IBF - Updates - 2010 (Q2 v1.0)

QUARTERLY UPDATES Q2 2010

Copyright Š 2010 by Institute of Business & Finance. All rights reserved.

v1.0

Quarterly Updates Table of Contents ANNUITIES ANNUITY NON-NATURAL PERSON RULE ANNUITY PROVIDER SELECTION CLARIFIED ANNUITY HISTORY NATIVE AMERICANS AND ANNUITIES SAVINGS AND RETIREMENT YEARS DIRE RETIREMENT PREDICTIONS REMOVING IRA FUNDS PENALTY-FREE WITHDRAWAL PENALTY FAVORS ANNUITIES CHARITABLE GIFT ANNUITIES IRS GUIDELINES ON PARTIAL 1035 EXCHANGES

1.1 1.2 1.5 1.6 1.7 1.8 1.9 1.11 1.13 1.17

FINANCIAL PLANNING FINANCIAL AID RETHINKING HOME OWNERSHIP

2.1 2.2

MUTUAL FUNDS MONEY MARKET FEES TARGET DATE FUNDS

3.1 3.1

BONDS RECENT MUNICIPAL DEFAULT RATE BOND YIELDS AAA-RATED CORPORATE BOND DECLINES 2009 JUNK BOND DEFAULT RATES

4.1 4.1 4.1 4.2

ETFS ETFS AND THE FLASH CRASH

5.1

RETIREMENT PLANNING PRESENT VALUE OF SOCIAL SECURITY PAYMENTS REASONS TO WORK AT AGE 67 MONTHLY SOCIAL SECURITY BENEFITS GENERATING LIFETIME INCOME

6.1 6.1 6.2 6.4

ECONOMICS WORLD’S LARGEST ECONOMIES [JUNE 2010]

7.1

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NON-NATURAL PERSON RULE

The "non-natural" person rule used in the Tax Reform Act of 1986 has consequences for trust-purchased annuities that had remained somewhat unclear. The IRS, in a private letter ruling released in 2009, examined application of the non-natural person rule in the case of a trust with invested assets in a single premium deferred variable annuity.

Reaching an outcome generally favorable to those involved with annuities, the Service concluded the rule, which would disallow a trust from reaping the annuity tax benefits to which an individual annuitant is entitled, does not apply.

In the ruling request an individual, whom we will call Mr. White, died leaving a will providing a certain portion of property be placed in a trust. Trust terms required the trustee to divide property in separate shares for each remainderman and that, if the life beneficiary survived Mr. White, the income from each share would be distributed to the life beneficiary. We will call the life beneficiary Mr. Green.

The trustee wished to invest some trust assets in a single premium individual deferred variable annuity of which Mr. Green, the trust life beneficiary, would be the annuitant; the trust itself to be trust owner and beneficiary.

Found in Section 72(u) of the Code, the non-natural person rule states that if a contract is held by a person who is not a natural person (e.g., "non-natural" person), it is not treated as an annuity contract for tax purposes. Generally, this means income (growth) is treated as ordinary income to the contract owner. If the non-natural person rule applies, the annuity holder loses the income tax deferral on the interest earned inside the annuity contract and must include this amount in income each year.

Congress created an exception to the non-natural person rule. Generally, the non-natural person rule was put in place as part of the Tax Reform Act of 1986, in order to curb perceived abuses, primarily by corporations, of the income tax-free treatment of interest accumulating in a contract. Prior to the 1986, it was thought that nonqualified annuity contracts were being purchased by corporations in order to provide tax-deferred funding for nonqualified deferred compensation plans, a type of benefit plan which typically is available to top executives. The exception to the non-natural person rule states an annuity contract held by a trust or other entity as an agent for a natural person is considered to be held by a natural person.

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In determining the trust in the private letter ruling was not subject to the non-natural person rule, the Service looked to the legislative history of Code section 72(u). This history states an annuity contract will be considered owned by a natural person if the nominal owner is not a natural person (such as a corporation or a trust) but the beneficial owner of the annuity contract is a natural person.

The Service concluded even though the trust is the owner of the variable contract, it is a nominal owner as compared to Mr. Green, the life beneficiary, and the trust remaindermen. The trust is the nominal owner but Green and the remaindermen are beneficial owners. This particular letter ruling involved a fact situation in which the same individual (a natural person) was the sole life trust beneficiary and the sole annuitant under the annuity contract.

It is interesting to consider whether the Service would have reached the same conclusion if the trust's life income beneficiary and the annuitant were not the same person or if the trust had several life income beneficiaries but only one was named as the annuitant.

ANNUITY PROVIDER SELECTION CLARIFIED Interpretive Bulletin No. 95-1, issued on March 6, 1995 by the Department of Labor (DOL), outlines the DOL's perspective on the standards to govern [under the Employee Retirement Income Security Act (ERISA)] a plan fiduciary's selection of an insurance carrier when purchasing annuities for the purpose of distributing benefits under an employee pension benefit plan.

One way a qualified pension or profit-sharing plan extinguishes its liability to a plan participant is by purchasing a "qualified distributed annuity" contract. Purchasing the annuity from an insurance carrier rather than paying proceeds directly out of plan assets has generally been the favored approach for most qualified plans due to the increased ease of operating the plan. Regulations issued by the DOL explicitly recognize a transfer of liability from the qualified plan when such an annuity is purchased from an insurance company licensed to do business in the given state.

Qualified distributed annuity contracts mirror the provisions of the qualified plan as to the normal form of benefit payable (i.e., Life Only, Life and Ten-Year Certain, or Qualified Joint and Survivor Annuity, etc.) as well as provide the actual amount accrued under the plan and payable under the annuity. Such annuities may be immediate or deferred.

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Generally, distributed annuity contracts may be purchased for participants and beneficiaries in connection with the termination of a plan, or in the case of an ongoing plan, annuities might be purchased for participants who are retiring or separating from service with vested accrued benefits payable at some future date (the annuity starting date).

The DOL maintains the purchase of annuities to satisfy a plan's liability to participants is a fiduciary decision. As such, ERISA requires a fiduciary to act with the care, skill, prudence and diligence under the prevailing circumstances a prudent person acting in a like capacity would use. In addition, the fiduciary must act for the exclusive purpose of providing benefits to participants and beneficiaries and defraying reasonable plan administration expenses as well as discharge their duties with respect to the plan solely in the interest of the participants and beneficiaries.

Bulletin No. 95-1 states a plan fiduciary choosing an annuity provider for the purposes of making a benefit distribution must take steps to obtain the safest annuity available, unless under the circumstances, it would be in interests of plan participants and beneficiaries to do otherwise. The plan fiduciary should conduct an objective and thorough analytical review designed to select the "safest available" annuity provider. Of particular note as of the current date, Courts have not defined by ruling the "safest available" standard other than through several lawsuits brought by the DOL against a number of employers who purchased Executive Life annuities after terminating their over-funded pension plans.

Relying solely on ratings provided by insurance rating services would appear to not be sufficient to meet the standard. In searching for an annuity provider, fiduciaries must evaluate a number of factors including: 1.

2.

3.

4.

Quality and diversification of annuity provider's investment portfolio Size of the insurer relative to the proposed contract Level of the insurer's capital and surplus Lines of business of the annuity provider and other indications of an insurer's exposure to liability 5. Structure of the annuity contract and guarantees supporting the annuities, such as the use of separate accounts 6. Availability of additional protection through state guaranty associations and the extent of those guarantees 7. Strength of any parent or affiliated company of the annuity provider

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Costs and Other Considerations Situations may develop in which it is in the best interest of participants and beneficiaries to purchase an annuity not necessarily the safest available annuity. Such costs and considerations that might influence the purchase of a competing annuity that is not necessarily the safest available are: 1. Safest available annuity is only marginally safer, but disproportionately more expensive than competing annuities.

2. Participants and beneficiaries are likely to bear a significant portion of increased costs when the marginally safer annuity is purchased rather than the competing annuity.

3. Annuity provider offering the safest available annuity is unable to demonstrate the ability to administer payment of benefits to participants and beneficiaries.

According to the DOL Bulletin, a fiduciary's decision to purchase more risky, lowerpriced annuities to ensure a reversion of excess assets paid solely to the employersponsor in connection with the termination of an over-funded pension plan, would violate the fiduciary duties under ERISA to act solely in the interest of the plan participants and beneficiaries.

A fiduciary may not purchase a riskier annuity solely because there are insufficient assets in a defined benefit plan to purchase a safer annuity. In this situation, the fiduciary may have to condition the purchase of annuities on additional employer contributions sufficient to purchase the safest available annuity.

Special care should be taken in reversion situations where fiduciaries selecting the annuity provider have an interest in the sponsoring employer (i.e., where the trustee is the plan administrator and the employer). This relationship may be considered a conflict of interest, which might affect their judgment and therefore create the potential for violation of the ERISA prohibited transaction rules.

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ANNUITY HISTORY Annuities, in one form or another, have been around for over two thousand years. In Roman times, speculators sold financial instruments called annua, or annual stipends. In return for a lump sum payment, these contracts promised to pay the buyers a fixed yearly payment for life, or sometimes for a specified period of term. The Roman Domitius Ulpianus was one of the first annuity dealers and is credited with creating the first life expectancy table.

During the Middle Ages, lifetime annuities purchased with a single premium became a popular method of funding the nearly constant war that characterized the period. There are records of a form of annuity called a tontine. This was an annuity pool in which participants purchased a share and, in turn, received a life annuity. As participants died off, each survivor received a larger payment, until finally, the last survivor received the remaining principal. Part annuity, part lottery, the tontine offered not only security but also a chance to win a handsome jackpot.

During the 18th century, many European governments sold annuities that provided the security of a lifetime income guaranteed by the state. In England, Parliament enacted hundreds of laws providing for the sale of annuities to fund wars, to provide a stipend to the royal family and to reward those loyal to it. Fans of Dickens and Jane Austen will know that in the 1700s and 1800s, annuities were all the rage in European high society.

Annuities owed this popularity among the upper class to the fact they could shelter annuitants from the "fall from grace" that occurred with investors in other markets.

The annuity market grew very slowly in the United States. Annuities were mainly purchased to provide income in situations where no other means of providing support were available. Few people saw the need for structured annuity contracts to guarantee themselves an income if they could rely on support from their extended families.

Annuities were mostly purchased by lawyers or executors of estates who needed to provide income to a beneficiary as described in a last will and testament.

This all began to change at the turn of the 20th century, as multi-generational households became less common. The Great Depression was especially significant in the history of annuities. Until then, annuities represented a miniscule share of the total insurance market (only 1.5% of life insurance premiums collected in the US between 1866 and 1920).

During the Great Depression, investors sought out more reliable investments in order to safeguard themselves from financial ruin. With the economy less stable than it had ever been, many individuals looked to insurance companies as a haven of stability in what seemed a sea of anything but.

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NATIVE AMERICANS AND ANNUITIES Throughout the 1800s, annuities played a big role in Native Americans losing their lands to the U.S. Government. During this period it was quite common for the government to entice Indians into trading their vast lands for trinkets and guaranteed annuities, often at rates constituting gross underpayment. The tribes were forced into smaller areas, where their only real income was those annuities. When the Native Americans needed additional money to purchase food and clothing, they could only buy from certain Government-approved traders, who would extend credit to the Indians.

As the Indians' debts to these traders increased, the tribes were forced to sell more land to cover their loans. In one instance, the Governor of Indiana, which was then a territory, settled seven treaties in four years with First Nations in southern Indiana, Wisconsin, Missouri and Illinois. Natives sold their land for what amounted to two cents an acre (in some cases less), paid in guaranteed annuities. Historians generally agree the First Nations, in this and many other cases, were deceived in selling at this price.

Land treaties signed by the First Nations are, technically speaking, legitimate legal documents. They received goods, annuities or a sum of money in return for a parcel of land. Later, however, these seemingly legitimate exchanges left many native peoples aggrieved and bewildered, as they had never truly understood what they were selling. To them, there was no such thing as private property, so it is likely they were unaware they would no longer be able to use the land after they sold it. To make matters worse, treaties were often negotiated under duress. Native leaders were bribed and softened up with alcohol, and when that did not work, threats were often made to stop payments on annuities from past treaties. Whenever these strategies failed, the U.S. Government was also not averse to sanctioning militant efforts to force the Native Americans off their lands.

As time went on, a number of Native American tribes became increasingly dependent on annuity payments, compelled to sell more and more land to the federal government. In a span of 14 years the Potawatomi tribe, for one, signed six land treaties, which resulted in the tribe giving up large swaths of land in Illinois, Michigan, Wisconsin and Indiana.

Instead of turning against the government, this tribe from the Chicago area became so reliant on annuities they would do anything to protect their flow of payments. This included acting as peacemakers on behalf of the government when, in 1827, their kindred Winnebago tribe from southern Wisconsin threatened to rise up against white settlers.

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SAVINGS AND RETIREMENT YEARS The number of years savings can be expected to last is a question worrying many current and soon-to-be retirees. The answer hinges on a number of issues, including how much annual income needed, what inflation does in the future and, most importantly, how long you will live. Researching life expectancy is one way to fill in this blank in their retirement plans. But how is life expectancy calculated and should you put much reliance on it when planning for the future?

Averages Life expectancy can be defined as the average age at which a group of people of the same age and gender are likely to die. It is determined by taking all the ages at which the people in a group are likely to die and then averaging them. Half will die by that age and half will live past it.

The most important thing to remember about life expectancy is it does not lock in at birth. As you get older, the age which you are expected to live gets higher because the people in your age group who have died are no longer counted in the equation. For that reason, you cannot just check your life expectancy at age 65 and base your planning on that for the rest of your life. For example, the life expectancy at birth for males born in 1931 was 59. Those who lived to age 30 then had a life expectancy of 67. At 65, those remaining can no anticipate living not two but 12 more years to age 77. And once they reach 70, life expectancy increases to 79.

Life Expectancy Tables Tables showing life expectancies for various groups are used by employers to figure pension benefits, by insurance companies to sell life insurance and annuities, and by taxpayers who are following IRS rules for computing minimum distributions from retirement plans. No two life expectancy tables will be exactly alike. Their data depends on when and how the tables were created, where the death rates came from and whether they have been adjusted to make them more current.

For example, some companies still use the "83 GAM" table to calculate how much they need to provide their retirees with a lifetime of monthly pension payments. 83 GAM is based on 1966 data, which was updated with projections to 1983. Other companies use the newer UP-94 table, recommended by the Society of Actuaries, which shows significant increases in life expectancies at most ages. The UP-94 table projects men age 55 will live to age 80 and women to 84½. And someone who is 80, according to the table, can look forward to another 8-10 years of life.

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Plan for Your 90s Life expectancy figures are conservative. According to Dr. Kenneth Manton at Duke University's Center for Demographic Studies, individuals who do not smoke, maintain a healthy weight and keep their blood pressure and cholesterol under control with diet and exercise could live 10-15 years longer than current tables project. If longevity runs in your family, your odds are even better. Unless you have life-threatening health problems, plan on living into your 90s.

DIRE RETIREMENT PREDICTIONS The American Health Care Association is a federation of 50 affiliated associations that represents more than 11,000 non-profit and for-profit assisted living residences, nursing facilities and sub-acute care centers. Two polling firms were commissioned by the AHCA to conduct a national telephone survey of 800 adult Americans ages of 34-52 years in September 1998.

Forty percent of Americans will experience their most costly purchase in life, long term care, during their retirement years. Despite this fact, 27% of Baby Boomers think they are covered by long-term care insurance, but in reality, only about 6% of the elderly have this type of coverage and very few Baby Boomers do.

Four out of five respondents did not know how long-term care is paid for and 25% say they are unwilling to consider paying for any additional insurance to cover these costs.

While 41% are willing to pay up to $50 per month for long-term care insurance, in most cases this is well below actual costs. According to the American Council of Life Insurance, long-term care insurance policies range from approximately $30-$440 a month per individual, depending upon age of the policyholder and level of coverage provided.

While 68% of Baby Boomers know they are not financially prepared to handle long-term care costs, only 15% correctly identified Medicaid, the government program for the poor, not Medicare, as the principal source for long-term care funding assistance. Two out of three believe they should not be forced into poverty to get government assistance for long-term care, but that is exactly what Medicaid requires.

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Women are particularly vulnerable to financial and emotional devastation from long-term care needs, because they earn less and live longer than their male counterparts. In addition, they are the most likely caregivers when older relatives or spouses become frail or ill and need care; 41% of women interviewed who had been in caretaker roles had been forced to quit their jobs or take a leave of absence. Fifty percent said they had to cut back their working hours and give up space in their own homes to accommodate loved ones needing care.

As more women are employed full time, it becomes increasingly difficult for them to fill the requirements of caring for aging parents and relatives; 46% said they were forced to hire nursing care to help with the tasks. The prospect of having to provide care to aging relatives and spouses can be a huge emotional drain as well as a financial hardship. But once they have cared for parents and spouses, these women must worry about themselves—who will care for them? Who will pay for their care?

REMOVING IRA FUNDS PENALTY-FREE Once required distributions begin, the balance in your IRA on December 31st of the previous year is divided by life expectancy to determine the RMD for the year. You have two choices for figuring your life expectancy: the recalculation method and the fixed term method.

Recalculation Method The recalculation method recognizes that every year a person lives, life expectancy gets a little longer. So each year you will need to consult IRS life expectancy tables to determine your new life expectancy and divide that into the IRA balance. This allows the IRA to last longer than would be possible using the fixed-term method.

But there is a potential drawback to the recalculation method. In many cases, after your death the recalculation reduces life expectancy to zero and requires income taxes to be paid on the entire remaining IRA one year following death. These taxes are in addition to any estate taxes. If your spouse is the beneficiary of the IRA and survives you, this problem can be avoided. The spouse can roll over your account into a new IRA and start a new minimum distribution schedule. But if your spouse does not roll over the IRA, the entire account is taxable one year after your spouse's death. Other beneficiaries do not get the special treatment that a spouse does.

The result is that if the IRA owner and spouse die in their seventies or early eighties and had used the recalculation method, the entire IRA account would have to be distributed and taxed shortly thereafter. That deprives the heirs of most of the amount in the IRA plus future tax deferral that might have been possible.

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Fixed-Term Method Under the fixed-term method, each year after minimum distributions are begun, one year is subtracted from the previous year's life expectancy to determine the current life expectancy. That means your IRA will be depleted by the end of your initial life expectancy. The advantage of the fixed-term method is the IRA can continue under the distribution schedule after your death. That makes the fixed-term method the better option when your beneficiary is not a spouse or is a spouse whose life expectancy is shorter than yours.

Choosing Your Heirs Choosing a calculation method is only half your work. You also have to name a beneficiary (or beneficiaries) for the IRA, and that person's life expectancy can be used with yours to calculate distributions and possibly make the IRA last longer.

When your IRA has a named beneficiary (simply naming someone in your will does not count), instead of looking up your life expectancy in the IRS tables you look up the joint life expectancy of you and the beneficiary. If the beneficiary is younger than you are, the joint life expectancy will be longer than your single expectancy. That reduces minimum distributions amounts and stretches out the life of the IRA. But there are limits to how far you can stretch out the IRA. When the beneficiary is more than 10 years younger, you assume the beneficiary is only 10 years your junior. After your death, the beneficiary can elect to re-compute the minimum distributions using only his or her life expectancy.

Selecting a younger beneficiary and using the fixed-term method is the best combination of choices for anyone who wants to maximize the life of an IRA. You are assured the IRA will not be depleted if you outlive your life expectancy and the beneficiary can continue using the tax deferral for many decades. Here are some general rules that might help you: 

An IRA will last longer if you calculate RMDs using the joint life expectancy of you and a younger beneficiary.



If your spouse will need the IRA to maintain a standard of living, name your spouse beneficiary regardless of other issues.



A spouse who inherits an IRA should roll over the account to a new IRA. That allows survivor to name a new beneficiary and begin a new distribution schedule.



When the actuarial tables show the spouse owning an IRA is likely to die before the spouse who is beneficiary, the recalculation method probably should be used. That ensures no matter which spouse dies first the IRA should outlive both of them. But it penalizes the next generation if the younger spouse dies first.

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

A younger spouse should select the fixed-term method. That minimizes problems whether the IRA is inherited by the other spouse or by a younger generation.



When your spouse will have other assets and will not need the IRA, name a younger individual as beneficiary, such as a child or grandchild. This will minimize required distributions during lifetime and allow your heirs to benefit from tax deferral for decades to come.



If your spouse will need some but not all of the money, consider splitting the IRA into two or more accounts so heirs can also benefit. Not all mutual fund companies allow one individual to have more than one IRA, so you might have to move the second IRA to another firm.

WITHDRAWAL PENALTY FAVORS ANNUITIES Keeping your IRAs intact until age 70½ is wise. It allows money to grow tax deferred.

Upon turning 70½ you must begin withdrawals. To keep them low, you can base them on the joint life expectancy of you and your beneficiary. However, you must choose one of three withdrawal formulas. The method you choose will make only a little difference early on, but it will make a huge difference once you or your beneficiary dies. The two most common methods are known as term certain and recalculation. You can use recalculation only with your spouse as beneficiary. You may also select a blend of the two known as the hybrid method. Before you make a decision, keep these two points in mind: [1] You must notify your IRA custodian in writing about the method you are selecting. If you do not, the custodian may choose one for you—almost always recalculation. If neither of you cites a preference, the IRS will assign you the recalculation method.

[2] Once a method is chosen, you are stuck with it for the rest of your life. Make the decision yourself so you can be sure it suits long-term goals. Here are the benefits and disadvantages of each method:

Term certain You divide your retirement account balance by the joint life expectancy of you and your beneficiary. You must use the IRS mortality tables in Publication 590, available free by calling 800-829-3676 or log onto http://www.irs.ustreas.gov. In each subsequent year, you subtract one from the previous year's divisor. For example, let us say you have an IRA worth $350,000, you are 70 and your beneficiary is 65. Since joint life expectancy is 23.1 years, divide $350,000 by 23.1; the answer, $15,152, is your minimum distribution for the year. The following year, you divide your account balance by 22.1.

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If you feel that because of illness or heredity either you or your beneficiary stands a good chance of dying sooner than the IRS mortality table predicts, you ought to consider term certain. That is because the IRS will allow the survivor to continue to subtract one year from joint life expectancy divisor each year as if the other were still alive.

Downside What if you live longer than the IRS predicts? Over the long run, term certain forces you to deplete more of your account than either of the other calculation methods. For example, if you are 70, your beneficiary is 65 and your tax-deferred account totals $350,000, over 10 years you withdraw ~$206,978 in minimum distributions, assuming the account grows an average of 7% annually. That is about $8,174 more than if you used the recalculation method, described below.

Recalculation In the first year, you compute withdrawal as you would using term certain. The following year, however, instead of subtracting one from the divisor, you again use the IRS mortality tables to determine joint life expectancy. For instance, in Year Two, our hypothetical couple in the previous example would have a joint life expectancy of 22.2 years.

Who Benefits Retirees whose primary concern is withdrawing as little as possible from their accounts.

As long as both of you are alive, this is clearly the best method, since you will still have money in your account even after you turn 95. What if your beneficiary dies prematurely? Let us say you have been making mandatory withdrawals from an account that was worth $350,000 at age 70½. When you are 80, your spouse dies at 75.

Using the recalculation formula, you will be forced to refigure your annual withdrawals solely on the basis of your life expectancy. The next year, when you are 81, you will be forced to take out ~$45,377 under recalculation, compared with $32,293 had you used term certain.

Hybrid This method uses the recalculation formulation but creates an artificial age for your beneficiary based on the IRS's tables. Sounds complicated, but it is all clearly explained in Publication 590. Who benefits? Retirees who want to withdraw as little as possible but would also like some protection against the possibility their beneficiaries might die prematurely.

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Downside Your withdrawals will be slightly higher than under term certain for the first few years.

For instance, the couple in our example would withdraw a total of $208,640 over 10 years, vs. $206,978 under term certain. After the first decade, though, they would begin withdrawing less each year than with term certain. In Year 16, for instance, they would take out $41,348, vs. $43,512. The rule is, the older your beneficiary, the sooner you begin to see this method's benefits.

CHARITABLE GIFT ANNUITIES People are looking for legitimate forms of tax relief. Additionally, more and more Americans are facing the probability that Social Security will be a completely inadequate "safety net" for their retirement. These concerned people are looking for tax-favored ways to augment their future retirement incomes.

Charitable gift annuities (CGAs) provide one solution to these concerns. A gift annuity offers immediate tax relief, and has the potential to provide some tax-free retirement income. In exchange for the gift contributions made to a charity, the charitable institution guarantees a retirement income, either immediate or deferred that can last for the entire lifetimes of the donor and spouse. In addition to the economic advantages, the donor can experience the satisfaction of seeing a part of the proceeds of a gift put to immediate use in a charitable institution.

How Charitable Gifts Work One popular method is the gifting of an irrevocably assigned life insurance policy to a charity. In that scenario, the donor deducts premiums as gifts, and upon the donor's death, the charity reaps a substantial benefit. Variations of charitable remainder trusts are another option for deferred giving. While the donor enjoys the benefit of lifetime income, the charity must wait for the donor's death before taking ownership and utilizing the gift remainder. A CGA, however, which is reinsured with an immediate annuity provides the charity with the advantage of immediate access to a significant portion of its gift proceeds.

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Charitable Gift Annuities A CGA is one of the easiest forms of planned giving. In exchange for an immediate gift to a legitimate 501(c)(3) charity, the donor is promised a specified lifetime income. The exact amount of that gift is agreed upon at inception. Typically, the life income goes to the donor or is shared as a 100% joint and survivor option to the donor and spouse. The arrangement is that simple. There is an agreement of understanding between the donor and charity. The charity's stability and reputation provide peace of mind to the donor. If the charity ceased to make the agreed upon payments, the donor would be a primary creditor against that institution.

The maximum rates of return typically paid on these uninsured annuities are established by the American Council on Gift Annuities. The ACGA was established in 1927 as an answer to the "bidding wars" for donor dollars. Meeting each three years, this grouping of a large number of substantial national charitable organizations uses interest and mortality assumptions to set up current actuarial tables.

In a traditional situation where the donor dies around his or her actuarial life expectancy, the charity would have paid him a combination of interest and gift principal, which yielded a remainder of 50%. It is that substantial "expected remainder" which helps drive the IRS's acceptance of the CGA as a legitimate gift with well-defined tax advantages. In the event a wealthy donor accepted a rate of return below the ACGA tables, it would pass on an even larger gift portion to the charity at the donor's death. In the event an organization offered rates of return considerably above the established

How Annuity Reinsurance Works Remember that the agreement is for the charity to pay a lifetime income to the donor.

Once the agreement is completed, the manner in which the charity invests its assets to carry out that goal is exclusively the charity's business. The organization can take the full proceeds of the donor's gift to a bank's trust department and ask them to manage the assets in a portfolio. The bank, however, cannot guarantee principal will last for the donor’s lifetime. In the event market conditions seriously diminish the value of a portfolio, those continued income payments may cease. Also, in the event that a donor significantly exceeds life expectancy, all the resources of the gift may be exhausted.

If the gift proceeds are gone, the charity must reach into other resources to continue lifetime payments. By utilizing annuity reinsurance, however, these risks can be completely eliminated. In a reinsurance transaction, the charity takes the entire gift from the donor and in turn purchases a life annuity from an insurance company with the proceeds. The annuity can be immediate or deferred. The cost of purchasing that lifetime annuity is lower than the amount of the gift.

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In the case of immediate income annuities to donors in their seventies or older, the charity may be able to obtain the life annuities at a 35-50% discount. That spread between gift and purchased annuity represents outright cash that is available today to the charitable institution. The balance can be invested in an endowment fund or used for other purposes.

When a donor is concerned about the guarantee of income a charity is making, the annuity reinsurance is a valued dimension helping the donor proceed with the gift. The charity is able to reassure the donor a financially strong insurance company stands behind its commitment to guarantee lifelong income. The charity transfers to the insurance company all interest rate risk, investment risk and mortality risk. The insurance company actuarially assumes all of these risks. In addition, the insurer takes on administrative duties of income payments and tax reporting.

If Donor is Very Old or In Poor Health In these situations, the charity may purchase a life annuity with a period certain guarantee. Such an annuity provides a life income regardless of donor's lifespan plus it guarantees income payments for a minimum fixed period, say 10 years. If the charity is both the owner and beneficiary of the annuity, it could benefit from any unused future guaranteed payments in the event the donor dies within the 10-year guarantee period.

Gifting an Appreciated Asset Younger donors may have an asset that has appreciated considerably. Take the example of a doctor who purchased her clinic in the 1970's for $100,000 and at age 55 wishes to sell her building so she can then go and work as a chief physician at a hospital for the next 10 years before retirement. The clinic's value has appreciated to $500,000. Selling it outright would trigger a $400,000 capital gain. If our doctor gifted this appreciated property to her hospital, the hospital could liquidate it at its current market value with the following results: The doctor would receive a tax deduction based on its appreciated current value and the nonprofit institution would not have to deal with the capital gains tax. The doctor would then be guaranteed an income that not only reflects the current value of her gift, but also its compounded value over the next decade before that retirement income stream commences.

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Annuities

1.16

The taxes become a little more complex in this case. While the outright immediate deduction is still taken, there will be some recognition of capital gains because the gift was not completed outright—the doctor still reserved the right to future revenue.

However, at retirement, she can pay her remaining capital gains taxes on an "installment plan" over life expectancy. A part of each income payment would be taxed as either ordinary income or as capital gains. When the remaining capital gains have been paid off over the doctor's actuarial lifetime, a few good things happen: If the doctor is living, her guaranteed life income payments continue; with the capital gains having been paid off, her annuity income stream will be taxed at a much lower rate.

Prospecting for Charitable Gift Annuities The CGA can also be structured to allow for the creation of a life insurance estate upon the donor’s death. If the donor is willing to accept a reduced income stream, part of the donation may be diverted to pay premiums on a life insurance policy. This will generate a death benefit to relatives that could replace the capital gifted to the charity. Or the charity can be named as beneficiary of the life policy to receive the death benefit as a future gift.

A gift annuity's yield varies according to age. For example, if you were to set up a $10,000 gift annuity at 60, you would earn $690 a year and deduct $3,733 on your tax return for the year in which you make the donation. The deduction is equal to the gift's present value minus the lifetime income the IRS estimates you will receive. If you were to make the donation at 80, you would get $940 a year and a $5,038 deduction. A two-life gift annuity, which pays income to the survivor for life after the donor's death, offers a slightly lower yield.

The Benefits of Charitable Annuities Most gift annuities follow yield guidelines set annually by the American Council on Gift Annuities; rates are the same for men and women. To estimate what your yield and tax deduction would be on $10,000 gift annuity, find your age below:

Charitable Deduction for a $10,000 Gift Age 50 55 60 65 70 75 80 85

Rate 6.5% 6.7% 6.9% 7.2% 7.7% 8.4% 9.4% 10.5%

Deduction $3,234 $3,433 $3,733 $4,049 $4,344 $4,666 $5,038 $5,531

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Since a portion of your income will be considered a return of principal, part of your annual income will be tax-free. How much depends on your age. For instance, if you were to make a donation at 60, the tax-free portion would be 38%. If you were to set up a gift annuity at 80, tax-free amount would be 56%.

Returns on gift annuities are less than those paid on commercial annuities. For instance, if a 65-year-old man bought a $20,000 single-life fixed annuity from Presidential Life, he would receive $1,910 a year, also partly tax-free. If the same man donated $20,000 to his favorite charity as a gift annuity, he would earn $1,440 a year and get an immediate $8,098 tax deduction. If he donated appreciated stock, he would avoid capital gains taxes.

You can start receiving income from a charitable annuity immediately. If you wait, however, your deduction and eventual yield will be considerably higher. For example, if you established a $10,000 gift annuity at age 50 with the Salvation Army and deferred payment for 10 years, you would get a $5,458 deduction and start collecting $1,170 a year at 60. If you donated the same amount at 60 and started payments immediately, you would get $690 a year and a deduction of $3,733.

IRS GUIDELINES ON PARTIAL 1035 EXCHANGES Under Section 1035 of the IRC, annuity owners may exchange one annuity contract for another annuity contract and the exchange may qualify as a tax-free exchange. Revenue Procedure 2008-24 alters the subsequent tax treatment of the two annuity contracts (the original contract and the new contract) if the exchange involved is not a full exchange of the original contract. In other words, if all the proceeds in the original contract are not exchanged into one or more acceptable contracts, then this "partial" exchange may not be tax-free under Section 1035.

Revenue Procedure 2008-24 provides that if amounts are withdrawn or surrendered from either contract for a 12-month period beginning on the date the exchange proceeds are received by the recipient company, the partial exchange will be retroactively disqualified unless one of the following events occurs after the exchange and prior to the withdrawal, annuitization, change of ownership or surrender. When there is more than one owner, one of the following exceptions must apply to each owner; the exception does not have to be the same for each owner:

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[1] Owner reaches age 59 ½ [2] Owner's death (death claim paperwork) [3] Owner's disability (with doctor's statement) [4] Finalization of owner's divorce (copy of divorce decree will be required) [5] Owner's loss of employment [6] The amount withdrawn is allocable to investment in the contract before 1982 (referred to as pre-TEFRA cost basis, carries over on an exchange) [7] The distribution is from a qualified funding asset within the meaning of Code section 130(d) (think structured settlement annuity) [8] Other “similar life event”

Amounts subject to pre-TEFRA cost basis or from qualified funding assets are not “events” that can “occur” after a particular date. However, the other listed events must occur after the partial exchange in order to avoid disqualifying it. For example, if a contract owner completes a partial 1035 exchange after reaching 59 ½ and then takes a withdrawal from one of the annuity contracts within a year of the exchange, the exchange will be disqualified unless one of the other events has occurred after the exchange or exceptions number [6] or [7] above apply. Additionally, the IRS has provided no guidance explaining what constitutes a “similar life event.” This ruling applies to partial 1035 exchanges completed on or after June 30, 2008.

Effect of Violating the New Rules If the partial exchange is disqualified, the amount originally exchanged from the source contract is subject to taxation as a withdrawal from the source contract. That amount would be taxable to the extent of any gain in the source contract and would generally be subject to the 10% additional tax penalty unless contract owner were 59½. Both the gain calculation and contract owner’s age would be determined as of the date the funds were exchanged out of the source contract, not the later date when the 1035 exchange is voided. Tax consequences of the exchange being voided include:  The exchange will be treated as a distribution from Annuity “A,” taxable to extent of gain in Annuity “A” on the date of the exchange.  The money received by Annuity “B” in the exchange will be treated as regular premium.  Cost bases in both contracts will have to be adjusted to account for different treatment.  Additional tax reporting will be triggered for one or both companies.

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Financial Planning

2.FINANCIAL

2.1

AID

When a public school sends a student an acceptance letter, it is not usually mailed with a financial aid package. Families should go to www.fafsa.gov and complete the Free Application for Federal Student Aid (FAFSA). It is helpful to have last year’s federal income tax return when completing the form; if the tax return has not been completed, use estimates. FAFSA determines federal grant and loan eligibility (i.e., Pell Grants, Stafford Loans and the PLUS loans for parents); most states use FAFSA. Once the prospective student becomes FAFSA eligible, the school builds a student aid package that includes grant money, loans and work study. Those eligible for a Federal Pell Grant will carry such eligibility to every school applied to.

The next step is for the family to subtract all aid money from actual costs. Calculate what the family’s total cost over 3-5 years will be, since a small percentage of students complete an undergraduate degree in less than four years while a high percentage take more than four years. Determine what percent of the total is in grants and scholarships and what percent is in educational loans (that must be paid back).

The amount of aid can vary each year. Some scholarships are only available for the first year. Other students may not initially receive a scholarship but qualify after the first year.

Still, if family income remains stable, first year funding is a good indicator of what can be expected for the rest of college.

Federal student loans are not based on a credit rating. These loans do not require a cosigner. The student must be a U.S. citizen or permanent resident, not have been convicted of certain crimes and enrolled at least part time in a college or university that leads to a degree. Private loans will look at credit reports, require a co-signer and usually charge a higher rate of interest. The federal parent PLUS loans look for a lack of bad credit, but their criteria is quite liberal.

Most schools have a limited amount of Federal Work Study funds, which may be included in a student’s financial aid package. If a student receives a work-study award, the school will provide information about jobs on campus. Students in these programs typically work 15-20 hours a week.

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Financial Planning

2.2

Expected Years in Retirement Around the World Official Retirement Age

Average Actual Retirement Age

Expected Retirement Years

Japan

67.0

68.9

14.1

U.S.

67.0*

64.6

17.6

Germany

65.0

62.1

19.8

U.K.

65.0

63.2

18.8

Italy

65.0

60.8

21.7

Spain

65.0

61.4

20.9

France

60.0

58.7

24.0

Greece

58.0

62.4

19.8

Source: OECD (* born in 1960 or later)

RETHINKING HOME OWNERSHIP In 1918, the federal government began its “Own Your Own Home” campaign. Home ownership rose from ~40% in the 1940 to ~60% in the 1960s and then hovered around 65% until the 1990s, reaching a peak of 69.4% in mid-2004. By the middle of 2010, the figure was 67.2%. The table below shows home ownership rates in some of America’s largest cities.

2010 Homeownership Rates Atlanta (58%)

L.A. (50%)

Boston (67%)

Miami (68%)

Chicago (70%)

N.Y. (51%)

Detroit (75%)

San Diego (55%)

Las Vegas (59%)

S.F. (58%)

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Mutual Funds

3.MONEY

3.1

MARKET FEES

Depending on the recent year and month cited, money market assets have ranged from $3.8 down to $2.8 trillion. Under 2010 SEC rules, money market funds must increase liquidity, limit investments to only the highest quality securities and shorten average maturity. Taxable money market funds must hold at least 10% of assets in cash or securities such as Treasurys. At least 30% of assets must be in cash or Treasurys maturing in 60 days or less.

TARGET DATE FUNDS Before investing in a target date fund, ask the following questions: [1] What is the fund’s “glide path”?

This refers to how the fund will change its asset allocation over time.

[2] Is the fund’s objective to get an investor “to” or “through” retirement?

Your retirement might be in 2030 and when 2030 arrives, the fund still has 80% of its assets in equities.

[3] Does the fund take a tactical or strategic asset allocation approach?

Management may or may not have the ability to deviate from the weightings.

[4] Is the fund diversified beyond stocks and quality bonds?

The portfolio might own commodities, high-yield securities or real estate.

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Bonds

4.RECENT

4.1

MUNICIPAL DEFAULT RATE

From the middle of 2009 to the middle of 2010, just 223 out of more than 40,000 municipal issuers defaulted on their payments, representing a default rate of $6.4 billion, or 0.002% of outstanding municipal debt (source: Municipal Market Advisors).

BOND YIELDS At the beginning of 2009, investment-grade bonds yielded 5.25 percentage points more than Treasurys, while junk 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 Merrill Lynch Master II High Yield Index, the gap between Treasurys and high-yield bonds hit a peak of 21.82 percentage points in midDecember 2008. For the 2008 calendar year, high-yield bonds as a broad category were down by about a third.

AAA-RATED 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 Treasurys. 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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4.2

2009 JUNK 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 yearend 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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ETFs

5.ETFS

5.1

AND THE

FLASH CRASH

On May 6th, 2010, when the Dow fell as much as 9.2% during the trading day, a number of ETFs (mistakenly) lost almost all of their value. Exchanges decided to cancel any trades executed at prices 60% or more away from precrash levels. ETFs account for 10% of all exchange-traded securities, represented ~70% of the cancelled trades.

For some ETFs, the NAV fell 8% while the market prices plunged 60% or more. One trader owned shares of a sector ETF worth $15 a share; the trader set a stop-loss order to be triggered at $14. Some of the shares ended up trading for just 14 cents on May 6th. The two most important lessons learned from the flash crash were: [1] avoid trading on volatile days and [2] use limit orders instead of market or stop-loss orders.

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QUARTERLY UPDATES RETIREMENT PLANNING

Retirement Planning

6.PRESENT

6.1

VALUE OF SOCIAL SECURITY PAYMENTS

According to IRS Publication 590, the life expectancy of a single 65-year old is 21 years; joint life expectancy for a couple is 26 years. The next table shows the present value of a $30,000 annual benefit for someone age 65 whose life expectancy is 20 years.

Present Value of Social Security [$30,000 annual benefit / age 65] Discount (Inflation) Rate

PV of Cash Flow

3%

$452,000

5%

$380,000

7%

$324,000

9%

$280,000

REASONS TO WORK AT AGE 67 The table below, based on a 2009 survey by Sun Life Financial, lists the seven top reasons why some people plan on working at the age of 67.

Why Americans Work At Age 67 Reason

%

Reason

%

Earn enough to live well

83

Not ready to end career

56

Stay mentally engaged

80

Be close to people

61

Health care benefits

64

Social security won’t last

54

Love their career

63

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6.2

MONTHLY SOCIAL SECURITY BENEFITS Monthly Social Security Retirement Benefits [projections based on 2010 calculations] Year of Birth Current Earnings

1948

1949-53

1954-58

1959-63

$7k — $14.4k

$707

$718

$725

$726

$15.4k — $22.8k

$916

$936

$948

$950

$23.8k — $31.2k

$1,125

$1,153

$1,171

$1,174

$32.2k — $39.6k

$1,334

$1,371

$1,394

$1,398

$40.6k — $48.0k

$1,544

$1,588

$1,617

$1,622

$49.0k — $56.4k

$1,753

$1,806

$1,840

$1,846

$57.4k — $64.8k

$1,933

$1,962

$1,981

$1,984

$65.8k — $73.2k

$2,031

$2,064

$2,085

$2,089

$74.2k — $81.6k

$2,129

$2,166

$2,190

$2,194

$82.6k — $90.0k

$2,227

$2,268

$2,294

$$2,29

$91.0k — $98.4k

$2,325

$2,370

$2,399

$2,404

$99.4k — $106.8k

$2,423

$2,472

$2,503

$2,509

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Retirement Planning

6.3

Social Security Early Retirement Reduction Factors Months Before Normal Retirement 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24

Percent Reduction 0.6 1.1 1.7 2.2 2.8 3.3 3.9 4.4 5.0 5.6 6.1 6.7 7.2 7.8 8.3 8.9 9.4 10.0 10.6 11.1 11.7 12.2 12.8 13.3

Months Before Normal Retirement 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41 42 43 44 45 46 47 48

Percent Reduction 13.9 14.4 15.0 15.6 16.1 16.7 17.2 17.8 18.3 18.9 19.4 20.0 20.4 20.8 21.3 21.7 22.1 22.5 22.9 23.3 23.8 24.2 24.6 25.0

Normal Social Security Retirement Age Born < 1938

Normal Age 65 years

Born 1955

Normal Age 66 years, 4 months

1939

65 years, 2 months

1956

66 years, 4 months

1940

65 years, 6 months

1957

66 years, 6 months

1941

65 years, 8 months

1958

66 years, 8 months

1942

65 years, 10 months

1959

66 years, 10 months

1943-1954

66 years

1960 or later

67 years

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Retirement Planning

6.4

Social Security Crossover Point [payments start 3 years before normal retirement] Discount Rate 0%

When Reached 3 years

Discount Rate 6%

When Reached 19 years, 2 months

2% 4%

14 years, 5 months 16 years, 3 months

8% 10%

24 years, 7 months 49 years, 3 months

GENERATING LIFETIME INCOME Generating Lifetime Income With $500,000 Investment Mix

Average annual income for 30 years

Median portfolio after 30 years

100% fixed-rate annuity annuitized

$26,300

$0

50% stocks & 50% in bonds

$26,200

$775,800

25% in stocks & bonds 75% fixed-rate annuity annuitized

$26,300

$193,950

25% in stocks & bonds 75% fixed-rate annuity annuitized

$26,300

$387,900

25% in stocks & bonds 75% fixed-rate annuity annuitized

$26,200

$81,800

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ETFs

7.1

7.WORLD’S

LARGEST ECONOMIES [JUNE 2010]

World’s Largest Economies [June 2010] GDP (trillions)

2010 Growth Rate

Trade Balance

Jobless Rate

Budget Deficit (% of economy)

Gross Debt (% of economy)

U.S.

$14.8

3%

-3%

9%

11%

93%

China

$5.4

10%

6%

4%

n/a

n/a

Japan

$5.3

2%

3%

5%

10%

227%

Germany

$3.3

1%

6%

9%

6%

77%

France

$2.7

1%

-2%

10%

8%

84%

U.K.

$2.2

1%

-2%

8%

11%

78%

Italy

$2.1

1%

-3%

9%

5%

119%

Brazil

$1.9

6%

-3%

8%

-3%

43%

Canada

$1.6

3%

-3%

8%

5%

82%

Russia

$1.5

4%

5%

9%

4%

n/a

Spain

$1.4

0%

-5%

19%

10%

73%

India

$1.4

9%

-2%

n/a

6%

n/a

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