Stonegate in The News and Blog Posts

A common concern among our clients is their income in retirement. When you’ve received a paycheck for much of your life the prospect of retiring and no longer having that recurring income can be really tough emotionally. This is how we help you recreate that paycheck in retirement.

A significant portion of the average retiree’s income comes from their portfolio these days. Invested assets will generate income from three sources:

• Interest on bonds and other types of bond like investments
• Dividends on equity and grow investments
• Distributions and capital gains; this is a difficult area to estimate since it can vary widely each year.
• You will also have Social Security payments at some point perhaps at your full retirement age of the latest when you are 70.Social Security is in effect an inflation adjusted bond, if you are receiving $2,500 per month ($30,000 per year) with bond yields as low as they are and assuming a 2% yield you would need to have $1.5M in bonds to generate that much income.

The remainder of your income will come from the capital gains distributions and possible liquidation of your portfolio each year. It is a common concern that people have that they are selling part of their portfolio each year to augment their income needs. As long as the net average total amount you withdraw from your portfolio does not exceed 4% annually, this should not be a concern. Multiple studies have shown that at a 4% safe withdrawal rate the odds are very high that you will not deplete your savings over 30 years. (We recommend you have detailed projections created since this is a general guideline).

Psychologically it may be useful to have money automatically transferred from your portfolio to your checking account each month automatically, we set that up for a lot of our retired clients. That is effectively part of your retirement paycheck with your Social Security and any other recurring income you may have.

The “Bucket” Approach

We use the “bucket” approach. To make sure you have reserves to meet that “paycheck” need and to also act as a buttress against market declines, you should have three buckets from which to draw funds:

• A cash reserve held in very liquid investments that are very low risk. This could be a money market account, savings account, and possibly very short term treasuries and CD’s. We typically recommend a reserve bucket that is the equivalent of 8-12 months of your cash flow need. This cash reserve should be automatically replenished from dividends and interest generated from your portfolio. It is also replenished when it becomes too low by rebalancing and also bonds maturing (if you have individual bonds as part of your portfolio).
• A bond reserve with the safest bonds in a bond portfolio created to meet your particular cash needs and circumstance. The amount held in bonds varies also depending on the portfolio allocation you have chosen. In any case it’s recommended you hold anywhere from 3-7 years’ worth of your spending need in the safest bonds. We suggest either municipal bonds, CD’s or government bonds, all of which have either very low risk or no risk associated with them. We do not recommend using corporate bonds since the additional yield does not justify the additional risk. Corporate bonds also have a nasty tendency to become “correlated” with the stock market during bear markets like the one we experienced in 2008.
• The third bucket are the growth assets you have in your portfolio, including large stocks, small stocks, REIT’s, etc. When times are good and your portfolio grows rebalancing these investment will periodically replenish both your bond bucket and also your cash bucket.

An advantage of this approach is it enables you to make it through a lengthy bear market without having to liquidate growth assets that might have declined in value. With the cash reserve and the bonds, you may have 4-8 years of protection against that happening. This is an important strategy to reduce the effect of “sequence” risk on your portfolio. For a detailed explanation of sequence risk read one of our past blogs.

Stephen Craffen

We’ve all seen this on the front pages of magazine’s like Money and Kiplinger’s: “Five funds you need to buy now!”, or “The 50 Best Mutual Funds and ETF’s for 2018.” You may also be familiar with Morningstar’s star rating system where they rate a fund on a scale of 5 stars with 5 the highest. Advisors and consumers have relied on that star system for years to help them choose mutual fund managers. Does it really help? In 2017 the Wall Street Journal investigated the system and analyzed its predictive value; their result: Morningstar’s system is not particularly useful in predicting future performance. When they examined many 5-star funds they also discovered that many of the funds were small when they received a 5-star rating, with their high rating attracting many investors causing the fund to grow dramatically with ratings in future years falling. That might be evidence that many managers cannot invest the same way they did when they were small or that their performance might have been based originally on a few lucky picks.

A case in point is the Fairholme fund, Fairholme invests in US stock independent of size, and they seem to be all over the map over the years, investing in large, midcap and small cap at various times. (Full disclosure we use to use this fund). For years it outperformed its peers by a wide margin (13% per year), then suddenly it experienced a terrible year in 2011. That year the fund lost over 32% while the S&P index gained 2%. (Around the same time Morningstar named Fairholme fund of the year). Now if you compare Fairholme to the S&P 500 index, the Russell Midcap Index and Russell 2000 it has severely underperformed all of them:

Since their focus on company size has been variable we think it is fair to compare them to these three indices.
So how can you tell a manager’s performance is really based on skill? (Something you would have wanted to know about the manager of Fairholme in 2010 when they seemed to be crushing most equity indices). There are ways to analyze their performance using statistics. Comparing a manager’s performance against various indices provides useful information regarding their investment approach (this is called style analysis). You can then compare their performance against a “synthetic” fund that is composed of those indices. Using the composition of the fund and comparing it to a combination of index funds that would match that composition some have concluded that it would take at least 18-20 years to determine if Fairholme’s out performance (before 2011) was manager skill or luck. For some funds with a more volatile track record it might take as long as 100 years before it can be shown with a high degree of certainty that a fund’s performance is based on skill.

Active managers also have some headwinds when compared to an index fund: the low expense ratio and greater tax efficiency of most index funds. Most actively managed funds have expense rations in the .8-1.2% range annually while most index funds are in the .1-.35% range. Just to match an index the fund manager has to automatically outperform it by .7% or more, a high hurdle. That combined with the fact that Index funds tend to be more tax efficient means that at the beginning of every year a fund manager has to beat an index by over 1% on average just to justify their existence.

Over the years we have gradually concluded that it is easy to try to find a fund that seems to have beaten the market but it is hard to find one whose performance can be proven to be skill and not luck. Because of this we mainly use funds and ETF’s that are index based or based on a strategy that is not an attempt by a manager to “beat” the market but is instead based on a mechanistic strategy. A strategy meant to capture a certain risk vs. return component of the market or a particular exposure that fits into our client’s overall asset allocation.

Choosing a financial planner or advisor can be a daunting task, especially if you are faced with trying to determine how they are paid, how competent they are, and what credentials are actually important. Let’s discuss each of those “three C’s.”

Compensation

Advisors may be paid through commissions, fees or a combination of both. When an advisor “sells” you a financial product like a mutual fund or an insurance policy they are paid by the insurance company or brokerage firm that “creates” the product. Some advisors are only paid by you; they may charge you for a detailed analysis of their finances and/or they may charge you a percent of any investments they manage for you. There are also advisors that both receive commissions and also are paid by you (“fee-based”) for a plan or for asset management. Whomever you hire, it is important to understand how they are paid since it might (but not always) affect the types of advice you receive. An advisor that charges for a plan or an asset management fee and cannot receive commissions is generally considered a “fiduciary.” A fiduciary is someone that works for you and must legally act in your best interests not their own. Generally, advisors that are compensated this way and act as “fiduciaries” have the fewest conflicts. They should be diligent in disclosing to you any conflicts that might still exist and how they will either avoid the situation that leads to the conflict or how they will “manage” it.

(CFP® certificants will be required to act in your best interests for financial advice regardless of their method of compensation beginning in October 2019.)

With fee-only advisors you always know the cost of the relationship since you pay them directly, with commission based advisors you may not have a clue since sadly there is no requirement that they disclose how much they earn from products they might sell you.

Competency

How can you tell your advisor is competent? It sure is difficult but there are some things to consider. First do they have a certification? There are plenty of advisors out there who do not, yet they have official sounding titles like “wealth advisor.” We’ll describe the education and certification that real advisors should have below. Besides having a designation or certification you may want to drill in on the advisor’s core competency by asking some pointed questions, including “how many years experience do you have,” and “what are your specialties?” Make sure the advisor has formal training in areas they claim as specialties. You may want to ask to view a sample analysis they did for a client (any advisor should have a sample with names changed or blacked out). When you look at the sample plan make sure it has at least the following sections:

• Planning Assumptions
• Clients goals
• Detailed analysis with backup and discussion
• Detailed recommendations with a discussion of the potential impact of the recommendations and tradeoffs among various recommendations
• Action item list with due dates

That is just a partial list. Not all advisors will have competency in every area so it is important to discover how they deal with that. For example, Fee-Only advisors cannot sell products but they may recommend you purchase more life or disability insurance. Do they have a list of trusted outside experts that they work with? Does that list include attorneys, insurance agents, and possibly accountants?

There is one membership organization that has pretty specific requirements for their members, that is the National Association of Personal Financial Advisors (NAPFA). Their members are required to:

• Submit a financial plan for peer review
• Be CERTIFIED FINANCIAL PLANNER™s (CFP®)
• Take 60 hours of continuing education every 2 years (the highest requirement in the industry).
• Adhere to a strict requirement that they be fee-only and act as fiduciaries in every circumstance. In fact they sign an oath compelling them to act as fiduciaries in every circumstance.

While even those strict requirements are not a guarantee that the advisor is competent it does certainly increase the chances that they are prepared to properly assist you.

Credentials

The financial planning field is saddled with a plethora of titles and supposed certifications. It seems as if this is meant to make things more confusing for the consumer who is trying to get good advice. We suggest you ignore all titles like “wealth manager” or “financial consultant” and instead ask what actual education and certifications the person has. While many certifications exist the most important are the ones that require a broad background in many aspects of financial planning. There are two that fit that bill, CERTIFIED FINANCIAL PLANNER™ (CFP®) and Chartered Financial Consultant (ChFC). The CFP® designation is more widely known and it requires that certificants take a comprehensive exam, and a course that requires them to actually write a financial plan. The CFP® designation is owned and awarded by the CFP® board a non-profit organization that protects the mark and also sets high standards for the behavior of its certificants. The ChFC requires more course work but it’s certificants do not have to take a comprehensive exam, they do have to write a financial plan though.

The CFP® board has adopted a very strong set of ethical requirements for their certificants including a new requirement that they act as Fiduciaries whenever they are providing financial advice (beginning October 2019). That strong requirement does not exist for ChFC certificants.

You may encounter many advisors with both designations. You may also encounter advisors who have continued their education and received an advanced degree in the field including a Masters or PhD. Advisors who have done that should be considered the educational “elite” in the field.

One other designation worth mentioning is the Chartered Financial Analyst (CFA) which is owned and awarded by the CFA Institute. While the designation is only focused on investment analysis and management, advisors who hold the designation have acquired very deep knowledge in that specialty. The designation requires that applicants pass 3 exams that are roughly 6 hours in length and the course material includes statistics, economics, investment analysis, portfolio management, etc. Roughly 8-15% of candidates actually finish and receive the designation. Like the CFP® designation certificants are required to adhere to a very strict set of ethical standards. If you are hiring an advisor to help manage your portfolio this designation is important.

Conclusion

We suggest you consider advisors who are fee-only, act as fiduciaries and hold the CFP® or ChFC designation as a minimum.