MONEY investor protection

Why You Might Get Shut Out of Wall Street Deals

Exterior visual door security system
Rudi Tapper—Getty Images/iStockphoto

The SEC is reviewing its rules governing who can invest in privately traded securities.

A Securities and Exchange Commission review of its “accredited investor” rule could ultimately make it tougher for people to invest in privately traded securities — high-risk investments with potentially high rewards.

Under the rule, only well-heeled investors are permitted to buy these private placements — securities that are not registered with regulators or traded on exchanges. The idea is to protect Mom and Pop investors from the risks of these illiquid securities, typically issued by small or startup companies and sometimes found to be issued or sold fraudulently.

The criteria, in place since the rule was established in 1982 and never adjusted for inflation, generally require that investors have $1 million in assets or earn at least $200,000 a year to qualify to buy these securities.

But some critics want the SEC to impose other criteria, such as certain professions, arguing that net worth and income are not the best measures of investor sophistication. Others, including the U.S. Government Accountability Office, say the 1982 levels are too low.

The review marks the SEC’s first under the 2010 Dodd-Frank financial reform law, which requires one every four years. The SEC can develop new rules to change the standards but does not have to make any changes.

Investor advocates see the review as their chance to persuade the SEC to tighten requirements for buying the securities. In 2011, Dodd-Frank required the SEC to exclude the value of an investor’s primary residence from the net worth calculation, but the securities still are reaching investors who lack the financial sophistication to take on the risk, they say.

Companies that issue the securities worry that changes could limit their access to capital.

Small brokerage firms that often sell private securities can earn commissions of roughly between 7 percent and 9 percent.

The SEC’s Investor Advisory Committee discussed the issue at a July 10 meeting and expects to propose recommendations when it reconvenes in October.

SEC staff members have met directly with other groups, including the Angel Capital Association, a trade group for investors in start-ups, and the Public Investors Arbitration Bar Association, an organization of lawyers who represent investors in securities arbitration disputes.

JOBS Act Interactions

Consumer advocates have become more concerned about the accredited investor rule because of a related issue raised by the 2012 Jumpstart Our Business Startups Act, which loosened a long-standing ban on advertising the offerings.

Under that law, issuers may advertise their private offerings to mass consumers, such as in television commercials, even though their sale is still restricted to accredited investors.

“Thanks to the JOBS act, once private offerings are now essentially public offerings,” said Barbara Roper, investor protection director of the Consumer Federation of America, and a member of the SEC’s Investor Advisory Committee. Her concern: that unsophisticated investors who meet the requirements of “accredited investor” advertising will see those pitches and buy in.

The SEC could leave the financial thresholds in place but limit the percentage of total assets that someone can invest in private offerings, Roper said.

Another choice would be to deem some investors as “sophisticated” because of their professions. Accountants and certified financial analysts, for example, would be deemed savvy enough to take on the risk. SEC Chair Mary Jo White described the approach as possible “alternative criteria” in a letter to U.S. lawmakers last year.

The SEC declined to comment on its review and would have to vote on any changes.

MONEY College

Why Your College-Bound Kid Needs to Meet Your Financial Planner

Parents showing jars of money
Jamie Grill—Getty Images

Sheltering children from tough money choices now can lead to unhappiness later on.

When I schedule a meeting with parents to talk about college costs, I always ask if the student will be attending the consultation.

About 80% of the time, the parents say no. Their usual response: “He’s too busy,” or “We would rather not include her.”

That’s a big mistake.

What I do is help estimate the final costs that the parents will be facing, taking into consideration projected financial aid, merit awards and the family’s current resources. Those costs can vary widely, from $5,500 a year to attend a community college while living at home to over $70,000 per year to go to a private college such as New York University.

Students should be involved from the start, so they can understand the financial issues that their parents will be facing. Students need to see the great disparity in cost outcomes among the different colleges on their wish list.

When I meet with the whole family, we can narrow down the types of schools that would be affordable to the parents as well as meet the academic and social needs of the student.

That way, we can avoid a situation in which a high school student, ignorant of any financial implications, pursues whatever college he is interested in. Then, in April of his senior year, when all of the acceptances and awards arrive, his parents review the options and say, “We can’t afford any of these.”

At that point, the only choices are for the student to attend a school he’s not happy with (such as a local college commuter school), or for the parents to go into deep debt in order to finance an education they cannot afford.

So I try my best to convince the parents to invite their student. Perhaps the parents are trying to shield their finances from their children. Eventually, however, the kids will be part of the parent’s estate planning. The earlier the children know about the parent’s financial situation the better. If a family limits the college search to the types of colleges that meet all needs (financial, academic, and social), then the only outcome in senior year will be a happy one for both the parents and the student!

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Paula Bishop is a certified public accountant and an adviser on financial aid for college. She holds a BS in economics with a major in finance from the Wharton School and an MBA from the University of California at Berkeley. She is a member of the National College Advocacy Group, whose mission is to provide education and resources for college planning professionals, students and families. Her website is www.paulabishop.com.

MONEY Aging

As You Age, You Need to Protect Your Money — From Yourself

Piggy Bank Locked Up
Andy Roberts—Getty Images

A financial planner explains why he couldn't help his client when she became delusional.

After three decades as a financial planner, I’m seeing more and more clients reach, not just retirement, but their final years. An issue that becomes especially important at this stage of life is how to help clients protect their financial resources from an unexpected threat — themselves.

One of my saddest professional experiences came several years ago when one of my long-time clients, a woman in her late 80s with no family and few close friends, abruptly fired me. Because Mary had no one else, I had helped her in many ways beyond the usual client/planner relationship and even reluctantly agreed to serve as her trustee and power of attorney in case she became incapacitated.

At what proved to be our final quarterly review meeting, Mary initially seemed confused. I was able to reassure her about the stability of her finances, and she seemed clearer by the time we finished. Three weeks later, I received a handwritten letter from her: “You have my finances in a mess. I can’t get to my money. You are fired.”

I was stunned. Yet ethically I was required to comply with her wishes by moving her holdings to another broker.

Several subsequent conversations demonstrated that Mary was suffering from periodic memory loss and delusion. Had she been disabled by a sudden accident or a stroke, I could have stepped in. Yet, because her decision to fire me was made at a time when she was arguably still competent, my hands were tied.

In theory, I could have gone to court with my power of attorney or in my position as trustee and petitioned to have Mary declared incompetent. But that posed a problem: Essentially, I would have been telling a judge, “Mary fired me as her adviser. I’d like to have her declared incompetent so I can re-hire myself as her adviser.” There was no way I was going to ask a judge to do that. I had a clear conflict of interest.

Since this experience, I have confirmed the wisdom, given the potential for conflict of interest, of never serving as a trustee or power of attorney for a client. With the help of suggestions from several other planners, I’ve also learned some strategies to help protect clients from themselves.

One tool is to ask clients to sign a statement authorizing a planner concerned about possible irrational behavior to contact someone, such as a family member or physician, designated by the client. While this would not prevent a client from firing an adviser, it would provide a method of discussing the issue and also involve another person in the decision.

Another possibility is to put clients’ assets into either an irrevocable living trust or a Domestic Asset Protection Trust (in states that allow them) and naming someone other than the client or the planner as trustee. While the client, as the beneficiary, would have the power to fire the trustee, concern about a trustee being fired irrationally could be mitigated to some degree by having a corporate trustee. In addition, with a DAPT, the beneficiary client would not have the power to amend the trust without the agreement of the trustee. This would give some protection against self-destructive choices by a client who was gradually losing competency. One disadvantage of this approach is cost, so it isn’t an option for everyone.

Perhaps the most important strategy is to work with clients to create a contingency plan in the event of mental decline. It could include arrangements to consult with family members or other professionals such as physicians, social workers, and counselors. For clients without close family members, the plan might authorize the financial adviser to call for an evaluation, by professionals chosen in advance by the client, if the client’s behavior appeared irrational. This team approach might alleviate clients’ fears about being judged incompetent by the person managing their assets.

The possibility of mental decline is something no one wants to consider. Yet it’s as essential a financial planning concern as making a will. Helping clients build financial resources for old age includes helping them create safety nets to protect those resources from themselves.

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Rick Kahler is president of Kahler Financial Group, a fee-only financial planning firm. His work and research regarding the integration of financial planning and psychology has been featured or cited in scores of broadcast media, periodicals and books. He is a co-author of four books on financial planning and therapy. He is a faculty member at Golden Gate University and the president of the Financial Therapy Association.

MONEY Banking

Why People Mistrust Financial Advisers

Untrustworthy businessman crossing fingers behind back
RubberBall Productions—Getty Images/Vetta

A financial planner says people can be cynical about her work. Her own experience as a bank customer helps explain why.

Very often, we financial planners convey the impression that getting your financial life into shape is easy. And that we’re in control of our finances.

If we had a bit of humility, we’d admit that we share the same frustrations as our clients.

Like dealing with low interest rates on checking accounts in combination with high banking fees.

“You get interest on this account,” the customer service representative from my bank said. This was about a month ago. I had called the bank upon receiving my monthly statement.

“Yes,” I replied. “I got a penny last month. A penny. And now you want to charge me $25 a month to have a checking account?”

She had to laugh.

I was calling to ask why a $25 charge had shown up on my formerly free checking account.

She asked if anything had changed. It had. I had paid off all my big debts. I was in much better financial shape.

Well, that explained it.

Now that I had repaid my loans to the bank, apparently my relationship with it wasn’t sufficient to earn me free checking. I was no longer paying the bank large amounts of interest, so it would start charging me this monthly fee. That is the way it works.

If this makes sense to you, you must be a banker.

Okay, that was a low blow. But for me, it’s an example of why so many clients have a bad attitude toward financial services institutions and professionals.

It’s not just the malcontents, it’s everyone. The surveys confirm that the public does not hold financial services institutions in high regard.

Many of my clients been burned before. And they’re probably still getting burned by such ridiculous tactics as fee-ing the customer to death or the inability to get a new mortgage or a small business loan without a dossier three feet thick that proves you do actually pay your bills.

I told the woman on the phone, “I just opened two checking accounts at another bank for my twin daughters. The other bank is going to charge $12 a month for each account. And as soon as my girls go show their college IDs, the accounts will be free. So tell me why I should pay you $25.”

I spoke politely, without a trace of anger.

Eventually, the customer service representative found a way to give me some credit for direct deposit of my paycheck. And she switched me to an account that will ding me only $7 a month.

Of course, if the bank had wanted to provide the best deal for a longtime customer, they could have recognized this direct deposit before. But they hadn’t. They had just slapped a fee three times larger than on my new account, perhaps hoping I wouldn’t find out how I could save some money.

Cynicism? Anger? The emotions that I feel are the same ones that people have when they approach me as a professional. As a certified financial planner I have much larger ideas that I need to convey to our customers and the general public than “I won’t cheat you or slip in something that benefits me and not you.”

But it’s tough to get through all that dreck first and get on to the important ideas.

I told the customer service representative that I didn’t mind giving up the penny in exchange for a lower monthly fee.

When I told this anecdote to one of my partners, he just had to raise the ante. “Last month, I got three pennies,” he said.

Another happy financial services customer.

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Harriet J. Brackey, CFP, is the co-chief investment officer of KR Financial Services, a South Florida registered investment advisory firm that manages more than $330 million. She does financial planning for clients and manages their portfolios. Before going into the financial services industry, she was an award-winning journalist who covered Wall Street. Her background includes stints at Business Week, USA Today, The Miami Herald and Nightly Business Report.

MONEY Financial Planning

What My 3-Hour Lunch Says About Good Financial Advice

Women at a lunch meeting
Colorblind—Getty Images

Financial planning isn't about investing for retirement or saving for college; it's about turning your vision into reality.

It was Suzanne’s birthday. I really wanted her to have the next best thing to a day off. So I, the adviser, and Suzanne, my client, scheduled our meeting at Guglhupf, a lovely local restaurant.

In 2005, when I formed my company, I was sitting at one of Guglhupf’s upstairs tables when I came up with the tagline of my firm: “Driven by a Vision.” Now, years later, spending a sunny afternoon on Guglhuph’s patio with Suzanne, I had a powerful moment of living that ideal.

Suzanne is a visionary, an entrepreneur. She first came to me as a client because she wanted to be sure that the various ventures she had underway didn’t encumber too much of her wealth — that her assets wouldn’t all be at risk and that she would have enough set aside for her family’s future needs and her own retirement.

At its core, financial planning is helping people realize their vision. And for my entrepreneurial clients, I’m helping them navigate some very complicated waters at a time that’s emotionally charged due to hope, desire, exhaustion, and frankly, being stretched too thin.

These conversations can’t happen inside financial planning software, and they don’t happen on the pages of a financial plan. They aren’t about “Do I have enough money to fund my financial goals?” These conversations are about figuring out how to make those goals come to life.

And this is without my being a business consultant. I don’t know the trades of the businesses my clients start. What I do know is that there are risks associated with what they’re doing, and that likely their venture’s cash flow isn’t going to be as healthy as the projections project. I expect that there’ll be a need for another capital infusion. All of these things are going to impact their other financial planning goals: paying for their child’s education, for example, and being financially independent one day. They know all this too.

However, I believe that when a person has a strong vision for a world they want to impact — their community, their life’s energy making that impact — that inner urge trumps saving for retirement. It doesn’t trump it to the point of being reckless and blinded by today’s enthusiasm, but we recognize that they’re standing at the center point of the see saw, one foot on either arm, finding that balance between today and the long-term tomorrow.

I’ve never snuffed out their flame by saying, “You can’t do that.” I think that’s because I know what it’s like to be driven by a vision. It is my role to identify the risks I see, offer suggestions of how to look at it from another angle, ask them to name a Plan B, and beat the drum of the importance of managing cash flow. Then, I support them in their new venture, in whatever way reasonable.

At this meeting with Suzanne, there was an extra-special payoff. While I do try to stay out of the specifics of my clients’ businesses, over the course of our three-hour lunch we brainstormed about how she might finance one of her new ventures. I realized I knew some people who might be interested in funding it, and I promised to put Suzanne in contact with them. I later did, and they ended up providing money to Suzanne for this project.

So this meeting epitomized my work: My clients are driven by a vision, and I am driven to help them achieve that vision. And if we can enjoy a decadent dessert together, that’s even better.

MONEY IRAs

This Simple Move Can Boost Your Savings by Thousands of Dollars

Stack of Money
iStock

Last-minute IRA savers and those who keep their money in cash are paying a procrastination penalty.

Individual Retirement Account contributions are getting larger—an encouraging sign of a recovering economy and improved habits among retirement savers.

But there is an “I” in IRA for a reason: investors are in charge of managing their accounts. And recent research by Vanguard finds that many of us are leaving returns on the table due to an all-too-human fault: procrastination in the timing of our contributions.

IRA savers can make contributions anytime from Jan. 1 of a tax year up until the tax-filing deadline the following April. But Vanguard’s analysis found that more than double the amount of contributions is made at the deadline than at the first opportunity—and that last-minute contributions dwarf the amounts contributed throughout the year. Fidelity Investments reports similar data—for the 2013 tax year, 70% of total IRA contributions came in during tax season.

Some IRA investors no doubt wait until the tax deadline in order to determine the most tax-efficient level of contribution; others may have cash-flow reasons, says Colleen Jaconetti, a senior investment analyst in the Vanguard Investment Strategy Group. “Some people don’t have the cash available during the year to make contributions, or they wait until they get their year-end bonus to fund their accounts.”

Nonetheless, procrastination has its costs. Vanguard calculates that investors who wait until the last minute lose out on a full year’s worth of tax-advantaged compounded growth—and that gets expensive over a lifetime of saving. Assuming an investor contributes the maximum $5,500 annually for 30 years ($6,500 for those over age 50), and earns 4% after inflation, procrastinators will wind up with account balances $15,500 lower than someone who contributes as early as possible in a tax year.

But for many last-minute savers, even more money is left on the table. Among savers who made last-minute contributions for the 2013 tax year just ahead of the tax-filing deadline, 21% of the contributions went into money market funds, likely because they were not prepared to make investing decisions. When Vanguard looked at those hasty money market contributions for the 2012 tax year, two-thirds of those funds were still sitting in money market funds four months later.

“They’re doing a great thing by contributing, and some people do go back to get those dollars invested,” Jaconetti says. “But with money market funds yielding little to nothing, these temporary decisions are turning into ill-advised longer-term investment choices.”

The Vanguard research comes against a backdrop of general improvement in IRA contributions. Fidelity reported on Wednesday that average contributions for tax year 2013 reached $4,150, a 5.7% increase from tax year 2012 and an all-time high. The average balance at Fidelity was up nearly 10% year-over-year to $89,100, a gain that was fueled mainly by strong market returns.

Fidelity says older IRA savers racked up the largest percentage increases in savings last year: investors aged 50 to 59 increased their contributions by 9.8%, for example—numbers that likely reflect savers trying to catch up on nest egg contributions as retirement approaches. But young savers showed strong increases in savings rates, too: 7.7% for savers aged 30-39, and 7.3% for those aged 40-49.

Users of Roth IRAs made larger contributions than owners of traditional IRAs, Fidelity found. Average Roth contributions were higher than for traditional IRAs across most age groups, with the exception of those made by investors older than 60.

But IRA investors of all stripes apparently could stand a bit of tuning up on their contribution habits. Jaconetti suggests that some of the automation that increasingly drives 401(k) plans also can help IRA investors. She suggests that IRA savers set up regular automatic monthly contributions, and establish a default investment that gets at least some level of equity exposure from the start, such as a balanced fund or target date fund.

“It’s understandable that people are deadline-oriented,” Jaconetti says. “But with these behaviors, they could be leaving returns on the table.”

Related:

 

MONEY Estate Planning

What Parents Can Learn From Philip Seymour Hoffman’s Will

Philip Seymour Hoffman
Victoria Will—Invision/AP

When it comes to deciding who inherits what, the law gives the dead wide latitude to impose a number of conditions.

On Tuesday, the will of Oscar-winning actor Phillip Seymour Hoffman was released to the public. In addition to dictating who would receive various parts of his estate, the document also contained a more esoteric request: that his son, Cooper, be raised in one of three cities—New York, Chicago, or San Francisco—to ensure that he would grow up in a rich cultural environment.

It’s an understandable request (and as a New Yorker, I’m flattered we made the list), but is it really legal to dictate where your children grow up after you’ve already passed on? And, more broadly, to what extent can one control their descendants’ actions post-mortem?

By law, Hoffman could not have ordered his child’s guardian to keep Cooper in a particular place. Gerry W. Beyer, a professor at Texas Tech University School of Law, explains that wills can do no more than transfer property from the deceased to their survivors. That said, there are plenty of ways the dead can use property to encourage (or, some might say, coerce) descendants into living a certain kind of life.

If you want to influence your survivors to do something—finish college, go to mass, take good care of Fido, etc.—the best way to do it is to promise them money on the condition they fulfill your request. For example, if you want to make sure your son takes his education seriously, you can leave him $10,000 on the condition he is admitted to a top-ranked college. If Junior knows too many late homework assignments could mean missing out on a huge payday, he’s probably going to hit the books.

Because the deceased have no obligation to give away anything after death, courts tend to give them wide latitude in how their wealth is distributed. The only clear restriction is that inheritance cannot be conditioned on an illegal act (kill the neighbor and you’ll get my car). Otherwise, the condition must simply avoid acting against “public policy”—it can’t encourage something the state doesn’t like—and defining what that includes is almost entirely up to an individual judge.

Ample room for interpretation can sometimes lead to controversial results. In a landmark 2009 ruling, a judge upheld the will of a Chicago dentist that denied funds to any of his grandchildren who married a non-Jew. Various family members sued, arguing the clause provided monetary incentive towards racism. “It is at war with society’s interest in eliminating bigotry and prejudice, and conflicts with modern moral standards of religious tolerance,” one (disinherited) granddaughter wrote in a brief to the Illinois Supreme Court. The verdict? Too bad. The judge found no reason why her grandfather could not choose to favor those descendants who followed his religious traditions.

According to Beyer, this type of decision isn’t uncommon. “This is something the court is doing in its equitable powers,” says the professor. “You can even find similar cases in the same state that go different ways.”

Highlighting this issue, the Supreme Court of Pennsylvania had previously ruled against a different will that also attempted to mandate religious observance. In that case, the document required a son to “remain faithful” to his father’s religion in order to receive any money. Unlike the Illinois case, this court found that the will contradicted the state’s Bill of Rights, which declared no human authority could interfere with acts of conscience. Does that sound inconsistent? Now you’re getting the hang of it.

Luckily, there are some relatively standard limits to what strings one can attach to their will. Beyer advises that courts will often use public policy arguments to deny provisions that are “manifestly unfair or unreasonable.” For example, a provision that would grant a person money for divorcing their spouse would be ruled invalid.

However, when it comes to the more contentious issues, there’s no telling how a case will turn out. Hoffman graciously chose to merely suggest that Cooper be raised in a cultural center, leaving the final decision completely up to Mimi O’Donnell, the mother of his children and inheritor of his estate. However, had Hoffman chosen to stake O’Donnell’s inheritance on keeping his son in a major city, Beyer says, the outcome would rest on the relevant court’s prerogative.

“Where you draw the line can be kind of fuzzy,” Beyer says. “People have done a lot of strange things.”

MONEY Financial Planning

The One Time Raiding Your Kid’s College Savings Makes Sense

Broken money jar
Normally, breaking into your college savings accounts is a no-no. Jeffrey Coolidge—Getty Images

It's never a great idea, but in an emergency tapping funds earmarked for education beats sabotaging your retirement plans.

Lauren Greutman felt sick.

She and her husband Mark were about $40,000 in debt, and were having trouble paying their monthly bills. As recent homebuyers, the Syracuse, N.Y. couple were already underwater on their mortgage and getting by on one income as Lauren focused on being a stay-at-home mom.

“We were in a really bad financial position, and just didn’t have the money to make ends meet,” remembers Greutman, now 33 and a mom of four.

There was one pot of money just sitting there: their son’s college savings, about $6,500 at the time. That is when they had to make a tough decision.

“We had to pull money out of the account,” she says. “We thought long and hard about it and felt almost dishonest. But it was either leave it in there, or pay the mortgage and be able to eat.”

It is a quandary faced by parents in dire financial straits: Should you treat your kids’ college savings—often housed in so-called 529 plans—as a sacred lockbox, or as a ready source of funds that may be tapped when necessary.

Precise figures are not available, since those making 529-plan withdrawals do not have to tell administrators whether or not the funds are being used for qualified higher education expenses, according to the College Savings Plans Network. That is a matter between the account owner and the Internal Revenue Service.

TIAA-CREF, which administrates many 529 plans for states, estimates that between 10% to 20% of plan withdrawals are non-qualified and not being used for their intended purpose of covering educational expenses.

It is never a first option to draw college money down early, of course. Private four-year colleges cost an average of $30,094 in tuition and fees for 2013/14, according to the College Board. Since that number will presumably rise much more by the time your toddler graduates from high school, parents need to be stocking those financial cupboards rather than emptying them out.

Joe Hurley, founder of Savingforcollege.com, has a message for stressed-out parents: Don’t beat yourselves up about it.

“The plans were designed to give account owners flexible access to their funds,” Hurley says. “I imagine parents would feel some guilt. But I don’t think they should. After all, it is their money.”

Why the Alternative Might Be Worse

Keep in mind that there are often significant financial penalties involved. With non-qualified distributions from a 529 plan, in most cases you are looking at a 10% penalty on the earnings. Withdrawn earnings will also be treated as income on your tax return, and if you took a state tax deduction on the original investment, withdrawn contributions often count as income as well.

Not ideal, of course. But if your other option for emergency funds is to raid your own retirement accounts, tapping college savings is a last-ditch avenue to consider. That’s not only because you do not want to blow up your own nest egg, but because it could make relative sense tax-wise. And as the saying goes, you can borrow money for college, but not for retirement.

“If you think about it, a parent who has a choice between tapping the 529 and tapping a retirement account might be better off tapping the 529,” says James Kinney, a planner with Financial Pathway Advisors in Bridgewater, N.J.

If the account is comprised of 30% earnings, then only 30% would be subject to tax and penalty, Kinney explains. And that compares favorably to a premature distribution from a 401(k) or IRA, where 100% of the distribution will be subject to taxes plus a penalty.

Lauren Greutman’s story has a happy ending. She and her husband made a pledge to restock their son’s college savings as soon as they were financially able. It is a pledge they kept: Now eight-years-old, their son has a healthy $12,000 growing in his account.

She even runs a site about budgeting and frugal living at iamthatlady.com. Still, the wrenching decision to tap college savings certainly was not easy—especially since other family members had contributed to that account.

“We tried to take emotion out of it, even though we felt so bad,” Greutman says. “Since we didn’t have money for groceries at that point, we knew our family would understand.”

Related: 4 Reasons You Shouldn’t Be Saving for College Just Yet

MONEY 401(k)s

Why Your 401(k) Won’t Offer This Promising Retirement Income Option

More investors are flocking to deferred annuities, which kick in guaranteed income when you're old. But 401(k) plans aren't buying.

Longevity risk—that is, the risk of outliving your retirement savings—is among retirees’ biggest worries these days. The Obama administration is trying to nudge employers to add a special type of annuity to their investment menus that addresses that risk. But here’s the response they’re likely to get: “Meh.”

The U.S. Treasury released rules earlier this month aimed at encouraging 401(k) plans to offer “longevity annuities”—a form of income annuity in which payouts start only after you reach an advanced age, typically 85.

Longevity annuities are a variation of a broader annuity category called deferred income annuities. DIAs let buyers pay an initial premium—or make a series of scheduled payments—and set a date to start receiving income.

Some forms of DIAs have taken off in the retail market, but longevity policies are a hard sell because of the uncertainty of ever seeing payments. And interest in annuities of any sort from 401(k) plan sponsors has been weak.

The Treasury rules aim to change that by addressing one problem with offering a DIA within tax-advantaged plans: namely, the required minimum distribution rules (RMDs). Participants in workplace plans—and individual retirement account owners—must start taking RMDs at age 70 1/2. That directly conflicts with the design of longevity annuities.

The new rules state that so long as a longevity annuity meets certain requirements, it will be deemed a “qualified longevity annuity contract” (QLAC), effectively waiving the RMD requirements, so long as the contract value doesn’t exceed 25% of the buyer’s account balance or $125,000, whichever is less. (The dollar limit will be adjusted for inflation over time.) The rules apply only to annuities that provide fixed payouts—no variable or equity-indexed annuities allowed.

But 401(k) plans just aren’t all that hot to add annuities—of any type. A survey of plans this year by Aon Hewitt, the employee benefits consulting firm, found that just 8% offer annuity options. Among those that don’t, 81% are unlikely to add them this year.

Employers cited worry about the fiduciary responsibility of picking annuity options from the hundreds offered by insurance companies. Another key reason is administrative complication should the plan decide to change record keepers, or if employees change jobs.

“Say your company adds an annuity and you decide to invest in it—but then you shift jobs to an employer without an annuity option,” says Rob Austin, Aon Hewitt’s director of retirement research. “How does the employer deal with that? Do you need to stay in your former employer’s plan until you start drawing on the annuity?”

Employees are showing interest in the topic: A survey this year by the LIMRA Secure Retirement Institute found 80% would like their plans to offer retirement income options. The big trend has been adding financial advice and managed account options, some of which allow workers to shift their portfolios to income-oriented investments at retirement, such as bonds and high-dividend stocks. Some 52% of workplace plans offered managed accounts last year, up from 29% in 2011, Aon Hewitt reports.

“The big difference is the guarantee,” says Austin. “With the annuity, you know for sure what you are going to get paid. With a managed account, the idea is, ‘Let’s plan for you to live to the 80th percentile of mortality, but there’s no guarantee you’ll get there.'”

Outside 401(k)s, the story is different. Some forms of DIAs have seen sharp growth lately as more baby boomers retire. DIA sales hit $2.2 billion in 2013, more than double the $1 billion pace set in 2012, according to LIMRA, an insurance industry research and consulting organization. Sales in the first quarter this year hit $620 billion, 55% ahead of the same period of 2013.

Three-quarters of those sales are inside IRAs, LIMRA says, since taking a distribution to buy an annuity triggers a large, unwanted income tax liability. But the action—so far—has been limited to DIAs that start payment by the time RMDs begin. The new Treasury rules could accelerate growth as retirees roll over funds from 401(k)s to IRAs.

“For some financial advisers, this will be an appealing way to do retirement income planning with a product that lets them go out past age 70 1/2 using qualified dollars,” says Joe Montminy, assistant vice president of the LIMRA Security Retirement Institute. “For wealthier investors, [shifting dollars to an annuity] is also a way to reduce overall RMD exposure.”

Could the trend spill over into workplace plans? Austin doubts it. “I just don’t hear a major thirst from plan sponsors saying this is something we should have in our plan.”

Related:

How You Can Get “Peace of Mind” Income in Retirement

The New 401(k) Income Option That Kicks In When You’re Old

Need Retirement Income? Here’s the Hottest Thing Out There

MONEY ETFs

Hot Money Flows into Energy and Bonds

Dollar sign in flames
iStock

Sometimes it pays to follow the crowd. At other times, you'll get burned.

All too often, I see investors heading in the wrong direction en masse. They buy stocks at the top of the market or bonds when interest rates are heading up.

Occasionally, though, active investors may be heading in the right direction. A case in point has been the flow of money into certain exchange-traded funds in the first half of this year.

Reflecting most hot money trends, billions of dollars moved because of headlines. The Energy Select SPDR exchange-traded fund, which I discussed three weeks ago, gathered more than $3 billion in assets in the first half, when crude oil prices climbed and demand for hydrocarbons remained high.

The Energy SPDR, which charges 0.16% for annual management expenses and holds Exxon Mobil , Chevron , and Schlumberger , has climbed 22% in the past 12 months, with nearly one-third of that gain coming in the three months through July 18. Long-term, this may be a solid holding as developing countries such as China and India demand more oil.

“We think the Energy Select SPDR is a play of oil prices remaining high and supporting growth for integrated oil & gas and exploration and production companies,” analysts from S&P Capital IQ said in a recent MarketScope Advisor newsletter.

Headlines also favored European stocks as represented by the Vanguard FTSE Developed Markets ETF , which holds leading eurozone stocks such as Nestle, Novartis , and Roche. The fund has been the top asset gatherer thus far this year, with $4 billion in new money, according to S&P Capital IQ.

As Europe continues to recover over the next few years and the European Central Bank keeps rates low, global investors will continue to benefit from this growing optimism.

The Vanguard fund has gained nearly 16% for the 12 months through July 18. It charges 0.09% in annual expenses and is a solid holding if you have little or no European exposure in your stock portfolio.

Rate Hikes

Not all hot money trends make sense, however. As the economy accelerates and interest-rate hikes look increasingly likely, investors are still piling money into bond funds, which lose money under those circumstances.

The iShares 7-10 Year Treasury Bond ETF , which holds middle-maturity U.S. Treasury bonds, continued to rank in the top 10 funds in terms of new money in the first half. The fund, which holds nearly $5 billion, is up nearly 4% for the 12 months through July 18, compared with 4.2% for the Barclays U.S. Aggregate Total return index, a benchmark for U.S. Treasuries. The fund charges 0.15% in annual expenses.

While investors were able to squeeze a bit more out of bond returns in the first half of this year, they may be living on borrowed time.

The U.S. Federal Reserve confirmed recently that it would be ending purchases of U.S. Treasury bonds and mortgage-backed securities in October. This stimulus program, known as “QE2,” has kept interest rates artificially low as the economy has had a chance to recover.

The phasing out of QE2 could be bearish for bond funds.

Will interest rates climb to reflect growing demand for credit and possibly higher inflation down the road? How will the ending of the Fed’s cheap money program affect U.S. and emerging markets shares?

Many pundits believe public corporations may pull back from their enthusiastic stock buybacks and trigger a correction. Yet low inflation and modest employment gains may mute bond market fears.

“The Fed is on track to complete tapering in the fourth quarter, and we think there is essentially no chance that it will move the fed funds rate higher this year,” Bob Doll, chief equity strategist with Nuveen Investments in Chicago, said in a recent newsletter.

“With the 10-year Treasury ending the quarter at 2.5%, the yield portion of this forecast is more uncertain,” Doll added, “although we expect yields will end the year higher than where they began.”

While there could be any number of wild cards spoiling the party for stocks, it is wise to ignore short-term trends and prepare for the eventual climb in interest rates.

That means staying away from bond funds with long average maturities along with vehicles like preferred stocks and high-yield bonds that are highly sensitive to interest rates.

Longer-term, shares of companies in consumer discretionary, materials and information technology businesses likely to benefit from a global economic resurgence will probably be a good bet.

Just keep in mind that the hot money can be wrong, so build a long-haul diversified portfolio that protects against the downside of a torrid trend going from hot to cold.

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