Roth 401(k) Plans -- The Next Big Thing

Prediction time (something I rarely do). Roth 401(k) plans will take off in 2006. They may be a little slow getting out of the gate since a lot of folks are just learning about them and the IRS hasn't provided a ton of guidance. But, I predict Roth 401(k)s will become more popular than traditional 401(k)s. Why? Because they combine all of the great benefits of regular 401(k)s with the non-taxability of the Roth IRA. Below is a table which compares the provisions of the two types of 401(k) offerings.

When we've run the calculations, the Roth beats the traditional over the long haul due to the investment growth never being taxed. That's huge, and it overcomes forgoing the 401(k) deduction today. When might the traditional 401(k) deferral be better? Since there's tax on withdrawals within five years of contribution, if you're going to withdraw right away then the Roth 401(k) may not be best for you. Since our clients are a more wealthy lot, we expect the Roth deferrals will be the last money they ever spend -- if they ever spend need to spend it. That's why we're pushing Roth 401(k)s as great wealth accumulation vehicles.

For more information on Roth 401(k)s read the article by PensionOne Advisors ( http://www.pensionone.com) at: http://www.pensionone.com/insights/bi2005-08.pdf

Equity Indexed Annuities -- A Sucker's Bet

The heat is on. More and more articles ("Popular Annuity Can Be Tricky," WSJ, 10/15/05; "EIAs: Behind the Hype," Financial Planning, October 2005; "Do Clients Understand Equity Indexed Annuities?," Morningstar Advisor, 10/27/05) are raising the warning flag about equity indexed annuities (EIAs). And, rightly so. EIAs are a great example of an investment product designed to be sold but not bought. The whole premise of EIAs plays on the fears of uneducated investors. The product pushers oversell the risks of equity investing to the point that the purchasers are willing to give up huge portions of upside return in order to be protected from the exaggerated downside risk.

Investment risk needs to be put in perspective. First of all, investors need to understand that risk and reward go together. It's fundamental. If you don't want to take risk, then don't expect a huge return. If you want a huge return, then don't expect to do it without risk. Sure, there are anecdotal exceptions, but those have more to do with luck than skill. Diversification is the way to minimize risk and optimize expected returns, but that's a subject for another day.

The second point is that time reduces the probability of a sustained loss. That's why we're big proponents of long-term investing. Let's check the record using the S&P 500. The worst one-year loss for the S&P 500 beginning in 1926 was -43.4% in 1931. The worst ten-year period? An annualized loss of only -0.90% (1929-1938). The worst 20 years? Surprise! Not a loss, but a +3.1% annualized return (1929-1948). Furthermore, most investors overestimate the history of loss years. See my August 31, 2005 blog, but also consider that in the 79 years 1926 - 2004 over 70% of the years the S&P 500 had gains (non-negative returns), and the average return of the good years (non-negative returns) was 22.7% versus the average -12.6% loss of the bad years (negative returns).

So, back to EIAs. Folks who buy EIAs are so fearful of a loss they're willing to live with an 8%-13% commission to a broker, surrender penalty periods of ten years or more, about one-third of the return of the actual index, tax penalties for withdrawals before age 59 1/2, no dividends, and no capital gains treatment for the appreciation. Some deal. Which is why EIAs are only sold to little old ladies and the unsuspecting. Which is why the SEC and the NASD are beginning to take notice.

Who’s Paying Your Advisor?

A recent report from financial-planning.com (“NASD Fines Eight B-Ds for Accepting Fund Kickbacks,” Giselle Abramovich, 10/17/05) points out the problem of compensation in the investment industry. Here’s a portion of the news:

“The NASD has fined eight broker-dealers, including one fund distributor, $7.75 million for giving preferential sales treatment to mutual funds in exchange for lucrative trading commissions from directed-brokerage agreements. Four of the companies are subsidiaries of National Planning Holdings, which collectively paid $3,850,000. They include Invest Financial, which paid $1,520,000; National Planning Corp., which paid $1,308,000; SII Investments, which was fined $658,500; and Investment Centers of America, which was penalized $363,500. Other companies charged included Commonwealth Financial, which was fined $1,400,000; Mutual Service Corp., fined $1,300,000; Lincoln Financial Advisors, fined $950,000; and Lord Abbett Distributor, fined $255,000.

“Lord Abbett, the fund distributor, was accused of paying three brokerages more than $900,000 in trading commissions to be included in their lists of recommended funds and on their internal Web sites. Lord Abbett also gained enhanced access to the dealers' sales teams through participation in broker training events, according to the NASD. Two of the companies received the commissions directly for carrying out the trades. The third company, which did not have a trading desk, split the payment with a clearinghouse that completed the trades in its place, according to the NASD.

“The NASD has been busy on the directed-brokerage front in recent months, fining 15 brokerages--including six subsidiaries of AIG $34 million in June for these violations. Since it began its crackdown, some of its cases have been handled in conjunction with the Securities and Exchange Commission.”

Think of the hundreds (thousands?) of investors who thought their advisors were acting in the client’s best interest. Surprise. The advisor was acting in his (I’m sure no women advisors were involved) own best interest.

The honest and ethical investment advisor will never accept compensation from anyone other than the client. That means no revenue-sharing, no bribes, no kickbacks, no Caribbean vacations, no NFL tickets – just fully-disclosed compensation from the client.

The wise investor should ask the following questions of his or her advisor:

• Other than the fee or commission you charge me, in what other ways are you compensated?
• Do you or your firm accept compensation for promoting certain securities or placing them on a “select list?”
• Where commissions are charged, explain the differences in commission or payment to you based on the security you recommend.
• Are you provided any form of non-cash compensation for meeting certain sales levels, such as vacations, access to sporting events, computer equipment, etc.?
  

The NASD, SEC, and Elliot Spitzer will continue to hunt down the dishonest advisors and investment firms. I’m sure there will be far too many culprits who will escape the net. So, be smart and ask the right questions.