "There are a lot of guys out there kicking themselves," says John Bowen, CEO of CEGWorldwide, in San Martin, Calif. "They thought they would lose clients if they didn't change stripes. They forgot they were advisors and became facilitators."
Many top advisors who lost clients in 1998 and 1999 because they got sucked into the tech maelstrom now are seeing some of those ex-clients, and others like them, sheepishly waiting in their reception areas. And a surprising number of advisors are turning away prospects with tech portfolios down 70% in the last year. As veteran commentator Nick Murray told attendees at last March's Financial Planning Association's annual retreat, advisors can be more productive and happier working with clients they like. This was one reason, Murray added, why the multifamily-office model offering a broader portfolio of services to fewer clients has so much potential.
When exploring an engagement with clients, it's important to determine what kind of relationship they want. Two years ago, Undiscovered Managers CEO Mark Hurley unnerved many advisors with the prediction that they were about to face an onslaught of competition from giant institutions. Hurley was right about the wave of competition, but the jury is still out on whether they will succeed. "The institutional assumption is that it's a faceless relationship," Levin says. "Hurley's scale argument works best for people who are newer in the business and those delivering strictly asset management."
Asset Allocation And MPT On Trial
Probably no principles of financial planning have faced greater challenges in the past five years than asset allocation, diversification and modern portfolio theory (MPT). The unparalleled performance of large-capitalization U.S. growth stocks prompted many to question the validity of these academic theories that were as widely accepted among practitioners as the notion that the Earth is round.
But questions about MPT have come from other quarters besides the discredited momentum crowd. Several critics in both academic and professional circles are examining the entire approach to investing that evolved from applying MPT to financial planning for individuals and finding some serious problems.
Near the top of the list is the static investment environment underlying all the assumptions upon which modern portfolio theory is based. A quick look at the financial world today and the world of two years ago reveals just how dynamic and transitory markets can be. The same goes for a client's risk-tolerance profile. Some professionals like C. Michael Carty of New Millennium Advisors in New York City note that risk-tolerance questionnaires measure a client's attitude toward risk at one point in time. It's an open question as to how many advisors update them on a frequent basis.
Dave Loeper, chairman of financeware.com in Richmond, Va., has spent much of the last year traveling the financial planning conference circuit espousing his own views on the subject. "Investment risk is not something an investor has a maximum tolerance for and then endeavors to experience," he says. "It is something he begrudgingly accepts because the consequences of not accepting it are more painful than the investment risk he accepts."
Another point Loeper and other
have harped on is that while MPT defines risk as volatility, risk for most individuals is the failure to achieve their goals. That is likely to spawn a major redefinition of risk in the next few years.
Time, Money and Monte Carlo
In recent years, the tool that the advisory profession has turned to most often to resolve these discrepancies is Monte Carlo simulation. Unfortunately, there is one glaring problem with Monte Carlo simulation. It produces terminal wealth numbers expressed in a normal distribution.
As Harold Evensky of The Evensky Group in Coral Gables, Fla. observes, even a cursory look at stock market returns reveals that their distribution is anything but normal. Look at returns on the Standard & Poor's 500 Index for the last 30 years. How many years were clustered right around that 8%, 9%, 10%, 11%, 12% average? Very few.
Many would argue that time reduces volatility substantially and that equities, viewed over a 20- or 30-year period, look much more attractive. Time does reduce the range of annualized returns, but as the Nobel Laureate economist Paul Samuelson has written, it doesn't reduce the variability of a terminal wealth goal. Just ask the thousands of folks who retired in late 1999 with $2 million and now have $1.3 million or less. Simply put, a lot more clients aim for a terminal wealth target of, say, $2.5 million, than attempt to achieve a 10% annualized rate of return on their portfolios.
Stick To Your Game Plan
Some advisors who were strong enough to defy the inexorable temptation of the tech bubble failed to avoid another cardinal mistake over the last five years- jumping in and out of asset classes. The two asset classes that served most frequently as hot potatoes for sophisticated professionals were real estate investment trusts (REITs) and emerging markets.
After emerging markets crashed in 1997 and 1998, many advisors suddenly discovered that clients were losing sleep over what was typically no more than 2% to 5% of their portfolio. Whether it was a case of advisors not fully explaining the risks of this asset class or clients only hearing what they wanted to hear is immaterial. "Even as advisors, it's very easy to succumb to short-term temptations," Adkins says. "But I'm more and more convinced that what people refer to as the art of investing is really the voodoo."
Are Annuities Part Of The Answer?
For the last five years, few financial products have been more reviled among professional advisors than variable annuities. With mutual fund sales loads declining, they have become viewed as the last refuge of those wannabe planners seeking to sell the highest commission product possible.
Yet a growing number of leading practitioners are coming around to the realization that clients need some kind of stable income stream. Blayney admits that for years she believed individuals "with a good financial advisor could self-annuitize." She still does, but adds that annuitizing a low-expense annuity can simplify the problem. "You give up some flexibility, but an annuity can allow you to take a lot more equity risk."
Much of the recent change in perception has come through the efforts of TIAA-CREF, which formed an advisory board with top advisors to discuss these issues. Many innovative ideas have been put forth, such as the notion of using an immediate annuity to help fund the purchase of a long-term care insurance policy.
But annuity marketers themselves are undergoing a transformation. In an article published in the Journal of Retirement Planning, Michael Lane, president of TIAA-CREF's advisory-services unit, wrote, "I always thought annuitization was the worst thing you could do. After running the numbers, it turns out annuitization is a significantly better option for retirement both in the amount you receive, and if structured right, it is guaranteed for as long as you live. It provides both discipline and security."
With many baby boomers facing a serious retirement savings shortfall, look for immediate annuities to play a bigger role in the years ahead.