The convertible bond market is practically an asset class all to itself because of the hybrid nature of these instruments. A convertible bond is essentially a bond issued by a corporation that allows holder to convert the bond to stock based on a predetermined formula. This is typically an option and not a requirement. So in a sense, you as the investor have the benefit of both a stock and a bond holding. Most convertibles will be issued with a maturity of at least 10 years. In most cases the coupon (interest rate) is issued at a lower rate than non-convertible issues by the same corporation.
The biggest benefit to the issuer/corporation is the lower interest payment on its debt obligation. Should the bond get converted by the holder, the debt of the company disappears, but at the cost of dilution to existing shareholders.
The benefit to the holder of the bond is they can simply hold the issue to maturity/callable date with a guaranteed rate of return like any other corporate note, with only the credit quality of the underlying issue to be concerned about. Should the pre-determined conversion price be appealing, the holder can benefit from participation in the stock price appreciation through the conversion. Additionally, while the average maturity is more than 10 years at issuance, the conversion and callable features they are typically issued with actually lowers the average duration of a fairly well diversified convertible fixed-income portfolio.
In terms of buying fixed-income in general, the majority of investors would be better suited to diversify their fixed income holdings through bond funds and ETFs. This is primarily related to the pricing mechanisms of how bonds are traded on a negotiated basis. Most often the average investor will not see the same price for a fixed income issue that an institutional portfolio manager will receive.
Particularly in the case of convertible securities which can be far more complex than a traditional bond, a diversified portfolio manager or ETF is more appropriate. In the case of convertibles there are three basic characteristics that must be monitored. They are:
Conversion Price…The price paid to acquire the common stock.
Conversion Ratio…This determines the number of shares of stock the bond holder would receive.
Conversion Premium…This determines the premium paid between the conversion price and the current market value of the underlying security.
In terms of risk and volatility, it should be noted that because of the conversion feature of these bonds, they more often tend to correlate to price movements in the stock market, rather than correlating with the rest of the investment-grade fixed-income market which is more sensitive to interest rate changes. So as an investor, when you buy a convertible bond fund or an ETF, be prepared for the volatility.
In general they tend to be less volatile than most stock funds with returns that are not that far from stock market like investment returns. However, if you are looking to balance risk with other stock-based investments, convertibles will more likely increase your portfolios correlation and do little to reduce volatility if treated as a fixed income holding. For this reason you may want to allocate convertible securities in your portfolio as part of their equity exposure. However, when we are completing an analysis of an investment allocation… it may seem that a portfolio is weighted more towards fixed income than its stated target. In reality, it is a means to capture equity-market like returns with less volatility.
As an example, recent 10-year performance data reflects that the total US Stock Market Index is up 7.47% through Nov 30-2015. The Barclays US Bond Index is up 4.49% over the same period. Yet the Barclays US Convertible bond market index is up 6.40% over the same period.
What about volatility?…During the 2008 market crisis the total US stock market declined for the year approximately -37%. Conversely the convertible securities market fell by -29%. This is illustrative of equity-like returns with less price volatility.
As mentioned earlier, in most cases due to the way in which fixed-income is priced, many investors may be better suited to use active managers in the fixed-income markets. However, as convertibles tend to have more equity-like characteristics, returns have been more favorable with the lower-cost ETF and index-fund solutions. History shows little evidence that active management has played a beneficial role in this asset class when compared to the benchmark.
When evaluating convertibles and the role they may play in your investment portfolio, this like any other investment, should be done in the context of a larger long-term financial planning strategy. As such, it tends to be one of many different assets that comprise an overall portfolio’s construction. There is never any one asset class that can, or should, completely dominate an investment plan for any investor who wishes to take a strategic approach to financial planning. Hence it is prudent to limit exposure to these types of securities as it is for all asset classes.
As always, it’s important to remember that each investor’s circumstance is unique and should be addressed accordingly.
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In recent years the mutual fund industry has seen an enormous expansion of alternative investing strategies which have made a variety of investment approaches that had historically been available only to the high net worth investor, available to the general public. There are a whole host of alternative strategies to choose from, each with the same ultimate objective of lowering investment correlations with traditional assets like stocks and bonds.
Among these strategies is the Managed Futures strategy. Managed Futures have demonstrated the lowest historical correlation to both stocks and bonds among all alternative investment strategies. Simultaneously, this approach has performed well across both bull and bear markets. As an alternative strategy, Managed Futures collectively posted positive returns during the 2008 financial crisis, the 2000 bursting of the dot.com bubble, as well as the oil crisis of the mid 1970s.
This is an investment strategy that has been actively pursued by hedge funds and commodity trading advisors (CTA’s) since the late 1970’s as the number of contracts available to be traded in different areas of the markets were expanded by futures exchanges. Futures contracts are very similar to options contracts on stocks, which many investors commonly use. Futures contracts are contractual agreements made on the floor of a futures exchange which may represent trades in equity indices, currencies, fixed income or commodities. Some contracts are settled in cash, and others are settled with physical delivery.
In a Managed Futures strategy, the CTA may use a number of approaches to implement their trades in the futures market. These strategies can be very narrow in their focus, while some are very broad in the approach. The primary driving strategy of the futures market, which is also the most broad based and consistently successful are the momentum trading strategies. This is an approach that attempts to capture changes in trading momentum using both short and long-term signals. These changes in momentum are often linked to studies on behavioral finance which demonstrate how our bias as a collective group of investors often leads to changes in underlying asset prices. This “herd” mentality creates opportunities for the Managed Futures CTA to capitalize on both positive and negative momentum changes.
Since 1980, the Barclays CTA Index has had an average return of 10.04% annually (Gross of Fees). During that time the correlation to the S&P 500 Index has been about .01. Simultaneously, their correlation to the US Bond Market has been 0.14. (A correlation of 1.00 represents two assets that move in tandem, while a correlation of 0.00 represents two assets which are totally uncorrelated.) The worst single drawdown loss was -15.66%. Due to the fact that many CTA’s have historically used a much higher fee structure than what is typically acceptable in most publicly traded mutual funds, the returns net of fees are more likely lower on an annualized historical basis. What this demonstrates is that managed futures for several decades have delivered investment returns comparable with equities in an uncorrelated manner. That lower correlation when combined with traditional stocks and bonds has historically meant similar returns with lower overall portfolio volatility.
It should be noted that there is a fairly wide grouping of results across the CTAs in the Managed Futures market, as is true with all alternative strategies. This is partially the result of the skill level of the manager, as well as whether the environment is particularly favorable for a given strategy. Managed Futures tend to fare well when there are more clearly defined trends of an asset class experiencing a significant change in pricing, regardless of whether they are positive or negative trends. In environments when markets are choppy and move in a sideways direction, many CTAs will have difficulty identifying a specific set of trends.
What is most important to note, is that Managed Futures, like all alternative strategies are not intended to be an independent investment approach to be used on a stand-alone basis. Nor is it intended to be compared directly to a specific market index as a choice between one versus the other. These types of alternatives are designed to be used in conjunction with a typical asset allocation of stocks and bonds, serving as yet another diversifier of an individual portfolio to lower overall volatility, with nominal impact to investment returns.
All alternative strategies should be thoroughly understood before being implemented. Many alternative strategies often sound similar, yet after more close evaluation we may find they take on a substantially larger degree of risk, and may be much narrower in their focus as compared to their peers. It is important to complete your due diligence before implementing these strategies, or consult with your financial advisor.
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Albert Einstein was once purported to have said that compounding interest is “The most powerful force in the universe.” While the statement was likely intended to be facetious, it is a powerful force nonetheless. The power of compounding is significant. Compounding is the principle of earning a rate of return on your prior rate of return, as well as on your initial investment. This principle refers to dividends, interest and capital appreciation. This is also known more simply, as “making your money work for you.”
So just how powerful is this force in reality? In order to determine this, let’s assume two possible scenarios.
Investor A:
Begins investing at age 18 with $1,000.00 as an initial investment. Every year, for a period of 15 years, Investor A adds $100 per month to his investments while earning an average return of 7% per year. At the end of 15 years, Investor A is 33 years old and has accumulated $34,045.41. Investor A chooses at this point, to no longer contribute to his investments. Rather Investor A has chosen to let his current investment balance grow at the 7% average investment return for 32 years until they are 65 years old. Investor A, at age 65, has accumulated $296,714.97.
Investor B:
Begins investing at age 33 starts with an initial investment of $2,000.00 (2x the amount of investment that Investor A started with.) He contributes $100.00 monthly (the same amount as Investor A) until age 65, which is 32 years (So, 17 years of contributions beyond what Investor A chose to do). Investor B also earns an 8% average return for the 32 year duration of time (1% more than investor A). At age 65, Investor B has accumulated $191,427.46.
Results
What we see is that Investor A has made total contributions of $19,000 while Investor B has made total contributions of $40,400. Simultaneously, Investor A has earned a full 1% less than Investor B on investments purchased. Yet, Investor A has managed to accumulate an additional $105,287.51 more by the age of 65.
Novice investors may find this shocking. However, it is simply the power of compounding growth. This is so powerful, that a smaller investment with a lower return can outperform when time is on your side. The first lesson learned here is to note the importance of investing early in life while time is on your side.
Another factor to consider is the power of tax deferred growth which serves to amplify these numbers. As many of us realize, investments can, and will be, taxed as we earn interest, dividends and realize gains. While the above numbers are relevant, taxing these earnings during periods of growth will only erode the net figure. This speaks to the importance of utilizing tax shelters such as employer retirement plans (401ks, 403bs, etc.), as well as individual IRA’s as the first tool in order to save for retirement more efficiently.
In Summary
It should be prudent for every investor to begin a retirement strategy as soon as possible. In the case of many younger workers, they believe they don’t have enough money to make even a small investment for their future. While all of us have been young, more often than not, this is not really the case. We all tend to have some degree of waste in our spending habits to a certain extent. As financial planners we often stress to clients that the first bill you pay is to yourself. This is especially true in the case of younger people. Even if it is as little as a $50 monthly contribution into a diversified mutual fund, the sooner one creates good investing habits, the better future you will have. Many young investors believe retirement is too far off to worry about. As the above figures show, investing early is an important head start and may lead to an earlier retirement. Additionally, as older Americans have come to realize, time really does go by quickly. The earlier one starts to invest in the future, the more secure one will be as retirement gets closer.
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Self-employed investors, understand more than anyone, the importance of a return on their investments. Self-employment offers many potential tax benefits, which can be a lure to those who choose to follow that path. While there are various tax benefits through tax deductions, a small-business retirement plan is often overlooked.
Maximizing these benefits for those that have the free cash flow can be a major advantage of self-employment. In order to better understand the options available, we’ll divide these plans into two separate categories, Defined Contribution & Defined Benefit plans.
Defined Contribution Plans
A Defined Contribution plan is a plan that has a specific formula for contribution based on one’s self-employment wages. The first plan we’ll look at is the Simple IRA.
The Simple IRA
This plan is designed for an employer who has fewer than 100 employees, and those employees earn more than $5,000, and would like to establish a plan for the employer as well as their employees with very little overhead expenses. The benefit of the Simple IRA is that since it is an IRA, there are typically very little or no administrative costs. The plan allows you to contribute on your own behalf with only a small obligation to match your employees who are vested after a certain duration of having being employed within that organization. The negative aspect is the maximum dollar contribution for the owner is substantially lower than other plan options.
For 2015 the employer can contribute 100% of their compensation up to $12,500.00 or $15,500.00 for those over age 50. For each employee, the employer can choose to make either a 3% matching contribution or a 2% non-elective contribution, regardless of whether the employee chooses to participate in the plan. Once funds are contributed to a Simple plan on behalf of the employee that is eligible, the employee is immediately vested and the employee may take the funds with them when they leave. The plan must be in existence for at least 2 years before the assets can be rolled to an individual IRA upon the employee or owner leaving the business.
The SEP IRA
This plan is also an IRA with little or no administrative expenses. With a SEP IRA the contribution limits are much higher at 25% of the individuals adjusted gross income to a maximum of $53,000.00 for the year 2015. Each employee of the company, or any affiliated companies, must receive the same percentage in contributions as the employer. The employee is fully vested upon funding and cannot make their own separate contribution, as all funding comes from the employer. However, the employer can set up eligibility parameters that apply only to full time employees. They can be as stringent as three years of employment and having achieved at least the age of 21. Generally the SEP IRA is utilized for an owner and or family members in a business that does not have long-term employees, or any employees at all. The reason for this is the burden of the contribution is heavy on the employer.
The Self Employed 401k
This plan is not an IRA, but a qualified retirement plan under the Employee Retirement Income Savings Act (ERISA). It allows for a maximum of 100% of salary deductions up to $18,000.00 for 2015 (An additional $6,000 for those over age 55). Furthermore, beyond the salaried contribution, the owner can make a profit sharing contribution of another 25% of compensation up to a combined amount of $53,000.00 for the year 2015 ($59,000 for those over age 50). This plan has largely replaced the old money purchase and individual profit sharing Keogh plans of the past with its hybrid approach to contributions. One specific requirement is the plan is only available to self-employed individuals and their immediate families. If there is a non-owner working for the business, the employee may not contribute to this plan and must utilize a different option. One other key component is the reporting is a bit more complex. Once the plan assets reach $250,000.00, the participant is required to have the IRS form 5500 completed each year. This notifies the IRS of not just contributions, but plan balances as well. This plan also exists in a ROTH version which offers the tax-free growth, without the tax deductions. Much like the SEP IRA, this would not be utilized for an individual with employees.
Defined Benefit Plans
When it comes to individuals with substantial resources who wish to make contributions beyond that of the options referenced above, there are various options. A defined contribution can be in addition to one of the plans mentioned above. This type of plan establishes a future annual benefit in retirement. The annual contribution is typically the actuarial value of what is required to meet that benefit. Meaning if you are 60 and plan to retire at 65, the amount of the contribution will be substantial if you just started the plan. Most typically a defined benefit is simply a pension plan. The maximum contribution in 2015 is the actuarial value of $210,000.00. It is important to note that these plans have additional benefits testing that must be done to accommodate employees based on income and age. There are various versions of these types of plans, and depending on the demographics of your staff, the employer would want to have an independent actuary help create the plan design to ensure employees receive the maximum benefit and remain in compliance. The start-up administrative expenses can be as high as $5,000.00 with an annual expense of around $1,500.00 per year for annual filings and plan amendments. It should be noted that although an employer has an annual benefit to be calculated, typically the plan is just closed and the lump sum commuted value is rolled to an IRA in retirement.
Cash Balance Plans are another option and is somewhat of a hybrid, in that this plan is defined not an annual benefit in retirement, but rather a future closing value of the plan balance in retirement. This also requires the assistance of an actuary for plan design. This plan, can in certain circumstances, favor a more equitable distribution of funding for business partners that have a varying age range. There are once again benefits testing requirements that must be completed.
Non-Qualified Deferred Compensation plans are another option that can be built in addition to the other two. These can be a bit more restrictive for employees holding certain positions within the company, and may encompass for example, only VP’s of the organization. Once again there are many versions of these plans that need to be structured quite precisely. However, one major risk within a Non-Qualified Deferred Compensation plan is, unlike a Defined Benefit or a Defined Contribution plan where the assets in the account belong to the participant, here they are an asset of the company. So in the event of the business being dragged into litigation or a bankruptcy, the plan assets are usually subject to claims by the creditors.
When selecting which plan makes the most sense, one should be consulting not only their financial planner, but also a tax advisor. Should you choose a dual plan option because of the excess taxable income at your disposal, it is wise to seek an independent actuary who serves as a third party administrator specializing in plan design. Many insurance companies can provide this type of plan with actuarial services at a reduced administrative expense. However, in return there are usually very costly investment solutions with hidden fees that make the plan far more expensive versus designing them independently.
Plan selection is relatively simple when a small business begins. However, as a business grows and increases free cash flow, plan design can become much more complex when attempting to balance maximum tax benefits in contrast to the employers out of pocket cost.
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There are significant differences between a traditional Exchange-Traded fund (ETF) and an actively managed Closed-End fund which can be confusing to the average investor. There are certain basic features that one should understand before utilizing these solutions as investment options.
The first thing an investor should understand is what an ETF actually is and how it’s structured. An ETF, simply stated, is a mutual fund that tracks a specific market index, such as the S&P 500 index. ETF’s have been created to provide an investment option for just about every major market index that exists. For those investors who wish to take a passive approach to investing, ETFs are a low cost solution. In the case of the S&P 500 index for example, once can purchase the iShares ETF (IVV) with an annual expense ratio of 0.07%. When compared to the average cost of an actively managed mutual fund, which is closer to 1%, they seem very attractive from an expense ratio perspective.
Part of the reason ETF investing has become so popular is the low internal expenses. Yet index funds have been around for some time. So why the explosion in the ETF market? One reason is liquidity. An ETF trades like a stock on an exchange between investors and can be traded throughout the day. This allows investors much greater flexibility. Whereas, a traditional index mutual fund sells shares directly from the fund company to the shareholders, then subsequently buys the shares back when you wish to sell. This in turns requires the investor to wait until the 4PM closing price to exit or enter the market. And investor looking to trade intraday, or take a short position is not afforded this opportunity in a traditional index mutual fund.
What about a closed-end fund?
The difference here is that while a closed-end fund trades on an exchange much like an ETF, it is vastly different in many ways. The ability to trade on an exchange allows for the same degree of liquidity when it comes to intra-day trading. Yet these solutions can be quite misleading to the novice investor. A closed-end fund actually has a fund manager much like a traditional actively-managed fund. This means that the low cost components traditionally associated with ETF’s do not exist. In fact, in many cases closed-end funds are even more expensive than a traditional mutual fund. The investor is essentially paying the higher fees for fund management and internal trading costs and gaining only intra-day liquidity. The reason is there is actually a premium you must pay for the liquidity. Keep in mind that mutual fund companies earn more as their assets grow. Assets grow based on both positive market performance, as well as new money being invested into a fund.
Since a closed-end fund issues an initial number of shares at the public offering, those shares are often finite. They are then traded amongst individual investors. So a major revenue source (the ability to sell new shares) is eliminated. Many investors are unaware of this and mistakenly associate these types of closed-end funds with the low cost ETF market place.
So if intra-day trading is not a priority to you and you seek active management, would you be better off with a traditional mutual fund? With a closed-end fund it’s also important to note that it is quite common for these investments to trade at a fairly significant premium or discount to their net asset value (NAV). Simply put, when you add up the value of the underlying investments bought by the fund manager, it may be quite different than what the fund is trading for in the market place. Some can trade as much as 20% below or above its NAV. While this may create an opportunity for you to buy securities at a steep discount, you may also be substantially overpaying for them as well. In a traditional open-ended mutual fund, the funds closing price at 4pm always reflects the precise NAV without any premium or discount. It is important to be aware of these differences in pricing when looking at an investment in a closed-end fund.
Lastly, a major component to closed-end funds that is vastly different from an ETF is its ability to use leverage in the fund. Essentially the fund managers can borrow on margin to purchase a larger portfolio to try and increase dividend yield and net return. This however creates not only greater expenses, but also potentially much greater volatility. Ironically many clients who would never take out a loan, borrow on margin to purchase an investment. These investors are doing so unwittingly with closed-end fund holdings in their portfolio. In many cases the effective leverage in a closed-end funds portfolio can be as high as 50%-60%. Ultimately, this excess leverage has the effect of amplifying the returns whether positive or negative, which translates into greater long term volatility. An excellent resource to research such positions should you own them would be www.cefconnect.com.
Closed-end funds are also commonly offered as new issues by commissioned sales brokers who receive substantial markups in order to bring them to market. It is even more common for them to decline almost immediately after the investor received new shares of this new issue. When such a price change takes place, the market is effectively adjusting the price of the security for the compensation paid to the sales representative almost immediately.
In general, there is good reason to be a strong advocate for low cost ETF investing to gain exposure to the equity markets. However, when navigating investment options, less sophisticated investors would be well advised to avoid exposure to the increased risk and expenses commonly associated within the closed-end investment funds. When evaluating any investment vehicle it is important to examine all the pros and cons associated with each opportunity.
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Retirement is something that can require a great deal of planning. This involves investing, insurance, taxes, pension decisions…etc., and many of these decisions revolve around timing. An individual’s age and/or age of a spouse may play a substantial role in making important decisions. A common question for many pending retiree’s is often, “When can I retire?”
There are many variables that may dictate when retirement is viable. The traditional age has often been linked to Social Security’s definition of full retirement, which is age 65 for most Americans closing in on their retirement. In a number of cases, an individual may have accumulated a substantial enough amount in total retirement assets that an early retirement is quite possible. However, it is more and more common that retirement savings is maximized through tax shelters such as a 401k, 403b and individual IRA’s. In cases in which an individual has concentrated wealth in these tax shelters that is needed to meet their retirement income, the age restrictions on distributions can create a potential problem. A 401k and other employer-sponsored qualified retirement plans require an individual to reach age 55 before they can take penalty free distributions, presuming that the employee attained age 55 before they separated from service. In the case of an individual IRA, the account owner must reach age 59 1/2 before they can access their accounts without penalty. When penalties do apply, they are typically 10% in addition to any tax liability on distributions. So, for an individual who has an employer-sponsored plan that they are considering rolling to an IRA for greater investment flexibility, it is wise to consider the difference in the distribution rules.
Fortunately, there is a way around this for those individuals who wish to retire early and avoid the 10% penalty on an IRA, which can be substantial if your retirement account will be a significant source of income. This is known as a penalty-free distribution under IRS rule 72t. These rules apply to an IRA owner who has opted to take Substantially Equal Periodic Payments (SEPP). Under this method, the payments made must be withdrawn based on the greater of 5 years, or until age 59 1/2.
For example, an individual who began drawing their income at age 51 would need to continue the payments for at least 8 1/2 years. However, an individual who began at age 57 would need to continue until age 62, completing the 5-year cycle. Following this method eliminates the 10% penalty, but does not alleviate the tax burden. Distributions are still taxed at the ordinary income tax rates. Any failure to comply with the IRS methods would subject the investor to a recapture tax on the distributions.
In order to determine how much income your accounts will generate there are three different methods of calculation. They are the Required Minimum Distribution Method, the Fixed Amortization Method, & the Fixed Annuitization Method. Which method is utilized is a choice that the account owner can make, and is usually determined based on the amount of targeted income they wish to generate from the account. In the event that an IRA account owner wished to change the method once the 72t distributions have begun, the IRS permits a onetime change from the either the amortization method or the annuitization method to the required minimum distribution method.
The term Substantially Equal Periodic Payments does not imply that the payments must be withdrawn annually in a lump sum. The formula permits for the SEPP to be taken as a monthly income. The formula is simply divided by 12, and the IRS requirements have been met.
Considering the fact that investable liquid assets routinely fluctuate in value, it is entirely possible that an account owner could have made a very bad investment decision, and their account value is depleted before the 5 year period has been exhausted. In such instances, the recapture tax does not apply. There are several other circumstances that do not qualify as a violation of the 72t rules which would result in the investor being subject to the recapture tax. Among those would be if the investor were to become disabled or pre-decease the required distribution period.
It is important to note that drawing on a retirement account early is not a prudent thing to do just because the IRS has made provisions for one to do so. It should be done only after careful analysis of an individual’s retirement projections have been completed, and there is a significant degree of confidence that such assets can be stretched out long enough to provide for a retiree’s life expectancy. Additionally, there are often unique situations that clients may face, as well as a greater degree of complexity in the tax code. It is important to consult with a tax professional before making any decisions that might have a significant impact on your tax liability.
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Long-Term care insurance can be controversial. Unlike other insurance solutions, the decision as to whether you should own this type of coverage is up for debate. As with all financial decisions, this should be researched and determined with a great deal of thought.
For many people, a great deal of concern as our population ages, would be ending up in a nursing home. Alternatively a concern is that a relative, or oneself, would need to live in a nursing home or assisted care facility, but not being able to afford the right place. The harsh reality is that this type of care is expensive.
According to the 2015 Genworth Cost of Care Survey, the median annual cost of a room at an assisted living facility in the U.S. is $43,200. That same private room at a nursing home averages almost $91,250 per year. In more expensive regions of the country, such as the state of New York, the cost of care jumps to $49,200 & $136,437 respectively. As a result, the average individual should at educate themselves as to what options would best serve them.
Covering the costs of long-term care
There are four main ways that an individual can pay for long-term care. They are:
Medicare;
Medicaid;
Self-insuring (covering the cost yourself);
Purchasing a long-term care insurance policy
Many people believe that Medicare is the solution. However, Medicare only covers long-term care costs under very limited scenarios. Medicaid will cover these costs, but it is a “needs based” program that essentially requires an individual to be both sick, as well as indigent, in order to be eligible for aid. Many individuals spend a great deal of time consulting with attorneys and financial advisors regarding estate planning, so they may protect their assets for their heirs. This is becoming increasingly difficult as asset transfer look back periods have been increased to 5 years. It is possible that this time frame may be extended further in the future, and the ability to gift assets out of one’s estate in advance may be more difficult.
As demographics change over time as the population ages, it is likely that it will become more difficult to qualify for government assistance. Medicaid is typically a last resort for someone who needs care, but has already spent the majority of their personal assets. Because Medicare and Medicaid are not the best of solutions, it is important to have alternative plans to cover the costs. Some may have the resources to self-insure. For others, purchasing a long term care policy may make more sense.
How does long-term care work?
Long-term care (LTC) policies generally pay a specific dollar amount for each day of care that is covered by the policy. Services can include home health care, adult day care, respite care, care in an assisted living facility, or in a nursing home. The policy benefits are triggered when an individual needs help performing the normal activities of daily living (ADL), for example: bathing, eating or dressing. In the United States, there are currently approximately 10 million people who need help with ADL. As life expectancies rise, these statistics are expected to grow. The President’s Council of Economic Advisors estimates that 70 percent of people who reach the age of 65 will require long-term care in one form or another before they die.
Is a policy right for you
LTC policies are usually quite expensive, and are not for everyone. An LTC policy would not be a suitable purchase for an individual who has the following restrictions:
afford to pay the annual premiums,
does not have sizeable assets, or
social security is your only source of income
If, however, an individual desires to protect personal assets for their heirs and can afford the premiums, purchasing a policy is worth the look. Some individuals may purchase a policy for the peace of mind, so as to not be a burden to one’s relatives. In some cases a policy is purchased simply to be able to get into the right facility or even to be cared for with at-home care for as long as possible. Whether or not it makes sense to purchase a policy is most certainly a case by case scenario.
What to look for in a policy
If an individual concludes that a long-term insurance is worth considering for their circumstances, there are a few things one should consider prior to purchasing a policy. Some policies exclude certain pre-existing conditions. Most have an elimination period once an individual enters a facility, before benefits begin to pay out. It is imperative that the insurance company offering the policy is reputable and financially stable. Many policies have benefits that max out at a certain level. The policy should cover a broad spectrum of services as well from home care, to assisted living, and nursing home care. Preferably, it should be an indemnity reimbursement policy once an individual qualifies for benefits, rather than an itemized bill submitted for costs that have to be subsequently approved.
Another consideration is the possibility of coupling life insurance with a LTC policy. While most financial managers generally do not look at permanent life insurance policy favorably as an investment instrument, policies with a LTC rider should be considered. In this type of policy the LTC benefits can be paid in advance of the death benefit of the policy. It is essentially an advance on death benefit proceeds, and often pays more in aggregate LTC benefits than the death benefit. This is typically done with a cap on the monthly benefit. The advantage is simply that a traditional LTC policy can be a sizeable expense. However, if an individual dies suddenly, and never utilized the benefit, this effectively leaves substantial assets to the insurance company. While this is no different than car insurance or homeowners insurance, the difference is LTC policies often carry a sizeable premium. When coupling the life insurance policy with a LTC rider the total cost of coverage is often even more expensive, but there is a guarantee that some form of a benefit will be distributed. If the LTC rider is never activated, the beneficiaries will receive the death benefit as an alternative. Additionally, the underwriting process to determine insurability may be more stringent, as the insurer must weigh the risks of not only a LTC need, but the certainty of death. Those upfront costs associated with these policies are typically more expensive. However, because many offer a fully refundable premium at any point in time, they may seem attractive to an individual holding a heavy cash position which is earning a nominal interest rate in a liquid savings account. Transferring that cash into such a policy will continue to provide liquidity along with insurance protection.
When and how to apply
Being approved for LTC insurance becomes more difficult as and individual ages. As a result, the average age to purchase LTC insurance is 57. According to the American Association for Long-Term Care Insurance, approximately 50% of those waiting until age 70, will be declined due to health reasons.
It is a good idea to look not only at the insurance company’s credit rating, but also the company’s track record in this field of insurance. Many insurers have left the LTC insurance market because they found it too difficult to make actuarial projections on the viability of such an insurance product. Many still offer policies that are subsidized at the state level for part of the cost. In New York State there is the “NYS Partnership for LTC”. One downfall is that subsidies such as the NY state plan can preclude you from utilizing the policy benefits out of state with the same level of asset protection. With so many relocating in retirement, these policies (while more cost effective) may not be viable. However, some states with similar partnerships have agreed to meet the obligation of another state’s plan for those who have relocated. Some companies have had substantial premium increases after the policy is issued. In some cases, it is possible to purchase what is known as a “Ten Pay Policy”. This allows an individual to pay increased premiums for 10 years and the policy is considered to be paid in full and is no longer subject to policy increases. Other policies, such as those coupled with permanent life insurance, allow payment for a policy at an increased premium up front, and in return a request for a full refund should the benefit never be fully realized.
Tax Benefits
A little known benefit is that existing annuity contracts that are Non-Qualified (purchased outside of an IRA or employer based plan) are permitted to take a tax free withdrawal on any gains as long as the proceeds are utilized to fund the LTC premiums. This can be done on a monthly basis, or as a lump sum through a 1035 exchange. However, the annuity payments must be made payable directly to the insurer of the LTC policy. It should also be noted that not all policies accept 1035 transfers.
As you can see, there are many different things to consider before purchasing long-term care insurance. Deciding which option is the best solution can be difficult. However, receiving proper council and doing research will allow an individual to make an informed decision. Some forms of coverage make sense for those who are concerned with protecting the value of their estate. Others, who may have no heirs, may see no issue with spending their assets in order to provide for their care. In such instances, acquiring coverage may not be such a strong priority.
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One of the lessons learned in recent decades resulting from multiple market corrections and periods of increased volatility is that portfolio management has become more dynamic. Traditional asset allocation models of equities, fixed income, and cash equivalents may not be sufficient for growth and income oriented portfolios. In certain cases, alternative asset strategies may be appropriate as a means to supplement a proper asset allocation.
So what are “Alternative Investment” strategies?
The term alternative can mean funds invested in numerous areas such as:
Arbitrage Funds;
M&A Strategies;
Managed Futures; and
Long/Short Investing
One of the more prominent approaches in recent years is that of a long/short strategy. A long short strategy is traditionally associated with a hedge fund. In this kind of strategy, a portfolio manager may choose to buy equities and fixed income investments they feel are appreciating; while simultaneously shorting some of these holdings that they feel are going to decline. Hedge funds, for many years, have utilized this approach while maintaining greater flexibility to choose an investment strategy that can quickly adapt to a rapidly changing environment. Due to these funds limited regulatory oversight, their ability to stay nimble is unlike that of a traditional equity mutual fund that must stay fully invested at all times. A hedge fund has the ability to move assets in any direction, or potentially, stay in cash at times where value is difficult to find.
Financial planners will generally not advocate that investors actively attempt to time financial markets. Even the best mutual fund managers do this with very limited success. In fact many investment advisors often weight portfolios heavily towards ETF’s and index funds because there is so little evidence that an active equity manager will outperform his benchmark. Historically about 60% of large cap fund managers will not outperform the S&P 500 index. More recently, the data has been even less favorable to traditional equity managers. Aside from the higher costs associated with these funds, managers are typically obligated to remain fully invested even at times when they may not see value in the market. This greatly impairs the ability of an active manager to implement their best ideas. So if one were to advocate indexing through ETF’s, then what relevance is a long/short strategy in a portfolio? It would seem to be the antithesis of the data previously mentioned. However, recent data from the last 20-years indicates that when combining a long/short approach as a percentage of a portfolio to a traditional asset allocation, an investor actually reduces volatility while having a nominal impact on net returns. In other words, this approach may provide a similar level of overall long term returns, with reduced shorter term volatility.
Hedging Investments?
The question now is “should the average investor attempt to invest in a hedge fund as a mechanism to lower overall portfolio volatility?” For most investors, this is not a practical solution. Hedge funds can have limited disclosure and extremely high minimums that make them inaccessible to the general public. This makes them not suitable for the average investor. However, in recent years, the mutual fund industry began to recognize the demand for accessibility to the general public. They began to create long/short mutual funds, which are now available to everyone, as an alternative asset class. However, these alternative asset classes come with the traditional disclosures you would expect from traditional publicly traded mutual funds. An investor does need to recognize however, that along with these higher disclosure requirements, they are not as flexible as a traditional hedge fund. Nevertheless, they have been able to provide more overall portfolio flexibility to an active manager. It is important to note that the data from the 2008 market correction demonstrated that most long/short strategies failed to produce positive returns in all market conditions. However, the record also clearly indicated that these strategies tend to be useful at limiting losses in declining markets and producing relatively low volatility returns that can pay off with more consistent performance over time.
What are the benefits?
When examining the benefits, it is important to look at the data immediately after a major market correction as to not skew performance results after a significant market rebound. Consider that over the 10 year period ended September 30, 2009, the Credit Suisse Long/Short Equity Index generated an annualized return of 8.01%, with an annualized volatility of 9.96%. That compared with the Russell 3000 Index annualized returns of just 0.73% and an annualized volatility of 16.57%.
Of course, it should be noted that this 10 year period was an unusually weak period for stocks which saw two major market corrections beginning in 2000-2002 and again in 2008.
When examining more recent data after a significant market rebound, we find that the Russell 3000 Index for the 10 year period ending December 31st 2015 realized returns of 7.94%. While the Credit Suisse Long/Short Equity Index produced returns of 6.53%. So while the returns are clearly not as strong in more positive economic environments, the data suggests an approach that produces more consistency.
While this data shows the long/short strategy seems to fare better in periods of great stress, it’s important to be cautious about overweighting such a strategy, because not all market environments are periods of great stress. However, maintaining a portion of assets in such a strategy in conjunction with a traditional asset allocation has been shown to reduce overall portfolio volatility without significantly impairing returns.
The premise of asset allocation is to not time markets, but rather to manage risk by combining assets of a lower correlation amongst each other. The consistent reallocation of these asset classes requires constant selling into strength and buying into weakness. But over the years, as our economies have become more global, correlations have increased. This has made it harder for financial planners and independent investors to limit risk. The long/short approach is simply an additional piece of the asset allocation pie rather than a single independent investment strategy.
What are the risks?
Competitive demand for new products has created a rush to bring some of these products to the marketplace. Many mutual fund companies assigned managers to alternative mutual funds with little experience in the non-traditional investment space. However, there are several management teams whom have shown an excellent long term track record to date. The total collective suggested portfolio exposure to all forms of alternative assets is debatable, and dependent on one’s tolerance for risk. As a general rule, managers attempt to limit exposure to alternatives to between 5-15% of an investor’s holdings, dependent upon the objectives of said investors.
Historically, the track record tells us that this combination of traditional asset allocation models that incorporate alternative strategies as part of a multi-asset approach, not only lowers correlations across the sum of the portfolio, but also improves the probability of maintaining an income plan. Investors who experience lower volatility with only a nominal impact on longer term returns can more readily sustain a cash flow which is being proportionately withdrawn from a portfolio.
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Inflation is defined as the general rate of increase in the cost of goods and services and is the hidden tax that evaporates our purchasing power over time. Inflation is the result of more dollars chasing after fewer goods. Inflationary risk is one of the many risks that investors must cope with in the grand picture of retirement planning. While investing aggressively may create principal risk, being overly conservative may create inflationary risk.
According to the Bureau of Labor and Statistics (BLS), the cost of the average item purchased in 1984 for $1.00, would cost $2.28 in 2014. The BLS keeps multiple measurements of inflation using what is known as the Consumer Price Index (CPI). One of the versions of measurement, the CPI-U is used to determine the annual increase in benefits paid on national entitlement programs such as Social Security benefits. As the increase over a 30-year period clearly demonstrates, the cost of not investing with an adequate risk level can severely handicap one’s ability to maintain their lifestyle in retirement.
How accurate is the data the BLS has on inflation? Some of the evidence may suggest that the BLS CPI data may be underestimating the true cost of inflation in relation to the average American’s real world experiences. Over the decades the BLS has substantially modified the methods of how the official CPI data is acquired. At one time, prior to 1945 the CPI was known as the Cost of Living Index. It was determined by examining the cost of a fixed basket of goods with a constant weighting in order to maintain a “constant standard of living” for the average citizen.
Since 1945 many academic theories have evolved and developed around the topic of inflation and progressively moved away from the premise of measuring a constant standard of living. Many changes were made in the early 1980s and in the mid-1990s that evolved into the use of geometric weightings that altered the method of inflation based on consumer choices. As an example, if an individual could no longer afford to purchase filet mignon and instead began to buy less expensive pasta…the more expensive filet mignon would be reduced in weighting, while the less expensive pasta would be increased in its weighting on the CPI. While this may be a very fair representation of the actual behavior and activity taking place among consumers, to some, this is not a fair representation of the true cost of maintaining one’s lifestyle. Because eating pasta is not the same as eating a filet mignon.
Additionally, a number of hedonic adjustments were made to the CPI data as well. Hedonic adjustments are price adjustments to goods and services which are quantified based on quality changes. These adjustments are made via computer models using methods that are often viewed as somewhat cloudy and uncorrelated to real world experiences. As economist John Williams has pointed out, one such early example of a hedonic adjustment was the government regulations requiring the use of new gasoline formulas to decrease auto emissions. This initially had the impact of adding several cents a gallon, but the CPI excluded this increase as a quality adjustment, even though the consumer did actually pay the additional cost every time they visited the gas pump.
More recent examples are improvements in technology, which are used to artificially reduce the CPI. If a consumer purchases a new computer for the same price or more than the last computer they owned, the newer model may come with a number of new features which may be of no use to the consumer. These options may have been built into the computer. In the quality adjustments made by the BLS to the national CPI data, that more expensive model computer may have actually gone down in price even though the consumer may have actually paid more out of pocket. Yet, rarely are such quality price adjustments made in reverse. If an individual had to stand in line for an extra two hours to board a plane due to increased security checks, the BLS does not make adjustments to the cost of the ticket to reflect an increase in the price resulting from the decreased quality of service. Another example would be that the CPI data does not make adequate adjustments for the roll of paper towels that may cost the same, but has fewer sheets per roll than in years past.
The American Institute for Economic Research has compiled annual inflation data which is more directly linked to the cost of every day consumer purchases known as the Every Day Price Index (EPI). They have found at times a significantly higher inflation rate when compared to the geometric weightings used by the BLS, however, in some years their data was consistent with that of the BLS
A more thorough understanding of the BLS methods in determining the calculations in the rate of inflation is useful in forming an opinion on the accuracy of the data. It is quite possible that the BLS data is underestimating the true nature of the loss of purchasing power. If this is the case, the rationale for maintaining a longer term investment philosophy targeted with keeping up with and/or outpacing inflation is that much more paramount. While the current CPI methods suggest that broad based inflation is below 2%, many financial planners commonly model closer to a 4% baseline rate when projecting current trends. As a method to err on the side of caution, this allows a financial planner to place greater financial stress on the income projections of a retiree in order to more safely chart a successful course and prepare for the worst.
So when considering the impact of inflation on retirement plans, it may be wise to consider the difference between broad based CPI data versus the cost of more everyday items. Inflation is a serious risk to an individual’s retirement projections. Many of the economic theories used in calculating inflation may be quite useful in regard to political policy making and very long term forecasts. However, as an individual investor who is retired or preparing for retirement in the intermediate term, it may be important to look at the Cost of Living changes with a closer eye and emphasis on more everyday routine consumer purchases.
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One of the oldest debates within the investment community is between the benefits of value investing versus growth investing. Numerous arguments have been made in favor of both approaches at different times. A basic understanding of the two approaches must first be gained to evaluate a point of view.
Value Investing is based on the evaluation of securities which are trading at relatively low prices in relation to their earnings as well as other fundamental analysis. Value stocks produce returns that are most often comprised of both capital appreciation as well as dividends. These tend to be more established entities in comparison to their growth based counterparts.
Growth Investing targets securities which are expected to have faster rates of growth in the future when compared to the broad market indices. Growth stocks produce returns that are more often comprised of primarily capital appreciation and little to no dividend income. They are often more speculative in nature than their value oriented counterparts.
Value oriented securities are often viewed as more dependable because of the more consistent cash flow from dividends. However, in certain market environments they can be more volatile. As one such example, much of the large cap value sector is heavily weighted towards financials which can be a detractor in certain market environments. The S&P 500 value index is currently made up of a 25% exposure to the financial sector. In contrast the S&P 500 growth index is comprised of less than 10% financial sector exposure. During environments which may produce greater stress on financials, large cap value investing may be a more challenging task.
Historically, there have been various periods which have favored both value and growth investing over the short term business cycle. However, the timing of short term market movements has been an exercise in futility for the average investor and very often for investment professionals. The real question then becomes whether or not there is a clear winner over the long term performance trend.
The last decade has shown little evidence that either value or growth has been the dominant performer. The recent 10-year performance of Large Cap equities has given a slight edge to growth over value, with each having their years of outperformance. During the 10-year period ending September 2014, the S&P 500 Value Index had returns of 7.25%, while the S&P 500 Growth Index had returns of 8.90%. A similar result is seen when looking at the S&P 400 Mid Cap Value Index which had a return of 9.87% versus the S&P 400 Mid Cap Growth Index which returned 10.66%. The story is similar when looking at small cap equities; the S&P Small Cap Value 600 Index posted an 8.72% return, whereas, the S&P Small Cap Growth 600 Index had a 10-year return of 9.94%.
Taking a long term look over multiple decades has shown results that differ from the recent trend favoring value oriented securities. The academic work of recent Nobel Laureates, Eugene Fama and Kenneth French, in their Fama/French Three Factor Model has shown that value securities clearly outperform growth securities when given enough time. However, there are extended periods of time in which this trend can and has been reversed…an attempt to isolate a portfolio towards value or growth oriented securities can produce lower portfolio returns. Furthermore, this is in itself an attempt at timing market cycles, which has been historically difficult…if not impossible.
When looking at portfolio construction for the average investor, any bias in either direction should remain nominally tilted towards an increased weighting in one direction or the other. Often times the quest for cash flow resulting from dividends may drive an investor to heavily favor value over growth. As the last decade has demonstrated, this would have produced a lower cumulative return across US equities.
Investors focused on cash flow for the purpose of providing for and/or supplementing their lifestyle should be first concerned with aggregate returns. This is done by drawing cash flow proportionately from an overall strategic asset allocation that encompasses all asset classes and not simply on dividend income.
Dividends and value oriented securities are a fundamental part of proper portfolio construction. However, purchasing a security solely based on its dividend income is not a wise strategy. It is crucial to remember that dividends are not always a proper representation of the cash flow or the fiscal condition of an organization. Dividends distributions change, as do the economic cycles we must endure as investors. It is inevitable that we’ll face periods such as the recent decade in which less income oriented growth securities will outperform their value counterparts. Staying properly invested in a diversified allocation provides an investor the best risk adjusted probability of keeping pace with the markets and achieving their investment objectives.
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