Investing

Personally, I kind of doubt it. My net worth is pushing a million bucks again, now that the market has revived. And nobody, my canny investment manager included, seriously believes my savings will last until the end of my life. The horror of it is, the fact that my house is paid off and I have many hundreds of thousands of dollars in the stock market lifts me into the upper reaches of America’s financial strata. Eduardo Porter reports, in today’s New York Times, that the average American who’s looking at retirement within the decade has a grandiose $104,000 in retirement savings.

Lovely. That’ll keep you going for about four years, if no major expenses hit.

Porter points out that one reason for this unsurprising state of affairs is that, as he puts it, “Wall Street is bleeding savers dry.”

While that may be hyperbolic, his point is that the fees and blatant conflicts of interest that are part of large management firms’ standard business model drain workers’ savings at an alarming rate. Researchers at Harvard, MIT, the University of Hamburg, the University of Toronto, the University of Virginia, and the University of Pennsylvania have found that investment advisers routinely direct clients’ money to funds that share upfront fees with them, and that returns on these funds are weak compared with alternatives. Kickbacks are rife — some advisers have been paid $6,000 to $9,000 to get clients to roll over savings from 401(k) plans to IRAs.

So. Caveat emptor. Or you’re likely to find yourself with an empty bank account come retirement time.

For the time being, Porter concurs with Vanguard founder John C. Bogle in urging investors to seek out low-fee passively managed funds. As an example, Bogle posits a 30-year-old worker earning $30,000 a year, receiving an annual raise of 3 percent. If she invested 10% of her wages in a passive index fund, at age 70 she would have $977,000 in savings. If she put her money in a typical actively managed fund, though, she would end up with just $561,000.

Vanguard and Fidelity are funds with relatively low management fees. Be sure you find out the costs of the funds that appear in your 401(k), and pick the ones with the least rapacious practices.

Like U.S. workers, the British have seen their pensions take a beating recently. Hard-earned savings have been eroded by economic contraction across the Eurozone, which is having knock-on effects in the U.K. People in retirement and those close to retirement age are having to rethink their spending habits and cut down on treats they’d been looking forward to enjoying in their retirement for their entire working lives.

A new survey by Primetime Retirement has found 36% of over-55s are cutting back on spending in certain realms of life including going out, 65%, holidays, 62% and buying clothes 61%. This is because of falling real incomes for the over 55s. For people ages 55 to 64 £318 per week is the average income. However for over 65s this rate drops by 24%.

As a result people are looking for alternative forms of income to their standard pensions. One option to consider is a pension annuity.

A pension annuity converts money locked away in your pension scheme into a regular income. Most people in ‘defined contribution’ pension schemes have to use their pension fund to buy an annuity, which, because it works like an income, is liable to income tax.

There are many types of annuities, and the market is filled with annuity providers claiming to offer the best rate. Before purchasing any kind of annuity it’s important you seek sound professional financial advice. The Money Advice Service is a good place to start before contacting a financial advisor. It offers an annuity comparison table to compare various annuity providers and types of packages to find one that works for you. You just have to fill in a few financial details and the comparison page is then tailored to your requirements making it an effective way of starting your search.

In the U.S., it is important to consider your own circumstances carefully when thinking about investing in annuities, which in this country are a type of insurance product. Although for some people they can be a reasonable part of a larger plan, for most people they’re not the best choice, for the following reasons:

a) Some (but not all) annuities have no provision for inflation-adjusted increases. Thus, although I might get a 6% return on investment by putting a chunk of money in an annuity today, 6% on, say, $100,000 would give me $6,000 now and evermore, whether or not the company issuing the annuity invested my money so that in grows or falls in value.

Thus in 20 years at a reasonable 6% return on investment, my $100,000 might have grown to about $320,700 if managed professionally in a diversified portfolio. But I would still be getting only $6,000 a year…which in the year 2032 ain’t gonna buy much. The annuity issuer would have paid out $$120,000 to me; but it would make a profit of $220,000 on the investment of the $100,000 I handed over at the outset.

If instead I kept my money, had the principal managed professionally, and drew down a more conservative 4% from my investment, at the end of 20 years I would still have control over my entire fund. It would not amount to $320,7oo, but assuming a 6% growth rate and a 4% drawdown rate, I still would have more than $100,000 in savings.

b) When your money is in an annuity, it is tied up permanently. If you need it for some unexpected reason (say, you or your spouse has to go into a nursing home and without it the person will end up in a grungy Medicaid home), you can’t get it back.

c) No matter when you die—whether you live to a ripe old age (God help you!) or you drop dead tomorrow—the money may not go to your heirs. Thus you leave your offspring without the financial capital that they should reasonably expect to inherit as members of a middle-class or higher SES family. Some annuities continue to disburse payments to heirs until the end of a specified period; others do not.

d) Most variable annuities have hefty commission charges and fees. These range from 5% to 14%. Other fees combine to make annuities a very expensive investment. There are no-load annuities, but these are not widely known and not used much. Regulations in the U.K. are undoubtedly different from those in the U.S.; investors need to familiarize themselves with what the laws in their countries allow insurance companies to charge for these products, and to know what the costs will be before deciding to invest.

e) In the U.S., annuities have some complex and onerous tax issues associated with them.

For some people, investing in an annuity is a smart move, and for some, not so  much. Factors to consider include your age, your “fear factor,” your potential longevity based on your  health and the longevity of your immediate relatives, and your projected income tax rates through retirement. Study the matter carefully before investing in annuities—or, for that matter, in any financial product—and consult a trustworthy financial adviser and a tax professional. Remember it’s important to get it right first time. There is no room for second chances in annuities; once you’ve picked, you cannot change your mind.

Image: Piggy bank from German bank HASPA, around 1970. Georgh HH. Public domain.

This post is from John Reimer, CFA, of Stellar Capital Management, LLC. John is my financial adviser.

For the past few years low interest rates have made it challenging for anyone looking to generate income. At present, the yield on the 10-year Treasury bond is below 2 percent, the 5-year Treasury bond yields below 1 percent, high-quality short-term corporate bonds yield very little, and bank deposits and money markets offer next to nothing. The Federal Reserve has said it plans to keep interest rates low until at least 2014 and that it could extend the time frame even further depending upon economic conditions. What is an investor to do? Here are a few alternatives that can help an investor create income in what is a very challenging environment.

Variable-rate Preferred Stocks. Although technically a stock, the structure of these issues resembles a bond more than a common stock. Key features of variable rate preferred stocks:

1) They are issued at par value, normally $25.
2) They have a specified dividend rate, and many have a floor on the dollar amount paid.
3) They are structured to permit increases in the dividend paid.

An example of such a structure is a preferred stock with a minimum dividend rate of 4 percent based on a $25 issue price, equating to a $1.00 minimum dividend per share annually. If that issue is purchased at $20, the investor would receive a 5 percent yield ($1.00/$24). Should economic conditions change (rising inflation or rising interest rates), the base rate of the dividend will increase; should rates drop, the floor yield keeps income levels intact. These issues carry call and maturity features that are important to understand when considering the price per share one is willing to pay.

Step-up Bonds. These bonds pay a set dividend or interest payment for a fixed period of time, then, at specified intervals, increase the payment to a higher level. This structure helps mitigate the risk of rising interest rates in the future, as the coupon rates increase on a set schedule. Government agencies such as Fannie Mae, Freddie Mac, and the Federal Home Loan Bank, are the most frequent issuers of step-up bonds, but corporations, understanding investors’ hesitations with buying long-term, fixed rate bonds at low interest rates, are increasingly getting into the act. Again, the call and maturity features are important to understand when considering the price per share one is willing to pay.

Floating Rate Funds. These funds invest in floating rate notes or direct loans backed by companies considered to be at the lower end of investment grade or below. The notes are short-term in nature; the interest payment floats up and down, based on widely used benchmark rates such as LIBOR (London Interbank Offered Rate), or the Federal Funds Rate; and they are often secured by assets of the borrowing company. These notes/loans typically have lower levels of defaults versus pure high yield bonds because of the shorter nature of the loans and also tend to perform better in a rising rate environment due to the floating rate feature. The average default rate on the floating rate loans from 1997-2010 was 3.8 percent while the average default rate on high yield bonds was 4.9 percent. Because floating rate bonds are often secured by assets of the issuing company, the recovery rate on defaults is much higher than other forms of unsecured debt. They offer a good source of current income and typically pay out monthly interest.

High-yield Debt Funds/ETFs. High-yield bonds are issued by companies that are normally not as financially strong as companies that qualify to offer bonds at lower rates. A term used in conjunction with the high-yield market is “spread to Treasuries,” which means how much more a high-yield bond pays compared to a U.S. Treasury bond (typically the 10-year bond). Currently, that spread is wide. Of course, much of that spread is due to the recent flight to quality, which has pushed U.S. Treasury rates to near historic lows leaving the multiple of high-yield rates over Treasury rates far above average. The combination of the absolute level of interest income and the size of the spread to Treasuries serves to offset some of the risk associated with rising interest rates. To help reduce credit risk, mutual funds or exchange-traded funds diversify their portfolio into many individual bonds, so a single default does not have a big impact on the overall value of the investment.

Emerging Market Debt. Emerging and developing economies issue bonds to fund infrastructure development, just like the U.S. or any other developed country. An allocation to this type of debt security is another method to achieve diversification and higher income than domestic bonds. The easiest way to participate in emerging market debt is through mutual funds. Many emerging market funds hedge the currency risk, meaning investors are not directly affected by swings in the exchange rates. While emerging market credit qualities have been steadily improving, their currencies can be quite volatile so the hedging employed by some of the funds helps to alleviate some of the risks. Some firms offer unhedged funds, which are more volatile, but allow investors to participate in any currency appreciation of the underlying fund holdings vs. the U.S. dollar.

Although there is more risk in other income-producing securities, they do have a place in a diversified portfolio. Some investment vehicles, such as real estate investment trusts (REITs), pay quarterly dividends which can yield 5 percent or more. While most of these do not qualify for the reduced tax rate on dividends, they can still add cash flow to one’s portfolio. Some common stocks also have big dividend payouts. These are often in the range of 3-6 percent and you also get the benefit of the current tax law, which only taxes the dividends at 15 percent at the federal level. With equity investments, an investor should always look at the total return (capital gains and dividends), especially in an environment when stocks are not moving up rapidly. In addition, high dividends are great, but understanding the payout ratio (the amount of earnings paid out in dividends), is one of the ways to avoid the things that look too good to be true.

As you can see, while interest rates are low, there are many ways to secure decent levels of income and protect yourself and benefit from rising interest rates. In this environment, it is wise not to lock yourself into a long-term fixed-rate investment, as you don’t want to be stuck in a low yielding investment that will lose value if rates move higher.