by Wayne Firebaugh on July 8, 2010
Richard Dawkins, famed Oxford zoologist and atheist, has often said it is impossible to legislate morality. However, more than two years after the beginning of a market meltdown, a Congressional conference committee unveiled a 2,000-page bill trying to do just that.
This pending legislation represents the most significant changes to financial regulations since the Securities Act of 1933 and related Securities Exchange Act of 1934. Financial institutions will see new limits on their investing and lending activities and pay new fees to cover the cost of enforcement.
Unfortunately, Mr. Dawkins may be right because the legislation doesn’t resolve a fundamental question about how to protect individual investors. For several years, commission brokers and fee advisors have debated alternative standards of client care. Brokerage houses have argued for their continued adherence to the “suitability” standard. Suitability means a product is appropriate for a client’s investment needs and timeline.
Fee advisors have argued the suitability standard is too lax and that all recommendations should meet a “fiduciary” standard. Fiduciary means advisors must always act in the client’s best interest. If this seems a tad confusing, think of it as good and better – just like the popcorn sign at the movies. Suitability is good. However, fiduciary is better because many investment products could be suitable but maybe only one is in your best interest. Phrased differently, the suitability standard allows the broker’s interests to sneak into the equation.
It seems so basic that a bill to protect investors would require all investment professionals to act in their clients’ best interests – always. However, the pending financial legislation doesn’t. Instead, the bill directs the SEC to do a six-month study of the differences between the suitability and fiduciary standards. Then, the SEC can decide whether brokers have to be fiduciaries.
We can hope that the SEC will select the fiduciary standard for all investors. However, one word should give pause to that hope – politics. For years, Bernie Madoff managed to game regulators to prevent detection. How much more vigorously might brokerage houses besiege the SEC and Congress to prevent the fiduciary standard’s passage when hundreds rather than merely tens of billions of dollars are at stake?
You might wonder how this discussion of fiduciary versus suitability standards found its way onto a blog about paying for college. Are you getting answers about one of life’s biggest purchases, your kid’s college, from someone who provides suitable products or fiduciary advice?
by Wayne Firebaugh on June 25, 2010
Managing taxes is an important part of saving for college. S corporations can help manage a business owner’s tax burden because corporate income “passes through” to shareholders.
This means that S corporations don’t pay income taxes. Rather, shareholders pay the taxes on corporate earnings but not on any cash that is distributed. In addition, shareholders pay Social Security and Medicare taxes (the combined rate could be as much as 15.3%) on their salaries but not their share of these corporate earnings. So, S corporation owners have a built-in incentive to take their compensation as profits instead of wages.
According to the IRS, the average S corporation delivers approximately 41.5% of its economic benefit to shareholders as salary and the remaining 58.5% as profit distributions.
Even former Senator John Edwards organized his law practice as an S corporation. In just four years, Mr. Edwards avoided over $560,000 in Medicare tax. The magnitude of potential savings makes S corporations prime candidates for the abuse described in the General Accounting Office’s recently released report Action Needed to Address Noncompliance with S Corporation Tax Rules.
• 68% of S corporations filed in returns for 2003 and 2004 misreported at least one item. In 80% of those cases, the errors favored the taxpayer.
• 13% of S corporations paid inadequate wages to shareholders. The smallest corporations, those with one to three shareholders, were the worst offenders.
This favorable tax treatment is now in jeopardy. H.R. 4213, or the American Jobs and Closing Tax Loopholes Act of 2010, would subject the earnings of “an S corporation which is engaged in a professional services business if the principal asset of such business is the reputation and skill of three or fewer employees” to Social Security and Medicare taxes.
The bill goes on to include the following fields as professional service businesses: health, law, lobbying, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, investment advice or management, and brokerage services.
H.R. 4213 has passed the House but not the Senate. Unfortunately for S corporation shareholders, the Senate’s filibuster doesn’t seem that concerned with stripping this provision from the bill. As such, small business owners may soon need to consider ways to blunt its impact on their tax liabilities and college funding plans.
by Wayne Firebaugh on June 21, 2010
The Higher Education Act of 1965 requires proprietary and vocational (read “for-profit”) colleges, other than clearly designated “liberal arts” or non-degreed vocational programs, provide “an eligible program of training to prepare students for gainful employment in a recognized occupation.” Compliance is a condition for those colleges’ students to be eligible for federal financial aid including guaranteed student loans.
Unfortunately, the Higher-Education Act did not define “gainful employment”. So, now the Education Department is poised to issue a proposed rule that does. The DOE’s most-recent draft of the “gainful employment” rule bars federal aid for programs where a majority of the graduates’ loan payments under a 10-year repayment plan exceed 8 percent of their expected earnings.
Two weeks ago at the Career College Association (CCA) convention of for-profit colleges, this proposed rule dominated discussion. Critics of for-profit colleges argue that such institutions are about to receive comeuppance for aggressive recruiting practices and high tuition rates. I’m all for managing post-graduation debt. I also favor making sure students get the education they were promised. However, this proposed gainful employment rule doesn’t accomplish either goal. In fact, it raises some troubling questions:
• Why does the rule only apply to for-profit schools? Are graduates of traditional colleges immune to the burdens of student debt?
• What roles do students themselves play in their post-graduate debt burden? Why should the decisions of students who borrow more money to extend their college career penalize students who graduate on-time? Should the financial condition of students who rely on loans affect those students who have saved?
• Shouldn’t critics examine the “total cost to degree” rather than the absolute annual tuition rate when comparing for-profit colleges to other education options?
• Do for-profit colleges provide opportunities for educational innovations that the structures of not-for-profit institutions cannot easily foster?
The CCA estimates that 18% of programs at for-profit colleges will fail the test. Even worse, 33% of students at for-profit colleges attend one of these potentially failing programs. Fortunately, last week the DOE postponed implementation of the rule to allow additional study. Hopefully, the DOE’s final rule will consider not only these issues but also the most critical question about unintended consequences. Will implementation of this rule eliminate college as an option for less affluent or nontraditional students?
by Wayne Firebaugh on April 12, 2010
Thank you for your editorial “An affordable option for tomorrow’s tuition” (March 28), highlighting the need to begin saving early for college. As Southwestern Virginia’s first certified college planning specialist, I believe that prepaid plans are indeed valuable tools for many families who struggle to fund their kids’ college. However, the very guarantees that make these plans so attractive also represent an often ignored area of risk.
Virginia’s prepaid plan confronts the same challenges — tuition increases and investment performance — that parents face when saving for college on their own. Together, these two factors caused Virginia’s prepaid plan to report a June 30 deficit of $284 million. When pricing new contracts, the plan’s actuaries projected 7.5 percent annual tuition inflation compared to an average of 11.2 percent over the past five years. New contract prices also assume a 7 percent annual investment return instead of the double-digit losses of the previous two years.
Deficits present the possibility that Virginia’s prepaid plan cannot cover its obligations. Most families do not realize that the plan is not a direct obligation of Virginia. As such, families should not view prepaid plans as a risk-free way to combat rising tuition.
As published in The Roanoke Times, April 12, 2010.
