It’s not uncommon that we find ourselves in the awkward profession of critiquing someone else’s work in the world of financial planning. Mind you, we’re seldom put in a position to review a comprehensive financial plan crafted by a fiduciary CFP® Professional using advanced planning software, and that was clearly crafted for this particular client with love and care. Rather, we often find ourselves reviewing “a financial plan” that is not visible insofar as there is no actual written plan or advice, just the artifacts that are often part of a plan (i.e., investments, insurance, that fixer-upper rental property, etc.) In that context, we’re often put in the awkward position of being critics, in a professional sense.
Ironically, that seldom is so much the case with a DIY investment enthusiast or someone who has worked hard, saved well, but just never quite put all the things together in the right way. Rather, the critique is most often raised when we’re looking at the work of a pseudo-amateur; that is to say, someone claiming to be a planning and advice professional but for whom the skillset of financial planning has never actually been trained or manifested in some manner. Or, even worse, a self-professed “professional” in an anonymous medium like internet advice from strangers!
So today, we’re describing many of the glaring red flags that tell us that someone has taken the advice of an amateur over a professional, and what corrective actions can be taken to abate the harms caused by pseudo-professional financial advice, whether by self-interested salespeople or well-intended strangers (or the occasional brother-in-law).
Class ABC Shares
Regardless of the source or cause, there is effectively no reason for any investor today to hold a Class A, B, or C share class. For the uninitiated, mutual funds offered by companies such as American Funds or Lord Abbett often come in a variety of both investment strategies and share class. The investment strategies might differ. Fund #1 might invest in large cap growth companies in the United States, Fund #2 might invest in emerging markets economies around the world, and so on. Funds from many fund companies will also come with a share class, typically a Class A, B, C, or alternatively, an investor share, investment grade, institutional, or retirement share class; these are often described with letters such as Y, I, Int, Inv, or potentially the complete absence of a letter or signifier at the end of the name.
So, for example, a fund might be called something like the “Dividend Appreciation Fund A” or “Dividend Appreciation Fund F-1.” The fund itself is the same, but the share class denoted by the A, F-1, or other letters explains how the fund is paid for. All investment funds have some amount of operational expenses. While a tiny number don’t explicitly charge fees to their owners and instead make the money through lending or trading spreads or other strategies, most funds will have a basic gross operational expense ratio (often denoted as some amount of a percent annually), a net operational expense ratio which may reflect additional costs or discounts as a result of how the fund invests and makes its money, and then additional fees. The base gross or net expense ratios are typically universal regardless of the share class of fund you purchase, but the additional fees can vary dramatically.
For example, a fund might have a gross expense ratio of 0.50%, and net expense ratio of 0.45% because the fund makes some additional money that helps defray its costs. However, let’s examine the impact of that fund being a Class A, Class B, Class C, or Institutional share.
- A Class A version of the fund would likely take 5.75% of your investment off the top, so that if you invested $100 in the fund, you’d actually start out with $94.25 invested on day one and $5.75 paid to the brokerage selling the fund. But, in addition to the 0.5% gross expense ratio, the fund would also charge a 12b-1 “marketing fee” of 0.25% to you, for total gross costs of 0.75% or net costs of 0.70%.
- A Class B fund wouldn’t charge you anything off the top, but it would have a “contingent deferred sales charge,” so if you redeemed the fund within the next 7 years, you’d end up paying a back-end fee of 7% – (1% * the number of years you’ve owned the fund). So for example, you might have bought the fund 3 years ago and then decide to sell out of it. Unfortunately, that means you’d find yourself losing 4% of your balance upon selling. In the meantime, whether you held the fund for a short time or a long time, the fund would have an additional 12b-1 marketing fee of 0.75% and a service fee of 0.25% annually. So, the fund would cost 1.5% gross and 1.45% net, so long as you held it until the contingent deferred sales period of 7 years ended, after which the fee would drop to 0.25%.
- A Class C fund also wouldn’t charge you anything up front, but it has an ongoing 1% 12b1 fee and a one-year-long contingent deferred sales charge of 1%. Effectively, you’d pay 1.5% gross or 1.45% in perpetuity, or until the fund had been held for ten years, after which it might be converted to a Class A share with a 12b1 fee of 0.25%.
- An institutional share class wouldn’t charge you anything up front, nor would it carry a 12b1 fee. These share classes thus typically only cost the underlying fund operation fees, and in this example, would only cost 0.5% gross and 0.45% net.
So when you compare those choices, why would you ever pay for a Class A, B, or C fund? Well, historically, these have come with much lower investment minimums than institutional share classes; additionally, in a time before digital technology made “investment management” much easier, it was common to invest all of your money in one particular fund family through one particular broker. By doing so, the investor could enjoy steady accumulation and reinvestment within a single fund family while steadily accumulating increasing discounts on the up-front sales charge of the Class A shares until, eventually, those up-front sales charges would go away altogether.
But, in the decades since institutional share classes became available, the investment minimums for many of these funds have declined significantly, and many funds do not and have never charged any sort of sales charge or “marketing fee” to be paid to brokers who sell them (meaning that they have never recommended them). And even with the advent of no-commission trading and low-cost index ETFs, one is left to wonder why anyone would pay more than 0.1%-0.2% at the most for an investment fund.
To identify whether you or someone else has invested in Class A, B, or C shares, simply search for the “Ticker”, a 5-digit alphabetical code such as VFIAX or PONPX, and review the share class information made available directly from the fund company selling the investment. Specifically, search for terms “12b-1” or “expense ratio” and see what the funds actually cost.
If you’re invested in such funds through a retirement account, you can easily sell those funds in exchange for lower-cost index funds or alternative investment options. If you have a taxable account with a highly appreciated set of investment shares where selling could incur substantial taxes, an easy solution available through many brokerages is a tax-free share class conversion in which you can convert Class A, B, or C shares to a lower-cost institutional share class without incurring any capital gains on the sale. Just be mindful of the contingent deferred sales charges baked into newer Class B or C shares!
Permanent Life Insurance (without insurable risk)
This one should be obvious, but with such exciting terms as “Rich Man’s Roth,” “Laser Fund,” “MPI Retirement Strategy,” or “Bank on Yourself” bandied about, it’s no wonder that people get confused. Simply put: If you are not married, do not have children, and no one financially depends on you, there is almost no possible reason you would want or need permanent life insurance.
Now, I say that having bought myself a permanent life insurance policy (a Variable Universal Life policy) when I was 28, unmarried, without children, or financial dependents. However, I was the agent who wrote the policy for myself, and specifically did so with the intention of locking in a large amount of permanent life insurance on my own life for two key reasons: 1) Death benefit protection for my future spouse, and 2) Long Term Care Insurance, as the policy came with a chronic illness rider that would let me spend up to 75% of the substantial death benefit toward my long term care needs should I ever be unable to complete two activities of daily living as are required to be eligible for long term care payments. So, why claim there is almost no reason to want or need permanent life insurance if that were the case?
Well, simply put: most young people, unmarried people, and people without financial dependents don’t have any real need for a death benefit. Further, while you can add living benefits such as a long term care rider to your life insurance, this is often best done as a complement to a core life insurance need, not as a specific funding strategy for long term care or other risks. After all, there are things like disability and long term care insurance that are actually built to specifically address those risks!
So how do people end up with permanent life insurance they don’t need? Simple: It’s the core business model of many insurance companies, particularly large and well-established mutual life insurance companies, to sell life insurance to anyone who will buy and pass underwriting. An insurance company becomes an insurance company by having an effective underwriting process that screens out obvious risks and red flag applicants, taking in premiums, and paying out less in claims than it takes in as premiums and earns in the reinvestment of those premiums. Thus, for many insurance companies, it’s good business to sell as much life insurance as they can to young, healthy people with little risk that could cause them to perish prematurely.
So how do you know if you have unnecessarily expensive permanent life insurance? Well, the first way is simple. Ask the most obvious question: Does anyone actually need my income to survive without me? If the answer is no, it’s all but certain that you don’t need permanent life insurance.
What if you do have a spouse, children, or others who depend on you? Well, ask the next obvious question: If I died today, how long could my dependent loved ones live on the death benefit? If the answer is less than a year or two? Time to look for much cheaper term life insurance, and a lot more of it! There are plenty of complex ways to calculate exactly how much life insurance you need to protect your loved ones, but the simple math here is to ask the question of whether you have a benefit that could be even remotely adequate for the purpose of providing for your family in your absence. And don’t forget unpaid labor! Just because you’re not working doesn’t mean that you’re not a potentially valuable contributor to the family at a later date or doing lots of work for the family that would cost a significant amount of money to replace!
Beyond the actual elements of insurance, you have to ask the question: If I’m getting less insurance every day for every dollar I’m paying, what is the opportunity cost of the amount I’m overpaying by? It’s a simple platitude from the 90s, but it’s remained incredibly salient: Buy term and invest the difference. Unless you have maxed out your ability to invest tax efficiently in your retirement plans such as 401(k), 403(b), 457, TSP, or PERA, and also invested the maximum amount in available IRAs (whether traditional or Roth, directly or via back-door strategies), then you probably don’t need life insurance as an accumulation tool. Worse, life insurance policies designed for wealth accumulation strategies look very different than life insurance policies designed as risk management tools. This is because risk management means increasing the amount of insurance in the product and thus its costs, while an accumulation strategy demands that costs be low and well-controlled. A life insurance policy claiming to be both a wealth accumulation tool and a risk management tool is very poor at doing both.
Two/Three/Four-Fund Portfolios
This is an oddity that you’ll find less often as a byproduct of unscrupulous salespeople than you’ll find as a byproduct of reading too much Reddit. Simply put, two, three, or four-fund portfolios are generic portfolios of low-cost index funds that invest in only the most nominal basket of investment choices, essentially trying to capture substantial categories of the investment universe through total stock market indexes, international indexes, or aggregate bond indexes. But low-cost index funds are good investments, generally speaking, so what’s the big deal?
The problem here is less with the product and more with the strategy. While a 2-4 fund portfolio can be very simple and efficient to operate, it’s seldom going to be the most mathematically optimized portfolio for risk and reward factors. For example, while you might be able to construct an ultra-cheap portfolio consisting of a US total stock market fund, an international total stock market fund, and/or an aggregate bond fund that covers either domestic, international, or all bond markets, it simplicity often betrays many fundamental principles of a well-constructed portfolio.
For example, I have seen many investors who’ve constructed relatively efficient 2-4 fund portfolios who have left substantial gaps within their investment strategy. These include things such as:
- Using taxable brokerage accounts to save for college rather than 529 plans.
- Over-funding IRAs or Roth IRAs rather than using the larger contribution amounts available in their company retirement plans, and only contributing enough to get the company match because the plan doesn’t offer the same “perfect” blend of 2-4 funds.
- Investing in a single index fund family. Vanguard is great. Blackrock is great. State Street is great. Fidelity is great. There are plenty of great index investment fund companies. Spoilers: none of them offer the best index fund for every investment class and strategy.
- Misunderstanding what “total _______ market” means. If you look at the underlying holdings of a variety of index funds claiming to be total stock, total international, aggregate bond, etc. funds, you will often find that they hold dramatically different numbers of securities and in substantially different weights.
- Using an “off the shelf” 2-4 fund allocation that is grossly misaligned to their financial needs or that otherwise underweights or overweights certain asset classes such as mid or small cap funds, resulting in mathematically inefficient ratios of risk and reward given the supposed target and timeline of the investment!
These are just a few common mistakes I see among investment enthusiasts who think they’ve found a silver bullet or lightning in a bottle when it comes to investment portfolios. There are numerous benefits to a 2-4 fund portfolio, but no single portfolio performs consistently across all market conditions, nor can any one portfolio be applied efficiently and specifically to meet the unique investment needs of a diverse range of investors.
What to do when you find these problems
Simply put? Ask for help. Some things like share class conversions can be fixed easily with a phone call to your brokerage, or in some cases, by transferring your funds away from a product salesperson’s firm to a more “neutral” brokerage such as Vanguard, Charles Schwab, or Fidelity, and then requesting a share class conversion.
Life insurance can be cancelled, but if there’s already a substantial amount of money invested in it, then there can be tax consequences to simply cancelling it and cashing it out. Talk to a fee-only financial planner to get advice on whether a 1035 exchange into a different type of insurance could be a more tax efficient use of the dollars, and if that’s not the case, then you can try to use the available cash value to defray the cost of replacing the expensive permanent insurance with either lower cost term insurance or reinvest the proceeds toward other goals.
For 2-4 fund portfolios, you may not need to make a change! But stop to assess whether your portfolio is purpose-built for your individual financial plan and needs. If you know what those are and how to assess that, then get on it. If not, find an advisor near you and engage them to help you build out a more comprehensive financial plan that aligns your wealth with your vision for your life. Or heck, schedule an appointment with us, and we’ll be happy to help. The fundamental thing is realizing that no investment or insurance product, nor any particular financial strategy, is a financial plan unto itself. Each can be a valuable tool when used and applied appropriately, but you should always be cautious of the belief that there is any silver bullet solution for your holistic financial health.