Mutual funds, private money managers and a multiple
stock portfolio diversifies the investor from items a and b but not the
three remaining items.
Last,
once the investor has determined his “serious money” policy and he still
has a need to actively trade stocks, options, or other high-risk
investments then the investor should separate the “Serious Investments”
and establish a “Fun Money” account. A sophisticated asset allocation
policy is very effective but boring to the active traders. However, do not
expect to dip into the serious account.
3. The Investor’s Most Important Decision Is The Asset
Allocation
Policy, Not Security Selection Or Market Timing.
Professional
money managers generally accept this axiom but it has not filtered to the
general public.The
public is enamored with “switch and get rich”; however, the only ones
getting wealthy are the traders and stockbrokers…at the expense of the
investor. Once
the investor has developed an investment policy he must use discipline to
implement it.
He should maintain the percentage allocations only if there is a
life changing event. Rebalance your investment classes when they get out
of alignment by 7.5% or annually, whichever comes first. The “magic” or
discipline of an asset allocation policy forces you to buy low and sell
high.
4. Implement the Strategy Using the Policy
The
Investment Policy and Asset Allocation guide the allocation of all serious
investments among tax-deferred and taxable investments.
5.
Maximize
Tax-Qualified Retirement Plans
First, the investor should maximize the retirement
plans. With a qualified plan, the practice can take a tax deduction in its
amount of contribution, and the plan participants do not have to include the
contribution as current income. These plans require a whole host of
restrictions, have contribution and benefit limits, and commit the practice to
continuation of funding in most instances. The maximum amount of compensation
that can be considered in calculating a qualified plan contribution or benefit
is $170,000 in 2001. For most practices, the plans are also limited by the
definitions of “highly compensated”. It therefore takes a combination of plans
to maximize the tax-deferral. Qualified plans are often considered in two major
categories: Defined Benefit-Those that provide a set benefit to the employee
upon retirement and Defined Contribution-Those that provide a set contribution
amount to a plan while an employee is still working.
·
Establish a defined benefit plan, if financially feasible. It can consider up to $140,000
of an individual’s salary but it also is the most expensive. Often
small practices may be unwilling to commit to defined benefit plan but as a
group this benefit will “bond” the doctors.
·
Establish one or a combination of defined contribution plans in addition to the defined
benefit plan. In 2001, the investor can invest up to $35,000 or 25 percent of
his salary whichever is less in defined contribution plans. Each plan, such as
a 401(k), also has its limits, which, in 2001, is 15 percent or $10,500
whichever is less. While the 401(k)s are the most popular they are very
expensive administratively for practices and they do not work well in many
practices as they depend on the employees’ elective contributions. Other
ones to consider are Simplified Employee Pension (SEPs) plans which allow up to
15 percent or 25,500 ; profit sharing plans, which are the simplest but only
allow up to 15 percent of salary; and money purchase plans which require a
specific fixed percentage of covered payroll (up to 25%) that the practice will
contribute-in good times and bad. There is a whole “alphabet soup” of various
plans, such as cross-tested age weighted profit sharing plans.
A major advantage of a group
practice is the ability to finance better pension plans. In order to establish
a retirement system including the buyout of retiring physicians the practice
should form a pension team. It would include an investment advisor, attorney,
accountant, and plan administrator. The
attorney should draft documents and be responsible for overseeing the
qualification process with the IRS. The attorney should be involved in the
initial planning to help decide what form of plans best fits the client’s
unique circumstances. The accountant comments on the tax aspects and cash flow.
The plan administrator handles the record keeping, accrued benefits and design.
The investment advisor selects the investments best suited to fulfill the
practice objectives and monitoring the on-going performance of the managers.
Defined benefit plans required
customized documents. The practice can use pre-qualified documents for defined
contribution plans; however, if they it needs any changes it must develop a
custom-designed plan. If the practice chooses to use self-directed accounts
then it must understand that the administrative costs are higher.
Once the retirement plans are
established and the physician can allocate his assets according to the policy. The
amount of money vested in the defined benefit plan investment and its
composition will serve as a cornerstone to the individual portfolio. In
contrast, if the practice includes defined contribution investments the
physician will choose and invest appropriate amounts the fixed, equity, and
other choices to move the portfolio toward the “normal balance” as established
in the policy,
Regarding Individual Retirement Accounts (IRAs), if
the physician’s Adjusted Gross Income (AGI) is greater than $110,000
individually or greater than $160,000 if filing jointly then Roth IRAs are
not available.
If qualified, the physician pays the taxes but has tax free
earnings and early penalty-free withdrawals. Traditional-tax-deductible
IRAs have much
lower income disqualification and are only available if the
practice has no active employer sponsored retirement
plan.
6.
The Tax Drag
Tax-Deferred Retirement Plans shield the investment from capital and
ordinary income taxes. Unfortunately, one-half of all mutual funds are in
taxable accounts. High Net Worth
investors should avoid mutual funds for taxable investments because they do a
miserable job of tax management. The tax drag on investments is astoundingly
high. Mutual funds and money managers have discovered that investors choose
funds based on name, not performance. As
a result, many retirement plans havepoor
performing funds with brand names. Nice but not very effective.
7.
Prudently Managing Your Investments
First,
there are the legal implications. If the investor is a fiduciary in the
practice retirement plan then ERISA requires standards as a “prudent expert”
and strongly endorses hiring an outside fiduciary expert. The investor has
personal financial liability. Second,
if the physician uses a broker or advisor, it is essential that their interests
be aligned with his. With the recent turndown in stocks practices that have not
implemented a “procedurally prudent process” are left exposed to poor
investment performances and negligence suits. Third, if the investor is going
to manage individual stocks versus hiring a professional money manager he
should understand that because of increased market volatility, recent studies
indicate that it now requires 60 individual stocks randomly selected to
gain diversification. Professional Money Managers include mutual funds, private
money managers, and a new hybrid form of funds, exchange traded funds.
8.
Reduce The Total Expenses In Investments.
Mutual
Funds and money managers have found that investors choose funds by name
recognition, not performance, and expenses have doubled over the past ten
years. When investors were earning
15 percent or more on equities they were less sensitive. However, high
expenses, transaction costs, and commissions will destroy the growth of an
investment. Many expenses are much less apparent. Sixty percent (60%) of mutual
funds, for example, use a 12b-1 fee that has lower or no upfront fees. However,
if client sells the mutual fund before the cancellation date, say five years,
the remaining commission is charged.
How important are expenses? A 1 percent fee increase will
decrease an ending balance by 17 percent over ten years. A
stock that returns a historical average 10% less 3.5% for inflation, 3% for
expenses, 1% for commissions and 30% tax rate has a real return of minus .5%.
Fortunately, the SEC is requiring improved disclosure. Watch out for hidden
expenses. A fiduciary should know
every expense that the practice will incur and work to not allow it to be
excessive.
Single digit investment returns for balanced
portfolios in the new millennium may once again prove the norm, and
investors and fiduciaries will have to make excellent investment decisions
to meet return targets of even 9 percent.
In
this environment, cost control is essential in order for investors to
achieve their targeted net returns. Fiduciaries and investors must have a
good understanding of all investment-related expenses. However, this is
one of the most difficult and misunderstood areas.
The
following is a general overview of all expenses incurred by an investor
and a framework for evaluating them in the context of their function in
the process.
Apparent economies achieved in one step often result in higher
costs in another or sub-optimal results in another. Only by examining the
whole process can the investor avoid inadvertent trade-offs.
Total
investment costs often surprise investors. For example, they fail to
account for transaction fees for custodial services, trading costs charged
in addition to published mutual fund expenses, the spreads on principal
trades, and/or the fees paid to vendors with soft dollars.
Investment
Expenses
q Money
manager fees and/or annual expenses of mutual funds.
q Trading costs, including
a. commission
charges and
b. execution
expenses.
q Custodial charges, including
a. custodial
fees,
b. transaction
charges, and
c. cash management
fees.
q Consulting and administrative costs and fees,
including costs for activities that may be done internally or
externally.
Each
cost and expense can be obscured or moved from one category to another to
create an apparent savings. A high transaction and/or commission costs may
subsidize a low custodial fee. This often occurs across what is known as
the line. Above the line expenses are invoiced or appear as line item
expenses, while below the line expenses are netted out of the performance
of the portfolio.
9.
Always Stay In The Market.
If
you are going to time the market, that is, move in and out based upon some
criteria you should know the facts. Over
the past ten years (January 1, 1990 through December 31, 2000) the top forty
days accounted for 78% or a 11.8% return of the 15.2% average for the ten year
period in the S&P (Soruce: Factset). This means that 1.4% of days accounted
for more than three-fourths of the growth. If you were out just ten days then
you lost 3.9 percent or 26% of the return.
Why
Fiduciaries Must Understand Investment Management
It is extremely important for all fiduciaries to
understand the graveness of their responsibilities and potential
liabilities. Fiduciaries can be held personally liable for breach or
violation of these responsibilities, even to the extent of having to
restore lost profits to the plan. With the year-long plunge among many
investments physician and management fiduciaries who have not managed
their retirement plans in a prudent manor are at a heightened risk. The
U.S.
Department of Labor imposes responsibilities through the Employee
Retirement Income Security Act (ERISA), landmark legislation of 1974. ERISA holds
fiduciaries to an investment standard that approaches a professional
expert. All plans are subject to ERISA. Even if the fiduciaries select
401(k), 403(b) or similar plans they must manage the process and selection
of assets thoroughly. Unfortunately, many plan sponsors and
trustees are apathetic or unaware of the heavy responsibility on plan
sponsors and trustees for qualified tax-deferred retirement plans. The magnitude
and complexity of ERISA has led to wide spread lack of understanding of
its basic principles and a commensurate lack of understanding of the
potential liabilities under it. A high level of apathy has developed
among fiduciaries who seek comfort in claiming they are “covered” by
strictly word plan documents.
