Podcast: Brexit’s impact, fiduciary updates, and more…

Microphone

Recently, I joined The Lange Money Hour radio show for a lively Q&A with host Jim Lange. Jim and I discussed the June Brexit vote and how it might impact financial markets, as well as issues surrounding the “fiduciary rule” recently issued by the Labor Department. We also laid out the basics for investing in the “accumulation” phase of one’s investing lifetime. An edited transcript of our conversation appears below, or you can click on the following link to hear the entire segment:

http://www.paytaxeslater.com/radioshow/langemoneyhour_173.mp3

CONTENTS:

  1. Guest Introduction: Charlie Smith
  2. Brexit’s Trade Consequences
  3. Brexit and the Market
  4. Fair Value
  5. Fiduciary Advisors and New Rules
  6. Advice for Investors in the Accumulation Stage

Brexit Impact with Charlie Smith of Fort Pitt Capital Group

  1. Guest Introduction: Charlie Smith

Dan Weinberg:  And welcome to The Lange Money Hour.  I’m Dan Weinberg along with CPA and attorney, Jim Lange.  Tonight, we welcome back to the program Charlie Smith, executive vice president and chief investment officer of Fort Pitt Capital Group.  Over the course of his 32-year career, Charlie has held leadership positions at several Pittsburgh regional investment firms, and he’s been a frequent lecturer and commentator on the economy and the market.  You might have seen him on CNBC, or perhaps read his work in the Wall Street Journal.  Tonight, among other things, we’ll talk about the big news that everybody’s been talking about, the Brexit vote, the implications for U.S. investors and what we can expect for the remainder of 2016 as a result.  Plus, Charlie will talk about estimates of fair value for the U.S. stock market, what he thinks the Fed will do for the rest of the year, and his outlook for corporate earnings.  And with that, let’s get right to it.  Let’s get started on what should be a fascinating discussion by saying good evening to Jim Lange and Charlie Smith.

Jim Lange: Welcome, Charlie.

Charlie Smith:  Well, thank you, Jim. Great to be back.

Jim Lange: Well, before we get into the meat of today’s show, I do feel honor bound to say that I am not independent with Charlie or his organization, Fort Pitt Capital Group. Usually, when I have a guest on, no matter almost who it is, usually, they have a lot to offer, and I try to get the best information to my listeners that I can. But frankly, I never, or rarely, have any ulterior motive in terms of my own personal gain.  So, if somebody has written a book, let’s say Jane Bryant Quinn just wrote a book, I will certainly mention her book, or if somebody is going to be in town, or whatever it might be, I will mention that.  But usually, there is no gain or loss that I have, and usually, my relationship with my guests is completely independent. That is not true with Charlie Smith and Fort Pitt Capital Group and I feel honor bound to disclose this.  We do have a financial relationship whereby in the event that I bring a potential client to Fort Pitt Capital Group, we have an arrangement where our office does things that we call ‘running the numbers.’ We determine Roth IRA conversion amounts, Social Security strategy, how much people can spend, we get into estate planning and tax planning, etc. And Charlie’s team does another component.  So we do have a fee sharing agreement. The good news for the client is that they are not paying me a fee and Charlie and Fort Pitt Capital Group a fee. They are paying one fee, which, by the way, is identical to what Fort Pitt would charge anybody else, and then Fort Pitt Capital Group and I have a fee sharing arrangement.  So, if you like what you hear and you end up doing business with us, I should let you know that I am not independent with Charlie.

So anyway, with that introduction, right now, what is on everybody’s mind, and we’ve already seen some vacillation in the stock market, is the Brexit vote. So, if you could kind of take us through what has actually happened, what you think will happen, and why it is important for us as investors? I’m sure that our audience would be very interested, and very frankly, this is one of the areas where I think that you excel, which is, in your own words, getting a world view on events, interpreting them, and then trying to figure out what, if anything, you should do about it.

Charlie Smith: Okay, well, great. Yeah, I’d like to, sort of, frame the Brexit issue. Last week, the British people voted approximately 51 to 49 to leave the Euro zone, a political union which was established over the last 20-25 years to promote trade and really remove the barriers to trade within the entire European community. The British people have decided through a referendum that they no longer want to be part of the European Union, they voted that way, and the way the numbers worked out, it was a 51 to 49 vote in favor of Brexit, which is British exiting the EU, and it turns out that about 36% of the British vote eligible population voted to leave. But the final vote was 51 to 49.  And so, what happens next is…and by the way, this vote had no binding authority. The way that the British exiting the EU happens is via an official movement on the part of the Prime Minister to invoke what’s called Article 50 of the EU treaty, and basically, Article 50 says that the Brits have two years to put in motion the divorce, so to speak.  And so, what happens now is that the British leadership has to begin the process of the divorce. It turns out that Prime Minister Cameron, the Tory party leader, announced that he was resigning the day that the results were announced. So, there will be a new Tory Conservative Prime Minister who will be charged with implementing Article 50, should the Prime Minister decide to go forward with it. So, formally, the vote had no effect, but the British government will, over the next couple years, invoke Article 50 presumably, and move forward with the divorce.

Jim Lange: All right, and when you say it has no effect, but the new conservative Prime Minister will invoke it in the next two years…

Charlie Smith:  Yes.

Jim Lange:  …is that because he is doing his job in respecting the vote?

Charlie Smith: Absolutely.

Jim Lange: Even though, theoretically, he could say, “Well, I know that those hapless voters voted to do something that I don’t think is in England’s best interest, so therefore, I’m going to ignore it.” You’re saying, even if he feels that way, you think it is more than likely that he will invoke it and that there will be this economic separation?

Charlie Smith: Exactly. You know, the old saying ‘Careful what you wish for?’ The Conservatives had initiated this referendum sort of on the assumption that we’re going to put this issue to bed. There’s been all this talk, mostly due to immigration issues, on the part of the British populace, that they wanted out of the EU. So, the Conservatives said, “Okay, we’ll have a referendum on the idea that it will finally put the issue to rest. The British people will vote to stay in the EU and it would put the issue to bed.” And it turned out they were wrong.  All the polls ahead of the event were saying that remain, remain is winning, it’s winning, and then Brexit happened. So, I don’t believe that the leadership in Britain today can go against the will of the voters because a big driver of this referendum was “Hey, we’re tired of being ruled by the elites and not having our voices being heard.” So, if the leadership in Great Britain today said, “Hey, we’re not going to listen to the voters,” I think it would be sort of rubbing salt in the wound and really would be a death knell for the Conservative party in Britain if they were to ignore this.

Jim Lange: Okay. All right, so, let’s assume that you are right on this aspect and that the plan going forward is sometime, presumably in the next two years, the new Conservative Prime Minister invokes the act and starts the, let’s call it, economic divorce.

Charlie Smith: Yeah, starts the clock, and by the way, there’ll be a new election for Prime Minister on September 9th. So, that’s coming up fairly quickly.

Jim Lange: Okay. So, let’s assume that this happens.

Charlie Smith: Mmm-hmm.

  1. Brexit’s Trade Consequences

Jim Lange: What are the implications, I guess, for England, for Europe, and ultimately for U.S. and U.S. investors?

Charlie Smith: Sure, sure. Well, most of the talk, in terms of the market commentary since the vote was announced last week, was the uncertainty of the timeline, which we have just been talking about, and what the response of the EU leadership is going to be to the initiation of the divorce proceedings, and the concern has been that the EU leadership is going to want to punish the British people for making the move to leave the union. And so, how would they do that? They would make the terms of trade between Britain and all the remaining members of the EU much more onerous. They would block the ability of British companies to be able to trade with other companies that have remained within the EU.  The idea is that the EU leadership wants to prevent any other nations that are currently members of the EU from thinking about taking the same route that the British did because it would simply be too painful. So, there’s an incentive on the part of the remaining nations within the EU and the leadership of those nations to say to the rest of the community that have remained, “Look, we’re going to make it really painful for you to do what the British have just done. So, we’re going to limit the amount of trade.  We’re going to limit the ability of the British banks to function. We’re going to basically make it really, really difficult for the Brits to continue to trade in the way that they had previously as members of the EU and all the potential issues that go with that.”

Jim Lange: Is that a real possibility given that, at least it’s my understanding, that Britain has a lot more imports from the rest of Europe than exports. So, you know, in a way, yes, the EU holds some cards…

Charlie Smith: But the British have some really good cards too.

Jim Lange: Yeah.

Charlie Smith: Yes, exactly. Britain runs a trade deficit with the remainder of the EU. That is, they buy more from the remaining members of the EU than they sell.

Jim Lange: And a significant one also. Is that right?

Charlie Smith: Exactly, and Nigel Farage, who’s the EU…the EU has its own Parliament, and Farage is one of the representatives from Britain to the EU Parliament. Farage came out and said yesterday that basically it’s going to come down to if the leadership of the EU is going to try to, or be willing to, cut off their nose to spite their face?

Jim Lange: Okay.

Charlie Smith: Are they going to take an action which, in the end, will basically backfire on the economies of the wider EU by shutting out Great Britain? And we don’t know the answer to that. We’ve heard some comments from some members of the EU leadership over the last couple days that have been sort of petulant, and you can expect this after a very emotional vote has gone against them. But there’s been a certain amount of resentment that’s come out. So, that’s what we’re watching most closely as investors. We want to see what the response of the EU leadership is in terms of implementing, once Article 50 is invoked, restrictions on the terms of trade between Britain and the remainder of the EU.  That’s going to be a big driver and a big determiner of how much economic fallout comes from the Brexit vote, and we really don’t know the answer to that. We think that probably cooler heads will prevail.  London had become a big banking center. It had become basically the banking center for all of Europe.  There is some concern that we will have a new banking center and that a lot of the large multinational banks that are now headquartered in London are going to have to move their headquarters to Brussels or the Netherlands or some other place within the EU. That may happen. That’ll be more of a cost issue for some of the banks and more of a logistical, technical issue. But in terms of the broader economics and shutting down trade, we think that probably cooler heads will prevail because the potential for a scorched earth by wanting to punish the British is just too much to think about.

Jim Lange: Okay. Well, as I understand, you have always basically been, within certain limits, a free trader, if you will.

Charlie Smith: Yes, yes.

Jim Lange: All right. Do you think that, ultimately, that this vote was against free trade, or do you think it was against open immigration?

Charlie Smith: I think much more the latter. In fact, as I mentioned Nigel Farage, yesterday, in his remarks to the EU Parliament, he basically said, “Hey, we want to be your friends. We want to trade with you.  It’s just that the terms of the open borders agreements with regard to immigration were too much for the British people to take.” So, it was much more about immigration and the problems that have come from more than half a million new immigrants into Britain in 2015, for example, and all the associated social issues that went with that and the problems that were created. That was really the driver of the Brexit vote. And so, I think the British are going to try to impress upon the Europeans that “Look, if we can work to solve some of these other issues regarding immigration, there’s no reason why we can’t continue to trade just as we have in the past.” Now, there are some financial responsibilities.  The British were contributing significant amounts of money to the EU government, which goes away.  So, I think there is a certain amount of credence to the European’s argument that hey, you can have the benefits of being in the EU in terms of open trade markets without the responsibilities that come from supporting the EU logistically and providing money to help with making the EU run, so to speak. So, in the end, I think we’ll end up with cooler heads prevailing here, but I think they’re going to have to make progress on the immigration issues for the British to want to continue to negotiate trade agreements, and on the European side, I think there is a certain amount of sentiment that they want to punish the Brits.

Jim Lange: Okay. You had mentioned uncertainty, and you categorized that as the feeling that so many people have, and you’ve always seemed to me to be one of the cooler heads, if you will. So, of course, there is uncertainty, but do you think that it is more predictable of what might happen and what the implications are and what we should do about it, or do you really think that it’s really in flux and it’s just too tough to even have any reasonable guesses?

Charlie Smith: I think there is a certain amount of unpredictability to it, but I think the consequences, excluding the absolute scorched earth that I just talked about where the EU basically says, “Hey, we’re shutting out Britain completely,” won’t be hugely negative.  I think there are enough sellers of goods in places like Germany and France and Portugal and Spain and Italy, sellers of goods to Britain, that are going to say, “Hey, we don’t want to shut out the British.” So, that outcome, I think the scorched earth outcome where the Brits are completely shut out has a very low probability. So, from our perspective, the hugely negative outcome is almost off the table. It’s just a matter of how we’re going to negotiate these new terms of trade, and it’s going to be a long negotiation. So, I think there is a certain amount of uncertainty about those negotiations, but as long as that hugely negative outcome is blocked off the table immediately, or fairly soon in these negotiations, I think the markets will be able to right themselves and function pretty readily. So, what we’re going to be watching in the next few months is how aggressive the commentary is from the leadership of the remaining members of the EU about just how severely they want to punish the British, and that’s going to rule all the markets. When the EU leadership is saying that, “Hey, we have to make an example of the Brits,” the pound’s going to decline and the dollar will rally, and I think that’s the dynamic that we need to pay the most attention to. But I think in the end that the most negative outcome where the Brits are completely shut out is off the table because even the EU leadership recognizes that that would be bad for everybody.

Jim Lange: Will the differences in immigration and, maybe it’s not financial, although I suspect it’s related, the security issues, which I understand is a major portion of the EU, now this is not going to be at least the status quo, is this something that gives you pause?

Charlie Smith: Obviously, an event like what we saw recently at the Istanbul airport in terms of a terrorist attack, those are always issues that the market will try to deal with on a day-to-day, it seems, basis these days, but the British voting to leave on security and immigration issues basically says, to me, that there’s a willingness that maybe the EU hadn’t demonstrated in the past to start trying to solve, or put up some potential pushback, against some of these terrorist issues and some of the issues of ISIS infiltrating various segments of the continent. So, I think the British basically saying, “Hey, enough,” with regards to open borders, is actually a good sign in terms of the potential dampening of these terrorist events, and I think the market probably would look at it that way, as well.

Jim Lange: All right, well, you sound more positive than perhaps I might have expected.

Charlie Smith: Yeah, I suppose I do. I think the bureaucratic functions of the EU, and some of the side effects of the Eurozone, have become a negative for the broader European community. I think initially, opening the borders and opening trade and really getting rid of all the restrictions that come from trading between nations and making it a very large and broad trading block were a wonderful thing. But I think that some of the baggage which has been attached to the EU over the past five, six, eight years, particularly with regards to the immigration issues, have made it a negative for (it’s pretty obvious) the Brits, and there are many others within the EU, the Italians, for example, where the skepticism about the Eurozone has risen. So, I think this is a wakeup call, and it basically says to the EU leadership, “Hey, there’s some aspects of this whole proposition which aren’t working.”

  1. Brexit and the Market

Jim Lange: So, Charlie, you just gave, at least to me, the best explanation of what is going on with Brexit that I have heard. What I would like to ask you though, is you said okay, you’re going to be watching some things, and specifically, EU’s reaction and what they’re going to be saying and doing to Britain very closely. Can I ask what U.S. investors should be thinking about, and should they be buying?  Should they be selling? Should they be making travel plans to Britain while it’s cheap?  Should they go play golf in Scotland?  What should U.S. investors be doing?

Charlie Smith: Well, I’m certain Donald Trump would recommend that they go play at, I guess it’s Turnberry. I’m not sure if that’s his course, but yeah. Well, first of all, from the perspective of U.S. investors, we’re not thinking that this Brexit vote is an earth shattering event by any stretch. The percentage of U.S. GDP that’s represented with trade with Britain is some diminished percentage of trade, two percent, less than that. So, we don’t think that the Brits determining that they are going to exit is a material change for the U.S. economy in the short to intermediate term, or even the long term. What the vote does is send a message, as we were speaking before, to the globalists around the world that there are some hitches in the process.  Globalization, as I believe, is an unstoppable trend. It’s a juggernaut.  We’ve brought a couple billion people into the free markets over the last twenty years, and that has brought prosperity to, as I say, a couple billion people. That’s a wonderfully positive process. It does have some negative effects on the middle classes. You know, the manufacturing workers in the countries where costs are higher and production has been moved to the lower cost countries, those workers are hurting. And so, that’s a fallout from globalization that our leadership needs to deal with, and they will and they should. But in terms of the broader globalization process, I think it will continue. It may slow down a little bit as a result of this, but we don’t think this is a cataclysmic event for worldwide markets.  It may potentially be slightly inflationary as we limit some of the terms of trade in the short run, but I think the benefits of globalization are pretty obvious to most people around the world. And so, we don’t think that this event is going to reverse that by any stretch. It may slow it a little bit, but it’s not going to reverse it.  So, from the perspective of the markets, we don’t believe this is a game changer.

Jim Lange: Are you changing your asset allocation recommendations at all, or even saying okay, maybe this is even an opportunity to have a greater percentage of European exposure?

Charlie Smith: Not yet. Again, we’re watching to see what the commentary from the EU leadership is all about over the next five-six months. If we do get a sense that the EU is going to, for lack of a better term, cut off their nose to spite their face, we would have less inclination to invest in Europe over the very long term. In the short run, that sort of news would probably create some trading opportunities: the opportunity to buy some companies where their stocks get beat up because the assumption is that the trade restrictions are going up.  But it would, on balance, reduce our willingness to invest in Europe for the longer term if it appears as if the Eurozone is determined to punish the British.

Jim Lange: Well, Charlie, I always think of you as one of the great bargain shoppers, if you will.

Charlie Smith: Absolutely!

  1. Fair Value

Jim Lange: And you seem to do very well at, let’s say, picking either distressed, or, perhaps it might be more accurate to say ‘out of favor’ companies, and that brings up the issue of fair value, and could you talk a little bit about what fair value is and what the implications are for voters, both in terms of Brexit and even not Brexit, just in general? Because that’s such an important area.

Charlie Smith: Well, we believe there is an objective, mathematically determinable fair value for a business, and sort of by derivation, therefore there should be a mathematically determinable fair value for an entire marketplace. And so, we try to take what we see as consensus earnings estimates for, say, the S&P 500, which is the best proxy for the U.S. equity market, we believe. Large companies, obviously.  It doesn’t include a whole lot of smaller companies that make up a decent proportion of the U.S. equity market, but for our purposes of this argument, the S&P 500 is a decent proxy for the U.S. stock market.  If we can come up with what we believe is a reasonable estimate for profits for that set of companies, and we know what the interest rate is, long-term interest rate, they’re the discount rate on those profits, we should be able to come up with what we deem to be a reasonable value for those businesses. And so, we do that continuously for the S&P 500, and consensus estimates for the S&P for earnings for calendar 2016 are about $118 to $119 per S&P 500 share in aggregate. So, you have $118 in earnings for the S&P 500 in aggregate for calendar 2016. Given where interest rates are, and inflation rates, the PE multiple, or the multiple of those earnings that you’re willing to pay in the share price, should be somewhere in the seventeen to eighteen range. So, you take that $118 number, multiply by seventeen, it gets you fair value for the S&P of just over 2,000. 2,006.

We actually hit that in the days right after the Brexit vote. The S&P 500 declined from north of 2,100 down to just under 2,000.  So, we think the Brexit vote actually drove U.S. share prices right back to fair value. They were moderately, in a small way, overvalued pre the Brexit vote. But so, we see fair value for the S&P 500, on 2016 earnings, right around 2,000. Now remember, the stock market is a forward-looking mechanism. It’s going to try to discount the future and put the future into today’s prices.  So, the market is just now beginning to look at whatever 2017 earnings might look like, and earnings growth has been basically negative now for the S&P 500 for five quarters successively. So, what we’re doing is saying, “Okay, it looks like the rate of earnings growth for the S&P 500 has flattened out. It’s been negative for five quarters”, but actually, the estimates have actually been improving for 2017. So, we’re making a best guess for 2017 earnings for the S&P 500, somewhere in the 122-123 range.  You know, maybe a two-three percent type increase? Not a boxcar increase by any stretch. And we put the same seventeen multiple on that number. You know, we get a fair value for the S&P not too far north of where we are, maybe 2,100-2,150 today. So, two to three percent earnings growth is not going to get you real nice returns from the average stock.

Historically, earnings have grown at about six percent per year. So, the very conservative earnings estimate we’re using initially for 2017 of two to three percent growth is not going to get you even the average long-term rate of return for the typical U.S. stock, which is about nine percent. We’re looking at something well underneath that. So, we’re not all that aggressively positioned in our portfolios because stocks are right at fair value, and we’re not looking for all that great growth for next year for profits.

Jim Lange: Is there an argument that since some of the price earnings ratios of, let’s say, some of the companies or countries in the Asian rim that have a lower price earnings ratio, is there an argument that that potentially represents a buying opportunity if we’re going to use this fair value as one of the barometers of what to pay for stock? Or do we have some of the uncertainties of third-world accounting and those types of problems that might offset a more favorable price earnings ratio?

Charlie Smith: You nailed it exactly, Jim. When you invest outside the U.S., you’ve got some ingredients in the mix which create additional risk, whether it be accounting standards aren’t necessarily what they are here, you’ve got currency issues, you’ve got greater political risks because the rule of law isn’t necessarily the way it’s defined here in the U.S. So, that’s going to drive down the multiples that you typically see overseas. With regard to the emerging markets, which have had a really tough road the last three or four years, they are now in aggregate selling at valuations which are discounted to the U.S. valuations, and as that discounting mechanism continues to operate and the risks overseas are perceived as greater and greater, that’s when we’re going to get interested in looking more closely at those businesses. So, what I’m saying is, we need to see an even bigger discount given the trends that we’ve seen in the last couple of years with regards to the big declines in commodity prices, because so much of the emerging market profits are driven by commodities. So, there are probably four or five ingredients that would argue for a bigger discount and lower PE ratios in the overseas marketplace, particularly the developing marketplace, than even we see now. So, we’re cautious with regard to the overseas markets, but they’re certainly a lot cheaper than they were three or four years ago, and so they’re coming on the edges of our radar screen, I guess is the best way to put it.

Jim Lange: Okay. You had brought up that you think that globalization is almost an inevitable result, and that you seem to think that that’s what rational leaders are thinking about.

Charlie Smith: Mmm-hmm. Yes.

Jim Lange: And at the risk of getting political, it seems that presumptive nominees of both parties are not necessarily 100% free traders. We’ve heard pronouncements on both sides questioning NAFTA, the Pacific Trade agreements, you know, Donald Trump saying steel is coming back, that isn’t exactly consistent, and so is this a problem with both parties? Is this a problem with us? Do you think that these leaders don’t really mean what they’re saying?

Charlie Smith: I think they mean what they’re saying. As we mentioned earlier, there are side effects, for particularly the middle classes of many of the developed world’s populations that come from globalization, that are negative. There is a significant segment of the British population that said they didn’t even believe that the economic aspects, let alone the immigration aspects, of the EU were any good. There’s a large percentage of unemployed manufacturing workers here in the U.S. who would say that globalization was a negative, was a bad thing for much of the middle and working class. And I think the policy makers, to a certain extent, have failed in that they haven’t addressed those side effects in the proper way, and what has arisen from that failure is the Donald Trump phenomenon, the unwillingness of Hillary Clinton to be as positive about free trade as she had been previously. I think they are simply responding to the voices that are out there that are saying, “Hey, the middle class is, to a certain extent, suffering from some of the aspects of free trade.”

So, we’ve ended up with two candidates who are reflecting the frustrations and the anger that is out there.  That said, there’s still a very large, particularly young, population that, I think, recognizes that shutting yourself off from the rest of the world is not only economically, but socially, a negative. And I think, to a certain extent, some of us have forgotten what happened in the 1930s when we did institute Smoot-Hawley and we did shut down international trade, and the potential problems that come from that, I think there’s still a large segment of the U.S. populace that goes to Wal-Mart every week and recognizes that, hey, the goods that they can get so cheaply are a direct function of the manufacturing of those goods in places where the labor costs are lower, the costs are lower in general, and we benefit in aggregate from that, even though there are some industries like steel that have suffered dramatically from it.

Jim Lange: So, is it fair to say that if you were giving advice to either candidate or either party, or even Congress, that, in general, you would be encouraging free trade, but trying to do a better job of protecting some of the people who are hurt by it?

Charlie Smith: You need to basically say, “Okay, who are the folks that are suffering the most?” And sort of grade it on a scale and say, “Okay, are there industries that have been just completely devastated?  What can we do in terms of creating, say, some sort of safety net for those folks?” But you can’t go out with a blanket statement and say, “Hey, we’re going to protect everybody.” You have to sort of make a judgement, which is what politicians and our leadership anywhere is charged with doing, about who is hurting the most from this process, which, in broader terms, is benefitting billions of people, but make a judgement that those people that are hurting the most. Let’s see what we can do to fix them or help them.

  1. Fiduciary Advisors and New Rules

Jim Lange: Charlie, in this last segment, I’d like to address some new rules that I think are very important, that concern the fiduciary standard. But before we get into what the rules are, can we just step back for a minute, and could you explain to the audience what a fiduciary is?

Charlie Smith: Yes. A fiduciary is someone who has entirely your interests as the client as their top priority. That’s essentially the practical definition of it. In terms of the dictionary definition of it, it’s someone who is responsible and morally responsible for funds. Someone who is in charge of being sure that assets or resources are managed properly. But in terms of the practical definition in the investing world, a fiduciary is someone who is looking out for you, and you alone as the number one priority. And so, the fiduciary rule is one which applies to registered investment advisors. It does not apply to individuals who hold themselves out as brokers. That is, the financial broker who sells investment products might have the interest of the provider of that product ahead of your interest as a customer, and as long as they disclose that to you, they’re not necessarily required to operate under the fiduciary standard. So, that’s where the fiduciary standard comes from.

Jim Lange: All right. So, let me just make sure that our listeners understand this. If you are a registered investment advisor, which certainly you are and I am, both you and I have not only a moral, but a legal obligation to recommend what we believe is in our client’s best interest.

Charlie Smith: Exactly.

Jim Lange: On the other hand, a stock broker, or perhaps an insurance salesman, doesn’t necessarily have that subject to the new rule that we’ll get to. So, let’s say, for discussion’s sake, that I am a stock broker or an insurance guy, and you come to me and you say, “Gee, I’m interested in a safe investment,” and I say to you, “Well, oh, by the way, I have this wonderful annuity.  It’s going to cost you $100,000.”  And I don’t bother disclosing to you that I and my company are going to get a $10,000 commission, and if you think about it, now the investment, so to speak, is actually $90,000, not $100,000. That’s okay because I am not a fiduciary, and I’m not a registered investment advisor. I’m just a stock broker or an insurance person. But a registered investment advisor could not give that advice unless he or she honestly believed that that annuity was for the best good of the client, and that’s probably why, at least to my knowledge, neither one of our firms has ever sold one. I sometimes love when we call that ‘going to the dark side.’

Charlie Smith: Well, sure.

Jim Lange: All right, so, the fiduciary standard is looking out for the best interest of the client.

Charlie Smith: Putting the client first in all phases of your investment advice.

Jim Lange: Okay. Well, that’s what you have been doing and that’s what I have been doing and that’s what many other investment professionals have not been doing. So, what is new?

Charlie Smith: Well, the Labor Department has come out with a new set of rules labeled the ‘Fiduciary Standard,’ specifically for investments that are rolled out of 401(k) plans, or 403(b)s or other long-term investment plans, and this standard basically says that if you are rolling an investment into an IRA (an individual retirement account) from your 403(b) or 401(k), that the advice which is given to people with those accounts must be held to the fiduciary standard. So, this has roiled up all the providers of insurance products and investment products and annuities and index funds. The entire investing universe is trying to deal with this new regulation from the Department of Labor, and interestingly, there are some segments of the brokerage industry which have sued to reverse this law. There was an effort in the halls of Congress to repeal the new regulations, and the Obama administration vetoed the legislation, which was actually passed to repeal this. So, there has been a concerted fight against this legislation.  Actually, it’s not legislation. It’s rule making by the Department of Labor.

Jim Lange: All right. Now, since you and I are fiduciary advisors, at least in our office, this has not had an impact on the way we do business. Has this had any impact on the way you do business?

Charlie Smith: No, we’ve not changed our approach to the world that we operate in one bit. We are still out there searching the waterfront, so to speak, for the best companies, the best businesses at reasonable prices and investment products, whether they be an ETF, an index fund, whatever the product might be, we are vetting it and saying, “Okay, are there other alternatives?” We’re not being paid to offer this. We’re not being compensated in any way to offer this, even though it might have characteristics that don’t benefit the client. We just don’t do that. We’re looking for the best investment out there at the best price to serve our client’s interest.

Jim Lange: Well, I’m thinking about some of the, let’s say, existing insurance guys and people who have sold annuities. I would imagine that, I guess, theoretically, if they actually believed in their product and they actually believed that the annuity was the best thing for the client, despite the fees, etc., then it would be legal or appropriate for them to offer that.

Charlie Smith: Well, and if you can document, and that’s one of the big issues with the new regulation, as long as the broker can document that the product that they’re offering has ABC benefits and maybe costs less than an alternative, you’re going to be able to still operate as a broker. And it’s not just annuities that have issues attached to them. There are all sorts of generally higher fee financial products out there that have come under question as a result of the new DOL rule. So, from our perspective, the entire investment universe should be subject to the fiduciary standard.  It shouldn’t just be IRA accounts or 401(k) accounts. The entire investment spectrum should be subject to this standard.

Jim Lange: Well, that was actually the next issue I wanted to cover. So, the new ruling does not apply to non-IRA, non-401(k), 403(b), SEP, KIO, etc. So, let’s say, for discussion’s sake, that I am 66 years old.  To use a nice round number, I have a million dollars in my 401(k) plan. I have $100,000 in savings.  Now, if I go to a fiduciary advisor, they are already going to be looking out for my best interest with or without the new law.

Charlie Smith: Correct.

Jim Lange: But let’s say, for discussion’s sake, I go to a stock broker or an insurance guy that is not under a fiduciary duty. Is the law then that he must use the fiduciary duty on my million dollar 401(k), but he does not have a fiduciary duty with regards to my $100,000 outside the 401(k)?

Charlie Smith: That’s correct. That’s exactly right.

Jim Lange: Okay.

Charlie Smith: The fiduciary standard does not cover the waterfront in terms of investment accounts.

Jim Lange: All right, which is what you would obviously like it to do.

Charlie Smith: It would simplify things for the entire universe of investors, yes.

Jim Lange: Do you think that this will actually have an impact on the ability for stock brokers or other non-fiduciary advisors to survive?

Charlie Smith: Yes, absolutely. It already has, and the best indicator is the share prices of some of the brokerage firms and some of the insurance providers. They’ve seen their share prices, in the last six months as this regulation began to make its way to finality, the share prices of some of these providers of these brokerage oriented products have suffered mightily.

Jim Lange: Yeah. I can’t help but think having a fiduciary standard for some of our political leaders might be a groundbreaking wonderful thing for our country and the world.

Charlie Smith: Probably wishful thinking too, but…

Jim Lange: Probably extremely wishful thinking on either side of the aisle. Well, that brings us to perhaps one of the most important things. Most of my clients, and I think most of our mutual clients, tend to be IRA or 401(k) plan heavy.

Charlie Smith: Yes.

  1. Advice for Investors in the Accumulation Stage

Jim Lange: That is, we have a lot of clients who might have started their careers at a relatively young age, back in the day when you would go to work for a company and stay there for thirty or forty years, or with the university, and they had car payments and mortgage payments and they paid for their kid’s braces and they paid for their kid’s college, and it was always hard for them to save money, but they were prudent and they put money in their 401(k), or, if they were at a university, a 401(a) or a 403(b), and they kept doing that for thirty or forty years, and now they have a lot of money in their retirement plans, which is probably a relatively good formula for accumulating wealth and being able to retire with dignity in a manner in which you like. Can you give some advice to some of our 401(k) and 403(b) investors, who are maybe not necessarily towards the end of their career, but are still in the accumulation stages?  Even at the later portions of the accumulation stages. What advice would you have for our listeners who are, in effect, still working and contributing to their retirement plan?

Charlie Smith: So many of the investment providers out there want to make this complicated, and as with much in investing, it can be simplified. You can simplify things too much sometimes, but in terms of the 401(k), there are probably three things, particularly as a young person, that you need to do to be successful, and if you do these things, you will be successful in investing. There is no doubt. There’s not a question on this. Number one is max out your contributions, particularly if you have any sort of a matching feature to your plan. It’s one of the last remaining true tax deductions out there. So, you want to make sure you put away the maximum, and if you’re getting a match, that’s a hundred percent return if it’s a dollar for dollar match, and you can’t beat that anywhere else in the investment world. So, make sure you max out. Number two is invest in ownership. Invest in equities. Over time, the way our society is structured, you’ve heard this a million times, Jim, and I’m going to tell you one more time, the way our society is structured, the people that take the risk of owning a business, and, in this case, a portfolio of businesses, are the ones who generate the greatest return for themselves. The returns from owning a portfolio of stocks, of equities, don’t happen in a nice, neat, straight line the way they do with a bond or a CD. But literally, the way our society’s built, the people that take the risk of going into business earn a greater return. So, you want to own stocks.  Number three, don’t ever touch it.  Don’t do anything with it. Don’t borrow against it. Don’t take money out and suffer a penalty. Don’t ever touch it. Put it into stocks, keep adding to your stocks, and then ignore it. Don’t touch it. Look at it maybe once a year-and-a-half, every two years maybe. Those three ingredients, if you can stick to that plan, will make you a successful long-term investor.

Jim Lange: And this would be regardless of your risk tolerance, particularly for a younger investor?

Charlie Smith: Well, this is particularly applicable to younger people because they’ve got the time horizon, and they’ve got the power of compounding in their favor. So that if there is a 30% decline in the value of the portfolio, your withdrawal period is 25-30-35 years out. When you look back thirty years from now, that 30% decline is going to be a blip. You’re not even going to see it.

Jim Lange: Okay, young earners. You have heard it. Max out your retirement plan, always take advantage of the max. We didn’t talk about Roth portions, but you might consider a Roth portion in your 401(k). Invest in ownership. That is, owning companies, not borrowing or lending money to companies, and don’t look at your statements very often.

Dan Weinberg: All right, thanks so much to Jim and Fort Pitt Capital’s Charlie Smith for a terrific hour. All of The Lange Money Hour episodes are archived soon after they air on the Lange Financial Group’s website, www.paytaxeslater.com under ‘Radio Show.’