Process, Then Product

A few weeks ago I was reviewing with a friend and client. He reached out to get my opinion on what he should do with some extra income he's anticipating later this year.

Prior to making a recommendation, I asked him what he thought of his current financial situation as well as what he thought should be done. He responded that he had already spoken with two other financial professionals; one associated with Fidelity, his company's 401(k) sponsor, and another from Thrivent Financial. Each had recommended different strategies, and both sounded relatively compelling.

The representative from Fidelity had recommended an annuity for its tax deferred status. Thrivent meanwhile recommended a cash value life insurance policy for similar reasons.

As we spoke about these recommendations it became apparent that each representative, while well meaning, focused more on the outcome (the product), rather than working through a process to determine what's truly best.

From Barry Ritholtz's Washington Post article...

Process is simply the methodology used to accomplish an undertaking. It could be a simple checklist or a complex systematic approach. Process focuses on the specific actions that must be taken, regardless of the results.

Outcome is the result; it could be due to skill, luck, intelligence or many other random factors. At the end of the day, outcome is who won or who lost the game, how many planes landed safely, what stocks went up or down and what surgical patients lived or died.

The key to becoming more process focused is to understand that good outcomes follow good processes. Without understanding the underlying process, good outcomes could just as likely be due to blind luck as to skill.

Luck = outcome, and skill = process.

Back to my client and the competing recommendations. While I acknowledged that either the annuity or life insurance products might be a valid outcome for him, I asked a series of questions as part of my process to determine what he should do.

What we concluded is that early retirement is a possibility for this client and his wife. If he were to purchase an annuity and need to take distributions prior to age 59.5 (extremely likely), it would have presented challenges. First, distributions prior to this age are subject to a 10% "premature" distribution penalty. Second, unlike a taxable account where the average investor pays a 15% tax on investment income, a distribution from an annuity (at least any annuity sold after August, 1982 when the rules changed) is taxed at ordinary income rates on an earnings first, contributions last basis. Therefore, all of his initial distributions will be fully taxed at either the 28% or 33% bracket (whatever he ends up in).

I wasn't a huge fan of the cash value life insurance option either. He's already adequately insured. In order to defer taxation within a life insurance policy, an investor has to buy enough coverage to allow adequate savings inside the policy (IRS rules). Therefore, my client would be paying for a lot of coverage he didn't need; a waste of money. Also, in order to realize the full tax benefits of life insurance, the policy must be maintained, i.e., keep in force. Therefore, he'd be stuck with the policy (and the expensive premiums) forever.

My recommendation was that he continue to build his taxable investment account, and not purchase either the annuity or life insurance at this time. This gives him several options, depending on how and when his family's goals and values evolve over time. Plus, he can always utilize an annuity or life insurance. He just shouldn't do so now.

Yes, he'll have to pay his 15% of cap gains and qualified dividends in the taxable account. However, in his situation saving in a taxable account causes less pain than the other two products potentially help. Using a taxable account is even more compelling if he reads my blog (of course he will!) and adopts low cost, tax efficient Index Funds as his preferred investment vehicle for his additional expected income.

The other product recommendations aren't wrong. They're suitable. But "suitable" is a big problem with the brokerage industry; focusing on outcomes (products) can lead to advice that's only mediocre. It's much better to subscribe to a sensible methodology allowing an arrival to what's most appropriate versus cruising right into a product the company a financial advisor works for happens to promote (that you'll most likely be stuck with for a very long time). There's the additional issue of Brokerage Incentives, the notorious problem that probably played a role in Fidelity's and Thrivent's proprietary product recommendations.

My process of asking questions about my client's income trajectory, current finances, financial planning goals, as well as life values is what shaped my final recommendation. The best advice when faced with a financial decision is to enlist the help of an advisor with expertise, a process, and certainly one that works for a truly independent financial advisory practice.

#financialplanning #fiduciary #taxes