Warning: Investing in Mutual Funds Can be Hazardous to Your Wealth

For most mutual fund investors, the high fees, add on capital gains taxes, and blatant lack of transparency by the fund companies seem to be virtually ignored. Conversely, most investors don’t even realize there are other wealth building strategies out there that are superior to mutual funds.

If you are buying mutual funds today, you are disregarding the tax issue at your peril. In essence, if you are also holding your mutual funds for the long haul — 10 or 20 years — then you will pay a price down the line.

As you know, because of the way mutual funds are bought and sold, it is all too possible to lose money on your investment and also wind up paying significant capital gains taxes. Yet, low returns and capital gains taxes — the double whammy — have been happening every year since 2000, and if the predictions are correct, the excess taxes will continue to punch holes in your portfolio in the future.

Thus, it’s my opinion that reducing your taxes may be the strongest reason you have for making a separate managed account (SMA) a part of your wealth building strategy instead of mutual funds.

Capital gains taxes are but one explanation of why investors cannot get traction when they put their wealth into mutual funds. Many credit high mutual fund fees is another cause investors are flat-footed when it comes to mutual funds.

Here’s the classic “he said, she said” scenario. The Investment Company Institute, the fund industry’s trade organization, touts an overall mutual fund expense as a percent of assets at 1.17 percent.

On the other hand, KaChing, an investing and trading Web site, says mutual funds put the annual cost of actively managed stock funds at 3.37 percent. The site says ICI fails to factor in trading commissions, hidden fees and yes, taxes.

The tax liability is the biggest difference between KaChing’s analysis and the ICI’s position. Both organizations have a vested interest in their comments, according to an article (Feb 12, 2010) in the Wall Street Journal. The ICI represents the mutual fund industry, and KaChing markets investment services that compete with mutual funds.

No matter. To your clients, who are trying to save for retirement and manage their wealth, the cost of investing in funds can be enormous. Even the smallest percentage of expenses and fees can mean thousands of dollars less over decades. And the thought of more capital gains being fused with your portfolio in the future is reason to pause. For instance, while a client’s 2009 tax year is long gone, a great way to decrease your client’s tax liability for 2010 and future years is to get him or her out of mutual funds and into a separately managed account.

You are aware that separate accounts are similar to mutual funds, but go steps further. While mutual funds invest in a number of securities for a pool of investors, an SMA further tailors a portfolio for an individual investor. Consider a separate account is like a personalized mutual fund with an assigned money manager who takes his or her cues from clients and the financial advisor, but also has full discretion to make trades as the wealth manager sees fit. The client in a separate account owns his own securities. This gives the client a level of control not available in a mutual fund.

Switching to a separately managed account will generally help reduce your client’s tax burden. It can add up to a lot of money reflected in their return on investment (ROI) and be as much as 2 percent to 2.5 percent of the total annual return.

With taxable prone mutual funds recording short-term capital gains, investors in the 39.6 percent federal tax bracket have to yield a performance gross of 16.56 percent to net 10 percent. But in a separate account, they would have to gross only 12.5 percent to net the same 10 percent, according to Money Management Institute, the association representing separately managed accounts.

Taxes paid by investors in taxable mutual funds currently make up about 50 percent of the $10 trillion mutual fund market. Although mutual funds have produced some pretty solid returns over the years (don’t forget 2008), investors still seem largely unaware of the substantial gap taxes play in lagging mutual funds’ returns in the markets in which they invest.

One might think that mutual fund investors getting smacked a number of times with capital gains taxes each tax year since 2000 would have them looking for a better way to accumulate wealth.

No, not unless an astute financial advisor is there to guide them in escaping mutual funds and setting up an SMA to build wealth.

“Phased retirement” offers different financial options than traditional retirement planning

Webster’s Dictionary is always searching America’s Lexicon landscape for words or phases that are becoming popular on their way to becoming permanent. “Phased retirement” is a term we have seen with more and more usage in recent years brought on by many factors such as a sour economy, longer life spans and members of the baby boomer generation rewriting the book on retirement.

Phased retirement is a catch all term for retiring by gradually decreasing work time instead of abruptly upon reaching retirement age moving to Florida to be full time on the golf course. Your decision to phase in retirement can be on your own terms or by necessity. That is, more and more retirement age people find themselves in a no choice situation to keep working because simply they can’t afford to retire as soon as they’d hoped.

Others don’t wish to clock from 95 mph to zero in one stop. They want to gradually move into full time retirement by continuing to work part time, do volunteer work or tackle hobbies left on the shelve during their full-time working years. Either way, if you are considering a phased retirement you should be ready for some very different financial challenges that usually do not occur with the traditional retirement process.

Sure, the prime financial benefit of a phased retirement is that you will continue to get a paycheck, which may lessen the need to draw on your retirement savings, allowing your money to grow further.

Conversely, when you reduce work hours and salary, it could have a direct impact on your benefits at your company.

Here are a few considerations:
• Life insurance: May be tied to a multiple of your salary
• Long-term disability insurance: Determine what affect is has if you continue working with this form of insurance
• Company health insurance: Check your company health coverage to see if reducing work hours will affect eligibility
• Social Security: Phased in retirement could reduce benefits if you begin to collect SS before reaching retirement age and continue to work. (Each year before full retirement age is reached, the SS benefit will be reduced by $1 for every $2 you earn over a set limit, which is $14,160 for this year. The year when your client reaches retirement age, it’s $1 for every $3 earned to income limit of $37,680 for this year).
• Pension and other retirement benefits: This is a critical area. You could be vulnerable if your company doesn’t subscribe to letting employees receive pension benefits earlier. NOTE: Federal law allows workers to take pension benefits at age 62.

Typically, pensions are formulated by an employee’s service years and salary during the final days of his/her last days of employment. You can see, by phasing in retirement, the lower salary could reduce earning additional pension benefits. It’s important to check this out with your place of employment.

What about your 401(k)? Will you still be able to participate if working hours are reduced to part-time?

You might have to be creative in long term prospects of you considering both the extra income you would be receiving as a part-time working employee either at the original company or something unrelated and the long term effects on your pension and other savings programs. Using your savings funds to increase your assets value in separate accounts or annuities might be good options as you age.

As more and more companies consider the value of phased retirement, restrictions will undoubtedly loosen up. After all, not only does this reduce the compensation packages of long-term employees but also company sponsored phased retirement programs can be used to retain skilled older employees who would otherwise retire (especially in sectors where there is a shortage of entry-level job applicants). This can reduce labor costs or arrange training of replacement employees by older workers. While currently only 5 percent of midsize and large companies offer a formal phased retirement program, nearly 60 percent expect to develop one in the next five years, according to a recent survey by Hewitt Associates.

A growing consensus exists that the nature of retirement is changing. No longer do most workers wish to experience a sudden end to work, followed by an equally sudden onset of full-time retirement. Instead, many workers wish to ease in to retirement, transitioning out of the workforce with a reduced workload.

My advice is to be alert to this accelerated trend of phased retirement and develop asset strategies to accommodate your needs desiring this retirement lifestyle.

Customizing Your Portfolio: Riding in a Limo or Taking the Bus!

If you’re an pre-retiree or retiree who is invested into mutual funds, no doubt you have given thought to how great it would be to customize your holdings to reflect your individual financial needs.

In fact, as you know, in mutual funds you don’t own any of the stocks in your portfolio. You own shares of stocks. They‘re in an asset pool. It means your mutual funds relinquish control to what and when mutual funds managers buy and sell securities in your portfolio.
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Separately Managed Accounts (SMAs), on the other hand, are portfolios of securities handled by a money manager(s) that your advisor and you select. From there, your assets are usually invested in a diversified group of stocks or bonds similar to mutual funds.

There is a major difference, however, similar to taking the bus (mutual funds) to riding in a limo (separate accounts.). Instead of being one of thousands of investors in a mutual fund, you own the securities in a SMA –and you retain the option of rebalancing your portfolio assisted by your advisor and the pre-chosen professional institutional money manager or managers.

In short, with a SMA, YOU own your own private mutual fund.

A separate managed account allows you to have a say over how the money manager(s) select and trade securities in the portfolio based on your predefined investment strategy. This includes trading moves to reduce capital gains taxes as SMAs can be highly tax efficient.

SMAs are like having your own private limousine, “ says Peter Cieszko, managing director of Salomon Smith Barney’s Private Portfolio Group. “Owning mutual funds is like riding the bus.”

You with a separate account have the ability to exclude specific holdings from your portfolio. If you already owns lot of tech stocks in other accounts, or if you retired or still work for a tech firm and much of your assets is already riding on company stock options, you with his advisor’s help can set up a filter that prevents the money manager from putting Microsoft or any other high tech stock into your account.

Lynn Mathre, president of Asset Management Advisors in Houston, has found local Compaq Computer Corp executives, have substantial holdings in their company’s stock, which they can’t or don’t wish to sell. To offset that risk, Mathre asks her SMA money managers to avoid buying Compaq securities and to tread lightly in the computer sector, as well. “You can’t do that with a mutual fund,” she says.

In addition, it’s possible you find certain industries offensive—tobacco, alcohol, gambling (the sin stocks), and nuclear power, whatever. If so, you can ask for stocks from those industries be barred from your portfolio.

In short, you have the right, with a SMA to include or exclude securities based on your ethical, economic or political views. This is usually not possible with most mutual funds.

It’s the flexibility of customization available to investors that is significant. If an individual has strong feelings regarding social responsibility, the environment, or faith-based values, he or she can implement those beliefs through their portfolios. On the other hand, such restrictions may not be as important for many. But that doesn’t mean you client not change your mind a year or two later — restrictions can be placed or lifted at any time.
In the past, many separate accounts looked alike as a result of limited investment style offerings, usually only large-cap growth or value were available. Customization is more common today as international, mid-cap and small-cap styles are commonly offered also allowing you to take advantage of greater individualization regarding asset allocation and other investment options (ETFs, mutual funds, hedge funds, etc).

Nevertheless, the customization of the portfolio and the ability for the client to restrict certain types of securities is often underutilized. There are no hard numbers on this but probably somewhere around 25 percent of SMA clients use this capability. Other industry sources have reported more than 25 percent.
Chris Davis, the executive director of the Money Management Institute, the association representing the separately managed accounts industry, expects use of the customization benefit to increase. “It’s a feature that will grow in use as a portfolio grows in size and the client’s needs also grow,” Davis said.
Davis compared the customization element with a four-wheel-drive SUV. “You don’t use the off-road feature all the time,” he said. “But when you do get off the road, you’re sure glad you have it.”
Knowing you have the option of customization in a SMA portfolio is an important benefit, as you no longer have your hands tied when it comes to making investment decisions within your specific account holdings. The separate account puts the individual and his/her advisor in control. You ride in a private limbo rather than with the crowd on the bus.

Mutual Funds vs. Separate Accounts
Mutual Funds:

• Your client does not own his stocks
• Your client does not own his stocks
• Your client’s assets is pooled with other investors
• Your client or you have no say in a specific fund’s holdings

Separate Accounts

• Your client owns his stocks
• Your client can buy and sell securities in his/her portfolio
• Your clients has the option to include or excluded stocks in portfolio