What your Mutual Funds really cost
Financial Education
A very high percentage of people dealing with a financial advisor own “loaded” mutual funds. Mutual funds “A” shares, “B”shares and “C” shares are the most commonly sold products. There are “no load” mutual funds but advisors usually sell no load mutual funds if they wrap it with a fee. Occasionally, some advisors will claim loaded mutual funds are superior to no load funds. Hopefully, your advisor did not make that statement to you because it is not true. The salesperson that sold the “loaded” mutual funds benefits because of the ongoing commissions which come out of the investors’ mutual funds. These commissions and fees are directly or indirectly withdrawn from the funds. You, the investor, pays for those costs!
How do these funds work?
With “A” shares, a commission is withdrawn immediately on the money invested. These commissions (fees) may start as high as 8.25% and gradually decline with the more money invested.
For example, somebody invests $100,000 into an A share mutual fund with a 5% fee would mean $95,000 is what is the balance of the account. Monthly fees are still being withdrawn each month but the expenses are not transparent.
Mutual fund “A” shares offer breakpoints with the more money invested as long as it is in the same family of funds. Family discounts are often offered with family members investing in the same family of funds. It is common to see financial advisors put their clients” money in different families of mutual funds. When asked why the money was split into different mutual fund families, the most common answer is “to diversify your investments”. You can diversify your investments within numerous mutual funds offered within one family. Large families of funds offer blue chip, international, high yield, gold, small cap, large cap, etc. funds. Don’t you agree that diversifying in one family of funds would be to your advantage as opposed to diversifying in different family of funds. Remember, “A” shares within the same family get “breakpoints”. Breakpoints reduce the commissions you pay on “A” shares. Again, if other family members invest in the same family of funds, the total is added to allow all members to get the same breakpoint discounts. Keep in mind, the financial advisor must check the family discount on the applications in order to take advantage of the family discount. It’s common to see the family discount left blank on the application and it is also common to see one family member in one family of funds and the other members in totally different families. If you did not get your breakpoints because of the above scenarios, you should challenge your advisor on his/her reasons. I hope the motive was not for the advisor’s benefit at your expense!
Mutual fund “B” shares are back end commissions. The commissions typically reduce over the years. 6%, 5%, 4%, 3%, 2%, 1% and 0%. To avoid a back end surrender charge, you need to keep the funds until the end of 6 years. Make sure your advisor does not tell you “B” share mutual funds have no commissions as long as you keep it for 6 full years. The facts are that “B” shares have hidden fees that are more expensive than “A” shares. The SEC has now limited the amount of money that can be invested in “B” shares and now limit the “B” shares to 6 full years and then they convert to “A” shares since the hidden fees are less expensive. Hopefully, your financial advisor has not invested your money into different “B” shares through different families to get around the maximum allowed for each family. I would never own any “B” share mutual funds!
Mutual fund “C” shares do not charge a sales charge and either have a 1 year or no back end surrender charge. However, the hidden fees are usually more expensive than “A” shares, but not as expensive as “B” shares.
No load mutual funds have no sales charges and the hidden fees and expense charges are less expensive than A, B and C shares.
Exchange traded funds were first created in 1993 and its popularity has soared over the years. Today there are over 1.3 trillion dollars invested in exchange traded funds. ETF’s have lower expense charges than mutual funds and is very liquid. Purchasing an exchange traded fund has a minimal fee. A $100,000 exchange traded fund may cost you $4 to buy and sell instead of thousands of dollars. When you purchase an ETF, the account is yours only. Mutual funds have many owners. Mutual funds can only be sold and the close of the stock market regardless when you placed the order. ETF’s can be liquidated almost immediately.
Today, exchange traded funds are offered in just about anything you can imagine. Examples are S & P 500, small cap, large cap, oil, gold, silver, commodities, China, Russia, Japan, bonds, etc.
Non-qualified {after tax) mutual funds may generate “phantom income” if there is a dividend distribution even though you did not receive the dividend! This cannot happen with exchange traded funds. You only get 1099 if you actually receive the dividend.
The sophisticated investor can put option overlays on exchange traded funds to hedge his/her investment. You cannot put option overlays on mutual funds.
Despite the popularity of ETF’s, many people have never heard of them. Most people are educated by their advisor and financial advisors rarely seem to advocate the purchase of ETF’s. There simply is not enough commissions generated by ETF’s unless the advisor wraps a fee on the ETF.
Some financial advisors sell individual stocks, no load mutual funds and exchange traded funds and charge a fee on the account value. This appears to be better for the investor as the goal of the investor and advisor is to grow the value of the portfolio. Commissions generated, regardless if you make or lose money, may have a conflict of interest between the advisor and investor. A fee only advisor eliminates the potential conflict. Be careful regarding the fee you agree to pay. A 1% fee on the total investment is common although you may be able to find a lower fee. If you are paying over 1%, you may want to question why the fee seems high.
Regardless if you are investing in stocks, bonds, mutual funds, or exchange traded funds, you are still speculating with your money. It is my opinion that you should only risk your money if you are prepared to lose it.
Big wirehouses versus discount brokerage companies.
Typically, the big stock brokerage firms charge much higher fees for their services because they offer personalized service. Today however, the discount houses provide personalized services as well. There are several discount brokerage companies and the competition they have created benefits the consumer.
Bonds have appeal to some people because it is possible to receive a higher
interest rate than a CD or money market fund. I should caution you that bonds also have risks.
The most common bonds people invest in are corporate bonds, high yield bonds, municipal bonds and government bonds.
Corporate bonds are bonds backed by corporations. You are essentially loaning money to the corporation in exchange for receiving interest. The higher quality the bond, the lower the interest rate. Conversely, the lower the quality of the issuer of the bond, the higher the interest rate. The bonds are only as good as the corporation guaranteeing the bond. An analogy would be if two different people bought the same model car at the car dealership and both wanted financing. Buyer “A” has nearly perfect credit and gets a loan at the lowest rate available. Buyer “B” has fair to questionable credit and pays an extremely high interest rate to get the loan. That is because there is a much greater chance of repossession.
High Yield bonds are corporate bonds issued by high risk companies. The interest rates received will be much higher than blue chip corporations because the chance of default is much greater.
Municipal bonds are tax free bonds offered by sites and states for roads, construction, airports, universities, etc. The interest receive is tax-free so the interest rate is usually less than taxable bonds. Once again, the municipal bond is only as good as the issuer. Remember Detroit, Stockton, Harrisburg and many more.
Government bonds are bonds backed by the United States. The quality of these bonds are very high, but currently the rates are very low.
All bonds are bought in increments of $1,000 and have maturity dates. While you are holding the bonds, interest rates go up and down. If you were to sell the bonds before maturity, you may make or lose money depending on interest rates. Interest rates have an inverse relationship to the bonds. If rates drop, you may be able to sell your bonds at a premium, thus make more money. However, if interest rates escalate, you may have to sell you bonds at a discount, thus you would lose money.
I remember having a conversation with a gentleman a few years ago. He had his life savings in United Airlines corporate bonds which was yielding 7/12% at that time. I told him United was on the verge of bankruptcy and he should sell the bonds. He told me he was retired and he needed the extra income the bonds were providing him to supplement his social security. I told him I thought United was going to file for bankruptcy and he responded “The government won’t let United file bankruptcy”. I explained that United could indeed file bankruptcy and would still be flying the next day. United did flile bankruptcy, flew the next day, and this gentlemen lost his life savings!
Real Estate Investment Trusts are commonly referred as REITS. When you invest in a REIT, you are usually investing in office buildings, shopping centers , strip malls, apartments, etc. Most people purchase REITS from their financial advisors. Almost always, these are private REITS. Unfortunately, many investors cannot sell their REITS when they want to because they are highly illiquid. I have been told that the illiquidity was never discussed at the time of purchase. When financial advisors sell private REITS, the commissions are usually between 5% to 8%. You can invest in REITS that are publicly traded for a small fee. Publicly traded REITS are highly liquid and often have greater returns than private REITS. If you invested in a private REIT with your advisor, ask him/her why you were sold a private REIT as opposed to a publicly traded REIT. Also, you should ask why the liquidity wasn’t clearly discussed with you if applicable.
Fixed annuities, Immediate annuities, Variable annuities and Fixed-Indexed annuities.
Fixed annuities has some similarities to a CD. This annuity pays a fixed rate of return for a specified period of time. The longer you agree to hold the annuity, the higher the interest rate. Most fixed annuities offer a 3 to 10 year term with penalties for early withdrawal. Most of these annuities allow you to withdraw 10% per year without a penalty.
Immediate annuities pay a fixed amount of money for as long as you live. You give up all control of your money in exchange for a guaranteed lifetime of income. Immediate annuities offer a life only income. Life only income will pay you a larger amount of income, but it stops at death. This is risky if you have beneficiaries that you would like to give this income to in the event of your death. Other income choices are 5, 10, 15, 20 and 30 years period certain. This means if you died in the 7th year and you selected a 10 year life and certain, your beneficiaries will receive the remaining 3 years of income. The longer you guarantee income for beneficiaries, the lower the payout.
Variable annuities are mutual funds wrapped in an insurance contract. Because the mutual funds are sheltered in the insurance contract, the principal can be guaranteed if the rider is added to the variable annuity. The principal is guaranteed if the annuitant agrees to take a specified percentage each year and it is not to be exceeded. The annuitant may cash the annuity in, but the value will depend on the performance of the mutual funds at that particular date. The value may be higher or lower than the initial investment. Penalty fees may also apply as many variable annuities have a 5 to 7 year surrender period. Variable annuities have fees and expense charges that are greater than investing the mutual funds outside of the insurance contract. Mutual funds that are in the variable annuity do not get the benefit of long term capital gains if they made a profit. Variable annuities are taxed as ordinary income. Mutual funds without the annuity are taxed as long term capital gains which at the time of this writing, do not exceed 20%.
Variable annuities do not get the stepped up feature at death of the annuitant. For example, if the annuitant paid $100,000 for the annuity and at death, the annuity had a value of $200,000, the beneficiaries would pay ordinary income tax on the $100,000 profit. If the investor would have paid $100,000 for mutual funds without wrapping them in the insurance contract, and the value was $200,000 at death, the beneficiaries would get a stepped up basis at the $200,000, thus no income taxes would be due.
As long as the variable annuity is held, fees and commissions are withdrawn from the account value.
Investors need to realize the risks and expenses before purchasing variable annuities. Many people that I have talked to, did not realize the risks. Your advisor needs to discuss this with you in great detail because the prospectus that is given to investors are very confusing!
Fixed-indexed annuities is a blend between a fixed annuity and a variable annuity. Many insurance agents are now calling fixed-indexed annuities “hybrid annuities”. Fixed-indexed annuities were created in 1995 and have gained popularity since then. This is especially true each time the stock market has corrections.
Fixed-indexed annuities have evolved over the years and many of the newer annuities have some very attractive features. The gains in the annuity is linked to the performance of some of the indexes such as the S & P 500, Dow Jones Industrials, Nasdaq, etc. Fixed-indexed annuities offer various methods on the way the gains are credited. When you purchase a fixed-indexed annuity, you are NOT investing in the stock market, but you will receive interest based on the stock market indexes performance.
Fixed-indexed annuities CANNOT lose money due to stock market declines. Some insurance agents say they sell “Sleep Well” annuities because of this guarantee!
The newer fixed-indexed annuities offer income riders. Income riders offer guaranteed lifetime income for both spouses WITHOUT losing control of your money (unlike immediate annuities).
Fixed-indexed annuities are usually available for 5 to 15 years. The longer you commit, the larger the up front bonus. Many of these annuities allow you to withdraw some or all of your money without a penalty fee if you have certain health issues. There are a small number of annuities that provide higher income than what is normally paid out if the annuitant has certain health problems. This benefit is very attractive because many people will not buy long term care insurance or they get rate increases on their long term care premiums, therefor they cancel the policies. This “income doubler” is not meant to replace the need for long term care insurance, but it is there if needed.
Most fixed-indexed annuities have 100% of their money working for them. If the product has a bonus, it is GREATER than 100% Typically, the only fee is for the income rider or death benefit rider.
You must realize that many fixed-indexed annuities have the income rider, but at death, the income rider is not available to the beneficiaries. There are a few annuities that do pay the income benefit to the beneficiaries. Make sure your insurance agent explains this benefit to you in detail.
There are several fixed-indexed annuities in the market place today. It is a good idea to find an agent that is very knowledgeable on these products. Personally, I own some fixed-indexed annuities and they may be a good choice for you if you are suitably qualified.
When the lifetime income benefit is being received, a portion of the income is not taxable on non-qualified accounts. This is called an exclusion ratio.
All annuities, except immediate annuities, grow tax-deferred. Any profit, when withdrawn, are taxed as ordinary income. (non-qualified).
Tax-deferred annuities may reduce or eliminate tax on social security in certain situations. Tax-free bonds are not eligible to reduce or eliminate tax on social security even though they are tax-free
Occasionally, annuities get a “bad rap”. I believe some people are confused between the various annuities and I also believe some financial advisors have difficulty trying to convince people not to purchase a guaranteed annuity. They need your money at risk so they can get paid.
Life Insurance
Term insurance. Term has no cash value, but has a death benefit as long as the policy is in force. Originally, insurance companies offered annual renewable term. This was low cost coverage and the premium increased each year. Eventually, term insurance got expensive and most people eventually dropped the coverage.
The analogy I use is that term insurance is like renting an apartment. It is much less expensive than buying a house. Eventually, it becomes more expensive because the landlord charges you more rent every year. You can live in an apartment for 25 years and move out. There would be no equity when you leave. The two most common term plans offered in. The. "Old Days" was 10 year annual renewable term and 5 year renewable and convertible term insurance. ART increased the premium for 10 years. And in the 11th year the premium would skyrocket. That is when many people dropped the policy. 5 year R & C kept the premium level for 5 years, and it cancelled at the end of the 5 year term. You would have the opportunity to convert the term to a permanent policy within the 5 years without evidence of insurability as long as the conversion was with the same carrier. Eventually, insurance companies introduced 10, 15, 20 and 30 year level term premiums with the ability to convert the coverage to permanent insurance without evidence of insurability.
There are some companies that offer 10, 15, 20 & 30 year term policies with the guarantee to get back all of the premium paid at the end of he term period if the insured is still alive.
Many agents try to convince people to only buy term insurance and invest the difference. There are also many agents that try to convince people to cancel their permanent insurance and replace it with lower cost term insurance and invest the difference.
I believe term insurance is a temporary solution to a temporary problem. For example, if you have a 15 year mortgage on your hem and you want a 15 year term policy to pay off the mortgage in the event of your death within that time frame. Perhaps you borrow $250,000 from your bank to expand your business. The bank will probably require you to buy $250,000 of life insurance and assign the bank the beneficiary until the loan was paid off. Another example would be that you are married with 2 children. You want to make sure there would be enough money to raise the children and pay for their college education in the event of your death. Term would be an inexpensive way to get the guarantee if you want the coverage to stop after your kids graduate college.
Permanent insurance.
Once again, in the "Old Days", insurance companies offered two types of permanent insurance, participating and non-participating whole life insurance. Participating whole life would generate higher cash value than non- participating whole life because the policyholder would receive dividends over and beyond the cash value build ups within the policy. The premium for participating whole life
Is greater than the premium for non- participating whole life since non-participating whole life pays no dividends. Non-participating does have cash value build ups,but the accumulation will be less than participating. Therefore, the premium is lower.
The analogy for permanent insurance is it's like buying a house. Buying a house is more expensive than renting an apartment. However, the mortgage remains level whereas the apartment rent increases every year. Let's say you bought a house and sold it after 25 years. You would have equity when the house is sold.
Permanent insurance is a permanent solution to a permanent problem. For example, you have accumulated a substantial amount of assets and you would have a huge estate tax after you and your spouse pass away. Permanent insurance is the least expensive and most liquid way to pay the estate taxes after death. Perhaps you want to use cash values from an insurance policy to supplement your retirement. Permanent insurance is the solution, not term insurance.
Since the old days several new types of permanent insurance have been created.
Universal life is lower cost life insurance with a higher cash value accumulation. I believe universal life was the insurance companies way to "buy term and invest the difference within the policy.
Variable life was created to provide whole life insurance and investing the difference in mutual funds.
Variable universal life was developed to offer lower cost life insurance and invest the difference in mutual funds.
Last to die insurance was created to insure 2 lives, but the death benefit would not be paid until the second insured dies. This product is very popular to solve estate problems as the premium is less expensive than insuring two individual lives. This product is also attractive if one person is uninsurable and the second person is insurable. This product is very popular with spouses.
Equity-indexed life is the newest product recently developed. This product is very similar to fixed-indexed annuities. The gains are linked to the stock market indexes, such as the S & P 500, Dow Jones Industrials, Nasdaq, etc. the product is linked to the indexes, but is not invested in the indexes. You receive interest credited on the upside, but cannot lose money due to stock market declines.
This product is becoming very popular as policyholders like participating in the gains of the stock market without the risks that the variable products incur. After all, this is guaranteed insurance, and that is the primary reason so many people buy insurance. Most people, in my opinion, do not want to speculate with their life insurance needs. I really like equity-indexed life insurance.
Several insurance companies have reduced the costs of insurance because people are living much longer and insurance companies are using newer mortality tables to coincide with the longevity.
Disability Income.
Disability income insurance is possibly the most overlooked insurance product on the market today. The ability to earn income is the most valuable asset for working people. If you become disabled due to an accident, mental or physical disorder, how would you survive? Social security probably would not be enough to live on. And even if it was enough, inflation would seriously affect your standard of living.
Most companies offer disability income not to exceed 60% of your current income. When you look to buy a disability income product, make sure it has your "own occupation" benefit. For example, if you are a surgeon but can no longer perform surgeries, but you can make a substantial amount of money selling pharmaceuticals, you would be considered disabled. Having a residual benefit is also a great feature. Perhaps you can perform your regular duties only 50% of the time! you could receive a partial disability benefit for 50% of the actual benefit. Purchase a benefit that pays the disability until age 65 or lifetime if available.
If you do not have disability income insurance at work, you should buy a disability income policy first because insurance companies want to know how much disability income coverage you have in force. Insurance companies want to make sure it's not more profitable to be on disability instead of working. Most large corporations will have group disability coverage available for you without any questions asked.
You should also try to buy a disability income product that dies not deduct part of the benefit if you receive disability benefits from social security.
I own disability income insurance and I believe it you should strongly look into purchasing a policy for yourself.
Ask your CPA about buying a disability income policy with after tax dollars as the income benefit may be tax free.
Long Term Care
Long term care insurance is a good idea because there is a strong likelihood that one or both spouses may be in a nursing home. Many people believe Medicare will cover nursing care, however, this is not necessarily true. If you had a knee replacement and you were going directly from the hospital to the nursing home for rehabilitation, you will have coverage. If you were going to the nursing home because you have Alzheimer's disease, Medicare will Not cover the expense. It's possible you may be in the nursing home for several years in this scenario. You can see how this devastating disease could wipe out someone's entire life savings.
In the event the premium for this coverage is too expensive for you, increasing the waiting period before the benefit begins is one way to lower the premiums. Reducing the daily benefit and reducing the years of coverage are other strategies to lower the premiums. Today, most policies will provide benefits for home health care without having to be in the nursing home. Certain health conditions must be met in order to qualify.
Critical Illness Insurance.
Critical Illness Insurance is gaining in popularity. You may receive a benefit if you get cancer or have a heart attack. A few other illnesses may also pay the benefit. If you never get a critical illness and just don't wake up from your sleep, a death benefit will be paid to your beneficiaries.
Medicare Supplement Insurance
Medicare supplement insurance is for most people age 65 and older. Medicare only pays a portion of your health coverage so most people will buy a Medicare supplement policy to cover what part A does not cover. You first apply for the coverage 90 days before you turn 65 and the coverage is guaranteed issued without evidence of insurability. I believe you should strongly consider the prescription benefit even if you are not on any medication. As you get older, there is a high probability that you will eventually be on prescriptions.
Dental Insurance
Consider the actual dollar benefits and compare it to the premium you pay for the coverage. Dental plans vary so shopping policies is a good idea. Also, make sure your dentist is covered on your plan.
Major Medical
Group major medical is slowly being eliminated by many employers as the expense is getting exorbitant. If you are shopping for major medical insurance, decide if you want a policy that covers doctor visits, most of your prescriptions,most of your hospitalization, etc. the richer the plan, the more expensive the premium. If you are healthy, you may want to consider protection from catastrophic illnesses only. The premium will be lower.
You can also reduce your premium if you are willing to accept an HMO policy versus a PPO network.
Many people are interested in buying gold and silver. In fact, you cannot watch TV without seeing lots of commercials. I would suggest you compare prices and thoroughly research the company you are considering doing business with. Also, the amount of pure gold and silver may vary. Be careful on the quality of gold and silver you purchase. If the gold and silver is being stored for you, make sure it REALLY is being stored!
Reverse mortgages.
To qualify for a reverse mortgage, the youngest homeowner must be at least age 62. The loan is guaranteed by the federal government, therefore, their is no credit check or minimum income requirements. The money you receive from the reverse mortgage is tax free and you do not have to pay it back as long as you are living in the house. The loan is paid back if you sell the house, move out of the house, or you pass away and your beneficiaries inherit the house. The loan must be paid back before the sale can be finalized.
People that sell reverse mortgages must offer you a free consultation before the transaction can be completed. Reverse mortgages are highly regulated, and for some people, the benefits are very beneficial.
This book, Financial Education, is designed to educate you on many of the products you may or have already purchased. I have discovered that numerous people do not really understand what they have invested in. It's your money and you should have a very good comprehension of your investments or the investments you are considering. You should read this book 2 or 3 times because there is a substantial amount of information to absorb.