QUARTERLY UPDATES Q4 2008
Copyright Š 2009 by Institute of Business & Finance. All rights reserved.
v1.1
Quarterly Updates Table of Contents BONDS BOND YIELDS BONDS INSTEAD OF STOCKS? 2008 CORPORATE BOND DECLINES 2009 HIGH-YIELD BOND DEFAULT RATES
1.1 1.1 1.1 1.2
MUTUAL FUNDS 60% MUTUAL FUND CLUB CLOSED-END FUNDS MONEY MARKET FACTS FRONTIER FUNDS YEAR-END WINDOW DRESSING MUTUAL FUND RETENTION RATES MANAGER OF THE YEAR AWARDS
2.1 2.1 2.2 2.2 2.3 2.4 2.5
ETFS AND ETNS 2008 ETF AND ETN WINNERS AND LOSERS ETNS
3.1 3.1
FINANCIAL PLANNING JOINT TENANCY BASIS ADJUSTMENT FINANCIAL PLANNING SURVEY THE FUTURE OF HOME PRICES CLIENTS BECOMING MORE REALISTIC HOW THE EXPERTS ALLOCATE NO REQUIRED 2009 IRA WITHDRAWAL PROTECTING RETIREES FROM THEMSELVES WHEN THE ORDER OF GAINS AND LOSSES MATTER
4.1 4.1 4.2 4.2 4.3 4.3 4.4 4.4
ECONOMICS RECESSION MEASUREMENT 2008 BANK FAILURES
5.1 5.1
STOCKS BULL AND BEAR MARKET CYCLES LARGEST DOW PERCENTAGE GAINS COMMODITY VS. STOCK PRICES 2009 PROJECTED EARNINGS FOR THE S&P 500
6.1 6.2 6.2 6.3
ANNUITIES INTERESTING ANNUITY FACTS EIAS BECOMING SECURITIES
7.1 7.2
MISCELLANEOUS MONEY MARKET FACTS 2008 REIT RETURNS HEDGE FUND LEVERAGING ALTERNATIVE ASSETS CONVERTIBLES
8.1 8.1 8.2 8.2 8.2
TAXES 2009 TAX CHANGES AVOIDING AN IRS AUDIT
9.1 9.2
SOCIAL SECURITY ONLINE SOCIAL SECURITY APPLICATIONS 2009 SOCIAL SECURITY INCREASE SOCIAL SECURITY FOR MARRIED COUPLES
10.1 10.1 10.1
QUARTERLY UPDATES BONDS
BONDS
1.BOND
1.1
YIELDS
At the beginning of 2009, investment-grade bonds yielded 5.25 percentage points more than Treasuries, while junk gave about 15-18 percentage points more. At the beginning of 2008, those differences were 2 percentage points and 5.76 percentage points, respectively (source: S&P). According to the Merrill Lynch Master II High Yield Index, the gap between Treasuries and high-yield bonds hit a peak of 21.82 percentage points in mid-December 2008. For the 2008 calendar year, high-yield bonds as a broad category were down by about a third.
BONDS INSTEAD OF STOCKS? According to some analysts, bonds may be a better way to invest starting in 2009. These bond advocates point out an investor can get 8-10% a year in high-quality corporate bonds that historically have had one third the volatility of stocks. The attraction to fixed income is also due to the belief that the market has already priced in future risk. The spread between quality corporates and Treasuries is the widest seen in 75 years. The default rate for investment-grade corporate bonds is expected to increase from 0.3% to about 1.0% per year; the market is pricing in a 5% default rate. In the past, stocks have bottomed at about seven times earnings (versus a 10.5 times earnings ratio as of the end of 2008).
2008 CORPORATE BOND DECLINES While several broad stock market indexes were down 37-40% or more in 2008, a number of mortgage and corporate bonds lost 30-80% of their value. Commercial AAA-rated bonds were trading at 60 cents on the dollar during November 2008, yielding over 15 percentage points more than Treasuries. Corporate leveraged loans, many of which are fully secured by company assets such as buildings, machinery and receivables were trading for 65 cents on the dollar during the same period. Normally such corporate bonds trade at 100 cents on the dollar. All of these bonds had sharp sell-offs during the last few months of 2008 because banks and hedge funds that had used borrowed money were forced to liquidate parts of their holdings.
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BONDS
1.2
2009 HIGH-YIELD BOND DEFAULT RATES A January 2009 survey by The Wall Street Journal indicates that by the end of 2009, 9% of junk-rated debt will default. S&P expects a record-setting 14% for the year, while Moody’s is projecting a 15% default rate (vs. 4% for 2008) by year-end of 2009. Just a month earlier, Moody’s had predicted a 10.4% default rate for 2009. In 1997, the cumulative size of the high-yield debt market was $350 billion. By the beginning of 2007 it exceeded $1 trillion (in part due to the lowering of the ratings for Ford and GM bonds). The financial panic during September and October of 2008 saw junk bonds experience their two worst months ever, down -8.4% and -17.8% respectively (source: Citigroup High-Yield Composite Index).
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QUARTERLY UPDATES MUTUAL FUNDS
MUTUAL FUNDS
2.60%
2.1
MUTUAL FUND CLUB
The following three mutual funds were down more than 60% for 2008: -65% Legg Mason Opportunity Trust (LMOPX) -61% Winslow Green Growth (WGGFX) -60% Legg Mason Growth Trust (LMGTX) The losses of these three funds represent a lag of roughly 20 percentage points behind their broader category—domestic stock funds were down an average of 38% in 2008. In contrast, an ounce of gold peaked at an all-time record of $1,003.20 on March 18th, 2008.
CLOSED-END FUNDS A number of CEFs “juice” dividends by leverage, using borrowed money. During severe market declines such as 2008, these funds had fewer assets for collateral. This put them at risk of missing a regulatory cutoff beneath which they are barred from making payouts to shareholders. As of early January 2009, more than 150 of 525 CEFs that pay monthly or quarterly dividends had cut payouts. About 50 more such funds still yield more than 25% (source: Herzfeld). Under the Investment Company Act of 1940, closed-end funds must maintain asset coverage of at least 200% with respect to senior securities such as action-rate preferred securities. For each $1 of preferred stock issued, a fund must have at least $2 in assets. A fund is prohibited from declaring or paying a dividend that would put it below the 200% asset-coverage ratio. As of the beginning of 2009, there were approximately 630 stock and bond CEFs with an estimated $180 billion in assets, down from $300 billion at the end of 2007. Most closedend funds trade at a discount. The average CEF discount hit a record level discount of 26% on October 15th, 2008. Only two new CEFs came to market during 2008 (source: Herzfeld).
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MUTUAL FUNDS
2.2
MONEY MARKET FACTS Reserve Management Company offered the first money market fund in the early 1970s. These New York money market funds “broke the buck” in September 2008. The Reserve fund owned $785 million of Lehman debt when the investment bank filed for bankruptcy on September 5th, 2008. The fund wrote down the debt to zero, thereby reducing its NAV to 97 cents a share. Prior to this, there had been just one occasion when a fund broke the buck. This earlier instance occurred in 1994 when a small fund, Community Bankers U.S. Government Money Market Fund sustained losses in financial derivatives; the fund was geared towards institutions so no small investor lost money. Before Reserve Management incurred the September 2008 problem, there had been at least 20 other instances wherein fund companies (e.g., Bank of America, Northern Trust and Wells Fargo) also incurred money market losses. However, in all such instances, the fund company stepped in and made the fund whole. The average annual expense ratio of a money market fund is 0.58% according to Morningstar. Money market funds as a whole: [a] hold about 20% of all municipal debt outstanding, [b] hold about 20% of all marketable Treasury bills and [c] hold more than 40% of outstanding U.S. corporate commercial paper.
FRONTIER FUNDS According to a number of market observers, “emerging markets have been picked over in terms of interesting ideas; investors looking for significantly mispriced and undervalued opportunities need to look farther afield.” Such frontier markets, so-called because they sit at the edges of the investment world, have outperformed the S&P 500, the MSCI Emerging Markets Index and other benchmarks over the past 10 years. Examples of frontier funds include: T. Rowe Price Africa & Middle East Fund, Claymore/BNY Mellon Frontier Markets, Morgan Stanley Frontier Emerging Markets Fund, Market Vectors Africa, PowerShares MENA Frontier Countries and Lazard Emerging Markets Equity Fund.
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MUTUAL FUNDS
2.3
Countries on the investment frontier can be thought of as “emerging emerging markets”—just beginning to get their economies in order. China 20 years ago would have been a frontier fund, Brazil or Poland 10-15 years ago. Today’s frontiers are places like Pakistan, Jamaica, Trinidad, Tobago, Bulgaria, Ukraine, Nigeria (e.g., 150 million people and just 10 million bank accounts), Bangladesh (e.g., poised to take the contract drugmanufacturing business from India) and Vietnam (replacing manufacturing plants in China).
YEAR-END WINDOW DRESSING Portfolio managers have been doing year-end window dressing since the 1929 crash. A fund that engages in window dressing hopes to “present a financial statement of sound appearance” for their reporting period. Reading a December report alongside the same year’s June report will help ensure the advisor is not getting a naively rosy view. Sometimes referred to as “banging the close,” one year-end window dressing tactic is for a small or micro cap fund manager to run up the price of what the fund already owns. There are examples of small cap stocks that increase by 33% the day before the end of the trading year and then drop by 10-20% or more by January 2nd or 3rd of the next year. In some cases, the run up is even more suspect when one discovers that the stock in question was down 80% for the calendar year (despite the bump up in last-day trading). Historically, 80% of all U.S. stock funds and 91% of small cap funds have beaten the market on the last trading day of the year. Roughly two-thirds of these funds end up giving back most of that gain on the first day of the following year. On a somewhat related note, a study by finance scholar Berk Sensoy shows 31% of U.S. stock funds pick a benchmark that does not closely reflect what they own—making it easier for management to beat “the market” (and receive a bigger bonus).
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MUTUAL FUNDS
2.4
MUTUAL FUND RETENTION RATES Manager departures are often a leading indicator of trouble within a mutual fund family. Parent companies have explanations for such departures, but managers generally do not leave if they have the support and analysis they need and they are paid at least relatively well. The table below shows mutual fund company manager retention rates.
Mutual Fund Company Manager Retention Rates [2003-2007] Fund Family
Retention
Fund Family
Retention
American Funds
97%
Hartford Mutual Funds
91%
Dodge & Cox
97%
ING Retirement Funds
86%
Vanguard
92%
Van Kampen
88%
T. Rowe Price
95%
Fidelity Investments
86%
PIMCO
89%
MFS
84%
Oppenheimer
92%
Principal Funds
85%
Alliance Bernstein
90%
John Hancock
85%
Franklin Templeton
92%
JP Morgan
82%
GMO
90%
Columbia
86%
American Century
91%
Black Rock
85%
Janus
92%
DWS Investments
82%
Invesco Aim
86%
Putnam
79%
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MUTUAL FUNDS
2.5
MANAGER OF THE YEAR AWARDS Listed below are Morningstar’s 2008 managers of the year. The picks are based on “longterm performance and strong stewardship.” Domestic Stock Charlie Dreifus of Royce Special Equity (RUSEX) runner-up: Bob Goldfarb and David Poppe of Sequoia Fund (SEQUX) Fixed-Income Bob Rodriguez and Thomas Atteberry of FPA New Income (FPNIX) runner-up: Bill Gross—Harbor Bond (HABDX) and PIMCO Total Return (PTTRX) International Stock David Samra and Dan O’Keefe of Artisan International Value (ARTKX) runner-up: Jean-Marie Eveillard of First Eagle Overseas (SGOVX)
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QUARTERLY UPDATES ETFS AND ETNS
ETFS AND ETNS
3.2008
3.1
ETF AND ETN WINNERS AND LOSERS
At the beginning of 2009, there were about 730 U.S. listed ETFs with $450 billion in total assets and about $100 billion in daily trading volume (source: Morgan Stanley). Listed below are some of the biggest gainers and largest losers; the S&P 500 lost 37% in 2008.
+ 61% ProShares UltraShort S&P 500 + 55% Vanguard Extended Duration Treasury ETF (20-30 year zero-coupon) + 34% iShares Lehman 20+ Year Treasury Bond Fund + 24% SPDR Lehman Long-Term Treasury
- 41% iShares MSCI EAFE Index Fund - 43% iShares Dow Jones U.S. Home Construction - 45% PowerShares FTSE RAFI Emerging Markets - 56% U.S. Oil Fund - 85% PowerShares Ultra Financial
ETNS Due to the financial meltdown in the second half of 2008, investors pulled out close to $500 million from 90 exchange-traded notes (ETNs), representing close to 10% of the ETN industry’s overall assets of $5.5 billion (source: Morningstar). The largest ETN, iPath Dow Jones-AIG Commodity Index Total Return, run by Barclays, has $2.7 billion and saw 12% of its outstanding shares redeemed. ETNs were invented by Barclays in 2006 to complement iShares ETFs. Other companies that offer ETNs include: Deutsche Bank, J.P. Morgan, Goldman Sachs and UBS.
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QUARTERLY UPDATES FINANCIAL PLANNING
FINANCIAL PLANNING
4.JOINT
4.1
TENANCY BASIS ADJUSTMENT
For married investors who do not live in a community property state, if a stock is transferred from one spouse to another spouse and death of the donor occurs within a year of the new ownership, there is no basis adjustment. Normally, death of a joint owner means that the survivor receives a step-up in basis on the donor’s half interest as of the date of death.
FINANCIAL PLANNING SURVEY According to a 2008 survey of households with $250,000+ of investments, the top five financial issues and decisions were (source: Wall Street Journal survey): [1] maintaining lifestyle, [2] increasing current asset level, [3] maintaining current asset level, [4] affording healthcare for family and [5] managing investment risk. All five of these issues were of similar importance. The same survey asked, “what were the top three reasons why a financial planner or advisor was used,” and close to two-thirds of the respondents said that they either wanted to make sure their money would last through retirement or because their perception was the professional would do a better job than they would. A third of respondents said they were using a planner or advisor to rollover a retirement plan. The next table, based on the same survey from the WSJ, asked respondents to rank the top five items most important to them when looking for qualities in a planner or advisor.
Important Qualities in a Financial Advisor Trait
Very Important
Works in my best interest
94%
Understands financial situations and goals
86%
Is available and responsive
69%
Willing to listen and discuss ideas
67%
Provides periodic measurement of plan against goals
63%
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FINANCIAL PLANNING
4.2
THE FUTURE OF HOME PRICES Karl Case, an economics professor at Wellesley College whose name adorns the S&P Case-Shiller home-price indexes, has studied house prices going back to the 1890s. According to Case, over the long run, home prices tend to increase at an inflationadjusted rate of 2.5% to 3% a year. William Wheaton, a real estate and economics professor at MIT, expects housing prices to increase at an annual rate of 1% above inflation. Moody’s Economy.com, a research firm, expects housing prices to increase at an average rate of 4% a year over the next couple of decades. In the long term, house prices are driven by fundamentals that are hard to predict: immigration, birth rates, the size and nature of households and incomes. From the beginning of 1990 to the end of 2008, the average U.S. home price is up about 35% adjusted for inflation.
CLIENTS BECOMING MORE REALISTIC Many of the 80 million baby boomers between the ages of 44 and 63 no longer expect their advisor to try and trounce the markets. Instead, these investors have less tolerance for missteps and less time to regain lost ground with every year that passes. The baby boomers are now largely satisfied with single-digit returns that match their retirement needs and keep pace with inflation. From 1926 to 2006, the average return for the U.S. stock market was 10.3%. However, during this period, the S&P 500 did not provide an annual return within plus or minus four percentage points of that average in 72 of the 82 years. Few advisors and investors realize the mathematics of loss. A 15% loss means an 18% gain the next year in order to break even. If a plan is expecting a 10% annual return, a 15% loss would require a 29.4% gain the next year or 13.8% for each of the next two years.
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FINANCIAL PLANNING
4.3
HOW THE EXPERTS ALLOCATE Harry Markowitz, who shared the economics prize in 1990 for his mathematical explorations of the relationship between risk and return, has 50% of his portfolio in stocks and the other half in bonds. John Bogle, founder of Vanguard funds, believes investors should rebalance their portfolios on a regular basis—yet, he has not made a change in his portfolio since March of 2000. The managing director of Morningstar, Don Phillips, recommends putting tax-inefficient assets in retirement accounts. Mr. Phillips owns TIPS and REITs outside his retirement plans. The author of the classic 1973 book, A Random Walk Down Wall Street, Burton Malkiel argued that a blindfolded chimpanzee throwing darts at the stock tables of The Wall Street Journal could pick a portfolio as well as a money manager. Malkiel admits that at any given time, a fourth to a third of his money is in individual stocks.
NO REQUIRED 2009 IRA WITHDRAWAL Normally, IRA owners should begin withdrawing money from their accounts by April 1st of the year they turn 70 ½. There has always been a one-time exception: the first (and only the first) withdrawal can be postponed until April 1st of the year after they turn 70 ½. Thus, someone who turned 70 ½ in 2008 could postpone his or her first withdrawal until April 1st, 2009—another withdrawal would have to occur by December 31st of 2009 (to make up for the withdrawal that was not taken out in 2008). The law has no impact for those who are required to make a 2008 withdrawal, only for those who would have normally been required to take any kind of withdrawal in 2009. For taxpayers who inherited an IRA and are liquidating the account under the five-year deadline, the 2009 withdrawal can be skipped. This means the five-year deadline would be extended to six years.
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FINANCIAL PLANNING
4.4
PROTECTING RETIREES FROM THEMSELVES In the 2008 book, Predictably Irrational, MIT Professor Ariely writes, “social norms, expectations and emotions guide investors more than reason. T. Rowe Price and others have found that retirees have a strong, but incorrect, belief that their nest egg, regardless of size, will provide more income than it can realistically generate.� Listed below are T. Rowe Price suggestions for marketing to pre-retirees: [1] Ask open-end questions and listen. [2] Figure out what motivated the client to come to your office and what he expects from the meeting. [3] Show a variety of options, from super-conservative to overly aggressive. [4] Provide planning options (e.g., work longer, increase savings, etc.). [5] Discuss guaranteed products such as variable annuities with living benefits. [6] Convey the value the advisor adds to their investment, both short- and long-term. [7] Emphasize asset allocation and portfolio modeling. [8] Stress that withdrawals rate above 4% (adjusted for inflation) can shorten portfolio longevity. [9] Deliver a unique experience, both in presentation and solution. [10] Suggest delaying retirement until after age 62 or increase savings rate.
WHEN THE ORDER OF GAINS AND LOSSES MATTER A $100,000 in the S&P 500 grew to over $2 million for the 25-year period 1978-2002; a 13% average annual return. If the order of returns were reversed (e.g., use 2002 returns for 1978, 2001 returns for 1979, etc.), the annualized return figure and ending value would be the same. However, if someone had a $100,000 in the S&P 500 at the beginning of 1978 and took out 5% each year ($5,000), adjusted for 4% inflation after the first year ($5 in 1978, $5.2k in 1979, etc.), he would have ended up with $1,115,000 by the end of 2002. Reversing the order of returns, the same investor would have ended up with just $373,000. Thus, the order of returns does become important for retirees or anyone relying on a portfolio for current annual income.
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QUARTERLY UPDATES ECONOMICS
ECONOMICS
5.RECESSION
5.1
MEASUREMENT
Before 2008, the smallest gain for the decade was 2001, when GDP rose 0.8%. The last time annual GDP was negative was 1991 (-0.2%). Two consecutive quarters of declining output generally defines a recession. The official call must come from the National Bureau of Economic Research, which tracks five key gauges: GDP (quite volatile and often revised), sales and income, industrial output and employment. The current recession began in December 2007. Since the Great Depression, only two recessions have run longer than this one, the first ending in 1975 and the other in 1982. Each of these two recessions lasted 16 months. If the December 2007 recession extends past March 2009, it will be the longest since the 1933 recession, which lasted 43 months. The next table, from the National Bureau of Economic Research, lists all of the recessions since 1933 and their duration (in months).
U.S. Recessions Since 1933 [Duration/number of months in parentheses] December 2007 to present March 2001 - November 2001 (8) July 1990 - March 1991 (8) July 1981 - November 1982 (16) January 1980 - July 1980 (6) November 1973 - March 1975 (16)
April 1960 - February 1961 (10) August 1957 - April 1958 (8) July 1953 - May 1954 (10) November 1948 - October 1949 (11) February 1945 - October 1945 (8) May 1937 - June 1938 (13)
December 1969 - November 1970 August 1929 - March 1933 (43) (11)
2008 BANK FAILURES It appears that 25 banks failed in 2008 and it appears that at least another 200 banks may collapse sometime during 2009.
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QUARTERLY UPDATES STOCKS
STOCKS
6.1
6.BULL
AND
BEAR MARKET CYCLES
The next table lists indexes and how they fared during bull and bear markets from the beginning of 2000 to 2008 (source: Thomson Reuters Lipper).
Bull and Bear Markets [2000 through 2007] Bear
Bull
Bear
Bull
Bear
Bull
Index
1/14/00 to 3/22/01
3/22/01 to 5/21/01
5/21/01 to 9/21/01
9/21/01 to 3/19/02
3/19/02 to 10/9/02
10/9/02 to 10/9/07
DJIA
-19.9%
+20.7%
-27.4%
+29.1%
-34.5%
+94.4%
DJ WI 5000
-24.7%
+18.6%
-26.4%
+23.9%
-32.4%
+133.5%
Gold
-7.5%
+4.2%
+6.4%
+0.8%
+9.3%
+130.2%
EAFE
-29.1%
+12.5%
-27.5%
+18.5%
-27.3%
+172.5%
NASDAQ 100
-54.1%
+20.6%
-45.1%
+33.5%
-46.3%
+168.9%
Russell 1000
-22.6%
+18.2%
-26.5%
+22.7%
-33.1%
+127.2%
Russell 2000
-13.5%
+19.5%
-26.2%
+34.1%
-34.7%
+174.6%
S&P 500
-22.7%
+17.7%
-26.1%
+22.0%
-33.0%
+120.7%
3-Month T-Bill
+6.9%
+0.6%
+1.1%
+0.9%
+0.9%
+14.8%
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STOCKS
6.2
LARGEST DOW PERCENTAGE GAINS The next table lists several the largest percentage gains for the DJIA (source: WSJ Market Data Group). Notice that all but two of these top 10 gains occurred in 1929 and early 1930s.
Biggest Dow Percentage Gains Date March 15, 1933 October 6, 1931
Close 62.1 99.3
Point Gain 8.3 12.9
% Gain 15.3% 14.9%
October 30, 1929 September 21, 1932
258.5 75.2
28.4 7.7
12.3% 11.4%
October 13, 2008 October 21, 1987 August 3, 1932 February 11, 1932 November 14, 1929 December 18, 1931
9387.6 2027.8 58.2 78.6 217.3 80.7
936.4 186.8 5.1 6.8 18.6 6.9
11.1% 10.1% 9.5% 9.5% 9.4% 9.3%
COMMODITY VS. STOCK PRICES A 2004 paper shows that during the worst-performing months for stocks between 1959 and 2004, commodities gained 1.4%. One of the authors, Yale’s K. Geert Rouwenhorst points out that during five of the nine months in 2008, commodities and stocks moved in opposite directions. During the last several months of 2008, stocks and commodities both suffered severe losses.
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STOCKS
6.3
2009 PROJECTED EARNINGS FOR THE S&P 500 At the beginning of October 2008, Thomson Financial reported that the consensus on Wall Street was that S&P 500 earnings would increase 47% from the fourth quarter of 2007; as of early January 2009, it is believed that earnings actually fell 15% during the same period. Surprisingly, analysts expect S&P 500 earnings to be flat for 2009 according to Thomson, but show a 33% year-over-year rebound in the fourth quarter of 2009. Goldman Sachs analysts expect U.S. business spending to fall 13% in 2009 and 7.6% in 2010. The earnings slump began in 2007 and since then, earnings have fallen six quarters in a row (through 12/31/08), the worst continuous drop on record. In December of 2008, Barron’s asked a dozen experts to forecast how the S&P 500 would do for the 2009 calendar year. Not one of these experts predicted the market would drop. All of them predicted gains of 5%-38%, with a 13% median. History shows that the vast majority of time, the stock market does almost nothing. According to Professor Javier Estrada, a finance professor at IESE Business School in Barcelona, Spain, if you took away the 10 best days of the stock market, two-thirds of the cumulative gains produced by the Dow over the past 109 years (1900-2008) would disappear. If you had missed the 10 worst days, you would have tripled the actual return of the Dow. The 10 days represent just 0.03% of the Dow’s record during those 109 years—10 days out of 29,694 trading days.
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QUARTERLY UPDATES ANNUITIES
STOCKS
7.INTERESTING
7.1
ANNUITY FACTS
According to ImmediateAnnuities.com, $100,000 invested in an immediate annuity will provide a 60-year-old (2008) couple with about $6,875 per year for life, with no decrease in benefits when the first spouse dies. As interest rates rise in the future, the dollar amount should increase. The Teachers Insurance & Annuity Association began in 1918 as a pension fund for college educators. Due to increasing life expectancies, a TIAA task force was created in 1950-1951 to examine markets back to 1880. The task force concluded that investing retirement money solely in fixed income was unwise because of inflation. Because of this conclusion, TIAA created College Retirement Equities Fund in 1952, the first U.S. variable annuity. Of the four major living benefits offered by variable annuities, the most popular is the guaranteed minimum withdrawal benefit (GMIB). This benefit allows a minimum annual withdrawal of 5-7% of premium, until the entire principal has been recovered. If the contract experiences positive returns, the income stream can last significantly longer than 14-20 years. During 2007, the average variable annuity offered 52 subaccounts (source: NAVA). The “typical” annuity owner is female, age 66, has an annual household income below $75,000 and is (or was) a professional such as a doctor, lawyer, teacher or owner of a business. During the first half of 2008, the five biggest sellers of variable annuities were ING, AXA, TIAA-CREF, MetLife and Lincoln National. These five companies accounted for over 40% of all variable annuity sales.
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STOCKS
7.2
EIAS BECOMING SECURITIES On December 17th, 2008, The SEC adopted Rule 151, which considers indexed annuities securities. Beginning January 12th, 2011 equity indexed annuities (EIAs) will be considered securities and under the jurisdiction of the SEC. The new definition applies only to equity indexed annuities issued on or after the January 12th date. The rule establishes standards for determining when EIAs are not considered annuity contracts. The SEC rule provides that an indexed annuity is not an “annuity contract� if the amounts payable by the insurer under the contract are more likely than not to exceed the amounts guaranteed under the contract.
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QUARTERLY UPDATES MISCELLANEOUS
Miscellaneous
8.MONEY
8.1
MARKET FACTS
Reserve Management Company offered the first money market fund in the early 1970s. This New York money market fund “broke the buck� in September 2008. The Reserve fund owned $785 million of Lehman debt when the investment bank filed for bankruptcy on September 5th, 2008. The fund wrote down the debt to zero, thereby reducing its NAV to 97 cents a share. Prior to this, there had been just one occasion when a fund broke the buck. This earlier instance occurred in 1994 when a small fund, Community Bankers U.S. Government Money Market Fund sustained losses in financial derivatives; the fund was geared towards institutions so no small investor lost money. Before Reserve Management incurred the September 2008 problem, there had been at least 20 other instances wherein fund companies (e.g., Bank of America, Northern Trust and Wells Fargo) also incurred money market losses. However, in all such instances, the fund company stepped in and made the fund whole. The average annual expense ratio of a money market fund is 0.58% according to Morningstar. Money market funds as a whole: [a] hold about 20% of all municipal debt outstanding, [b] hold about 20% of all marketable Treasury bills and [c] hold more than 40% of outstanding U.S. corporate commercial paper.
2008 REIT RETURNS Of the 114 stocks tracked by the Dow Jones Equity All REIT Index, only four posted positive returns for 2008; overall, this index had a total return of -40% for the year. Of the 114 equity REITs tracked by Dow Jones, 44 had losses greater than -50%; 10 were down 80% or more.
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Miscellaneous
8.2
HEDGE FUND LEVERAGING Hedge funds have now learned the ugly side to leveraging. By borrowing from banks, a hedge fund is able to invest $10 for every $1 of investor money. Although 10-to-1 is extreme, Long-Term Capital Management (and others) leveraged 30-to-1 in the late 1990s. The problem that hedge funds run into is when the underlying bank collateral starts to drop in value. Such collateral is “called” when a fund loses 25% of its value. Such a drop creates forced selling, pushing security market prices (and collateral) even lower.
ALTERNATIVE ASSETS Between 2002 and 2002, as stocks collapsed, endowments led by Yale beat the S&P 500 by huge margins thanks to alternative assets. In 1995, endowments had less than 10% of assets in alternatives; by 2008, the average had climbed to more than 30% (41% in the case of Columbia University). In 2007, Laurence Siegel, research director for the $11 billion Ford Foundation, wrote a paper waning that alternatives could suck the liquidity out of institutional portfolios. His argument was simple: If you used to rely on bonds to generate income, but you sell the bonds to make room for alternatives, there is little left to raise cash for capital needs or to fund operating budgets. Many hedge funds tie up investors’ capital for as long as three years. The typical privateequity fund (an “alternative”) makes “capital calls,” requiring investors such as endowments to pony up another 50-75 cents for every dollar they have already committed. Columbia is on the hook for another $1.6 billion in capital calls through 2012. With no gains to be found, many institutions are short on liquidity just when they need it most.
CONVERTIBLES Hedge funds are a major player in the $200 billion convertible-bond market. These securities took a large hit during 2008. In one month (October 2008), the average convertible-bond hedge fund lost 35%.
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QUARTERLY UPDATES TAXES
Taxes
9.2009
9.1
TAX CHANGES
The estate tax exemption for 2009 is $3.5 million, up from $2 million in 2008. The top federal estate tax rate remains at 45%. The annual gift tax exclusion increases from $12,000 to $13,000 for 2009; lifetime gift-tax exclusion remains unchanged at $1 million (note: the annual gift limitation does not reduce the $1 million amount). The basic standard deduction for a married couple is $11,400 ($5,700 if single) for 2009, up from $10,900 ($5,450 if single) for 2008. The amounts are higher for those age 65 or older, blind or if the taxpayer paid real estate taxes. Someone under age 50 can contribute up to $16,500 in a 401(k) plan for 2009; those 50 and over can add an additional $5,500 (or a total of $22,000). For 2009 only, those 70 ½ or older are not required to take money out of a traditional IRA and certain other retirement plans. The maximum amount of earnings subject to Social Security taxes rose to $106,800 for 2009, up from $102,000 in 2008. Taxpayers who use their vehicles for work can deduct their actual costs or rely on the IRS standard mileage rate, 55 cents a mile for 2009. For 2009, most taxpayers will begin to lose some of the value of their itemized deductions if their AGI exceeds $166,800, up from $159,500 in 2008. As in past years, the IRS and a number of software companies are offering free tax preparation and e-filing services for those with an AGI of up to $56,000 (known as the “Free File” program). For 2009, the IRS is providing this free service to most people, even if their incomes are well above the previous limits; this new option is expected to be limited.
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Taxes
9.2
Federal Income Tax Brackets [2009 vs. 2008] Rate
2009 Married
2008 Married
2009 Single
2008 Single
10%
< $16,700
< $16,050
< $8,350
< $8,025
15%
16,700-67,900
16,050-65,100
8,350-33,950
8,025-32,550
25%
67,900-137,050
65,100-131,450
33,950-82,250
32,550-78,850
28%
137,050208,850
131,450200,300
82,250-171,550
78,850-164,550
33%
208,850373,950
200,300357,700
171,550372,950
164,550357,700
35%
> 372,950
> 357,700
> 372,950
> 357,700
AVOIDING AN IRS AUDIT The IRS audited 1.01% of all individual income tax returns last year; the year before the figure was 1.03%. Both of these numbers are quite a bit lower than figures for the 1990s. The IRS has increased their review of individual returns with taxable income of $200,000 or more. A taxpayerâ&#x20AC;&#x2122;s chances of being auditing rise under any of the follow situations: [a] self-employed, file a Schedule C and deal in large amounts of cash [b] if it is suspected the taxpayer is hiding income abroad [c] claiming unreasonably high deductions in relation to income [d] numbers on a return do not match what the IRS received from an employer [e] numbers do not match what a financial institution reported to the IRS [f] a tip from an ex-business partner, ex-spouse or neighbor [g] investment in an abusive tax shelter
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QUARTERLY UPDATES SOCIAL SECURITY
Social Security
10.ONLINE
10.1
SOCIAL SECURITY APPLICATIONS
A person who goes into a Social Security office to apply for retirement benefits spends about 45 minutes consulting with a field officer. A new online application allows people to apply for retirement benefits in 15 minutes. According to Social Security, over the next 20 years, 10,000 people each day will become eligible for retirement benefits. The online program has no paper forms to sign and usually requires no additional documentation. Those with more complicated questions can still call the agency or visit an office. To use the online program go to www.socialsecurity.gov.
2009 SOCIAL SECURITY INCREASE More than50 million seniors will see their Social Security benefits increase 5.8% for 2009, the biggest cost-of-living increase in more than 25 years. For the average Social Security recipient, translates into an extra $63 a month, or $103 per couple. It is estimated that 21% of retirees rely on Social Security for 100% of their income, 13% rely on these benefits for 90-99% of their income, 31% for 50-89% of income and 35% for less than 50% of their monthly income.
SOCIAL SECURITY FOR MARRIED COUPLES The Senior Citizens’ Freedom to Work Act of 2000 included a “file and suspend” provision that permits spouses to collect spousal benefits when the primary worker is postponing Social Security retirement benefits. Often times, the best strategy is to: [1] have the lower-income spouse start to receive full retirement benefits when this person turns 65 (or 1-2 years later depending upon the recipient’s date of birth); [2] have the high-income spouse “file and suspend” his benefits as soon as he receives full retirement (age 65-67, depending upon date of birth); [3] have the high-income spouse receive spousal benefits from Social Security for the years for the years 66-70 and
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Social Security
10.2
[4] have the high-income spouse change over at age 70 and begin receiving his maximum Social Security benefits [which would now include cost-of-living adjustments (COLA) and delayed retirement credits (DRC)]—thereby no longer receiving 50% of the spousal benefit from the lower-income spouse. By delaying benefits until the maximum age of 70, the higher-income spouse maximizes his Social Security benefits (receiving about 85% more in monthly checks than he would have if benefits had begun at age 66. Additionally, the high-income spouse still received 50% of the lower-income spouse’s full retirement benefit for those “bridge” years (from age 65 or 66 to age 70). The idea behind this strategy is to maximize (by waiting until age 70) Social Security retirement benefits by taking advantage of inflation (COLA) adjustments as well as upward adjustments for delayed retirement credits (DRCs) from full retirement age of 66 until age 70 (note: after age 70 there are no additional DRCs).
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