Articles About Investments

Planning for individuals with disabilities poses unique challenges when coordinating across the potentially high cost of special care needs, Federal and state assistance programs such as Supplemental Security Income (SSI) and Medicaid, and savings strategies designed to work together with those assistance programs (which themselves can have complex requirements to qualify). For example, in 2014, Congress passed the “Achieving a Better Life Experience” (ABLE) Act that created the tax-favored 529A account, providing tax-free growth opportunities for individuals with disabilities… at least, those with a disability (or blindness) that was diagnosed before the age of 26.

529A accounts allow for annual contributions, from all sources, of up to $15,000/year (the annual gift tax exclusion limit) plus earnings of the ABLE beneficiary, up to the annual poverty limit for a one-person household. They also allow for tax-deferred earnings on contributions inside the 529A plan, and tax-free withdrawals for qualified disability-related expenses. While contributions cannot be deducted from income on Federal tax returns, many states do allow contributions to be deducted on state tax returns.  The caveat, however, is that most states also allow state-run Medicaid programs to recover expenses from 529A plans once the beneficiary has died (although five states, so far, have prohibited this, with more possibly to follow), which is important because this recovery-of-Medicaid-assistance provision has been a main reason that many individuals have opted against opening 529A accounts since they were created 5 years ago.

But despite their seemingly complex rules and restrictions – and the potential overhang of state Medicaid recovery at death – 529A accounts can still be used to effectively grow assets in a tax-efficient manner, while serving as a ‘spending account’ for a disabled beneficiary. In fact, advisors can help disabled clients to maximize the value of 529A accounts in light of state Medicaid recovery, particularly since the balance of growth and Medicaid recovery opportunities becomes especially pertinent when the beneficiary is expected to live for at least five more years.

Accordingly, the first step in maximizing the use of a 529A plan, “Contribute, But Don’t Distribute”,  is to grow the account balance as aggressively and as quickly as possible in the early years in order to maximize tax-free earnings. However, the balance should be kept below $100,000 if the beneficiary is receiving any SSI benefits (though if the individual does not receive such benefits, the account can be allowed to grow to the maximum account balance as specified by the state, which is often greater than the $100,000 SSI limit).

The second step to maximize a 529A plan, “Earn and Burn”, is to systematically withdraw funds any time the account balance reaches the target threshold (to keep the account balance from exceeding the targeted limit) and to use those earnings to pay for qualified disability expenses.

Finally, the last step, “When In Doubt, Empty It Out”, applies to beneficiaries who live in states allowing for Medicaid recovery from the remaining account balance after their death. In this stage, the account holder proactively spends down and uses the 529A account, in full, if/when the beneficiary’s health takes a turn for the worse or their life expectancy otherwise becomes more limited in time horizon (to ensure there’s nothing left in the 529A account shortly before the beneficiary is expected to die).

Ultimately, the key point is that, despite the complex rules around maintaining a 529A account and the risk of state Medicaid recovery taking away the account’s remaining contributions and growth, the expenses for which a 529A account can be used are broadly defined and thus offer flexible strategies for using 529A plans for the benefit of qualifying individuals who are disabled or blind, ensuring those dollars are fully spent for the disabled beneficiary themselves.

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Leveraging the success (and the systems and infrastructure) of tax-preferenced 529 college savings plans, in 2014 Congress passed the “Achieving a Better Life Experience” (ABLE) Act, which created a new “529A” version of the accounts, designed specifically to allow families to accumulate assets on a tax-preferenced basis for special needs beneficiaries. Which for some families may be a more cost-effective (and tax-favored) alternative to a special needs trust, and for others may at least supplement a special needs trust for a portion of the assets the family sets aside.

The caveat, however, is that similar to 529 college savings plans, the new ABLE accounts are established on a state-by-state basis, with everything from the costs to the state tax deductions varying from one state to the next. And because 529A plans are more likely to be used transactionally on an ongoing basis for their special needs beneficiaries… they’ll less likely to grow to a significant size. Which has resulted in some states deciding not to even offer the accounts. Making the process of selecting a 529A plan far more of a state-by-state evaluation effort than even traditional 529 college savings plans.

In this guest post, Andrew Komarow and Craig Breitsprecher of Tenpath Financial Group, an advisory firm with a specialization in working with families that have special needs beneficiaries, explores the current landscape of 529A plans, the key criteria to compare one ABLE account to the next, and what advisors should be mindful of in helping clients to select a plan. Including the fact that very few 529A plans are even designed to work with financial advisors directly in the first place, with only one broker-sold plan and no fee-based options. But with at least some potential workarounds for RIAs through their own custodial platforms.

And with potential legislation under consideration in Washington that might further increase contribution limits, expand age limits, and overall make 529A plans more appealing, ABLE accounts may increasingly need to become part of the financial advisor’s “quiver” of tools to use with clients. At a minimum, though, it’s important to be aware of the options that exist today, and what it takes to ensure that clients who do have a special needs beneficiary pick the plan that’s best for them.

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As the trend towards financial planning as the primary value proposition for financial advisors continues to gain momentum, one of the biggest challenges that emerges is freeing up the time to provide that financial planning advice to an ever-growing number of clients. As all growing advisory firms eventually get to a point where there just isn’t simply enough time in the day to devote to nurturing client relationships (and developing new ones) and do all the other stuff necessary to make the business actually happen! Accordingly, one of the most cost- and time-efficient ways to increase the time an advisor can spend better servicing clients is by outsourcing the process of implementing (and managing) investment planning recommendations to a TAMP, or turnkey asset management platform. Yet for those advisors who do decide to outsource their investment management, the question then becomes, with the dizzying array of TAMPs on the marketplace, how do you determine which one is best (or at least, best suited to the individual advisor’s needs)?

Accordingly, in this week’s #OfficeHours with @MichaelKitces, my weekly broadcast via Periscope, we examine six areas of due diligence questions to consider when choosing a TAMP, how to understand the real costs of TAMPs, and the various ways advisors can position the cost of paying for a TAMP’s services (alongside the advisor’s own advisory fee).

Of course, as an outsourced investment management platform, one of the first (and most important) questions to ask any TAMP provider is about how they approach investments in the first place. Because all investment management firms have some sort of philosophical preference…. and without getting into the merits of one strategy over another, the reality is that whatever approach a TAMP uses is going to become your approach if you use that TAMP. Which means, ultimately, you as the advisor are going to be the one responsible for not only selling that investment philosophy (and process) to your clients, but also defending that approach when the inevitable bear market or stint of underperformance occurs. So be certain the TAMP’s philosophy is one you’re ready and willing to defend… and that the TAMP has a process to execute that philosophy, and a performance track record to validate they can deliver!

From a more nuts-and-bolts perspective, other key points to consider when evaluating a TAMP include: make sure that the TAMP is approved on your platform (if you’re under a broker-dealer), or that the TAMP can work with your custodian (if you’re with an RIA); what sort of additional technology do the various TAMPs offer (because there is a wide variety amongst providers, with some offering their own proprietary solutions, others not offering any, while still other TAMPs bolt on other third-party platforms); and what amount of additional staff support does the TAMP offer (or not), including administrative services, investment research, and marketing support.

And don’t forget that you need to determine how much the TAMP actually costs. As with anything, you get what you pay for, and at least in the TAMP marketplace, the pricing usually coincides with the level of service and support that’s provided. But, some TAMPs do price higher than others, and you need to factor in the expense ratios of the investment products they use as well, which get stacked on top of the TAMP’s base fee and can materially impact the all-in cost to your client!

Finally, bear in mind that if you plan to use a TAMP, you have to figure out how you’re going to pay for the TAMP. Some advisors simply treat the TAMPs fees as an additional cost to the client over and above their own management fee (just as the client would have paid a mutual fund manager’s expense ratio above-and-beyond the advisor’s own fee), while other advisors treat the TAMP’s fee as a business expense (because they would have otherwise had to hire and pay staff to see to those duties) and pay it from their own advisory fee, while other advisors “share” the fee with their clients, tacking on only a portion of what they’re paying the TAMP and absorbing the rest of the fee themselves (in lieu of the other staff they would have had to hire anyway).

Ultimately, the key point is that it’s important to spend time taking a deep look at each TAMP provider to make sure that you’re both a good fit for each other, both from a pure philosophical investment viewpoint, and with respect to the technology and other support services the TAMP does or does not offer (which you may or may not need!), and make sure that their offerings address the needs of your clients and how you want to run your business. No one TAMP is the best solution for every advisor, and it’s worth your time to do the due diligence to find the right one for your current and future needs in serving your clients.

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It is a standard requirement in financial services that financial advisors must first determine an investor’s risk tolerance before making any investment recommendations for their portfolio. Yet in the modern era, good financial advisors don’t just invest a portfolio for growth or preservation of principal alone, but to achieve the investor’s goals, and whatever required return (and associated risk) those goals necessitate. Except in practice, doing so is sometimes impossible – because not all investors are able to tolerate the amount of risk they need in order to achieve their goals in the first place!

For financial advisors, this leads to two alternative paths for implementation. The first is to take a more “authoritative” approach, where the financial advisor is literally “the authority” – the expert – whose job is to implement whatever the investor needs to achieve the goal (i.e., to invest them for what they need, regardless of their tolerance), and then bears the responsibility to help their clients stick with the plan and stay the course (i.e., “behaviorally manage”) through the inevitable market downturn. By contrast, the second option is a more “accommodative” approach, where the financial advisor may educate and make suggestions to the investor about why they need (and should be more comfortable with) a greater level of risk, but in the end accommodate however the client wishes to invest (since it’s their money and their decision in the end, even if it’s a path inevitably doomed to failure by generating insufficient returns).

On the other hand, arguably the real problem is not just about deciding whether to be more authoritative or accommodative with respect to an investor’s mismatch between their need for risk and tolerance to take it, but recognizing that their need for risk is so (problematically) high because their goal itself is very demanding and risky in the first place. Which means the best path forward may not be about trying to determine the “optimal” portfolio at all (because there really isn’t one) but is instead about helping clients to adjust their goals such that they don’t need more risk than they can tolerate in the first place. In other words, the advisor doesn’t need to be authoritative or accommodating of the client’s high-risk-need and low tolerance if the goals can be adjusted so the client no longer has that high-risk need after all!

Or stated more simply, in a world where portfolios aren’t just invested for growth or preservation of principal in the abstract, but specifically to achieve certain goals, the first step of the process is not to align the portfolio to the client’s risk tolerance, but to align the goals (and the amount of risk they would necessitate) to the client’s risk tolerance in the first place. Because once goals themselves are aligned to risk tolerance… implementing the optimal portfolio turns out to be remarkably straightforward!

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One of the fundamental principles of long-term investing is the recognition that, while markets may go up and down and be volatile in the short-term, eventually the volatility tends to average out into favorable long-term growth rates. Accordingly, the conventional wisdom in the face of market volatility is simply to keep invested and stay the course. Of course, those who are approaching or transitioning into retirement need to be cognizant not to draw down the portfolio too much waiting for those returns to average out – a phenomenon known as sequence of return risk – but as long as investors stay a little flexible on their retirement goals, and spend reasonably conservatively, that sequence of return risk can generally be managed.

However, the fact that investors will for the most part simply have to accept whatever returns the market gives – and in whatever sequence it provides them – means that different generations of investors may have substantively different experiences with long-term investing simply based on whatever happens to occur during their particular investment sequence and the “investment cards” they’re dealt.

In turn, this effect is further amplified by the fact that early investment experiences often shape a lifetime of investment behavior – from Baby Boomers that experienced favorable market returns coinciding with the rise of the 401(k) and have stuck with markets during their difficult years, to late Gen X’ers and Millennials who have had to wait as much as a decade or more simply to see the markets recover to where they started when they first begin investing (hearkening back to the experience of a Lost Generation of investors after the Great Depression who never returned to stocks after the scarring experience of the crash of 1929 and its slow recovery during the Great Depression). And in fact, a growing volume of data on investor behavior is suggesting that younger investors are indeed far more skeptical of stock markets and long-term investing… a challenge that may not necessarily reverse itself even as the market improves (just as the bull market of the 1950s and 60s didn’t necessarily win back Depression-era investors).

The fact that the generational timing of young adulthood – and the market returns that coincide with it – may have such a long-term behavioral influence notably also extends to financial advisors themselves, as Baby Boomer advisors in their early 60s today saw a raging bull market for the first 20 years of building their careers, while younger Gen X and older Millennial advisors have had to wait 10-15 years just to see the markets recover to where they invested their first clients! Which raises the question of whether advisor attitudes about the value of providing investment management, and the active vs. passive debate, may also be heavily shaped by the advisor’s generational experience and the timing of when they happened to launch their advisor career?

Ultimately, though, the key point is simply to recognize that mere birth year may actually be responsible for a far more outsized portion of our lifetime investment behavior and experience than is commonly acknowledged. As even if a long-term portfolio can mathematically recover from almost any sequence of returns, it doesn’t mean that certain generations of investors – and advisors – will behaviorally do so themselves, based on whatever early-years’ experience the market happens to give them during their formative years?

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One of the biggest trends in the investment industry in recent years has been explosive growth in the variety, availability, and use of exchange-traded funds (ETFs). Not only because they are more tax efficient, have more flexible trading, and are typically less expensive – which has made them a popular way to implement passive investing strategies – but also because even advisors who actively manage portfolios themselves appear to be used ETFs are the core “passive” building block for their active ETF strategies. However, the industry still shows that the overwhelming majority of advisors still use mutual funds as well, which in turn raises the question: how, exactly, do advisors choose between mutual funds versus ETFs and select the particular investment vehicle they’re going to use… and from the asset manager’s perspective, what should fund companies be doing to get their investment solutions in front of advisors?

In this context, a recent industry study published by Erdos & Morgan provides a fascinating look into what advisors actually view as the most important factors when selecting fund providers. Not surprisingly, performance and fees rank were top-ranking factors, but advisors also place a high value on a fund provider’s approach to managing volatility and their perceived trustworthiness… and surprisingly (or not) weight at all on the fund company’s marketing materials, wholesalers, or “thought leadership” white papers. And the trend is especially pronounced amongst the RIA channel, which sits the furthest from traditional commission-based fund distribution models, and appears to be the most likely to take a “don’t call us, we’ll call you” approach to selecting fund providers to work with.

In fact, another study from Advisor Perspectives (also looking at fund company selection by advisors) found that advisors are becoming increasingly sophisticated in regards to evaluating a fund’s fees and performance, instead of relying on the higher-level “rankings” from research providers (e.g., Morningstar’s star ratings). And to the extent that advisors want “value-added” services from fund providers, the desire is not for practice management advice, but simply more accessibility to deeper investment expertise, from having more direct access to fund managers and research analysts, and demanding that wholesalers themselves be increasingly investment savvy (with real investment expertise like CIMA certification) as well.

The bottom line, though, is simply that with all the rapid changes occurring in the industry, there is growing recognition that the traditional distribution approach of fund providers and asset managers is changing. Yet thus far, fund companies appear to be struggling to adapt, leading to especially low reputation scores from RIAs compared to advisors working at broker-dealers, and substantial negativity towards traditional wholesalers. The good news, however, is that in the end, client assets still have to be invested somewhere… which means there is a substantial opportunity for the fund providers that can learn to adapt most quickly to the new normal of how advisors select investment solutions.

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Earlier this week, Vanguard announced that in August it will begin offering commission-free ETF trading through its Investor.Vanguard.com online brokerage platform on a whopping 1,800 ETFs… which includes not just its own ETFs, which were available commission-free already, but virtually all ETFs, including those from all their major competitors like Blackrock, State Street, and Schwab (on top of the 2,500+ mutual funds already available through Vanguard without trading fees). Yet while the media immediately jumped on the announcement as a new stage of the price wars on ETF trading costs, as Vanguard’s platform will offer nearly 5X – 10X the breadth of ETFs as their largest competitors… the real significance of Vanguard’s announcement is much bigger.

In this week’s #OfficeHours with @MichaelKitces, my Tuesday 1PM EST broadcast via Periscope, we discuss why the real impact of Vanguard’s announcement is a potentially fatal disruption to the nature of no-transaction-fee (NTF) ETF platforms themselves, undermining existing pay-to-play distribution agreements to the most popular NTF ETF platforms today, and potentially pushing RIA custodial platforms instead to charge advisors (or investors) a more transparent and less conflicted basis point fee directly for the clearing, custodial, and other services they provide.

Some historical perspective on the use of shelf-space and revenue-sharing distribution agreements for fund providers may be helpful to understand why Vanguard’s announcement is so disruptive. The first “no transaction fee” (NTF) online brokerage platforms got going in the 1990s, pioneered by companies like Schwab with their OneSource program, establishing a giant online supermarket of mutual funds that were made available (and funded) by 12b-1 shareholder servicing fees and sub-TA fees instead of charging “traditional” transaction fees to purchase a fund. But then along came ETFs, which “felt” like mutual funds to many consumers who wanted to be able to buy them without transaction fees as well… except, ETFs don’t have a 12b-1 fee or a sub-TA fees! As a result, when the online brokerage platforms wanted to offer ETFs under a no-transaction-fee platform, they needed a new way to get paid. What emerged was brokerage platforms negotiating “distribution” agreements directly with the ETF providers that effectively said, “If you want to be listed in our NTF platform, you need to pay us directly”, taking the form of other a revenue-sharing agreement (paying basis points for assets on the platform) or “shelf-space” agreements (which are typically negotiated flat fees and not set as basis point directly, though they are still effectively loose basis point equivalents based on total assets). The key point: one way or another, fund providers had to pay to be on the NTF platform, which is why most NTF ETF platforms have a limited lineup (or only those providers willing to pay).

And, mostly out of necessity for distribution opportunities, many fund providers have paid to be on these platforms. The bold exception to this trend was fund companies like Vanguard and DFA, which were notorious for not paying dollars under the table to get onto these NTF platforms. Early on when many NTF ETF platforms were being built out, Vanguard still wasn’t nearly as dominant in the ETF space as they are today, so many companies allowed Vanguard onto their platforms as a way to validate their platform (with Vanguard’s name recognition) in the hopes of attracting clients who might also use some of the other NTF funds (that do pay to be listed). But as Vanguard has continued its meteoric rise over the past several years, Vanguard attracted so much in assets onto these platforms that it was adversely impacting the profitability of the entire platforms… leading companies to swap Vanguard out for other ETF providers that were more willing to pay to participate.

And that is why it’s such a big deal that Vanguard made the announcement this week that it’s going to make virtually all ETFs available on its own online brokerage platform. The significance is that they’re offering a no-transaction-fee platform without requiring the same back-end shelf space payments that all the other brokerage and custodial platforms require. In other words, the latest move by Vanguard isn’t a price war against ETF trading fees; instead, it’s declaring war on the entire model of asset managers being forced to pay back-end revenue-sharing and shelf-space agreements to get onto those platforms in the first place, by offering their own and not charging the asset managers what everyone else charges!

How will this potentially play out from here? ETFs that currently pay NTF platform fees are compelled to increase their expense ratios to cover the cost (because the money has to come from somewhere to pay)… except now ETF providers have a problem: their ETF expense ratios are boosted higher to compete on NTF platforms at companies like Schwab, Fidelity, and TD Ameritrade, but the higher expense ratios to cover the distribution costs on those platforms will reduce their competitiveness on the new mega Vanguard platform! As a result, ETF providers may be compelled to start creating a new series of their popular ETFs, with those additional distribution costs stripped out, creating a lower-cost “clean ETF” that can better compete in a true NTF environment. Yet once this happens, since the ETFs will be available elsewhere as well (just with a transaction cost instead) it will recreate the multiple-share-class effect we have now in mutual funds, where there’s a higher cost version of the mutual fund in the NTF platform – because it’s pushed up by the 12b-1 and sub-TA fees – and then there’s a lower cost version of the same mutual fund you can buy directly. Which ultimately will lead to consumers (and advisors) adopting whichever fund is cheaper in their situation, putting further pressure on custodians to offer less conflicted models where investors (or advisors) are simply charged a transparent basis point fee for the clearing and custodial services provided instead.

But ultimately, the key point is to acknowledge that the real news is not that Vanguard is simply offering a larger NTF platform than other providers. The real news is that this may be a fatal disruption to NTF platforms themselves, and a step towards a more transparent model of custodial services over the more conflicted models of back-end distribution agreements that currently exist!

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Donor-advised funds (DAFs) are flexible tools which can be used for a number of charitable giving purposes. One increasingly popular use is to use an “endowment-style” DAF in lieu of a private foundation for those with charitable intentions of leaving a legacy that will continue to have an impact on the world many years into the future, given that DAFs are cheaper to operate, more tax efficient, more flexible, and eligible for higher limits on tax deductibility of contributions. However, while much attention has been given to how individuals should allocate a portfolio throughout their own lifespan, considerably less attention has been given to the question of how to best allocate a portfolio if one’s time horizon is “forever”. Especially when it has flexibility with respect to its distributions.

In this guest post, Dr. Derek Tharp – a Kitces.com Researcher, and a recent Ph.D. graduate from the financial planning program at Kansas State University – analyzes considerations when coordinating investment and spending policies of an endowment-style DAF, finding that for donors who have the willingness and ability to be flexible in their distribution policy, investment allocations can be much more aggressive than those commonly adopted by endowments, generating far more income for charitable beneficiaries and build a larger endowment value to sustain giving well into the future.

The traditional approach to investment an endowment is still a well-diversified conservative or moderate growth portfolio – e.g., a 60/40 portfolio – owing in large part to the fact that most endowments have a high need for distribution stability (e.g., university endowment funds that need to fund ongoing operating costs that universities have become highly dependent on). However, in the context of an endowment-style DAF, the reality is that individual donors often have far more flexibility about when and how much they donate. Which is important, especially with the possibility of 100+ year time horizons that allow for immense (and intuitively-difficult-to-grasp) compounding.

In fact, a Monte Carlo analysis (based on historical market returns) of an ultra-long-term endowment-style DAF with a flexible (e.g., percentage-of-assets) distribution policy finds that shifting a fairly modest $100k endowment-style DAF from a balanced portfolio allocation (50/50) to an aggressive allocation (100/0) would result in an extra $13.6 million in inflation-adjusted median endowment account value after 100 years, while also generating an additional $5.6 million in distributions to charitable institutions along the way (albeit with some volatility in annual distributions from year to year)! Further, adopting a simple dynamic spending/distribution strategy (e.g., forego a distribution in years with less than a 2.5% real return), results in an additional $6.1 million boost in real residual value and $1.2 million more in cumulative charitable distributions (as distributions are skipped in some years but made up over time)!

Ultimately, the key point is to acknowledge that willingness to accept some spending instability, coupled with ultra-long-term time horizons to compound, makes it feasible to have a far more aggressive portfolio that still result in substantially more assets going to the charitable institutions that donors care about. Of course, donors must be willing to stay the course, avoid projecting their personal risk tolerance onto the endowment, and be comfortable adopting an allocation that is much more aggressive than the “norm” among prominent endowments… but donors should be cognizant of the tremendous potential of investing more aggressively (and the impact of long-term compounding) if they are willing and able to be flexible!

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As one of the more common processes developed in advisory firms, there is a high level of interest by both advisors and clients in how investment performance is actually calculated. While it may seem straightforward in determining the ups and downs of a portfolio, there are actually quite a bit of assumptions and factors that take into consideration time periods, account values, and especially deposits and withdrawals, in addition to the actual performance of the underlying investments in a portfolio.

On the surface, it may seem straightforward in how these calculations are developed; however, in practice, there are often many areas and methods that are not as understood, and can become a source of confusion as advisors select a method for providing this critical information to clients, regulators, and other industry bodies such as GIPS.

In this article, Chris Hastings of Panoramix (a portfolio performance reporting software solution for advisors) provides a detailed reference for the different methods of calculating performance, why the various methods can produce substantially different return results (especially when there are substantial cash flows in/out of the portfolio), and some of the pros and cons of each method.

Ultimately, the reality is that there is no “right” choice for how to compute performance – because the “right” methodology actually varies depending on the context in which it’s being used – but advisors should be familiar with the different methods, and when they are most appropriate, so they can adequately defend their choices, and identify performance reporting software solutions that are capable of providing the return calculations they need.

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