IBF - Updates - 2011 (Q3 v1.0)

QUARTERLY UPDATES Q3 2011

Copyright Š 2011 by Institute of Business & Finance. All rights reserved.

v1.0

Quarterly Updates Table of Contents MUTUAL FUNDS FEES TIED TO PERFORMANCE MANAGED PAYOUT FUNDS GO ANYWHERE FUNDS FEE IMPACT RATE INCREASE EFFECTS ON BOND FUNDS INDEXING UPDATE INFLATED YIELDS FLOATING RATE FUNDS NEW RULES FOR MONEY MARKET FUNDS CLOSED END FUNDS ABSOLUTE RETURN FUNDS

1.1 1.1 1.1 1.2 1.2 1.2 1.2 1.3 1.3 1.4 1.4

STOCKS GAMING QUARTERLY EARNINGS ESTIMATES DEFINING EMERGING MARKETS SMALL CAP DIVIDEND STOCKS LARGE, MID AND SMALL CAPS

2.1 2.1 2.1 2.5

BONDS MUNICIPALITY UPDATE

3.1

REAL ESTATE BOTTOM OF THE REAL ESTATE MARKET CALIFORNIA HOUSING VALUE OF U.S. REAL ESTATE

4.1 4.1 4.2

ANNUITIES LONGEVITY INSURANCE FIXED RATE VS. VARIABLE ANNUITIES

5.1 5.1

COMMODITIES HISTORICAL UPDATE FOR GOLD AND COTTON SILVER PRICES UNEQUAL COMMODITY INDEXES

6.1 6.1 6.1

HEDGE FUNDS HEDGE FUND QUESTIONS

7.1

FINANCIAL PLANNING INDIRECT ELDERLY CARE COSTS INCREASE $1 MILLION IN BENEFITS PROPHETS OF ERROR 401(K) LOANS U.S. HOUSEHOLD NET WORTH DEVELOPED VS. DEVELOPING COUNTRIES U.S. EXPORTS AND IMPORTS 401(K) REALTIES

8.1 8.1 8.2 8.2 8.2 8.3 8.5 8.5

INCOME TAXES WHAT 2011-2014 DEDUCTION COST TAX REPORTING COMMODITY FUND TAX REPORTING

9.1 9.1 9.2

ESTATE PLANNING ESTATE PLANNING COMPUTER ACCESS PROVIDING FOR PETS POWERS OF ATTORNEY DOCUMENTS TO LEAVE AT DEATH SPECIAL NEEDS TRUST

10.1 10.2 10.3 10.4 10.5

QUARTERLY UPDATES MUTUAL FUNDS

Mutual Funds

1.FEES

1.1

TIED TO PERFORMANCE

In theory, incentive fees to active fund managers should result in better fund returns; some studies reflect this belief while other studies indicate that such incentives mean management takes additional risk. The backward-looking nature of performance fees is one reason many investors object to them. As of the middle of 2011, less than 5% of all open- and closed-end funds had incentive fees (e.g., Fidelity began such incentives in the 1970s and now has about half of its equity fund asset management fees tied to incentives.

A 2008 Lipper report found that for the 10-year period 1998-2008, incentive-fee funds outperformed their category average by a 0.74 percentage point per year. When looking at returns adjusted for risk, incentive-fee funds beat their peers over a 3- and 5-year period, by not for the 10-year period. It could be argued that virtually all funds have tied their fees to performance since a top-performer attracts more money, which means more money under management and more dollars in fees collected.

MANAGED PAYOUT FUNDS A chief objective of managed-payout funds is to provide a steady income stream without incurring the costs of variable annuities with living benefits. Some managed-payout funds tie their distributions to market interest rates; others determine payouts based on historical returns. A large number of these funds make distributions from income and principal. Managed-payout funds generally invest in a sampling of the sponsoring firm’s mutual funds. Some advisors view a managed-payout fund as just one of several building blocks (i.e., annuities, pensions, Social Security, etc.) that comprise a client’s retirement income.

GO ANYWHERE FUNDS A concern of “go-anywhere” funds is that investors have no idea how the portfolio will change if the market suddenly changes, which means advisors do not know if such a fund will complement other investments in the client’s portfolio. Some of these flexible funds stick mostly with stocks, others shift between stocks, bonds and cash, while still others invest in assets ranging from private transactions and commodities to real estate, emerging markets and derivatives. By July 2011, there were over 250 go-anywhere funds, which are often compared to world allocation and moderate allocation funds.

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Mutual Funds

1.2

FEE IMPACT The table below shows a $10,000 investment returning 3%, 6% or 9% and having an annual expense ratio ranging from 0.1% to 1.5%. The purpose of the table is to show the impact different expense ratios have on total return over five years.

Cumulative 5-Year Gain on $10,0000 Annual Expense Ratio

3% Annual Return

6% Annual Return

9% Annual Return

0.1%

$1,537

$3,319

$5,316

0.5%

$1,314

$3,070

$5,037

1.0%

$1,041

$2,763

$4,693

1.5%

$773

$2,462

$4,356

RATE INCREASE EFFECTS ON BOND FUNDS As of the middle of 2011, a one percent increase in interest rates would result in a return of -1.9% for short-term, -4.7% for intermediate- and -9.4% for long-term bond funds.

INDEXING UPDATE As of the middle of 2011, U.S. stock index funds and ETFs hold 44 cents for every $1 in active funds. Vanguard passed American Funds as the largest mutual fund complex in late 2008. The average asset-weighted expense ratio for U.S. stock index funds and ETFs is 0.19%, versus 0.92% for actively managed funds (source: Morningstar).

INFLATED YIELDS During March 2011, the 173 TIPS mutual funds tracked by Morningstar reported SEC yields ranging from -0.77% to +5.58%, with at least a dozen funds yielding at least 5%. Four of the seven ETFs that specialized in TIPS had yields higher than 5%, with PIMCO 15-Year U.S. TIPS Index offering 6.1%. Surprisingly, at the time, no TIPS were yielding more than 1.75%.

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Mutual Funds

1.3

In 1988, the SEC forced mutual funds to include only dividends and interest income in the yield they must show investors. The return from TIPS comes from interest income plus inflation adjustments in principal. The SEC has not yet issued any guidelines for TIPS reporting. Given the way many TIPS funds interpret the SEC yield formula, the change in inflation over the latest reported period gets added to interest income to produce an annualized figure. Thus, when inflation averages ½% for a month, the SEC annualized yields can work out to close to 6%. Advisors should focus on the real yield instead of the SEC figure for this category.

FLOATING RATE FUNDS Income generated by bank loan (floating-rate) funds has long been based on Libor (London Interbank Offered Rate), a standard measure of what banks charge on another to borrow. Over 40% of these funds have “Libor floors,” a minimum level at which income payments start to go up if rates increase. While this feature ensures a minimum yield, it also acts as an anchor. For example, ABC gets a bank loan in which it pays 4.75% plus a Libor floor of 1.25% (at a time when Libor was 0.25%). This means the lender is getting 6% a year from ABC. Since it is a floating-rate loan, the loan coupon can adjust every 90 days. The borrower will not enjoy a higher yield until Libor rates increase more than a full percentage point (above the 1.25% floor).

Your client’s need to understand that besides credit risk, the floating rate the loans are providing may not increase until interest rates have gone up enough to offset what the Libor floor might be.

NEW RULES FOR MONEY MARKET FUNDS As of February 2011, the SEC releases monthly snapshots of money market funds’ “shadow” prices that reflect the actual market value of fund holdings as opposed to the $1 NAV at which investors buy and sell shares. Shadow prices have been murky until 2011 because the SEC required such disclosure only twice a year; the SEC data was provided in a format inaccessible to small investors.

Your clients can find shadow pricing data by going to www.sec.gov. There is a 2-month delay in the disclosure (e.g., data released January 31st will reflect shadow prices from November 30th). The 2011 rules were designed to reduce risks in the wake of Reserve Primary Fund which “broke the buck” in September 2008 by dropping to 97 cents due to its holdings of Lehman Brothers debt and a wave of shareholder redemptions.

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Mutual Funds

1.4

Shadow prices are carried out to four decimal places; investors should not panic if any deviation stays within the range of $0.995 to $1.005 (since they would still be able to buy and sell shares for exactly $1). Events such as interest rate changes, a ratings downgrade or investors dumping fund shares can cause shadow prices to move. For example, a 1day rate increase of one percentage point (extremely rare) would cause a $1 shadow price to fall to $0.9983. An October 2010 report shows shadow prices ranging from $0.9982 to $1.001 for money market funds rated by S&P.

CLOSED END FUNDS As of early 2011, there were 650 U.S. closed-end funds (CEFs) with a cumulative valuation of $200 billion; more than 400 specialize in bonds. The average selling price has gone from a 4% discount to just 1.6%. During the 2008 crash, the average CEF fell to 74 cents on the dollar (source: Herzfeld). Advisors can find data on discounts by going to websites such as cefconnect.com and cefa.com.

ABSOLUTE RETURN FUNDS Absolute-return strategies seek a positive return in all market conditions by using cash equivalents, low volatility investments and then taking long and short stock positions (going long the positions expected to go up and shorting equities that are expected to drop). The problem with some of these offerings is that investors are likely to select funds that have the highest return since such returns are “absolute.�

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QUARTERLY UPDATES STOCKS

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Stocks

2.GAMING

2.1

QUARTERLY EARNINGS ESTIMATES

The percentage of companies that have beaten expectations is often cited as a barometer of corporate profitability (positive earnings surprise). However, the high frequency of such positive surprises is so common that such expected profitability may not be much of a predictor. In short, there is no reliable evidence that the stock market as a whole will earn higher returns after periods with more positive surprises. For example, even during the depths of the financial crisis, from the third quarter of 2008 through the first quarter of 2009, 59-66% of companies beat expectations (source: Wharton Research Data Services).

The process of earnings forecasting has changed over the past several years. Today, what used to be called “low-balling” is now called “guidance.” The analyst guesstimates what a company will earn over the next year or calendar quarter. The company then “walks down” the analyst’s forecast by providing a series of progressively lower targets until the analyst’s newest prediction falls slightly below where the actual number is likely to come in.

DEFINING EMERGING MARKETS According to an October 2010 report from the IMF, the average annual income for the U.S. was $47,100, $10,470 for Brazil, $4,280 for China and $1,180 for India. MSCI uses four criteria to determine if a country’s economy is emerging: [1] Household incomes tend to be much lower than those in the developed world.

[2] Country is transitioning from an economy based on agriculture to manufacturing.

[3] Country is taking on legal, regulatory and political steps for modernization.

[4] Financial markets for stocks and bonds are not yet sophisticated.

SMALL CAP DIVIDEND STOCKS Understanding a company's capital allocation decisions is a critical element in the investment process. This is especially important in a market when corporate balance sheets are generally in excellent condition and, in many cases, flush with cash. Dividends are by nature the byproduct of healthy free cash flow generation.

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Stocks

2.2

Based on a 2011 study by Royce Funds, of the approximately 4,150 domestic small cap companies (those with market capitalizations up to $2.5 billion), 1,181 were dividend payers as of the end of the second quarter of 2011; of these dividend-paying companies, 757 had a dividend yield of at least 2%.

In order to better understand the return characteristics of small cap companies, Royce Funds sorted the small cap Russell 2000 Index into those that pay dividends and those that do not. The Russell 2000 constituent companies were rebalanced in accordance with Russell's rebalancing practices, which consist of an annual reconstitution in June and the quarterly addition of any new index entrants via IPOs. In addition, Royce re-sorted the universe each month into dividend- and non-dividend payers. Performance data was then calculated using month-ending prices. Royce went back as far as there was reliable data—to 1993—and were able to assess 18 calendar years of performance, which encompassed three full market cycles, along with the peakto-current period as well.

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Stocks

2.3

Russell 2000 Average Annual Returns Year

Dividend Stocks

Non-Dividend

Russell 2000

2010

25.0%

28.9%

26.9%

2009

13.0

41.3

27.2

2008

-24.5

-41.3

-33.8

2007

-8.0

2.8

-1.6

2006

20.1

17.1

18.4

2005

3.8

5.8

4.6

2004

23.0

16.3

18.3

2003

36.6

56.6

47.3

2002

-0.2

-33.3

-20.5

2001

13.2

-5.9

2.5

2000

23.6

-24.6

-3.0

1999

-5.9

48.3

21.3

1998

-2.8

1.7

-2.5

1997

32.3

13.5

22.4

1996

22.2

11.1

16.5

1995

24.0

32.5

28.5

1993

18.8

17.8

18.9

1993-2010*

10.6%

7.0%

8.7%

*annualized (average annual total returns)

Perhaps most compelling was the outperformance of dividend-paying companies within the Russell 2000 relative to their non-dividend paying counterparts for the entire period measured, 1993-2010. The average annual total return for the 18-year period was 10.6% for small cap dividend payers versus 7.0% for those that do not (and 8.7% for the Russell 2000). Contributing to this attractive total return was outperformance in most, although not all, down market calendar-year periods.

When measured over multiple periods, namely rolling 3- and 5-year return periods, dividend-paying small companies performed reliably well. In fact, dividend payers outperformed in 61% of all monthly rolling 3-year periods (186 total periods) and 65% of all monthly rolling 5-year periods (162 total periods). In both 3- and 5-year return periods, the average return for dividend payers was significantly higher.

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Stocks

2.4

Russell 2000: Annualized Monthly Rolling 3-Year Periods [1993-2010] Average of all periods

Dividend

Non-Dividend

Russell 2000

10.1%

5.9%

7.7%

Russell 2000: Annualized Monthly Rolling 5-Year Periods [1993-2010] Average of all periods

Dividend

Non-Dividend

Russell 2000

10.6%

5.6%

7.8%

As might be expected, dividend-paying companies outperformed non-dividend paying companies and the Russell 2000 over all four peak-to-trough periods (see below).

Conversely, and not unexpectedly, they trailed in three of the four trough-to-peak periods. Dividend-paying companies outperformed in two of the three full market cycle periods and trail in the peak-to-current period.

Russell 2000: Peak-to-Trough Cumulative Returns Peak

Trough

Dividend

Non-Dividend

Russell 2000

6/30/2007

2/28/2009

-50%

-55%

-52%

2/29/2000

9/30/2002

43

-64

-35

4/30/1998

9/30/1998

-17

-29

-24

5/31/1996

7/31/1996

-5

-19

-13

-7.4%

-41.7%

-31.0%

Average

Russell 2000: Trough-to-Peak Cumulative Returns Peak

Trough

Dividend

Non-Dividend

Russell 2000

6/30/2007

4/30/2011

106%

154%

129%

2/29/2000

6/30/2007

121

169

144

4/30/1998

2/29/2000

-3

124

62

5/31/1996

4/30/1998

68

47

57

73.0%

123.4%

97.7%

Average

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Stocks

2.5

Russell 2000: Peak-to-Peak Cumulative Returns Peak

Trough

Dividend

Non-Dividend

Russell 2000

6/30/2007

4/30/2011

3%

14%

9%

2/29/2000

6/30/2007

215

-4

58

4/30/1998

2/29/2000

-19

61

22

5/31/1996

4/30/1998

59

19

37

64.6%

22.3%

31.8%

Average

Despite an abundance of small cap companies that pay dividends, very few fund managers focus on dividends within the small cap universe. Most focus on capital appreciation instead of total return, while in the large cap universe, total return or equity income approaches are far more common. This fact is further borne out by Morningstar data. Of the 548 small cap objective funds identified by Morningstar as of June 30, 2011, only four funds have dividend, income or total return in their respective names (two of which are Royce Funds). Yet dividends in the small cap universe perform the same role that they do in the large cap area—they tend to reduce a stock price's downside volatility.

LARGE, MID AND SMALL CAPS Historically, small and mid cap stock returns have peaked in the year following a market bottom and then become lower in the following few years. Since 1926, small caps have averaged 41% in the first year of a bull market, followed by gains of 12% in year two and 9% in year three. Likewise, mid caps slow from 37% to 10% to 6% (source: Bank of America).

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QUARTERLY UPDATES BONDS

BONDS

3.1

3.MUNICIPALITY

UPDATE

In 2010 and 2011, the SEC stepped up its review of certain municipal bonds, with a focus on “tobacco bonds” and “dirt bonds.” Tobacco bonds were sold by states and backed by payments from tobacco companies that flow from their legal settlements in the late 1990s. Dirt bonds were issued to help finance infrastructure for in some states.

Historically, high-quality municipal bonds had yields equating to ~82% of similarmaturing Treasurys. Yields paid by municipalities now often exceed Treasurys.

For the 2010 calendar year, the default rate for municipal bonds was less than 0.2% (source: Bank of America). Even during the Great Depression, California never defaulted on any of its bonds. Some critics view California’s finances as “terrible” while also noting “but the California Department of Water and Power is doing just fine.”

Debt Loads The table below shows the 10 states with the highest and lowest combined pension and long-term debt liabilities. On average, debt service represents less than 10% of a state’s budget.

State Debt Loads: Pension and Long-Term Debt Liabilities As share of state GDP

As share of per capita income

Hawaii (16%)

Connecticut ($9,400)

Mississippi (16%)

Hawaii ($8,000)

Connecticut (15%)

Massachusetts ($7,900)

W. Virginia (15%)

New Jersey ($7,200)

Massachusetts (14%)

Illinois ($$6,700)

Kentucky (14%)

Alaska ($$6,400)

Rhode Island (14%)

Rhode Island ($6,300)

Illinois (14%)

Kentucky ($5,100)

New Jersey (13%)

Mississippi ($5,000)

New Mexico (13%)

W. Virginia ($4,900)

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BONDS

3.2

Funds and Inverse Floaters As of early 2011, the Eaton Vance National Income Fund was offering just under 6%.

The fund owns mostly long-term bonds, but also holds inverse floaters, which magnify up and down moves. Some funds that get good marks include: Fidelity Intermediate Municipal Income, Vanguard Intermediate Tax-Exempt, PIMCO Tax Managed Real Return, JPMorgan Tax Aware Real Return and Ivy Municipal High Income.

Late Disclosure DPC Data studied 17,000 bond issues and found more than 56% filed no financial statements in any given year between 2005 and 2009. More than a third of these borrowers missed three or more years; the number grew to 40% in 2009. Compared to earlier DPC Data studies, this 2010 study shows municipalities are getting worse, not better with the timeliness of their filings. For example, the utilities district of Clay County, Tennessee did not file a disclosure for 10 years.

The annual audited statement often contains detailed information (e.g., pension and health care liabilities) not included in other documents. Many cities, states, hospitals and other public borrowers do not make general financial records accessible. And, when they do, a number of these reports are either confusing or spotty. This information must be filed with the Municipal Securities Rulemaking Board, a self-regulatory organization that posts the documents on a website called EMMA. In contrast, public disclosure for corporate securities are consistent and released much earlier.

1841 An 1841 depression pushed eight states and a territory called Florida into default. From 1841 to 1842, yields on these bonds went from ~8% to just under 40%. Property taxes in Indiana and Ohio went up eightfold in the early 1840s. In 1843, the U.S. Congress rejected a bailout plans for the states. To this day, Mississippi has not paid back some of these bonds.

High-Yield Municipals Valuation questions about illiquid securities, many classified as “junk,” have been a longterm concern among many regulators. Rated junk municipal bonds total ~$54 billion, a small slice of the $2.9 trillion municipal debt market. One well-known municipal bond fund’s NAV dropped 44% from September 2006 to November 2008, while the average for similar funds during the same period was less than 12% (note: the wellknown fund’s name does not indicate it is high yield or risky).

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BONDS

3.3

High Yield Corporate vs. Municipal High Yield Index [2011] Barclays Bond Index

Value

Issues

Average Size

U.S. High Yield (corporate)

$970 billion

1,873

$518 million

Municipal High Yield

$54 billion

3,174

$17 million

The Reality It is estimated that individual investors hold two-thirds of all municipal bonds. Despite the 2010 and early 2011 municipal bond selloffs, The Wall Street Journal points out, “The fact that states have the ability to raise taxes…few analysts expect even one state to default on its debts.”

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QUARTERLY UPDATES REAL ESTATE

Real Estate

4.BOTTOM

4.1

OF THE

REAL ESTATE MARKET

Three often-overlooked indicators as to whether or not a real estate market has started to rebound: local unemployment rates, rents and foreclosures. It used to be that the three biggest determinants of a property’s value was location, location and location; in a slow economy it could be jobs, jobs and jobs. In the case of rental rates, the general rule is that if real estate prices are more than 15 times annual rents, the market favors renters—under 15 and the market favors buyers. Finally, healthy communities have fewer foreclosed properties. Key Indicators in housing include (source: Center for Housing Studies at Harvard):  Housing as a share of GDP 17% in 2010 and 21% in 2005  Home ownership rates 67% in 2010, 69% in 2004 and 67% in 2000  Monthly payments (median-priced home with 10% down and 30-year mortgage) $900 in 2010 and $1,360 in 2007  Percentage of household income spent on median-priced home payment 18% in 2010 and 32% in 2005  Sale price, new single-family home (2010 dollars) $222,000 in 2010 and $240,000 in 1980

CALIFORNIA HOUSING Between 1980 and 2010, the value of a median-price, single-family home in California rose by an average of 3.6% per year, from $99,550 to $296,820 (source: California Association of Realtors, Freddie Mac and the U.S. Census). Even if that median-priced house sold at the most recent market peak in 2007, the average annual price growth was 6.6%.

Growth of $1 from 1980 to 2007 or 2010 1980-2007

1980-2010

California home

$5.63

$2.98

DJIA

$14.41

11.49

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Real Estate

4.2

There is another way to look at homeownership in California. If one of your clients was thinking about buying the median-priced home in California decided instead to invest the 20% down payment of $19,910 plus the normal homeownership expenses (above the cost of renting) over the years in the Dow Jones Industrial Average (DJIA), the value of the stock portfolio would have been worth $1.8 million by the end of 2010. This means the stocks would have been worth $1,503,000 more than the home. If the analysis is based on 2007, the stock portfolio would have been worth $2,186,120, exceeding the house value by $1,625,850.

VALUE OF U.S. REAL ESTATE The total value of U.S. real estate was ~$18.3 trillion by the end of 2010, down ~26% from its 2006 peak and the lowest since 2003.

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QUARTERLY UPDATES ANNUITIES

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Annuities

5.LONGEVITY

5.1

INSURANCE

By giving a lump sum to an insurance company, your client can guarantee a future income by purchasing a fixed-rate annuity today—also known as longevity insurance.

For example, during middle of 2011, a 54-year old male could invest $10,000 in a fixedrate annuity, pay $3,100 a year for the next 29 years and then begin taking money out two years later (age 85); the amount of annual income for the 85-year old was guaranteed to be $52,300 a year. Making annual contributions of more than $3,100 a year would increase the annual amount.

FIXED RATE VS. VARIABLE ANNUITIES For someone age 65, some variable annuities with a living benefit will guarantee a 5% annual withdrawal; an immediate fixed-rate annuity will provide lifetime income of 7.8% for females (8.4% for males). At age 75, the same variable annuity guarantees 6% annual income for new investors; an immediate annuity guarantees 10% annual income for females (11.1% for males) at age 75.

The major difference between the immediate annuity and variable annuity is that there is usually a zero balance when the immediate annuity owner dies; remaining value of the variable annuity owner is unknown since the investment is subject to the markets ups and downs. The 2011 IBF study below compares a living benefit variable annuity with an immediate annuity with the following assumptions: [1] investor is age 65, male, invests $100,000 and needs income [2] living benefit is used immediately—5% annual withdrawal starts first year [3] the $5,000 living benefit is sent out the first day of each year [4] 100% of the variable annuity is invested in a small cap blend subaccount [5] subaccount performance before fees is same as mutual fund category [6] annual variable annuity total expenses are 3.7% (subaccount, benefit, M&E) [7] performance figures are for 11 years (2000 through 2010) [8] the fixed-rate annuity is immediately annuitized ($8,400 a year for life)

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Annuities

5.2

Living Benefit Variable Annuity [100% invested in small cap blend] 2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

total

$5k

$5k

$5k

$5k

$5k

$5k

$5k

$5k

$5k

$5k

$5k

$55k

VA market value

$105k

$106k

$83k

$109k

$122k

$122k

$133k

$124k

$74k

$90k

$104k

$104k

Immediate annuity

$8.4k

$8.4k

$8.4k

$8.4k

$8.4k

$8.4k

$8.4k

$8.4k

$8.4k

$8.4k

$8.4k

$92.4k

VA withdrawal

Despite taking out $5,000 each year, the variable annuity has an ending market (liquidation) value of $104,000. Over this 11-year period, the immediate annuity paid $37,400 more than the variable annuity with a 5% living benefit distribution. As a side note, over this same period (2000-2010), $100,000 in small cap blend mutual funds grew to $234,350 after 11 years.

Two things that help the variable annuity investor: [1] an 11-year period is shown ($104k vs. $90k if the illustration was for the 2000-2009 period) and [2] the investor is not forced to use an asset allocation model—which is required by almost all carriers that use a living benefit (e.g., over the same 11 years, $100,000 invested in a balanced mutual fund grew to $156,000 vs. $234,350 for small cap mutual funds). What hurts the variable annuity is the 11-year period used represents a below-average performance period for small cap stocks (8% annualized if no withdrawals).

Anniversary Market Adjustment The next table is exactly the same as the table above, but with one difference: the living benefit variable annuity contains an annual step-up provision. Whenever contract anniversary market value is greater than the previous highest anniversary contract value, the living benefit ratchets upward—e.g., instead of getting 5% on $100,000 (or $5,000 a year), the investor now gets 5% on $105,000 or an even higher value.

This “ratcheting” effect locks in a new minimum annual benefit that can never decrease while the investor is alive. The variable annuity investor gets more money each year, as shown below, with no meaningful effect on the market value (such figures have been rounded to the nearest $1,000 in the table).

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Annuities

5.3

Living Benefit Variable Annuity [100% invested in small cap blend] includes annual ratchet when anniversary value increases 2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

total

VA withdrawal

$5k

$5.2k

$5.2k

$5.2k

$5.5k

$5.5k

$5.5k

$5.5k

$5.5k

$5.5k

$5.5k

$59.1k

VA market value

$105k

$105k

$83k

$109k

$122k

$122k

$133k

$124k

$74k

$89k

$104k

$99.9k

Immediate annuity pays

$8.4k

$8.4k

$8.4k

$8.4k

$8.4k

$8.4k

$8.4k

$8.4k

$8.4k

$8.4k

$8.4k

$92.4k

Over this 11-year period (2000-2010), the immediate annuity paid $33,300 more than the variable annuity with a 5% living benefit distribution. The variable annuity investor has a liquidating value of $99,900 not $104,000. For comparison purposes a $100,000 immediate annuity has a remaining present value (PV) of $91,000 for a 75-year who started receiving $8,400 annual payments at age 65.

If you add immediate annuity cumulative distributions ($92.4k) to the $91,000 PV (75-year old), total valuation is $183,400 vs. a total value of $159,000 for the variable annuity ($59.1k + $99.9k).

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Annuities

5.4

S&P 500 Index Subaccount [1990-1999] Let us go through another example, but include a different subaccount (S&P 500) and a different period—the 1990s (18.2% annualized return for the S&P). Thus, we will be using a 10- and not 11-year period plus the best decade stocks have experienced since the 1950s).

Living Benefit Variable Annuity [100% invested in large cap blend] 1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

total

VA withdrawal

$5k

$5k

$5k

$5k

$5k

$5k

$5k

$5k

$5k

$5k

$50k

VA market value

$89k

$106k

$106k

$107k

$100k

$127k

$146k

$183k

$222k

$256k

$256k

Immediate annuity pays

$8.4k

$8.4k

$8.4k

$8.4k

$8.4k

$8.4k

$8.4k

$8.4k

$8.4k

$8.4k

$84k

Living Benefit Variable Annuity [100% invested in large cap blend] includes annual ratchet when anniversary value increases 1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

total

VA withdrawal

$5k

$5k

$5.3k

$5.3k

$5.3k

$5.3k

$6.4k

$7.3k

$9.1k

$11.1k

$64.1k

VA market value

$89k

$106k

$106k

$106k

$100k

$126k

$144k

$181k

$218k

$242k

$242k

Immediate annuity pays

$8.4k

$8.4k

$8.4k

$8.4k

$8.4k

$8.4k

$8.4k

$8.4k

$8.4k

$8.4k

$84k

Over this 10-year period (1990-1999), the immediate annuity paid $19,900 more than the variable annuity with a 5% living benefit distribution. However, the variable annuity investor has a contract with a liquidating value of $242,000.

For comparison purposes a $100,000 immediate annuity has a remaining present value (PV) of $91,000 for a 75-year who started receiving $8,400 annual payments at age 65. If you add immediate annuity cumulative distributions ($84k) to the $91,000 PV, your total valuation is $175,000 vs. $306,100 for the variable annuity ($64.1k + $242k).

We have now looked at an extremely good decade (the 1990s) along with a belowaverage 11-year period (2000-2011) for the variable annuity investor. By “blending” these two figures and periods of time with some simple averaging for the variable annuity, the “average” figure comes to $229,560 (variable annuity investor) vs. a $175,000 PV for the immediate annuity investor now age 75. All distributions for both investment vehicles have been included.

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Annuities

5.5

Phrased another way, we have combined 11 years (small cap) with 10 years (S&P 500).

Using a mediocre period (2000-2010) for small caps with an exceptional 10 years (1990s) for the S&P 500 (shown as large cap blend), results in a large advantage for the variable annuity ($229,560 vs. $175,000 for immediate annuity).

Asset Allocation Subaccount Let us go through one more example for the 1990s; instead of using a stock portfolio, we will use asset allocation subaccount for the variable annuity investor.

Living Benefit Variable Annuity [100% invested asset allocation] includes annual ratchet when anniversary value increases 1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

total

VA withdrawal

$5k

$5k

$5.3k

$5.4k

$5.6k

$5.6k

$6.0k

$6.6k

$7.4k

$7.8k

$59.7k

VA market value

$93k

$106k

$108k

$110k

$101k

$120k

$130k

$147k

$155k

$154k

$154k

Immediate annuity pays

$8.4k

$8.4k

$8.4k

$8.4k

$8.4k

$8.4k

$8.4k

$8.4k

$8.4k

$8.4k

$84k

Over this 10-year period (1990-1999), the immediate annuity paid $24,300 more than the variable annuity with a 5% living benefit distribution. However, the variable annuity investor has a contract with a liquidating value of $154,000. The immediate annuity has a remaining PV of $91,000. Including all distributions results in a total value of $213,700 ($154,000 + $59,700) for the variable annuity and $175,000 for the immediate annuity ($91,000 + $84,000).

20-Year Example Using the S&P 500 Finally, let us look at a continuous 20-year period (1990-2009) using an S&P 500 index subaccount for the variable annuity. All other assumptions remain the same (e.g., 65-year old, immediate distributions, etc.). As you can see, the first table is an exact repeat of an earlier table. The second table is quite a bit different since it begins with a much higher starting point for the variable annuity investor (since this investor has already experienced a great decade—the 1990s).

Living Benefit Variable Annuity [100% invested in large cap blend] includes annual ratchet when anniversary value increases 1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

total

VA withdrawal

$5k

$5k

$5.3k

$5.3k

$5.3k

$5.3k

$6.4k

$7.3k

$9.1k

$11.1k

$64.1k

VA market value

$89k

$106k

$106k

$107k

$100k

$127k

$146k

$183k

$222k

$256k

$242k

Immediate annuity pays

$8.4k

$8.4k

$8.4k

$8.4k

$8.4k

$8.4k

$8.4k

$8.4k

$8.4k

$8.4k

$84k

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Annuities

5.6

Living Benefit Variable Annuity [100% invested in large cap blend] includes annual ratchet when anniversary value increases 2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

total

VA withdrawal

$11.1k

$11.1k

$11.1k

$11.1k

$11.1k

$11.1k

$11.1k

$11.1k

$11.1k

$11.1k

$111k

VA market value

$201k

$161k

$111k

$125k

$122k

$113k

$114k

$105k

$56k

$55k

$55k

Immediate annuity pays

$8.4k

$8.4k

$8.4k

$8.4k

$8.4k

$8.4k

$8.4k

$8.4k

$8.4k

$8.4k

$84k

Over this 20-year period (1990-20099), the immediate annuity paid $27,000 less than the variable annuity with a 5% living benefit distribution. The variable annuity investor has a contract with a liquidating value of $55,000 (due to devastating losses of the 2000s plus an annual distribution of $11,100). The immediate annuity has a remaining PV of $56,000 (85-year old receiving $8,400 a year):

1990-2009: Immediate Annuity vs. Variable Annuity (S&P 500) Immediate annuity

Variable annuity

Distributions during 1990s

$84,000

$64,100

Distributions during 2000s

$84,000

$111,000

Remaining present value

$56,000

$55,000

total

$224,000

$230,100

Based on actuarial mortality tables, a healthy 65-year old man has a 33% chance (44% chance if female) of living beyond age 90. For a 65-year old couple, there is more than a 50% likelihood that one or both will live beyond 90. According to Financial Research, Inc., a 65-year old retiree who takes out $45,000 a year (adjusted for inflation) from a $1 million portfolio of stocks and bonds has a 25% chance or running out of money before age 92. However, if the 65-year old were to invest $400,000 in an immediate annuity and takes the balance of annual income from the remaining $600,000 stock and bond portfolio, the chance of running out of money drops to just 6%.

Ibbotson Guidelines Ibbotson proprietary software guidelines show that the older the investor, the more that should be invested in an immediate fixed-rate annuity (e.g., 20% at age 65 and 35% at age 75). The same software recommends an additional 30% be invested in a variable annuity with a minimum withdrawal benefit, whether the person is age 65 or age 75.

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Commodities

6.HISTORICAL

6.1

UPDATE FOR GOLD AND COTTON

Back in the early 1980s, during gold’s previous peak, inflation was over 12% a year and interest rates were 14%+. The $1.6 trillion invested in gold exceeded the $1.4 trillion value of U.S. stocks.

Futures prices for cotton peaked for 2011 in March, when the price per pound reached $2.15, the highest price in the 140 years that the commodity has traded on an exchange.

During July 2011, the price for December delivery was 98.6 cents a pound.

SILVER PRICES The market for silver is much smaller than many other commodities, making the metal and futures prices potentially quite volatile. For example, gold futures contracts trade about four times more than silver futures contracts. Roughly 17% of gold’s total supply is held by the world’s central banks, versus less than 5% for silver. During the 2008 financial crisis, silver dropped to $9 an ounce. During July 2011, the price of 32 ounces of silver equaled one ounce of gold; over the past three decades, it took an average of 63 ounces of silver to equal an ounce of gold. The last time silver was considered expensive compared to gold was in 1983.

Based on 1981 prices, when gold and silver both peaked in price, silver should be selling for $140 an ounce on an inflation-adjusted basis (since its 1981 peak) versus about $2,000 for gold (which reached $1,600 in late July 2011).

UNEQUAL COMMODITY INDEXES Modern commodity indexes got their start in 1956, when the Commodity Research Bureau created an index based on futures contracts to measure potential price inflation.

The first CRB index contained barley, lard and rye, but not oil or gold. The 10th and most recent revision of the index includes crude, gold and 17 other materials and is known as the Thomson Reuters/Jefferies CRB Index.

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Commodities

6.2

In the early 1990s, Goldman Sachs began publishing its own commodity index, then sold it in 2007 to S&P, which renamed it the S&P GSCI. The Dow Jones-UBS index was created in the late 1990s. A 2006 index, DBIQ Optimum Yield Diversified Commodity Index Excess Return, which was started by Deutsche Bank in 2006, tries to offset some of the possible problems caused by contango by buying futures contracts due within a month plus other contracts that do not come due for a number of months. The table below shows the composition of three broad commodity indexes as of the middle of 2011 (source: Index providers).

Three Commodity Indexes and Tracking ETFs S&P GSCI ETF: GSG

Dow Jones-UBS ETF: DJP

DBIQ Excess Return ETF: DBC

70% energy

35% energy

60% energy

15% agriculture

28% agriculture

19% agriculture

7% industrial metals

16% industrial metals

11% industrial metals

3% precious metals

15% precious metals

10% precious metals

4% livestock

5% livestock

--

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QUARTERLY UPDATES HEDGE FUNDS

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Hedge Funds

7.HEDGE

7.1

FUND QUESTIONS

Before recommending a specific hedge fund for a client, get answers to the following questions:  A list of institutional investors, the contact person and their phone number o telephone several customers and find out their satisfaction level  Explanation of the fund’s performance o have management explain how the fund has done so well  What the fund’s watchdogs have concluded o fund auditors are required to enroll in the AICPA program o trades executed internally may be easily altered by a brokerage firm o fund bank accounts and track record should be verified  Check management’s resume o contact manager’s former boss and colleagues o seek release waiver to verify manager’s previous track record  Look at credit report and any SEC filings o check on the firm’s credit history ($60 from Dun & Bradstreet) o check SEC website any carefully read any ADV filed  Find out about the fund’s history and the history of its manager o LocatePlus may be able to provide names, addresses and SS numbers o International Business Research will search newspaper clippings  Asset safety o who is in charge of custody and security of the assets o what is the relationship between the fund, trading firm, custodian, etc. o last time the fund’s books or operations were independently audited  Trading supervision o what are the safeguards against trading irregularities o how are traders supervised o length of time to liquidate all positions  Subscriptions and redemptions o number of investors who have come and gone since fund inception o list of money laundering checks in place o growth of personnel and who has left in the last 1-2 years

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QUARTERLY UPDATES FINANCIAL PLANNING

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Financial Planning

8.INDIRECT

8.1

ELDERLY CARE COSTS INCREASE

Since 1994, the percentage of adult children caring for their parents has tripled to 10 million people (source: U.S. Health and Retirement Study, a data bank collected by the University of Michigan). The financial toll on care providers who are 50 or older averages $304,000 per person in lost wages, pension benefits and Social Security benefits over their lifetime.

For women, the cost is higher, $324,000 ($143,000 in lost wages, $50,000 in lost pension benefits or matching contributions and the balance from lost future Social Security benefits); for men, the average lifetime loss totaled $284,000. Another study found that depression, hypertension, diabetes and pulmonary disease were among caregivers’ morecommon health problems. The group also experienced higher rates of stress and were more likely to smoke or drink plus were less likely to get preventive health screening (source: 2010 study released by MetLife).

Providing Care for an Aging Parent 1994

2008

men

3%

17%

women

9%

28%

$1 MILLION IN BENEFITS If a 66-year old couple retires and begins taking retirement benefits, the couple will end up collecting a combination of cash and health-care entitlements from Social Security and Medicare will total $1 million over their remaining life expectancy. The monthly Social Security checks will come to $550,000 after inflation and health-care services paid

by Medicare another $450,000 after inflation.

The average worker who retires in 2011 receives a benefit that is 23% higher after adjusting for inflation than the monthly benefit received by the average worker who retired 20 years ago. Moreover, the typical worker who retires 10 years from now is promised an initial benefit that is 14% higher after adjusting for inflation than the average worker who retires in 2011.

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Financial Planning

8.2

PROPHETS OF ERROR In 2005, a psychology professor at the University of Pennsylvania published a 20-year analysis of over 27,000 judgments about the future from over 280 experts. The study shows that, in aggregate, the experts did little better, and sometimes considerably worse, than a “dart-throwing chimpanzee.” For example, Paul Ehrlich (The Population Bomb) wrote in 1974, “If I were a gambler, I would take even money that England will not exist in the year 2000.” In the early 1990s, Lester Thurow, an MIT economist, was one of several experts who predicted that Japan would dominate the 21st century; he also noted Europe also had a chance.

401(K) LOANS Generally, there are few restrictions as to who can borrow from their 401(k). The loan cannot exceed half the account balance, or $50,000, whichever is less; the investment company that oversees the account often charges an initiation fee of $75. The borrower pays back principal plus a reasonable rate of interest (both of which are fully credited to the borrower’s 401(k) account. Roughly 40% of the money borrowed from these plans is used for debt consolidation, 32% is used for home improvement or repair, 19% for home purchase, 14% for car purchase and 11% for college expenses (source: Vanguard Group).

The 401(k) loans come due within 60 days after the employee loses his/her job. Whatever interest and principal is not repaid, is considered an early withdrawal and subject to a 10% IRS penalty if the borrower is under 59 ½.

U.S. HOUSEHOLD NET WORTH During 2007, the net worth of U.S. households peaked at ~ $65 trillion before dropping to ~ $50 trillion by the beginning of 2009. By the end of 2010, the figure was just under $60 trillion. Stocks and real estate represent close to two-thirds of this amount; surprisingly, bonds and cash equivalents collectively represent less than 10%. As of the end of 2010, U.S. households held close to $15 trillion of debt ~ 80% of which was from home mortgages (source: U.S. Federal Reserve).

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Financial Planning

8.3

DEVELOPED VS. DEVELOPING COUNTRIES It is projected that ~90% of GDP growth worldwide in the 6-year period ending in 2015 will be generated outside the U.S., with China and India contributing more than onethird. Today, the U.S. remains the world’s largest single economy with more than 40% of the world’s investable universe (source: MSCI market cap data as of 12/31/2010). Both here and abroad, multinationals now constitute a significant number of all publicly traded companies and represent a driving force in worldwide economic integration.

Despite having most of the world’s population, consumption in the developing world is still only 25% of the world’s total. The discrepancy illustrates demand for goods and services has significant potential to grow, and could represent a vast market for companies around the world (e.g., Buick now sells more cars in China than in the U.S. and McDonald’s plans to double the number of its stores in China by 2013).

Information below is from the World Bank database and International Monetary Fund.

The developed world represents 33 countries; the developing world is comprised of 150 countries in the group of emerging and developing. Figures for consumption and population are as of 2009; those for GDP are based on estimated data for 2010.

Developed vs. Developing Countries Developed Countries

Developing Countries

% of world consumption

75%

25%

% of world population

16%

84%

GDP growth

2.7%

7.1%

Outstanding Debt Securities U.S.

Non-U.S.

1990

64%

36%

2000

42%

58%

2010

38%

62%

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Financial Planning

8.4

Historically, stock and bond markets have often offset each other’s ups and downs. While there may be compelling reasons to invest in any one of these asset classes on its own, when combined, this diversified portfolio has the potential to provide investors comparable results with reduced volatility over longer periods (sources: stocks—MSCI ACWI), bonds—Barclays Capital Global Aggregate Index and 60/40 blend—60% MSCI ACWI and 40% Barclays).

Risk and Returns Annualized Return

Standard Deviation

Global stocks

8%

15%

Global bonds

7%

6%

60/40 blend

8%

10%

The global fixed-income market dwarfs the global equities market, weighing in at roughly $91 trillion in debt outstanding at the end of 2010. That’s nearly double the almost $52 trillion in market capitalization represented by the world’s equities, and it is tied to a much more diverse universe of issuers that extends well beyond publicly listed corporations.

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Financial Planning

8.5

U.S. EXPORTS AND IMPORTS The table below shows the top 2010 destinations for U.S. exports and imports (source: U.S. Commerce Department).

Largest U.S. Exporters and Importers [2010] Exporters

Importers

Canada

China

Mexico

Canada

China

Mexico

Japan

Japan

U.K.

Germany

Germany

U.K.

S. Korea

S. Korea

Brazil

France

Netherlands

Taiwan

Singapore

Ireland

401(K) REALTIES The 401(k) was embraced by large companies as a way to transfer the burden of funding employee retirement to employees. Over the past 30 years, the 401(k) has become a multi-trillion dollar industry.

The median household headed by a person aged 60-62 with a 401(k) account has less than one quarter of what is needed to maintain its standard of living in retirement (source: Federal Reserve). Even counting Social Security and any other pensions or savings, most 401(k) participants appear to have insufficient savings.

Vanguard, one of the largest 401(k) providers, has changed its advice on how much people should save, from 9-12% to 12-15% (combined employer and employee contributions) due to market uncertainties as well as what could happen to Social Security and Medicare.

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Financial Planning

8.6

Advisors often cite that 85% of pre-retirement income is needed to maintain a client’s living standard. The median 401(k) plan held by households headed by those age 6062 is under $150,000 (which would generate $9,100 a year for a couple, according to NY Life). Since the median income of such households is $88,000, the 85% needed would be $75,000. According to Fed survey data, Social Security will make up 40% of such preretirement income, leaving a shortfall of over $39,000 a year. Just 8% of households approaching retirement have the $637,000 or more needed to generate the $39,000 annual shortfall during retirement. Half of these families have a pension income expected to cover about two-thirds of the shortfall.

Low Stock Holdings More than 60% of 401(k) investors in their 20s own little or no stocks; in plans where company stock was an option, 30% of those over age 40 had more than 20% of their 401(k) account invested in that one stock (source: EBRI and ICI). In a Schwab survey, 53% of investors said they found choosing 401(k) benefits was more confusing than selecting health care plans.

Ask Harvard A Harvard professor asked 400 Harvard staff members, many with graduate degrees plus 250 MBA students from Wharton to select the best allocation for a $10,000 401(k) among four S&P 500 index funds. Since the funds all had virtually identical portfolios, those surveyed should have selected the fund with the lowest expenses. Instead, many made their selection based on past performance; others tried to “diversify” among the four funds, even though the holdings were the same. Even with a “cheat sheet” of annual fees and loads, only 10% of the Harvard staffers and 20% of the MBA students selected the fund with the lowest expenses.

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Income Taxes

9.WHAT

9.1

2011-2014 DEDUCTION COST

For the period 2011-2014, the top 10 individual tax deductions and credits will cost more than $3 trillion in forgone tax revenues (source: Congressional Joint Tax Committee). By contrast, the top 10 corporate tax breaks will cost just $350 billion over the same period.

It should be noted that individual income taxes bring in more than four times as much revenue as corporate taxes. Here is a breakdown of the revenues given up by the federal government for the 2011-2014 period, based on tax regulations as of the middle of 2011 (source: WSJ):          

Health and long-term care insurance premiums paid by employers: $660 billion.

Mortgage interest deduction: $485 billion Capital gains and dividends (the 15% rate): $405 billion Pre-tax pension contributions: $305 billion Earned-income tax credit (for low-income taxpayers): $270 billion Deductible charitable contributions: $240 billion Deduction for state and local taxes: $235 billion 401(k) earnings not taxed while in the plan: $210 billion Capital gains at death (no tax on appreciated assets): $195 billion Social Security benefits not taxed: $175 billion

TAX REPORTING All investment providers are required to start tracking each customer’s cost basis and holding period for securities purchased or acquired (e.g., gifts or inheritance) and report such information, along with sales proceeds, on IRS Form 1099-B. The first part of the new regulations will go into effect for 1099s for 2011. Tracking for open- and closed-end funds starts January 2012, with the first reports going to the IRS in 2013. Most ETFs will be subject to these same rules.

Your clients can calculate basis in one of three ways: FIFO, identified shares or average cost per share. The “double category” method of averaging is being phased out by the IRS; as of April 1, 2011, the two averaging methods were combined into a single category—average cost per share.

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Income Taxes

9.2

If your client does not indicate which shares are being sold by the settlement date, the provider will use a default method. For stock investors, brokers will use FIFO as default; for mutual funds and ETFs, the broker gets to pick the default method. Most mutual fund companies choose average cost as the default—once a client “defaults,” average cost must be used for all remaining shares of that fund or ETF while newly acquired shares are not restricted to the average cost method. Brokers are required to report cost basis for securities acquired (and later sold) in 2011 and later.

COMMODITY FUND TAX REPORTING Generally, mutual funds are not allowed to hold commodities directly—so they have turned to ETFs that are formed as partnerships, trusts or corporations. For example, SPDR Gold Shares holds gold bullion in a grantor trust, thereby subject to a 28% longterm capital gains tax rate because physical gold is considered a collectible. A number of ETFs issue an annual K-1 to shareholders, requiring the investors to pay higher tax preparation fees because the ETF is a partnership.

The Sprott Physical Silver Trust, a Canadian fund, is a foreign corporation that can qualify for the 15% rate because the fund files a special tax form. Powershares BD Commodity Index Tracking Fund and the United States Oil Fund have gains and losses classified as 60% long-term and 40% short-term, regardless of the funds’ holding period.

Surprisingly, an investor in a publicly traded partnership could end up filing a tax return in multiple states, even if the investor has only one house and lived in the same state for his entire life. All partners of a publicly traded partnership have to file in each state where income generated for the partnership exceeds a certain amount (think oil wells spread out over several states). Mutual funds must usually send out 1099s by February, but ETF partnerships often get extensions and do not file returns until September 15. Some report results to investors by March 15 and others send a letter post a website notice before the April due date with estimates of income.

Some investors who own a publicly traded partnership within a traditional IRA or Roth IRA may have to file a separate 990-T form and pay taxes at a corporate rate. Such taxation only occurs if taxpayer has more than $1,000 of UBTI (Unrelated Business Taxable Income) within the IRA for the year.

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Estate Planning

10.ESTATE

10.1

PLANNING COMPUTER ACCESS

Often left out of the estate planning discussion is testator’s personal computer and access codes (PINs). The co-author of Your Digital Afterlife (2011) recommends that your clients make an inventory of anything of importance on the family computer, including the user name and all passwords. There are over 20 paid services providing “digital” estate planning (i.e., DataInherit, Entrustet and Legacy Locker).

An RIA, LJPR in Troy, Michigan, provides a free form that you can use with your clients. The fill-in form is actually a testamentary letter (letter of final instruction) and can be downloaded by going to ljpr.com (click on “Services,” then “Estate Planning” and “Letter of Instruction Form.” LJPR’s 7-page form, called a Letter of Final Instruction, includes the following introductory paragraph: “The purpose of this letter is to state my final wishes and to provide you with valuable information you will need to finalize my estate. Although legally binding documents exist regarding my estate, this letter will give you specific information not contained within those documents. My intent is to provide you with answers as to the who, what, where, how, and why in order to finalize my estate. I hope that the contents of this letter will help you and more importantly I hope that you will carry out my wishes.”

The letter is followed by a series of blank spaces with easy-to-follow headings such as a list of people who should be contacted as soon as possible after your client dies (i.e., family, friends, clergy, funeral director, attorney, life insurance agent, employer/business associate and financial advisor). By listing the names, phone numbers and e-mail addresses of those who will play a relevant role in the decedent’s estate will make the executor’s (or trustee’s) job easier.

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Estate Planning

10.2

A testamentary letter can cover topics such as: funeral and burial instructions, specific wishes regarding organ donations, personal property that should go to certain people (e.g., “my gold watch should go to my oldest nephew”), where valuable papers can be found (e.g., will, trust, birth certificate, marriage certification, Social Security Card, insurance policies, deeds, bank accounts, PINs to accounts and computer files, credit card accounts, tax returns and stock certificates) and where monetary assets are held (e.g., safe deposit box and keys, safe, mutual funds, brokerage accounts, retirement plans and beneficiaries, annuities and beneficiaries plus any debts). The testamentary letter can end with a client’s wishes as to how the estate should be administered:    

I hope my trustee will consider the following wishes when paying out trust assets I would like the trustee and other representatives to be compensated as follows I suggest my executor and/or trustee use the following advisors Finally, I would like to explain why I have made some of the decisions regarding my estate and the named representatives

Once completed, your client should sign and date the testamentary letter.

PROVIDING FOR PETS In the U.S., there are close to 87 million cats and 79 million dogs (source: American Pet Products Association). For your clients who wish to include their pets as part of their estate plan, there are two types of pet trusts. A traditional trust, which is effective in all states, requires your client to designate a trustee who regularly pays money to a designated person as long as he/she cares for the pet. A statutory trust, valid in 46 states, is a simpler plan in which state law dictates the details of the pet trust.

The traditional or statutory can be structured as a living trust (which takes effect right away and protects the pet if your client becomes unable to care for the pet) or a testamentary trust (which becomes effective only when the client dies). Either trust document should have a non-binding letter of instruction (which could be part of letters testamentary) that covers the care of the pet: food, routine, grooming and medical care.

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Estate Planning

10.3

POWERS OF ATTORNEY Some financial institutions reject even perfectly executed powers of attorney because they are concerned about their own potential liability. Less than a dozen states have adopted the Uniform Power of Attorney Act, which gives bank employees greater protection from civil lawsuits, allowing them to more discretion in deciding which powers to honor or refuse. Fortunately, there are ways to “bullet proof” these legal documents: Set it up early. Once the power is established, the agent has instant access to your client’s money. One way to avoid this is a springing power that goes into effect only after your client has been diagnosed as being incompetent by usually two or more doctors.

Set it current. Some legal sources suggest that powers of attorney be renewed every six months in order to minimize disputes with banks and brokerage firms.

Check with the financial firm. Perhaps the best way to make sure a power of attorney will be accepted is to verify what is required by the client’s bank and brokerage firm.

Keep it under lock and key. A power of attorney (POA) that becomes effective as soon as it is signed will not provide the agent with any benefit unless the agent has access to the original document.

Restrict the power. One way to minimize possible abuse is to spread powers to multiple people. For example, your client could have a POA that applies just to the ABC Brokerage Firm; another POA may give a different agent the power over just the XYZ Bank.

Plan for gifts. If your client is planning on making future gifts while alive, specifics about any gift-giving program should be included in the POA. Retirement plan accounts. The client’s POA may wish to include a provision allowing the agent to roll over an IRA or pension account into a surviving spouse’s (or other designated beneficiary’s) IRA account.

Other states. If your client spends a fair amount of time in more than one state, the POAs should comply with each state.

A fallback trust. Your client may want to set up a disability trust—a type of revocable living trust—to become effective if the POA does not work. Such a trust can avoid the court from having to assign a guardian or conservator.

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Estate Planning

10.4

DOCUMENTS TO LEAVE AT DEATH The following is a list of documents that your clients should consider leaving in a series of files whose location is known to loved ones. These comprehensive folders can be accessed by family members if there is an emergency. The documents can be stored with an attorney or kept at home in a fire-proof safe.

Consequences of not keeping these kinds of records can be significant: [1] state treasurers currently hold $35 billion in unclaimed bank accounts (search for unclaimed assets at MissingMoney.com) and [2] tens of thousands of workers fail to claim pension assets each year (source: U.S. Dept. of Labor).

Documents to Leave at Death File Name

Paper

Marriage and Divorce

 marriage license and divorce papers

Insurance and Retirement

 life insurance policies  IRA and pension plan statements  annuity contracts

Health Care Confidential

   

Bank and Brokerage

 bank and brokerage firm statements  list of all user names and passwords  safe deposit box information (+ key)

Proof of Ownership

    

The Essentials

 wills, trusts and letters of instruction

personal and family medical history durable health care POA living will DNR order

real estate and cemetery deeds proof of loans made and debts owed stock certificates partnership and corporate agreements tax returns

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Estate Planning

10.5

SPECIAL NEEDS TRUST One of the most important things parents of children with special needs can do is set up a special needs trust (supplemental-needs trust). A child can be denied significant Medicaid and Social Security benefits if more than $2,000 of assets are in his name.

Assets in a special needs trust are not counted against the dollar limit. A personal residence, car and personal items are also not counted toward the $2,000 limit.

Funding for special needs trusts typically come from the parents’ life insurance.

Money can be placed in a special needs trust while the parent is still alive, but any funding should be done by anyone but the parents and child. For example, assets contributed by a parent to the trust can easily disqualify the child from receiving Medicaid and Social Security benefits.

Advisors recommend child’s guardian and trustee be different people. The guardian should be someone who understands the child’s needs and gets along with the child. The parents can prepare the guardian by drafting a letter of intent, outlining their wishes for the child, information about the child’s mental and physical health and the child’s likes and dislikes (e.g., types of food, entertainment, clothes, etc.). The trustee should be someone who is knowledgeable about finances and investments. Using different people means there is a system of checks and balances.

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