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Financial Planning > Tax Planning

Income planners take note: Madoff a cautionary tale

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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 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.

Kaplan says she believes it is a bad idea to diversify portfolio managers because no one is minding the “big picture.”

Jeremy Portnoff, an advisor with Portnoff Financial, Union, N.J., notes that diversification comes in many forms. One example is coverage by the Federal Deposit Insurance Corporation, Washington, D.C., and SIPC. “I never thought would be important to discuss (such coverage) with clients until now,” he says. Portnoff also cites tax diversification, and fund diversification such as having 2 funds in an asset class like an actively managed and index fund or exchange traded fund. Using a strategic asset allocation portfolio along with a tactical portfolio manager would provide diversification, he adds.

Dylan Ross, an advisor with Swan Financial Planning, East Windsor, N.J., says if a portfolio is not matching the market, then more diversification is needed. “Any over- or underweighting of a company, industry, or sector, amounts to a bet that has equal chances of being right or wrong he observes, adding that “investing costs make the financial consequences slightly worse for being wrong than the reward for being right.”

“A common misconception,” according to Ross, is that multiple bets diversify away risk but in reality, “the more bets one makes, the more of these negative-sum games they are participating in; therefore, they have a greater their likelihood of under-performance.”

Professional family offices and wealth managers already diversify client assets but the practice can also make sense for smaller clients, according to Bedda D’Angelo, president with Fiduciary Solutions, Durham, N.C. If, for instance, a client has 401(k) money with one mutual fund company, then D’Angelo will not put other assets outside of the 401(k) with that same fund family.

While diversification can be useful, it “is not the answer to everything,” according to Tom Davison, a financial advisor with Summit Financial Strategies, Columbus, Ohio. In some cases, it is used when there is poor risk control such as limited visibility into what is being done with client funds, he explains. “You can say that’s diversification, but purely driven by the fact you don’t (or can’t) know what you are doing–or at least not fully.”

Diversification can add complexity to a portfolio, he continues. However, it is useful when it reduces risk by introducing assets that have low correlation, Davison adds.

That depends on how it is executed, he explains. For example, while buying the same type of index fund from 2 providers is not useful, buying 2 funds with different investment philosophies can be helpful, according to Davison.

The question of whether the definition of diversification should be broadened to include clients’ diversification of financial planners meets with differing views.

For instance, Summit Financial Strategies’ Davison maintains that “getting a second opinion in the investment world is healthy. So is getting a second opinion in the financial planning world.”

But Kaplan of Kaplan Financial Advisors says that a second opinion is not a good idea unless the client is unhappy with the first advisor and is planning on making a switch. She asserts that “people got into trouble with Bernie Madoff not because they were working with one person, but because that one person was a ‘black box’ with no accountability and all the tools to deceive.”

Several financial advisors note that a financial planner is part of a team effort and works best when the team works well together.

Maas Capital Advisors’ Corbeau says that he has been asked only once or twice to opine on another planner’s work and that in general, as long as a team of allied professionals works well together, “the opportunities for ‘screw-ups’ are limited.”

More frequently, he continues, he is asked to provide a second opinion on investment strategies as a prelude to becoming the client’s advisor. In these cases, he says, since he strongly believes in asset allocation, a client has to buy in 100% with this philosophy

Fiduciary Solutions’ D’Angelo also believes in the financial planning team approach. “You can’t have 2 people working the same position on a team,” he adds. “They just trip over one another and nothing gets done.” When 1 of the team of financial professionals insists on being the quarterback for the financial team, then “a turf war erupts at the client’s expense.”

She says she does not include an insurance agent on the team, because “insurance agents usually attempt to take over the case to sell their own products and are unwilling to wait their turn at bat.”

But it is appropriate to seek a second opinion from an advisor as long as that advisor is qualified, D’Angelo continues. “The operative word here is ‘qualified.’ A stock broker is not a money manager, a money manager is not an insurance agent, and a CPA is not an attorney. All have biases. If you seek a second opinion, it should be from an advisor that performs substantially similar services and maintains identical professional credentials.”

Portnoff of Portnoff Financial, says that having more than 1 planner “might be cost prohibitive and confusing for the individual if conflicting advice is given. It might not be a bad idea, however, to have a second financial advisor that is contracted on perhaps an hourly basis just simply to review what is being recommended in order to validate what the client is doing and possibility look for any red flags or missed items. “That could be reasonable in terms of cost.”

Baron Financial’s Benante differentiates between getting a second opinion which he says can be a good idea and hiring multiple advisors which he maintains is not.

Hiring more than 1 advisor can result in “inconsistent or fragmented services” leaving the client with advice that is too conservative or too aggressive, as well as creating the dilemma of how to coordinate conflicting advice and what portion of a client’s assets will be given to each advisor.

Protect your income plan

Steps to take to keep your income plan on track

  • Don’t give all your money to just 1 manager
  • Read advisor ADV disclosures filed with the SEC
  • Separate the duties of an investment manager and a custodian
  • Keep it simple
  • Understand your investment and its role in the income planning portfolio
  • Ask questions
  • Pick transparent investments that can be tracked in the paper or Internet
  • Diversify by fund family as well as asset class
  • Diversify through FDIC and SIPC coverage
  • Diversification should be used bring uncorrelated assets into a portfolio, not because an investment is not understandable

Source: summary of suggestions from advisors who were interviewed by Jim Connolly for the above article.


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