Last month’s column about strategies that are overhyped to consumers generated several emails suggesting other strategies I should mention. As a refresher, my definition of “overhyped” is a strategy that gets a lot of attention but probably doesn’t have as big a positive impact as is touted, is likely to have a negative impact, or for which there are very few clients who can or will attempt to execute the strategy. The list is not to suggest that all are universally worthless. In the right situation, there can be benefits to be had.

Net Unrealized Appreciation

The tax rate on long-term capital gains is lower than the rate on ordinary income. Net unrealized appreciation (NUA) offers the ability to take gains on employer stock that would normally get taxed at ordinary rates when distributed from a retirement plan and get those gains taxed at the more favorable long-term gains rate.

You simply roll out the stock to a brokerage account and pay ordinary income taxes on the shares’ cost basis. From that point, you can sell the shares and pay long-term capital gain rates on the appreciation. It’s a pretty slick maneuver but we have only seen it work well a few times.

There are several factors conspiring to keep NUA utilization low. First is meeting the qualifications. One needs a “triggering event.” These are death, disability, separation from service, or reaching age 59½. When a triggering event occurs, the shares distributed in kind to a taxable account must be of actual stock so phantom stock, options and the like are not eligible.

Finally, other assets can be rolled into an IRA but the entire plan balance must be fully distributed in the same tax year. Distribute the shares in one tax year and roll the rest to an IRA in another and the entire value of the shares distributed is ordinary income, not just the basis.

The second set of sticking points surrounds the basis of the distributed shares. It is common for the basis to be large enough that the tax due on that ordinary income is higher than the client cares to pay. This immediate taxation is a deterrent, particularly if the distribution is made prior to age 59½ because unless an exception applies, the client will owe the 10 percent early distribution penalty.

Further, the client is taxed on the basis but gets no cash from the distribution and cannot have taxes withheld. The client must take the cash to pay the taxes from elsewhere because cash is received from the shares only when the shares are sold.

The best scenario is one in which the basis is low and the appreciation is large. Because you can cherry-pick only the lots with low basis for a distribution and roll remaining plan assets to an IRA, more people should be able to take advantage of NUA but that’s not the case. It has been a mixed bag regarding how many plan administrators have good records of the lot by lot basis and know how to facilitate a qualifying group of transactions.

Yet another significant factor is behavioral. We have found that many people whose company stock has done well enough to consider NUA, have a hard time selling the stock to diversify. The stock has been good to them for a long time and in their minds that trend should continue. They simply don’t see concentration risk as applicable to their company. Often, they will use the gain taxes that would be due on top of the ordinary income from the basis as an excuse to continue holding the stock.

Use A Risk Tolerance Questionnaire To Determine Portfolio Structure

Enter your assets, fill out a questionnaire and voila, the best portfolio mix for you will be created. Man, it would be great if it were that simple. 

Most risk tolerance questionnaires have no scientific validity but even those assessments that are validated, can be overhyped by my definition. They are often presented as critical to getting the portfolio right, but I do not see them as critical to client success.

Clients don’t just need to know what to do. They must actually do those things to be better off. The portfolio mix isn’t “right” if clients won’t stick to the plan. That means hand holding in tough times or countering FOMO (fear of missing out) in good times.

There can be a significant discrepancy between what a risk tolerance test says, what a client says and how the portfolio needs to be structured to achieve a goal. These differences compound when working with couples. At the end of the day, compromises between what the client wants and what the client needs must be negotiated. The discomfort that can come from these differences is sure to manifest so planners must be prepared to coach clients to deal with that. 

I have not seen a risk tolerance questionnaire that leads to a significantly different outcome than simply asking clients what they want, what they fear, what they have owned, and what they have done in past bad markets and then having a good conversation about risk. It pains me to say that because I am a bit of a research junkie and would much prefer something more scientific but so far, I haven’t seen any evidence that a particular risk questionnaire, sans the conversation and coaching, produces better outcomes than other questionnaires.

Now, I don’t think it is a bad thing to use a questionnaire to get the conversation going but clients’ success comes from a quality risk conversation, a sound portfolio design and ongoing behavioral coaching, not by matching a portfolio mix to a score on a questionnaire.

Add Alternative Investment Products To Portfolios

“The multi-billion-dollar endowments own alternatives so you should too.” Rubbish. To start, a client with a couple million bucks typically doesn’t have access to the same programs the endowments do. Moreover, the goals, temperament and resources of such clients have little, if any, resemblance to such funds. 

Higher costs, greater dependency on management’s crystal ball, less transparency, low tax efficiency, and limited or no access to the funds, all make alternatives unattractive. These negative qualities are not outweighed by the purported benefit of low correlation. Low correlation is only a benefit if the return of the alternative’s zig is big enough to counteract the rest of the portfolio’s zag.

They don’t seem to do that very well. A recent sign of their failure comes from Morningstar’s John Renkenthaler. He broke retail alternative funds into two types “1) thoroughly useless and 2) mostly useless.” (Source: “Judgement Day”, Morningstar magazine, Summer 2019) The term “mostly useless” was his descriptor of the five best alternative categories of funds over the 10 years from 2009-2018. The funds did poorly not just when stocks did well but in years when stocks did poorly, exactly when alts are supposed to save the day.

I believe that many clients need stocks to have a reasonable chance they will reach their financial goals. I believe many clients need the stability of high-quality fixed income products to have a reasonable chance they will reach their financial goals. There is not one client I have ever worked with that needs an alt product to reach their goals. Further, I do not believe that any client will fail because they omitted alts. The record shows clients are more likely better off without alts than with them.

Sell Your Life Insurance Policy For Cash

In order for the party buying a life insurance policy to receive a return, a death benefit must be collected. The return is function of the difference between what the buyer pays the client, the death benefit the buyer receives and the time until death. Clients with conditions expected to shorten their life spans generally get the better offers with the highest offers going to those with the worst conditions.

I have only once heard of a situation in which the selling a policy became the best choice. The client was terminal and the family had no way to keep the policy in force, so it was sell the policy for something or likely receive nothing. The income of the client was low, so the ordinary income taxes were not as costly. For that family, a sale was a true blessing. Nonetheless, most families with some means will be better off keeping the life policy in force and collecting the tax-free death benefit themselves rather than settling for a smaller often highly taxed amount from a sale.

I have still more to share, but I’ll have to save the other overhyped strategies for another time. In the meantime, if you think of more, email me.

Dan Moisand, CFP, has been featured as one of America’s top independent financial advisors by Financial Planning, Financial Advisor, Investment Advisor, Investment News, Journal of Financial Planning, Accounting Today, Research, Wealth Manager, and Worth magazines. He practices in Melbourne, Fla. You can reach him at [email protected].