Bogleheads on Investing – Episode 008 transcript

Allan Roth

Allan Roth is our guest in Episode Eight, and our focus is on the investment advice industry. Allan is a licensed CPA, a Certified Financial Planner (CFP), author, writer, adjunct professor, and Founder of Wealth Logic, an hourly based investment advisory and financial planning firm.

Allan’s book, How a Second Grader Beats Wall Street is a best-seller. He has also written for The Wall Street Journal, AARP, Money, Financial Planning Magazine and numerous other publications. This episode hones in on the investment advice and including the pros and cons of hiring an adviser, various ways to pay an adviser, and do-it-yourself investing.

This podcast is hosted by Rick Ferri, and is sponsored by the John C. Bogle Center for Financial Literacy.

Transcript

Episode 008-guest Allan Roth

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Rick Ferri, April 5, 2019

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Rick Ferri:  Welcome to Bogleheads on Investing episode number eight. In this episode I’ll be talking with Allan Roth. Allan is a nationally known personal finance speaker, writer, and the founder of Wealth Logic, an hourly-based investment advisor and financial planning firm.

Hello everyone, my name is Rick Ferri and I’m the host of Bogleheads on Investing, where each month I interview a new guest about different areas of personal finance.

My guest this month is Allan Roth, the founder of Wealth Logic, an hourly-based investment advisor and financial planning firm. Allan is a nationally known writer and speaker on personal finance. Over his career he’s been the chief  financial officer of two multi-billion dollar corporations and consulted with many other corporations while at McKinsey and Company. He also taught investments and behavioral finance at the University of Denver Colorado College and the University of Colorado. Allan received his MBA from Northwestern University Kellogg School of Management. He is a CPA and a certified financial planner. His book, “How a Second Grader Beats Wall Street: Golden Rules Any Investor Can Learn,” has been a best-seller. He’s also written for AARP, The Wall Street Journal Financial Planning magazine, and has appeared on numerous TV and radio shows. Allan’s professional goal is never to be confused with Jim Cramer.

With no further ado, let’s get Allan Roth on the line. Hi Allan, how are you?

Allan Roth: Good, Rick. Thanks for having me.

Rick Ferri: I really appreciate you joining us on Bogleheads on Investing and today we’re going to talk about a couple of main topics.  The first thing that we’re going to talk about is the general advisor industry which you’ve been in for a while. The second thing we’re going to talk about are individual questions about investments per se.  So we’ll be talking about municipal bonds and insurance and so forth as an investment. So let me go ahead and get into this. 

There are so many people out there calling themselves financial advisors. Could you tell us what a financial adviser is?

Allan Roth: Well it’s really easy to get licensed to call yourself a financial advisor. The series 65 exam is not exactly rocket science. It’s even easier to get an insurance license, where you can call yourself a financial advisor or financial planner. But the quality of financial advice varies all over the map, from purely sales oriented to advice-only models.

Rick Ferri: Well I’ve got some data here that I want to go over with you because I think it’s interesting. There really are three basic broad categories of advisors and they would be the “RIAs” or registered investment advisors; brokers who work in the brokerage firms and probably have a series 7 exam which is the brokerage exam; and then there are insurance salespeople. Would you agree that those are the three broad categories?

Allan Roth: Yeah, I think so.That’s a pretty good way to characterize it.

Rick Ferri: So let’s not get into how many people fit in each category and I just looked up this data. By far the biggest category are the brokers and according to FINRA in 2019, basically the end of February, there were 629,862 registered brokers who were working in 3,667 registered brokerage firms. So that’s a pretty big number. By the way that’s down a little bit from 2007, down about 45,000 from 2007. So we’ve lost brokers since the financial crisis.

Insurance salespeople; this was a little bit tougher, and there might be some overlap here too because a lot of brokers have their insurance licenses. But insurance sales representatives– 489,880 insurance salespeople out there.

Let’s look at the investment advisor space. These are the people who are doing assets under management or hourly and some of these might also be selling insurance and some of these might also be what we call dual registered, which is brokers plus assets under management. Anyway, the number of RIA’s is 30,266. Eight thousand of those are dual registered as brokers and investment advisors, which leaves a little over twenty thousand basically fee-only advisors who are just collecting fees. So when I add up all of these and I take into consideration some overlap it becomes a number of about 1 million people out there calling themselves financial advisors.

Allan Roth: A lot of financial advisors out there. Like you said, there’s overlap between the three. You can be all three at once so you can’t just assume that all brokers are evil and all RIA’s are good. I’ve seen some very good brokers sell some low-cost index fund portfolios and some so-called fiduciary RIA’s/CFPs sell products that, I’m not kidding, had over a five percent annual fee.

Rick Ferri: I’ve seen a lot of that too. They even get on the internet. You can find people that are charging just for a simple money managed account, you know one and a half percent per year. Even up to– somebody showed me one that was two and a half percent per year. So it can be quite high, and that doesn’t include the cost of the funds themselves, or whether or not the advisors are trying to do active management or trying to outperform the market. 

Allan Roth: Yet there’s this belief that fee-only means there’s no conflicts of interest, and let’s face it, anytime a dollar changes hands including my hourly model, there are conflicts of interest, and the best regulator out there is the consumer. Make sure that you understand it. Simplicity almost always trumps complexity with one exception being taxes.

Rick Ferri: Let’s get into the conflicts of interest. Let’s start out with the commission model first, where an advisor is paid a commission to put their clients into certain products, and depending on which product they put their client into, they’ll get a higher fee or a higher commission or a lower fee or lower commission. Let’s talk about commissions and what is the benefit of using an advisor who does commission. And what are the disadvantages of using advisors that do commission. 

Allan Roth: Well, let me first say as an hourly advisor I’ve got bias, and on all of my answers, so I want to just disclose that. Commission, not only how much they will get paid in commission, but will they get that vacation at the Broadmoor resort, other things that are driving why they’re selling what they’re selling.

So the pros are that typically it’s a one-time fee and quite frankly many times I see, you know,  AUM charging more than people would be paying under a commission model. But you know obviously they sell what they’re being paid to sell and it’s the least transparent. You can’t find out how much the person is getting for selling that product.

Rick Ferri: The tax laws, recent tax law changes have actually changed a few things. If you’re paying commission now that actually comes out of the amount that you’re paying for the product and so when you sell whatever it is you sell you’re not paying taxes on the commission part so it’s actually a more tax advantaged way of doing it. I’ll say – another way. If you bought something like American Funds and you had a million dollars- I’m not advocating American funds, but if you had a million dollars and you invested them through a broker in just American funds, I believe that there’s no commission to buy American funds and the broker gets a quarter of a percent, 12b-1 fee, which comes off the top on an annual basis. Well you’re not paying taxes on that 0.25%, so it comes out pre-tax, comes out of your returns.

Allan Roth: Yeah you’re absolutely right. I totally agree with that. The new tax law has made commissions more tax efficient. 

Rick Ferri: Yeah that’s interesting. Advisers will complain profusely about anybody who gets a commission and yet now the AUM fee is not as not as tax efficient. Now let’s go to the next way in which advisors get paid which is percent of assets where some people call this fee-only. What are the benefits of paying an advisor for percent of assets and what is the disadvantage.

Allan Roth:  Well fee only includes assets under management, the ongoing percentage and hourly as well. But the AUM in particular, the assets under management,  you have a million dollars, I charge you 1%. That’s, you know, ten thousand dollars a year. The pros are that the advisor doesn’t get paid to sell a particular product and in this regard, far more transparency because you can see what the adviser is taking out of your portfolio. But you actually have to go and look. Many people I speak to don’t know how much they’re paying on the AUM.

The cons are that they’re paid to capture your assets. Are they really going to tell you to pay your mortgage down. And talking about the new tax law, the majority of people aren’t getting a tax deduction on the entire amount of the interest they’re paying on their mortgage. So they’re paid to capture assets. They’re paid to overcomplicate things because if the advisor gives you just a handful of funds and doesn’t make changes on an ongoing basis the client is going to say, “Why am I paying for it?” So the cons are the over complication, capture assets and constantly making changes.

Rick Ferri: I’m going to throw another one out there. I think that doing an all-in fee, it’s not quite a wrap fee according to the SEC definition, but when you add in financial planning to portfolio management and you’re charging for financial planning based on the amount of money somebody has with you, the person who has $2,000,000 is paying twice as much for financial planning as the person who has $1,000,000, but they’re getting the same service.

Allan Roth: Well not only that, but you know oftentimes I’ll have clients with- they’ve just sold their business- they’ve got tens of millions of dollars, all in cash so that’s a relatively simple plan to do. You know other times I have people that come to me with $100,000 in three different annuities and I can’t help them on a cost-efficient basis. So the amount of financial planning really isn’t correlated all that well to the size of the portfolio.

Rick Ferri: And I agree. So my view has been that you should pay for portfolio management some low fee, if that’s what you want, ongoing portfolio management. And everything other than that: financial planning, estate planning, some sort of tax planning, insurance planning and everything else should be separate, should be a separate billing function based on the amount of time it takes to help a client. That’s my belief.

Allan Roth: Yeah I totally agree with you. The one exception would be as a financial planner I’m not licensed to do estate planning. I’m not an attorney so I work with the client’s attorney to make sure that my plan is consistent with their estate plan. 

Rick Ferri: You don’t do tax returns either, correct.

Allan Roth: I am a CPA but, yes, I do not do tax returns.

Rick Ferri: So those two things would be outsourced. Somebody else would do them. 

Allan Roth: I am licensed. Well a lot of what I do is tax related, looking at what are the tax implications of moving the portfolio to something more tax efficient etcetera. What are the taxes that are going to have to be paid versus the benefits going forward.

Rick Ferri: Let’s go to the third model which is hourly, which is also called advice-only. And that’s what you’ve been doing for some time. Personally, that’s what I’m going to be doing, starting now launching my new  firm. And thank you for your help, by the way, in giving me some guidance on how to do that. But the hourly model: the benefits and the disadvantages?

Allan Roth: Well you know I obviously am very biased and I’m thrilled by the way that you’re going into the hourly model. You know I argue that every profession on earth-sorry for this really bad joke- but even the oldest profession on earth is fee-for-service.

Rick Ferri: Did you come up with that?

Allan Roth: I think I did. I’m not positive. Giving advice and not having a way to profit from advice in my opinion lowers, not eliminates, but lowers the conflicts of interest. You know I can recommend any product anywhere, paying down the mortgage, a CD at a particular bank with an easy early withdrawal penalty etcetera. So I love it from that respect. 

Cons are, there still an incentive to overcomplicate, to make sure that the client has some dependency. The adviser can say I think I know what sectors are going to outperform, or what the market is going to do, so we need to meet quarterly, etcetera, to keep billing fees. Many say that it’s easy to pad our fees, but I would argue that’s just completely fraud. So fraud can be done in any of the three models.

Rick Ferri: What else do you have for us?

Allan Roth: Well again any time a dollar changes hands there’s conflicts of interest. So make sure that when you meet with the advisor you understand what it is they’re wanting to do. You agree with it. It’s that simple: that you understand what the total fees are. That you can explain it to any eight-year-old. Be your best regulator, that’s my advice.

One last thing I think is a pro to the hour advice only model is that it’s the most painful and pain is good. When I say painful, the client gets an invoice. They have to make a payment, write out a check, do a bill pay or something like that so they know what they’re paying. And that pain is a good thing so they understand what they’re paying. Again, so many clients don’t know what they’re paying in the way of commission or even the AUM. So transparency and pain is good.

Rick Ferri:  Wouldn’t that they’ll prevent somebody from calling you if they really needed to. In other words if you know, like a lawyer or someone, if you pick up the phone, every time I pick up the phone and call you I know I’m going to have to pay something. So that might be a deterrent for me to actually call when I should.

Allan Roth: Absolutely. The same thing can happen if you’re having a medical issue but don’t go to see the doctor. So you just have to make sure that the advice you’re giving is worthwhile and you know, my own particular model is my agreements give the client the right to cancel any invoice on anything they don’t think they’ve received value from.

The first time I met John Bogle roughly 16-17 years ago, he told me a story that resonated with me. The advisor meets with a client and the client wants a new portfolio. The advisor designs the simple, low-cost balanced portfolio and the client goes away. Next year the client comes and says well take a look at my portfolio. What should I do? And the advisor says, “nothing”. The year after that same thing happens, and the year after that. The client finally says, “Why am I paying you, you’re telling me to do nothing.” And the advisor answers, “To make sure you DON’T do something.”  And that kind of resonated with me and my hourly model. That once she designed the plan, sticking to the plan and doing nothing is the right way to go.

Rick Ferri: So what you’re saying is the advisors who are charging 1% and doing both money management and financial planning, the financial planning portion is really done in the first year. Why are they continuing to charge 1% per year every single year after that. 

Allan Roth: Exactly.

Rick Ferri: I want to ask a couple of questions about fees because I’ve been doing a lot of debating on Twitter with other advisors about this 1% AUM fee, and on average when you look at all the data from various places, if a client has 1 million dollars the average fee, AUM fee, to manage that portfolio and provide some financial planning or maybe not provide financial planning, just to manage the portfolio is 1 percent. So a million dollar portfolio would be ten thousand dollars and I argue about this. I say, “Well why would you pay ten thousand dollars to have a portfolio managed?” My gosh you can go to Betterment or you could go to Vanguard and have it managed with a professional for just a fraction of that and the advisors who are charging one percent come back and say well we add value.

But what I don’t understand though is how much does an actual financial plan cost? I look at some data from Michael Kitces and he’s got a very in-depth study about the cost of financial planning, how financial planners get paid. And generally he says that the typical financial plan runs anywhere between 10 and 20 hours, so call it 15, and the typical financial planner gets paid, if you can break it down to an hourly basis, two hundred to two hundred and fifty dollars an hour. So net-net, the average median financial full-blown financial plan is around $3,500.

This is just a middle-of-the-road number and I know that varies widely from one side to the other. So the advisor who is charging a two million dollar client almost 1%, just call it 0.9, it’s charging the client 18,000 dollars, and if the financial plan cost 3,500 the client is paying $15,000 a year to have their two million dollar portfolio managed, which to me as a  former portfolio manager seems extremely high. So I don’t understand how the 1% AUM wrap fee, if you will, works out, when the cost of financial planning, and it’s usually just a one-time cost, correct, is really not that high.

Allan Roth: You just hit on something. It’s a one-time cost, so yeah, you’re right. I would guess my average plan is around 15 hours or so. I’m more expensive than that $450, but once the plan is done and we move towards simplicity, then there’s some pretty easy rules to give clients on how to manage their own portfolio, and rarely do things change that much in one year. Occasionally somebody sells their business or something like that and the plan needs to be updated. But it’s pretty much a one-time plan. I tell all my clients my goal is after the engagement is to be fired, and I’m proud whenever the client at the end of the plan says, “this is great, you’re fired”.

Plans can be simple or very complex depending upon what situation the client is in, but then once the plan is done there’s simple rules going forward because I really know that I don’t know what the markets are going to do, or anything like that. If the market plunges and they want me to charge them an hour to tell them to stick to the plan and rebalance and buy, now that stocks are on sale. I’ll do what it allows, use their money, but I would do it.

Rick Ferri: You know not everybody can afford financial planning, right. I mean if you’ve got a million dollar portfolio or two million you probably can afford a financial plan but there are some alternatives now for people who don’t have a lot of money. Not only are there companies like Vanguard and Betterment and now Schwab charging relatively low fees but there are hourly planners out there who will help people. Correct?

Allan Roth: Yeah absolutely, and probably the best group of hourly planners I know are with  Sheryl Garrett, and the Garrett Planning Network.They really try to help the middle market and are terrific advisors. I’m not a member of the Garrett Network but think very highly of Sheryl Garrett and her network. 

Rick Ferri: I have known Sheryl for many years and they do a great job. Now some of them do manage money, I understand, but I think the focus of that organization is on hourly.I know that if you’re going to hire a financial planner you need to really ask them, even if they’re in the Garrett Network. You really need to ask them,”how do you get paid” and what their business model is.

Allan Roth: No absolutely, no matter what model you’re using, I think the most important question is how much am I paying in total fees because you mentioned that 1% AUM. Say they put you in other funds that have another, let’s say 0.5% in average fees, and what really matters is one’s real return, how much you’re making after inflation. So if let’s say a balanced portfolio might beat inflation by 3%. If you’re paying 1.50% in total fees, I don’t care whether it’s hourly, commission, AUM, the fund fees, you’re giving away half of your real return, your real growth.

Rick Ferri: I want to ask you about these robo-advisors. I mentioned them a minute ago. Well,  Betterment, and Vanguard is sort of a robo-advisor, and now Schwab is charging just a flat fee. They just came out last week and said that their fee is going to be $30 a month for portfolio management and financial planning, basically unlimited financial planning. Who do you think these services are designed for. I mean how deep did they get on the financial planning side for the low fee?

Allan Roth:  Well you know any time fees go down it’s a wonderful thing. Don’t forget Schwab has had the Intelligent Portfolio, the zero fee, but of course, there have fees in other areas as well.  So anytime fees go down I think it is a wonderful thing. In terms of the financial planning that they’re giving? Quite frankly I don’t know exactly what they’re giving. I know that there are some conflicts. I’ve written even where I disagree with Vanguard on again, on paying down that mortgage and such, so you know all advice has some bias, but a good financial plan and a low fee is a wonderful thing. I’m a big fan of robo-advisors. I think software can manage portfolios better than people. There’s a lot of data to show that advisors were very heavily in stocks at the market high in ‘07 and turned to cash in the market in ‘09. Software is going to do the opposite, it is going to stick to the asset allocation and rebalance. So I think it’s absolutely a wonderful thing. 

But it’s also kind of a cookie cutter approach. Rarely do I have a client come to me that doesn’t have a portfolio already with huge tax ramifications of getting out so it doesn’t fit into a cookie cutter sort of portfolio that robo-advisors typically use. I agree with that if everything was tax-free it would be easy and you could easily just move people around, but the real problems are working around the tax issues. I certainly could not turn my portfolio over to a robo-advisor because I would have huge tax ramifications for mistakes that I’ve made earlier on. For the fact that there weren’t total stock index funds when I started investing and the like.

Rick Ferri: So I’m going to question a little bit off topic but you know balanced funds seem to do a lot of the work of a robo-advisor, like Vanguard LifeStrategy funds or Vanguard Balanced Index Fund. And I know that Ishares–also Blackrock also has Ishares that are doing balanced type investing. What do you think of just using a balanced fund to do everything?

Allan Roth: Probably the best robo-advisor out there if it’s ultra-low fee, again the target-date retirement funds as long as they’re very, very low cost,  are great robo-advisors that do all of that for you, the one thing you don’t get is the asset location. I’ve always argued that investing is simple. I never argued that taxes were. What I do for my clients is try to put certain assets like fixed income things that are taxed at higher rates in the tax deferred accounts and very tax-efficient investments like total stock index funds in the taxable account. So you do lose that tax efficiency by going to a one fund sort of solution with the target date or a balanced fund.

Rick Ferri: But there are tax efficient balanced funds. 

Allan Roth: Yeah that’s true. They’re not putting the assets in the right tax wrapper. They may not generate as much in the way of taxes but the fixed income for clients that are in a high income bracket, that’s much better located in the tax deferred accounts. Because if you have stocks in the tax deferred accounts what you’re doing is eventually creating what would have been a long-term capital gain…and you can defer that (on a taxable index fund, you’re in control of the capital gain). So [in a tax-deferred account] you’re converting it [gains] to ordinary income when you have to start taking it out, either to live on or for the required minimum distributions. 

Rick Ferri: Got it, Allan I was at an ETF conference about a month ago and the big thing that they started talking about there was this thing called direct indexing and and what direct indexing is is you give a money manager, call it a million dollars and they buy all 500 stocks on the S&P 500 with that million dollars, fractional shares, well they might do some sampling and buy two hundred and fifty stocks. And then they’ll selectively sell-off individual stocks when there’s a loss to generate a tax loss and then they might replace that with another stock that is not part of the 250 or they might wait 30 days and rebuy the stock and avoid tax wash rules, whatever their particular strategy is. But the idea is that you can generate a lot of tax losses and if you happen to have a big taxable gain in a low-cost basis security or some other reason it’s going to give you a big tax gain this is a way of offsetting some of those taxes. I look at it skeptically, but what are your views on direct indexing?

Allan Roth: Yeah Wealthfront was the first robo-advisor that I saw doing it and I wrote about it and I think that it’s a wonderful thing, but the tax alpha as they call it is really overstated. So what happens, assuming that the market moves up over the long run, the amount of tax losses generated go down year after year after year and there’s very little tax gain going forward. But the problem with this is that the fees stay forever, the complexities stay forever, but the tax benefit goes down. And don’t forget the tax benefit is just a deferral because if you eventually sell them you’re going to have to pay that very large capital gain because you’re left with the stocks that had the biggest winners.

So it is good, I am for it. I typically will have a client do that if let’s say they want to donate some money a few years from now to a charity, to a donor-advised fund. So they could put a hundred, two hundred thousand dollars in there, get the tax losses, be left with some stocks that have very large gains, and then donate it to a charity. 

The other option is they can always just take over the several hundred stocks that are left in the direct indexing and stop the fees, but then you’re left with the complexity of a portfolio with hundreds of stocks.

Rick Ferri: Over time you don’t have the tax losses to use but you’re left with all these stocks and you have to pay fees on it if you want somebody to continue to manage it. I was talking with some people in the industry, though, maybe there’s a way to take those 250 to 500 stocks and convert it to ETF shares. Hasn’t happened yet but I’m talking with various people in the industry and it sure would be great if you could take those 250 to 500 individual stocks, turn them into State Street or Vanguard or someone and get issued shares of an ETF of an S&P 500 fund. The cost basis of your shares would be the cost basis of the aggregate cost basis of the stocks that you have, but at least it could make it easier and make it more now you’d only have one security now instead of 250 to 500, and the IRS isn’t missing out on anything here.

So maybe perhaps somebody will figure out how to do that, and what to me would make this direct indexing a little bit more palatable than currently what happens at the end of it all.

Allan Roth: I’d be a little surprised. I hadn’t heard of that, by the way, but yes I’m left with,you know, 280 stocks. I don’t think the IRS is going to let me convert that to something that has all 500 without paying taxes on it. That would be my hunch. But I had not heard of that idea before.

Rick Ferri: Yeah and it’s just an idea. And it’s just again you’re not getting away with not paying taxes because your cost basis on the ETF, years that you were issued would be the total aggregate cost basis of the stocks that you currently held so, you know, I’ve talked with numerous people in the industry about this idea. I think if that actually occurred, if you were able to actually do that at the end of this in direct indexing then it would make that whole concept much more popular, and I think it would be a trillion dollar industry. But you know again that was just an  idea and it’s not there yet.

So before we move on to the next topic, you are an hourly adviser, I have become an hourly  advisor. So I can guess that’s a trend of at least one. Do you think that this hourly model will continue to grow, or do you think that the AUM model will continue to grow or maybe some other model like retainers or subscription-based is another model that might grow. What do you think the advisor industry and fees are going?

Allan Roth: Roughly, I think it was a year and a half, two years ago, I interviewed Bill McNabb when he was CEO of Vanguard. I asked him the question, will hourly take over and I agree with his answer that it won’t. It took a long, long time for people to move from the commission model to the more popular AUM model now are what’s growing in popularity and it would be a very long time before hourly would take over. I also think that people like paying in a painless sort of way and the AUM model is a whole lot less painful than the hourly model. So yeah I don’t think that the hourly, I think it’s going to gain in traction, but I think it will be the minority model for probably the rest of my life. 

Rick Ferri: What do you think about subscription base which is another way of billing? You’ve got financial planners out there that are charging between let’s say 150 to 300 dollars per month. 

Allan Roth: You think it’s good but the problem that I have with that is the complexities vary all over the map and it’s the same sort of thing, that a good financial plan is lasting with rules going forward, and not the need to keep paying. 

Rick Ferri: Let me ask a question. I’ll get back to something I asked before about the difference between managing money, you know, an advisor who is managing money, and advisors who are doing just financial planning and just advice, and then there are the ones who do both. What is your view of a fair fee for just the money management side, the percentage of the population who are delegators and they don’t want to manage their own portfolios.They want somebody else to do the tax loss harvesting, do the tax management. They want to be able to call somebody up and say send me a check for $10,000 or whatever, do the tax allocation and you know maintain the portfolios. What do you think a fair fee is for the adviser who’s going to do that?

Allan Roth: I’d say no more than 0.30 percent which is what Vanguard charges on their Personal Advisory Services. Yes if somebody doesn’t want to think about it, doesn’t want to do anything then yeah an hourly planner is not the right choice. An AUM planner is the better choice, and again keeping fees ultra-low, either through a robo-advisor that has you know, the financial planning built-in, or a Vanguard Personal Advisory Service which is a hybrid robo model, I would argue. Fees have to stay very, very low.

Rick Ferri: A lot of advisors I think kind of take shortcuts when trying to get people to invest with them and I was in the advisory business for thirty years; now ten years as a broker and then twenty years with an AUM company that managed investment portfolios, and only now I’m going into hourly because they don’t have that company anymore. 

You know a lot of advisors use these risk tolerance questions and Monte Carlo simulation models, and a lot of these things that make it sound so sophisticated and scientific as to how they go about creating a portfolio and managing that portfolio. What do you think about all of these questionnaires and Monte Carlo simulation?

Allan Roth: I’ve written a couple pieces, you know, the risk of taking risk profile questionnaires, did Monte Carlo simulations fail, and first of all on the questionnaires, typically when I take one, I get that I should be somewhere between 70% and 90% in stocks. And what they’re doing is measuring my willingness to take risk at that moment, and after ten years of a bull market we all think we have a very high willingness to take risk.

And then stocks plunge and suddenly that willingness to take risk goes away. And second, the biggest problem with these things is they don’t measure one’s need to take risk. You know, as our friend William Bernstein puts it when you’ve won the game, quit playing .That doesn’t mean 0% stocks, but take risk off the table. So they don’t measure that. So in spite of being told I should be 70 to 90% in stocks, I’m 45% in stocks and not about to change

Regarding Monte Carlo simulation I’m a big believer in Monte Carlo simulation, which actually came from a firm McKinsey and Company that I worked for a couple of decades or so ago. But the problem with Monte Carlo simulation are assumptions and by the way a Monte Carlo simulation is a model that runs a thousand or more iterations of what asset classes might do and calculates the probabilities that you’ll have enough to live out in retirement.

Like any model that happens to be good, and I argue Monte Carlo simulation did not sail in 2008-2009, it was the assumptions that went into the Monte Carlo simulation of incredibly high returns, very low volatility because the planner is going to know when to get out of the market, and all sorts of false assumptions that went in there. So Monte Carlo simulations are good, but the assumptions have to be very real.

Rick Ferri: I don’t use questionnaires either and a lot of these canned programs that financial planners use that have Monte Carlo simulations in it have a lot of garbage going in on the inside. They really do, so the advisor really needs to understand the dynamics of Monte Carlo simulation and make their own assumptions and make them realistic on the front end so they can get something useful on the back end. But I don’t think that occurs nine out of ten times.

Allan Roth: Probably ninety nine out of a hundred. I’ve looked at several different financial  planning pieces of software and ultimately decided I’m doing my own financial planning and not using any of their software. 

Rick Ferri: I want to now turn to some investment questions that were posed on the Bogleheads forum specifically for you because you’ve written about and talked about various asset classes and I want to go over some of those asset classes or investments with you so you could give us your current views. Let’s start with municipal bonds. What are your views on the state of the municipal bond market and if someone was to be a municipal bond investor what would you recommend?

Allan Roth:. First of all, never buy the muni bonds directly. The bid-ask spreads of muni bonds can easily be in the one to three percent category. The largest spread I’ve ever seen was ten point two five percent and my client by the way happened to be an attorney with the Securities and Exchange Commission in Washington DC had no clue about that. And then on individual muni bonds even in Vanguard statements, if you look at the yield, that yield includes the amortization of premium which is really paying back your own principal. 

So if you’re going to buy a muni bond I would buy an ultra low-cost muni bond fund like the Vanguard Intermediate-Term Tax-Exempt Fund. With that said I own a little bit of it. I do not let my clients put more than 20% of their fixed income in that fund and the reason is that even after a ten-year bull stock market, municipalities and states, their pensions still have, according to Moodys, 1.6  trillion dollars worth of unfunded pension liabilities and their actuarial assumptions with about a seven, seven and a half percent return, which I think are aggressive. So that if stocks don’t do very well over the next decade, and especially if stocks decline over the next decade as baby boomers retire, there’s going to be a lot of stress on those municipalities and there could be some systemic default. A  new correlation with stocks that has never happened before. So I’m okay with low-cost muni bond funds to a limited degree. Munis represent about 10% of investment grade bonds, and I don’t let my clients go more than twice that allocation to 20%.

Rick Ferri: Okay, next question. International bonds and international bond funds. What are your current views on adding these to a portfolio? 

Allan Roth: I think they’re okay. I generally don’t recommend them. I own a tiny little bit myself. When Vanguard launched its international bond fund they asked me to write about it. I did and I kind of gave it a ho-hum recommendation. First of all, never buy an expensive international fund and never buy an unhedged international bond fund. An unhedged international bond fund is going to behave very much like a foreign currency fund. But the problem with the Vanguard fund, although it’s very good and it’s the best international bond fund out there, is that it’s more expensive and it doesn’t include the cost of currency hedging.

And you know, I understand their argument that international bonds are the single largest of the four categories: US stocks, international stocks, US bonds, international bonds, and I’m a believer in diversification. But let’s face it, if the US government goes out of business, and the US government issues the vast majority of the investment-grade bonds, then all of our portfolios will fail. So I think there’s less importance there. But if somebody wants the international bond fund, the Vanguard one, I’m fine with them keeping it or buying some.

Rick Ferri: I think you and I have similar views on the fund. It’s like if you already have it, if you want it, fine. But it’s not something I would recommend in a portfolio. But if you have it or you want it, it’s okay. Next question and this is going to be your favorite one I think. Equity index annuities, you’re a big fan I hear.

Allan Roth: Oh yes, yes all the up-side of the market, no downside risk. Yeah, I’ve written about these extensively and you have to give them the smell test. How can somebody give you the upside of the market, no downside risk? You reverse engineer it. You look at the portfolio of the insurance company offering it and you can see that they’re 80 to 90 percent in bonds, you know and 10% to 20% in stocks and real estate, other investments that you could have bought directly. So you know what you’re doing is buying the portfolio indirectly, paying the agent who’s making 10% when you buy the product, making money for the insurance company, covering their overheads etcetera. You know, it’s not going to deliver what it says. There all sorts of tricks, caps, the S&P 500 Index stripped of dividends.

You know, one I just saw was sold at a much higher rate but they had subsequently, after the client bought it, lowered the maximum return to 4%. So they’re going to earn somewhere between zero and four percent, the money’s locked up. They’re going to get less than what they could have gotten on buying a treasury fund.

Rich Ferri: Not a good deal. So basically what you’re saying it doesn’t pass what you call your reasonableness test. What is your reasonableness test?

Allan Roth:  It’s reverse engineering, it’s, I call it the smell test. How are they going to deliver what they’re promising to you? How do they make money off of it? How can they own a mostly bond and a little stock portfolio, give you all the upside of the market, no downside risk? You know reverse-engineering it. What’s in it for them? They’re not doing it because they’re charitable organizations trying to make you rich. It’s like the call that you get trying to sell you the oil well partnership that has never had a dry well in their twenty years. Why the heck are they calling you? Why wouldn’t their current investors want to be getting in? Common sense is not all that common. The last  thing about the smell test is, not always, but roughly 99% of the time that I’ve heard something that just sounds too good to be true, it usually is. 

Rick Ferri: But not all insurance type products for investing are bad. Let’s take a single premium immediate annuity. There’s been a lot of good things written about some people using those. Would you agree?

Allan Roth:: Yeah. I think it’s certainly the best of all the insurance company annuities. That’s when let’s say you pay a million dollars and the insurance company turns around and they say they’re paying you 60,000 dollars a year in income for the rest of your life. So it’s not a bad product. But it’s not income if you think about it. If you do the math, that million dollars /60,000 dollars example, it’s not income because you have to live over 16 years just to get your principal back.

Number two it typically doesn’t have an inflation adjustment. There’s only one company that I know of that does, and that’s Principal, and of course that really lowers the amount that you get paid. So if you’re doing a SPIA that pays a flat amount you’re getting less and less spending power every year. But it’s certainly not a horrible investment.

And two annuities I often recommend are number one, delaying Social Security. That’s the best deferred annuity on the planet because it’s a government sponsored inflation adjusted annuity. And then second, roughly 75% of the time I do an analysis of somebody that is retiring with a pension, it comes out better to take the payment than to take the lump sum and roll it over to the IRA. And when you think about both of those examples no commissions are being paid, no insurance company is making a profit and covering their overhead, so those are probably the best two annuities on the planet.

Rick Ferri: A good answer, Allan, thanks. And by the way, I did interview Mike Piper for Bogleheads on Investing and he talked all about the benefits of delaying Social Security. That was a great podcast.

Allan, I had one Boglehead who is in the Thrift Savings Plan, which is the government plan like a 401k for government employees and the military. He’s going to be retiring soon and wants to know your thoughts about leaving the money in the plan rather than taking it out or rolling it into an IRA.

Allan Roth: Yeah well let me say I’ve been on Federal News Radio many times and you know once I joked will someone hire me into a government agency, pay me one dollar, give me enough time to roll my IRAs into the Thrift Savings Plan, and then you can fire me. It is that good. I wish I had access to the Thrift Savings Plan. I love the simplicity. I love the ultra-low cost. But really what I love the most is the G fund. That’s a bond issued by the Treasury only for US government employees and what it does is gives you an intermediate term bond rate without the downside if interest rates go up, it’s a stable value sort of thing and because a tax deferred account is the perfect place to hold bonds and that’s a superior bond. You know I love it, I wish I had access to it, so hopefully that answers the question. Don’t take your money out. 

Rick Ferri: probably does. And I always wondered why other governments don’t copy the Thrift Savings Plan with their own 403-b plans. I mean the 403-b plans I’ve seen some of the most horrible investment choices, such high-cost. I wish some of these trustees on these 403-b plans for medical professionals and for teachers would just look at the federal government’s Thrift Savings Plan and copy it and save their participants ungodly amounts of money over time.

Allan Roth: Well when I help a client company set up a 401k or move a 401k, I tried to design it after the Thrift Savings Plan, but I don’t have access to a G fund type of security .

Rick Ferri: Okay, got it. I’ve got a question now from a Boglehead who has been listening to you and reading your stuff and thinks you’re great and he wants to get into the industry. So if somebody out there decides they want to do the right thing for clients and they like what they’re hearing on these podcasts, like what you’re saying, and they want to get into the industry. Would you recommend they do that? What advice would you give somebody who makes a kind of a mid-career change to get into the financial advisory industry?

Allan Roth: Yeah that’s a tough question. I got into the hourly business only after a couple of decades of corporate finance and living frugally. So I didn’t need to make a whole lot of money my first year. And in my first year, by the way, my total revenue was $500. So probably, if they’ve got a family, kids into college, etcetera, the best advice is to go to work for an AUM financial advisor, kind of learn the business, and then decide whether or not they want to go out on our own. 

As you know, I’m an advocate of the hourly model, but it’s very hard for somebody who needs to make a living to just start a practice on the hourly model.

Rick Ferri: I started in the brokerage world for ten years to learn the business and that’s where I received my CFA charter and ended up getting a Masters of Science in finance, and then I left after ten years of learning the industry and getting my education, to go out and start my own company managing money and after that for 20 years now I’m going out and doing hourly. So I agree with you that doing hourly is very difficult if you’re just going to go out of the block just getting in the industry and doing something else to get some experience is generally going to be helpful.

Allan Roth: Yeah, and incentives matter by the way. If paying my kids’ college tuition were dependent upon me selling you that annuity in your IRA with all the upside of the market, no downside risk I would do it. I would think I’m a force for good and I would think that you and Allan just don’t understand it. You’ll be sorry when stocks plunge!

Rick Ferri: Allan, let me ask you one final question. Could you give us your list of what investors should be looking for when they go to hire an advisor. 

Allan Roth: You know, meet with the advisor, see what it is they’re offering to do for you. If they’re telling you they’re going to beat the market, run. But meet with the advisor, listen to him or her, what they’re saying. Are they trying to move you from complexity to simplicity? That’s a good thing.  A good advisor can help you build the right asset allocation for the amount of risk that you want to take. They can help you maximize that diversification, minimize the fees. They can provide discipline to stay the course, and as I think I mentioned, advisors as a whole time markets probably as poorly as individuals, if not worse. I’ve always said that investing is simple,  I never said taxes were. So maximize that tax efficiency. Help you on retirement planning, which assets to spend first.

Quite frankly, in retirement if you delay Social Security, which is typically the thing to do, Mike  Piper’s Open Social Security Calculator is absolutely wonderful, then they can sell stocks with the long-term capital gain at a zero percent tax rate, things like that. Help them understand risk management. Argue, a good advisor needs to argue with you and push back when they don’t agree with you. So those are things that a good advisor can do. So meet with the advisor, see what it is they’re suggesting to do, and then always ask what are the total fees that I’ll be paying. And just one last thing. The advisor you’re thinking of hiring needs to be willing to be the bad guy to help you get you out of where you are, because sometimes firms don’t like losing money and there needs to be a lot of push back to get them to move forward.

Rick Ferri: That’s great advice Allan. Thank you for being on Bogleheads on Investing today. We really appreciate you giving us your insights. It’s been a  wonderful talk. Good luck with your practice.

Allan Roth: Thank you, Rick.

Rick Ferri: This concludes the eighth episode of Bogleheads on Investing. I’m your host Rick Ferri. Join us each month to hear a new special guest. In the meantime visit Bogleheads.org. and the Bogleheads wiki, participate in the forum and help others find the forum .Thanks for listening.

[Music] 

[Applause]

Investment adviser, analyst, author and industry consultant

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