Investment Corp

A changing landscape

Environment improves for small fund companies as bigger firms struggle with market hangover

By David Hoffman

March 28, 2010 6:01 am ET

The mutual fund industry has long been dominated by a handful of companies, but continuing fallout from the recent market downturn and other structural factors have created opportunities for nimbler, smaller companies to gain more business.

No one is saying that The Vanguard Group Inc., Capital Research and Management Co.’s American Funds and Fidelity Investments — the three largest fund groups ranked by long-term mutual fund assets — will cease to be major players. But lingering investor discontent, the result of virtually universal poor fund performance during the recession, could allow smaller competitors to gain market share, fund executives said at an InvestmentNews round table on the fund industry held Feb. 9 in New York.

MARKET SHIFT

“I think there’s a big market shift going on right now,” said James A. Jessee, president of MFS Fund Distributors Inc. “Part of it is, you have a lot of assets with those companies where people are disappointed in the results, and they are looking for alternatives.”

But more than disappointing performance might be at work, said Frank Waltman, executive vice president of product management for Virtus Investment Partners Inc. It may be that some firms have gotten too big, he said, making it particularly hard for them to accumulate assets — especially in the wake of a recession.

“If you just look at the asset base and the normal redemption rate on that asset base, the amount of gross sales you have to generate just to overcome the natural pace of redemptions is huge,” Mr. Waltman said.

Structural changes in the marketplace might also help smaller asset managers gain business from the wirehouses.

“[The wirehouses] have enhanced their management. Their research people are really strong. They’ve taken some of the best from institutional firms,” said Stephen P. Fisher, president of New York Life Investment Management LLC’s MainStay Funds.

As a result, these wirehouses are more willing to consider funds that they may not have considered before, the fund executives said.

“What has been a great surprise for us is the acceptance among wirehouses to look at smaller firms,” said Russell M. Parker, chief marketing and distribution officer of FBR Asset Management Holdings Inc.

Of course, dealing with wirehouses is a double-edged sword for fund companies.

During the thick of the recession, many in the fund industry said that wirehouses were demanding more from fund firms in return for selling their products.

Mr. Parker, however, suggested that that is no longer the case.

“There was a time when the asset management side of the equation had maybe a lot of power at the harm of distributors, and then there was a time where the distribution had an awful lot of power at the peril of the asset managers,” he said. “I think the market has allowed the pendulum to come back closer to center.”

BALANCE OF POWER

That may be true, but it is still a struggle for smaller firms to negotiate with wirehouses and distributors generally, said Thomas R. Trala Jr., the chief financial officer and chief operating officer of one such small firm, Turner Investment Partners Inc.

“Where the pendulum stands for a firm the size of Turner, clearly, the advantage is still to the distributors,” he said. “In fact, the larger firms may be getting better deals than a firm our size that relies on that [distribution] relationship.”

That said, this is a pretty good time to be a boutique firm, Mr. Waltman said.

Another effect of the recession is that investors and financial advisers are demanding to know who is managing their money and how, he said. That gives an edge to boutique managers who provide more personal service, Mr. Waltman said.

It also helps that because of disappointing returns over the past two years, distributors are looking for successful firms to market to investors, Mr. Parker said.

“They are actually embracing the boutique, because if nothing else, it’s a new name at a time when people have had some of their appetite soured against the bigger players,” he said.

Midsize asset managers, however, are not being embraced. They are in a particularly difficult spot because “they’ve got a fairly expensive model in place, and they don’t have the scale, and their margins are coming down,” Mr. Jessee said.

That makes them attractive mergers-and-acquisitions targets, he said.

And now that the markets are a little less volatile, making it easier to agree on a sales price, M&A activity will likely increase, Mr. Parker said.

Not all the deals, however, will involve midsize companies, Mr. Waltman said.

There have been a number of big-name acquisitions in recent months, including Invesco Ltd.’s purchase of Morgan Stanley’s Van Kampen Funds Inc. in October for $1.5 billion.

Bank of America Corp. sold the long-term-asset-management business of its Columbia Management Group LLC subsidiary to Ameriprise Financial Inc. in late 2009.

Also last year, Barclays PLC sold its Barclays Global Investors unit, including its iShares exchange-traded-fund business, to BlackRock Inc. for $13.5 billion.

There may be more such deals ahead, Mr. Waltman said.

“I do think there will be some larger deals as you see insurance companies and banks looking at their book of business and really focusing on what their core business is,” he said. “In many cases, that may not be asset management.”

Insurance companies, however, are in a particularly good position to deliver the income-oriented products that retiring baby boomers want, Mr. Fisher said.

“Having an insurance company, New York Life, as a parent, [MainStay Funds] has the ability to offer some guaranteed product, and we’re seeing a lot of interest in immediate annuities,” he said.

GUARANTEES

Although income-oriented products will be winners in the years to come, Mr. Jessee said, he hasn’t seen much evidence that advisers are enthusiastic about selling guaranteed products.

“Clearly, the guaranteed-income or guaranteed type of solutions are something investors are going to seek out and want,” he said. “I’m just not sure advisers, for the most part, have gotten comfortable with that.”

One of the products that advisers will likely demand, Mr. Jessee predicted, will be “flexible funds” that allow the fund manager to invest across various sectors and styles.

E-mail David Hoffman at dhoffman@investmentnews.com.

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Products on the horizon

March 28, 2010 6:01 am ET

The following is an edited transcript of InvestmentNews‘ mutual fund round table, held in New York Feb. 9. It was moderated by reporter David Hoffman.

InvestmentNews: These last two years have been very volatile for the mutual fund industry. Assets are starting to come back, but there seems to be a slowdown, if not a complete halt, in product development. Now that the recession is beginning to fade, what new products might we see from mutual fund providers?

Mr. Fisher: More income-related products. We’re seeing a lot of demand for income. Clients are saying to the advisers, “We need income.” Some [products will combine that] with some appreciation, so you’ll have some products that are income-oriented, but they’ll be more multisector — balanced funds with a tilt, broader asset allocation, broader mandates to search the world for bonds and stocks to be able to get a global portfolio of income with some growth potential. We’re definitely seeing a lot of that.

I think you’ll continue to see growth or expansion in global mandates. The U.S. is a big debtor nation. I think people have recognized that a good portfolio should have more international solutions, whether they’re equity or fixed-income. And then finally, I think we’ll see more guaranteed-income solutions around the whole fixed-income area. It’s a big area.

In addition to more traditional fixed-income [investments], I think we would expect to see more guarantees, whether in the form of immediate annuities or more innovative packaging of mutual funds with guarantees. We would expect people to look for more guaranteed solutions in light of what’s been going on in the last 18 months in the market.

InvestmentNews: That seems to be something people have been talking about for a long time, and what I hear is that it’s very expensive to put together. How do you overcome that?

Mr. Jessee: I think the advisers are, at this point, uncertain how to use the products. They’re unsure of the pricing, and so I think there’s hesitation on their part to adopt it. But ultimately, the guaranteed-income or guaranteed type of solutions are something investors are going to seek out. I’m just not sure advisers, for the most part, have gotten comfortable with that.

Mr. Waltman: It hasn’t worked that well in the past, and going forward, it’s a “show me” game. Show me that it’s going to work, and show me that it’s going to guarantee that income.

Mr. Parker: I think the target date products, while they have been well-received in concept, have been almost unfairly tested. They’ve been put to the test in a very difficult market, and I’m not so sure they have accurately reflected their capability. I think the jury is still out.

Mr. Waltman: Look at what happened to the 2010 target date funds in 2008, when they lost on average about 22%. That’s out two years. The expected outcome didn’t take place. The expectation that investors had when they put money in those products didn’t hold water.

InvestmentNews: So what can the fund companies and the fund advisers do about that? Do they go back to the drawing board with those products?

Mr. Waltman: In target dates, you are seeing a lot more alternatives being included in the asset mix and in the glide path. I think that’s one way to mitigate heavy declines when markets are really pulling back.

Mr. Jessee: Part of it, too, is making sure people understand what they’re buying. You know, even with the target dates that were a couple years out, I think the assumptions made in the allocation were that the person may retire but then will still hold the investment through their retirement years, which as we know is typically going to be a 20- to 30-year experience.

So I think people were confused when they saw a specific date, that that was the endpoint, and I’m not sure that was always the allocation that the folks had. I do think [we're] seeing more alternative-type strategies coming into the retail marketplace. Clearly, we’re seeing some pretty good momentum on that side.

Mr. Fisher: We’re seeing a lot of interest in immediate annuities. You’re essentially giving an insurance company a lump sum, and you get an IOU for a lifetime income stream. I think where the industry has gotten in trouble is trying to put a whole lot of things together. But having that become more and more legitimized as an asset class, as part of an entire portfolio complemented by funds, may be a solution that will be easier for advisers to understand. They are getting the idea of an immediate annuity. And then if you couple that with a diversified portfolio, you’re able to say, “Some portion of this portfolio we have guaranteed,” and that may allow us to take more risk or a longer-term view with some of our other investments.

Mr. Parker: Your question about product development is interesting. I was thinking about this the last few days. I don’t know what is the cart and what is the horse. But I think it’s been less about product development and more about trying to tailor our respective stories a little bit better in the context of: Where do our products fit in the mix, particularly now with development of the [unified managed account], which is forcing advisers to look at investors’ positions beyond just what they hold? Looking at what’s in the client’s 401(k) and looking at things more holistically, I think, has challenged us as asset managers to refine our story as opposed to changing the product.

Mr. Jessee: It’s very expensive, too, to roll out lots of new product. I’m not sure the marketplace wants to hear [from us] every time, “Hey, we got a new product, we got a new product.” So I think taking the thoughtful approach of filling out where you may have gaps [is better]. We’ve tried to take things that we’ve had success with on the institutional side and think about ways that we can package that into something that would make sense for a retail investor. I think the other thing we’re seeing, too, is a lot more interest in a more flexible-mandate type of portfolio. You know, we went through a period where [we had customers] fill out the style boxes and to a large degree, that still exists. But clearly, investors and advisers like the idea where you take the handcuffs off the investment team and let them seek out the best opportunities around the world and among various asset classes.

Mr. Waltman: I agree. It’s also not about allocating to multiple asset classes; it’s about giving [portfolio managers] the ability to pull back and be defensive and go to cash. So people have learned through “08 that sometimes it pays to be really cautious and to go to cash. The buy-and-hold philosophy that worked forever broke down in “08.

Mr. Fisher: I think this down market showed that all the corners were very correlated, and [even though] you created what was traditionally thought to be a very thoughtful diversified portfolio, you were down almost as much as someone who was just in large-cap. And so the idea is to have a firm that has the ability to invest in those assets, but in a strategic way.

Mr. Parker: We also have to pay attention to the clients’ appetite. Their appetite today is less for sophisticated products and more for a return to basic and fundamental stories.

InvestmentNews: Are advisers telling you that clients are looking for alternatives to just buy and hold?

Mr. Parker: Well, at the risk of starting off on a negative, clients clearly have had reason to throw up their hands and wave the white flag. And likewise, there are advisers who at the end of the day are no different. They’re consumers, and they have the same frustration and, candidly, the same cynicism. I think what they’re looking for from folks on our side of the fence are answers — potential solutions as to how they can stem the tide. I think what we’re hearing from a lot of our distributor partners is less about a sophisticated product and more about a fundamental story, and I think that pervades everything we do.

It goes to the way we have our collateral. Many of us have a warehouse full of collateral that’s now outdated because all the benchmarks we used for the last 10 or 20 years are meaningless, because their history is not a benchmark, or a complete benchmark the way it once was. We’re now refashioning our story to get to a much more — and I’m sorry for overusing the word — fundamental approach. And that goes to the appetite for alpha, and that goes with the client’s and adviser’s discussion about what are they going to do differently now — which is not just putting more money in the same funds that they owned three years ago.

InvestmentNews: In an environment where you are going back to basics, it seems like some of the boutiques have carved out a niche for themselves, not in the basics but in style investing or sector investing or something along those lines. In this environment, is it harder for the boutiques to compete?

Mr. Waltman: I would say no. I think with the boutiques, it’s that you have a very specialized approach that you believe in as a pure investor. I think maintaining and telling that story and getting it out to the advisers is more important than ever. They’re looking to get back to basics, and back to basics is knowing what you’re investing in and knowing the people behind who’s investing your money and understanding how they do it and why they do it.

Mr. Parker: You know, after spending years with larger firms, I saw the market pooh-pooh boutiques. They had these artificial requirements. Three-year track record, $150 million under management, and so forth. Now, for the first time, I would have thought the distributors would give the boutiques the veritable Heisman. They’re actually embracing the boutique, because if nothing else, it’s a new name at a time where people have had some of their appetite soured against the bigger players, for all the obvious reasons, and they’ve also recognized that they’ve left a lot of alpha on the table having these artificial requirements for smaller shops.

Mr. Jessee: The rise of the advisory platforms is going to continue to play a big role in how advisers access asset managers, and that opens up the door for the boutiques. At the end of the day, you’re going to compete based on performance and your ability to deliver alpha, and at what cost you’re willing to pay for that.

Mr. Parker: Absolutely.

Mr. Jessee: It seems to me the tougher side is maybe if you’re not exactly a boutique shop. You have some of the expenses and costs of being more of a midsize player, and how do you grow to be one of the big ones? I think that’s probably a little more the challenge.

Mr. Fisher: I sort of have an interesting perspective here. At MainStay, we call ourselves multiboutique management. We’re a good-sized firm, but we’re organized around smaller boutiques because we think alpha can best be created in smaller groups as opposed to larger. I mean, it works either way, but we found it successful. So we’ve kind of leveraged the boutique aspect of the smaller firms that we’ve purchased, and we give them their independence, yet we sort of benefit from the broader distribution and other additional resources that you might get at a bigger firm. So I would agree with you. We’ve seen quite a lot of interest in our boutiques. I think advisers are interested in looking for alpha wherever it may be, and I think the gatekeepers at the larger distributors are very open to new ideas.

InvestmentNews: It also seems that we are seeing more M&A activity in the last few months. I’m wondering if you expect that to continue, and why or why not?

Mr. Jessee: I think it will. And again, I think it’s the midsize firms. They’re not exactly a boutique, they’ve got a fairly expensive model in place, they don’t have the scale — and their margins are coming down. So I think those are the more likely candidates.

Mr. Waltman: I do think, though, that there are some larger deals still out there, as you see insurance companies and banks looking at their books of business and really focusing on what their core businesses is, and in many cases, that may not be asset management. So they may be looking to shed that piece.

Mr. Parker: And notwithstanding the economics, there’s a real reason for smaller shops to need to be acquirers, because there’s only so much organic-growth capability without waiting an awful long time to see that realized. You have to go out and complement your existing capabilities. And candidly, it’s a very strong buyer’s market.

Mr. Fisher: I would expect it to continue as well. We’re starting to see a pickup. I think money managers are no different than other businessmen — they don’t like to feel like they sold at the bottom. They’re used to selling stocks near the top. And I think with some improvement in the market, I think we’re now at a point where prices are fair.

Mr. Waltman: With the volatility in the market, I think that what you’ve seen over the past year is the difficulty of actually valuing companies and valuing a deal. Putting a price tag on a company is a very difficult task when you’re in the midst of this recovery, or even earlier when the markets were really in tough shape. So I think once the markets settle down, we’ll have a little bit more certainty in asset level and flow level, and we’ll be able to value a company with reasonable certainty. Then you’re going to see the deals start to pick up.

Mr. Parker: A lot of the driving forces behind the M&A activity is distribution. The folks that have it can leverage it, and the folks that don’t have it are looking for a home, a platform, a mechanism to maintain and grow their assets. I think it’s probably a hotter sales element than it was five years ago.

InvestmentNews: The largest companies — the Fidelitys, the Vanguards — control the bulk of the assets. Do you see that changing at all, based on what we’ve seen in the last couple of years?

Mr. Jessee: Yeah. I think there’s a big market shift going on right now. Part of it is, you have a lot of assets with those companies where people are disappointed in the results, and they’re looking for alternatives. So, yeah, I think there’s quite a bit of market share shifting right now. I think the big companies probably have a little bit too large a percentage, and it’s hard to continue to generate the returns at certain levels.

Mr. Waltman: [Given] the size of the large firms, it’s difficult to continue growing at that pace. If you just look at the asset base and the normal redemption rate on that asset base, the amount of gross sales you have to generate to just overcome the natural pace of redemption is huge. And to continue that growth at that pace — it can be unsustainable.

Mr. Fisher: Performance is difficult, too. I mean, obviously, there’s some outstanding large firms out there. But when you start getting lots of funds over $100 billion, in some cases over $200 billion, it’s hard to argue going to market. And the opportunity firms with a billion dollars in a fund or whatever, the flexibility’s much greater, especially given the type of volatility we’ve had in the market, not just domestically but on the global basis. So I think all of that’s probably playing toward some reduced consolidation. I saw some data very recently from the [Investment Company Institute] that suggested this was the first year in some time where the share of the top five [mutual fund firms] dropped very significantly. And I think that may very well continue.

Mr. Parker: Let’s not forget that if there’s ever a time, ever a market to have the investor and the adviser be sensitized to overexposure — overexposure to a larger shop — this has been it.

InvestmentNews: Have your firms undergone a lot of cost cutting?

Mr. Jessee: The market downturn did force you to take a look at all of the areas of the company and think of which ones you could potentially pull back from that would have little impact to the end-investor or the adviser. At the end of the day, we had a couple of field positions [that were cut]. We still maintain a very large field but looked at smaller territories. Ultimately, I very much agree with the idea of having long-term continuity in the relationships. I value that very highly. But conversely, there were just some obvious ones that we could get some savings from. You know, nothing real dramatic on our side.

Mr. Parker: We’re building out an adviser-assisted and institutional business after traditionally being a direct-marketing business. So the one word that’s not in our vocabulary right now is “maintenance,” because we’re building. And having said that, this is not unlike the conversation about it being a good time to be a buyer. This is also a great time to be acquiring talent, because, unfortunately, people have had to cut resources. That means some great talent is available in distribution, in marketing, sales obviously, but also on the portfolio management side, the analytical side.

Mr. Fisher: I was going to say, we’re in a unique position, too, at MainStay. We have a very strong parent in New York Life [Insurance Co.], so we were actually building through this downturn. We had a record year in 2009, and we continue to grow. That said, I think that hiring industrywide may begin more in what we call the hybrid wholesalers and the internals, [who] can provide very good service to financial advisers and home offices without all the travel costs, which is quite substantial these days.

Mr. Jessee: There are obviously huge growth opportunities in the [defined-contribution-only] business, so we added to those teams last year. We added to some institutional positions because we thought that, for a person or two, there were large asset opportunities. We’ve recently formed a relationship with a large U.S. distributor that is going to require more coverage out in the field, so we’ve been adding wholesaler positions specifically to help cover that firm. So we’re adding, but you’re making a bet [between] your fastest-growing areas and areas that may be more in a maintenance mode and then shifting resources accordingly.

InvestmentNews: Tom, I’m curious about your thoughts on this, because I know you’re hiring some analysts. What’s your take on the environment right now?

Mr. Trala: I agree, generally speaking, that this is a good time to be a buyer of talent. We used the October 2008 market shift to take measure of who we had in the shop, and we found that we had a fair amount of legacy folks who weren’t properly set and were maybe too seated, so they were part of the cutting of staff.

We also muscled through early “09. By the middle of “09, we were hiring in sales, and we found that there was some fruit to be picked out there — not only the junior people but also some senior people who had been let go. Of course, a firm the size of Turner, we needed that seniority to establish territories. So we were really fortunate. Now, of course, we’re not quite a year on, so I can’t say we have a gelled retail-sales force. We’re only talking about 10 in the field, with five supporting back at the shop. We’re not talking about a large firm, to put it in perspective. Turner’s got a $2.5 billion-dollar fund family with 13 funds, so no doubt, I’m probably the smallest of the fund families sitting at the table. But it’s enough, because I really don’t care whether [The] Vanguard [Group Inc.] or Fidelity [Investments] loses market share, because I’m so far back down here in the market share game, that I can pick up gross flows regardless of what’s going on at that level. We’re hiring analysts now as the second step of hiring.

InvestmentNews: Looking at the distribution channels, what changes do you see going on out there?

Mr. Jessee: The one thing I’d say is that at the end of the day, the wirehouse is still a large distribution opportunity for everybody, but there’s no doubt that in the last couple of years, you saw several advisers go into the regional firms. So the one thing I’d say is that the comeback of the regional firms present us with a good opportunity. The independent side is obviously a very important side, too. The nice thing that we find with our independent business is, they tend to buy more products, so if the typical wirehouse relationship buys two and a half MFS funds, our average independent adviser is buying five-plus.

Mr. Parker: I think there’s a direct relationship between the bullishness of the market and the willingness for the adviser to listen to the respective asset manager. And when things have changed like they have, asset managers now have a greater opportunity to have a conversation, and they have a more welcoming ear among advisers.

InvestmentNews: You are building your business. On what channels have you focused?

Mr. Parker: Well, surprisingly or not surprisingly, we thought our first foothold should be among the [registered investment advisers], and we’re very fortunate that we have a nice business among the RIAs who trade through the institutional platforms. What has been a great surprise for us is the acceptance of smaller firms by the wirehouses. Five years ago, the wirehouses may not have looked at them, but there are now academic studies that support why big firms should not be leaving alpha on the table and should be working with smaller firms. So subsequently, we’re excited that we’ve had opportunity to be on Broadway, when we thought we’d be in New Haven for a while.

Mr. Fisher: There’s been a lot of changes at the wirehouses. They absolutely continue to garner a tremendous amount of the business for all of us. They’ve been through their transition. They’ve enhanced their management. Their research people are really strong. They’ve taken some of the best from the institutional firms, so they’re really quite easy to do business with. They’re very clear in terms of what they’re looking for in money managers, and as such, we do a lot of business there. But it’s also a good time to be a financial adviser. You have a lot more choices than you had before. You have some strengthened wirehouses, some strengthened regional firms. It’s never been easier to be independent. So I think all of us are looking at the various channels and then serving them the way they want to be served.

InvestmentNews: But it is more costly to go after RIAs, isn’t it?

Mr. Jessee: It’s hard to make gross generalizations, but in general, RIAs probably want more of an institutional relationship with MFS. It’s not quite as heavy on the traditional wholesaling. So maybe we come out once, twice a year, explain the process, and give them that type of information, as opposed to a traditional wholesale approach. When they implement strategy, they do it across their entire client base, so you see large amounts come in. Conversely, if they’re taking out, you see large amounts going out. So we approach the RIA side more with a hybrid approach and separate them from the traditional independent wirehouse side.

InvestmentNews: Getting back to the wirehouses, I was under the impression that they were trying to squeeze more out of the asset managers in terms of revenue sharing because their own bottom lines were under pressure. Is that something you have seen?

Mr. Parker: Maybe before making a comment about what the squeeze has been, typical to lots of businesses, the pendulum has to swing to one extreme before getting back to center. People would argue which extreme happened when, but there was a time when the asset management side of the equation had maybe a lot of power at the harm of the distributors. And then there was a time where the distribution had an awful lot of power at the peril of the asset managers.

I think the market has allowed the pendulum to come back closer to center, and there’s been greater collaboration. You want to talk about the economics, but I do think there’s been a more collaborative dialogue now than there has been. And maybe it’s just a “kumbayah” benefit of what we’ve all been through, because all of us have been affected by this market almost equally, and I think it’s made for better conversation. And we’ve all seen one extreme or the other, but I think now it’s a little bit more balanced. Hope that lasts.

InvestmentNews: Switching gears a little bit, what do you think about the growth that we’re seeing in ETFs? What are the implications of that growth to your businesses and to the mutual fund industry in general?

Mr. Jessee: Well, it seems from what we’ve seen, so far most of the growth on the ETF side has been more on the passive side. On the active side, there’s lots of talk and lots of product development, but so far in terms of actual close, it’s been primarily the passive approach. It’s not a business that we’re particularly interested in, frankly, active or passive at this point.

InvestmentNews: Why is that?

Mr. Jessee: We’re a firmly committed active manager, so we’ve never gone down the route of a passive approach. On the active side of the ETFs, I think it does [raise] some challenges around portfolio disclosures [in] that it’s tough to run a $180 billion business and have the portfolios that would potentially have transparency on a daily basis. That’s a difficult one for us. So it’s not something that we see we want to be an early adopter in.

Mr. Waltman: I also think you look at the ETF marketplace, and it’s really serving two different clients. One is more retail-oriented, and it’s more of the passive [approach], looking for the index-type product. The other is more of the institutional trader that’s looking for access to different asset classes and levered type of access. The institutional trader market [is one] that most mutual fund companies, for the most part, are not in. They’re in the business of long-term investing. And so I think that sort of is one side of the market.

On the other side, mutual fund companies want active investors, not the more index passive investing of ETFs, and that’s why they’re going to stick to their knitting in that regard.

Mr. Fisher: I think it’s positive for the industry to see those flows go into essentially a mutual fund. Yes, 99% of the flows are going into the passive; active is just beginning. But I think it’s healthy. It probably has taken a lot of money from more traditional index mutual funds — some stock money. Instead of buying an individual stock, you can buy a whole industry, a whole financial services [sector], which is probably positive. It’s had a little more impact on the [separately managed account] than on the straight mutual fund. And I think any competition is good. The active managers will have to continue to produce alpha or there’s an alternative out there. So I think it’s been positive. It’s keeping a lot of flows in the industry, and I would expect it to continue.

Mr. Parker: I would agree that it’s positive. We’re not in the ETF business — at least at this point, we’re not in it — and I think philosophically, you can’t argue that it is an absolute. The fact that we’ve had advisers and investors embrace ETFs I think is significant of the paradigm shift from institutional to individual. I don’t think we call it retail any longer. And that’s a positive thing. I also think what’s very positive is, it’s complementary. Not to sound Pollyannaish, but I do believe that none of us on either side of the equation, and those that participate in bulk mutual funds and ETFs, are interested in a zero-sum game. I do think that in the right market, this will expand the business and free up a lot of the investible dollars that have been on the sidelines. And whether it goes into ETFs or open-end funds or SMAs, I don’t think it’s nearly the threat that people have ascribed it to be.

InvestmentNews: Tom, what’s your take on it?

Mr. Trala: As a smaller firm, we are decidedly active, and so we don’t want to be seen as someone who sort of comes or sits behind a passive ETF. I’m not so sure we’d be very good at it. So we do look at the active ETFs, which we know is a fraction of not only the overall ETF but the overall investible dollars. We could easily take one of our products and sort of port it over to an active ETF. But I don’t think it’s a game changer. I think we [could] pick up some dollars. It would be nice to be in a couple of different channels, meeting a couple of different people that we don’t already know through our mutual funds. And so we’d see it almost as an opportunistic sort of introductory vehicle. That’s about where we are.

Mr. Fisher: It doesn’t get talked about a lot, but the passive fits much better with equities. Fixed income, where the index could be several thousand bonds which are impossible to replicate, creating a 100-bond ETF, has very high sort of tracking error and might not be as ideal. So I think where it’s stuck so far makes sense — sort of an alternative to an index mutual fund. But we’ll have to see going forward how much it expands beyond that.

Mr. Parker: It is Darwinian. We have sector-specific funds, and I think a few years ago, we would have been put up against ETFs, and history has shown that active management in sectors sometimes beats those passive ETFs. And that Darwinian nature of the business, whether you’re looking at ETFs versus open-end funds, it’s no different than when you’re looking at equities and fixed income. It depends on the performance at the time, the investor’s needs, and hopefully, there’s room, and there’s enough investible assets for all to survive. There was a time not too long ago where people called a separate account a real threat to open-end funds, and look what we’ve proven there. They’ve been a great complement. Clearly, the ETF is not cachet; it’s a very formidable piece of our business. And I think the prize will go to those folks, whether on the distribution side or the asset management side, who figure out a way to [make it] work — if not by owning those products, at least by being in a business to complement each other in some form or another.

InvestmentNews: Given the popularity of ETFs, do you think they will drive down expenses and costs on mutual fund products?

Mr. Jessee: Well, as the point was made earlier, I think competition’s good for the marketplace. Bottom line is, if people have low-cost alternatives available, they’ll put pressure on everybody to make sure that expenses are reasonable, and if you do not provide the performance, people are not going to overpay for a beta play. So ultimately, I think it’s good for the marketplace, because the end-investor will end up with a better value. So again, I think it’s positive.

Mr. Trala: I don’t know the actual stats, but I saw something that said long-term investible assets in the fund business are $7 trillion. Does that sound about right? And maybe 10%-12% of that, under a trillion, is in ETFs. The way I see ETFs being used, as we’re an active asset manager, is in portfolios, to gain exposure to one thing or another on a very short-term basis, not to reduce turnover of the stocks. I don’t know the split between the retail user, who’s ultimately using it in place of a mutual fund, versus an institutional portfolio manager, who’s using it in place of a stock. If it were 50/50, I’d say OK, there’s $325 billion chomping at the mutual fund apple, and at some point, they’ll reach critical mass and really be able to drive down fees. But even if it’s 10% of the overall asset pie, I’m not so sure there’s enough buyers yet at the table demanding an accounting, if you will. It’s almost too small. Within the next 10 years, yeah, maybe — if it kind of gets that critical mass.

InvestmentNews: Do you think the SEC is going to do anything about 12(b)-1 fees this time, and if so, what would you like to see happen?

Mr. Waltman: Sure. I think it’s a jump ball right now. You have [SEC Chairman] Mary Schapiro saying that we’re going to definitely have a proposal in 2010. Then you have Buddy Donohue [director of the SEC's Division of Investment Management] saying that there’s more important things to be focusing on. So you’re getting that sort of mixed message. So honestly, I couldn’t tell you one way or another what’s going to happen. I know that it may not happen this year, but obviously, within the next three years, there will be some type of revamp of the 12(b)-1. Personally, from my perspective, the 12(b)-1 has worked very well. In existence for 30 years, it has really done its job, helped grow the industry and also reduced fees over time. So I think it’s worked well, and I think that if it stays in existence as is, with some tweaks around disclosure, etc., I think it will continue to be a positive for the industry.

InvestmentNews: Jim, what are your thoughts?

Mr. Jessee: We’ve had this on the table for the last several years. It doesn’t seem to go away. But what I would like to see is more-meaningful disclosure and better clarity. People should understand what it’s being used for and what they’re paying. If they don’t want to purchase a fund that has a 12(b)-1, there’s plenty of other choices. But I would like to see us get back to disclosure that’s actually meaningful and understood, and not just another line item in a large document.

InvestmentNews: What is “more-meaningful disclosure”?

Mr. Jessee: Maybe a better description of what a 12(b)-1 even means. I don’t think the average layperson understands what it is. You know, maybe it means being more clear in terms of dollars and cents. Right now, it’s obviously a basis point disclosure in the prospectus. Maybe it’s something that says, “If you have $10,000 or $100,000 in the investment, this is what the cost is going to be, and this is what it’s being used for.” Those would be things that the average layperson could understand. And again, give them the choice. If they don’t want to pay it, there are other options available.

Mr. Parker: We’re all up for greater transparency. I think from a legislative standpoint or from a government intervention, I think we’d much rather see people focus on capital gain on funds than maybe 12(b)-1.

InvestmentNews: The last time there was a focus on 12(b)-1, everything was on the table, including repeal. How would that change the industry?

Mr. Jessee: Well, one thing — and we’ve already seen it happening to a large degree anyway — is the advisory platforms’ being a vehicle that people use to purchase funds. I think they’re going to continue to grow in popularity. I think you would see potentially money that’s in C shares probably most likely gravitate into those types of products. I mean, the B share business is effectively extinct. It’s, what, 3% of the industry flows right now?

Mr. Fisher: It would bring simplicity. We would see a great reduction to the number of share classes. It would probably require some discussion, a dialogue with distributor and manufacturer, to understand the fees and the products, and the needs of both.

Mr. Jessee: I do think the industry’s obviously grown tremendously in this 30-year period, and part of what’s driven it is that people like having choice. They like having different options. Back in the first 50 years of the industry, when front-end costs were traditionally 7% or 8%, it was a fairly slow-growing industry. So I think choice, as well as [making sure] people understand what they’re paying for, are good things.

Mr. Parker: But let’s not lose sight of what it was created for in the first place and how people have actually used it to the benefit of the ultimate investor.

InvestmentNews: Does that mean you’re in favor of the 12(b)-1 going away?

Mr. Parker: I’m not so sure it’s a question of whether it should go away or not go away. I think maybe the bigger challenge is to communicate more fully and, from an education standpoint, have the American public understand what the utility of the 12(b)-1 is. I think that may be our bigger dilemma.

Mr. Jessee: I think some smaller players in the industry would have a very tough time financially. The bigger companies with the scale will end up being fine, but you could, in fact, reduce the competition by having some small mutual fund organizations not be able to compete without having that revenue source.

InvestmentNews: Does that ring true for you guys?

Mr. Waltman: From my perspective, it would put everybody on an even playing field, because they’re not going to change it for one group, and not for another. So it would be an across-the-board change, and whether you’re a smaller player or a larger player, it’s going to be a fundamental shift in the overall business. And you have to adapt to that. And whether it’s adapting as a smaller player or a bigger player, you’ll have to do that.

Mr. Trala: Turner’s been a no-load family, so we’ve learned to live without 12(b)-1. But it would help to probably name it something other than “12(b)-1.” It would be nice to call it something else. That would go a long way — shed some light on what it actually is. I think prohibition of it is probably never the right answer.

Mr. Jessee: In our world, the bulk of the 12(b)-1 is going to the financial adviser for the ongoing service that they’re doing. And so while there may be technology improvements, the adviser still has ongoing meetings with the investor, and it’s a way that they continue to effectively be paid for the service they’re providing there.

Mr. Trala: So it’s a basis point or two perhaps around the edges but by and large still used to compensate individuals who are advising. It might have been by paper, and now it is electronic, or used to be delivered in person, now it’s by e-mail or something.

InvestmentNews: With so many assets going into fixed-income funds right now, it could be construed as a bubble. Does that raise any concerns?

Mr. Jessee: One thing in our business today that I’m most concerned about — and part of it is having survived the “94 bond market period and also the late “80s — is the fixed-income investor. Let’s face it, nobody likes to lose money, but the equity investor who loses money understands it was a risk trade, and the fixed-income investor, I think, has very unrealistic expectations of potential volatility. They tend to buy the funds like they would shop a [certificate of deposit], and whoever has the highest yield is the best one to buy. We all know that that’s not a particularly effective way. In fact, you can get in absolutely the wrong product.

So I do get concerned [that] people are going to be surprised with what happens with fixed-income portfolios. So what we’ve tried to do is talk to the sales desk about what will happen. And rates will go up at some point. I’m not saying we think it’s going to happen in the next three months, but sometime in the next couple of years, I think it’s safe to say rates will be higher than they are today. And [we want to] make sure somebody didn’t go out, flee from equities just to fall into a bond trap.

Mr. Fisher: We’ve been talking a lot about municipals, because, one, their duration is shorter than your Treasuries, and if we do get a tax increase, which most people would bet on, that’s going to be [favorable]. The technicals will be very strong, there will be a lot of demand, and in fact, those bonds will likely hold up a lot better. So we’re talking about potentially transitioning money that’s not in an [individual retirement account] into the muni market as a real positive. And we’re also talking about more flexibility funds that can give you some income and some growth potential, but in more conservative equities, more conservative bonds with some active management. So they’re not just left standing there. We hear a lot from people, “No one ever told me when to sell.” So they’re in intermediate bonds, interest rates go up 200 basis points, they lose money. But in a flexible portfolio, the manager’s doing that, and the broker doesn’t have to call you, “Is it OK if we sell this?” So I think those are all things that are helping.

Mr. Parker: We’ve seen a re-newed interest in balanced funds. Even though it’s a little inconsistent with some of the platforms that are highly asset-allocation-driven and much more specific to the fund, we’ve seen a real interest in balanced funds.

InvestmentNews: So what keeps you guys up at night these days?

Mr. Parker: We have been blessed of late that people’s perspectives have come back to normal — their expectations for performance, etc. I’m concerned that with a wild run-up in the market and the return of a bullish market, that people may revert to the proverbial greed factor, and that will completely destroy what has been a benefit of the recent market. And that’s recalibrating people’s more realistic expectations.

Mr. Jessee: I think the fixed-income side concerns me — that people have unrealistic expectations of what a portfolio manager can do in a rising-rate environment. And you know, again, with a lot of bond investors, any type of loss — even a 3%-4% loss — is unacceptable. And I do get concerned that we’re going to have people very disappointed as we saw in other periods of rates’ going up.

Mr. Waltman: Mine is more global — a double-dip recession. You see employment out there that has not come back as strong as we’d like to see it. And if you look at the beginning of the recession, consumer spending is what kept us out of a recession for much longer than anticipated. I think that that consumer spending is further out, and if it doesn’t come back, we can see another dip. That’s what keeps me up.

Mr. Trala: My perspective seems unworldly by that regard — and it could be my accountant upbringing — but probably the things that keep me up at night are stickiness of assets, paying sales guys on gross and [things like that].

Mr. Fisher: I take a bigger-picture approach, I guess. I think it’s really trusted integrity in the financial system. I mean, after all, we’re offering products with a long-term payoff, and middle America — really most of America — is losing its faith and trust in the integrity of the system, and whether we like it or not, we’re lumped in with everybody else.

InvestmentNews: Is the ICI doing enough of a job to ensure trust in mutual funds?

Mr. Fisher: I think they are, but I think it’s incumbent on everybody. I mean, this isn’t just somebody speaking in Washington. I think it’s every firm, every wholesaler. I think it’s incumbent on all of us in how we advertise and what we promise and the products we offer. This is a really important time to really stick to basics and have the right messages. And I don’t think the ICI can do that on its own without all of us. Taking a long-term view, I think we are in a great industry, but this is an important time. And if you read the paper, the public’s angry, and they have a lot of reasons to be angry, and we have to show them that we offer the right solutions and [that] we deserve their trust. They’re trusting us with $7 trillion.

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The debate goes on: To Roth or not to Roth?

For the superwealthy, conversion is a slam-dunk; others should be more careful

April 4, 2010 6:01 am ET

The following is an edited transcript of an InvestmentNews.com webcast held in New York on March 9. Moderators were InvestmentNews deputy editors Evan Cooper and Frederick P. Gabriel Jr. Panelists were Ed Slott and David B. Loeper. To listen to the archive of the webcast, visit Investmentnews.com/rothtranscript and click “View archive.”

InvestmentNews: Ed, you’ve been a proponent of Roth conversions for quite some time. Overall, do you still think it makes sense to convert?

Mr. Slott: It’s one of the biggest practice-building opportunities for any adviser right now, and any adviser that’s not addressing this is making a huge mistake.

I’m not necessarily saying to do a Roth or not to do a Roth, but remember, in 2010, every client with a 401(k), a 403(b), an [individual retirement account], any sort of retirement account like that that has an eligible rollover distribution is a Roth conversion candidate, regardless of income. So this opens the floodgates for Roth conversions, and if your clients aren’t getting this information from you, chances are, they’re getting it from somewhere else, because they’re all interested.

Most people are worried about what’s going on in the government — probably see tax rates’ going much higher. I believe tax rates will go through the roof, just taking into account everything that’s going on. But here’s the big opportunity for advisers: As the president said, there’s a deficit of trust among clients who are unhappy and looking for advisers who can give them this type of advice. The floodgates are open.

And another important point is that the floodgates are open for a whole new crowd of clients — high-net-worth, high-income clients who never qualified for a Roth before, and those people are looking for advice on whether to convert or not. And I think that’s probably a place to start.

People with the largest IRAs are probably the best candidates for a conversion for estate-planning reasons if they have the money to pay the tax. They don’t need the money for a long time; that’s a key.

Need is a key requirement, not so much age. For example, someone converting after the age of 70 years is not converting for himself or herself, because the cost versus the benefit in the life expectancy is probably not worth it; they’re probably converting for the next generation or for grandchildren.

For estate-planning purposes — if you don’t need the money and you want to pass it on — it’s almost a slam-dunk, especially if you have clients like mine who are over 701/2 and hate required distributions. All of my clients who are taking required distributions are being forced to take money they don’t need, pay tax on it and add it to their existing income. So now all the other items on their tax return start to cost more. They start to phase out their exemptions, deductions, credits — all the tax benefits that tend to phase out when your income increases.

The thing those clients like about a Roth conversion is that once you pay the tax, Roth IRAs have no required minimum distributions. Once the conversion is done, the people who don’t need the money can just let that Roth IRA grow for the rest of their lives. And if they have a spouse, they can leave it to the spouse, who can also roll it over to his or her own Roth IRA and let that grow for years uneroded by taxes. Then it will pass to beneficiaries — at some point, it’s going to pass to a non-spouse beneficiary — and they will have to take required minimum distributions, but only after the death of the Roth IRA owner and the spouse if the spouse is the beneficiary. And even then, the required distributions they take will be tax-free.

Since conversions are a great way to transfer wealth, especially if the client doesn’t need the money, many wealthy or high-income people who didn’t qualify before are looking for this information now. And the more money a person has, the more they hate taxes. That’s just the golden rule. They see what’s going on and realize that they’re going to be hit with any tax increases first, and it might pay to bite the bullet now at relatively low rates. I believe we’re in probably the lowest tax rates we’ll ever see in our lifetime, just looking historically. And values are relatively low. So it’s almost a double sale on Roth IRAs — rates are low, and values are low.

And I’m not talking about values’ being low because of the stock market — they are low because of that; some of them are still depressed — but low in relation to the values that they will be in 20, 30 or 40years with growth that will never be taxed again.

I would also target people who have named a trust as their IRA beneficiary. Most people who have named a trust probably did it because they had large IRAs worth, say, $5 million or $10 million. The reason somebody names a trust is because they don’t want a $5 million IRA going to a 16-year-old.

Now, with a traditional IRA, when the required minimum distributions go to the trust after death, they may end up getting trapped, and a lot of these trusts are discretionary trusts where the trustee has discretion and may not pay out the required amount to the trust beneficiaries and accumulate the funds in the trust. Well, when that happens, they get hit with the highest tax rates in the land, trust tax rates, and that’s a big hit. For example, in 2010, an individual wouldn’t hit the top rate, 35%, until taxable income exceeds $373,650, but a trust hits that rate after just $11,200 of income. So most trusts are going to get walloped with taxes under that scenario.

A great planning move for these people would be to convert their IRA now to a Roth IRA. They probably couldn’t before, because of the income limits. I would say to those people, especially if that IRA’s going to a trust and you’re going to lose, say, 40% a year just in accumulations in a trust, [that] you make that a Roth IRA. Yes, there are required distributions after death, but the accumulations will not be taxed in the trust, because Roth IRA distributions after death will be tax-free. It removes the trust tax problem, and a lot of these people can’t stand that extra tax hit.

There’s one group on the estate-planning side where I think it really pays — those who don’t need the money, have the money to pay the tax and want to pass funds over to their children or grandchildren income-tax-free. A conversion also reduces their estate because if they convert, say, a $10 million IRA and they end up paying, say, $3 to $4 million of tax, that tax reduces their estate as well, so less money will be taken in estate tax, whatever that tax will be.

That’s one group that I think is a slam-dunk on the Roth conversion.

InvestmentNews: Dave, what makes sense and what doesn’t make sense about Roth conversions?

Mr. Loeper: I’d agree with Ed that it’s a slam-dunk if all your clients are people who have money coming out of their ears that they have no use for, and regardless of what the markets do in the future, you know that they’re going to have plenty of resources. It’s also a slam-dunk if all your clients are worried about estate issues.

But I’m not sure such people represent the preponderance of the client base of most advisers. And there’s a lot of uncertainty about what most people have to deal with.

Future income tax [rates] likely will be higher; I think that’s a pretty common consensus. A lot of times, we look at it from the perspective of somebody who’s young, [for whom] compounding over many years will make up for the immediate tax bite. We had already mentioned how people hate the costly RMDs that are associated with tax-deferred accounts. Beneficiaries, as Ed mentioned, might be in a position to have very high ordinary income tax rates applied to the benefits that they get. After all, the government has been very good to us over its entire existence, and it’s going to honor its promise for tax-free treatment forever, and there’s no chance of that ever being repealed.

InvestmentNews: Hmm, sounds like a little sarcasm there.

Mr. Loeper: We know how much it will cost to convert — that’s certainly something you can calculate — and we have the ability to model what the future values and goals of the client will be, so the question you have to ask yourself is: Of these things that are Roth benefits, which are certain, and which have some uncertainty?

The only thing we really know with certainty is what the costs are today. Future income tax rates might change, tax-free compounding over many years may not be a benefit, and all the other things are subject to some amount of uncertainty. Now, how much that all adds up to be depends on the unique client case, and every client is completely unique.

If you care about your clients, you have to be really careful about the assumptions that go into these analyses.

You should be particularly wary of an analysis of conversion in isolation of other goals and other assets or those that assume that the client is going to be in the exact same tax bracket and pay the same rate every year for the rest of his or her life. There’s no chance of that occurring, and you shouldn’t rely on a tool that’s assuming that. Also, avoid any tool that’s ignoring the risks and excesses of extreme markets — the markets are highly uncertain, and they always are, despite what many people might say. And then, also, just looking at everything from a marginal tax rate, because the reality is, [if] you’ve got somebody who has a $100,000 required minimum distribution coming out and they’ve got an $80,000 spending need, it’s not all going to be taxed at the marginal rate; their effective rate’s going to be much lower.

So you should take a step back and objectively understand, first, that the decision to convert an IRA — and again, I’m not talking about somebody who is deciding between an after-tax decision to go to an IRA or an after-tax decision to go to a Roth; in that case, it’s a no-brainer, go for the option of getting tax-free — means that you’re with certainty paying a tax now that you have the choice to avoid.

Now, that could certainly make sense, but there’s some hope associated with that. You would do that under the assumption that markets are going to treat you well enough that you wouldn’t need that money at some later date. Once you give the money to the government, you have no chance of getting it back.

Also, while we’re all looking at this assumption that tax rates are certain to go higher, there are some things like the fair tax — in essence a national sales tax — being discussed and getting some momentum. In 1999, when Clinton was in office, you would have never guessed that we’d be paying low capital gains rates on dividends from stocks. So it’s an erroneous assumption to say that there’s no chance that such changes can occur.

I am just a little bit suspicious that Capitol Hill wouldn’t be tempted to cease the tax-exempt status when there are thousands of millionaires that are not paying any taxes.

InvestmentNews: Dave, let’s look at the case study you provided about a couple in Virginia.

Mr. Loeper: I chose Virginia because that’s where I live, and it has a moderate state income tax rate.

And this might be somewhat typical of a fairly common client. They’re 66 years old, they’ve got $1million in IRAs and $378,000 in taxable assets — which is about the amount of the tax bill in connection with converting the IRA to a Roth.

The couple has a lifestyle need of being able to spend $90,000 a year net after taxes, adjusted for inflation. They are fortunate enough to be on a government pension, from which they’re getting $75,000 a year in non-inflation-adjusted pension benefits.

They have an estate goal of leaving behind $1 million. We’re going to plan on a life expectancy of 96, which is the 80% percentile of the spouse. We’re going to use a 60/40 allocation, which is our balanced allocation. We’re going to assume 1% advisory fees and investment expenses combined, 20% annual turnover, and then on any taxable assets that might exist, we’re going to realize 80% of the gains as long-term.

Most important, when we run the Monte Carlo simulation on this, we’re going to calculate dynamic taxes. That means that for this 30-year plan, we’re going to calculate 30,000 tax returns, 1,000 simulations, and each year, we’re going to calculate what the taxes would be in each individual year, based on forced RMDs, based on market behavior and all that stuff, which is much more realistic than assuming a fixed rate.

As for the confidence level — and this is not considering what beneficiaries would have to pay — we see that the regular IRA actually has 82% confidence versus 73% for the Roth, but of course, taxes are still owed on the portion that’s left in the IRA.

InvestmentNews: What does 82% confidence versus 73% mean?

Mr. Loeper: The percentage of the trials that exceeded that $1million estate goal and provide the $90,000 net inflation-adjusted spending need after tax.

And of course, any Monte Carlo simulation you run is only as good as the assumptions that go into it. This is based off of our capital market assumptions.

If you don’t like our capital market assumptions, I reran the analysis using 637 historical 30 year periods, and it happened to be the same intersection for probability for the Roth conversion.

I’ve taken the Roth conversion percentile outcomes distributions versus the regular IRA, and RMDs are indeed going to create some taxation, and force some excess money beyond the spending desires and spending goals of the client. And we see throughout the distribution, there’s a fair amount in taxable assets that end up getting distributed at low confidence levels. As we start going down through the distribution towards higher confidence levels; even at the 75th percentile, we see some taxable assets.

Now, we don’t know what the beneficiaries’ tax rates will be, but I can back in to calculate the tax rates that are needed to be at parity with the certainty of writing that check for $380,000 to the government in 2010 or 2011 that I don’t have to do and I have the option to do later if I’m making so much money that I don’t need it.

It’s very unlikely that the government is going to have a negative tax rate, like the fifth and zero percentile; your beneficiaries are not going to get your IRA assets and on top of that get a contribution from the government. So clearly, if you’re in very, very positive markets for this client’s set of goals, there’s a huge benefit of it. It’s also very unlikely that your beneficiaries are going to be at a 7.88% tax rate.

Understand that all those benefits, though, were at three to 28 times the goal that the client actually had. When you start working towards the middle of the distribution and downward, you discover that the tax rates have to be pretty darn high to make writing a check this year to the government make sense. At the 75th percentile, the beneficiaries would have to be at almost a 62% tax rate, and even at the median, at the 50th percentile, they’d have to be at a 34% — not marginal but blended — tax rate. And once again, here you’re at a goal that is already at two times the goal that they wanted to leave behind.

The one problem in all this analysis is the assumption that the plan is never going to change.

The odds are very high that the plan indeed is going to need to change. In fact, in the course of the next five years, there’s about a 68% chance that the plan will either become overfunded or underfunded, drifting into needless sacrifice. If the client’s got an extra $1 million or $2 million around, they might change their goals. Similarly, if they become underfunded, their goals might change too. We would argue that it should be your job to keep the client on track and adequately funded for the goals they personally value, and what choices they have amongst those goals.

But even if tax rates and goals were knowable in advance with certainty, just the market uncertainty alone means that conversion may be highly advantageous or merely a push or fairly detrimental — all depending on how bad the markets are.

The biggest Roth advantage usually exists when outcomes far exceed the goals that any client might have in really outstanding markets. For many, I would argue that there’s no need to rush to write that check. You can convert later, when some of the uncertainty of time has passed. You don’t want to be in a position of regretting having written that giant check and then having a need for that money.

InvestmentNews: So in essence, what you’re saying is that maybe it’s not such a great idea for most moderately wealthy people to convert or, at best, to just wait a while and see if conversion makes sense. Ed, how do you respond to that?

Mr. Slott: I do a lot of consumer seminars, and it seems that the people who come out for these events, especially now, are those who have $1 million or more in an IRA. There are a lot more of them out there than most people think, and maybe I tend to attract them.

But one of the misconceptions that most people have is that it’s all or nothing. People say, “Should I convert or shouldn’t I?” Well, a lot of people might be in the middle somewhere and should do partial conversions.

It’s important for advisers to mention that to clients: You don’t have to convert everything, even this year. Yes, it’s true; whatever you convert this year gives you a two-year deal, which lets you hold on to money for quite a long time. You include half the conversion income in 2011, the other half in 2012.

Mr. Loeper: At higher tax rates in 2012.

Mr. Slott: Right.

Mr. Loeper: It’s not really free financing. The government is mortgaging future tax revenue to get [revenue] now. And they’re making it sound like it’s free financing for half the tax bill, but they’re going to make up more than they’re paying on government bonds when the new tax rates kick in next year.

InvestmentNews: Ed, what are the other benefits to converting all or in part now?

Mr. Slott: Well, the other thing David pointed out, which I agree with, is that clients approaching age 701/2 will be forced to take this money anyway — maybe not as much. But the problem with required minimum distributions, you almost can’t change your mind at that point, because required minimum distributions cannot be converted. And some clients aren’t aware of that, even now, for a couple of reasons: First, they just don’t know the rule exists, and second, required minimum distributions for 2009 were waived, but they’re back now. So you still see some clients that want to convert now and convert it all after 701/2.

So once they hit 701/2, they have to first take their required distribution — and they can’t convert that money — so then if they want to convert, they actually have to take more money out to convert. So a lot of them should really look at this decision before hitting 701/2. In the 60s is a sweet spot for this, just looking ahead, that you’re going to be forced to take this money at higher rates anyway.

But the partial conversion is not a bad way to hedge your bets. You know, do a little in “10, “11 and “12, and little by little, get something into tax-free territory.

InvestmentNews: Wouldn’t this be something you would want to ease clients into? Ed, even your very wealthy clients probably would rather not go through all this and then have you say, “Oh, by the way, before you leave, you have to cut a check for $3 million.”

Mr. Slott: Well, yeah, it’s a lot of money, but you can actually work the estimated tax rules and the two-year deal to hold on to your money for a long time.

For example, let’s say you converted in January or do so now; you really don’t have to come up with any money for that conversion until April 15, 2012. You can hold on to your money for over two years, so whatever you earn on that, it’s like the government’s giving everybody — for a limited time — an interest-free loan to build a tax-free savings account. And as David said, yes, the rates kick in at “11 and “12, but you really don’t have to start paying the estimates. By April 15, 2012, you’ll owe the tax bill on the first half in “11, and then you’ll get into regular estimates for the next year. But you’re really holding on to a lot of that money for longer than most people think.

InvestmentNews: If a client decides to go the partial route, what would be the best way to approach it? What assets do you convert first?

Mr. Slott: What David said is right; it’s a client-by-client scenario.

Again, I go back to my three core questions: When, what and where? When do you think you’re going to need that money? If the client needs the money within five years of conversion, then generally they are not a conversion candidate. In fact, if they’re already thinking about when they can spend it, conversion is not for them. The power of the Roth is in the long-term tax-free compounding.

The “what” concerns what they think future tax rates will be. If they truly are convinced that they’ll be taxed at a lower rate in retirement, then conversion is not for them.

And finally, there’s the where — meaning: Where will the money come from to pay the tax? Nobody should go broke converting, so that’s where partial conversion comes in.

Then there are other items on a tax return to consider. I had one large client who lost a bundle to [Bernard] Madoff. Thanks to new rules that allow the deduction of those Madoff losses, my client — who still has $6 million in an IRA that [Mr.] Madoff didn’t get his hands on — can convert that money tax-free because of the losses he is able to deduct.

That’s an extreme situation, of course, but many other people have had a rough time, such as businesspeople who have had losses in their S [corporations], who may have situations that can reduce the cost of conversion. Again, that’s where partials may come in.

Another great thing to remember is the Roth re-characterization, which lets you undo any change. Anyone who converts this year has all the way up to Oct. 15, 2011, to change their mind for any reason at all and re-characterize or reverse all or part of the conversion to bring it right back to the point where you pay the lowest amount of tax.

For example, if any of someone’s 15% tax bracket is going unused, you should be able to throw in at least enough Roth conversion income to use up the bracket allowance, because it’s really a bargain.

InvestmentNews: David, tell us how you think advisers should approach partial conversions in terms of which assets go first. What would you do? How would you handle it?

Mr. Loeper: If you take a look at the [case study] analysis [available at InvestmentNews.com/rothira], we could have analyzed converting half of it. But all that would have done — throughout the probability distribution — would be to have lowered, at the fifth and 25th percentile, for example, the effective negative tax rate that they have to have if the markets are zooming. It would have been a bit more detrimental than it would have needed to have been at the 75th or 95th percentile, so there was a cost to it. And there is cost. There’s a lot of uncertainty that you’re dealing with.

Now, that’s not to say that I’m always against conversion or partial conversion; I’m not at all. But there are other things you can do to impact your tax bite — for example, putting your fixed-income investments in your tax-deferred accounts that will be subject to [taxation as] ordinary income, whether they’re in your taxable account or tax-deferred. Plus, in theory at least, because we normally assume equity returns are going to be higher, that will minimize the amount of RMDs that you’re going to be forced to make in future years.

So here’s my advice: Put your equities in your taxable accounts, where you can at least get favorable capital gains treatment, even though the dividend treatment’s going away.

I would definitely concur that if a client faces a reasonable probability of being forced into excess RMDs, taking advantage of making withdrawals from taxable accounts to support a lifestyle need now, in doing a conversion, a partial conversion, to capitalize on a 15% tax rate, then it makes sense again.

In each client case, therefore, it’s always a matter of minimizing taxes that you can avoid with certainty and exploiting low tax rates, as well as tax location benefits for asset classes — something you can also control. I can’t control what future tax rates are going to be, though.

Mr. Slott: And that’s one of the benefits of a Roth. You’re using known values.

One thing that the conversion does is remove the uncertainty of what future tax rates will be. I mean, whatever you’re paying now, it’s a known value, and that’s why a lot of these calculators that people are using really don’t help until you have better numbers, because the biggest input item is future tax rates. I have people who get their own solution by putting in a low tax rate and then say, “Oh, maybe I shouldn’t convert.” Other times, they put in a high tax rate and say, “Oh, I had better convert.” So you won’t have those numbers.

The best way to do it, like I said before, is probably try a conversion now; you really have nothing to lose, because it can be re-characterized up to Oct. 15, 2011. That’s over a year away, so by that time, you’ll have more-accurate numbers.

Maybe there’s potential appreciation that happens right now in the Roth. Let’s say you have $100,000, and by Oct. 15, it’s up to $150,000; you still only owe tax on the $100,000.

InvestmentNews: David, are Financeware clients asking about how to make the conversion decision?

Mr. Loeper: I’m really surprised at how much common sense most people have. I think most of the clients recognize that there’s not really a rush to do it; they’ve got a free option to do it sometime in the future. If I say, “I’ve run the analysis, and it doesn’t make sense for you to write a big check,” that’s what they wanted to hear. And for the goals that they value, it is oftentimes the right decision.

InvestmentNews: Aren’t these a hard sell for advisers? If clients walk into an adviser’s office and are told all about this Roth conversion, they’ll think the adviser looks pretty smart. But as soon as they are told to cut a check for $30,000, they’ll think the adviser looks a little less smart.

Mr. Slott: I would never say it’s a hard sell, because it shouldn’t be any sell. You know, the adviser’s neutral on this. The adviser doesn’t get a cut of everybody who does a Roth.

But I’ve got to tell you, on the other side, I have clients who know that they might have to write a check now, but what they get for that, their future tax rate, at least on Roths, will be 0%. You can’t beat a 0% tax rate.

Mr. Loeper: The tools that a lot of advisers are using are assuming certainty about something that’s uncertain.

InvestmentNews: Speaking of tools, David, could you identify some tools that might be helpful?

Mr. Loeper: No commercials here, but I haven’t seen one that I would trust for an analysis.

People are confused; they don’t know what the answer is. What the industry is doing — and Wall Street has a reputation for this — is exploiting action. They want movement, and they can exploit action and get movement by creating misleading tools that cause action. Whether that action is in the client’s best interest or not is highly in doubt, but there are many tools that can make very convincing presentations to get people to part with their money, and that’s what a lot of the industry is about, unfortunately.

Mr. Slott: Roth conversion discussions should be done as a service to clients, and maybe even to prospect for new clients, but based on good information that you’re going to do an analysis and address that to the benefit of the client.

There are those clients who just don’t want to have to pay any tax when they’re in their 70s or 80s; maybe they’re retired and don’t have income coming in. That’s the last time they want to have to suffer maybe a higher rate, and some of them are willing to pay some money now [in order to avoid that].

InvestmentNews: Aside from converting existing IRAs to a Roth, will you discuss the strategy of making non-deductible traditional IRA contributions and then converting those to a Roth?

Mr. Slott: To me, that’s a no-brainer. I did that myself. I put $6,000 in a non-deductible IRA and converted it to a Roth. To me, that’s just moving the money from one pocket to the other, and it’s tax-free in the other pocket. There’s absolutely no cost to doing that.

Mr. Loeper: If you’re going to pay taxes on the additional amount, it’s a no-brainer to stick it in a Roth or use a Roth 401(k). However, if you’re not maximizing what you can deduct, it all depends on your individual situation. In a paper I wrote on this topic, I gave an example of a 30-year-old who will not be in a particularly high or particularly low tax bracket in retirement, but [considering] the lifestyle cost of making a non-deductible contribution when he could avoid taxation and have more money working tax-deferred, it was actually beneficial for him to not make a Roth contribution. So it depends on the client.

In general, things that you can control with certainty, like not paying taxes now, is something that you should not ignore and just not jump on the bandwagon because some tool was designed to generate action.

Mr. Slott: For most clients, David’s argument makes sense if that extra savings is invested, but most clients, you know, while you’re doing their taxes, they’re talking about where they’re going to spend the refund. So most of that money that’s generated by the extra deduction is spent, and if it’s spent, to me, it’s wasted in that analysis.

InvestmentNews: Do you have any other thoughts on anything we’ve said thus far? Is there anything you want to add that we didn’t cover?

Mr. Slott: We talked about a no-brainer for estate planning, but I also think it’s a no-brainer for very young people. They have very small IRAs, very low tax brackets, or they’re just starting out. It’s very good to start out with Roth IRAs [because of] compounding over time. The greatest moneymaking asset anyone can posses is time. I did it for my own daughters as teenagers, opened Roth IRAs. It’s a great thing to mention to clients for their kids and grandkids if they have a little side income on a job. You know, that really adds up over time.

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Investment in young people can pay off

Not all planners will work with them, but they can turn into blue-chip clients in time.

By Lisa Shidler

March 7, 2010 6:01 am ET

Twenty years ago, investment adviser Greg Merlino woudn’t take on clients unless they had at least $250,000 of investible assets. For one young man, however, he made an exception, and it turned out to be one of the best decisions he ever made.

Mr. Merlino, whose firm manages $75 million, put the 30-year-old client on a systematic savings program. Today, the client holds the biggest chunk of the assets the adviser manages — $25 million.

“If I told him he didn’t meet my ideal situation, he never would have grown into this great client,” Mr. Merlino said. “I thought this guy would be successful, but I didn’t think he’d turn into the type of client he is now.”

Many advisers don’t market their services to younger people, because working with them is not as profitable as handling money for middle-age and older individuals. Those advisers who do relax guidelines on minimum assets often put young clients through a rigorous screening process and establish different fee structures and protocols to make sure they can still make money while satisfying their clients’ expectations. The hope is that these customers will thrive financially and eventually can be treated like other clients.

To determine whether a young client has the potential to increase his or her net worth substantially, pre-screening is a must, said Brian Peardon, a wealth adviser at Harrison Financial Group, which manages $200 million in assets. His firm turns away younger clients who don’t want to be coached and who don’t meet savings requirements.

SUPER SAVERS

Evan Shear, a certified financial planner and branch manager for The CrossleyShear Group, which manages $300 million, sets aside his firm’s $200,000 minimum requirement for younger clients if they are willing to save about 20% of their earnings a year.

“My view is [that] someone who is 30 and has the ability to put that money away will be one of my best clients by the time they’re 50,” he said.

Advisers who do take a chance say their young clients are open to being coached.

“Ultimately, they follow our advice to the T more so than clients of other age groups,” said David Hefty, chief executive of Cornerstone Wealth Management, which manages $125 million in assets. “They’re more engaged in terms of wanting to build the financial plan and follow the plan.”

Still, Mr. Hefty concedes that taking on these younger clients often means spending extra time with them, dealing with such matters as student loans, tax-planning, mortgage-financing and estate-planning issues.

Accepting the fact that these clients may take more of an adviser’s time also means accepting the fact that advisers may not earn much profit from these clients in the near term, said Chris Michalak, a principal at Moneta Group, which manages $7.2 billion in assets.

‘ONE RELATIONSHIP’

Mr. Michalak said his firm takes on young clients, regardless of the size of their investible assets, if they are the children of older clients. “If they’re the children of current clients, there’s not a lot we can do,” he said. “We tend to look at the family as one relationship.”

“Some years, it’ll be extremely profitable, and some years, you’ll lose money with these relationships,” he said.

Mr. Peardon said the only way his firm can devote attention to these younger clients is to develop a less costly way to serve them. While his firm offers its younger clients the same services it does the older ones, it has discovered that most of the former prefer e-mail and demand fewer office visits, which reduces the firm’s costs.

“We’ve been able to reduce the time and money so that everything is operating more efficiently and we can get a profit from this age range,” he said.

Mr. Merlino offers clients who don’t meet the firm’s minimum-assets guideline a pared-down version of a financial plan, which ordinarily costs up to $8,000, and charges commissions rather than asset management fees.

Having a cost-effective system of working with younger clients is essential, agrees Don DeWaay, founder and chief executive of DeWaay Capital Management, a registered investment advisory firm, and DeWaay Financial Network, a broker-dealer. The two firms manage $900 million in assets.

His firm’s younger advisers build their practices by working with younger clients.

“The problem with younger clients is [that] seasoned advisers don’t have the time or interest to work with these people,” he said. “These young investors aren’t getting compromised by working with younger advisers, because they have backup from more seasoned advisers.”

NOT THEIR DAD

Younger advisers also often have more in common with younger clients, said Justin Smith, 29, an adviser with Jonathan Smith & Co., which manages $23 million in assets. The firm belongs to his father, but he oversees the younger clients.

“I can sit down and have this conversation with them, and they don’t feel like it’s their dad telling them what to do,” he said. “I tend to enjoy it. I know if we can get these clients thinking like they should about markets and investments, they’re going to be our easiest clients in 10 to 15 years.”

One adviser who targets younger customers said he has reaped unexpected dividends from his relationship with them.

“When I decided to go into this market segment, I was reading in books that it’s hard to make a living in this segment,” said Lyman Jackson, president of Jackson Financial Management, which oversees $12 million. “And certainly there’s a lot of truth to that.”

“But many of these young families have referred us to their parents,” he said. “Just in the first two months of the year, we got two sets of parents referred by younger clients. You start serving other family members if you’re doing a good job for people.”

E-mail Lisa Shidler at lshidler@investmentnews.com.

Hilary Johnson contributed to this story.

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Keeping up with the Joneses

March 7, 2010 6:01 am ET

If there is one stage of life in which competing demands for income are most intense, it is when couples first start out. It is a time when they typically make the biggest purchase of their lives — a home — as well as when they begin the most expensive long-term project of all: raising a family. And let’s not forget getting an early start on retirement planning. Precisely because of these many demands, planners advise young couples to get into the saving and investing habit. To demonstrate the challenges facing such couples — and possible courses of action — InvestmentNews created a hypothetical young family and asked two seasoned financial planners, Janet Stanzak and Thomas J. Henske, to review their finances and come up with some solutions.

The Jones family: John, 35, and Jenny, 34, have two children — Jenna, 9, and James, 6.

Income: John, assistant director of human resources at a computer software company, earns $135,000.

Jenny, an accountant at a midsize regional firm, earns $70,000.

Major assets: Residence: single-family house purchased in 2005 for $425,000; now worth $375,000

Retirement funds: John’s 401(k) account, $40,000

Jenny’s 401(k) account, $3,000

College savings: $25,000

Emergency savings: $10,000

Major liabilities: Mortgage balance:

$380,000 (30-year fixed), at 6.5%; monthly payment (plus taxes and insurance), $2,951

Credit cards: Payments of $300 a month on total debt of $15,000

Insurance: John has a term life policy through work with a death benefit of $675,000, for which he contributes $1,200 a year; Jenny has a term life policy (also through work) with a death benefit of $350,000, for which she pays $600 a year.

Concerns:

College and retirement saving. Now that Jenny has returned to work after a five-year hiatus, the Joneses would like to ramp up saving for college and retirement. But the couple is not sure where to invest after the 2008 market crash erased $20,000 from John’s 401(k) account. The market rebound last year has restored about $10,000 of that.

Credit card debt. To landscape and furnish their new home, the Joneses ran up $15,000 in credit card debt. They don’t know whether they are making a sufficient monthly payment on the balance.

Inheritance. Jenny expects to receive a $50,000 inheritance following the death of her grandmother. They don’t know what to do with that money.

Mortgage debt. The couple is also concerned about owing more on their mortgage than their home is worth. They don’t want to move, but have heard about people walking away from “underwater” mortgages.

Ms. Stanzak’s solutions

COLLEGE SAVING

Using a college savings calculator, I ran one scenario for James, assuming that half, or $12,500, of the current college funding dollars are designated for him. To fund 100% of a four-year college — $220,065 — would require monthly contributions of $653 (assuming college costs rising at 6% per year and a 7% return on investment). That’s just for James, and does not include the calculation for Jenna. Funding 100% may not be realistic. As for specific investments, consider Section 529 plans. After-tax contributions to a 529 plan grow tax-deferred, and distributions to pay for the beneficiary’s college costs come out federal-tax- free. Some states offer tax incentives to investors as well.

RETIREMENT SAVING

A good goal would be to maximize their 401(k) contributions — the maximum deferral is $16,500 in 2010 — or to make annual contributions of 10% to 15% of income. The Joneses should consider completing a retirement analysis to determine the appropriate amount to save and invest each year. Also, a complete risk tolerance assessment is needed to determine an asset allocation with which they can be comfortable and which also helps them meet their goals. Their current portfolio provides no diversification. Typically, a diversified portfolio includes cash, fixed income (bonds, CDs), large-cap stocks, small- and mid-cap stocks, international stocks, and often real estate and commodities as a hedge. The couple’s uncertainty after the losses in John’s 401(k) plan suggests that more than 25% should be allocated to cash and fixed income to give the portfolio a more conservative allocation, thus potentially reducing volatility.

CREDIT CARD DEBT

It appears that the $300 a month is the minimum payment. At 12% interest, it would take 368 months — over 30 years — to pay off the cards, and it would cost $14,545 in interest. If they double the payment to $600 a month, it would take 29 months — about 2 years — to pay off the debt, and it would cost $2,347 in interest. But a better option is to use part of Jenny’s $50,000 inheritance to wipe out all credit card debt. In the future, they should use credit cards only for purchases they know they can pay off each month.

INSURANCE

The Joneses should complete a capital-needs analysis to see exactly how the premature death of either spouse would affect the family’s ability to meet expenses. In addition, the analysis would take into account paying off debts such as their mortgage, credit cards and auto loans, as well as college and retirement funding. This needs analysis would determine how much insurance they actually require. At their age, lower-cost term insurance makes sense, but in addition to the group coverage provided to John, he should consider a policy of his own. The group coverage will end if he changes jobs and a personally owned policy can be maintained, regardless of insurability in the future.

EMERGENCY FUND

They Joneses should build up their cash reserves to equal six to 12 months of income. This can be saved in a money market or in short-term CDs.

MORTGAGE DEBT

They would have trouble refinancing, because they owe more than the home’s value. They could pay down some of the loan balance with the inheritance and try refinancing at that time. They’d have to pay $42,500, plus closing costs, to obtain a $337,500 mortgage with 10% in equity in the house. This would use most of the inheritance and is unrealistic in their current situation.

Mr. Henske’s solutions

COLLEGE SAVING

They are behind in their college savings. To be on track, Jenna’s account should have at least $90,000, and James should have $60,000. They’ve got some work to do in adding regularly to these accounts. From an asset allocation perspective, I always like the age-based models, as they take the guesswork out of this important part of the planning process and help prevent taking an emotional approach to the investing process.

RETIREMENT SAVING

Both John and Jenny should max out their 401(k) contributions. If either of their employers has a Roth 401(k) option, they should take advantage of it. Wherever possible, they should convert any traditional IRAs or former employer 401(k) balances to Roth IRAs. Because the couple sustained losses in the ‘08 crash and seem to be uncertain about equities, I would recommend a less aggressive portfolio to ease them back; they can always readjust the portfolio as their risk tolerance matures. Here’s my recommendation: 55% equities (half in emerging markets and half in developed markets), consisting of large-cap core (5%), large-cap growth (11%), large-cap value (11%), mid-cap (8%), small-cap (3%) and international (17%); 27% taxable fixed income, divided among Treasury inflation-protected securities (5%), high yield (4%), investment-grade corporate (14%) and international/ foreign fixed income (4%); and 18% alternatives, consisting of global real estate (2%), private equity (2%), commodities (4%) and absolute return (10%).

CREDIT CARD DEBT

It would seem logical for them to use their inheritance to pay off the debt. Clearly, from a rate-of-return standpoint, it makes sense. Another option would be to pay off a portion of the debt from the inheritance and then pay down the balance down at the rate of $500 a month. This would get them in the habit of putting money aside. When the debt is eventually paid off, they can switch these payments into a long-term dollar-cost-averaging investment strategy and make those payments into a balanced mutual fund portfolio.

INSURANCE

John is significantly underinsured. The rule of thumb is to protect 10 to 20 times your income. Based on an annual income of $135,000, there should be a minimum of $1.35 million of life insurance on John. The good news is that assuming he’s healthy, he could probably get a policy for the same cost — with double the amount of coverage — by going outside of his employer’s plan. This would also protect him, should he leave his current employer or if his company were to eliminate its life insurance benefits. Jenny’s coverage should also be doubled, at least. The same strategy of looking outside her company for a policy would let her do so for about the amount she’s paying for her present policy.

EMERGENCY FUND

They need to build adequate reserves of at least 12 months’ living expenses — about $72,000. They can use the $50,000 inheritance and existing $10,000 in emergency savings to get started.

MORTGAGE DEBT

The Jones’ current mortgage rate, 6.5%, is significantly higher than what’s available in the marketplace today. Unfortunately, the home value is currently less than the mortgage outstanding, which will make it highly unlikely that the lender will allow this borrower to refinance. They cannot just walk away from the house without significant consequences, such as having to declare personal bankruptcy, which would affect their ability to get any type of credit for years to come.

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Young don’t see value in rolling the dice

Coming off one of the worst decades for stocks, they take a more conservative outlook on investing

By Jeff Benjamin

March 7, 2010 6:01 am ET

Advisers who work with clients in their 30s are witnessing something they’ve never seen before from younger investors: high levels of risk aversion.

“I’m talking with a lot more younger clients today who are worried about avoiding losses, and wanting to take the kinds of conservative approaches that have historically been appealing to older folks,” said Clinton Struthers, who advises on $110 million as the owner of Struthers Financial Services.

“It used to be all about “the sky’s the limit’ when it came to advising younger people,” he added. “But now, I see their whole outlook is more conservative as a result of so much uncertainty about the future.”

That caution, as the financial planning community is realizing, is grounded in the general economic turmoil and investing experiences of the past few years.

Any multiple-decade snapshot of the stock market can usually be made to look optimistic, but for most people in their 30s, a personal investing history doesn’t go back much farther than 10 years.

In that time, the financial markets have experienced two very harsh cycles — leaving most investors about where they were a decade ago.

With that in mind, it’s understandable that today’s thirty-somethings might be among the most gun-shy of generations.

Understandable, but not acceptable — at least not if there’s any hope of staying ahead of taxes and inflation.

“The biggest hurdle right now is to get those people in their 30s to step off the sideline and embrace some risk,” said Tim Knepp, chief investment officer at Genworth Financial Asset Management, a firm with $7 billion under management.

Mr. Knepp underscored the recurring theme that is being presented to risk-averse young people across the land: Time is on your side.

“The market pays you to take risks, and 30-year-olds should keep that in mind,” he said. “When you’ve got to make up losses, your greatest risk is not portfolio volatility, it is loss of purchasing power.”

Encouraging younger investors to save as much as they can — and then invest as aggressively as they can stomach — seems to be a standard message throughout much of the financial planning industry these days.

But there are still a variety of ways to execute a plan once the investor is on board.

“For younger people, their biggest asset is their potential income stream, and their capacity to bear risk is very high,” said Neal Ringquist, president of Advisor Software Inc.

“If you’re in your 30s, you could easily be 100% in stocks and afford to lose 40%, and still make it up over your lifetime,” he added.

Advisor Software is a financial technology firm and a registered investment adviser that manages more than $200 million for other financial advisory firms.

Because people in their 30s, in general, are wealthier in income than assets, Mr. Ringquist views salaries as an asset under the resource category of a household balance sheet.

Other examples of resources are real estate and investments.

The other side of the household balance sheet is claims, which are all legal financial liabilities, such as debt.

“We’re looking at the household through a balance sheet to determine a capacity to bear risk, not just risk tolerance,” Mr. Ringquist said.

With that in mind, he is a strong proponent of life insurance and disability insurance, which are rarely considered high priorities among younger investors, especially if they’re single or childless.

“Looking at the household balance sheet leads to certain implications that people might not always realize,” he said. “Because the income stream is the biggest asset, you need to protect anything that might cut into it.”

Not all financial advisers factor in the personal residence as part of an overall financial plan, but managing the cost of a home should be a priority for younger clients, according to Bert Whitehead, president of Cambridge Connection Inc.

“There were a lot of young people who made mistakes in real estate during the run-up,” said Mr. Whitehead, who charges clients he advises a flat or retainer fee.

“People paid too much for the houses they were buying, and then put the rest of their money in stocks or whatever,” he said.

While Mr. Whitehead believes in appropriate use of aggressive, long-term investing strategies for younger investors, he also favors maintaining cash reserves that could be tapped to cover mortgage payments in the event of a job loss or illness.

Taxes are another issue that should be considered early, according to Laurence Greenberg, president of Jefferson National Life Insurance Co.

He recommends low-cost variable annuities once the allocations to traditional qualified retirement plans such as 401(k)s and IRAs have been maxed out.

“The recent dislocation in the markets has made everyone question whether they’ll have enough money when they’re ready to retire,” Mr. Greenberg said. “The best way to make sure you have enough money is to save it, and when saving, there’s nothing more valuable than tax deferral.”

As with any strategy, the key is finding one that works and sticking with it.

That’s something a lot of investors — as well as a lot of financial advisers — have struggled with in the wake of the market’s upheaval.

“One of the benefits of being in your 30s is, virtually any investment strategy can work pretty well because you have so much time,” said Michael Ball, president of Weatherstone Capital Management, which manages $425 million.

“The problem is, people in their 30s are impatient,” he added. “They’ll try something once and if it doesn’t work right away, they just write it off.”

Long-term outlooks and historical performance charts notwithstanding, it ultimately boils down to suitability, and that might be where advisers face their greatest challenge.

“All you can do, as financial advisers, is encourage your clients to be aggressive enough,” said John Diehl, senior vice president of business development at the Hartford Financial Services Group Inc.

“The investment time frame will help determine the asset allocation mix,” he added. “I’d say for people in their 30s, a minimum 80% in equities makes sense, but not if somebody is going to lose sleep.”

E-mail Jeff Benjamin at jbenjamin@investmentnews.com.

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Thirtysomethings ask: ‘What do we do now?’

Rocked by the recession, they are focused on debt rather than savings

By Jessica Toonkel Marquez

March 7, 2010 6:01 am ET

Over the past year, at least six young couples have come to investment adviser Susan Spraker in desperate need of financial help. All of them have children, and the wives, for the most part, have been laid off or are stay-at-home moms. The husbands, many of whom were in real estate or financial services, have lost their jobs and are now in positions that pay far less. All of them are dealing with high amounts of mortgage debt after taking out jumbo loans for homes they couldn’t really afford.

“They all had these lifestyles of high expenses,” said Ms. Spraker, whose firm, Spraker Wealth Management Inc., has $60 million under management. “Now they are dealing with the shock of: “What do we do now?’”

The financial crisis and recession have had a major impact across all segments of the population, and the young-emerging-affluent class has not been immune. This group has cut back its spending, is heavily in debt and is more focused on improving cash flow than saving for retirement — at least for the short term. While they are not as conservative when it comes to investing as affluent people in general, they are less tolerant of risk than they used to be. They also consider it important to have a written financial plan, even though they acknowledge that they don’t take enough time to manage their finances.

In a December survey of a group it calls the “accumulating affluent,” Merrill Lynch Wealth Management found that 56% had made some adjustments to their lifestyle in the last year. Half had cut back on personal luxuries such as spa visits, and gym and country club memberships, compared with 43% in the affluent population in general.

The survey also found that 57% of the younger group expressed concern about the effect of the economy on their ability to meet their financial goals.

HIGH DEBT LEVELS

One defining characteristic of the young-emerging-affluent class is debt. Whether because of cheap credit or profligate spending, these people are now carrying much more debt than affluent people overall.

Phoenix Marketing International, which at the request of InvestmentNews looked at Americans 30 to 39 with $150,000 or more of annual household income, or investible assets of at least $100,000, found that they have a debt-to-liquidity ratio of 58%, compared with just 18% for the affluent in general.

“Clearly, [the] younger-emerging-affluent [class] has been impacted most keenly by the deleveraging of consumer credit,” a recent Phoenix report says. “With enormous amounts of debt, these investors will be unable to take advantage of many wealth accumulation offers over the short term, and many will likely have to put retirement planning on the back burner.”

Indeed, when Phoenix asked younger affluent people what their single most important financial goal is, only 23% said it is to “assure a comfortable standard of living for retirement” compared with 47% of affluent people overall. The top financial goal for young people (24%) was “improving household cash flow,” a top goal for only 14% the affluent people in general.

While young, debt-strapped investors may not be candidates for retirement planning right now, Phoenix says they offer opportunities for services targeted at credit management and cash flow planning.

Sheryl Garrett, founder of the Garrett Planning Network Inc., which comprises 300 fee-only financial advisers and planners, tells clients who have significant credit card debt to attend a consumer credit-counseling session. Once they’re on the road to recovery, it helps if financial advisers check in with couples monthly to see how they are doing with managing their expenses, she said.

In the Phoenix survey, 59% of respondents said they were willing to take on “calculated risks” to make money, compared with 51% of the affluent market overall. When asked to describe their investment approach, 82% of the younger respondents chose the words “moderate risk” or “risky,” compared with 72% of the total market.

David Thompson, managing director of affluent-market research for Phoenix, said the gap between the young affluent and the total market has significantly narrowed from five to 10 years ago. “The risk profile has become much more conservative,” he said.

Nearly 48% of the young affluent believe it is important to have a written financial plan, compared with 38% of the total market. But 41% say they don’t take enough time to manage their finances, compared with 33% of the total market.

Salesforce.com senior account executive Don Readhimer, 35, who travels frequently for his job, said before hiring Rick Salmeron as his financial adviser two years ago, he rarely looked at his portfolio. Mr. Salmeron is president of Salmeron Financial Network Inc., which has $30 million under management.

“There’s just very little time,” Mr. Readhimer said. “The only time I looked at my investments was during tax time or when we needed the money to do something like buy a car or take a trip.”

Mr. Readhimer and his wife, Anne, also 35 and a food technology director at Yum Brands Inc., have no kids as yet, earn about $400,000 a year, have $260,000 in their 401(k) plans, other investments totaling $340,000 and another $100,000 in their bank accounts, Mr. Readhimer said. They also have mortgages totaling $326,000 on their home, which was purchased six years ago for $380,000.

Mr. Salmeron has found that clients like the Readhimers appreciate the financial planning services he can offer. “My younger clients value time — a lot,” he said. “It’s a huge value to them, because it’s so scarce.”

Lyman Jackson, president of Jackson Financial Advisors Inc. in Newton, Mass., knows that only too well. When he decided to target an emerging-affluent clientele, many of them young parents with children, he realized he would have to make some concessions in light of time constraints.

To accommodate his clients’ busy schedules, he spends a lot of time driving to their homes, staying late at his office for after-work meetings, or arranging meetings in the early morning. And, of course, he often has to call clients back, if kids are screaming and yelling in the background.

NEED FOR FLEXIBILITY

“It’s not a 9 to 5 job, let’s put it that way,” said Mr. Jackson, who oversees $12 million. “Sometimes I go to their homes, and I meet with them around their dining room tables. You have to have a tolerance for kids, but it’s interesting, because it gives you a window into how they live.”

Just a few weeks ago, in fact, Mr. Jackson went to the home of one of his clients who lives outside Boston, to deliver an updated life insurance policy — worth $1.5 million — that does a better job covering a $340,000 mortgage, plus the future education expenses for their two young boys, ages five and eight.

For the client, who together with his wife makes about $400,000 a year, has a net worth in excess of $750,000, and carries no debt outside of the mortgage, the flexibility and the family-friendliness that Mr. Jackson offers have been key during their two-year relationship.

E-mail Jessica Toonkel Marquez at jmarquez@investmentnews.com and Hilary Johnson at hjohnson@investmentnews.com.

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