When it comes to understanding the potential risks, costs, and advantages of the various investment “products” offered today, a prudent investor must begin by understanding the role of the person from whom they are purchasing the investment.  Many consumers have a tendency to refer to our broker or financial advisor interchangeably depending on what sort of investment purchase they are making.  The reality is that brokers and financial advisors are two different titles that determine how the investor is charged and what sort of duty is owed to the investor when making a recommendation.  Before undertaking any investment, a potential customer should inquire as to the exact role the seller is playing.

This piece focuses the majority of attention to the potential downsides of the securities products or wealth manager relationships to highlight the sorts of problems one may face in the market.  Recognize that the majority of investment advisors and wealth managers are operating within regulations but any investor should be mindful of potential risk and undertake due care in all their dealings.

“Brokers” follow the traditional model for compensation of financial professionals.  Brokers typically charge a commission, either from a percentage of the purchase or flat fee, for each transaction made by a client.  These commissions do not always have to be disclosed by the broker and may vary depending on the type of security bought or sold, thus incentivizing the broker to recommend products that earn a higher commission.  See, Bert Whitehead, There are Conflicts Inherent In Assets-under-management Pricing, Investment News (Nov. 27, 2011 6:01 am), http://www.investmentnews.com/apps/pbcs.dll/article?AID=/20111127/REG/311279984.

This sort of pay incentive may tempt a less ethical broker to engage in practices like “account churning” where the broker will recommend clients to buy or sell securities with the intent to drum up business.  See, Josh Brown, Business Model Darwinism, Wall Street Journal (Nov. 29, 2011 10:13 am), http://blogs.wsj.com/financial-adviser/2011/11/29/business-model-darwinism/.

These potential conflicts may leave an investor overinvested in an area that pays the broker higher commissions as opposed to a diversified portfolio representing a broad array of investments.  A broker’s duty to their investor-client is that they determine the investment product to be sold be “suitable” for the particular investor; given the investor’s wealth, level of knowledge or sophistication in understanding the market, and the investor’s stated goals related to overall risk and goals in the market.  For an example of how the commission works, a retiree invested in relatively low-risk mutual funds but wishing to increase income may be advised to invest in a Real Estate Investment Trust (“REIT”).  The broker could have recommended dividend-paying stocks as opposed to the REIT but the broker will receive a higher commission for the sale of the REIT than the stock.  The broker received a commission for the purchase of the mutual fund at the time it was bought and now receives another commission for the purchase of the REIT.

Certified fee-only financial advisors, on the other hand, are fiduciaries that owe their clients a duty to act in the best interest of the client. The financial advisor generally charges the client based on the amount of assets under management with the advisor.  This model is not without potential drawbacks, however.  A financial advisor may still charge a higher fee for managing certain types of investments over others – e.g., 1.5% fee when managing equities while only 0.5% when managing bonds.  Such a fee structure leads to the potential for the same sorts of conflicts outlined above with brokers that leave an investor over-concentrated in the higher fee investments at the expense of a balanced portfolio.  As the name suggests, investment advisors are involved in counseling clients in all manner of investments, not just those in the stock market.  Other potential conflicts arise if the advisor counsels against investments such as annuities or the payment of mortgages and other tax deductable gifts.  Such actions have the potential to lower assets under management, and thus the advisor’s fees, even if they are ultimately more beneficial to the client.  Clients should remember also that the fee, when shown as a percentage, may look small but can be a considerable sum when the advisor deducts the fee directly from the client’s account.

Whether a traditional broker or fee only advisor, the financial professional works for, or at least purchases securities through, a corporation called a broker-dealer.  Some broker-dealers are massive, well known investment banks while others are independent firms that are quite small.  While most financial firms and wealth management professionals will abide by all applicable regulations of the licensure and treat their clients with the utmost good faith, it is helpful to consider the possibility of impropriety to assess both the risk you are willing to undertake and what to look for in a broker.  An aggressive, risk-taking broker may be exactly the investment professional a wealthy investor allocating a portion of assets for high risk/high reward growth may be looking for but would not necessarily be appropriate for a more conservative retiree on a fixed budget.  Fortunately, state and federal regulatory authorities provide registration requirements on the industry and a means for the customer to search this information.

The financial firms, professionals, and the securities they sell fall under numerous federal and state regulatory schemes – e.g., the Securities and Exchange Commission (“SEC”), and the Financial Industry Regulatory Authority (“FINRA”).  Namely, nearly all securities products must be registered, and the brokers and brokerage firms must be licensed to sell securities.  Additionally, any registered security is required to provide a prospectus, or general accounting of the underlying financial information, needed to make an informed decision on the solvency of the underlying corporation(s) or other interest in which the investment is being made.  An investor would be wise to investigate the wealth manager and ask questions about why the manager recommends a particular investment vehicle, the fees associated with the product, and how the product will build the client’s diverse portfolio and fit within a risk strategy.  Tax consequences, both long and short term, should also be addressed.

Below is a summary of the various investment products frequently bought and sold through wealth managers and the typical commissions associated with each.  Each product has particular benefits and risks associated with the investment of which potential investors should be aware.  Investors should understand the particular nature of each type of investment before agreeing to its purchase.  Be aware that even a registered fee-only financial advisor may still have to pay the fees and commissions associated with a type of product to buy or sell it from a broker-dealer.

STOCKS

Stocks are one of the most familiar investments for the vast majority of people.  Stocks are sold in “shares” that represent an ownership interest in a corporation that is issued by the corporation as a means to raise capital.  Most stocks bought and sold by typical investors are listed on one of the major U.S. stock exchanges such as the Nasdaq or New York Stock Exchange (“NYSE”).  These stocks are grouped based on performance (e.g., Fortune 500, Dow Jones Industrial Average), industry sector (e.g., technology, energy, etc.), or by the size of the corporation.  Size is often referred to by the amount of market capital (“cap”) a corporation would typically have available.  Market capital is the sale price for a share of stock multiplied by the number of shares outstanding.  A well-known example would be Exxon Mobile (XOM), a large corporation with $363.95 billion in market capital listed on the NYSE.  It is a very “large cap” stock.  Its long-term performance has made it a part of the Dow Jones Industrial Average, and its business as an oil and natural gas provider classifies it as part of the Basic Materials sector.  Such a stock is often referred to as “blue-chip” and would have a low level of risk associated with its returns.   As a corporation’s cap decreases into the mid-cap and small-cap range, however, the amount of stability generally decreases and the risk of loss increases.  The potential for gain also increases.   This, of course, only represents publicly traded stocks accepted for trade on U.S. exchanges.  There are numerous “penny stocks” that trade “over the counter” or as “pink sheets” or foreign stocks on foreign exchanges that are not traded on major U.S. exchanges like the NASDAQ or NYSE that carry significant risks for the less experienced investor.  In addition to the possibility that the value of your ownership shares will go up, some stocks will also confer on the owner dividends – a share of the corporation’s profits.  If you are considering investments in these types of stocks, pay careful attention to what you are buying, risking, and how the investment fits your goals.

In the age of the Internet, stockbrokers come in three typical shapes and sizes.  A full service broker brings to mind the traditional view of the broker as the individual who recommends the stocks to buy and sell and actively manages your stock portfolio.  A full service broker allows a potential investor to discuss their plans, risk tolerance, and goals with the broker in order to tailor an investment strategy but is subject to the risks discussed previously.  They may call from time to time with advice on managing the portfolio and can present reports on their recommendations.  Full service brokers typically take a per-trade commission between 1-2% of the value of a stock trade.

Discount brokers are the next step in the chain.  Discount services generally provide stock analysis data on their website and let the investor determine the strategy and particular stocks to buy and sell.  The brokers are then available over the phone to answer questions and take trades.  Discount brokers typically charge a flat fee per trade so long as the trade is less than a certain volume of stock shares.  Costs can range from $10 to $20 but may be as high as $50 per trade with a limit of around l,000 shares or less per transaction.

Finally, online brokers provide access to the same sorts of market data that would be available from discount brokers but you, the client, make the trades over the Internet without input from a broker.  Online traders typically charge a flat fee per trade of anywhere from $7 to $15.  Many brokerage firms now offer each level of service for their clients to choose from.

IPOs

Initial Public Offerings, or IPOs, are the first shares of stock sold by a corporation on the public market.  Purchasing IPOs grants an investor shares of stock in the company as purchasing any other stock would but comes at increased risk since the stock belongs to a newly capitalized business.  While the stock must still register with the SEC and provide a prospectus, investing in IPOs is a risky gamble not suited to all investors  (Initial Public Offerings: Eligibility To Get Shares at Broker-Dealers, http://www.sec.gov/answers/ipoelig.htm.  “Brokerage firms must consider if the IPO is appropriate for you in light of your income and net worth, investment objectives, other securities holdings, risk tolerance, and other factors.  A firm may not sell to you IPO shares unless it has determined the investment is suitable for you.”).  IPOs became big news among investors during the tech bubble of the late-90s and again recently with the launch of the Facebook stock offering.  Purchase of IPO shares come with the same fees associated with stock purchases but the nature of the initial offering can compound the fees.  The company first sells the initial shares to an underwriter, generally a large investment bank, who then sells the shares to broker-dealers.  The underwriter does not typically sell these shares to individual investors or even all the various broker-dealers.  See, Initial Public Offerings: Why Individuals Have Difficulty Getting Shares, http://www.sec.gov/answers/ipodiff.htm.

The resulting problems can be two-fold.  First, the broker-dealers involved in the initial purchase may favor selling shares to individual investors who purchase in large quantities; thus favoring wealthy investors.  Second, a broker whose firm has purchased a large number of IPO shares from the underwriter usually receives a higher commission on the sale of those shares and may push the IPO shares over sales of currently traded stocks.  See, Helen Kearney, Analysis: New Broker Standard Could Hurt IPO Sales, Reuters (Sep. 9, 2010 3:23 pm), http://www.reuters.com/article/2010/09/09/us-brokers-ipos-analysis-idUSTRE6883L820100909.

PRIVATE PLACEMENTS

Private placements, or private offerings, are securities issued by a corporation to investors outside the public markets.  Most private placements are exempt from SEC registration (see, Jane J. Kim, Cracking Down on “Private Placement” Investments, Wall Street Journal (Mar. 27, 2010), http://online.wsj.com/article/SB10001424052748704211704575139831790780958.html), but the client putting up the capital must be an “accredited investor,” see  Accredited Investors, U.S. Securities and Exchange Commission, http://www.sec.gov/answers/accred.htm.  An accredited investor must have a net worth of greater than $1mm or have a yearly income greater than $200,000 per year as an individual or income greater than $300,000 per year jointly with a spouse.  These limitations exist because these types of investments are often highly risky and are illiquid; i.e., they are nearly impossible to resell to get the cash back out.  See, Paul Sullivan, An Investment Asks, How Much Can You Afford to Lose?, N.Y. Times (May 20, 2011), http://www.nytimes.com/2011/05/21/your-money/21wealth.html?_r=1&pagewanted=all.

Investors are often attracted to private placement investments due to the high rate of return on the investment; yet these returns, if they happen at all, can take years to pay out.  If the company invested in fails during the period of the investment, the money is gone and the investor is out everything.  Broker-dealer commissions on private placements are also quite high, providing ample incentive to pitch them to clients seeking income.  Commission fees for brokers on the sale of private placements can be as high as 7-8%.

OPTIONS

Options are contracts that set a price to buy or sell a particular type of investment for a particular amount of time.  See, Options Defined, Nasdaq.com, http://www.nasdaq.com/investing/options-guide/definition-of-options.aspx.

Most options are purchased on publicly traded exchanges but the underlying investment may be stocks, bonds, commodities, or any number of other types of investment products.  Because the value of the option is tied to an underlying investment, the option is a type of derivative investment.  Risk in buying options is specifically defined because the option confers the right to buy or sell at a particular price, but does not obligate the option-holder to do so.  The option buyer can only lose the price paid for the option.  The option seller, however, can be subject to a great deal of uncertainty and risk because the contract obligates the option seller to buy or sell the security if the option buyer exercises the contract.  There are two types of options – puts and calls.  A put grants the option buyer the discretionary right to sell the underlying security at a certain price and obligates the option seller to buy at that price, should the buyer decide to exercise the right.  A call grants the option buyer the discretionary right to buy the underlying security at a certain price and obligates the buyer to sell the security at that price, should the seller decide to exercise the right.

Every option contract has an expiration date by which the contract must be exercised.  The expiration date may be for a very short or much longer period of time, depending on the contract.  The duration, however, is a factor when pricing the amount paid to purchase the option.  The duration of the agreement, along with the price for which the underlying security must be bought or sold – the “strike price” – are the two of the three factors used to price the option.  The more favorable the time period and strike price are to the buyer (and thus riskier to the seller), the more expensive the option.  The third factor in option prices is the volatility in value of the underlying security.  Generally, more volatility in a security’s price will lead to a greater price for the option since the volatility will magnify the seller’s risk.  The option price is called the “premium.”

Money is made on the purchase and sale of options by correctly predicting changes, or lack thereof, in the market for the underlying security.  The option to buy/sell the security at a particular price is often quite a bit less than buying the security outright.  Therefore, an option buyer can purchase the ability to buy or sell the security at a particular price for a particular amount of time and hope the market moves up (for buys) or down (for sales) as predicted in that amount of time.  The profit is in the payoff for locking in the favorable price.   If the market does not move as the option buyer predicts the buyer simply does not exercise the option and he or she has only risked and lost the price paid for the option.  The option buyer may also use that locked-in price to protect an investment from loss.   This “hedging” can assure holdings in a particular security can assure the security can be sold at a particular price to avoid total loss.  The option seller is subject to quit a bit more risk but is assured the upfront money the buyer paid in the option’s premium.  If the buyer does not exercise the option, this profit is already in pocket.  However, if the option is exercised the option seller is contractually obligated to buy or sell the underlying security at the strike price, likely at a loss.

Because most commonly traded options are available through the same major exchanges as stocks, the same brokers will offer the purchase of options in the same manner as stocks.  This generally leads to the same percentage commissions for full service brokers or flat fees for discount or online brokers outlined in above for stock purchases.

STRUCTURED PRODUCTS

Structured products are derivatives that function similarly to options but are a broad array of alternative securities products created to meet specific needs not offered by traditional investment products.  Structured products encompass a large variety of complicated instruments, including “swaps.”

Structured products are investment notes underwritten by banks or investment houses that make a “bet” on the performance of some underlying equity or select group of equities.  See, Edward Siedle, Private Banks Stuff Structured Notes into Discretionary Accounts – Deny Fiduciary Responsibility, Forbes (June 7, 2012 2:19 pm).

The “note” guarantees payment of a set amount by a particular date and is bought for some discounted price below that amount.  Because the product is so complexly structured through the underwriter, the risk is not always directly linked to the underlying equity.  There is also risk in the institution underwriting the note failing and thus being unable to repay the sum owed, as was the case with Lehman Brothers products in 2008-2009.  On top of all this, the structured products do not pay interest income to the investor.  These products are extremely complicated and were created for the institutional investor rather than individuals.  Because of this, the notes are often written in terms that heavily favor the underwriting bank or investment firm.

Structured products do not trade on any public exchange so investors owning these products are usually locked in until the period for payment comes due.  Brokers take about a 2% commission when selling the structured product but can take 3% or more when buying them back because of the severe illiquidity in the secondary market for structured products.

BONDS

Bonds are loans made from an investor to a corporate or government entity that can be resold on the market.  The bond is “purchased” for the loan amount and in return the investor receives interest payments for the set period of time until the price of the bond is to be repaid.  See, Bond Basics, http://www.publicbonds.org/bond_basics/bond_basics.htm.  The period for the bond coming due is called the “maturity date” and the bond will pay a fixed interest rate at set intervals until the maturity date is reached; generally twice per year for U.S Treasury bonds.   Because the payment of principle and interest are set, the institutional brokers often call bonds “fixed income” investments.

Individual investors most often trade in municipal or Treasury bonds due to the lower risk associated with those bonds.  Treasury bonds are backed by the full faith and credit of the federal government and cannot be “called” – i.e., paid back at a set price before the maturity date ending the interest income from the bond.  See, Education Center: How U.S. Treasury Bonds Work, Yahoo Finance, http://finance.yahoo.com/education/bond/article/101185/How_U.S._Treasury_Bonds_Work.  Because of the low risk nature of U.S. Treasury bonds, the interest income, or “yield,” is relatively low versus other investments.  The security to yield ratio of U.S. bonds however, has become something of a yardstick an investor can use when analyzing other investments.  If a seller is advertising some other type of investment as very low or no risk with a rate of return substantially higher than a Treasury bond, the risk of that investment is likely being understated.

Bond prices and bond commissions are closely linked.  The amount the bond will be paid back at the maturity date is “par value” of the bond.  The price the bond is traded for is quoted in two parts however; the price you can sell the bond for and the price at which you can buy the bond.  The difference between these two values is indicative of the commission the broker can take and can range between 0.5% and 4%.  The commission is higher on older bonds traded on the secondary market than on recently issued bonds.  This is because the risk in bonds is tied to the prevailing interest rates.  The interest the bond will pay is typically set when the bond is issued.  Since the interest rate has generally gone down in the past few years, bonds paying higher rates will trade at higher costs.

PROMISSORY NOTES

A promissory note is note agreement for a direct loan made by an investor to a small corporation or other venture.  Promissory notes may be pitched to potential investors in the same vein as a private placement or a bond.  In this way the investment may seem as “safe” as more traditional investment opportunities but will tempt investors with double-digit rates of return.  See, Investor Alerts – Promissory Notes Can Be Less Than Promised, FINRA.org, http://www.finra.org/Investors/ProtectYourself/InvestorAlerts/PromissoryNotes/P006050.  Many promissory note offerings are connected to legitimate companies and are becoming more common with the passage of the JOBS act that places fewer restrictions on small businesses seeking to raise capital. See, John F. Wasik, Fight Financial Fraud With Tricks of Your Own, N.Y. Times (May 9, 2012), http://www.nytimes.com/2012/05/10/business/fight-financial-fraud-with-tricks-of-your-own.html?_r=1.  With the increase in offerings however, there has also been an increase in fraud associated with the sales of promissory notes, particularly those aimed at retirees and senior citizens.  There have been instances of promissory notes that are connected to business that never existed for the sole purpose of defrauding investors.  Even legitimate notes are highly risky investments and can still be wiped out should the company fail to take off.  Anyone considering investments in promissory notes should assure the business and dealer are registered with the SEC, FINRA, or their state securities regulatory authority to make sure their purchase is legitimate and the company actually exists.  Be especially wary of those notes that claim to be insured against risk.  The investment may not actually be insured at all or may be insured by a foreign company that is not subject to U.S. legal jurisdiction.  See, Broken Promises: Promissory Note Fraud, U.S. Securities and Exchange Commission, http://www.nytimes.com/2012/05/10/business/fight-financial-fraud-with-tricks-of-your-own.html?_r=1.

Broker commissions on promissory notes can be extremely high.  Even on the most legitimate notes can carry fees of between 2% and 10%.   Fees can be as high as 30% to 50% in less legitimate offerings, especially when the seller is not licensed to broker these types of securities or the broker is working outside the authority of the dealer firm to market notes intended for sale to institutional investors to individuals.

MUTUAL FUNDS

Mutual funds are one of the most common investment products owned by individual investors.   Mutual funds are investment companies that pool together money from many different investors and reinvest that money into stocks, bonds, commodities, currency, and any number of other securities.  The investor purchases “shares” of the fund which are then dependent on the value of the pool of assets held by the fund.  This is the fund’s Net Asset Value (“NAV”).  The shares of the mutual fund are not traded on the public exchanges and can only be purchased from the fund company and sold back to the same company.  Mutual funds must be registered with the SEC and are subject to regulation.

Traditionally, the price of fund shares included not only the NAV of the shares of the fund but the commissions associated with the purchase and management of the fund as well.  In the context of mutual funds, these commissions are not labeled as such; instead referred to as “loads.”  When these loads are charged – at time of purchase in the case of “frontend loads” or as “Contingent Deferred Sales Charges” upon selling the shares – determines what “class” of mutual fund shares you are purchasing.  Class A, B, or C shares refer to how the load is charged.  For a detailed explanation on how and when the loads are charged on each class of shares, FINRA provides a breakdown at http://www.finra.org/Investors/ProtectYourself/InvestorAlerts/MutualFunds/p006022.  Generally, upfront fees take from your initial investment, lessening the number of shares you actually purchase while backend fees take from your return when selling the shares.   Upfront loads associated with Class A shares tend to be the highest but those funds also typically charge lesser fees over the course of the fund.

All mutual funds may charge additional fees paid during the course of the year to cover the cost of running the fund.  These fees are known as 12b-1 fees after the SEC regulation governing the charges.  12b-1 fees are extracted from the returns of the fund and therefore cut into any gains returned to the shareholders over the life of the fund.  These fees are extracted automatically and cover costs relating to marketing, sales, broker compensation, and compiling and mailing fund prospectuses.  To charge 12b-1 fees the fund must adopt a 12b-1 plan and the notice of all fees and loads must be provided in the fund prospectus.

Recently, funds charging load fees have fallen into disfavor and “no-load” funds have become the most popular mutual funds with customers.  While B- and C-class shares may have “no load” upfront, the charges over time are high enough that the SEC prohibits them from being truthfully classified as “no load” funds.  Traditional load-class shares (other than class-A shares with their upfront load) charge annual 12b-1 fees in the area of 0.4% to 2% of the value of shares owned.  “No load” funds, on the other hand, are limited to charging 0.25% of the total value of shares owned.  The difference is made up in how the fund is managed.  Some, but not all, traditional funds are actively managed by a financial advisor throughout the life of the fund.  This management is paid for in part by the ongoing fees.  The “no-load” funds dispense with active management thus making the amount and type of investments held within the fund static.

UNIT INVESTMENT TRUSTS

A Unit Investment Trust (“UIT”) is another type of investment similar to, yet distinct from, a mutual fund.  Like a mutual fund, the UIT holds some group of underlying securities and then sells “units” to investors based on the net asset value of those underlying investments.  See, Unit Investment Trusts (UITs), U.S. Securities and Exchange Commission, http://www.sec.gov/answers/uit.htm.  Unlike a mutual fund, the UIT usually offers these units in a one-time-only sale and some are not offered on a public market.  Though the sponsor of the UIT must buy back the units, there is no guarantee that the NAV paid will recoup the initial investment.  The underlying investment portfolio in the UIT is not actively traded and the units in the fixed portfolio are held for a fixed time before the trust ends and they investment is paid out.  Because the investment portfolio is fixed, there is little information to gauge how the trust performs or even much the investor can do if the UIT investment goes bad.  A prudent investor interested in the purchase of UITs must read the trust prospectus very carefully to understand what securities are held by the trust.

The fee structures of UITs closely track those of mutual funds and a buyer must pay close attention to the fees associated with buying and selling the units.  Unlike mutual funds with distinct “classes,” the UITs may be subject to upfront and backend loads as well as ongoing expenses.  See Beware of Price Unit Investment Trusts (UITs), Responsible Investing Blog, http://www.responsible-investing.net/news_sep07_uit.html.  However, because UITs are not actively managed, the ongoing operations expenses are generally lower than that of mutual funds.  When UITs are a good buy, they are generally traded on a major exchange, have very low load charges, and clearly stated annual operating expenses.

EXCHANGE TRADED FUNDS

A subtype of UITs is the Exchange Traded Fund (“ETF”).  ETFs also operate in a similar manner to mutual funds or UITs by allowing investors to own shares representative of a broad portfolio of common equity securities but with shares of the funds traded on an exchange.  The simple version of these funds can be a relatively good investment with commissions and fees averaging just less than 1%.  See, Too Much of a Good Thing, The Economist, Jun. 23, 2011, available at http://www.economist.com/node/18864254.  Investors must always be sure of what they are buying with ETFs to make sure they are not getting into the more complicated, and speculative, variations.

Lately, this fund subtype has spawned numerous subtypes of its own.  There are now ETFs designed to do anything from increase when the market goes down, to double or triple daily market movements, or to bet on derivatives or other alternative investment classes.  For an in-depth explanation on how ETF subtypes can lose money even when the market moves favorably, see SEC-FINRA alert at http://www.sec.gov/investor/pubs/leveragedetfs-alert.htm.

This uncertainty has led to a disconnect between the market value of the underlying assets and the trade prices of ETF shares.  For example, the net asset value of the fund may be quite high yet the share price may remain low because no buyers are willing to take on the price.  See, Eleanor Liase, Risks Lurk for ETF Investors, Wall Street Journal (Feb. 1, 2010), http://online.wsj.com/article/SB10001424052748703837004575012772071656484.html.  These “spreads” between market and asking price on the shares of smaller funds are where institutional brokers can gouge investors and has caused concern for some fund managers. Big investors can avoid the spread problem by trading shares for identical collections of the underlying portfolio, an option not available to the smaller investor.

VARIABLE UNIVERSAL LIFE (VUL)

A VUL policy is a life insurance policy that also buys into a mutual fund-like portfolio of investments.  Payment on the policy is usually split between the insurance and the investment.  The term life insurance policy pays out like any other at the death of the policyholder.  The investment, on the other hand, becomes a source of value against which the investor may take out tax-free, low interest loans.  The selling point for brokers is that the investment will simultaneously pay for life insurance while securing a source of funds for unexpected expenses later in life.  See, Walter Updegrave, Variable Universal Life: The Pitch, The Pitfalls, CNN Money (Feb. 5, 2007 5:52 pm), http://money.cnn.com/2007/02/05/pf/expert/expert.moneymag/index.htm.  This characterization is not wholly accurate.

VUL policies have two major catches: fees and tax consequences.  First, brokers and insurance companies take a substantial portion of the investment in fees and commissions.  The upfront load to purchase the policy can range from 5% to 11%.  See, James H. Hunt, Variable Universal Life Insurance: Is it Worth it?, http://www.consumerfed.org/pdfs/VULReport0203.pdf.

Then there are the annual management fee charges that can range from 1% to 2% yearly even after the initial load payment.  The insurance policy itself also comes with a “mortality and expense” charge of another 1% or so per year.  Then, there are the tax problems associated with the policies.  The money paid for the premium and the investments is not tax exempt and is taxed at state and federal rates around 3%.   If the policy is ever canceled or allowed to lapse, the balance of all the tax-free loans against the fund investment principal immediately become taxable under that year’s income at the regular income tax rate.  The loans may provide emergency income in case of illness during retirement but if the emergency also deprives the investor of sufficient income to continue paying the policy the tax bill could wipe out any advantage stemming from the payments.  Finally, if the investor wishes to get out of the investment and cancel the policy, there are often severe “surrender charges” for discontinuing the policy.  The surrender charge is usually a percentage of the value of the policy that decreases for each year the policy is held.  In the first years of the policy, the charge can be close to 50% of the total value of the policy.

ANNUITIES

An annuity is a type of insurance product that is purchased via an upfront payment or a series of payments that then guarantee a rate of return for a period of years.  Cameron Huddleston, What to Ask Before Buying an Annuity, Kiplinger.com (Aug. 2007), http://www.kiplinger.com/basics/archives/2002/04/story25.html.  Most annuities sold to retirement investors are deferred annuities.  There are also immediate annuities with payments that begin immediately. See Equity Indexed Annuities – A Complex Choice, FINRA.org, http://www.finra.org/investors/protectyourself/investoralerts/annuitiesandinsurance/p010614.

The money paid into the insurance grows at the rate of return in order to provide periodic payments for the life of the holder – the “annuitant” – and may also include a death benefit for a surviving beneficiary (that often requires a separate 1% yearly fee to purchase).  Annuities are often sold to investors saving for retirement because of ability to defer the tax liability for earnings while the assets accumulate.  The problem is that the annuitant cannot begin to receive payments until age 59½ or they will incur a penalty on the earnings.  There are also steep “surrender fees” for withdrawing the money from the annuity early.  What’s more, the income from the annuity is only tax deferred and income will still be taxed at the normal income tax rate on receipt of the payment.  Finally, the annuities are not FDIC insured and the ability to pay is subject to the health of the company issuing the contract.

There are three main types of annuities determined by how the rate of return is treated – fixed annuities, indexed annuities, and variable annuities.

Fixed Annuities

Fixed annuities contract for a set rate of payments to the annuitant for the duration of the contract.  Generally, someone planning for retirement purchases the annuity to provide monthly income payments.  The fixed rate of return removes market-related risk from the investment but does not allow for growth.  The annuity assures against losses but effectively ties up the money in the investment for the duration, unless the annuitant is willing to take the penalty fees – generally around 10%.   Fixed annuities are less likely to offer the death benefit than variable annuities.  The commissions earned on the sale of fixed annuities can vary greatly, between .05% and 5%.

Indexed Annuities

Sellers of indexed annuities offer them as something between the fixed and variable annuities in that it allows for upside when the underlying market index (e.g.. the S&P 500) goes up but assures that a drop in the market index will not decrease the value of the policy.  See Investor Alert – Equity-Indexed Annuities – A Complex Choice, FINRA, http://www.finra.org/investors/protectyourself/investoralerts/annuitiesandinsurance/p010614.

The reality, however, is much more complex.  The indexed annuity is able to offer “no downside risk” to the principle by investing in options and other derivative investments rather than the fund itself.  The price of this strategy is that any gain is capped by one of a number of different devices, depending on the plan: a “participation rate,” a Spread/Margin/Asset fee, or an interest rate cap.  The rate/fee is often around 3% to 5% of any gain and the terms can be changed over the life of the annuity.  The effect of each is that the insurance company retains some of the gain in order to preserve costs and profits, and therefore offer less return than investing directly in the index over the long term.  Like the other annuities, the indexed varieties also lock up the funds used in the purchase for long periods before the payout begins and early withdrawal comes with high penalties – often between 10% and 20%.  Commissions on the sales of indexed annuities can be as high as 9% and sales houses have been known to offer incentives such as trips to Disney World to top-selling agents.  To be clear, the indexed fund does guarantee that the investor will not lose money but that guarantee comes at a high price.

Variable Annuities

The variable annuity offers a policy that invests in mutual fund-like subaccounts to provide a return along with an insurance policy that guarantees a return on the payout of the account.  See, Lewis Altfest & Ellie Lowder, Are Variable Annuities a Good Investment?, Wall Street Journal, May 14, 2012, available at http://online.wsj.com/article/SB10001424052702303916904577376193314287640.html.  Because the mutual fund investment is inside an insurance policy, any gains in the account are tax deferred (but are taxed when paid out).  After purchase, and until the time when the annuity begins payout, is known as the “accumulation phase.”  The annuitant can manage the risk/reward of the fund(s) investment while the policy builds value.  Upon reaching the payout date, generally 59½, the annuitant can choose to redeem the full investment or to annuitize the account and receive payments.  During that phase, any withdrawal of funds from the account is hit with a 10% tax penalty.  On top of the tax penalty are “surrender charges” to the insurance provider for withdrawal in the first years of the contract that start around 8-10% in the first year and decline by about 1% per year for the first six to eight years of the contract.  The “payout phase” begins once the annuitant has reached the minimum retirement age in the contract and elects to activate the payout option.  Once the payout option is exercise, the policy is final and can no longer be canceled or the balance withdrawn.  The payout during this time is variable on the performance of the underlying funds, with the bottom set by the contract guarantee.  Unless the annuitant has also purchased some sort of death benefit on the plan, the value of the annuity is in outliving the amount of time needed to receive enough payments to break even on the initial investment.

Fees and commissions on variable annuities often mirror those of mutual funds.   The broker selling the annuity can receive up to 5% in commission for selling the policy.  See, Steven Merkel, Getting the Whole Story on Variable Annuities, Investopedia.com (Oct. 10, 2010), http://www.investopedia.com/articles/04/111704.asp#axzz1yYeu6i00.  There are also other possible front-end load fees and the underlying funds charge 12b-1 fees for maintenance of the fund account.  Finally, the policy itself charges administrative fees and mortality and expense charges in the 1.5-2.5% range that lower any monthly returns on gains in the fund accounts.

REAL ESTATE INVESTMENT TRUSTS (REITs)

REIT investments apply the corporate “shares” ownership structure to real estate investments.  Though all REITs must have some sort of underlying corporate or trust structure, there is a crucial characteristic that will determine the nature of the investment – whether or not the shares of the REIT are traded on a publicly listed stock exchange (e.g., the NYSE).  See, Investor Alert – Public Non-traded REITs—Perform a Careful Review Before Investing, FINRA, http://www.finra.org/Investors/ProtectYourself/InvestorAlerts/REITS/P124232.  Shares of a publicly traded REIT are traded on an exchange like shares of any publicly traded stock.  Shares of a non-traded REIT function more like the shares of registered but non-traded stock or even that of a private placement, and as such are not as freely bought or sold.

All REITs must first be set up as a corporation or trust.  That corporation then purchases and manages real estate properties and/or the mortgages of real estate properties to pass the profits from managing the real estate on to the shareholders.  In order to qualify as a REIT for tax purposes, the corporation must distribute at least 90% of its taxable income on to shareholders as dividends.  REIT income must meet the following threshold tests to qualify: 95% coming from the financial investments (rents, dividends, interest, etc.) and at least 75% of that coming from the real estate holdings (rents, sale of property, etc.)  The dividends passed to investors are not taxed at the corporate level but are taxed as capital gains upon payment to the investors.  It is the requirement for payment of dividends that often attract investors into REITS, as the dividends average around 4% for traded REITS, with top-performing traded REITS earning as high as 11% in 2012.  Despite the requirement to pay dividends on profits, there is no guarantee that the REIT will be profitable and if the ratio of income to liabilities falls too low, the REIT can suspend payment of dividends in order to stay afloat.

While not as crucial as the traded/non-traded distinction, investors should also be aware of how and what sort of real estate the REIT is investing in.  REITs can generate income by investing in equity, through the ownership, development, and management of rent producing properties; or in mortgages, by making loans or purchasing mortgages and profiting from the interest earned. Some hybrid REITs invest in both equity and mortgage.  Once an investor is aware of how the profit is generated, they should take note of the type of property in which the REIT is investing.  For example, the real estate held could be industrial property, office property, retail, or residential holdings.  The REIT could specialize in malls, medical parks, or multi-family apartment buildings.  Some REITs hold a mix of real estate types in mixed-use developments or diversify with individual holdings across a variety of property types.  All of this information must be available in the REIT prospectus.

Exchange Traded REITs

Shares of traded REITs are available on public stock exchanges like the NYSE and feature many of the same characteristics of stocks.  At the initial offering (IPO) stage, they may be subject to up to a 7% discount in favor of the underwriter on the offering along with the normal stock purchase commission charge.  REIT corporations are classified as small and large cap shares in the same manner as traditional corporate stock would be and are subject to similar risk.  See, Jennifer Popovec, When it Comes to REITs, Is Bigger Really Better?, National Real Estate Investor (Jun. 21, 2012 10:22 am), http://nreionline.com/finance/reit/is_bigger_better_for_reits_06212012/.  Like a corporate stock, the value of REIT shares is subject to fluctuations in the market as well as conditions in the industry that affect the balance sheet of the business – in this case real estate.  The advantage to being exchange traded, however, is that the shares are highly liquid; they are easily bought and sold.

Non-Traded REITs

There are two types of non-traded REITS: public non-traded REITs and private non-traded REITs.  The public variety are registered with the SEC, even though their shares are not traded on a public exchange.  Private REITs function like private placements in that they do not have to be registered with the SEC.  Potential purchasers of private REITs must be confirmed as accredited investors to purchase shares because these investments carry such high risk.

The attraction for investors is that non-traded REITs advertise a higher rate of return than their traded counterparts without the worries of stock market fluctuations.  The catch is that both varieties of non-traded REITs also carry higher fees than traded REITs.  A recent study by the University of Texas at Austin has found that 71% of these REITs cannot meet expected returns because the fees associated with them are so high.  The upfront load charge, split between the sponsor offering the product and paid to the management company for overseeing the properties, can range from 12-15%.  The commission to the broker can range between 7-10% of the value of investor’s ultimate purchase of shares.  See, Bruce Kelly, Most Nontraded REITs Underperform Market, Investment News (Jun. 10, 2012), http://www.investmentnews.com/article/20120610/REG/306109997.

Assuming the high-end fee of 15%, the ultimate effect of these fees is that 1) only 85% of the investor’s dollars end up actually purchasing shares, and 2) only 85% of the total pool of money invested in the REIT is put into buying and developing the real estate portfolio.

Further complicating non-traded REIT investing is a lack of transparency in valuation and accounting.  As mentioned above, REITs are not guaranteed to return a dividend and the decision to pay a dividend is ultimately up to the corporate Board of Directors.  Non-traded REITs often pay their initial dividends out of the pool of the investment, as it is only after collecting investors’ monies that the REIT begins to purchase property.   Investors routinely receive only statements listing the valuation of distributions (if any) and the value of the current shares (usually set at $10 per share).  Until recent investigations by the SEC and FINRA, the REIT sponsors would rarely, if ever, re-valuate the outstanding shares of the REIT.  As a result, investors of older non-traded REITs have seen the value of their shares drop suddenly and rapidly when the new valuations are undertaken, the result being significant losses of principal.  New regulation on these products has instituted disclosure requirements for the underlying valuation of shares every 18 months.  In response to the regulatory scrutiny, non-traded REIT sponsors are moving to reduce fees, provide better disclosure, and update shareholders on valuation and financial status more frequently but issues remain.

A last feature of non-traded REITs is the lack of secondary market for the shares.   Investments in non-traded REITs of can lock shareholders into their purchase for the duration of the period the REIT will operate until it ultimately goes public on an exchange, liquidates its holdings, or merges with another REIT.  This time period can be seven to ten years.  During that time, the shares are illiquid and cannot be cashed out for full value if the investor needs access to the principal in the case of a financial emergency.  Many non-traded REITs do offer a redemption program to return shares to the sponsor but the redemption is often at a discount, for a small number of shares per year, and/or can be cancelled by the sponsor if things go bad or too many shareholders want out.

TENANTS IN COMMON (TIC)

Many investors that end up in TIC investments do not purchase the investment as a “security” but as a property interest in exchange for another real estate holding the investor already owns.  This “like-kind” exchange of real estate properties allows an investor to sell off one real estate holding and move the proceeds into another, an exchange that nets deferment of taxes on the sale of the first property.  Such an exchange is a “1031 exchange” named for the section of the IRS tax code allowing such a transaction.  See, What is a TIC?, Real Estate Investment Securities Association, http://www.reisa.org/sections/about.tic.php.  TIC itself is a legal arrangement set out under the property laws of the state in which the property is located.

The term Tenancy in Common is actually a legal term defining the ownership interests among two or more owners of real property.  Each holder of title to the property has an undivided interest in the whole share of the property.  Each titleholder may transfer that interest and is entitled to profits from the property in proportion to the ownership share.  In forming the TIC for an exchange, however, the sponsoring entity will acquire a property that will produce an income – usually through rent of the space – and then set up the exchange for potential investors through a broker or exchange agent.  The investor then creates a single-member LLC in his or her name to own the title interest in the TIC property.  Ideally, this exchange would provide continual income to the investor while deferring capital gains on the sale of the original property until the TIC interest is sold or liquidated.  In the mean time, the investor-owners of the TIC are relieved of responsibility of property management since the sponsoring entity moves to set up a management agency as part of the share purchase price.

The catch can begin at the exchange with how the IRS classifies the deal.  The IRS may reject that the new TIC interest is more like a sale of property and a subsequent investment rather than an exchange of one property interest for another in-kind.  If the IRS rejects the exchange, the investor owes capital gains tax on the sale of the original property.  Second, the TIC investment is quite complicated and can function similarly to that of private placement and TIC investors must be certified as “accredited investors.”  The rules require the offerings to be quite small – capped at 35 investors.  These risks alone make these complicated transactions highly risky for unsophisticated investors who are owners of a property they have formerly managed themselves but now seek retirement and an advantageous way to rid themselves of the duties as a landlord.

These risks also suppose the investment performs well.  Unlike a REIT, the TIC investment is likely concentrated in a single property development.  If the underlying property runs into issues with leases, property values, or local economy the investment can lose value quickly.  If the investment starts to fail and faces foreclosure, the owners of the TIC are contractually liable to the TIC corporation to supply capital if the board institutes a “capital call.”  The capital call requires the investor to put more money into the already failing investment and if the turnaround is unsuccessful, foreclosure can result in the loss of principal and the additional capital.  Additionally, the interest in the TIC is illiquid and cannot be sold on any secondary market.  There is no option for the investor to extricate him or herself from the investment should the payment of income be insufficient or stop completely.  In the event of needing to get money invested in the TIC out to cover a financial emergency, the only way to do so is to resell the interest to the sponsoring agency.  The redemption of the interest is likely to be at a discount and is subject to penalties and other fees.  Like REIT shares, the TIC interest redemption is subject to suspension by the sponsoring agency if the things go wrong with the property investment.

Because the sale of TIC interests requires a formal offering memorandum in the vein of private placement investments, they are often classified as securities for sales purposes even if they qualify as real estate for IRS 1031 exchange purposes.  Because of this, licensed brokers are needed to sell the TIC interests to investors.  Brokers fees on the TIC investment are often around 7% on the transaction.  See, Bruce Kelly, TIC Investments Come Back to Bite, Investment News (Feb. 19, 2012 6:01 am), http://www.investmentnews.com/article/20120219/REG/302199966.  Because brokers are required by regulation to conduct their own due diligence on the TIC investment, some TIC sales include an extra 1% on top of the commission to complete that “due diligence.”  The failure of some of these brokers to undertake this due diligence has led to regulatory scrutiny and litigation against the broker dealers offering these properties.  See, Laton McCartney, Investing in TICs? Proceed with Caution, Financial Planning (Feb. 28, 2012), http://www.financial-planning.com/news/tenant-in-common-investments-cautions-2677581-1.html?zkPrintable=1&nopagination=1.

The foregoing information has been provided by The White Law Group.  The White Law Group is a national securities fraud, securities arbitration, and investor protection law firm based in Chicago, Illinois and Boca Raton, Florida.  For more information on the firm, please visit http://whitesecuritieslaw.com.