Coffee heat rising

Can Savings Replace Pensions?

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.

An Alternative Option to a Standard Pension

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.

Investing in a Low-Interest-Rate Environment

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.

Serendipitous Stock Market Fluke…i think…

So the Dow is up over 400 points today, after last week’s bizarre drop. This worked out nicely: the rollover I made from GDU’s 403(b) to the big, professionally managed IRA arrived in Stellar’s precincts just as stocks were headed south. With any luck, the boys will have bought a lot of stuff on the cheap which is now worth a ton of money.

With any luck. But…

But I don’t like it. I don’t like volatility in general, and this particular spasm of volatility is hugely whim-whammish. Volatility tends to presage pullbacks, slowdowns, not-getting-rich periods. Yea, verily, losing pretend-money periods. Check out this interesting podcast, which pretty much reflects my sense. “Like he said.”

Yesh. A couple of weeks ago, I finally figured out how to get around the state’s prohibition on moving my money (my money, goddammit) from the university’s 403(b) plan to my IRA, where a broad spectrum of wisely calculated investments in blue chips vastly outearns the staid mutual funds that have held 16 years of retirement contributions.

As you may recall, the bureaucrat who directs the state’s RASL program (whereby the state ponies up almost $20,000 worth of unused sick leave earnings over a three-year-period) announced that if I rolled my 403(b) savings she would declare me “not retired” and deny payment of this valuable benefit. Since my traditional IRA has been known to earn as much as $8,000 in a month—but more typically makes about $1,800 to $2,000—we’re talking about sacrificing a substantial increase in potential extra earnings, probably enough to wash the 20 grand of RASL. Intensely annoying.

Well. Duh! The trick is to leave enough cash in the 403(b) to cover the drawdown until February 2012, when the last of the three RASL payments will be issued. That, in the large scheme of things, isn’t very much: only about $11,000.

So I emptied TIAA-CREF, which still held a little in an annuity that I mistakenly thought could not be rolled into Vanguard (which the university swapped into Fidelity when it dropped the Vanguard option a year after offering it), and then I rolled all but 11 grand out of Fidelity to the big IRA. This moved about 155 grand into the better-performing instrument. The bulk of that arrived in the cash fund last week.

Naturally, I was not happy to see the market take an all-time record-breaking dive. Now I feel better, at least temporarily. But I remain wary.

Nor was I pleased when the latest factotum I reached at Fidelity remarked that a lot of university retirees use this strategy to rescue funds from underperforming 403(b)s. How many times did I discuss this with how many other corporate bureaucrats there? How many of them told me they’d never heard of the State of Arizona’s you-can’t-take-it-with-you rule? And how much would I have been helped if the first guy I reached there had suggested doing this, rather than my  having to figure it out on my own over three months of cogitation?

Oh, well.

We’re in the money, we’re in the money
We’ve got a lot of what it takes to get along.*

…for the nonce.

*The Gold Digger’s Song, by Harry Warren, 1933

Financial Freedom: Building the bankroll, part 2

We’ve seen that a key part to underwriting Bumhood is living below your means and using the resulting extra cash from income to build savings.

The corollary to this important principle is that your money needs to work for you. That means it has to earn money instead of you having to go to work to earn a paycheck.

How to make this happen? Invest. Your strategy should not be excessively conservative, because truly safe, FDIC-insured instruments such as high-interest savings accounts and CDs don’t return enough to keep up with inflation. Although clearly some cash should reside in your bank or credit union, where it will be insulated from a major market crash such as the one we recently saw, to grow your money you have to take some risk. This means investing something in the stock market or (yes!) in real estate.

Investment plans that work to support bumhood are long-haul arrangements.* Savings should be invested for the long term in reasonably stable instruments such as fairly staid mutual funds and left there, even when the market slides. Low-overhead mutual funds are an excellent choice, because the various costs involved in maintaining them do not bite significantly into your gains. Vanguard and Fidelity funds lead the pack here.

Some mutual funds buy stocks; others buy bonds; still others are balanced funds with a variety of investments. Read the prospectus for each fund that interests you, and be sure your choices don’t duplicate each other. Most advisers suggest that equities investments be allocated about 60 percent to stocks and about 40 percent to bonds, because as a general rule when stock values fall bond values rise. (This is a huge oversimplification, as I’m sure we’ll hear from readers. Study up on investment products. Several “For Dummies” books on the subject have good to excellent reviews, and regular reading of the Wall Street Journal and the New York Times business section can be instructive.)

Stocks and bonds are not the only places to grow savings. Some people have done well investing in rental real estate. This also is a long-term hold: expect to keep the property for 10 to 20 years before it turns a profit. As we’ve seen, for investors real estate presents no less risk than the stock market, and so you  need to be prepared to watch values go up and down. A quick perusal of Amazon’s offerings on real estate investment will clue you to the amount of snake oil out there: be extremely careful, and do not operate without a trusted adviser who can prove his (or her) expertise. As with the stock market, it’s important to do your homework and know what you’re doing before investing. If real estate interests you but the prospect of dealing with renters does not, consider a real estate investment trust (REIT) or an REIT mutual fund. Sometimes limited partnerships invest in commercial real estate, although this tool is probably not for everyone.

Because money sitting in the bank does nothing for you—it just sits there—it’s crucial to put your savings to work by investing in a diversified set of financial instruments, ranging from the relatively safe (CDs, the money market) to relatively risky. The degree of risk depends on your age (i.e., how many years you have left to make up any losses) and your personality. To make money work for you, you’ll need to take some risk with some part of your savings. But as you draw closer to your projected escape from the day job, it makes sense to pull back from riskier investments and shift funds to more conservative tools.

One way or another, at any age your savings should be working for you, and some part of it should be in stocks or instruments that earn similar returns. Over the years, my savings have returned about 8 to 9 percent, on average. Of course, that faltered when the Bush economy crashed. While the artificially pumped-up economy was hot, some months I would earn $8,000 on a $250,000 investment. Although all that went away when the market collapsed, returns are now back up in the 8 percent range.

Thus if I draw down the widely recommended 4 percent—more than I need to live on, as a matter of fact—savings will continue to grow even without my adding any  new cash.

And voilà! Full-blown financial freedom: Return on passive investments that meets or exceeds the amount you need to support yourself. The less you spend on your lifestyle, the more you can save, the more you can invest, and the sooner you can get off the day-job treadmill. Living below your means, faithful, regular saving, and wise investments can spring you free sooner than you think.

The Financial Freedom Series

An Overview
The Health Insurance Hurdle
Own Your Roof
Bankrolling Bumhood, Part 1


* I am not an investment adviser! I am just a writer sitting in front of a computer. No part of this information should be taken as investment advice. For advice on financial planning, consult a tax professional and a certified financial planner. Always read all prospectuses and related information before investing in any stock, bond, or mutual fund.

Return-of-Premium Insurance: Is it a good idea?

Over at Bargaineering, Jim recently discussed an relatively new insurance instrument called “Return of Premium Insurance.” This is a type of term life policy whose issuers promise to return your money after the policy expires.

In term insurance, you pay a specific monthly or annual premium so that the company will pay a benefit to your survivors should you die an untimely death. Unlike whole life insurance, which builds something like equity at a very low return, term does not pretend to be any sort of “investment.” It exists simply to protect a spouse or children from the loss of your income. A policy normally has a beginning and an end (typically ten to thirty years), after which it expires and, if you still need coverage, you have to buy a new one.

Return of premium (ROP) insurance offers to return your premiums after the policy expires. In other words, if you paid a total of, say, $15,000 over the term of the policy, at the end of the term you get the 15 grand back. Thus you appear to be getting something for nothing: the insurance coverage works like any term policy, but the amount you pay for it is returned to you if you outlive the policy.

This, we’re told, amounts to a kind of “investment,” and oh, joy, the money you get after 30 years is tax-free! (It’s really not income: it’s a refund.) This strategy supposedly has the advantage, in addition to providing “free” insurance coverage, of forcing you to save over a long period.

Let’s think about that.

ROP insurance costs significantly more than ordinary term insurance, and the costs are going up in 2010 because regulatory agencies now require companies to return a significant portion of your premiums should you cancel the policy before the end of the term. These policies can cost as much as 50% more than a plain term policy. If you can afford to pay that much for life insurance premiums, it stands to reason that you can afford to pay the cheaper amount for the same coverage with a term policy and put the difference away in a mutual fund.

A few insurance premium calculators that don’t make you a target for insurance salesmen reside on the Web. According to this one, an ordinary 30-year term policy for a 30-year-old man ranges from about $620 to $825 a year. A middling premium for term insurance, then, would be about $720. A similar calculator for ROP shows him paying $2,270.50 a year for a 30-year ROP policy.

The difference between $2,271 and $720 is $1,551 a year, or $129.25 a month.

At the end of his 30-year policy, our ROP buyer, who by then is 60 years old and contemplating retirement, gets $68,130 back. At that time, an average 4 percent inflation rate  has reduced the buying power of this amount to $21,005.75, in 2010 dollars.

What happens if our consumer buys the old-fashioned, plain-vanilla term policy and stashes the extra $129 a month in savings?

Let’s say he starts with nothing but invests the $129, faithfully, month after month, in a mutual fund returning a fairly typical 6 percent. In 30 years his fund is worth $129,582.44. The corrosive effect of inflation erodes the purchasing power of this amount, over 30 years, to $39,952.69. But even this pallid value is almost twice as much as he would have had were his premiums simply refunded to him.

Meanwhile, however, the insurance company is not hiding our consumer’s premiums under a mattress. It also is investing the money, but instead of a mere $129, the company has his entire ROP premium to invest: $189.25 a month. In 30 years at 6 percent, the policy earns $190,104.47 for the insurance company. After the company returns $68,130 to the customer, it sees a profit of $121,975.

That’s assuming the company stays in business for 30 years. We’ve seen what “too big to fail” means…who would have thought, just five years ago, that major banks would go down in the dust? An insurance company is just another financial institution, no more nor less vulnerable to the vagaries of future recessions than any other corporation. If the company folds before the 30-year policy expires, our consumer could very well lose all of his “investment,” since a bankrupt company is unlikely to honor a contract to return money it doesn’t have.

Pretty clearly ROP life insurance is a great idea…for the insurance companies!