Financial Professionals Winter 2019

The optimal savings vehicles are client-specific, both in what they may have available to them, and in what would be prudent for their specific situation.  Nonetheless, in general, this is usually the right order (exceptions and other issues at the end) for a typical client who expects to be in a lower tax bracket in retirement than they are now:

1. Tax-deductible, employer-based retirement plans (such as a 401(k) plan) to the extent of any match – a match just can’t be beat!
   • For a married couple, priority of funding must consider:
     • the better match
     • the better investment options (but if the spouse with poor options is changing jobs soon it can be rolled over to an IRA so it doesn’t matter as much)
     • the longer deferral (the younger spouse will have lower RMDs in retirement if desired)

2. HSA savings account – tax-deductible on the contributions and tax-free withdrawals (if used for medical expenses) later (ideally in retirement).

3. Tax-deductible, individually-controlled retirement accounts (such as a traditional IRA) – broad investment options and generally more favorable “exceptions” if early withdrawal became necessary.
   • For a married couple fund the younger spouse’s first.

4. Tax-deductible, employer-based retirement plans (such as a 401(k) plan) from the match (see #1 above) to the limit.
   • For a married couple, priority of funding must consider:
     • the better investment options (but if the spouse with poor options is changing jobs soon it can be rolled over to an IRA so it doesn’t matter as much)
     • the longer deferral (the younger spouse will have lower RMDs in retirement if desired)

5. Tax-free retirement vehicles (such as Roth IRAs).
   • For a married couple fund the younger spouse’s first (this currently doesn’t matter, as there are no RMDs, but the law could change)

6. If education funding is desired see College Funding.

7. If tax-inefficient investments (such as taxable fixed income) will not fit inside the previous options on this list see Asset Location Strategy (the five items at the end).

8. Taxable investments (regular brokerage accounts).

Important caveats and other comments:

1. I have ignored liquidity needs in the list above.  Of course short-term liquidity may take precedence over some of the options listed and funding #5 (since original contributions can be withdrawn without penalty) prior to #2-4 might make sense.  (Though probably not in place of #1.)

2. I have ignored the “investment” opportunity of reducing debt.  There may be behavioral and psychological issues that would impact the order, but from a purely financial perspective, there is low-rate (typically mortgage) debt and high-rate (typically consumer) debt:
   • High-rate debt should generally be paid after #1, but it will depend on the specific situation.  (Perhaps the client can both pay off the debt in a reasonable time frame and fund retirement vehicles.  If they are going to max out the retirement plans every year going forward, they probably want to use them now too, not just after the debt is gone, since there is no “catch-up” when fully funding.)
   • Low-rate debt should probably be paid down at #6 or #7 (in that order) if either is applicable.

3. Investing in human capital (education or skills), particularly for a younger person, might be a better investment than many of the options above.  (Though probably somewhere below #1.)

1. Fixed income is held for risk reduction, not return enhancement. It is the ballast that allows the ship of your portfolio to withstand the financial storms that periodically roil the markets.
2. It is conventional wisdom that “correlations go to one” in times of stress, but this is incorrect. Correlations between risky investments go up, but the correlations between risky assets (stocks) and safer assets (investment-grade bonds and cash) go down in periods of market stress.  Thus, the fixed income portion of a portfolio should include only the safest categories of bonds.
3. A fixed income portfolio should be equally weighted between nominal bonds and inflation-protected bonds to hedge unexpected inflation, unless the investor has exposures elsewhere that should be hedged (e.g. a very large pension with no COLA, or a real-estate portfolio with long-term, fixed-rate financing and short-term leases).
4. If foreign bonds are used in a portfolio they should be currency hedged.
5. Since liquidity in the bond market is higher for large (institutional) transactions than for smaller (retail) transactions, (inexpensive) bond funds, rather than individual bonds, are typically better for retail investors.
6. Due to interest being recognized immediately and as ordinary income, fixed income is ideally held in tax-sheltered accounts. If that is not possible, alternative exposures might be advantageous.  In addition, some alternative exposures might be better than traditional fixed-income investments regardless.  Here is a list of alternative types of fixed income grouped by when/why they should be considered:
   1. Better tax treatment but lower return (so benefits correlate with tax-bracket and interest-rates):
      1. Municipal bonds.
      2. Variable annuities (a plain-vanilla, inexpensive wrapper solely to defer income taxes).
      3. Permanent life insurance.^*
   2. Better tax treatment without any reduction in return (so advantageous if fixed income would otherwise be held in a taxable account):
      1. Non-deducible contributions to IRAs or other retirement plans (defers interest that would otherwise be taxable annually).
   3. Potentially higher returns (tax treatment is not a primary factor):
      1. Debt reduction if the after-tax interest rate on the debt is higher than an equivalent-duration bond with no credit risk.^*
      2. Social Security delayed-claiming (equivalent to purchasing TIPS).^*
      3. Pension annuitization rather than taking the lump sum is equivalent to purchasing fixed income.^*
      4. Human capital investment (additional education and training), particularly for younger individuals.^*

---

^*Other factors, in addition to just taxes and rate of return, will affect the prudence of this option.

Financial Professionals Fall 2018

No advisor is perfect, but there are a few rough indicators (also see The Quality Advisor’s Alpha/Gamma/Sigma and How to Evaluate an Investment Advisor) that I use to recognize the quality of another advisor.  Below are three examples in each category (this is not an exhaustive list), with my favorite simple indicators in bold:

1. Does the advisor help the client address things that are important, but that another professional will get paid for rather than the advisor?  If not, that tells me they are more interested in a paycheck than in helping the client.  Does the financial advisor:
   1. recommend an umbrella policy? (Most advisors don’t sell P&C insurance.)
   2. make sure the client’s estate planning is up-to-date and adequate?  (Most advisors aren’t estate planning attorneys.)
   3. review the client’s mortgage(s) to see if refinancing is advisable?  (Most advisors don’t sell mortgages.)

2. Does the advisor do things that help the client, even when the client doesn’t notice?  Virtually all advisors execute on things where the client would notice if they were doing it wrong, but what about if the client would have no idea?  Does the financial advisor:
   1. employ a prudent asset location strategy? Getting the asset location right gets the advisor no credit (except with very rare clients who are very knowledgeable) but is clearly advantageous to the client.  It’s also more difficult than ignoring it.
   2. tax-loss harvest throughout the year or just at year end (or, worse, not at all)?  Since investments grow (on average), harvesting economically meaningful losses when they occur is important – they may not exist at year end.
   3. rebalance the portfolio in a systematic, well-thought-out manner?  Many portfolios, particularly smaller ones, are too-often neglected. (While the larger portfolios are overtraded!)

3. Does the advisor do things that sound (or look) good but are actually counterproductive?  Does the financial advisor:
   1. recommended small-cap growth funds? Of course that sounds like a great idea – who wouldn’t want to buy small growing companies?  Except voluminous academic research concludes this is a terrible investment category.
   2. tell the client that they can safely retire when they really can’t?  That will make the client happy – until they run out of money later!
   3. make frequent changes to the portfolio?  Overtrading leads to worse performance, but most clients (erroneously) take it as a sign the advisor is “doing something” for them.

4. This last category really sets quality advisors apart.  Does the advisor recommend things (strongly even) that actually cost them (the advisor) money?  Many prudent actions can reduce the size of the portfolio, and thus the amount of fees or commissions an advisor will earn for managing that portfolio.  Nonetheless, when appropriate, does the financial advisor:
   1. recommend delaying Social Security benefits? (Thus increasing portfolio withdrawals in the short run.)  This is virtually always a prudent recommendation.
   2. recommend paying off (or down) the mortgage?
   3. recommend directing additional savings to the employer’s retirement plan rather than to the taxable portfolio managed by the advisor?