Episode 126 – Supporting the Four Corners of your Financial House with guest P.J. DiNuzzo, CPA, PFS®, AIF®, MBA, MSTx

Episode: 126
Originally Aired: May 14, 2015
Topic: Supporting the Four Corners of your Financial House with guest P.J. DiNuzzo, CPA, PFS®, AIF®, MBA, MSTx

The Lange Money Hour: Where Smart Money Talks
James Lange, CPA/Attorney
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Supporting the Four Corners of Your Financial House
James Lange, CPA/Attorney
Guest: P.J. DiNuzzo, CPA, PFS®, AIF®, MBA, MSTx
Episode 126

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TOPICS COVERED:

1. Guest Introduction: P.J. DiNuzzo, CPA, PFS®, AIF®, MBA, MSTx
2. The DiNuzzo Stack Analysis
3. Fiduciary Responsibility
4. Behavior Coaching
5. Taking Advantage of a Dynamic Withdrawal Strategy
6. Cost Effective Portfolios
7. Tax Management of a Portfolio
8. Rebalancing

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1. Guest Introduction: P.J. DiNuzzo, CPA, PFS®, AIF®, MBA, MSTx

David Bear:  Hello, and welcome to this edition of The Lange Money Hour, Where Smart Money Talks.  I’m David Bear, here in the KQV studio with James Lange, CPA/Attorney and author of three best-selling books, Retire Secure!, The Roth Revolution, and now, Retire Secure! For Same-Sex Couples.  Most people recognize that proper asset allocation is essential to the long-term financial success of their retirement planning.  But too many investors fail to consider all the factors of their situation.  For perspectives on making sure you have all four corners of your financial house supported, The Lange Money Hour welcomes P.J. DiNuzzo back to the show.  A nationally recognized expert in investment management, P.J. has been featured in numerous business publications and TV shows.  Approved as one of the first one-hundred Dimensional Fund Advisors, he’s rated a five-star advisor by Paladin Registry Investor Watchdog, scoring in the top one percent of America’s more than 800,000 investment advisors.  Based in the Pittsburgh area, his firm, DiNuzzo Index Advisors, also consistently ranks among the country’s top five-hundred investment companies.  Among other topics, Jim and P.J. will discuss the benefits of Advisor Alpha and one stop shopping.  It’ll be an interesting, informative hour, and listeners, since today’s show is live, you can join the conversation with your questions and comments.  Call the KQV studios at (412) 333-9385.  And with that, I’ll say hello, Jim and welcome back, P.J.

Jim Lange:  Welcome back, P.J.

P.J. DiNuzzo:  Thank you very much.  Thanks for having me.

Jim Lange:  So, before we get into the substance of the show, I feel honor bound to tell you that I am not independent with P.J.  Usually, when I have a guest, I try to get the top national experts in the country, and I will often plug a book, but I don’t really necessarily plug their services, and very frankly, I don’t have any financial interest.  They sell some more books, great.  But it’s not like I make any more or less money if that happens.  That is not the case with P.J. and myself.  P.J. and I have an arrangement where if somebody comes to our office first, let’s say, looking for advice of the, let’s call it, big picture: estate planning, tax planning, Roth IRA planning, Social Security planning, etc., and they’re also interested in investments, P.J. and I have an arrangement where our office does that type of work, what I’ll call ‘big picture strategies,’ and then P.J., using low-cost index funds, actually manages the money.  And P.J. and I split the fee.  Now, we think that it’s a win-win-win.  That is, it’s a win for our firm because we get to do what we like best and are best at, which is all these strategies, how much you could spend, Roth IRA, Social Security, tax loss harvesting, the big picture, the best way of providing for your grandchildren and children, estate planning, etc.  P.J. does a marvelous job on actually investing the money using low-cost indexes, and he gets to do what he’s very good at, and it’s a client that otherwise might not have come to him.  But we think the real win is for the client, who gets the combination of our strategies and his money management, and one of these days, I’m going to go find a lie detector person with a lie detector test and tell people (and probably even do it live) and say, “I do not know of a better combination, or a better way to have money managed, than our firm doing the strategy part and P.J. doing the money management parts.”  But I did feel compelled to say that I am not independent with P.J.  So, P.J., where I’d like to start is, one of your strategies that you have been using for years, and something that I think is so valuable to the marketplace (and I think the whole theme of today is all the ways that other than just pure investments that people should be looking to and areas where you add lots of value), is what we call the DiNuzzo Stack Analysis.  Maybe you could tell our listeners some of the benefits, and even for the do-it-yourselfers, how some of them could do this to some extent, but it’s much, much different than the vast majority of money managers, and I just think it’s a wonderful tool, both in terms of results and psychologically.  So, could you tell our listeners about the DiNuzzo Stack Analysis?

2. The DiNuzzo Stack Analysis

P.J. DiNuzzo:  Yeah, Jim.  That’s a great place to start with your layout for this evening, you know, talking about Gamma and Advisor Alpha, how we can add value between our services for clients even over and above the asset management, which we talk a lot about.  We refer to it as a ‘suitable portfolio asset allocation strategy,’ and the key, Jim, here would be that these are what the professionals, the institutional folks, would refer to as ‘liability-driven.’  So, in liabilities, we talk a lot about the DiNuzzo Money Bucket Stack Analysis, and it works out really well in Pittsburgh.  We’re dealing with these, you know, I’ve been dealing with DFA since early 1990s.  Two to three Nobel Prize winners and a board of directors, we’re trying to take these high-browed, high-minded Nobel Prize winning strategies and bring them to folks in Pittsburgh and allow them to have wealth enhancement in their overall wealth.  And really, by making it liability-driven, we start off with the needs bucket, and what we’re looking at is, for an individual’s food, clothing, shelter, healthcare and transportation, we want a conservative solution for that investment strategy, generally somewhere between 20% to 30% in stocks.  And as you said earlier, Jim, when the behavioral scientists go back and sort of do their forensic work and dig through the bear markets and uber bear markets, let’s say circa 2000, ’01 and ’02 when the market’s down 50%, ’08 and ’09 when the market’s down 60% from top to bottom, pretty much universally, the first people that head for the exits are people who are overly aggressively invested.  And that can seem like common sense to a lot of the audience as listeners, but the folks that come to us that we work on jointly, given their age, maybe they should have a weighted average of 40% or 45% in stocks, and we see 70%, 80%, 90% in stocks.

It always seems fairly unique whenever we have these, but I just literally had a consultation earlier today.  Gentleman’s close to ninety years of age, his portfolio’s about 90% in stocks.  And you don’t need a Ph.D. in finance to say that’s overly aggressive.  There’s a conflict of interest involved which we stay away from.  You know, we have a 100%, as you mentioned earlier, fiduciary standard to do what’s in our client’s best interest, and it is a lot harder.  As you mentioned on occasions, for our average client who’s retired, we have three buckets, three solutions for them: again, the needs for food, clothing, shelter, healthcare and transportation, the wants bucket for their discretionary expenses, that’s for dining out, vacation, helping the children or grandchildren, just obviously discretionary: what you like to spend money on over and above the needs, and then, finally, the dreams bucket, we call it dreams/wishes, the dreams would be while we’re still alive, what we like to do, taking an extra vacation, buying a new car maybe a year or two sooner than we would normally buy it, whatever we like to do as far as that extra bucket, if we do have assets there, and then the wishes, of course, refer to the beneficiary designations for our children.  So, sometimes, in that top bucket, we even have two strategies there, and we’ll have a total of four strategies in the household.  And what we find is, by these being very specific, we refer to it as a ‘liability-driven’ asset allocation, that individuals are able to ride out the market a lot better when they know that they have a specific portfolio for every dollar that they’ve saved very hard and worked very hard for over their entire life.

Jim Lange:  So, let me see if I understand this right.  So, let’s say that you were a classic 50/50 or 60/40 (that is, 50% stock, 50% bonds, or 60% stock or 40% bonds) type investor.  And let’s even assume, for discussion’s sake, that that might even be appropriate.  And let’s say that that person went to you.  By the time you’re done with them, they’re not going to have one portfolio.  They’re going to literally have three or four different portfolios.  So, this isn’t like a psychological thing to make people feel more comfortable.  You’re actually going to have that money in a separate account, or somehow differentiated and not just thrown together.  Is that right?

P.J. DiNuzzo:  Yeah, that’s correct.  If we took a simple example, Jim, let’s just…to make the math easy, let’s say someone had a million dollar portfolio, whereas most firms are just going to place that all…keep it in one account, one account places it just in one strategy.  We’re going to usually trifurcate that and have that, let’s say, for example, we have $300,000 in the needs bucket, $400,000 in the wants bucket, and the residual $300,000 in the dreams and wishes, specific strategies for those.  And in one thing, Jim, that works out really nice is that as a residual benefit, it does help them from what we call a ‘behavioral science perspective.’  It does allow them to sleep better at night.  We’re not doing that for the initial purpose.  We’re doing it to customize that for the liabilities that they have, or the remainder of their life.  The clients really like it because we have a plan, a strategy, an implementation, a reason for doing something with every dollar in their portfolio, and folks really like that holistic, complete loop, you know, having everything tied down and having a reason for everything that we’re doing, how we’re investing their life savings.

Jim Lange:  Well, one of the things…and you mentioned behavioral, and we’ll get to that soon, but it seems to me that if I have $300,000, it’s very conservatively invested in, let’s say, cash and CDs and fixed income, and we get another 2008 or 2001 and we have a very significant deterioration of the market, I know that there’s a couple hundred thousand dollars that I can spend before I have to go into the market.  So, therefore, I can be a lot more relaxed, where, if I have even just the same total allocation in one account, I go, “Oh my goodness!  I lost 40% of my value.  I’d better run for the hills.”

P.J. DiNuzzo:  Yeah, you react a lot differently when it’s just all in one account.

Jim Lange:  Yeah, which is what I think is really good.  And then the other thing, and I guess this is a slight overlap of what we’re going to get to, is that since there are different types of taxation, whether it be IRA or Roth IRA or after-tax dollars that are highly appreciated or after-tax dollars that have little or no appreciation, you can actually become more tax-efficient and combine, let’s say, the different stack analysis.  So, for example, I would imagine for the long-term money, or the wish list (if you used that phrase), that might be where you would keep the Roth money.  And that might be 100% stock, where other monies might be 100% or 80% bonds, cash, fixed income.

P.J. DiNuzzo:  Yeah, exactly.  And that even gets into another topic.  We’re rolling right along.  But, you know, one of the other ones there, Jim, oftentimes, we’ll do that.  It depends.  It literally is customized from case to case.  But we can often, if clients have a sizable amount of assets in after-tax and taxable accounts, as well as qualified accounts, IRAs, and even the Roths, you know, to put the icing on the cake, so to speak, if they have that, we can even do what we refer to as the asset location.  And, as you said, you know, doing a tax maximization as far as placing certain asset classes in different portfolios, which, sometimes, is the inverse.  One thing, Jim, that I just thought about that you had just mentioned, I had forgotten to mention earlier, was the cash reserve bucket.  So, that’s one thing that’s different, as well, is, you know, we want clients going into retirement, they have twelve times their monthly living expenses.  And it’s surprising.  A lot of other firms want to basically maximize their revenues.  So, they’ll tell you to keep $5,000 in cash in your local bank and let me manage everything.  So, you know, if we have a client whose monthly spending in retirement’s $8,000 a month, that’s $96,000.  So, let’s just call it $100,000.  That’s our minimum threshold.  We want that in the bank, FDIC-insured.  People sleep a lot better.  They’re not hopping in and out of portfolios.  And then the other end, we get a lot of clients, and especially, you’ve seen since ’08 and ’09, our maximum will be three years times their monthly expenses.  So, we can prove to clients that there’s no reason…we call one year times your monthly expenses is a belt…two years is a belt and suspenders, three years is a belt and suspenders with a bunch of duct tape wrapped around your belt.  I mean, you don’t need to go any more than that.  So, we’ve been able to place hundreds of thousands of dollars to work for clients and prove to them that you have a 99.9% chance you’re not going to need this money any point in time in the foreseeable future.  And let’s place it into a conservative strategy.  It can net you one or two, maybe three percent more per year, a huge value add for clients.

3. Fiduciary Responsibility

Jim Lange:  Well, you said a couple things, and earlier, you mentioned fiduciary advisors.  I think it’s important for listeners to understand, whether they’re going to us or anybody else, that, to oversimplify, there’re two types of advisors in the world: The first, that are fiduciary advisors that have the moral, and I believe all advisors have the moral obligation to do what is in the client’s best interest, but also, like you and me, have the legal obligation.  So, let’s say, on a typical client, you might say, “Well, we want you to have $50,000, $100,000 in cash, and we don’t need to manage that.  That can just be in an FDIC-insured account.”  So, that’s kind of chipping away at what you’re charging.  I know that, for example, you have been a big advocate of TIAA…

P.J. DiNuzzo:  Yes.

Jim Lange:  …and other guaranteed income funds, where sometimes, other advisors might want the whole pie.  But if somebody has, say, $300,000 in TIAA, rather than trying to get that money out as quickly as possible, you’re saying, “Hey, we think that that is a good thing.”  Or maybe if there’s a highly appreciated asset, maybe don’t sell that tomorrow and throw it in the mix, which goes against you trying to maximize what you’re going to receive from any one client.  But I think it will maximize your long-term good will, which I think is really a good thing.  So, we started to talk about one of the advantages of this stack analysis is that it helps people, in effect, behave more rationally or more appropriately when there is a downturn, or, for that matter, a spike in the market.  And I know that there is a paper right in front of us, and I believe that Vanguard itself said that the ‘behavior coaching’ (which is the term that’s used here), just by itself, is worth 1.5%, and I know that guy…is it Murray, or Dean Murray?  Nick Murray!

4. Behavior Coaching

P.J. DiNuzzo:  Oh, Nick Murray, yes.

Jim Lange:  Nick Murray.  He says that that’s worth going to an advisor just by itself.  Just getting people to behave properly, and…

P.J. DiNuzzo:  It more than pays for, you know, the fee.

Jim Lange:  Right, because we are human animals.  We sense fear, we run.  So, if the market goes down, instead of rebalancing and actually putting more money in the market, we run and get out of it.  Can you talk a little bit about behavior coaching and some of the benefits?  I know that you have some great statistics on that, also.

P.J. DiNuzzo:  Yeah, Jim.  The behavior coaching, and I think it’s important to reiterate the macro point that you were just making that, you know, the recent research that’s come up from Morningstar and Vanguard regarding retirement planning and advisor value, just what we’re talking about tonight, conservatively from both of those organizations, is estimated by their best estimates to be able to add three percent per year in value to clients, to their portfolios, over what they would do themselves.  So, you know, we’re just not nibbling around the edges here.  It’s a huge amount of money.  And this has nothing to do with, we talk about the indexing doing better, the DFA being the best index firm.  This is just all of the things that you do with your team of attorneys, estate planning attorneys and CPAs in your office.

What we’re doing on the retirement planning and the investment management is over and above just the straight management straight ahead.  But the behavior coaching, basically, over the recent approximate twenty-year period of time, the S&P 500’s averaged a little bit over 8% per year, and there’s a company out of Boston, Massachusetts, Dalbar, that tracks investor behavior.  So, they’ll take a look at accounts in all the national brokerage firms, Schwab, TD Ameritrade, Fidelity, Scottrade, E*Trade, etc., and say what are individual and do-it-yourself investors, how are they performing.  And over a recent twenty-year period of time, individual investors did about four-and-a-quarter percent, while just investing in the S&P did over eight.  Now, again, to hold apples to apples, this was all stock portfolios.  This was their stock positions, either individual stocks or mutual funds, and, you know, we’ve got an image that…I know you like, we talk about the emotional roller coaster of investing, and we’re going to go through a roller coaster, spring, summer, winter, fall, over a typical five-year market cycle, and individuals doing a little bit over four percent versus eight, we make the point over and over that they just didn’t get off or on that roller coaster just one or two times the last twenty years at inopportune moments.  It’s a lot of mistakes to underperform by that much.  A lot of mistakes.

Jim Lange:  Yeah, and I think you had the same study actually showed people in the identical fund, where a particular fund, whether it’s an index or an active fund…

P.J. DiNuzzo:  Or even active, yeah.

Jim Lange:  …the individuals did much, much worse than the fund that they’re investing in.  And you could say, “How could that be?!?  If it’s X-Y-Z fund and that fund earned eight percent, how could an individual who’s in that fund have earned four percent?”  It’s because they got excited and they got in while it was at its high point, and then they feared and they got out at its low point.  And that might be sometimes one of the most valuable things that a good fiduciary advisor can do, which is do the stack analysis which makes people feel more secure as it is, and then when the times are good and when times are bad, help them make rational decisions, not emotional decisions.

P.J. DiNuzzo:  Yeah.  And Jim, the behavior coaching point that you made really works in both directions.  Keeping people in the market, but also helping them maintain their discipline in rising markets.  So, if one of your buckets is at 50/50, I’d be remiss to say we haven’t received dozens of phone calls the last couple years, we’ve been in a bull market, and individuals were like, “You know, the market’s really moving.  What if I move up to 60?  What if I move up to 70 or 80 from my 50?”  So, it’s also keeping that discipline on rising markets, as well.  We look at it, basically, that each individual has their own index, so to speak, and that if they only need five-and-a-half percent in their total portfolio to be successful, they don’t need to be concerned about what the NASDAQ’s doing.  If it’s up whatever percentage point it may be, we’re always concerned about playing defense first, never overextending ourselves and never taking on more risk in a portfolio than we need to be successful.

David Bear:  Well, let’s take a break right now.

BREAK ONE

David Bear:  And welcome back to The Lange Money Hour.  I’m David Bear, here with Jim Lange and P.J. DiNuzzo.

Jim Lange:  So, we are talking about ways other than pure investment that add value, again, whether it’s a do-it-yourselfer or somebody who has managed money, and, in our case, in our office, and I will repeat again for those of you who just joined me, that I am not independent with P.J. DiNuzzo.  We do have a working relationship where our office does tax strategies, Roth IRA conversion, Social Security, estate planning, etc. and P.J. actually does the money management, and together, we charge one percent or less.  So, I am not independent with P.J.  And one of the things that his office does that might add at least a half a percent of value is known as ‘dynamic withdrawal strategies.’  So, this is probably more for people who are just about or are already retired, and they are taking money from their portfolio to live.  That is, they are not living on their wages.  So, P.J., how does a dynamic withdrawal strategy add value, and what do you do that might be different than somebody who isn’t up on these strategies?

5. Taking Advantage of a Dynamic Withdrawal Strategy

P.J. DiNuzzo:  Yeah, Jim.  The dynamic withdrawal strategy, we would take a look at, is basically on two axes: let’s say, looking forty years with a forty-year life expectancy moving in forty, thirty, twenty, etc., and also looking at safe rates of withdrawals from portfolios from 20%, let’s say, up to 60%.  We’re generally not more than 50/50 in retirement, taking withdrawals out of a portfolio.  But, you know, anytime you just use, you know, carte blanche or quick and dirty-type numbers, you’re at a safe rate of withdrawal at four percent, well, if the individual’s 74 years of age and in a certain type of portfolio, they may be able to withdraw five-and-a-half percent per year.  It might be six-and-a-quarter.  Also, in addition to that, you need to know what their legacy concerns are.  Individuals with legacy concerns sort of fall into one of three camps.  They’ll say, you know, “Hey, you know what?  I came into this earth with nothing.  If I leave my kids everything, nothing, so be it.  I’m fine with that.”  Or they’ll say, “You know what?  I really have a specific number in my head that I’d like to leave my beneficiaries.”  Let’s use the children example again.  “And it’d be X dollars per child as a minimum.  If I can leave them at least that, I could spend down to that.”  And a lot of other folks will say, “You know, I like to live my life the way that I can, enjoy myself, not worry about it, and I’d like to leave my kids as much as possible.”  Those are three completely different legacy perspectives, and those all come into play with the withdrawal strategy, and there’s nothing worse in my mind, or, at least, a tie for nothing worse when we get introduced to a new prospective client, we start meeting with them and they’re just fretting beyond comprehension that they’re going to run out of money, or they’re not taking a safe rate of withdrawal when they really are.  And if their portfolio is restructured, they can easily handle it.  So, we refer to it as a ‘dynamic withdrawal strategy.’  This is ongoing.  We’re looking at this every time we’re in a progress meeting with clients, be it every six months or once a year, or it can even be twice a year, maybe it’s a go-to meeting for one meeting and a face-to-face for the other.  And it really is just a very small adjustment as we are ongoing, going through retirement through all these minor changes.  But again, as you said, these national organizations have identified that clients are able to add potentially up to from one-half of a percent to almost three-quarters of a percent per year over the lifetime of the client.

And that one dovetails into the next topic you had, Jim, into the spending strategies, and in spending strategies, the withdrawal sourcing and order is really the key.  Typically, again, there’re always exceptions to rules, but typically, we’re looking to take withdrawals from a client’s taxable account first, down to their sleep at night number, to draw that down, and then starting to take money from their qualified account from their IRA, for example, for the audience.  So, it’s really about managing.  We can do a lot more tax management in those taxable accounts, and if the audience wants to think of individual or joint accounts, because we can harvest losses.  We can offset gains versus losses.  There’s a lot of management that we can provide to be able to keep the taxes down, where, as you know, Jim, on the withdrawals that are coming out of IRA accounts, basically, by and large, every penny that comes out, if the audience wants to think of it as basically being taxed the same way as your W2, your earned income, your hands are really tied in that.  So, the spending strategies that the withdrawal sourcing order on how we’re doing that has huge benefit for clients being able to make that analysis and provide them with the correct advice.

Jim Lange:  And the other thing that I have noticed with our mutual clients is, as a result of that analysis, and as a result of spending the assets in the right order, and Roth IRA conversions (and we’ll get to Social Security), that people can actually safely spend more money and not run out of money.

P.J. DiNuzzo:  Yes.

Jim Lange:  Because I think a lot of times, particularly if people aren’t really familiar with withdrawal strategies, you know, they just sometimes might mechanically say, “Okay, I have a million dollars.  I can spend four percent of that,” or now some of the people are saying less, “Okay, so I can take $35,000 out and the analysis ends right there, when if we’re a little bit more clever about it, we can actually, by using some of the tax optimization and the DiNuzzo bucket analysis, actually safely take out more money,” which is a great benefit to clients, particularly for those who do want to enjoy their later years.  I know that Jane Bryant Quinn talks about that all the time.  She’s saying, you know, “Fly first class.  If you don’t, your kids will.”  But probably, if you combine some of these strategies, I like to think of it is as you’re not only cutting up the pie differently, but you’re actually making a bigger pie.

P.J. DiNuzzo:  Yes.  Yeah, you’re expanding the pie.

6. Cost Effective Portfolios

Jim Lange:  Yeah.  So, why don’t we go on to, let’s call it, ‘cost-effective portfolios,’ because I was just in with a client today, and he was grousing that he was paying a money manager one percent, and the internal assets that the money manager was managing were a set of mutual funds that themselves had about a one-and-a-half percent internal cost.  So, he had to make two-and-a-half percent just as a break even.

P.J. DiNuzzo:  Yeah.

Jim Lange:  Why is that so important, and what, if anything, are you doing differently than other firms about that?

P.J. DiNuzzo:  Yeah, the cost-effective…you know, that’s probably one of the largest reasons why Vanguard is growing to be the largest retail mutual fund in the United States, because of how low their fees and expenses are.  You know, Benjamin Franklin “A penny saved is a penny earned,” in your portfolio management, one percent less per year is one percent more in Mr. and Mrs. Jones’ pocket in their portfolio.  I was just looking, doing a portfolio analysis yesterday, and as you mentioned, Jim, it wasn’t quite as high as your recent experience, but it was 1.08%, was the average operating expenses in the portfolio, and our average DFA if we’re, let’s say, in a 60/40, 60% stocks, 40% bonds, we’re around 0.32%.  So, there’s almost three-quarters-of-a-percent difference right there.  So, what we’ve found in most cases, and again, the audience would never want to do anything solely based on price or low expenses, but in most of our cases, two-thirds to three-quarters of our fee is paid for by how much lower our overall expenses are, and in a lot of cases, our entire fee pays for our investment management fee.  So, by building these cost-effective portfolios, everybody knows we’re big proponents, we’re the largest, oldest, pure index firm manager in the city of Pittsburgh.  One of the beauties of efficient market theory is how low of an expense these index funds are.  It puts a lot of wind in your sail to get started.  Then, once we get into the indexes, I was using the Vanguard funds when I started in the late 1980s, my practice in the early 90s, but I had known at that time DFA was the premier performer in index management, and applied for them.  And as we talk about, we were one of the first one-hundred firms in the country that got accepted by DFA.  So, to also be able to add on top that additional performance, we get asked all the time, “How’s DFA done over one percent per year better with their small index versus Vanguard’s small index over the last thirty-plus year period of time?”  That’s a huge value add for clients.  The indexes are outperforming, and then with DFA being able to add even a little bit additional value, that’s a huge value add for clients for wealth enhancement on your cost-effective portfolio topic.

Jim Lange:  Yeah.  It’s interesting listening to your DFA history, if you will, because I have my own and I’ll make it brief.  But maybe about three years ago, I determined that DFA was the best set of index funds on the planet and I wanted to represent them.  I’m sorry, this goes back even further.  And I went to DFA and I said, “I’d like to represent your funds.”  And they said, “No.”  And I was shocked because I thought I had such a clean record, etc.  And they said, “That’s because you have a relationship with an active money manager.  We only want to work with passive money managers, and the fact that you are working with an active one, we don’t want to work with you.”  And I was disappointed, but there wasn’t much I could do about it.

Then, in later years, making a long story short, when they saw some expertise on the tax side, the IRA side, the Roth side and the best-selling books, they finally said, “Okay.  We’ll let you represent DFA.”  And then, I realized that I didn’t want to be a money manager because I don’t have the skill set that you and your office does, so I went to DFA and I said, “Well, who is the best index manager in Western Pennsylvania?”  And there was zero hesitation.  It was P.J. DiNuzzo, and even though I knew you a little bit, I didn’t know you well.  Then we got together, and the results, in terms of…I think I’m allowed to say this, that in 2012, together, our firms picked up $40,000,000 of assets under management.  Last year, 2013, we did a combined $50,000,000, and these are just unbelievable numbers compared to anything that I have done before.  And this year, it’s even on a higher trajectory because I think a lot of smart people are saying, “Hmmmm, P.J.’s this great money manager using the best set of index funds on the planet, and Jim and his firm are doing a great job with Roth and Social Security and how much we could spend and tax planning and estate planning, etc., and it’s all for one percent or less depending on how much money’s invested.  This is a good deal.”

And the other thing that, you know, to me, is kind of amazing is at least…and I know that this won’t last because somebody’s going to die, somebody’s going to move, or something like that, but we do have a 100% retainage rate.  So, all the benefits that we’re talking about are things that clients are actually enjoying.  But the next area that I wanted to talk about, and this is an area near and dear to my heart, is tax management.  And now, I’m not going to be talking about Roth IRAs or even tax loss harvesting, although that’s important, and I guess it all ties in, but if you could talk about the difference, for example, how you might invest a IRA account from a non-IRA account, which dollars you would spend first, and what you mean by tax management of portfolio that, again, Vanguard and Ibbetson say could be anywhere from maybe a quarter to a three-quarters-of-a-percent difference?  Which is huge.

7. Tax Management of a Portfolio

P.J. DiNuzzo:  Yes.  Yeah, a huge difference, especially when you compound these year over year.  On the tax management, Jim, one of the nicest things is DFA identified the major asset classes that they could add value in by creating tax-managed indexes.  So, we have five of our major asset classes that we don’t use the regular DFA indexes.  We use the DFA tax-managed indexes.  So, for example, U.S. large, U.S. large value, U.S. small, U.S. small value, international large value, and they have a real estate fund that’s more tax advantageous as well as an emerging market core fund.  So, really, when you start taking a look at being able to drive down and reduce those capital gain distributions over the course of the year, and again, as you compound it over time, huge value is added in the portfolio.

One of the other things we’ve been able to do, and, in fact, we were just chatting on a case, you know, Jim, you and I were out in the lobby before we came in, just got some great advice from one of your CPAs.  We’re working on a joint case.  And basically, I refer to it as a tax bracket smoothing, a tax bracket arbitrage-type of situation.  If clients want to think that…and we’ll get into the Roth conversions in a moment, but there’re some very exciting planning opportunities from the time that the last spouse retires until you get to age seventy-and-a-half.  When you’re at seventy-and-a-half, the IRS knocks on the door and says, “Hey, we want to get our hands on this money you’ve been growing tax-deferred for decades and decades.”  So, you know, a lot of times, we’re actually going in and harvesting some gains in that, let’s say, 65- to 70-year age bracket, and we’re filling up some brackets.  Let’s say, maybe we’re going to fill up the 15% bracket.  So, it may seem counterintuitive initially to individuals.  You know, “Why do I want to sell a security and recognize some gains?”  When we run the numbers and take a look…I mean, again, you’ve got the best number runners that…I’m not patronizing you, Jim, but you have the best number runners I’ve ever run into.  And we run these numbers in the office.  It’s in black and white that we’re very far ahead, harvesting these gains in a lower tax bracket, and if this individual typically is going to be locked into a materially higher tax bracket once they retire.

Jim Lange:  Yeah, and I think that’s frankly one of the favorite things that we like to do, and I guess we’ll talk about Roth IRA conversions and Social Security later, but actually quantifying the result of different actions and seeing which ones make the most sense, I think is a really good idea.  And I love the idea that DFA has…even though within the same asset class, will manage things differently for an after-tax or taxable account than they will for an IRA account because one thing that people hate is, what are called, ‘phantom gains,’ which is when their fund throws off significant income and there’s no buy or sale of the fund.

P.J. DiNuzzo:  Hmm.

Jim Lange:  And maybe that’s not down to zero with the DFA accounts, but at least significantly reduced.

P.J. DiNuzzo:  Yeah, it could be catastrophic in some cases.

David Bear:  All right, well, let’s take another break at this point.

BREAK TWO

David Bear:  And welcome back to The Lange Money Hour with P.J. DiNuzzo and Jim Lange.

Jim Lange:  And once again, I feel honor bound to mention that I am not independent to P.J. DiNuzzo.  We have an arrangement where our office does some of the strategic work like Roth IRAs, Social Security, how much you could spend, estate planning, etc.  His office does the actual money management using low-cost index funds, and together, we charge one percent or less, and we split that.  So, I am not independent, and that is not the case with the vast majority of the guests here.  And we are talking about some of the different ways other than the underlying investment itself that add the value to a portfolio and to a client’s life, and one of the areas that we have to talk about, because I know it’s a very important part of what you do, P.J., is rebalancing.  So, if you could tell our audience a little bit about rebalancing in general, and then how you do it and what you might do that might not be a hundred percent standard in the industry?

8. Rebalancing

P.J. DiNuzzo:  Yeah, Jim.  Portfolio rebalancing, again, can add material value to the client’s portfolio, net-net.  Over time, the estimates are anywhere from a quarter of a percent maybe up to about a third of a percent.  And in a rebalancing, what clients want to think about, if you’ve gone through, whether it’s with us, you know, with us and Jim’s team or another firm, you’ve gone through, you know, your spending needs, you know, your assets and liabilities, you know, where your money’s going to come out of retirement for your needs, for your wants, if you have any ‘extra money.’  Once you get these portfolios set up, for example, if you started on January the 1st of last year at a 50/50 strategy and just let that portfolio run, you could easily be at 65% or even 70% stocks right now.  So, we always want to think about the market as a yin and yang.  We want to think about the front and the back.  And while return is great, and the more money we have in stocks is going to increase our probabilities for return.

Also, we want to think about playing defense first.  What about the downside?  And a 70% stock portfolio’s significantly more risky and more volatile than the 50% stock.  So, if the audience wants to think it’s also equally about maintaining their unique risk profile, you set up those portfolios with a certain strategy for a reason: You want to maintain those risk profiles.  So, the first audit we would do…and we literally in our practice, Jim, do a daily rebalancing audit on our accounts.  There’re two audits: The first one is a macro audit.  We don’t want any clients getting out of a 10% band on the equities versus the fixed income.  So, again, use that 50/50 example, if we have 50% in stocks, we certainly don’t want them growing above 60% or shrinking and contracting below 40%.  But where more of the activity really happens is within the micro rebalancing, so to speak, and that would happen between U.S. large, U.S. small, international large, international small, emerging markets, etc., where you’ve got all these living, breathing organisms, so to speak, investment organisms across the planet Earth, and you get very wide ranges.

Last year, the U.S. market’s up 32%, so our U.S. large is up 32%.  U.S. large value and small value are up in the low 40% range, and emerging markets lost money last year.  Emerging markets, in all likelihood, beyond a shadow of a doubt, will make the most money for all of us over the remainder of our lifetimes, but it lost money last year when our markets were up 32%.  Tremendous rebalancing opportunity last year, and if people, once they sit in a seat and they’re willing to work through the process a little bit, Jim, they understand, you know, it’s a tremendous track record.  In the U.S., we’ve got an 85-year track record in our U.S. indexes.  We have approximately close to 40 years in international and about 25 years in emerging markets.  We should have a tremendous amount of confidence that by forcing ourselves, which is that hardest trade to make, literally, I’d be lying to you if I told you I didn’t have a hard time every time I hit the button.  But last year, for example, I’m going in and shaving a little bit off of U.S. large value, small and small value, that had made 40%, and buying an emerging market that lost a couple percent, buying real estate that broke even, and, of course, feeding the bonds a little bit, not that it always works out this way, but emerging markets so far this year are outperforming the U.S. market, the S&P 500.  Real estate’s having a crazy year.  We’re well into double digits already in less than half of a year.  But that’s typically what we see, and we always tell clients you want to give at least a five-year period, but by forcing yourself to sell high and forcing yourself to buy low, that’s what’s adding value and increasing your performance over time.

Jim Lange:  Yeah, and I want to emphasize, this is not market timing.  This isn’t, “Oh, I think the market’s going to go up.  I’m going to buy.”  “Oh, I think the market’s going to go down.  I’m going to sell.”  This is a mechanical rebalancing of getting you back to your regular original goals and comfort level that adds so much.  And frankly, it ties into the area that we talked about before, which is behavior coaching, because for somebody who is looking at their portfolio and they’re seeing 30% and 40% gains, and large and small U.S. companies, to be told by their advisor, “We think that you should sell some of that and buy something that is losing money,” is pretty hard to swallow and something that very few people on their own are going to do.  But actually, you receive greater diversification, hence safety, and ultimately greater return by utilizing that strategy.
So, I think that that kind of ties in directly with coaching.

Now, the other thing that I think is interesting is…and this is where I think that we can sometimes add tens, hundreds, and sometimes over like a forty-year period or more, even as much as a million dollars or more, is in the area…and this is probably more my area, of Social Security maximization and Roth IRA conversions.  So, I was just with a client today, and your firm and our firm independently came up with the same strategy, that the client should continue taking Social Security on their divorced spouse’s record until they were seventy, and then start taking money based on their record, and then, potentially depending on how their relationship is, getting married, and then, ultimately, having the next spouse take Social Security on the person who waited until seventy.  And sometimes, the difference in these strategies is tens of thousands of dollars, sometimes even more, and adding this kind of value when people didn’t even think about maximizing Social Security, that it actually does a lot to ensure just more money for the family.  And that’s, frankly, one of my favorite things, and particularly in estate planning.  Typically, estate planning is, you know, is dividing up the pie, if you will, between children, grandchildren, spouse, etc.  But what’s really fun is making a bigger pie, and one of the ways you can do that is coming up with the best Social Security strategy.  And I know that you also use Social Security strategy and tie that into how you invest a portfolio.  So, if somebody has a pension or Social Security, you might invest differently than if they did not.  Is that right?

P.J. DiNuzzo:  Yeah, that ties into what we refer to in the office as ‘guaranteed income.’  That guaranteed income and, you know, Jim, whenever you’re looking at a client, and we’re telling them, you know, they look a little quizzical sometimes because, like you said, they’re not familiar.  This isn’t something that a do-it-yourselfer is going to come up with themselves, managing their portfolio.  But I’ll look a client dead in the eye and I’ll tell them, “Whatever I can do to be able to grow your money 8% per year, guaranteed for two, three, four years, from full retirement age to age seventy, I can’t do that anywhere else.  I can’t look you in the eye and say, ‘I can guarantee I can grow your portfolio’ with indexes or anything else.”  So, the Social Security maximization, as you said, is what your firm is experts at.  We do work as well.  We concur on a regular basis.  But significant value, the national averages from the research I had seen, it estimated a value add of about $40,000 in additional cash flow over the average couple’s lifetime.  What I’ve seen in our case, again, this is anecdotal, but I’ve seen easily in the $50,000 to $100,000 bracket.  I know the last two or three cases we worked on, it was in the $100,000 to $140,000 category in additional cash flow over their lifetime.

Jim Lange:  Yeah, and we’ve actually had, I think, four shows on Social Security, and all the experts, including Jane Bryant Quinn, are big fans of optimizing the strategy, and partly as a woman’s issue, to get a higher income for the survivor, who tends to be the woman.  We don’t have much time left, but the other area that I love to work with you on is, and again, the area of making a bigger pie, is with the Roth IRA conversions.  And what we love to do in our firm is, we like to what we call ‘run the numbers,’ determine an optimal long-term Roth IRA conversion strategy, and then instead of having to fight with you or fight with the money manager of wanting that in the portfolio, wanting that isolated because that’s often invested differently, is coming up with the optimal Roth IRA conversion strategy, tweaking it every year, and then having your firm execute on it.

P.J. DiNuzzo:  Yes.

Jim Lange:  And that’s just something that I love, and…

P.J. DiNuzzo:  Tens and tens of thousands of dollars, I’ve seen case after case come out of your office in tax savings for clients over their lifetime.  And those are real hard dollars, tens of thousands of dollars that they’re putting in their pocket instead of paying it to the government in taxes.

Jim Lange:  Yeah, and one of the things that I really like about it is, you had mentioned earlier, you know, people have different goals in terms of providing for their children and grandchildren, but who wouldn’t say, “Well, gee, if it’s at least a break even for me,” and it’s usually actually good for the client, who wouldn’t do something that could potentially save tens, hundreds, and, in some cases, over a million dollars to the next generation that doesn’t cost them money?  You know, you might have a great insurance policy that might be worth a million dollars to the kids down the road, but in the meantime, you’re paying the premium.  If you’re doing a Roth conversion strategy, and you yourself measured in purchasing power, are at least a break even or a plus, and the next two generations are better off by a lot of money, you’re really adding a lot of value, which is what I think that our firm does best.

David Bear: Well, this is probably a good time to call it quits for tonight.  I wanted to say thanks to P.J. DiNuzzo.  Listeners, you can reach him directly at his website, www.dinuzzo.com.  Thanks also to Dan Weinberg, our in-studio producer, and to Lange Financial Group program coordinator, Amanda Cassady-Schweinsberg.  As always, you can hear an encore broadcast of this show at 9:05 this Sunday morning, here on KQV, and you can also access the audio archive of past programs, including written transcripts, on the Lange Financial Group website, www.paytaxeslater.com under ‘Radio Show.’  While there, check out the series of short videos from Jim’s interviews with John C. Bogle, founder of the Vanguard Group.  And you can also call Lange offices directly at (412) 521-2732.  Finally, mark your calendar for Wednesday, July 2nd at 7:05 pm when we’ll welcome Larry Kotlikoff, a nationally-recognized Social Security expert, to the next new edition of The Lange Money Hour.

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