QUARTERLY UPDATES Q3 2009
Copyright Š 2009 by Institute of Business & Finance. All rights reserved.
v1.1
Quarterly Updates Table of Contents ECONOMICS PREDICTING THE END OF A RECESSION FOREIGN DEBT LEVELS
1.1 1.2
MUTUAL FUNDS FOCUSED FUNDS ACTIVE VS. PASSIVE MANAGEMENT: 2009 ETF UPDATE LEVERAGED ETFS INVERSE AND INVERSE LEVERAGED ETFS ETF WEB RESOURCES EMERGING MARKET SMALL CAP FUNDS MUTUAL FUND MERGERS STABLE-VALUE FUNDS FRONTIER FUNDS 2008 FUND RETURNS MONEY MARKET FUND COMPOSITION MERGED MUTUAL FUNDS FUNDS THAT EMPHASIZE DIVIDENDS MONEY MARKET FUND CONSIDERATIONS CONCENTRATED FUNDS GREEN FUNDS USER-FRIENDLY PROSPECTUS
2.1 2.1 2.2 2.3 2.4 2.5 2.6 2.6 2.6 2.7 2.7 2.7 2.8 2.8 2.9 2.9 2.10 2.10
FINANCIAL PLANNING EARNINGS, REBOUNDS AND CHASING RETURNS CREDIT-RATING FIRMS FAT TAIL INVESTING CREDIT SCORES IMPROVING A CREDIT SCORE RETURNS FOR IVY LEAGUE SCHOOLS EDUCATION VS. HEALTH CARE COSTS
3.1 3.1 3.2 3.3 3.4 3.4 3.5
FINANCIAL PLANNING (CONT.) MANAGED FUTURES SAFETY OF LIFE INSURANCE COMPANIES COMMODITY STUDIES LASTING IMPACT OF LOSSES MONTE CARLO SIMULATION HARVARD ENDOWMENT FUND RETURNS REASONS TO DIVERSIFY MONEY MANAGER RANKINGS
3.5 3.6 3.7 3.8 3.9 3.9 3.10 3.11
ANNUITIES ANNUITY SALES
4.1
STOCKS AND BONDS BEAR MARKET BENEFITS STOCKS VS. BONDS MARKET CAP FOR S&P 500 STOCKS INDEXED CDS HISTORICAL P/E RATIO SECURITIES LENDING I BOND PAYMENTS HOW BOND FUNDS LET INVESTORS DOWN
5.1 5.1 5.2 5.2 5.3 5.3 5.4 5.4
RETIREMENT FUNERAL SHOPPING MAXIMIZING SOCIAL SECURITY BENEFITS ROTH CONVERSIONS REVERSING A ROTH IRA CONVERSION DISABILITY INSURANCE
6.1 6.1 6.1 6.2 6.2
REAL ESTATE HOUSING DECLINES HISTORY OF AMERICAN HOME OWNERSHIP REIT DEBT REAL ESTATE FUND UPDATE HOUSING MARKET UPDATE (FALL 2009) EXPENSIVE U.S. HOUSING MARKETS REVERSE MORTGAGES
7.1 7.1 7.2 7.3 7.3 7.4 7.4
QUARTERLY UPDATES ECONOMICS
1.1
ECONOMICS
1.PREDICTING
THE
END OF A RECESSION
The nonprofit group, National Bureau of Economic Research (NBER) defines a recession as “a significant decline in economic activity spread across the economy, lasting more than a few months” (note: the most recent recession began in December 2007). It is generally believed that the six-member NBER Business Cycle Dating Committee will wait until the U.S. economy has improved to the point when GDP was restored to its former peak (before declaring the end of a recession). Even though unemployment figures are often considered a lagging indicator, a number of experts (e.g., Northwestern University economist Robert Gordon) feel the four-week moving average is a very reliable signal; the cresting of this average typically means a recession is within six weeks of its end. However, a recovery can begin even if jobs are slow to come back—if households are confident enough to increase spending in anticipation of better times. In every recession, the economy breaks some rule. Listed below are seven widely used gauges of economic recovery (listed in no particular order): [1] University of Michigan consumer expectations—this index is based on how well off households say they and the country are. [2] Retail sales—a rise in consumer spending. [3] Single-family housing starts, annualized—the number of homes construction is started each month. [4] Spread between Treasury and corporate bonds—a drop in Baa-rated corporate bond yields relative to 10-year Treasury notes shows investors are less fretful about extending credit to companies (making it easier for them to expand). [5] Purchasing Managers’ Index—based on a survey of purchasing managers; shows how well the manufacturing sector is doing. [6] Orders for nondefense capital goods-excluding aircraft—company orders for big ticket equipment. [7] Initial jobless claims, four-week average—in the past, when the number of Americans filing new claims for unemployment peaked, the economy soon began to recover.
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1.2
ECONOMICS
FOREIGN DEBT LEVELS The table below shows debt as a percentage of 2008 GDP for a select group of countries (source: Eurostast).
Foreign Debt as a % of GDP Country
Debt %
Country
Debt %
Spain
40%
France
68%
U.K.
52%
Italy
106%
Germany
66%
Euro zone
70%
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MUTUAL FUNDS
2.FOCUSED
2.1
FUNDS
According to focused fund manager Charlie Bobrinskoy (Ariel Focused Fund), a fund that typically holds just 20-30 stocks, “it is hard to find 100 great investment opportunities; why put your money into your 100th or 50th best idea, when you can put it into your 6th or 19th best?� The average stock fund has roughly 170 holdings; the typical focused fund owns just 25 different equities. Those who advocate focused funds point out that an overly diversified fund can mimic an index fund, but at a much higher cost. Since focused fund managers have little room for error, they tend to emphasize in-depth stock research and tend to buy securities selling at a deep discount. For your clients, the challenge of owning a focused fund is they often require more patience than most investors realistically have. Focused funds tend to have low turnover rates.
ACTIVE VS. PASSIVE MANAGEMENT: 2009 For the five-year period ending June 30th, 2009, an S&P study showed that at least 75% of all bond fund managers lagged behind their respective bond index; the sole exception was emerging market debt funds. For mortgage-backed securities funds, 98% underperformed their index; 92% in the case of long-term investment-grade bond funds. On an asset-weighted basis, index returns beat actively managed fund returns in all 13 fixed-income categories over one and three years, and 11 of 13 categories over five years. Only emerging market debt and global income funds beat their indexes over five years. In the case of equity funds, 60% of the large group underperformed their respective indexes. The S&P study, as well as other recent studies, shows that when there is less information about companies, such as small caps or foreign issues, or less liquid markets, such as real estate or emerging market bonds, active management can provide an edge. A 2009 study by FundQuest looked at the returns of thousands of actively managed funds from the start of 1994 through the end of 2008. The study showed that more than 75% of active managers of foreign small and mid cap growth funds beat their benchmark index. By contrast, fewer than 25% of inter-mediate-term government bond funds beat their index.
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2.2
What is always missing from the ongoing debate of active versus passive management is the value of using a broker. If an advisor can steer the client away from some fund that was up 125% last year (and ends up with a -57% loss by the end of this year), provides a strategy to permanently reduce taxes or gives ideas as to how a portfolio can be insured or properly structured, any ongoing fees are a bargain.
ETF UPDATE As of September 2009, over $670 billion was invested in ETFs. The biggest players in the ETF marketplace are shown in the table below. Fidelity has just one ETF and T. Rowe Price has no plans to offer any ETFs. The 10 largest ETF funds account for roughly 40% of total ETF assets; just 10 ETFs account for nearly two-thirds of average daily ETF trading volume. There were 846 ETFs and 36 sponsors as of September 2009. The average ETF has an expense ratio of 0.6%, up from 0.4% at the end of 2005, largely due to the offering of more complex products. About a dozen ETFs have assets of more than $10 billion; these large funds have bid-ask spreads of less than 0.09%.
ETF Sponsors—September 2009 Sponsor
Assets
Sponsor
Assets
Barclays
$317 billion
ProShares
$26 billion
State Street
$152 billion
Van Eck Global
$8 billion
Vanguard
$66 billion
Bank of NY Mellon
$7 billion
Invesco PowerShares
$37 billion
U.S. Commodity Funds
$7 billion
Commodity ETFs came into existence in 2003 and represent about 9% of the ETF universe. During August of 2009, the U.S. Natural Gas Fund (UNG) was trading at a 16% premium to gas futures while PowerShares DB Oil Fund, which tracks crude oil futures, was trading at a 0.3% premium. Small ETFs can have substantial bid-ask spreads. A few have spreads of more than 13%; nearly 200 ETFs have spreads of over 0.5%.
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2.3
Actively Managed It took the ETF industry almost 10 years to get regulatory approval for actively managed funds (e.g., PowerShares Active Alpha series, Grail American Beacon Large Cap Value, RiverPark series, PIMCO, State Street and Vanguard). In addition to looking at relative performance and market expectations, consider the following to decide whether index funds or actively managed funds (or both) make sense for you. Consider index funds if: [1] You lack the time or desire to research and monitor funds. [2] You are content to match the overall market, not beat it. [3] You want lowercost funds. Index funds typically have lower expense ratios. [4] You are investing in a taxable account. Index funds are typically more tax-efficient than active funds. Consider actively managed funds if: [1] You have time and interest to research and monitor funds. [2] You want to beat the market. Long term, top funds may outperform their indexes (though active funds can underperform as well). [3] You want more downside protection. Some active managers strategically increase cash holdings in times of distress. [4] You are looking for broader diversification. In categories such as bonds, active funds may provide more diversification.
LEVERAGED ETFS For the first half of 2009, some pairs of ETFs designed to profit from opposite moves in markets had both either risen or fallen. ProShares Ultra Real Estate, which aims to double the daily performance of the Dow Jones U.S. Real Estate Index, was down 46%. ProShares UltraShort Real Estate, designed to deliver twice the inverse of the index’s daily rise or fall, lost 64% over the same period (while the index fell 12%). Exchange-traded funds that use leverage often have returns that do not match their objective. For example, the S&P 500 dropped 38.5% in 2008, but the double-leveraged S&P 500 short fund (UltraShort S&P 500 ProShares), rose 61%, not 77%. The ProShares fund designed to return twice the opposite of the Dow Jones U.S. Real Estate Index was down 50% for 2008 while the index was also down 43% (note: based on the ETF’s description, the index should have gained about 86%, less its expense ratio, any loan interest and trading costs). Where the confusion (and faulty math) comes in is the wording of leveraged funds’ objectives. Typically, these funds are designed to have two or three times the returns of their underlying index; in the case of “short” funds, the return is expected to be 2-3 times the opposite of what the index experiences. However, in both cases (long and short), such math is based on the index’s daily move—not its cumulative move over a week, month, quarter, year or some other extended period of time.
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For example, suppose you have a 2X “long” ETF with a beginning NAV of $100 and a corresponding index that also happens to have a starting point of $100. The index goes up 5% the first day (from 100 to 105) and then drops 10% the next day (from 105 down to 94.5). While your client might think the corresponding ETF should fall 11% from its peak (5.5% loss x 2), the ETF actually will fall 12%. Here is why: for the first day, the 2X fund goes from $100 to $110; the second day it drops from $110 to $88 (a 20% loss). The disparity becomes even greater over an extended period. For example, on October 10th, 2008 you had a client who had $100,000 into an S&P 500 index fund and wanted to offset this position by putting $50,000 in the UltraShort S&P 500 ProShares (a 2X ETF). Two months later, despite large market swings, the S&P 500 was virtually unchanged from its October 10th starting date. The “2X short” ETF fund experienced a cumulative return of -24% (a $12,000 loss from the original $50,000).
INVERSE AND INVERSE LEVERAGED ETFS The performance results shown in the table below are for the first three quarters of 2009 plus the first day of October (when the market dropped 2%—a plus for all of the funds listed below). The “Should Be” column shows what the loss should have been (e.g., if the DJIA were up 8% for the year, a DJIA short fund should be -8%; a 2X DJIA should be 16%). The “Actual” column shows the actual return of the fund. As you can see, actual losses have been far greater than what should have been—using simple math (note: all ETFs have an expense ratio and brokerage fees which should, rightfully, narrow the gap between “Should Be” and “Actual.” There are three reasons for the differences between the “Should Be” and “Actual” returns: [1] ETF expense ratio, [2] cost of margining (in some cases) and [3] magnification of consequences when index moves in opposite direction hoped for (e.g., if X drops 40%, it will take a gain of >60% to get back to even).
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ETF Short Funds ETF (symbol)
Benchmark
Should Be
Actual
UltraShort S&P 500 (SDS)
S&P 500 (2x)
-28%
-40%
Short S&P 500 (SH)
S&P 500
-14%
-20%
Inverse 2x S&P 500 (RSW)
S&P 500 (2x)
-28%
-44%
Short Dow 30 (DOG)
DJIA
-8%
-15%
UltraShort Dow 30 (DXD)
DJIA (2x)
-17%
-32%
Large Cap Bear 3x Shares (BGZ)
Russell 1000 (3x)
-48%
-60%
UltraShort SmallCap 600 (SDD)
S&P SmallCap 600 (3x)
-31%
-47%
UltraShort Russell 2000 (TWM)
Russell 2000 (2x)
-37%
-52%
Small Cap Bear 3x Shares (TZA)
Russell 2000 (3x)
-56%
-72%
UltraShort Russell 2000 Growth Russell 2000 Growth (SKK) (2x)
-37%
-62%
Short MSCI EAFE (EFZ)
MSCI EAFE
-17%
-26%
UltraShort MSCI EAFE (EFU)
MSCI EAFE (2x)
-34%
-50%
ETF WEB RESOURCES Cumulative investments in ETFs represent about 5% of what is invested in mutual funds. Funds have been around for more than 80 years; the first U.S. ETF was launched in 1993. Listed below are free web sites designed for ETF advisors and investors. morningstar.com/goto/etfs: perhaps the most comprehensive ETF internet resource. finance.yahoo.com/etf: basic knowledge plus a large number of data tables. marketwatch.com/tools/etfs/html-homeasp: includes snapshot of the day’s biggest gainers, losers and most actively traded; site also features profiles and fund details as well as searches based on a wide range of criteria. indexuniverse.com: a mix of research, analysis and breaking news; this site is geared more toward sophisticated advisors and investors. etftrends.com: this site was started by Tom Lydon (a well-known ETF writer) in 2005 and generates 8-10 articles a day.
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etfguide.com: launched in 2003 by two former financial advisors, this site provides news, commentary and research plus weekly picks and pans. etfdb.com: portfolio constructor by using one screen at a time; the site caters to longterm as well as active traders.
EMERGING MARKET SMALL CAP FUNDS As of September 2009, there were just 10 emerging market small cap funds (e.g., Templeton, Wasatch and Matthews) and just one such ETF (SPDR S&P Emerging Markets Small Cap ETF).
MUTUAL FUND MERGERS Over the past couple of years, 300-400 mutual funds merged with other funds. Fund families tend to merge funds that are poor performers into other funds. Another reason can be expenses; very small funds cost more to manage.
STABLE-VALUE FUNDS Stable-value funds typically invest in highly rated corporate debt and highly-rated structured securities, such as asset-backed securities, commercial mortgage-backed securities and residential mortgage-backed securities. The goal is to deliver returns that are 1-2% higher than a money market fund. The funds back up these bonds with contracts, known as wrappers, from banks, insurers or other financial companies. The protection provided by these wrappers cost a fund 0.15-0.20% of its assets per year. A key measure of a stable-value fund’s financial health is the ratio of its actual market value of its underlying holdings to its book value. The ratio was 99% at the end of 2008, 95% in the early part of 2009 and 98% in August of 2009.
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2.7
FRONTIER FUNDS Frontier markets are generally those that do not make it to “emerging” status because they are too small, illiquid or otherwise inaccessible. Such traits can make their price movements dramatic. While commodities are a driver in many frontier markets, so are long-term domestic growth prospects. The long-term story is likely to a convergence of incomes, technology, living standards and labor costs. The MSCI Frontier Markets index, which contains 25 countries, peaking in January 2008, then dropped 69% by early March 2009. From the bottom hit in March 2009, the index rose 51% by the beginning of June 2009. For this 2008-2009 period, the correlation between frontier markets, the S&P 500 and the MSCI Emerging Markets index was extremely high.
2008 FUND RETURNS The best performing domestic equity fund earned 0.4% for 2008; the second-best performer posted a loss of -2.6% (vs. -34% for the Dow and -38% for the S&P). At the beginning of 2008, there were just 14 stock and balanced funds that had beaten the S&P 500 for nine years in a row. By the end of 2008, there was just one fund (a “lifestyle” fund of stocks and bonds—Manning & Napier Pro-Blend Maximum Term Securities) that had done better than the S&P for each of the past 10 years (-35% vs. -38%).
MONEY MARKET FUND COMPOSITION Money market funds can put as much as 5% of assets in securities with the secondhighest credit rating, known as A2/P2. As of the end of June 2009, 96% of eligible commercial paper in money market funds was tier one and the 4% balance tier two. According to the SEC, only a modest percentage of all money market funds hold any tier two paper.
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MERGED MUTUAL FUNDS During 2008, 208 mutual funds merged; for the first half of 2009, there were 208 such mergers. Fund mergers occur for one or more reasons: [1] to eliminate duplicate offerings, [2] to get rid of poor historical returns and [3] to save money. A mutual fund typically becomes profitable once its asset base is $50 million or more. Many large fund companies are only interested in overseeing funds that have assets of at least $500 million.
FUNDS THAT EMPHASIZE DIVIDENDS For 2008, the typical dividend-focused fund lost about 25%, while the S&P 500 dropped about 38%. Fund managers believe that while the ranks of companies that pay good dividends have thinned, dividend growth eventually will rebound along with the economy. The appeal of dividend funds is straightforward: [1] dividend preferential tax rate of 0% or 15%, [2] rising dividends provide some inflation protection and [3] dividend rates can be very competitive to CD and short-term bond rates. When considering dividend-enhanced mutual funds, keep in mind that fund strategies differ. Equity income funds emphasize a high level of income by buying stocks of companies such as utilities as well as other industries wherein investors expect lower growth or a possible future dividend cut. Other funds, which focus on “dividend growth” or “dividend building,” are looking for companies whose dividends may not be high now, but are expected to grow in the future. These funds sometimes yield 2-3% less than an equityincome-type fund. Examples of dividend-oriented funds include Thornburg Investment Income Builder, T. Rowe Price Dividend Growth, Franklin Rising Dividends, Eaton Vance Dividend Builder and Vanguard Dividend Growth.
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MONEY MARKET FUND CONSIDERATIONS As of October 2009, the average money market fund had a seven-day yield of just 0.05% (source: iMoneynet Inc.). From the middle of 1999 through the first three quarters of 2009, the typical taxable money market fund’s yield ranged from just under 6% (early 2001) to well under 1% (middle of 2009). Over the same period, inflation ranged from a 2% (second and third quarter of 2009) to about 5.5% (third quarter of 2008). From the middle of 2002 until toward the end of 2006, the average money market fund’s return was less than inflation by an average of 1%. According to Lipper data, the average short-term investment-grade bond fund beat the average taxable money market fund over the 10 years through mid-September 2009 (3.8% vs. 2.6% annualized). But short-term funds actually trailed money funds over the past three and five years. Although short and ultra-short funds are often a favored choice for liquidity and yield, advisors cannot assume all offerings are safe—Schwab YieldPlus lost 35% in 2008 and was down 10% for the first three quarters of 2009.
CONCENTRATED FUNDS Based on Morningstar data, there were 300 funds with 40 or fewer stocks, excluding funds of funds and index funds, out of a universe of 4,800 equity funds as of the end of the 2009 third quarter. According to Morningstar’s data on volatility and performance: [1] as a group, concentrated funds have not consistently outperformed or underperformed funds with more diverse holdings and [2] on average, concentrated funds are not more volatile than diversified funds. Most stock funds adopt “the safety-in-numbers” approach, with an average of about 180 stocks. A Morningstar study of returns from 1992 through 2006 fund that volatility was fairly close between the least and the most concentrated funds, as measured by standard deviation.
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GREEN FUNDS In many ways, “green” investing is a subset of socially responsible investing, where fund managers typically use a set of screens to weed out stocks of companies that do not meet certain criteria, usually relating to environmental, social and corporate-governance issues. There are three dozen dedicated green mutual funds and ETFs. These sectors can be quite volatile, as illustrated by the bankruptcy of multiple ethanol and biofuel producers as well as struggles among small solar-power companies. Examples of green portfolios include: Claymore/MAC Global Solar Energy Index, Market Vectors Solar Energy, PowerShares WilderHill Clean Energy, New Alternatives, Winslow Green Growth, Pax World Global Green, Portfolio 21, Northern Global Sustainability Index, Alger Green, Green Century Balanced and PowerShares Water Resources.
USER-FRIENDLY PROSPECTUS Starting in 2010, mutual funds must provide brief summaries describing a fund’s investment objectives and strategies, risks, costs and performance. Also required to be included in the summary is information on the fund’s investment advisers and portfolio managers, procedures for buying and selling funds, compensation to brokers and tax implications. Funds have the option of including these summaries as early as March 2009. Your clients will be able to find the summaries at the front of a fund’s prospectus. Fund companies can provide investors with just a printed copy of the summary, provided they post it and the full prospectus online and make printed copies available upon request
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QUARTERLY UPDATES FINANCIAL PLANNING
FINANCIAL P LANNING
3.EARNINGS,
3.1
REBOUNDS AND CHASING RETURNS
From March 9th to August 29th, 2009, the DJIA was up 46%. For its entire 113-year history, only six rebounds in the Dow have been bigger and faster. The Dow had a 46% gain in the 117 days ending April 30th, 1930; it then lost almost 51% over the next year (meaning a $10,000 investment increased to $14,650 and then dropped to $7,179). Another 47% upswing in 1971 led to a choppy decline of 37%. In March 2009, stocks traded as low as 11.7 times their average earnings for the previous 10-year period, adjusted for inflation. The long-term average is 16.3 times earnings. Research consistently shows investors chase past performance, buying whatever has made the most money for other people. What is not commonly understood is that investors also chase their own past performance, buying more of whatever they themselves have made the most money on. Research by Harvard economist David Laibson shows 401(k) participants tend to add significantly to whichever funds they already own that have gone up the most. In the classic book, “The Intelligent Investor,” Benjamin Graham wrote, “The investor with a portfolio of sound stocks should expect their prices to fluctuate and should neither be concerned by sizable declines nor become excited by sizable advances.” According to Graham’s definition, if one cannot exercise that kind of emotional control, then they are not an investor.
CREDIT-RATING FIRMS The SEC designates 10 credit-rating firms as “nationally recognized.” The title is important because many companies require the use of a nationally recognized credit rater when relying on a rating. The big three firms, Standard & Poor’s (McGraw-Hill), Moody’s and Fitch (Fimalac SA), are paid by debt issuers for ratings; other firms are funded by subscriber fees. Critics feel firms paid by issuers, such as the big three, create a conflict of interest.
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FAT TAIL INVESTING For the 2008 calendar year, a 60/40 portfolio (60% stocks and 40% bonds) lost about 20% (note: the typical balanced fund was down 27% while the S&P was off 37%). Standard portfolio construction tools assume that such a loss occurs once every 111 years. A number of brokerage firms believe conventional assumptions about market behavior substantially underestimate risk. New Wall Street tools assume market returns fall along a “fat-tailed” distribution (as opposed to the traditional “skinny-tailed” standard deviation distribution). Mathematician Benoit Mandelbrot recognized the relevance of fat-tailed distributions (meaning extreme returns are more likely than conventional wisdom has dictated) in the 1960s. These modeling tools were never widely used, partly because the math was so complex. During the middle of 2009, Morningstar’s Ibbotson Associates unit began to include fattailed assumptions into its Monte Carlo assumptions, which estimate the odds of reaching retirement financial goals. The new assumptions present risk quite differently. Under a fat-tailed distribution, a 60/40 portfolio should experience a loss of 20% once every 40 years (vs. once every 111 years under a normal (“skinny-tailed”) distribution, assuming a bell-curve-type distribution (note: the validity of standard deviation is highly questionable if there is not a bell curve distribution—which there is not, according to critics of standard deviation). Fat-tailed assumptions can lead to conservative portfolios by cushioning the downside while sharply curtailing the upside. Nobel Prize winner Harry Markowitz pioneered standard deviation as a risk measurement tool for investors. A criticism of his analysis is standard deviation gives equal weight to upside and downward movements—yet, most investors fear losses much more than they value gains. According to PIMCO’s Mr. Bhansali, “comprehensive measures of risk fail you in many cases when you need them the most.”
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CREDIT SCORES Your clients actually have several different credit scores. FICO, developed by Fair Isaac Corporation, ranges from 300 to 850 and varies depending on which credit bureau is reporting the FICO score and the kind of lender that is requesting a score. Three credit bureaus, Equifax, Experian and TransUnion, each sell their own proprietary scores. Credit scores are misunderstood, for example: [1] they do not reflect a client’s whole financial picture, just a snapshot of their debt at a point in time; [2] it is irrelevant whether there is a balance due, but it does matter if payments are made on time; [3] the score bought by someone may not be the score seen by lenders and [4] credit inquiries can show up on a report, even if client is not applying for new credit.
FICO Credit Score Factor and Weight
Explanation
Payment history [35%]
Payment history—bills paid on time and if not, frequency of late payments.
Amount owed [30%]
How much is owed on each account and how much of each credit limit is used.
Credit history [15%]
How old is each account.
New credit [10%]
Number of new accounts or queries.
Types of credit [10%]
Kinds of debt.
A credit score does not reflect income, employment history or assets. It does not show whether rent or utilities are paid on time. Credit bureaus have no idea whether or not someone pays a bill in full or carries a balance each month. All they know is the amount owed on the most recent statement. The biggest concern is how much available credit is being used. Generally, keep credit use to less than half the credit limit to minimize the impact on your credit score. About 30% of a FICO score is based on “credit utilization” (amount owed), a broad term that includes how much of each credit card limit has been used, how much one has borrowed as a percentage of total available credit and how big the dollar balances are; the most important factor of a FICO score (35% of total) is whether or not bills were paid on time. One late payment can ding a score for up to a year; very late payments can impact a score for 2-3 years—collections and bankruptcies can affect a score for up to seven years.
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Closed accounts in good standing will stay on your credit history for a decade. A credit history can go back 30 years. Preserving credit history can be a plus. If you do not formally close an account (but instead let the issuer close it for lack of activity), the longer the account stays open, thereby adding to your credit history. Credit scores are not affected by “soft inquiries” such as being pre-approved for a card or when a credit card company is keeping tabs on your credit. However, in other instances, someone checking your credit, even though you are not applying for a loan, can knock 15 points off a score. Shopping around for a car, education or mortgage loan only counts as one inquiry as long as it is all done within a few weeks. Your clients can see all factors used to determine a score (but not their credit score) for each of the three major reporting agencies for free, once a year, by going to AnnualCreditReport.com.
IMPROVING A CREDIT SCORE There are three main crediting reporting agencies, Experian, Equifax and TransUnion. Reporting agencies are more concerned with how revolving credit (e.g., credit cards) is handled than installment debt (e.g., car loan and mortgage). Listed below are five ways to improve a credit score. 1. 2. 3. 4. 5.
pay bills on time; payment history counts for ~35% of a credit score. lengthen credit history; ~15% of a credit score is based on history. keep credit balances low (25% of available credit if possible); ~30% of a score. minimize credit score requests; ~10% of a score. ask credit reporting agencies to stop unsolicited credit offers.
RETURNS FOR IVY LEAGUE SCHOOLS The returns earned by Ivy League schools such as Harvard and Yale have become legendary in recent years. The stated reason for their success has been a higher-thannormal allocation to “nontraditional” asset categories such as emerging market equity and debt, energy and commodities. For example, as of the middle of 2008, Yale had just 10% allocated to U.S. stocks but 29% to real assets.
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3.5
Most individual investors do not qualify for hedge fund, private equity or venture capital partnerships that make up a large part of university endowments. At Yale, 25% of the endowment was in “absolute return” vehicles such as hedge funds and another 20% in private equity. However, during the 2008 meltdown, a number of endowment managers learned the downside of illiquidity. Exit doors for most private equity and venture capital funds slammed shut. Existing positions stopped yielding cash flow and demands were made to investors for additional capital. A number of investors in these illiquid positions were forced to sell during a weak market to fund cash needs and also to meet prior commitments to these and other investment funds. For the fiscal year ending June 2009, the University of Pennsylvania was expecting to post a 16% drop, Harvard was anticipating a 30% decline and Yale a 25% loss.
EDUCATION VS. HEALTH CARE COSTS According to the chief economist at Moody’s Economy.com, over the 10-year period ending December 31st, 2008, education costs rose 5.9% annually versus 4.2% for health care costs. Over this same period, wages and income rose 3.7% per year. As a side note, The Federal Reserve pointed out that U.S. household net worth dropped by $11 trillion in 2008. This 18% decline equaled the combined GDP of Germany, Japan and the U.K.
MANAGED FUTURES The Barclays CTA Index was up 4% for 2008 and gained an average of 12.2% since 1980, losing money in only three of those calendar years (1980 through 2008). Academic research shows commodity futures have kept pace with inflation and rivaled returns of stocks, with the feature of tending to go up whenever stocks or bonds go down. Despite these appealing features, there are several negatives to futures funds: [1] Many commodity trading advisors (CTAs) charge a 2% annual fee plus 20% of any “new net profit” plus client may have to pay up to 6% “introducing broker” fee (after all, the broker or advisor needs to be compensated) in order to get into the futures fund. [2] Historical figures of CTAs are tainted—they include return results only from those managers who choose to report their returns to industry databases (few, if any, lesserknown advisors are going to report bad numbers). [3] Correlation coefficients with other classes could increase—this often occurs when a new investment idea is embraced by the financial services industry.
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3.6
SAFETY OF LIFE INSURANCE COMPANIES An A.M. Best study spanning 1977 to 2007 found that just 0.06% of insurers with an A++ or A+ grade were impaired one year later, compared to 2.0% of B and B- carriers and 6% of C and C- insurers. Fitch, Moody’s and S&P each have seven variations of an A rating; 47% of insurers have some type of A rating from Fitch, 81% from S&P and 89% from Moody’s. A.M. Best has four different types of A ratings. B grades are even more spread out. Fitch, Moody’s and S&P each use nine versions of B, defined as everything from “good,” “adequate,” “marginal,” “weak,” “questionable,” and “poor.” The table below, based on 2,100 ratings awarded to 809 life insurance companies in early 2009, shows what percentage of the insurers rated received a rating of “excellent.”
Percentage of Insurers Rated “Excellent” # of Insurers Rated
% Rated “Excellent”
Standard & Poor’s
282
81%
A.M. Best
598
66%
Moody’s
140
55%
Fitch
452
47%
TheStreet.com
625
11%
Rating Agency
According to information analyzed by Money Lab and Consumer Reports, “Moody’s and S&P say their rating scales are not necessarily directly comparable with other agencies’ because of differences in data, rating criteria and scoring models.” Fitch says its B+ rating is comparable to Best’s C++. TheStreet.com (formally Weiss Ratings) says its Cequals Best’s B++, S&P’s A+, Moody’s Baa3 and Fitch’s A-. TheStreet.com is the only agency that does not accept payment from any companies it rates. Its research is financed by the sale of guidebooks and reports to investment advisors and libraries. By contrast, 100% of Best’s and Moody’s ratings are paid for by insurers. Fitch and S&P ratings are hybrids; insurers sponsored 44% of Fitch’s ratings and 82% from S&P. Generally, financial strength ratings are based on analysis of an insurer’s balance sheet, capital and reserve ratios and other financial vital signs. The data is mostly from reports insurers file with state regulators plus market data from independent sources. All five of the major services use this objective data in their proprietary “quantitative” analysis models.
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3.7
Analysis from TheStreet.com ends with the analysis described above. The other four agencies meet with an insurer’s management team and learn about the company’s plans. These meetings add an element of subjectivity and create a potential conflict when the insurer pays the rating agency.
COMMODITY STUDIES Roger Ibbotson and Peng Chen (also of Ibbotson & Associates) completed a research paper in 2003-2004 that attempted to discern where hedge fund returns came from. According to Chen (May 2009 interview in Wealth Manager magazine), “two-thirds of the returns are tied to the stock market…We found that hedge funds compared to other money managers are probably a better place to generate alpha, and we still believe that.” One of the earliest academic pieces on commodities was a 2004 Yale University article by Gorton and Rouwenhorst titled, “Facts and Fantasies about Commodity Futures.” Using an equally weighted index of 34 different commodity futures for the period July 1959 to March 2004, the authors concluded, “In addition to offering high returns, the historic risk of an investment in commodity futures has been relatively low—especially if evaluated in terms of its contribution to a portfolio of stocks and bonds.” A March 2004 study commissioned by PIMCO and conducted by Ibboton (“Strategic Asset Allocation and Commodities”) was also quite positive about the use of commodities, “in addition to impressive historical returns, commodities had the lowest average correlation to other asset classes; yet, the positive correlation to inflation supports the idea commodities result in real inflation-adjusted returns.” In September 2006, Harry Kat at City University in London published, “Is the Case for Investing in Commodities Really that Obvious?” Kat believed investors and advisors had a too simplistic approach to supply and demand. According to Kat, “Supply and demand relationships in commodity markets are extremely complex and completely different for different markets; even experts are known to get it very wrong at times.” Kt noted that the 2004 Gorton and Rouwenhorst study (see above) only looked at one specific portfolio—a different portfolio could easily have produced very different results. The Gorton and Rouwenhorst study did not “account for the high degree of heterogeneity in commodities.” Kat also cites a 2006 paper by Erb and Harvey (“What Every Investor Should Know About Commodities”) that pointed out commodities do not offer investors a consistent risk premium.
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3.8
Earlier inflated claims about commodity returns are less frequent, partially due to an indepth study of historical returns of individual commodities and criteria used to produce commodity indices. Opinion is still quite divided over the degree of protection commodities add to a portfolio as well as their reliability as a hedge against inflation. The table below shows correlation coefficients for asset classes over a threeyear period ending December 31st, 2008.
Correlation Coefficients [2006 thru 2008] TIPS
REITs
Commodities
T-bills
Foreign Stocks
TIPS
--
REITs
0.4
--
Commodities
0.4
0.3
--
T-bills
0.2
0.2
0.2
--
Foreign Stocks
0.4
0.6
0.6
0.2
--
Foreign Bonds
0.7
0.3
0.2
0.1
0.4
Foreign Bonds
--
LASTING IMPACT OF LOSSES The table below shows the impact of a portfolio loss of -10% up to -50% and the number of subsequent years needed to recover (assuming positive returns ranging from 2% to 10%).
Recovery Time After a Loss Subsequent Return
Degree of Portfolio Loss -20% -30% -40%
-10%
4%
2.7 years
5.5 years
9.0 years
12.7 years
17.2 years
6%
1.7 years
3.7 years
6.0 years
8.5 years
11.5 years
8%
1.2 years
2.7 years
4.5 years
6.5 years
8.7 years
10%
1 year
2.2 years
3.5 years
5.2 years
7.0 years
-50%
For retired investors, a loss can be particularly painful if periodic withdrawals are being made. Basic studies show that the sequence of annual returns has no impact on ending value, but this is certainly not the case if there are periodic withdrawals. A market drop, coupled with an income withdrawal can compound any such loss.
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FINANCIAL P LANNING
3.9
MONTE CARLO SIMULATION A number of financial advisors have become skeptical about the validity of Monte Carlo simulation: “I take whatever probability of failure that comes out of the simulation and add 20%” (William J. Bernstein, author of The Four Pillars of Investing). Other critics point out that there are no standard assumptions used; Monte Carlo software programs frequently use different assumptions about interest rates, inflation and volatility. A major criticism of this simulation is that its validity is based on an asset’s return being a bell-shaped curve. While a bell-curve model indicates that there is almost no chance of a greater than 13% monthly decline in the S&P 500, such declines have happened at least 10 times since 1926 (e.g., -16.8% in October 2008, but not another such drop until October 1987 when the market returned -21.5%).
HARVARD ENDOWMENT FUND RETURNS For the fiscal year ending June 30th, 2009, the median loss for the typical large endowment fund was -18%, versus 27% for Harvard (for the category “real assets,” which includes commodities and real estate, the annual loss was almost 40%). Harvard’s endowment managed pointed out the fund’s annual return over the previous 10 fiscal years averaged 8.9%.
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3.10
REASONS TO DIVERSIFY The table below shows seven asset categories and the best-performing category for each of the past 25 years (shown in boldface type).
Total Returns: 1984-2008 S&P 500
Small Stocks
EAFE Index
Emerging Markets
U.S. Bonds
Foreign Bonds
1984
6.3%
-7.3%
7.9%
---
---
1985
31.7%
31.0%
56.7%
---
15.1% 22.1%
Cash 9.8%
27.2%
7.7%
1986
18.7%
5.7%
69.9%
---
15.3%
23.0%
6.2%
1987
5.2%
-8.8%
24.9%
---
2.8%
18.4%
5.5%
1988
16.6%
25.0%
27.9%
40.4%
7.9%
4.4%
6.3%
1989
31.6%
16.3%
12.0%
65.0%
14.5%
4.3%
8.4%
1990
-3.3%
-19.5%
-22.7%
-10.6
9.0%
7.8%
1991
30.4%
46.0%
14.0%
59.9%
16.0%
11.2% 16.0%
1992
7.6%
-11.0%
11.4%
7.4%
5.8%
3.5%
1993
10.1%
18.4% 18.9%
34.9%
74.8%
9.7%
11.1%
2.9%
1994
1.3%
-1.8%
-7.3%
-2.9%
0.2%
3.9%
1995
37.5%
28.4%
6.6% 9.9%
-5.2%
18.5%
19.7%
5.6%
1996
22.9%
16.5%
6.7%
6.0%
3.6%
4.9%
5.2%
1997
33.3%
22.4%
2.0%
-11.6%
9.6%
3.8%
5.3%
1998
-2.5%
14.5%
-25.3%
8.7%
13.7%
4.9%
1999
28.6% 21.0%
21.3%%
30.9%
66.4%
0.8%
-5.2%
4.7%
2000
-9.1%
-3.0%
15.1%
30.6%
11.6%
3.2%
5.9%
2001
-11.9%
2.5%
19.5%
-2.4%
8.4%
1.6%
3.8%
2002
-22.1%
-20.5%
14.7%
-6.0%
10.3%
1.6%
2003
28.7%
47.2%
41.4%
56.3%
4.1%
16.5% 12.5%
2004
10.9%
18.3%
21.4%
25.9%
4.3%
9.3%
1.2%
2005
4.9%
4.5%
17.1%
34.5%
2.4%
-4.5%
3.0%
2006
15.8%
18.4%
27.2%
32.6%
4.3%
6.6%
4.8%
2007
5.5%
-1.6%
17.1%
39.8%
7.0%
9.5%
4.7%
2008
-37.0%
-33.8%
-45.2%
-53.2%
5.2%
4.8%
1.7%
5.6%
1.0%
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3.11
MONEY MANAGER RANKINGS The table below shows the 10 biggest asset managers at the end of 2008. Barclays was acquired by BlackRock in late 2009 (meaning Blackrock was the largest money management company at the end of 2009); asset numbers represent billions of U.S. dollars (source: Pensions & Investments).
12-31-08 Largest Money Managers Manager
Market
Total Assets
U.K.
$1.52b
Germany
1.47b
State Street Global
U.S.
$1.44b
Fidelity Investments
U.S.
$1.39b
AXA Group
France
$1.38b
BlackRock
U.S.
$1.31b
Germany
$1.15b
Vanguard Group
U.S.
$1.14b
J.P. Morgan Chase
U.S.
$1.14b
Capital Group
U.S.
$0.98b
Barclays Global Investors Allianz Group
Deutsche Bank
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Annuities
4.1
4.ANNUITY
SALES New Variable Annuity Sales [ranking and market share percentage: 1st Quarter 2009]
Rank / Insurer
%
Rank / Insurer
%
[1] MetLife
13%
[11] AIG
4%
[2] TIAA-CREF
12%
[12] Pacific Life
3%
[3] AXA Financial
10%
[13] Nationwide Life
3%
[4] Prudential Financial
7%
[14] Hartford Life
2%
[5] John Hancock Life
7%
[15] U.S. units of Aegon
2%
[6] U.S. units of ING
6%
[16] Sun Life of Canada
2%
[7] Lincoln National
6%
[17] Fidelity Investments
2%
[8] Jackson National
5%
[18] Ohio National Life
1%
[9] Ameriprise Financial
4%
[19] Mass Mutual Life
1%
[10] Allianz Life
4%
[20] Thrivent Financial
1%
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Stocks and Bonds
5.BEAR
5.1
MARKET BENEFITS
Ask your clients, “Would you rather start investing during a bull or bear market? A 2009 T. Rowe Price study shows that those who began to systematically invest in equities during past severe bear markets were significantly better off 30 years later than investors who began during bull markets. The study looked at four hypothetical investors who each invested $500 per month into a retirement account that mimicked the S&P 500 over a 30-year period (dividends reinvested). One investor started in 1929, one in 1950, another in 1970 and the fourth investor began in 1979. The two bear market investors who began making contributions in 1929 and 1970 started just before two of the worst market declines in modern history. From 1929 through 1938, the S&P averaged -0.9% per year; +5.9% per year during the 1970s. Each of these investors made contributions that totaled $60,000 ($500 x 12 months x 10 years). By the end of 1938, the first bear market investor had $88,255; the second bear market investor had $86,047 by the end of 1979. The two bull market investors, who also had cumulative investors of $60,000, ended up with $152,359 (1950-1959) and $137,370 (1979 through 1988), a 19.4% and 16.3% annualized S&P 500 return. Despite the initial advantage the two bull market investors experienced, cumulative returns at the end of 30 years (the initial 10 years cited above plus 20 more years) favored the bear market investors because they acquired more shares during the bear market periods. Even though the 1930s marked the beginning of the worst 30-year period for stocks, the S&P 500 averaged an annualized 8.5% from 1929 to 1958. Over this 30-year period, the market was up 960%. The other bear market investor (who started in 1970 had a 30-year total return of 1,753%). In contrast, the two bull market investors (who began in 1950 and 1979) each earned less than 400% over 30 years.
STOCKS VS. BONDS Over the past half century, the best year for stocks was 1975 (+37% for the S&P 500); the worst year was 2008 (-37%). By contrast, the best year for bonds was 1982 (+36%), while the worst year was 1999 (-6%). The Reuters/Jefferies CRB Index, the oldest global commodities index had annualized returns of 8.6% for the 10 years ending 12/31/2008. Over the past 200 years, stocks have beaten bonds by 2.5 percentage points a year, with half of that advantage occurring 1949-1965, according to Rob Arnett of Research Affiliates. QUARTERLY UPDATES
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5.2
MARKET CAP FOR S&P 500 STOCKS At the end of 2008, Standard & Poor’s lowered market capitalization guidelines used for a number of its indexes. The cut-off capitalization for a stock to be considered in the S&P 500 is now $3 billion or greater; $750 million to $3.3 billion for the S&P MidCap 400 and $200 million to $1 billion for the S&P SmallCap 600.
INDEXED CDS Indexed CDs have been around for two decades, with annual sales in the $2-3 billion range. The investment is issued by banks and typically sold by financial planners and brokers. Investors who cash out early can lose money. During the third quarter of 2009, Barclays Bank offered an indexed CD based on the S&P 500 with a five-year term. The CD owner will earn up to 50% of the S&P 500’s gain; if the S&P 500 has a cumulative loss over the five-year period, the investor gets back 100% of principal. Some indexed CDs have what are called “barriers” or “knock out rates.” These terms, found in the CD contract, can limit the investor’s return. For example, suppose your client bought a CD tied to the S&P 500 with a 60% “barrier.” If the S&P had a cumulative gain that ever exceeded 60%, the investor would end up getting back just principal. If the term of the contract was five years, this means that if the S&P was up a total of 60.01% after 19 months, the client would have to wait another 41 months to get back his principal (there would be no gain since the barrier was breached at some time during the contract’s term). Besides carefully reading the CD contract, the advisor needs to discern how the underlying index’s value is measured as the market goes up and down. Some CDs used average quarterly or annual returns; others use a more straightforward “point to point” method. Some indexed CDs base their returns on two or more indexes. Indexed CDs are not tax efficient and are best owned in a sheltered account. The investor is taxed each year on “phantom” income, which in the case of an indexed CD is generally a small predetermined amount listed in the CD’s disclosure statement. Indexed CDs are generally FDIC insured (principal and interest) up to $250,000 per account.
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5.3
HISTORICAL P/E RATIO According to Morgan Stanley, since 1984, the S&P 500 has had an average trailing p/e ratio of 16.9; from the beginning of 2007 through the third quarter of 2009, the p/e has ranged from just under 11 (toward the end of 2009) to about 15 (middle of 2007). Based on a “forward” p/e (12 month forecast), the p/e was 14.7 as of the end of September 2009, just below the 25-year average (1984-2009) of 14.9. Surprisingly, low expected earnings per share (EPS) usually translate into higher stock returns. The Ned Davis Research table below covers the period from the beginning of 1980 through February 2009. As you can see, when expected EPS is high, returns have suffered. Expected EPS Growth
S&P 500 Gain Per Year
> 14.2%
-3.4%
4.2% to 14.2%
6.5%
< 4.2%
11.7%
Buy/hold
6.8%
SECURITIES LENDING Securities lending allows a fund to make money on its stocks and bonds, without having to sell them, by lending them out and earning interest. Borrowers post cash collateral of 102-105 cents on the dollar. According to Data Explorers, securities lending generated about $1.4 billion in gross income for the U.S. mutual fund industry in 2008. The lending firms earn more by taking the interest payments and reinvesting them. It is estimated that securities lending can add up to 1/4th of 1% of a funds annual return; in the case of small stock funds, the “bonus money” can add a full percentage point. Some fund managers, acting as lending agent, keep 50-100% of the income generated from the lending. Other firms, such as T. Rowe Price and Vanguard rebate 100% of all securities lending money back to the funds that generated it. Revenue bonds are secured by a public service or enterprise, such as a water or sewer utility. For core, essential services, revenues for these types of bonds have generally remained strong. While history is not a perfect future guide, consider:
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5.4
I BOND PAYMENTS Series I Savings Bonds (I bonds) investors will earn 0% for the first months of 2010, the first time this has happened since 1998. I bonds, which all have a maturity of 30 years, are comprised of two parts: a fixed rate (set at 0.10% by the Treasury for new issues that are purchased during the middle of 2009 and last for the bondâ&#x20AC;&#x2122;s life, and the inflation rate as measured by the CPI. For the September 2008 to March 2009 period, the inflation rate was an annually adjusted -5.6%. The interest rate credited to I bonds cannot fall below zero (source: www.savings-bond-advisor.com and Bankrate.com).
HOW BOND FUNDS LET INVESTORS DOWN In theory, bond funds should be a haven from bear markets in stocks. The most widely used investment-grade bond market benchmark, the Barclays Capital Aggregate Index (formally the Lehman Aggregate) gained 5.2% in 2008. But what about the first five months of 2009? For the first five months of 2009, the average intermediate-term bond fund lost 4.7%; excluding the top 5% performers (-3.5%), funds in the bottom 95% lost an average of 20.7%. The reasons the losses were so steep was many intermediate-term bond funds held risky bonds. The Barclays (Lehman) index is only comprised of investment-grade debt issues. Since 1999, there has only been one year (2003) when the average fund topped the index.
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Retirement
6.FUNERAL
6.1
SHOPPING
The Federal Trade Commission spells out your clients’ rights involving funerals on its Web site (ftc.gov and type “funerals” in the search box). Advisors should recommend their clients compare prices from at least two funeral homes. Another useful site is the nonprofit Funeral Consumers Alliance (100 local chapters). AARP has detailed articles on how to shop for a funeral and burial arrangements.
MAXIMIZING SOCIAL SECURITY BENEFITS If someone needs extra money between the ages of 62 and 70 and the only choice is either taking Social Security benefits or tapping tax-deferred retirement accounts, the decision may largely depend upon what can be earned in the tax-deferred accounts. The higher the return, the more sense it makes to take Social Security benefits either early or at one’s normal retirement age. Generally, if the tax-deferred return is above 5%, taking Social Security is the better option. Roth IRA withdrawals are not included as income when determining the taxation of Social Security benefits. However, taxable money withdrawn from a traditional IRA or other tax-deferred account is included.
ROTH CONVERSIONS As of January 1st, 2010, individuals may convert their traditional IRA into a Roth IRA, regardless of how much money they earn. Before 2010, those with modified adjusted gross incomes of $120,000 ($176,000 if a joint return) could not make the conversion. Taxpayers can either report the conversion amount as income for the year of conversion or spread out the tax liability over the subsequent two years—if the conversion is done in 2010. For example a $50,000 conversion made in 2010 could either be reported as $50,000 of additional income for 2010 or $25,000 of income for 2011 and $25,000 for 2012. If a conversion is made any year other than 2010, taxes must be paid for the year of conversion. Generally, it does not make financial sense to make a Roth conversion if the tax liability is paid from money inside the traditional IRA.
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Retirement
6.2
REVERSING A ROTH IRA CONVERSION You may have clients who converted a traditional IRA into a Roth IRA and subsequently experienced a moderate-to-severe market loss in the newly created Roth IRA. Such an event would result in an ordinary income tax liability on the converted amount even though the client later experienced a drop in value. By reversing a Roth IRA conversion, you can help the client eliminate any inflated conversion tax bill. Your clients have until October 15th (of the year of conversion) to reverse the conversion. The deadline is applicable whether or not the taxpayer extended the filing date of their tax return to October 15th. When a traditional IRA is converted, the IRA custodian or trustee reports such information on IRS Form 1099-R. When a traditional IRA is converted into a Roth, the taxpayer pays ordinary income taxes on the entire amount converted—but such tax liability assumes the investor converted all traditional IRA accounts. If your client holds multiple IRAs, the taxable percentage is based on the total balance of all traditional IRAs. If a converted account is reversed (the IRS uses the term “recharacterization”), the tax hit disappears. A taxpayer must wait at least 30 days after conversion before the reversal (recharacterization) can occur.
DISABILITY INSURANCE According to the U.S. Commerce Department, one in seven workers can expect to be disabled for five years or more before they retire; one in five will suffer a disability lasting a year or more, according to the National Association of Insurance Commissioners. Three in 10 workers who enter the work force today will become disabled before retiring. Of the more than 6.8 million workers receiving Social Security Disability benefits (which average $1,000 a month), half are under age 50. To qualify for such Social Security insurance, one must be disabled for five calendar months and have a disability expected to last for a total of at least 12 months or otherwise end in death. The disabled person must also be unemployable at any occupation, not just his or her own line of work. The National Safety Council gauges that 90% of disability accidents and injuries are not work-related and, therefore, not covered by workers compensation. One disability reinsurer (JHA) believes 90% of disabilities are caused by illness, vascular problems, musculoskeletal conditions and cancer are among the medical causes of most disabilities, with pregnancy an additional factor for women.
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Retirement
6.3
According to Harvard University, medical disability led to nearly half of the 1.5 million bankruptcy filings in 2001. An earlier study by the Housing and Home Finance Agency found that 48% of home foreclosures were the result of disability while just 3% resulted from the homeownerâ&#x20AC;&#x2122;s death.
Top 6 Causes of Long-Term Disability [source: JHA Disability Fact Book, 2008] Musculoskeletal 27%
Cancer 10%
Circulatory System 13%
All Other 9%
Nervous System Disorder 12%
Injury / Poisoning 13%
Top 6 Causes of Short-Term Disability [source: JHA Disability Fact Book, 2008] Musculoskeletal 22%
Pregnancy (complicated) 8%
Injury / Poisoning 13%
Cancer 8%
Pregnancy (normal) 12%
All Other 8%
Types of Disability There are two types of disability income (DI): short- and long-term. Short-term DI insurance typically pays a percentage of salary for 13-52 weeks after a short waiting (elimination) period, such as one day for an accident and eight days for an illness. Longterm DI kicks in after the short-term policy has expired. The percentage of salary payments is generally in the 50-67% range. The checklist below can help your client compare different disability policies (source: American Council of Life Insurers). [1] How is disability defined? Some benefits are based on any occupation while others are based on own occupation (a more expensive policy). [2] How will benefits be paid? Some policies make payments if you can only do part of your job; others pay benefits if you are unable to work full time. [3] What is the policyâ&#x20AC;&#x2122;s elimination period? Almost all policies have a waiting period before benefits commence. [4] Are benefits paid if the disability results in less income? Some policies will pay the difference between what you are earning now versus pre-disability.
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Retirement
6.4
[5] Is there a return-to-work or rehabilitation provision? Some policies help pay for training or work environment modification. [6] Is there a new waiting period if there is a reoccurring disability? If there is a relapse within a specified period after returning to work, most policies will not require an additional waiting period. [7] Is there a cost-of-living adjustment (COLA)? A COLA provision ensures increased payments in the future (but policy premiums are much higher). [8] What about mental illness or substance abuse? Policies usually limit payments for such disabilities to two years unless institutionalization is required. [9] Is the policy non-cancellable and/or guaranteed renewable? A non-cancellable policy means premiums can never be decreased. Guaranteed renewable means premiums can only increase for the entire class, not a specific individual. Both of these types of policies can usually be renewed until age 65 and cannot be cancelled as long as premiums are paid.
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7.HOUSING
7.1
DECLINES
The table below show percentage decline in home prices by city from the June 2006 peak through June of 2009 (source: S&P/Case-Shiller); 32% of all mortgages have negative equity, meaning property is worth less than its out-standing debt (source: 1st American CoreLogic).
Housing Percent Decline [6-2006 through 6-2009] City
Decline
City
Decline
Las Vegas
- 54%
Washington D.C.
- 31%
Miami
- 48%
Chicago
- 25%
San Francisco
- 43%
New York
- 21%
Los Angeles
- 41%
Boston
- 14%
San Diego
- 41%
Denver
- 9%
HISTORY OF AMERICAN HOME OWNERSHIP From 1900, when the U.S. census first started gathering data on home ownership, through 1940, fewer than half of all Americans owned their own homes. Home ownership actually fell in three of the first four decades of the 20th century. But from that point forward (with the exception of the 1980s, when interest rates were extremely high), the percentage of Americans living in owner-occupied homes steadily increased. Today, more than two-thirds of Americans own their own homes. Among whites, more than 75% are homeowners today. We are a nation of homeowners and home speculators because of Uncle Sam. Before the Great Depression, the government played a minuscule role in housing (the 1913 federal tax code allowed a deduction for home mortgage interest payments). Until the 20th century, holding a mortgage came with a stigmaâ&#x20AC;&#x201D;you were a debtor. Mortgages were also hard to come by. Lenders typically required 50% or more of the purchase price as a down payment. Interest rates were high and terms were short, usually 3-5 years. Home ownership was largely divided between the wealthy (who paid cash) and working class folks who built their own homes because they could not afford a mortgage. The Depression changed every-thing. Between 1928, the last year of the boom, and 1933, new housing starts fell 95%. Half of all mortgages were in default.
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7.2
Herbert Hoover signed the Federal Home Loan Bank Act of 1932, laying the groundwork for massive federal intervention in the housing market. In 1933, Roosevelt created the Home Ownersâ&#x20AC;&#x2122; Loan Corporation to provide low interest loans to help out foreclosed homeowners. In 1934, F.D.R. created the Federal Housing Administration, which set standards for home construction, initiated 25- and 30-year mortgages and cut interest rates. In 1938, his administration created the Federal National Mortgage Association (Fannie Mae), which created the secondary market for mortgages. In 1944, the federal government extended generous mortgage assistance to returning veterans. Easy credit, underwritten by federal housing programs, boosted homeownership rates; by 1950, 55% of Americans owned a home. By 1970, the figure had risen to 63%. It became cheaper to own than rent. Federal intervention also unleashed vast amounts of capital that turned home construction and real estate into critical economic sectors. By the late 1950s, for the first time, the census bureau began collecting data on new housing starts. During the 1960s and 1970s, those who had been excluded from the postwar housing boom were aided by the newly created Department of Housing and Urban Development, which expanded ownership to minorities. The 1976 Community Reinvestment Act forced banks to channel resources to underserved neighborhoods. Activists successfully pushed Fannie Mae to underwrite loans to buyers once considered too risky for conventional loans. During the late 1990s and the first years of the new century, the dream of homeownership turned hallucinogenic. The Clinton and Bush administrations engaged in the biggest promotion of homeownership in decades. Both pushed for public-private partnerships, with HUD and government-sponsored financiers such as Fannie Mae. New tools, including securitization of mortgages and subprime lending, made it possible for even more Americans to live the dream.
REIT DEBT In recent years, equity REITs pursued higher leverage to boost profits. The greater the debt, the higher the risk; companies with less debt are less volatile. From 1996 through the first quarter of 2009, REIT leverage as a percentage of asset value went from 40% to 75%. Debt as a percentage of net operating income went from a ratio of 4-1 to just over 6-1.
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7.3
Milton Cooper, often credited with starting the modern REIT era when he took retail landlord Kimco Realty public in 1991, stated, “Very little can go wrong with 25% debt; I’d love to see the (REIT) industry not get seduced by leverage.” Public Storage’s leverage was 27% during the first part of 2009. Analysis by Green Street showed that of the 29 major REITs studied, Public Storage had the best track record, delivering an average annual return of 15% to investors over the 15 years ending December 31st, 2008. Green Street found that during those 15 years, every one percentage point increase in leverage was accompanied by a 0.4% decrease in annual returns for equity REITs in general.
REAL ESTATE FUND UPDATE As of the middle of 2009, the biggest real estate funds were Vanguard REIT Index, Fidelity Real Estate Investment, T. Rowe Price Real Estate, DFA Real Estate Securities and Russell Real Estate Securities. The largest real estate mutual funds own a wide variety of commercial real estate such as office space, storage facilities, shopping malls, medical and industrial buildings. The funds own shares of big, publicly traded REITs such as Simon Property Group, Public Storage Equity Residential, Vornado Realty Trust and AvalonBay Communities. The largest real estate ETFs include: iShares Dow Jones U.S. Real Estate Index, iShares Cohen & Steers Realty Majors Index, SPDR Dow Jones REIT and Vanguard REIT ETF. Some advisors view equity REITs almost like a bond holding, since the category has historically provided a high dividend stream. Other advisors feel the category’s 1.5 beta makes it a riskier-than-normal consideration.
HOUSING MARKET UPDATE (FALL 2009) Based on the 10- and 20-city S&P/Case-Shiller Home Price Indices, housing prices peaked in June or July 2006. From their peak to April 2009, these two indexes were down 34% and 33% respectively. As of September 2009, S&P estimated that there were still about one-third more existing homes for sale than average.
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7.4
EXPENSIVE U.S. HOUSING MARKETS The table below shows the most expensive housing markets in the nation, based on the average price paid for a 2,200-square-foot, four-bedroom home for the first three quarters of 2009. For the second year in a row, La Jolla topped the list; the lowest price similar home sold for $113,000 and was located in Grayling, Michigan (source: Coldwell Banker Real Estate).
2009 Most Expensive U.S. Housing Markets Market
Change From 2008
Average Price
La Jolla (San Diego), CA
+17%
$2,125,000
Beverly Hills, CA
+11%
$1,982,000
Greenwich, Conn.
-15%
$1,519,000
Palo Alto, CA
-14%
$1,490,000
Santa Monica, CA
-12%
$1,461,000
San Francisco, CA
-10%
$1,363,000
Boston
-10%
$1,338,000
Newport Beach, CA
-15%
$1,316,000
Palos Verdes, CA
-4%
$1,237,000
San Mateo, CA
-20%
$1,090,000
REVERSE MORTGAGES As of February 2009, the maximum home value that seniors can borrow against for a reverse mortgage increased from $417,000 to $625,500. Congress also passed a 2% cap on the first $200,000 and 1% on any amount over that, with fees not to exceed $6,000. Other upfront costs include an insurance premium and closing costs.
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