byline: Michael Joyce

In April 2015, after nearly 40 years of no significant modifications to the rules that govern the retirement investment industry, despite great changes in retirement savings vehicles over time, the U.S. Department of Labor (DOL) issued proposed regulations to curb conflicts of interest in this marketplace.  After a long public comment period, lobbying efforts and subsequent revisions, the final rule became law on June 7 and is set to go into effect on April 10 next year. 

This regulatory development makes it imperative that businesses providing 401(k)s to their employees oversee plan advisors to ensure that they are in compliance with the new law.  According to the DOL, under the new rule, firms advising 401(k) plans and plan participants will be required to:

… make prudent investment recommendations without regard to their own interests, or the interests of those other than the customer; charge only reasonable compensation; and make no misrepresentations to their customers regarding recommended investments.

Historically, certain  retirement investment advisors (such as broker/dealers) have been allowed to invest  retirement dollars in stocks and funds they deemed to be suitable for a client —even if the investment was not in their client’s best interest per se — while accepting commissions and fees from the sponsors of those investment products.   The DOL asserts that the resulting conflicts of interest amounted to an estimated $17 billion in lost wealth annually for American retirement savers.  

The new regulation requires that when offering retirement advice, all financial advisors must now meet the higher “fiduciary standard” — that is, working in the client’s best interest.  In addition, the fees charged to investors and 401(k) plan providers must be both reasonable and clearly disclosed. 

When all is said and done, what the new law boils down to is how the word “recommendation” is defined by the DOL.  If an investment advisor is recommending a retirement product, then he/she must do so in the individual client or business client’s best interest.  Customization of advice is what qualifies a communication as a recommendation.  The DOL’s threshold of whether advice is considered a recommendation is explained below:

 

A ‘recommendation’ is a communication that … would reasonably be viewed as a suggestion that the advice recipient engage in or refrain from taking a particular course of action. The more individually tailored the communication is to a specific advice recipient or recipients, the more likely the communication will be viewed as a recommendation.

 

The DOL further specified what is not considered retirement investment advice and, therefore, not impacted by the rule.  A few of those exceptions are “… education about retirement savings and general financial and investment information…,” marketing materials and general communications such as newsletters and speeches. (For a more detailed description of what is not covered investment advice under the rule, see the DOL’s Fiduciary Rule Fact Sheet. https://www.dol.gov/agencies/ebsa/about-ebsa/our-activities/resource-center/fact-sheets/dol-final-rule-to-address-conflicts-of-interest)

During the rule’s public comment period, prior to its finalization, two important exemptions to the rule were developed and ultimately adopted.  The Best Interest Contract Exemption (BICE) states that advisors are permitted to receive commission-based compensation as long as they meet the fiduciary standard for the investment.  The financial institution must “…[give] prudent advice…, [avoid] making misleading statements…and [receive] no more than reasonable compensation.”  Additional requirements of the BICE are that the financial institution must disclose conflicts of interest, must clearly state the cost of their advice and may not compensate their advisors for making recommendations that are not in the best interest of the individual or business clients. Therefore, if a retirement plan advisor recommends investment products or rolls over investments to an IRA for which he will receive a commission, he will be required to sign a Best Interest Contract, guaranteeing that his recommendations are in the best interest of the client.    

The second exemption, the Principal Transactions Exemption (PTE), makes it permissible for fiduciaries “to sell or purchase certain recommended debt securities and other investments out of their own inventories to or from plans and IRAs” — as long as they uphold the same standard as described above for the BICE. 

Many experts have asserted that the requirements of the new regulation will make it impossible for smaller broker/dealers to profitably advise smaller businesses and investors.  They predict that robo-advisors (defined as online, automated, algorithm-based wealth advisors) will grow as a result of this new fiduciary law.  But even robo-advisors will be required to meet the fiduciary standard and prove that their fees are reasonable.

Those businesses that already use a Registered Investment Advisor (RIA) to manage their 401(k) are in luck because RIAs will be compelled to make only small operational adjustments as a result of the DOL’s new rule.  RIAs have always been held to the fiduciary standard, so they are accustomed to meeting the higher requirement of working in their client’s best interest and have the necessary systems in place to do so. 

One year after the publication of the final rule, on April 10, plan sponsors and retirement investment advisors will be legally bound to comply with the rule’s requirements.  Financial institutions will have a phased in implementation period for the BICE and PTE with fewer requirements – until the exemptions are fully applicable on Jan. 1, 2018.  With the new rule and exemptions in place, businesses will need to ensure that 401(k) plan advisors are in compliance with the DOL’s fiduciary regulations.  And their employees will be able to rest a bit easier knowing their retirement plans are better protected.

Despite assertions by some financial industry groups that the new DOL rules will cause costs for qualified plans to rise, it is more probable that the opposite will occur.  Under the bright light of more clear disclosure, costs for qualified plans will likely fall.  And, after all, is there anything wrong with acting in the best interest of financial consumers?

Michael Joyce, CFA, CFP, is founder and president of JoycePayne Partners of Richmond and Bethlehem, Pa. He is responsible for overall invest¬ment strategy, management of investment portfo¬lios and financial counseling services. Joyce can be reached at [email protected].

Investing in a startup has a high potential rate of return, but, since so many businesses fail each year, it is also one of the riskiest investments one can make.  Because the risk of losing one’s investment in a startup is very real, investors should enter a new venture with their eyes wide open and should size the investment appropriately to avoid jeopardizing their overall financial stability. 

The 2015 Virginia Chamber of Commerce’s State of the Commonwealth report states that most businesses started in Virginia “are able to survive for at least a year.”  But the Chamber’s data suggests that these nascent small businesses “are not necessarily well equipped to deal with the tasks they subsequently confront as they attempt to grow.” While the Chamber and its partners certainly aspire to improve the odds for Virginia’s newest businesses, this finding serves as a warning for potential investors in such ventures. 

When starting out, new business owners may be disinclined to use banks as lenders due to bureaucratic hassles and tight restrictions on lending (just ask anyone who has applied for a mortgage recently about banking red tape). Instead, they often seek capital investment from those closest to them; friends and family.  But a smart individual investor, who is usually putting his or her own family’s capital at risk with the startup capital outlay, will place restrictions on the borrower and establish clear boundaries for the investment. 

Prior to releasing any funds to a new business, an investor should insist upon reviewing the venture’s business plan.  A business plan delineates the owner’s intentions for the entity as well as its roadmap for growth. To protect an investment, then, a lender is well advised to carefully analyze the plan to determine if the owner’s projections are realistic.  Investors should also insist on periodic updates on the company and possibly access to the company’s books.

From the investor’s perspective, the ideal corporate structure for a new business is an LLC, since owners and investors cannot be held liable for the young company’s debts and unpaid bills.  Without the protections of an LLC, vendors and stakeholders can hold investors personally responsible for what is owed.  And remember, the newly formed LLC will, of course, be responsible for providing investors with K-1s, but a passive investor cannot deduct losses until he is also experiencing passive investment gains (PIGs).

If an investor has a specific timeframe for a return on his or her investment in a new business, it might be best to invest in the form of a loan.  Since dividends are not guaranteed, loaning money with a defined term can provide the investor with an income stream of regular loan payments with interest and will enable the lender to be higher in the capital structure of a company, which could mitigate downside if things go bad.  It is recommended that investors lend to new businesses at a risk premium to compensate for the speculative nature of the enterprise and the illiquidity of the investment.  Investors should even go as far as to insist upon a lien.  And, of course, they should make the loan official with proper legal documentation.

Another option for the startup investor is to receive preferred stock in exchange for the investment. Preferred stock can be structured to be converted to common stock at a later date.  The preferred stock option also enables the investor to be higher up in the capital structure than the owner, which is advisable in a risky, illiquid venture.

Certain business types have much higher margins than others and, therefore, offer a greater likelihood that investors will be paid back. The best route to success for the investor is to support a business with differentiating factors and with the potential for positive cash flow in the near-term.  Ideally, an investor wants the business to produce cash to pay interest or dividends with a path for liquidity.

Finally, an investor should go in to the new business venture prepared to walk away and should refrain from throwing good money after bad.  If an investor is open to investing a total of $150,000 in the new entity, for example, he or she may only want to commit $100,000 initially.  That way, the investor can re-evaluate the business’s performance over time and has options; to invest again later if profits are on the near horizon or, alternatively, to limit the capital outlay if things are headed south. 

While not assured of high rates of return, those investors who place careful restrictions on a startup investment and go into the venture informed and protected, can certainly increase the odds of positive outcomes. 

Michael Joyce, CFA, CFP, founder and president of JoycePayne Partners of Bethlehem and Richmond, Va., is responsible for overall invest¬ment strategy, management of investment portfo¬lios and financial counseling services. He can be reached at [email protected].

It is early 2016, but already this year we have seen increased volatility rear its ugly head in global financial markets.  After an extended period at below-average levels, volatility has escalated in recent months despite a stronger U.S. economy.  Dysfunction in the Chinese markets, the Federal Reserve’s recent interest rate hike and challenges in emerging markets all are contributing to increased global market instability.  At times like these, investors look to limit the impact of these factors on their portfolio.  What, then, can be done to mitigate volatility’s effects?  To help answer this question, I would like to discuss volatility in general and strategies to limit its impact and then follow up with some thoughts about why it is surprising that China’s markets are affecting volatility here. 

First and foremost, it’s important to understand that volatility is not risk.  Volatility is the movement of price in markets, whereas risk is the probability of actually losing money.  The two concepts overlap when volatility forces investors to sell at a discounted price, thus locking in a loss. 

One of the main reasons for investors to manage volatility through sound investment plans is to protect them from themselves. Emotional overreactions can lead to bad short-term investment decisions.  In a perfect world, investments that exhibit no volatility, such as bank certificates of deposit or savings accounts, would produce ample returns to cover the negative impact of rising inflation. Unfortunately, that is not reality, so each investor must incorporate some risk into his or her long-term investment plans in order to experience higher returns to outpace inflation over time.  Strategies to dampen volatility can reduce the probability of loss in a portfolio’s value and can, therefore, reduce risk. 

Diversification is one fundamental investment tactic that helps.  Investors should avoid putting all of their eggs in one basket and instead build a portfolio with a variety of non-correlated investments — such as emerging market small-cap stocks, large-cap U.S. stocks, different individual bonds and real estate investment trusts.  Additionally, investors should remember to rebalance portfolio holdings as allocation weights change due to market movements. 

One often overlooked method of dealing with volatility and managing portfolio risk is to match the time horizon for investments with the correct type of investment vehicle.  A 5-year horizon requires a different investment choice than a 30-year horizon.  Those retiring soon or paying college tuition in the near future, for example, should keep some funds in a money market account or in short-term bonds rather than in the stock market so that their reserve funds are not vulnerable to market volatility.  At such times, some experts suggest having eight years’ worth of expenses in cash or short-term bond reserves.  

Another way to curb the impact of volatility is to use market orders to establish investment limits.  Trailing stop losses can be used to define an absolute downside minimum and buy limits can be set to establish when to buy investments.  A knowledgeable financial adviser can help investors incorporate basic options strategies (such as buying protective puts and establishing collars) to reduce the impact of market volatility on investments. 

In our current global financial environment  — with chaotic Chinese stock markets manipulated by the government, historic lows in the energy sector, slowly rising U.S. interest rates and under-performing emerging markets — investors can mitigate risk by incorporating the above approaches to lessen the impact of volatility.   But it is important to remember that market volatility is, by definition, temporary and market movements should be considered in their full context.

As previously mentioned, many analysts are blaming some of the volatility in our markets on turmoil in the Chinese markets.  The two domestic Chinese stock exchanges, the Shanghai and Shenzhen, are notoriously volatile, so it is a bit confounding that U.S. investors are rattled by movements there.  To allay investor concerns regarding China in particular, it is important to remember that while China has the world’s second-largest economy (with a 2014 nominal GDP equivalent to about $10 trillion), its economy is significantly smaller than that of the U.S. (with a 2014 nominal GDP of approximately $18 trillion).   China’s economy is also good deal smaller than the EU economy in aggregate (with a 2014 aggregated nominal GDP equivalent to about $18.5 trillion).  It would not be surprising, then, if the improvement in the U.S. economy more than offsets continued weakness in China.

Remember, a skilled financial adviser can help construct a portfolio with the worst-case situation in mind, giving investors peace of mind and freeing them from worry about the effects of market volatility on their investments.

Michael Joyce, founder and president of JoycePayne Partners of Bethlehem, Pa., and Richmond, is responsible for its overall investment strategy, management of investment portfolios and financial counseling services. He can be reached at [email protected].

A heavyweight champion turned entrepreneur, George Foreman, made the following astute statement about retirement: “The question isn't at what age I want to retire, it's at what income.”  While retirement is an inevitability, doing so comfortably is not.  And even though every person’s retirement is different, when it comes to maintaining a lifestyle, there are a few guidelines that make sense for most people.

After more than 30 years in the financial advisor industry, I have observed that there are usually three stages of retirement, each requiring different levels of funding. The first few years can be relatively expensive, with increased travel and possible moving/transition expenses.  The second stage is usually more economical —travelling has become less appealing (“been there, done that”), and there are fewer transitions to fund. The final stage involves higher costs, with more spending on health care and/or long-term care.

Cash flow generated by Social Security — a major source of income for most retired individuals who have met the eligibility requirements — is one way to pay for these stages of retirement. Deciding when to start receiving benefits depends on many factors, including age, health, family history and access to supplementary funds. Generally speaking, the longer one can wait to receive benefits, the better. But remember, up to 85 percent of Social Security income may be taxed on the federal level, depending on other sources of income.

Pensions are another source of retirement cash flow. Prior to retiring, employees should speak with their HR department to ensure that they fully understand the options for pension payouts because timetables for payouts vary between plans. And since monthly pension payments are taxable income subject to federal and Virginia state tax, retirees are well advised to specify how much tax should be withheld from a pension payout so that they can avoid a big tax bill at year end. 

Additionally, employees should be sure they truly understand the nature of their pension. Government pension recipients can be subject to a formula that reduces the amount of Social Security benefits they receive. Pension recipients in the private sector are not subject to such a reduction.

Tax-deferred accounts, such as employer-sponsored retirement plans — 401(k)s and 403(b)s — and individual retirement accounts (IRAs), are popular and smart ways to save for retirement. Contributions are made with pretax money, grow without a tax drag, and taxes are deferred until a distribution is taken. Withdrawals are treated as regular income. Retirees should wait until they are 59½ or older before withdrawing from this type of account since taking money out of an IRA before that age is considered an “early distribution” and the withdrawal is subject to a 10 percent penalty tax.
Prior to the age of 70½, retirees should pull retirement income from taxable accounts. By tapping money from savings and investment accounts, retirees will not be paying much in taxes since many of those funds are considered return of capital.  Once  retirees reach 70½, they must begin taking RMDs (Required Minimum Distributions) from their tax-deferred accounts.

Another excellent savings tool, a Roth IRA (funded by after-tax income), is the last savings tool that retirees should tap. Since RMDs do not apply to Roth IRAs, retirees should defer withdrawing from this type of account as long as possible to let their investment continue to grow — using other sources of income to fund their lifestyle. If the account is at least five years old and the investor is 59½ or older, withdrawals from Roth IRAs are tax-free.

Since Roth IRAs have these special tax benefits, investors would be wise to consider a Roth conversion (converting another tax-deferred account into a Roth IRA). In this scenario, there will be taxes due — for converting pretax money into Roth money — but a Roth conversion can still be advisable. It’s best to pay the taxes owed for the conversion out of pocket rather than sacrifice IRA money.

Putting these savings strategies into practice will not only help retirees maintain their lifestyle but will also enable them to relax and enjoy their retirement years.  

Michael Joyce, founder and president of JoycePayne Partners of Richmond, Va., and Bethlehem, Pa., is responsible for overall investment strategy, management of investment portfolios and financial counseling services.  He can be reached at [email protected].

When choosing a financial advisor, investors are well-advised to consider carefully the ethical standard to which different categories of advisors are held. These legal standards vary greatly within the investment industry — and can directly impact investors’ returns and overall wealth-management plans.

The advisors who are held to the highest ethical standard in the investment industry are Registered Investment Advisors (RIAs).  RIAs are legally obligated to meet the “fiduciary standard”: that is, their investment recommendations must be solely in the best interest of their client.  When an RIA is developing a wealth management plan, he or she must ensure that the client’s interests come first. 

Brokers, on the other hand, have a considerably lower threshold of accountability to clients when compared to RIAs.  Brokers are required to recommend products they view as “suitable” for their clients.  Unlike the fiduciary standard followed by RIAs, this “suitability” standard means that a broker may suggest higher-priced investment products to a client — even if the broker is aware of lower-priced options. Most investors do not realize this difference in standards, even though it can be an important consideration when making investment decisions.

Since many brokers make a commission on the products they sell, potential conflicts of interest can impact the quality of advice the investor receives. Some possible conflicts of interests in the commission model of broker compensation that many investors are unaware of include:

• A commissioned advisor may be tempted to make recommendations that pay higher commissions when a less expensive and/or more profitable alternative is available.

• A commissioned advisor might be motivated to recommend that a client convert non-cash assets such as real estate and collectibles to cash that can be reinvested so that the advisor can collect commissions.

• A commissioned advisor might be incented to advise a client to make investments so that the advisor may collect a commission, when in actuality holding cash may be a better recommendation at the time. 

• A commissioned advisor may be tempted to unnecessarily buy and sell securities to generate commissions. (This practice is often referred to as “churning.”)

It is expected that the Securities and Exchange Commission will extend a stricter fiduciary standard to brokers within the next five years.  In April, the Wall Street Journal reported that those who support adopting a fiduciary standard for brokers do so because they believe the average investor does not understand the differences in the ethical standards that apply to different types of advisors. They argued, this “leaves the door open to abuses by brokers intent on selling products that pay them a commission, whether those investments are the best option for the buyer or not.”

Until this stricter fiduciary standard is required for brokers, though, investors seeking advice on their wealth-management plans might be better served by someone who is already held to the fiduciary standard, has no incentive to promote less-than-ideal products and is legally obligated to work in the client’s best interest. When it comes to your financial future and security, having the additional protection of a fiduciary standard is a wise investment.

Michael Joyce, CFA, CFP,  is the president of Richmond-based JoycePayne Partners. He is responsible for the firm’s overall investment strategy, management of investment portfolios and financial counseling services. Joyce can be contacted at [email protected].