Outspoken financial advisor and investment thought leader Eric Nelson, 39, is fired up about what he calls today's "new world" for retirement planning, wherein he is turning traditional asset allocation on its head. With bonds at a dismal 2% and 3%, the RIA argues that portfolios should hold at least 60% in stocks as the only realistic way to reach retirement income goals, he told ThinkAdvisor in an interview.
The candid blogger and CEO of Servo Wealth Management in Oklahoma City, Oklahoma, made waves in early 2014 reporting that his portfolio of Dimensional Fund Advisors funds – using an asset-class investing approach – was superior in performance to the returns of Warren Buffett, Jeremy Grantham and John Bogle over the decade through February 2014, which of course included that grim year, 2008.
Nelson's research used performance results of those top managers to represent active management, tactical management and indexing versus his asset-class approach.
One notable advantage of Nelson's tack is that it offers greater tax efficiency than many other approaches, Nelson says. Smart tax investing is necessary to reach client goals of highest after-tax returns. Nelson, a native of Syracuse, New York, who uses no exchange-traded funds, stresses that mutual funds are sometimes more tax-efficient than ETFs, which are widely touted for their tax efficiency.
ThinkAdvisor recently chatted with the opinion leader, who manages $55 million for 30 high-net-worth clients. Before launching his RIA, he was an FA with PaineWebber and Charles Schwab, among other firms. Here are highlights of our conversation, which featured a few 2015 tax-bill surprises and a how-to on asset-class investing:
What's hot on your mind?
It's a whole new world for retirement planning: Retirees need to become more comfortable with a little more short-term volatility in their portfolios that comes from holding more stocks. This is a scary proposition for someone who looks at security as the short-term value of their portfolio. But in reality, security is a portfolio with the best chance of earning a return over time that outstrips the amount of spending you need from it.
What do you suggest for the stock allocation, then?
No one with reasonable retirement goals can afford to have less than 60% in stocks, and some, who want to leave a legacy to their loved ones, might want to be as much as 70% or 80% in stocks. We're all living longer, so you need to ensure that you've done everything to maintain the purchasing power of your income over two or three decades.
But where do bonds fit in?
You can't afford to have too much in bonds that pay 2% or 3% and expect to eventually not dip into and deplete your principal while trying to maintain a growing stream of income.
What's your specific recommendation for bonds?
To have just enough parked in that asset class so that if the stock market goes down for a couple of years, you can sell those bonds to meet your yearly income goals and then revert to selling stocks only after the market has recovered. About two to five years of income in bonds and the rest in a diversified stock portfolio is the only way you can give yourself a high probability of earning enough so that the growth in your portfolio outstrips the growth in your spending. Do you always discuss the tax implications of an investment that you recommend to a client?
Absolutely. It doesn't do any good to make an 8% return if you pay half of it back in taxes. Tax management and smart tax investing has to be done on a customized basis, though, because everyone has different account structures depending on, say, life stage; or if someone has all their money in a taxable account, they might require a different strategy than a client that has 50% of their money in an IRA.
What should be one's mindset about investing and income taxes?
You want to make as much money as you can for the risk you're taking — and one easy way to do that is to pay less in taxes. At the same time, you can't focus only on taxes. So the goal is the highest after-tax return — not to pay the least amount of taxes.
Will there be any surprises for folks when they get their tax bills for 2015?
I think so. What always surprises people who hold mutual funds is when these funds distribute a lot of capital gains after a year in which they haven't made any money: investors get stuck with a tax bill without a gain. Last year, mutual funds wound up selling longtime positions that made them a lot of money over the years and distributed it at a capital gain of 5%, 10% or even 15% or 20% of the value of the portfolio.
Clients might be thinking, "Gee, I didn't make any money last year because stocks didn't go up — but at least I won't have to pay taxes."
They could be wrong. If the mutual funds distributed a capital gain, investors wind up paying taxes without a commensurate gain to show for it: They didn't get the benefit of those stocks that were sold for big gains over the last couple of years. Last year they got negative returns – but they got the tax bill that went along with the good returns because the stocks that did really well over the years were sold.
How effective are variable annuities to minimize taxes?
The whole notion of a variable annuity helping you with taxes is nonsense. But people hear "tax deferral" [and go for it]. It's being sold very well to them, and for good reason: agents and brokers make 7% or 8% commission on those things. A variable annuity is only a tax-deferred vehicle when you take the money out of it and pay income taxes on all the money, whereas, if you invested those same taxable dollars in, say, a Vanguard S&P 500 fund, you pay a little bit of taxes every year on the dividends. Then, when you sell, you pay long-term capital gains taxes. Therefore, it's much more tax efficient long term.
I gather you don't much care for VAs in general!
Variable annuities are almost universally horrible. I can say this as someone who sold them on commission back in my dark days. They're designed to be sold, not bought. They pay agents and brokers very high commissions. So because the payouts are so large, they're incentivized to sell annuities to people who really don't need them. Moreover, insurance companies have ginned up these things with pseudo-guarantees, saying buyers aren't going to lose money or that they're able to pass on the original principal value to their heirs even if it's dipped below that in a bear market. Strong selling point.
Yes. People feel they're getting some sort of free lunch: stock returns with no risk. In reality, they're paying a very high fee for that – and, you can do basically the same thing outside a variable annuity.
