Blog

Financial Pathways Opens Morris County Office

Increasing Demand for Fee Only Financial Advice Drives Firm’s Expansion

Flanders, NJ—Financial Pathways, an independent fee only financial planning firm headquartered in Bridgewater, NJ will be opening a new office in western Morris County to address a growing need for client-centered financial planning services.

James Kinney the founder of Financial Pathways. He explains the firm’s rationale for opening a branch office in western Morris county:  “We have noticed that several of our new clients were driving all the way down to our Bridgewater office from Morris County because they were having trouble finding the kind of unbiased planning advice that Financial Pathways is known for.  We are opening this new office to make fee-only financial planning services more readily available to residents of western Morris, Warren, and Sussex counties.”

Kinney has recently been admitted to the National Association of Personal Financial Advisors (NAPFA), a select organization of fee-only financial advisors with rigorous membership requirements and standards. NAPFA members only receive compensation directly from clients, thus eliminating conflict of interest that can arise when advisors are selling commission products. Financial Pathways is one of only two NAPFA registered fee only financial advisors in western Morris County, according to the NAPFA website.

Increasingly, potential clients are specifically seeking out fee only advisors, according to Kinney, resulting in growth opportunities for his firm. “People need to make these really important decisions regarding retirement, insurance, paying for college, or managing their investments.  When they turn to a professional advisor for help, they want to know that the advice they are getting is designed to help them realize their goals, rather than to maximize the advisor’s profit margins.  Working with a fee only advisor gives them peace of mind knowing their advisor has no hidden agendas.”

Financial Pathways new office will be located at 230 US Highway 206 in Flanders, and will be opening the week of September 15. For more information, call Financial Pathways at (973) 229-0801 or visit www.financialpathways.net.

 

Investment Returns over the Long Term – Lower Your Expectations

Clients often ask why we use such low expected returns in our financial plans.  We typically assume returns of 4 or 5% while long term average historical returns on both stocks and bonds are considerably higher than this.  Are we just being overly conservative?  Are we assuming “worst case scenario”?  

Sadly, I suspect we are simply being realistic.  The economy, and investment assets in general, will be facing headwinds over the next 30 years which we have not experienced in generations.  One is demographics, the other is interest rates and debt.  

The baby boom generation has seen a nearly continuous slide in interest rates since the early 1980s.  Those lower rates (aka cheap money) have fueled almost unprecedented growth in spending power of both governments and individuals.  They have also caused investment prices to skyrocket as cheap money flooded into stocks, real estate, and other investment assets seeking higher returns.  

Cheap money has become like crack to the economy.  The more we get, the more we need it.  Our cul de sac lifestyles are built on cheap debt.  Our government social programs are built on low interest rates.  

But rates have fallen to rock bottom.  We can’t go much lower.  While we may be able to enjoy these rock bottom rates a while longer, pressures will likely be building which inevitably will push rates higher.  And like any addiction withdrawal of the drug will cause pain.  

If interest rates on 10 year government debt rise from current 2% to 4% (and remember 4% seemed low only a few years ago!) interest expense (the largest item in the federal budget) will double.  Future government spending will be constrained.  This wouldn’t happen overnight, but stupidly our government has not locked in today‘s low rates by issuing long term debt, so the impacts of even a modest rate increase will be felt rather quickly in the federal budget.  This fiscal drag will be a substantial headwind for the economy.  

Meanwhile, on the household side with incomes barely growing, a rise in mortgage and consumer borrowing costs would dramatically reduce the affordability of big ticket purchases such as cars and more importantly to the economy, houses.  And in the world of investing, the end of cheap money means corporations won’t be borrowing money to buy back stock, one of the pillars of our current bull market in equities.   

When will interest rates move higher and how fast?  No one knows.  And I am by no means anticipating or predicting a market collapse.  I will leave that to those trying to sell books.  The current low interest low inflation environment that is so friendly to stock investors could continue for quite some time. A best case scenario is a slowly strengthening economy with a modest increase in rates and low inflation over a long period of time.  A worst case scenario might be a rapidly expanding economy unleashes inflationary forces which push interest rates rapidly higher.  That would almost certainly cause a subsequent market crash and recession.  There is room to consider the arguments of both optimists and pessimists.  

Looking forward over the next decade or two however, I would be surprised if interest rates do not become a drag on both the economy and investment performance.   Even in a best case scenario, rates cannot continue the downward march which has fueled investment growth over the past decades.  This is why we set lower return expectations than many of our planning peers.  Are we unduly pessimistic?  Maybe. But there is no harm in planning for the worst and hoping for the best.  

Mutual Fund Fees Explained

The low-down on mutual fund fees

One of my newer clients was reading her fund prospectuses (prospecti???) recently and asked me to explain how the various fees work.  After getting over my initial surprise that someone actually reads the fund prospectus (just kidding, I know you all do!), I figured that this was a topic that might be of interest to some other people out there.  After all, there is a lot of talk in the financial media about mutual fund fees – but I also find many people misunderstand how they work.  Fund expenses are complicated stuff, and although I will try to explain in simple terms, please forgive me if I cause your eyes to glaze over.

Management Fees.  These fees pay the manager of the fund (Vanguard, Pimco, etc.) to do their job.  The fund manager selects the investments that go into the fund.  Theoretically, the more the manager is doing (the more ACTIVE he is), the higher the fees are going to be.  An index fund typically has the lowest fees, because the fund’s investments are already selected for it.  All the manager has to do is buy and sell shares of stocks to mimic the holdings that comprise the index which the fund tracks.  This can largely be done by computer, so costs and fees are minimal.  A fund manager who researches and selects stocks will have higher costs to pay for his analysts and research tools.  And researching small companies, or overseas companies, or specialty market segments tends to be more difficult and expensive than researching large well known companies.

It is important to realize that management fees are paid for by the fund itself – not by the investor.  So if a fund advertises a return of 8%, that implies that the fund earned 8% after all its internal operating expenses were met.  While it may be surmised that if the same fund didn’t have its 1% in management fees it WOULD HAVE earned 9% – this is a somewhat flawed logic, since without the expenses that fund would not have existed in the first place.  See below for further discussion of the impact of fees on investor returns.

Sales Charges (aka “loads”).  These are fees which go directly to compensate the broker who sells the fund.  They are essentially a sales commission paid by YOU the investor.  Front end loads (typically identified as Class A) are paid for up front by the investor.  If you buy a fund with a 5% front end sales charge (load) for $1000, then $50 is taken out of your investment to pay the selling broker, leaving you with a $950 investment.  Level load funds (typically identified as class C) have fees usually of about 1% per year deducted from the investors account to pay the broker.  Over many years level load is more expensive – but since you paid less up front it is easier to sell the fund without any loss.

Most fee based or fee only investment advisors (as opposed to commissioned advisors) do not accept commissions on mutual fund shares, which means these sales charges will normally be “waived”.  If you are paying your advisor a fee for his services, make sure you are not also paying a commission.  That would be double dipping, and would not be appropriate in most cases.

12b-1 fees.  OK this may be the least understood (and least discussed outside the industry) of all mutual fund fees.  Many funds have a small annual fee called a 12b-1 fee listed on their prospectus.  This is a fee that is remitted to the brokerage firm that hold the shares and is supposed to pay for paperwork, marketing services, etc.  It is often used by commission brokers to pay an additional annual commission to the salesman.  However, these fees may also be used by custodians (such as TD Ameritrade) to offset the costs of including a fund in a No Transaction Fee trading platform.  In this case, the additional fund cost (typically about .25%) may be more than offset by the fact that an investor does not have to pay a trading cost or commission every time he buys, sells, or rebalances his portfolio.

Trading Costs.   The direct cost to the fund of executing transactions (buying and selling stocks or bonds) is not included in either of the above.  And it is almost impossible to determine what the trading costs of a fund are.  They are not listed in the prospectus.  As with management expenses, these are costs paid for by the fund before quoting any returns to investors – so these are not expenses you pay directly.  However, it is sensible to surmise that the more a fund manager trades in and out of stocks, the higher his trading costs.  Those who don’t mind reading a fund prospectus can look to the Turnover rate to estimate how often a manager trades.  A fund with a 10% turnover rate sells about 10% of his holdings in a given year.  This would be pretty low, and suggests the manager holds onto an investment for an average of 10 years.  A fund with a 100% turnover rate would on average sell every holding (and replace it with a new one) every year.  This would be a very high turnover ratio.

Tax Costs.  Don’t ignore the tax implications of a fund you own.  The more a fund buys and sells shares, the more likely you will be to see taxable capital gain distributions at the end of the year.  You will receive a 1099 and pay tax on these distributions.  Index funds tend to have fewer capital gain distributions – but not necessarily so!  High turnover funds are more likely to spin off taxable gains than low turnover funds.  And of course, you don’t have to worry about tax implications if your fund is owned in an IRA or 401k.

So is the lowest cost fund always the best choice?  Many in the media seem to take this simplistic approach, but it is not necessarily so.  It is true that most managers of your typical domestic stock funds fail to do any better than a similar index fund.  This is often attributed to the fact that the investments the fund holds needs to beat the index by the amount of the fee just to result in a tie!  Few managers seem to be able to generate these results solely by “picking” large cap US stocks.  So for exposure to these stocks, an index tracking mutual fund or ETF might be the best approach.  However, in more nuanced and complicated segments of the market (international, emerging markets, fixed income, alternative strategies) a good manager may be worth his keep even after considering fees.  This does not necessarily mean he will generate outsize returns.  In fact, a manager can just as well add value by avoiding trouble spots and reducing risk and volatility.  To support this premise, studies have shown that  active managers historically have enjoyed their best years (vis a vis their benchmark index funds) when markets are losing money.

Fund expenses are important – but they should not be the only consideration when choosing an investment to add to your portfolio.

Investment News article mentions Financial Pathways

Financial Pathways was mentioned in a recent Investment News article: 

 

Investment News is a leading weekly trade publication for investment advisors.  The article speaks to the somewhat unique way Luba and Jim work together on most client accounts at Financial Pathways.  In many other firms with multiple advisors, the client works with a single individual.  Luba and I have just found it more comfortable (and liberating!) to work together on most client accounts so we are both familiar with the details of each clients’ situation.  We believe it serves our clients as well, as they never have to wait for “their advisor” to return from vacation or return a phone call, or worry about what happens if one of us gets run over by a bus.

 

Financial Pathways Participates in Online Financial Planning Advice Forums

I have been participating for the past several months in several online services which provide free online financial planning advice to the public on topics ranging from budgeting and debt management to investments and retirement planning.  I consider it a form of pro bono financial planning, as many of the questions seem to be coming from young people just starting out, or people in rather difficult financial straits.

  1. Jim on NerdWallet
  2. Jim on Brightscope

I thought that some of the questions I answer may be of general interest to my newsletter readers, or you may know someone who could benefit from the advice.  Feel free to peruse my postings (and those of other participating advisors). The sites offer some great information.

Tax Diversification for Retirement Funds

The advice you are given throughout your working career is to save for retirement in tax deferred accounts, such as your 401k or IRA.  This makes sense.   By putting money in your 401k, or by making tax deductible contributions to your IRA or SEP IRA, you are able to invest more money than if you had to pay the tax man BEFORE investing.

Tax Deferral: Too Much of a Good Thing?

Perhaps then it is not a surprise that many retirees find themselves with almost all of their assets sitting in tax deferred retirement accounts.   Unfortunately this can cause its own problems.  In retirement, every dollar you take out of an IRA or 401k will be taxed as ordinary income.  If your roof or air conditioning needs replaced, you may need to take an additional distribution from your IRA to pay for it.  Since you know tax will be due on that distribuiton at the end of the year, you may need to take out an additional 20 or 25% just to pay the tax bill at the end of the year.

Retirees with substantial nest eggs in their retirement accounts may also encounter a tax problem due to Required Minimum Distributions.  The IRS requires that you begin withdrawing money from your tax deferred retirement accounts in the year you turn age 70 1/2.  The required distribution is based on IRS calculations of your expected longevity.  If you were a prodigious saver or effective investor during your younger  years, you may find that the IRS is making you take more money than you need to live on – and you will need to pay tax on that money as it comes out.

The answer to this problem is tax diversification.  Direct savings into a variety of account types.  Contribute up to the employer match in your employer 401k without fail.  After that, consider your options.

To Roth or Not to Roth?

If your taxable income is very high, then it probably makes sense to maximize your pre-tax contributions to 401k or other employer account.  If not, it might be better to put any money over the employer match into a Roth IRA.  Why?

  • While you don’t receive a current year tax deduction on your Roth contribution, that deduction isn’t worth so much iif your current taxable income is low.
  • Money will grow TAX FREE.  When you take the money out in retirement, you will owe no tax at all.
  • t is easier to access funds in a Roth for emergencies, college tuition, etc.  Since you already paid tax on the money you put in, you can remove those same funds without tax or penalty, even before the magical age of 59 1/2.
  • There are no Required Minimum Distributions from a Roth IRA. If you don’t need the money you can leave it in the Roth and let it grow until your kids inherit the account.  (and your kids will continue to reap the benefits of a Roth).

You can even convert traditional retirement accounts to a Roth – but that is a complex topic for another article.

Pay Tax Now for Flexibility Later. 

In addition to the Roth, I find that retirees with money saved in taxable investment accounts have much more flexibility when creating a retirement income and tax plan than those who only have 401k’s and IRA’s.  In an ordinary investment account we can utilize tax strategies that will take advantage of favorable tax rates on dividend and capital gain income.  We can sell investments that are down, creating losses that offset the tax impact of gains elsewhere in the portfolio.  It is often possible for the retiree to access money from a taxable investment account if needed for emergencies without generating any additional tax liability.   We can take money out at our own pace – the IRS will not force us to take income we do not need to live on.

Plan Ahead to Minimize Retirement Taxes.  

Choices you make during your peak saving years can have a profound impact on your tax burden in retirement.  A sound financial plan can help your optimize your tax situation – potentially saving you thousands or tens of thousands of dollars per year in retirement taxes.   Call Financial Pathways to discuss your own options, and for an overall retirement plan review.

 

The above is not to be considered legal or tax advice. 

 

Investment Risk in Retirement

The financial crisis of 2008 demonstrated clearly the devastating impact that investment losses can have on a retirement portfolio.  Many people who were almost ready for retirement saw their nest eggs cut in half in the course of a year or less.  Many people were forced to either delay retirement or scale back their lifestyle expectations as a result.

Recent retirees and those who are just about to retire are among those at the greatest risk from investment losses.  “Why is that?”, some might ask.  “The market came back since 2008, and investors who left their investments in place did pretty well.”  It is true that investors who left their stock portfolios intact did see their investments recover and go on to reach new highs – but the math works differently for retirees who must take distributions from their savings.

Lets consider our familiar investors, Bob and Don.  Both are recently retired, and both are starting to withdraw $3000 per month from their $500000 investment portfolios.

Bob is invested in a moderately aggressive portfolio, averaging 7.5% return over 20 years of retirement, while Don is invested in a fairly modest risk managed portfolio earning just 4%.  In the first year of their retirement, Bob’s portfolio loses 35%, after which it begins to quickly recover at 10% per year.  Don, in contrast, earns 4% every year.  Here is how the math works:

Bob’s Portfolio                Dons Portfolio
Balance % return Investment Return Withdrawal Balance %  return Investment Return Withdrawal
$500,000 $500,000
$289,000 -35% (175,000) (36,000) $484,000 4% 20,000 (36,000)
$281,900 10% 28,900 (36,000) $467,360 4% 19,360 (36,000)
$274,090 10% 28,190 (36,000) $450,054 4% 18,694 (36,000)
$265,499 10% 27,409 (36,000) $432,057 4% 18,002 (36,000)
$256,049 10% 26,550 (36,000) $413,339 4% 17,282 (36,000)
$245,654 10% 25,605 (36,000) $393,872 4% 16,534 (36,000)
$234,219 10% 24,565 (36,000) $373,627 4% 15,755 (36,000)
$221,641 10% 23,422 (36,000) $352,572 4% 14,945 (36,000)
$207,805 10% 22,164 (36,000) $330,675 4% 14,103 (36,000)
$192,586 10% 20,781 (36,000) $307,902 4% 13,227 (36,000)
$175,844 10% 19,259 (36,000) $284,218 4% 12,316 (36,000)
$157,429 10% 17,584 (36,000) $259,587 4% 11,369 (36,000)
$137,172 10% 15,743 (36,000) $233,971 4% 10,383 (36,000)
$114,889 10% 13,717 (36,000) $207,329 4% 9,359 (36,000)
$90,378 10% 11,489 (36,000) $179,623 4% 8,293 (36,000)
$63,415 10% 9,038 (36,000) $150,808 4% 7,185 (36,000)
$33,757 10% 6,342 (36,000) $120,840 4% 6,032 (36,000)
$1,133 10% 3,376 (36,000) $89,673 4% 4,834 (36,000)
$0 0% 0 0 $57,260 4% 3,587 (36,000)
$0 0% 0 0 $23,551 4% 2,290 (36,000)

Bobs Average Return:        7.5%                                                        Don’s Average Return:     4%

Here are a few important things to notice:

Note that despite the rapid growth of his portfolio after that first year, Bob NEVER FULLY RECOVERS FROM THE LOSS and never catches up to more conservative Don!  The reason is the distributions he has to continue taking from the account to pay his living expenses in retirement.

Bob’s average rate of return during the entire 20 years was 7.5% while Don’s return was 4% – but Don’s money lasted 3 years longer than Bob’s.

As financial planners, helping our clients manage risk is an extemely important part of what we do.  When the stock market keeps setting new records – it is also one of the hardest parts of our job!  It is hard to persuade our older clients to be satisfied with modest returns in a lower risk portfolio when they hear their neighbors boast of 30% returns.  But the very definition of planning implies a focus on the future rather than the past.  And we simply cannot know for certain that 2014 or 2015 will not turn out more like 2008 than 2013.  Plan for the worst – hope for the best.  Your retirement and investment plan needs to be built to survive whatever the future throws at you.

Important Takeaways:  

  • Recent or soon to be retirees need to be especially prudent about investment risk.
  • Never risk more than you can afford to lose.
  • Don’t be greedy.
  • Don’t be fooled by markets which seem calm and stable – market sentiment can change in a heartbeat, and world events will always be completely unpredictable.
  • A lower rate of return can actually provide more money to spend in retirement if it allows the investor to sidestep significant market losses.

 

Putting Investment Returns in Perspective. 

Small Numbers – Big Difference.

What is the difference between a 3% return and a 7% return?  4%?  Doesn’t sound like much, does it?  But these small numbers can have a tremendous impact on your retirement portfolio over time.

Let’s consider two savers, Bob and Don.  Bob has contributed $1000 per month to his 401k for the past 25 years, and invested in a blended portfolio of stocks and bonds which has earned an average of 7% per year.  Don in contrast, is extremely risk averse.  He has invested the same amount of money, but parked it all in his 401k stable value fund, which earned a steady if unexciting 3%.

So Bob earned 4% more than Don – what difference did that have on their portfolios over 25 years?

  • Bob’s portfolio ($1000/month invested for 25 years at 7%) would have grown to $810,000.
  • Don’s portfolio ($1000/month invested for 25 years at 3%) would have grown to $446,000.

In order for Don as a risk averse investor to accumulate the same retirement nest egg as Bob, he would have had to save $1820 per month at 3%, almost twice as much as Don had to save in order to achieve the exact same result.

Risk averse investors take note:  You may need to contribute a higher portion of pay to your retirement plan than your more aggressive co-workers if you hope to achieve the same long term accumulation goal.

 

 

Returns quoted are hypothetical in nature and do not reflect actual returns on any investment.  Although riskier investment assets have outperformed conservative investments over most long term periods in the past – there is no guarantee this will continue to be the case in the future.  

 

Health Care Planning and Obamacare Tax Credits

I was brushing up on the Obamacare rules today and found a very useful caculator from the Kaiser Foundation which will tell you exactly how much income you can make and qualify for health insurance tax credits (aka subsidies) based on family size and income.  This is important stuff for the self employed and middle income families paying for their own health insurance.  For instance, a family of five in New Jersey making $109,000 per year can expect the government to pay almost $9000 toward their insurance premiums in the form of tax credits.  But if someone in that family gets a $1001 raise, or if a child gets a part time job after school and makes a couple thousand bucks, they will get $0 in subsidies.  That raise and or taking that job will cost this family (which is struggling with high cost of  living in NJ as it is) $8000 per year.  A family in this position is far better off not taking the job or forgoing the raise.   “Sorry son.  I understand you want to get that first job and start working for a living, but we just can’t afford it right now!”

We are also finding this to be fertile ground for early retirement planning.  Those who retire before the age of 65 often need to purchase individual health insurance policies, which can be quite costly.  However, early retirees with money in both taxable and tax deferred retirement accounts are often able to keep income low during the first few years of retirement by deferring Social Security and using taxable investments rather than tax deferred accounts.  (withdrawals from 401k and IRA accounts are taxable income).  By carefully managing retirement income during these early years, many retirees can likely qualify for very valuable health care subsidies.  In some cases, the government will pay for your entire health insurance bill – even as you sit on a very large retirement account!

It might even make sense to forgo the COBRA insurance offered by your employer.   Why?  Because the premiums you pay for a COBRA policy are not eligible for tax credits unless you buy your policy on healthcare.gov.

The law is a dream for financial planners.  It is complicated, cumbersome, and difficult to understand – but offers great opportunities for those who incorporate the law into their financial planning efforts.   Complicated may not be good public policy, but it is more job security for financial planning professionals!

Debit Card Security Concerns

credit card security

Debit cards are very popular.  Unlike credit cards, you have no statement to pay.  If you don’t have cash in your account, you can’t buy anything – so they act as a sort of budget enforcer.  There is no temptation to “let the balance ride” at the end of the month, which can result in a snowball accumulation of debt.

But for all the benefits, there are also significant additional theft risks.  As this article at Bankrate.com points out, debit cards offer signficantly less fraud protections than credit cards.  Since money comes directly from your bank account, it is gone before you discover the fraud.  With credit cards, the money is only gone from the card issuer account – not yours!  Typically card companies will immediately credit your account if a fraudulent charge is made pending any fraud investigation.  With debit cards, you need to wait and hope for the bank to replace money into your account.

I am not recommending throwing away your debit/ATM card – but be smart and cautious when using them.  The Bankrate.com article does a great job explaining the risks.  I myself was surprised at the innovative ways crooks can steal card data!