For financial advisors, the $50 billion in losses estimated from the Bernard Madoff debacle offer a cautionary tale for those trying to ensure steady income in retirement.
The Madoff situation reinforces the need for diversification of assets and for due diligence in order to prevent an income plan from being derailed, these advisors say. Whether the definition of diversification needs to be broadened to protect clients’ retirement income is a related consideration, they indicate.
Many wealthy individuals as well as philanthropic organizations invested heavily with Madoff, an investment manager. In some cases, whole portfolios were invested with Madoff’s now defunct company, Bernard Madoff Investment Securities, New York.
The first step in helping to immunize an income plan against a Madoff-type meltdown is to look at what mistakes were made, advisors say. Part of this examination is to differentiate between due diligence and diversification.
“It boggles the mind how anyone could put all of their money in 1 fund,” says Jim Holtzman, a financial advisor with Legend Financial, Pittsburgh. Important questions such as ‘how are you achieving these results?’ were not being asked, he says. While it might be conceivable to achieve returns of 12%-13% year after year, an advisor needs to know how these results are being obtained, Holtzman stresses.
Georgia Bruggeman, a financial advisor with Meridian Financial Advisors, Holliston, Mass., says that due diligence in the Madoff matter could have begun simply by reading the advisor’s ADV, a disclosure form that advisors are required to file and can be accessed at www.sec.gov. The ADV reveals 2 complaints against Madoff and fines in both cases, she notes.
Other warning signs that could have been picked up with due diligence include total compensation through commissions, which she maintains is “very unusual for a hedge fund manager.”
In addition, an investment manager should never also act as a broker-dealer, Bruggeman notes. The “cachet,” of having a desired money manager such as Madoff, prompted some advisors to refer clients to him even though they had never met with Madoff. “If you can’t sit down across a table and have a conversation with the manager, find someone else.”
Finally, Bruggeman recommends, “stay away from sophisticated, complicated strategies and keep it simple. There is plenty of money to be made with simple.”
Anyone who invested with Madoff was putting trust in him, says Rick Shapiro, a financial advisor and tax expert with Investment & Financial Counselors, Hartford, Conn. Shapiro adds that “when you can’t do the due diligence due to opaqueness, you are making a leap of faith.”
The “key” to all investments is to understand the investment and the role that investment has in a client’s overall portfolio, according to John Deyeso, a financial advisor with Financial Filosophy, New York.
The problem in the Madoff case, he continues, is that investors did not have answers for those 2 points and did not ask for clarification. “All they looked at was the returns history and said, ‘let’s keep going!’”
What no one asked about, according to Deyeso, is “the returns or processes or even how the strategy works.” If there is a steady year after year return, he continues, then one has to ask what is being done to adjust risk to keep those returns constant. It’s a major red-flag that there was no fluctuation in the returns.”
The second red flag, he adds, is not understanding what is owned, even if it is just for the reason of seeing how it correlates to other investments such as real estate and private equity.
So, he says, “the fatal flaw was not in the managers’ diversification, but in the lack of understanding and the unwillingness to ask questions.”
Thomas Cloud, a financial advisor with Eleven Two Fund Management, Marietta, Ga., says that he recommends clients check on several points before selecting a financial planner including: knowing what you own, putting money in investments that can be tracked in the newspaper or on the Internet, using an independent custodian, as well as making sure that accounts are insured for fraud by entities such as the Securities Investor Protection Corporation, Washington, D.C., which covers up to $500,000 per account.
Investors should “never” give complete custody of assets to an advisor and should get statements from an independent third party, Gordon Bernhardt, president of Bernhardt Wealth Management, McLean, Va., explains.
The use of an independent custodian provides a level of comfort knowing that an independent party is providing pricing and values to clients and that the investments are also kept in the clients’ names, according to Anthony Benante, a wealth management principal with Baron Financial Group, Fair Lawn, N.J.
While due diligence is a critical component of protecting portfolios and thus, income in retirement, financial advisors also say the Madoff situation underscores the need to make sure that a portfolio is diversified. There are many ways to achieve this, they say.
Morris Armstrong, a financial advisor with Armstrong Financial Strategies, Danbury, Conn., says that no more than a certain percent should be handled by 1 manager. He said in 1st quarter 2008, he realized that he was using 2 funds of 1 portfolio manager and had to move some money to another fund family.
Retail investors are often “lulled” into thinking that they are diversified even if the mutual funds they hold have “significant overlap,” says Eve Kaplan, Kaplan Financial Advisors, Berkeley Heights, N.J. For instance, if 3 of 4 funds are large cap growth funds with slight variations, that is not a diversified portfolio, she says.