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Getting It Wrong

Investors often believe the wrong things about investment products and strategies. Here's what clients may be thinking and how brokers correct the misinformation.* IRAs--People believe IRAs are a great way to transfer wealth.In a poll of 200 people age 50 and older, American Skandia found 30 percent say they're using an IRA to pass along wealth to their children.However, 70 percent or more of IRA

Investors often believe the wrong things about investment products and strategies. Here's what clients may be thinking and how brokers correct the misinformation.

* IRAs--People believe IRAs are a great way to transfer wealth.

In a poll of 200 people age 50 and older, American Skandia found 30 percent say they're using an IRA to pass along wealth to their children.

However, 70 percent or more of IRA assets is typically consumed by taxes when the IRA owner dies, says Ed Slott, a CPA in Rockville Centre, N.Y., who publishes the newsletter "Ed Slott's IRA Advisor." The cause: People just don't pay attention to beneficiary designation rules.

Chris Jones, a PaineWebber rep in Austin, Texas, sees people designate in their wills that IRA assets go into an irrevocable trust for children. "When the husband dies, all the money goes directly to the trust for the kids rather than to the surviving spouse," he says. "They don't realize distribution must be taken immediately and taxes paid."

Jones advises clients to name the spouse as beneficiary, who then can name the kids as beneficiary. That stretches out the IRA assets without taxes coming into the picture in such a big way.

Slott recommends brokers pay closer attention to beneficiary designation forms. Don't assume the spouse is the best choice. "The goal is to keep the IRA assets growing as long as possible after death," Slott says. "You need to explore whether the beneficiary should be split up between spouse and children." Note, too, that after age 70-1/2 many IRA elections become irrevocable.

Take special care to keep the beneficiary designation form on file, Slott warns. He says he's seen many financial advisers and their clients lose the form. "If it can't be found, then the beneficiary usually defaults to the estate and all the assets must be paid out," Slott says.

* Mutual Funds--People don't believe they're taxed on mutual fund dividends.

"Clients will tell me, 'I put 10,000 dollars in the fund, it's worth 15,000 dollars now, so I've made 5,000 dollars,'" says Phillip Cook, a broker with Financial Network Investment Corp. in Torrance, Calif. "They'll get a 1099 showing dividends and say, 'I shouldn't have this; I don't need to pay taxes.'"

Taxes are due on dividends even if they didn't receive them or reinvested them.

Cook has particular trouble when clients sell mutual fund shares after reinvesting dividends for many years. "People don't realize that the income tax basis is higher than, for example, the 10,000 dollars they've put in--say 12,000 dollars. If it's worth 15,000 dollars at the time of sale, most of the gain would be taxed as long-term capital gains, but some would be short-term capital gains. Sometimes clients get angry because it's so complicated."

Cook recommends that brokers explain the source of dividends, show the difference between ordinary dividends and capital gains dividends, and illustrate how variable they can be.

* Trusts--Trusts are bottomless pits of misunderstanding.

First on the list is the belief that trusts are only for the extremely wealthy. People think a simple will is all they need to avoid estate taxes. Wrong, says Rodney Cantrell, an Edward Jones broker in Washington, N.C. "I tell them, 'Here's how much money will go to the people you love, and here's how much will go to the people you don't love--the IRS.'"

Stephen Leimberg, an estate planning attorney in Bryn Mawr, Pa., says anyone with minor children should have a trust. It costs well under 2,000 dollars to draw up a basic family trust, he says.

Then there's the belief that a revocable trust eliminates wealth transfer problems. Revocable trusts avoid probate, but Carol Glazer, a Morgan Stanley Dean Witter broker in New York, finds that investors think that means they also avoid estate taxes. "I ask, 'What are you trying to avoid?'" Glazer says. "Then I explain why probate exists, that it's costly, but not terrible."

People also believe setting up a trust will prevent family feuds. However, the typical asset management strategy used in a trust does just the opposite, Leimberg says. For example, a trust that contains all of a husband's assets directs that his wife be paid income as long as she lives, with whatever is left going to the children.

"The wife will say invest everything in the highest-income bonds the broker can find because she wants regular income," Leimberg says. "The kids will insist on investing in stocks because they know bonds would be bad for them over 20 years. The trustee then says, 'I'll split the assets evenly to satisfy both.' Now the wife has much less to live on, the kids have less invested in the market and it creates a family feud."

Leimberg suggests brokers talk to estate planning attorneys about drawing up a trust that specifies that the assets will be invested for total return for all parties. "That way the spouse will get a percentage each year of what the trust is worth," he says.

* Annuities--People believe annuities hide assets from Medicaid eligibility.

Glazer has clients who have been told they can qualify for long-term care benefits under Medicaid, as long as they get their assets low enough. Buying annuities, they're told, shelters assets from Medicaid scrutiny. What they're not told is that annuity assets can actually trigger ineligibility.

According to LTC Consultants, a long-term care insurance marketing consultant in Nashville, Tenn., Medicaid compares the amount of the annuity to an investor's life expectancy. Any projected payout that exceeds life expectancy is treated as an asset transfer. Medicaid then looks back three years to see if an investor has given any assets away and five years to see if any assets were transferred to an irrevocable trust. Medicaid could deem an investor ineligible for long-term care benefits for 10 years or more.

* Insurance--People believe variable life insurance is primarily an investment.

The mass marketing campaigns of variable life insurance policies are misleading, says Stephen Cordasco, a First Union Securities broker in Philadelphia. The products allow investors to put part of premium payments into investments and part into other insurance vehicles. The insurers say that over time, the investment growth will be high enough to pay the premiums.

The trouble is, Cordasco says, the products are expensive and designed for a specific type of high-net-worth investor. "For most people, buying a mutual fund and term insurance will do the same thing for less cost and trouble," he says.

* Bonds--People believe bonds are the best investment for retirees.

Cantrell finds new retirees don't stop to think how long they're likely to live in retirement. He shows them how life expectancies keep rising, then shows them the rising cost of a postage stamp and a new car.

His favorite eye-opener question is: "What is your strategy for tripling your income over the next 30 years?

"They don't know what to say," Cantrell says. "So I show them how equities can add that extra to overcome inflation."

* Asset Allocation--People believe it's a bad move to put assets in an underperforming subclass.

James Knaus, a financial planner with LaBrecque Jackson Price & Roehl in Troy, Mich., finds that lots of clients question the practice when growth stocks are hot. But he has them look at Morningstar's equity-style matrix, plotting the top performing funds for the previous calendar year.

They see how nearly all the funds plot out on one of five blocks on the matrix. "I tell them the same style can't always be a winner in the long term," Knaus says. "Since we can't know when each style will be a winner, we must participate in subclasses."

People also believe asset allocation simply means buying several mutual funds. "I see people who put money into an index fund and don't realize they own many of the same stocks they have in their 401(k)s," Cordasco says.

Hillery Schanck, an IJL Wachovia rep in Virginia Beach, Va., often finds new clients come to him with portfolios of a half-dozen or so of the best long-term performing mutual funds. "They may be diversified by fund, but not by investment," Schanck says. "I use software to show them how their holdings overlap and actually create risk, rather than reduce it."

As much as 10 percent to 20 percent overlap won't hurt a portfolio, says Bill Chennault, head of Overlap, a Kansas City, Mo., developer of mutual fund investment analysis software. Brokers often correct individual equity overlap, but fail to see all the equities are in the same sector or two, he says.

* Value Investing--People believe value investing is dead.

Look at the numbers. Value funds had an average return of 1.36 percent compared with 45.61 percent for growth funds from Jan. 1, 2000, to June 7, 2000, according to Morningstar. The average annual return over three years for value funds was just 9.32 percent, while growth funds returned over 28 percent.

People forget it was only a few years ago that value stocks posted robust gains, explains Scott Cooley, a Morningstar senior analyst. "In 1997, there was a feeding frenzy around financial funds," he says. "The average specialty financial fund was up 45 percent, while the average tech fund was up only 9 percent."

The recent gains in tech companies have come from multiple expansion, Cooley says. "To duplicate Cisco's performance over the past few years, you'd have to assume the P/E ratio will go from 120 now to at least 300, and its fundamentals would have to increase from record levels. The time will come when investors won't be willing to pay so high a price for earnings."

Regional bank funds, an example of value stocks, don't need much improvement in fundamentals to generate 12 percent to 14 percent return going forward, Cooley says.

John Elwood, a Dain Rauscher broker in Chicago, finds it helps to compare investing in stocks to buying a business. "When you look at real cash returns of a business, there's no way you'd buy Cisco at these prices," he says.

Elwood shows clients how the current growth strategy is unsustainable. The universe of stocks showing price gains in the past three years has narrowed, he says. An average of three-fourths of all stocks (S&P 500, NYSE and Nasdaq) are below 1997 highs.

"Mutual funds are buying the same 25 percent of stocks, as much as half of the rest are at historically cheap valuations," Elwood says. "It has to spread out or the game will end."

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