Hosted by Creative Planning Director of Financial Education, Jonathan Clements and President, Peter Mallouk this month’s podcast takes a closer look into surprises clients encounter as Creative Planning onboards assets recommended by former advisors. Included is an in-depth discussion on suitability standards, used by most of the large brokerage houses compared to the fiduciary standard, used by Creative Planning all the time! Plus, you won’t want to miss each of their monthly tips! Join us as we explore tax law updates, tax planning strategies and ways to avoid surprises from purchasing investment products!
Time Stamps
[0:00] –What are some of the things Peter Mallouk notices when brining on assets from other advisors?
[3:53] – Fiduciary standard. What does that mean?
[8:36] – Tax planning & tax law changes
[14:17] – Peter Mallouk tip of the month
[15:11] – Jonathan Clements tip of the month
Transcript:
Jonathan Clements: Hi, this is Jonathan Clements, director of financial education here at Creative Planning in Overland Park, Kansas. And with me is Peter Mallouk, president of Creative planning, and we are Down the Middle. Peter, you bring on new clients here at Creative Planning all the time. And when you bring them on, often they bring on their financial horror stories, these products they’ve been sold by their previous financial advisor, broker, life insurance agent. Tell me some of the things that you see when clients bring their finances to you, and you look at them for the first time.
Peter Mallouk: I think the two things’ people are surprised about the most are if they’re in something they can’t get out of. So, they might have bought a policy and they said, “Well, these are just investments. I can buy and sell them whenever I want, that’s what I was told.” Well, that means the mutual funds within the annuity or policy can be bought and sold whenever you want, but you can’t get out of the policy without paying 8% or 4% or 3%. Somebody I saw last week is stuck for eight years before it drops to 1% penalty. And that’s because obviously the agent’s getting paid a commission up front and the insurance company wants to recoup, and people are pretty upset when that happens.
I actually go through; I’ve had clients that have actually had their money stolen. I had somebody two weeks ago that have been investing in silver, and every year they’d come in and their return was higher and higher, and then they had most of their money with us, thankfully, and he called me sharing with me that on TV his advisor had been arrested. And it turned out there was no silver, it was a several hundred-million-dollar fund. So, I always just tell people, “Look, no one took your money. You have money, but you’re paying a pretty big fee and you’re going to be stuck here for a while.”
The other group, and this happens far more frequently, is folks that are in products that they don’t realize are owned by the parent company of the advisor. So big national brokerage houses, they own a lot of their own products and most of those products are in different names. So, they come in and they go, “But all these funds are different companies.” They’re really not. And so instead of having the best investments from all over the world, they wind up having this selection where the parent company is promoting their own products. And so, you’re usually paying more for a product that is probably performing less well than all of the alternatives that exist on Planet Earth.
And I think they’re just surprised or disappointed to find that, “I had no idea that that’s the case.” Because often we’ll come in and we’ll say, “Okay, this is what we recommend. And by the way, your fee on this fund’s going to go from 1.1% to 0.07%.” “Well, how can that be? This one must be better. That’s why I’m in this one.” And then we explain, “Well, it’s not better. It costs more, it creates more taxes, and it’s owned by the company of the advisor that you’re with.” I think that’s the most surprising thing to people. They really feel like when they go to an advisor, that that advisor is like a doctor or a lawyer or a CPA and that they’re going to put them in a better place and they’re required to, and that’s not how the financial advice industry works in the United States.
Jonathan: You know, one of the things, one of the big misperceptions out there is people see these advertisements all the time on TV from the big national brokerage firms, and they just assume that these are the best. And they don’t realize that when you talk to knowledgeable financial planners, that actually people tend to get the worst deal when they go to the big national brokerage firms. That’s where you end up getting the in-house products with these high fees. That’s where half the time the broker might be working on a fee basis and then half the time, they’re selling you a commission product. And essentially, they aren’t a true fiduciary. So, talk about that, the fiduciary standard, obviously that’s a big issue here at Creative Planning.
Peter: Yes. So, if you go to a big brokerage house, you’re almost guaranteed that the person that you’re dealing with might be a fiduciary some of the time, but a lot of the time is a broker and doesn’t have to act in your best interest. That you might get products that are not owned by that place that that person works, but that place almost certainly owns a bunch of products. That you’re probably going to be in a portfolio that would be more expensive than if you were somewhere else. And you’re right, that really surprises people. And it comes down to the difference between a fiduciary and a broker. So, a fiduciary has to do what’s in the best interest of the client, that’s not a professional rallying cry, that’s a legal standard.
A broker only has to do what’s suitable. And when was the last time you asked for suitable anything? A suitable meal or a suitable spouse or suitable sex, nobody wants suitable anything. They’re all looking for the best that they can get. And the fiduciary standard’s the highest standard that exists under the law and the brokerage standard, the suitability standard, is the lowest standard that exists in the law. Because ultimately prison food is suitable food, right? Suitable is a very, very low standard. And this is governed by the buyer beware laws. “Hey, this is a capitalist society,” and this is what the big brokerage house is saying. This is a capitalist society. Everyone’s a grownup, let them do their own due diligence, and the government shouldn’t get involved. And the fiduciary side says, “Well, we’re not telling the government to make recommendations, simply to say that advisors need to act in the best interest of the client just like a doctor does, just like a CPA does, just like a lawyer does.” It’s not some crazy standard.
Now, why do the brokerage houses not want that? Because they make a lot of money selling their own products. And the second they have to switch to the fiduciary standard; how can they justify an investment that’s 1% that could be bought for 0.1%? How can they suddenly recommend their own product when there’s a product from a different company that might perform a little bit better? So, it makes it very difficult for them. They’re going to lose a lot of their profit centers. How can you ever sell something on a commission that can be bought without a commission? So, it would really hurt their business to suddenly be held to the fiduciary standard. The way this battle gets won is much the way low-cost investing has been won, is the fiduciary side needs to get so strong that the brokerage side has so much to lose that they eventually have to convert. And either that’s going to happen or there’ll eventually be a regulation that’s passed that requires it.
Jonathan: And if you look at the numbers, firms like Creative, independent firms that follow a fiduciary standard, have been growing super-fast. Meanwhile, the big brokerage firms are struggling as their growth has not been great in recent years, I think in part because they are not true fiduciaries and people are starting to recognize this. So even if it’s expedient in the short term in terms of their profits to not be fiduciaries all of the time, in the long term it’s probably going to kill them. So surely at some point they’re going to say, “We have to change.” Or do they just keep up the game until there’s no more juice left in it? What happens here?
Peter: I think the game’s got a long way to go. Because for perspective, the big brokerage houses are multi-trillion-dollar firms, with a T. Creative Planning is one of the largest independent firms in the country that works with individuals, is $37 billion, with a B. So, we’re talking about a very, very big discrepancy. The typical brokerage house might be 100 times larger, for perspective, than Creative Planning. In the independent world Creative Planning is considered big, because the typical firm is a couple people managing $100 million dollars, and we’re calling that a firm. That’s not in the same league as the brokerage houses.
I like to think of Creative as being big enough to give the client all of the services that they need, but very, very small compared to the brokerage house, where you’re going to know your advisors and your teams and be able to navigate the firm well. You get everything you need, but it’s not overwhelming. But I think that’s a new thing. There are only a couple large independent firms. And so, I think we have a long way to go. And I think you’re going to have to see a few $100 billion independent firms emerge before I think it really raises an eyebrow in the brokerage world.
Jonathan: So, you’re going to have to be a $1 trillion firm before …
Peter: I don’t think that’s happening in my lifetime, but I think somebody’s going to do that at some point.
Jonathan: All right. So, let’s change topics here. Tax season. One of the things unique about Creative is you help people with their taxes. Not a lot of firms do that, right?
Peter: Yeah. We’ve got almost 100 people that come to work every day here at Creative Planning that do nothing but help people with tax issues, legal issues, that’s what they specialize in.
Jonathan: And of course, this year, early 2019, we’re all doing our taxes under the 2017 tax law.
Peter: Yeah, which is going to surprise a lot of people, I think.
Jonathan: Yeah. And one of the big changes is, we now have seen a doubling of the standard deduction. So, a lot of those tax deductions that you used to be able to take, you can’t take any more. Particularly in the part of the country where I live, in New York, you can’t deduct all of your state, local, and property taxes anymore. There’s a cap on that.
Peter: Yeah.
Jonathan: Also, there’s a cap on the size of the mortgage on which you can take it, deduct the interest. And as a consequence, a lot of people who previously itemized their deductions are either going to find their itemized deductions as barely larger than their standard deduction, which means they’re only going to get marginal benefit from the additional tax deductions they have, or they’ll end up with standard deduction. For a couple in 2019 the standard deduction is $24,400. So, it’s pretty high. It’s double what it used to be. And it has a couple of implications for people. One of them is, they may not be able to deduct their charitable gifts. And so, one of the things that there’s been a fair amount of talk about is bunching your charitable contributions, so that instead of doing one charitable contribution every year you take all of three years’ worth of contributions and put them in one year. And one way to do that but to continue giving is to set up a donor advised fund. Maybe you could talk a little bit about those.
Peter: So, the idea of bundling deductions is, let’s say that you have pledged $10,000 a year, let’s just say to your church or place of worship. And you’ve pledged this for five years. And let’s say under the new tax law you’re going to get no break by doing that over five years. You could approach your place of worship and say, “Look, I pledged $50,000. I’m going to give it all to you this year.” And make sure with your CPA that you get a much better break. You make the same gift, we’re not asking somebody to give more, but now you get some of that money back from the IRS. So, your gift becomes subsidized a little bit versus losing all of the deductions there.
Another way that people can do that is what you referenced, Jonathan, which is a donor advice fund. And this has just got to be a huge boon for donor advice funds. We’ve set up hundreds here at Creative Planning and it’s accelerating because of the tax law. And basically, you could say, “Okay, every year I give $10,000 to charity, but if I do that, the way the tax law works I’m not going to get a break anymore because the gift isn’t big enough combined with my other things to get that deduction. So, what I’m going to do is I’m going to set up my own donor advice fund, my own charity, if you will, and the next 10 years I was going to give $10,000 a year, it’s $100,000, I’m going to put the $100,000 in the donor advice fund today. And I’m going to get a very big break this year and the whole deduction comes in this year. And then for the next 10 years, that donor advice fund can give away $10,000 a year.”
So again, we’re not changing the commitment we made to the charity or the charitable giving pattern that we have. We’re simply bunching them up into one calendar year to get the full advantage of the break.
Jonathan: And it’s a very smart strategy. And the other strategy that we just mentioned right now is for a lot of people, if they had mortgages and they were previously able to deduct their mortgage interest and it was a nice tax break, that may not be the case anymore. And depending upon your financial situation, it could make sense to pay off that mortgage if you have the extra cash, or if you’re going out to buy a house, the old rule about, buy the biggest house possible, take out the largest mortgage possible, may not be the best advice in the world anymore.
Peter: Yeah. You used to be able to sit down with your advisor and do the math on an after-tax basis. Does it make sense to carry a mortgage or not? And that math has changed. So, it’s time to revisit that. Might still make sense to carry a mortgage, but you’re definitely in parts of the country losing parts of that break.
Jonathan: Yeah. So, one of the consequences is, if you have bonds in your regular taxable account, you may actually save more in interest by paying down the mortgage than you’re earning on those bonds. Though presumably the smartest strategy is actually not own those bonds in your regular taxable account, right?
Peter: That’s right. You want to focus on asset location, which is where you put your assets. Take those bonds, put them in an IRA, a 401k where you’re going to pay no taxes on the income, put things that don’t create a lot of taxes like large US stocks in your taxable account. So really the mortgage and the way that you invest in stocks and bonds, all of that comes together under the new tax law. It might require some adjustments to your portfolio.
Jonathan: Yeah. So just to give people a little bit of an example so they understand what we’re talking about, let’s say you have a mortgage that is costing you 4.5% a year, and previously maybe you could deduct that and save 1/3 of the cost in taxes. But now if you’re not able to itemize your reduction, so you’re barely over the limit of the standard deduction, suddenly that 4.5% is really costing you 4.5%. If you had bonds sitting in your regular taxable account that are yielding 3.5%, it might make financial sense to sell those 3.5% bonds and pay off the mortgage. But the better strategy, as you’re indicating, is what you want to do is hold those bonds in your retirement account. That way you earn the 3.5% and you defer taxes on it and earning that 3.5% in the retirement account tax deferred may still be less costly than the 4.5% mortgage.
Peter: Yep, exactly right. I’m glad you did that example. That’s perfect.
Jonathan: So finally, we come wrapping up, its usual time, one tip for the month ahead. Peter, what’s yours?
Peter: Well, once a year you can go to annualcreditreport.com and get your credit report for free, and there’s no catch. And so, I recommend that everyone that’s watching this go to that website, get your free credit report, make sure there’s no surprises there, that no one’s stolen your identity or anything else, and that you’re in good standing, and put a reminder on your calendar to do that every year.
Jonathan: And when you look at the report, what you want to do is see if there are any accounts that you don’t recognize. If there’s an account there that you don’t recognize, that means that there’s a high likelihood that your identity has indeed been stolen. You might actually also want to look and see whether there’s any misreported information. For instance, at one point my mortgage company stopped reporting that I was making mortgage payments and it dinged up my credit report. A quick call and they said, “Oh yeah, sorry, we sold the mortgage to somebody else and there was a three-month lapse when we didn’t report that you were paying, and that’s why we crunched your credit score. Sorry.” And my tip for the month ahead is, imagine you were the executor for your own estate. Imagine you had to settle your own affairs after your death. How easy would it be, or would it be a nightmare? And if the answer is it would be a nightmare, maybe it’s time to start tidying up your finances so it isn’t a nightmare should you go into the next part.
Peter: That’s great advice. When we start with a client here at financial planning, we give them one piece of paper with just seven or eight things written in on it and we tell them to bring it to the first meeting. And I can’t tell you how many times somebody goes, “Oh my, well, this is going to take me forever to find.” I’m like, “If you can’t find these seven things, how is anyone else going to deal with your financial life if you not only die, which is when an executor kicks in, but if you’re incapacitated?” Because three out of four of us at some point in our life will be incapacitated, and someone’s got to help with all of this stuff. So yeah, I think that’s great advice. Just make sure your affairs are in order, not just for the people that you leave behind, but for yourself.
Jonathan: All right. Well, I think we’re out of time here. So, Peter, thanks a lot. This is Jonathan Clements for Creative Planning, and we are Down the Middle.
Disclosure: This commentary is provided for general information purposes only and should not be construed as investment, tax, or legal advice. Past performance of any market results is no assurance of future performance. The information contained herein has been obtained from sources deemed to be reliable but is not guaranteed.
