Believe and Obey

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Wholesale Rip-off Part 5: Selling the “Cure”

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This is part 5 of our monthly series about how money really moves in America, and thus how the financial services industry rips off average investors.  Parts 1, 2, 3, and 4 are here, here, here, and here.  This series is a direct result of more than a decade in this industry with a close-up view of the rip-off it truly is.

Getting Qualified is Like Getting Made

In the financial world, there are two types of investments: qualified and non-qualified.  The distinction is based upon how this money is taxed.  Qualified plans refer to employer-sponsored retirement plans that comply with the requirements of the tax laws, as well as a law called the Employee Retirement Income Security Act of 1974, or ERISA for short. ERISA-qualified accounts offer tax benefits, including tax deferral of income within the account, tax deductions or exclusions for contributions to a traditional qualified account, and the right to roll over fund balances into an IRA. By contrast, nonqualified plans don’t comply with those provisions and therefore aren’t treated the same way for tax purposes.

Technically, IRAs aren’t qualified plans because they aren’t offered by employers. Nevertheless, in considering the tax consequences, it makes sense to treat them in the same way as qualified plan accounts, because the tax deferral and deduction features are similar.  In fact, in the financial services world they are treated as identical and referred to as qualified products.

The main vehicle that the financial services sector uses to sell their products is through work-based retirement plans, popularly known as 401ks after their place in the Internal Revenue Code. Originally this section of the tax code was intended for high earning individuals to avoid taxes on their investment assets.  That changed in the wake of the Federal Reserve induced instability that we discussed last month.  Pursuant to the desire and need to turn away from pension plans that were too unstable to maintain, corporations and the financial services sector began to seek and obtain regulation favorable to replacing defined benefit pensions with defined contribution 401k plans.  These are qualified plans and regulated under the ERISA law.

In 1978, a provision was added to the Internal Revenue Code as part of the 1978 Revenue Act which allowed employees to make voluntary contributions to employer-sponsored retirement plans with pretax dollars.  Before 1978 employees could make voluntary contributions to plans established by employers and the growth of these plans was tax free but employees could not make tax-deductible contributions to these plans.  It is scarcely possible to overemphasize the importance of this policy change to the growth of defined contribution plans from then on.

Of course, no opportunity goes unexploited by the financial sector and quickly a retirement plan industry was built up that uniformly and regularly ripped off unsuspecting investors.  There in fact may be no bigger scam in the investment arena than 401ks.

In very short order in the 1980s millions of investors began to fund 401ks, and various forms of IRAs.  50% of companies offer a 401K and there are over 60 million people enrolled.  The thing about these products is that the choices are poor, usually 3 investment “models” to choose from: a conservative, a moderate and an aggressive portfolio.  Nobody can tell you what these portfolios consist of or how much the fees are.  This may be one of the few products that people buy without knowing either the cost or the quality of what they are buying.

What is Really Being Sold

What they are buying is in fact a lot of risk.  All the risk for the performance or lack thereof is on the investor.  All the crucial decisions are on the investor as well: how much to save for retirement; how to invest; how to make their accumulated savings last the rest of their lives. 

The results, as have been outlined previously, are of course terrible.  People are lousy investors.  In fact, the results are so terrible that over 50% are not saving for retirement at all and 33% have practically no retirement savings at all.  As for those that do have money in the market, they are suffering their own inability to invest wisely as the return statistics discussed in previous posts detail.

Where investors are particularly hard hit is in costs.  In an average retirement plan, there are probably over a dozen different fees: asset management fees; trading fees; marketing fees; recordkeeping fees; administrative fees, just to name a few.  The average actively managed mutual fund carries a fee of 1.3%, although they can go as high as 4 or 5%.

These fees are the key to how certain funds get into retirement plans to begin with.  Mutual funds rely on brokers and plan administrators to market or wholesale their funds.  In return these brokers get a payment known as a “revenue share”.  This simply means that for every dollar invested in a fund the fund gives the broker a certain percentage for their effort.  This is simply a kickback.  Were it not legal it would be known as a bribe.  In the end these funds and those who market them and those who “select” them are a part of a “pay to play” system. We will look at this in greater detail in a subsequent post.

Over time these fees are killing returns.  If you plug in a 2% fee differential into an investment calculator on say a $100K account over 50 years those fees eat up 63% of the gain.  So, in the end the investor puts up 100% of the capital; takes on 100% of the risk and for their trouble receives 33% of the return.  However, without these fees there is not enough money to pay all the players in this game.  Low-cost index funds are not marketed in this way and don’t have wholesalers attached to them in this manner because there are not enough fees generated.

The other fraudulent aspect of all of this is that investors think they are getting objective advice from the plan administrators and advisors when in fact they are being sold deeply compromised funds that are in the plan because of a conflict of interest supported by high fees.  This type of wholesaling occurs but is not part of my direct experience.  The disclosures of “revenue sharing” and the high fees are buried deeply in the prospectus under an avalanche of legalese and the whole enterprise is almost entirely sub rosa. (My personal experience was mostly in wholesaling non-qualified after-tax investments or investments that were coming out of a 401(k) account upon retirement as will be shown, but the mechanics of wholesaling qualified accounts is essentially the same).

As bad as all of this is, the average investor has no choice but to participate.  The tax advantages are too massive to ignore, and the benefits of tax-deferred growth are too appealing to forego.  A policy driven phenomenon has cornered investors into overpaying for underperforming investments because there are simply no other viable alternatives.

If an individual is lucky enough to attempt retirement, they must take the accumulated amount in their retirement plan and “roll it out”.  This means simply transferring it to an IRA and then beginning to take withdrawals in some fashion (This is, as we shall see, where I come into the picture). Awaiting the investor is an army of advisors with an array of costly, underperforming, and complicated products on offer.

 These consist mostly of annuities.  Annuities are insurance-based products. These products are tax advantaged in that the gains are tax deferred (there are therefore penalties for a pre-59 ½ age withdrawal).  You can fund these products with either qualified or non-qualified money (if using qualified money, you do not get any additional tax advantages making these products somewhat suspect for use with qualified funds).

 In its simplest form an immediate annuity takes your investment and gives you a monthly income for a period up to the length of your life. This is an easy product to understand and does produce a decent commission for an advisor and generally good results for the client.  The problem for the advisor is that they can only be paid once on these funds.  Therefore, they are loath to offer them.  Better to sell a product that can be “rolled” repeatedly over the investor’s lifetime to generate multiple commissions.

Other annuities are deferred.  These are annuities that have not been “annuitized” (turned into a stream of income).  While the investor is waiting to annuitize, the funds are invested in mutual fund like accounts that grow tax free as per the Internal Revenue Code.  They often are purchased with optional benefit “riders” that may protect your principal or provide you with a lifetime stream of income without having to lose control of the asset through annuitization.  The benefit is that the client (and therefore the advisor) still has control of the assets.  This means they can change annuities to generate extra commissions for the advisor.  Another downside to the client is that these annuities have penalty fees attached to them for a period of years.  This is usually a declining percentage of the amount of money taken out and is referred to as a surrender schedule.

Other annuities are fixed deferred annuities.  These too are relatively simple and appeal to the conservative investor.  The client does not give up control of the assets, so the advisor likes them to a degree (that degree being measured against the relatively paltry commission these products offer).  They also have surrender schedules.

Still others are so-called Equity Index Annuities.  These are deferred annuities (so advisors can get paid repeatedly from them).  They are tied to an index like the S & P 500 or an international stock index.  The client can get a gain based on the index up to a certain cap, but they typically cannot lose money.  These are very complex, consumer unfriendly products that carry long and burdensome surrender fees and if you do try to annuitize them, they are designed to provide a lousy income to the client.

The upshot of these products (other than immediate annuities) is that they are complicated and expensive.  Some deferred variable annuities with an optional benefit rider can cost up to 4-5%.  So, after running the gauntlet of saving and investing for retirement the investor is hit with another slap in the face in the form of an overpriced underperforming investment rip-off.

This same class of products, along with mutual funds and other more complicated investment vehicles are also heavily sold to investors using after-tax dollars to invest.  These are often but not exclusively higher income individuals who have maxed out their retirement plan contributions yet desire to invest more and gain some tax-deferral.

These products are some of the most heavily wholesaled and marketed products in the financial services universe as will be discussed soon.

How is it that people, often high income and well educated can fall prey to such a sales program?  As was discussed above the main reasons are fear and greed but the totality of the marketing program swamping the average investor is well-nigh emotionally irresistible.

This emotional irresistibility is created by the twin paragons of incompetency, the Media, and the Academy.  These two institutions are themselves bought and paid for by both the government and the financial services sector. The media is greatly dependent on the government and this industry for its continued existence.  The government grants the media access, gives them the stories they feed into the news cycle and of course grants them the license to stay on the air, as well as continually threatening them with regulation, or dismemberment.  The financial services industry provides access for stories and information as well as using the media to advertise its products and so constitutes the main income stream for these news outlets.  Given all that, it is not reasonable to think that the media will challenge the prevailing orthodoxy regarding the investment world.

The continual drumbeat from the business and investment shows as well as the information in the print media is to always be buying.  The mantra is that “now is always the best time to invest”.  If prices drop the refrain is to “buy the dip”.  These dullards are uniformly “buy-siders”, and their role is to be a cheerleader for mindless devotion to those pedaling overpriced crap.

In her revealing book Pound Foolish, journalist Helaine Olen details some of the myths that the media have conjured up in collusion with the financial services industry.  Some of these myths and the truth include:

  • Small pleasures can bankrupt you: Gurus popular­ized the idea that cutting out lattes and other small expenditures could make us millionaires. But reduc­ing our caffeine consumption will not offset our biggest expenses: housing, education, health care, and retirement.
  • Disciplined investing will make you rich: Gurus also love to show how steady investing can turn modest savings into a huge nest egg at retirement. But these calculations assume a healthy market and a lifetime without any setbacks—two conditions that have no connection to the real world.
  • Women need extra help managing money: Product pushers often target women; whose alleged financial ignorance supposedly leaves them especially at risk. Women and men are both terrible at han­dling finances.
  • Financial literacy classes will prevent future eco­nomic crises: Experts like to claim mandatory sessions on personal finance in school will cure many of our money ills. Not only is there little evidence this is true, but the entire movement is also largely funded and promoted by the financial services sector.  As she shows, when all else fails blame the victim.

Academia is just as bad a perpetuator of pre-packaged financial garbage.  So-called economists lend credence to the notion that people need to be always invested.  They support government policy as necessary and beneficial.  The entire academic economics profession is in thrall to a Keynesian ideology of active government, central bank monetary control and belief in the investment system as it is structured today.

The academy is co-opted by the desire to work at government run schools and universities as well as the need to tap into an ever-growing pool of government supplied grant money.  They are also in the back pocket of corporate America as they are provided with many consulting opportunities that greatly supplement their pay.   In addition to this there is the revolving door of employment between businesses, the academy and the government that binds all these groups together in the darkness (My apologies to JRR Tolkien).  It is also therefore unreasonable to expect this corner of the universe to question investing orthodoxy or the government policy that makes investing necessary nor to call out the glaring conflicts of interest that permeate the financial services industry.

In the face of this steady drumbeat of noise constantly telling investors to “stay the course” and “buy the dip” is it any wonder that average investors cave in and go along with the program.  When everyone in authority and all the so-called experts tell you to do something and almost everyone you know agrees, it is difficult if not impossible to chart a different course.

Never mind that the previously cited statistics show this approach to be an abysmal failure.  Never mind that neither the federal government nor the Federal Reserve have ever predicted a recession.  Never mind that the Federal Reserve has destroyed 97% of the dollar’s value since its inception in 1913, we should keep on listening to these shills for a system designed to help only their class and profession.

We can see now that the modern-day real-life Music Man has completed his task to a degree that would have stunned the fictional Professor Hill.  Government policy that benefits specific powerful lobbies has been implemented.  This has created a high tax, high inflation environment that led to the destruction of the corporate pension system and created the need for investment advice.  The same powerful lobbies then stood waiting ala the Music Man to sell unsuspecting people the high-priced underperforming investment “solutions” that are the hallmark of modern investing.  Anyone who might have had the credibility to object, such as academia or the media, were bought off like those whom Professor Hill co-opted in the movie.  The only difference, of course, is that this is real, not a movie and the results are a lot more destructive than just purchasing unneeded band supplies.

When money is fraudulently created, and injected into the economy in a way that benefits a rentier class of parasites, the effects are all too predictable.  Having crossed the Rubicon of immorality in the creation of the money it becomes all too easy to cut corners to get “your share”.  All that is needed now are the foot soldiers to carry out the rest of the rip-off and away you go.  How to enlist those foot soldiers?  By buying them off of course.

The actual moral compromises necessary to implement such a scam by the foot soldiers of the financial services sector is the aspect of the story to which we now turn next month, and alas where for me the story gets personal.

Praise Be to God

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