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QUARTERLY UPDATES Q4 2012

Š 2013 by Institute of Business & Finance. All rights reserved.

v1.2


Quarterly Updates Contents MUTUAL FUNDS AND ETFS LEVERAGED LOAN FUNDS LARGEST ETF FAMILIES FUND YIELD CALCULATING ETF COSTS DIVERSIFIED REITS ETFS

1.1 1.1 1.1 1.2 1.3 1.3

ANNUITIES VAS OFFERING BUYBACKS ANNUITIZATION FOR RETIREES

2.1 2.1

STOCKS AND BONDS MANAGED FUTURES VS. S&P 500 TIPS CONCERNS EARNINGS PER SHARE HIGH-YIELD MUNICIPAL BONDS

3.1 3.2 3.2 3.3

MASTER LIMITED PARTNERSHIPS MLPS MASTER LIMITED PARTNERSHIPS

4.1 4.1

TAXES INCOME TAX DEDUCTIONS 2013 CONTRIBUTION LIMITS HISTORY OF U.S. INCOME TAXES THE 0% CAPITAL GAINS RATE

5.1 5.1 5.1 5.2


FINANCIAL PLANNING COLLEGE COSTS RETIREMENT SAVINGS NEEDED REVERSE ROTH IRA STRATEGY SOCIAL SECURITY: CLAIM AND SUSPEND BENEFITS COMMON IRA MISTAKES NEST EGG WITHDRAWAL RATES LIABILITY FOR NURSING HOME BILL WITHDRAWAL ASSUMPTIONS SEEKING HIGHER INCOME AND KNOWLEDGE MEDICARE 2013 LONG-TERM CARE COSTS INVESTOR IGNORANCE PORTFOLIO REBALANCING BUYING A HOME

6.1 6.1 6.1 6.2 6.2 6.4 6.5 6.6 6.6 6.7 6.7 6.9 6.10 6.10

ECONOMICS ENERGY COST COMPARISON GLOBAL GDP [$72 TRILLION FOR 2012] NATURAL GAS GLOBAL IPOS DOWNSIZING

7.1 7.1 7.2 7.2 7.3


QUARTERLY UPDATES MUTUAL FUNDS AND ETFS


Mutual Funds and ETFs

1.LEVERAGED

1.1

LOAN FUNDS

Leveraged loan ETFs and mutual funds are sometimes recommended when there is a fear of rising interest rates. The interest rate on these loans is usually adjusted quarterly, thereby eliminating most, if not all, interest rate risk. However, the great majority of these loans have a junk rating, similar to high-yield corporate bonds. The typical leveraged loan closed-end fund is leveraged by 26% (in an attempt to enhance yield). In 2008, the average closed-end fund lost ~ 46%, while the average openend leveraged fund dropped 30%. During the third quarter of 2011, the typical closed-end leveraged loan fund lost 14%, while its open-end peer was down 4%.

LARGEST ETF FAMILIES Looking at market share as of October 2012, the five largest companies offering ETFs are the following (% of total U.S. market shown in parentheses): iShares (40%)

PowerShares (15%)

State Street Global Advisors (26%)

Van Eck (12%)

Vanguard (19%)

FUND YIELD Generally, a fund’s yield is whatever it pays out during the year in dividends and interest. For example, if a fund is selling for $20 a share and paid out $1 in dividends and interest payments, its yield would be 5%. Because a fund’s investments and its payouts change over time, advisors need to understand the difference between its 12-month yield and the SEC yield. The advantage of using the 12-month yield is that it reflects exactly what the ETF or mutual fund paid out over the past year and divides this amount by the fund’s current NAV. The disadvantage is that the fund may have a different payout for the upcoming 12-month period (i.e., it sells some high-yield securities).

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Mutual Funds and ETFs

1.2

The SEC yield reflects what the fund has paid out in interest and dividends over the past 30 days and then annualizes that figure. The measurement is more accurate for fixedincome funds since equity funds own stocks that tend to have “lumpy” payouts—bigger payouts near the end of the year or quarter.

CALCULATING ETF COSTS The table below shows the one- and five-year costs for owning $10,000 of the PIMCO Total Return ETF (BOND), the company’s flagship fund. The table assumes a $7 charge to buy and sell the fund and a bid-ask spread of 0.02% (source: IndexUniverse, October 2012).

Annualized Cost to PIMCO Total Return ETF Investors Cost

1 Year

5 Years

Expense Ratio

0.55%

0.55%

Bid-Ask Spread

0.02%

0.00%

Buy/Sell ($7 @)

0.14%

0.03%

Total (annual cost)

0.71%

0.58%

Charles Schwab has ETFs with an expense ratio of just 0.04% ($4 a year for a $1,000 investment). The next table shows the average bid-ask spreads by ETF category for September 2012 (source: IndexUniverse).

ETF Bid-Ask Spread ETF Category

Spread

ETF Category

Spread

U.S. Fixed Income

0.22%

Foreign Bond

0.85%

U.S. Equity

0.25%

Currency

1.06%

Foreign Stock

0.61

Inverse

1.65

Alternatives

0.65%

Leveraged

2.31%

Commodities

0.79%

Average

0.92%

Asset Allocation

0.84%

Average

0.92% QUARTERLY UPDATES

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Mutual Funds and ETFs

1.3

DIVERSIFIED REITS REITs are diversified in one of two ways: type of property and location. Critics of diversified REITs contend that transparency is reduced and measurement is more difficult; sector-type REITs can be more easily compared to a more-defined group. Some companies such as Franklin Templeton prefer to only buy REITs for its mutual funds that are specialized in one sector. As of early 2013, the five largest diversified equity REITs were as follows:

Largest U.S. Diversified REITs [2013] Name

Billions

5-Year Total Return

Vornado Realty Trust (VNO)

$15.0

-7.2%

Liberty Property Trust (LRY)

$4.2

44.2%

Duke Realty Corp. (DRE)

$3.7

-32.6%

W.P. Carey Inc. (WPC)

$3.3

94.9%

PS Business Parks Inc. (PSB)

$2.0

42.4%

ETFS As of November 2012, the ETF marketplace was valued at $1.3 trillion (vs. $10 trillion invested in mutual funds). iShares (BlackRock) remains the largest player with 41% of the marketplace, down from 60% in 2007. Next to BlackRock, the next two largest ETF sponsors are State Street (25% market share) and Vanguard (18% market share). There are over 1,500 ETFs, and almost all of them are passively managed. Vanguard recently introduced an index ETF that mimics the iShares Barclays 0–5 Year TIPS ETF; the Vanguard offering has an annual expense ratio of just 0.1%. On January 2013, SPDR S&P 500 ($120 billion) will celebrate its 20th anniversary as the first ETF. Today, this ETF represents 9% of all EFT assets. The first bond ETF began operations 10 years ago. The total fixed-income portion of ETFs represents just 18% of the ETF marketplace. The most popular bond ETF is PIMCO’s BOND ETF ($3 billion), which mimics PIMCO’s $278 billion total return bond fund. The table below provides some ETF statistics.

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Mutual Funds and ETFs

1.4

ETF Statistics [November 2012] Biggest stock ETF (SPY)

SPDR S&P 500 ($120 billion)

Biggest bond ETF

iShares iBoxx $ Investment Grade Corp. ($25 billion)

Total stock assets

$900 billion

Total bond assets

$237 billion

Largest 1-day redemption

June 23, 2008 (92 million shares of SPY)

Most positions (2,953)

Vanguard Russell 3000 (VTHR)

Biggest commodity ETF

GLD (SPDR Gold Shares) $75 billion

Actively managed ETFs

55

Cheapest ETF

0.04% (SCHX) Schwab U.S. Large Cap

Sponsors

49

Total countries represented

97

Most countries represented

50 (ACWX) iShares MSCI ACWI ex-U.S.

Average Bid-Ask ETF Spreads [September 2012] U.S. Fixed Income

0.22%

U.S. Equity

0.25%

Foreign Equity

0.61%

Alternatives

0.65%

Commodities

0.79%

Asset Allocation

0.84%

Foreign Fixed Income

0.85%

Currency

1.06%

Inverse

1.65%

Leveraged

2.31%

Average of all categories

0.92%

Source: IndexUniverse

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Mutual Funds and ETFs

1.5

Annualized Cost for ETF Investors [September 2012] Category

1-Year

5-Year

Expense ratio

0.55%

0.55%

Bid-ask spread

0.02%

0.02%

Commission to buy + sell

0.14%

0.03%

Total (annualized)

0.71%

0.58%

Source: IndexUniverse

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QUARTERLY UPDATES ANNUITIES


Annuities

2.VAS

2.1

OFFERING BUYBACKS

A number of issuers of variable annuities with living benefit riders—including Hartford, AEGON, AXA, and Transamerica—are making offers to buy back some contracts from contract owners. The possible short-term losses to the insurers are expected to be more than offset by their long-term savings. In general, some VA issuers are offering contract owners their cash value plus an additional amount. These insurers want to eliminate lifetime payment liabilities for a certain percentage of their contracts. Advisors should understand that such buyouts are not usually in the best interest of a contract owner. Moreover, any type of full redemption could easily trigger a tax event; gains and “buyout bonuses” are taxed as ordinary income if the contract redemption exceeds the original cost basis.

ANNUITIZATION FOR RETIREES Moshe Milevsky is an associate professor of finance at University of Toronto’s business school; he is also a founder of QWeMA Group, a company that develops products for wealth management and insurance, with a focus on retirement income. By adding an immediate fixed-rate annuity to the asset mix for a retiree, the likelihood of success increases (from 88% to 92%); the amount allocated to stocks also increases, while the expected legacy to heirs decreases. The table below is based on a target goal of $25,000 a year (which will add to the expected $35K a year from a couple’s Social Security).

Using an Immediate Fixed-Rate Annuity Allocation

Sustainability Expected legacy

Without Annuity

With Annuity

50% stocks 40% bonds 10% cash

65% stocks 15% bonds 05% cash 15% annuity

88%

92%

$444,000

$386,000

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QUARTERLY UPDATES STOCKS AND BONDS


STOCKS

AND

BONDS

3.MANAGED

3.1

FUTURES VS. S&P 500

The table below shows the five worst periods for the S&P 500, from the beginning of 2002 to the end of 2011. These negative returns are compared to returns from managed futures, as represented by the Barclays CTA Managed Futures Index.

5 Worst Periods for S&P 500 [2002–2011] Period

S&P 500

Managed Futures

7-16-1990 to 10-11-1990

-19.2%

9.7%

11-28-1980 to 8-12-1982

-27.1%

38.8%

8-25-1987 to 12-4-1987

-33.5%

9.7%

3-24-2000 to 10-9-2002

-47.4%

22.5%

10-9-2007 to 3-9-2009

-55.2%

18.3%

The next table covers the same period (2002–2011) and shows annualized returns for four different balanced portfolios. During this period, having a portion in managed futures helped limit downside risk but required a modest to moderate weighting in managed futures, something the client may perceive as being unacceptable—either due to the longterm track record of managed futures or their perceived risk (when thought of as a standalone asset).

5 Worst Periods for S&P 500 [2002–2011] 60/40

10% MF*

20% MF*

30% MF*

Annualized Return

-19.2%

9.7%

-19.2%

9.7%

Standard Deviation

-27.1%

38.8%

-27.1%

38.8%

Maximum Drawdown

-33.5%

9.7%

-33.5%

9.7%

60/40 = 60% S&P 500 and 40% Barclays Aggregate Bond Index * MF = managed futures as represented by the Barclays CTA Managed Futures Index

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STOCKS

AND

BONDS

3.2

TIPS CONCERNS Treasury inflation-protected securities (TIPS) are issued by the U.S. Treasury and are designed to keep pace with CPI increases. The first TIPS were issued in 1997. TIPS comprise two parts: a real return and a CPI adjustment every six months. The “moving part” is the CPI change. The “real return” is a locked-in rate that stays the same until the maturity date. Investors earn a fixed rate of interest on an ever-increasing amount of principal. Some analysts believe TIPS are only a good idea when the real return (locked-in rate) is 2% or more per year. As of February 2013, 30-year TIPS were offering a 0.5% real return (plus an inflation adjustment of face value every six months). Five-year TIPS had a real return of -1.4% annually. This means that if inflation were to average 0% over the next five years, the investor would lose 7% of principal (-1.4% per year for five years). In February 2010, the February 2040 was issued and has had a total return of 40% over three years. Since 2003, 10-year TIPS real returns have ranged from just over 3% (late 2007) to as low as -1% (late 2012).

EARNINGS PER SHARE There are several “earnings” figures reported by a corporation to its investors. Basically, there are three: net income, earnings per share, and diluted earnings per share. Net income for a quarter or year is the total profit on an after-tax basis. Since any stockholder only owns an extremely small fraction of even 1% of the company, investors will likely want to look at one of the two figures of earnings per share. Net income divided by the number of outstanding shares represents earnings per share (EPS). Sometimes, this can be a misleading number if there are investors or company employees who have rights to shares and such rights have not yet been exercised (i.e., warrants or options). Fully diluted earnings per share take into account all outstanding shares plus all shares represented by warrants or options not yet exercised. Some publications, such as The Wall Street Journal, Barron’s, and MarketWatch.com, use fully diluted earnings per share in their stories and reporting. This is considered a more conservative measure of a company’s profit than just EPS.

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STOCKS

AND

BONDS

3.3

HIGH-YIELD MUNICIPAL BONDS According to Moody’s, the cumulative default rate for high-yield municipal bonds from 1970 through 2011 was 7.94%; this translates into an average annual default rate of 0.19% (7.94/42 years). Over the same period, investment-grade municipal bonds had a cumulative default rate of 0.08% (or 0.002 per year). Total return figures for high-yield municipal bonds have been mixed: -24% (2008), 31% (2009), 4 (2010), and 11% (2011). During these same four years, long-term municipal bonds had the following returns: -10% (2008), 18% (2009), 1% (2010), and 11% (2011). High-yield muni bonds may be subject to event risk, for example, fees from activities from an airport terminal or special revenue bonds issued by American Airlines (which filed for bankruptcy in late 2011). The high-yield muni bond marketplace is estimated to be $65 billion, a small slice of the $3 trillion municipal bond market. Roughly 75% of the Barclays Municipal Bond High Yield Index is below-investment grade; the balance is in low-investment grade bonds. The biggest municipal bankruptcy in U.S. history took place in November 2011, when Jefferson County, Alabama, filed for bankruptcy with $4 billion in debt.

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QUARTERLY UPDATES MASTER LIMITED PARTNERSHIPS


Master Limited Partnerships

4.1

4.MLPS

Master limited partnerships (MLPs) are popular because of their high payouts that qualify for favorable tax treatment. As of December 2012, the Alerian MLP Index (symbol AMZ) had a 6.4% dividend yield versus 2.0% for the S&P 500. Over the past five years, AMZ was up 29% versus -2% for the S&P (five years ending December 17, 2012). Since its 1996 inception, annualized volatility has been 19%, only slightly higher than the standard deviation of the S&P 500. The Alerian MLP Index ETF (symbol AMZ) means the investor does not have to file a K1 form, which is normal for MLPs. This ETF (which is not leveraged) seeks to track the performance of the Alerian Infrastructure Index. The actual index comprises 25 energy infrastructure MLPs; the majority of the income from these holdings come from the transportation, storage, and processing of energy commodities. The index is cap weighted; its largest three holdings comprise over 26% of the portfolio: Kinder Morgan Energy Partners (KMP), Enterprise Products Partners (EPD), and Energy Transfer Partners (ETP). The ETF has a 4.9% annual expense ratio. Holdings are divided into three broad areas: petroleum transportation (41%), natural gas pipelines (33%), and gathering and processing (26%).

MASTER LIMITED PARTNERSHIPS Master limited partnerships (MLPs) can offer the investor an attractive income stream plus tax benefits. Tax on 80% of distributed income is deferred (until partnership shares are sold); the investor pays ordinary income taxes on the remaining income. Each year, partnership investors must fill out Form 1065 (Schedule K-1) to declare partnership income. MLPs pay out 5–6% a year and are projected to also enjoy 5–6% annual appreciation (source: Morningstar). The majority of MLPs have even increased their distributions by ~ 5% a year over the past 20+ years. The Alerian MLP Index is considered the benchmark for MLPs. Over the past 10 years (2002–2011), the index had an annualized return of 16.7%, about twice that of the S&P 500. MLPs that produce oil and gas are sensitive to commodity prices, as opposed to pipeline operators who get paid no matter what oil and gas is selling for. Popular pipeline operators include Energy Transfer Partners, Atlas Pipeline Partners, Genesis Energy, Magellan Midstream Partners, Western Gas Partners, and Kinder Morgan Energy Partners (the largest publicly traded MLP).

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QUARTERLY UPDATES TAXES


Taxes

5.1

5.INCOME

TAX DEDUCTIONS

One way for the federal government to either raise revenue or lower tax rates is to limit taxpayer deductions. The three biggest tax breaks for taxpayers are the following: employer-provided health insurance, mortgage interest deduction, and retirement plan contributions. According to the Tax Policy Center in Washington, only ~ 12% of taxpayers making < $63,000 itemize versus 90% of those taxpayers with earnings > $150,000. The top 5% of taxpayers (those earning $200K+) have itemized deductions representing ~ 13% of their income.

2013 CONTRIBUTION LIMITS During October 2012, the IRS announced 2013 retirement plan contribution limits.

2013 Contribution Limits Retirement Plan

Contribution Limit

Traditional IRA and Roth IRA

$5,500 (catch-up stays at $1,000)

Roth IRA Eligibility

$178,000 MAGI ($112,000 if single)

401(k)

$17,500 (catch-up stays at $5,500)

SEP-IRA

< $51,000 or 25% of compensation*

SIMPLE IRA

$12,000 ($2,500 catch-up)

* 20% of sole proprietor

HISTORY OF U.S. INCOME TAXES On February 13, 1913, passage of the Sixteenth Amendment authorized a federal income tax. The first time an income tax was used was to raise money during the Civil War; the tax was repealed in 1872 because money from the tax was no longer needed.

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Taxes

5.2

In 1894, a 2% income tax was levied on those who made more than $4,100 a year. In 1895, the U.S. Supreme Court ruled that a tax on wages, professions, and trades was legal. However, the income tax was ruled to be unconstitutional because it included a tax on rental income (a violation of the Constitution’s “direct tax” law). In 1909, a 1% “excise” tax for corporate income over $5,000 was enacted. A tax on income was enacted when the Constitution was amended in February 1913 by the required 36 states. Soon, the tax was “graduated,” ranging from 1–7% of taxable income. Before WWII, just one-third of the population earned enough income to be subject to the tax. After the war, half the country’s workers were subject to income taxes. Up until 1947, farmers paid little or no taxes because it was believed they did not keep good records and were not expected to keep good records. Today, 70% of the population is subject to income taxes. Close to $1 trillion is collected each year from individual taxpayers. The top 40 million pay close to $860 billion, and the bottom 104 million returns pay the balance of roughly $95 billion. Taxpayers challenging the legality of the 16th Amendment can face a penalty of up to $25,000.

THE 0% CAPITAL GAINS RATE The 0% long-term capital gains rate applies to individuals with taxable income of < $35,350 ($70,700 joint return); the dollar figures include capital gains. For example, a sole proprietor with taxable income of just $10,000 would not qualify for the 0% rate if his capital gains were $26,000. There are a few important points to keep in mind about the 0% and 15% capital gains rates: [1] state tax rates likely apply (e.g., California taxes capital gains at the same rate it taxes other taxable income), [2] the capital gains may tax more of a recipient’s Social Security checks, [3] children subject to the “kiddie tax” do not get the 0% rate, and [4] the 0–15% capital gains rate has some exceptions resulting in higher taxes (e.g., collectibles, rare coins, art, gains from the sale of a qualified small business, and previously depreciated property that has now been sold).

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QUARTERLY UPDATES FINANCIAL PLANNING


Financial Planning

6.COLLEGE

6.1

COSTS

For the 2011–2012 academic year, the average tuition and fees across the U.S. were $8,244 at four-year public universities and $28,500 at private institutions (source: the College Board). At the end of March 2012, Americans owed $904 billion in student loans compared with $679 billion owed on credit cards.

RETIREMENT SAVINGS NEEDED According to Fidelity Investments, typical wage earners should aim to save at least eight times their final annual pay to help ensure they can afford basic living expenses in retirement. By age 35, the goal should be to have saved at least an amount equal to your gross salary; by age 45, the goal is to have cumulatively saved three times one’s annual salary.

REVERSE ROTH IRA STRATEGY Advisors who have clients converting a traditional IRA into a Roth IRA should consider the following strategy: use several accounts and then cherry-pick at year-end if there are possible tax savings. The IRS allows a taxpayer to “undo” a conversion by October 15 of the year following the conversion to a Roth IRA. The most common reason to reverse is when the Roth’s account value has dropped since the conversion (because taxes are paid on the original amount converted). For example, suppose a client has $100,000 in a single traditional IRA account. Instead of setting up just one Roth IRA (for the conversion), consider establishing four different Roth conversion accounts and funding each one completely differently (e.g., long-term bond, REIT, growth stocks, and value stocks), with $25,000 going into each account. Wait until early October of the following year and see what has happened to the account values. Suppose three of the accounts increase (or remain level), but the REIT Roth IRA account drops in value from $25,000 down to $19,000. By reconverting this one account, taxpayer’s taxable income would decrease by $6,000.

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Financial Planning

6.2

SOCIAL SECURITY: CLAIM AND SUSPEND BENEFITS Each day, 182,000 people visit a Social Security office. One strategy considered by married couples is “claim and suspend.” The strategy is to have both working spouses wait until age 70 to collect the maximum benefit. Every year, the benefit is delayed after “normal retirement age” (NRA), which means an 8% annual increase in benefits (note: NRA is between age 65–67, depending upon the worker’s date of birth). Here is how the strategy works: [1] 1st spouse reaches NRA, files for benefits, and immediately suspends them [2] 2nd spouse can now apply and receive half of the spousal benefits [3] You cannot “double up” on this strategy (both cannot receive spousal benefits) [4] 1st spouse starts to receive benefits (the maximum) at age 70 [5] 2nd spouse receives maximum benefits (his/her own work record) at age 70

COMMON IRA MISTAKES As of November 2012, roughly 46 million U.S. households (two out of five) held a combined $5 trillion in IRA assets. According to the IRS, some of the most common (and costly) IRA mistakes made by taxpayers are as follows:

Excess Contributions You can make excess contributions in one of several ways: [1] writing a check that is in excess of the annual limit, [2] transferring accounts that are past the 60-day rule, and [3] making contributions and not being eligible to do so. If an excess contribution is made, the IRS can impose a 6% annual penalty on excess amounts. If excess contributions are made year after year, the total penalty can be substantial (i.e., the cost of amending several years of tax returns + IRS penalty + IRS interest charge). The excess amounts must also be taken out from the IRA or Roth IRA accounts.

Required Withdrawals Traditional IRA owners must start taking their required withdrawals by April 1 of the year after they turn 70½ (e.g., Ed has his 70th birthday in March 2012; he will be 70½ in 2012 and therefore must make a withdrawal sometime in 2013).

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Financial Planning

6.3

The required traditional IRA withdrawal amount is based on the cumulative value of the taxpayer’s traditional IRA accounts. The taxpayer fulfills the requirement if enough money is taken out of just one account—even if custodians of the other accounts report that a withdrawal is needed. If you have a client with a 401(k) who is still working for the company and owns < 5% of the company, there are no required withdrawals until the worker stops working at the company. However, if this same worker rolls over 401(k) money into a traditional IRA, the worker is subject to RMDs for the IRA account.

Realizing the Mistake If your client realizes an excess contribution has been made, for whatever reason, the mistake can be corrected penalty free if the excess is taken out before October 15 of the following year (the year after the excess contribution). The client should withdraw the excess plus any interest or gain from the excess amount.

Inherited IRAs Inherited IRAs have different withdrawal rules. If someone over 70½ dies and did not make a withdrawal that year, the beneficiary must make a withdrawal and claim it as ordinary income for the year. If an IRA is inherited from a nonspouse, the beneficiary must make annual withdrawals based on his life expectancy (starting the year after death). With a nonspouse-inherited IRA, it makes no difference as to the age of the decedent or the age of the beneficiary. If an IRA is inherited from a spouse, it can be rolled over into the beneficiary’s own IRA or set up as an inherited IRA. By setting up an “inherited” IRA account, withdrawals can be postponed until the deceased spouse would have turned 70½. Remember: If a client inherits an account from someone that is not their spouse, the account should be titled as an inherited IRA; annual withdrawals are still required but are based on the beneficiary’s remaining life expectancy. If someone inherits an IRA from a nonspouse and puts it into an IRA that does not indicate it was inherited, the costs can be extreme. For example, think of the accumulated penalty and interest charges for someone who inherited an IRA from a nonspouse 10–20 years ago.

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Financial Planning

6.4

NEST EGG WITHDRAWAL RATES Suppose you had a client with a $1 million nest egg (½ stocks and ½ bonds) who began taking withdrawals at age 65 at the beginning of 1973. Depending on the inflationadjusted withdrawal rate, the client would have been broke before age 77 (January 1977) if the withdrawal rate had been 7–8% per year; the entire nest egg would not have been wiped out until age 89 (January 1997) if the rate had been 5% (age 82–83 at a 6% rate). However, if the inflation-adjusted rate had been just 4% per year (i.e., $40K the 1st year and then $41.2K the 2nd year, etc.), the nest egg would have been worth $2.1 million when the client reached age 101. The three tables below, based on a 2009 analysis from Financeware and BlackRock (using Monte Carlo simulation), show how long assets will last depending on the period (20–30 years), the stock/bond mix (20–100% for stocks), and the inflation-adjusted withdrawal rate (1–7% per year), assuming a constant annual inflation rate of 3%.

20 Years of Withdrawals: Likelihood of Success Stock/Bond Allocation (%) Rate*

20/80

40/60

60/40

80/20

1–3%

100%

100%

100%

100%

4%

99

100

98

97

5%

93

94

91

88

6%

65

74

74

73

* Annual inflation-adjusted withdrawal rate

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Financial Planning

6.5

25 Years of Withdrawals: Likelihood of Success Stock/Bond Allocation (%) Rate*

20/80

40/60

60/40

80/20

1–2%

100%

100%

100%

100%

3%

100

100

100

98

4%

95

95

94

90

5%

68

75

77

75

6%

33

46

54

57

* Annual inflation-adjusted withdrawal rate

25 Years of Withdrawals: Likelihood of Success Stock/Bond Allocation (%) Rate*

20/80

40/60

60/40

80/20

1–2%

100%

100%

100%

100%

3%

98

98

98

96

4%

83

87

87

84

5%

46

58

63

64

6%

15

29

40

45

* Annual inflation-adjusted withdrawal rate

LIABILITY FOR NURSING HOME BILL There are 29 states with “financial support” laws that could result in a patient’s adult children having to pay for any unpaid long-term care bills. For example, in May 2012, a court of appeals ruled that a nursing home was entitled to $93,000 from the son of a patient who received care during 2007 and 2008.

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Financial Planning

6.6

WITHDRAWAL ASSUMPTIONS Suppose you have a client with $1 million who needs current income for the next 30 years. Assuming a constant annual after-inflation investment return (ranging from +5% down to -5% per year), here is how much the client could spend each year for the next 30 years (source: WSJ): Return*

Spend**

Return*

Spend**

5%

$65K

-1%

$28K

4%

$58K

-2%

$24K

3%

$51K

-3%

$20K

2%

$47K

-4%

$17K

1%

$39K

-5%

$14K

0%

$33K

* Return earned each year after adjusting for inflation ** Amount that can be spent each year for the next 30 years

SEEKING HIGHER INCOME AND KNOWLEDGE A December 2012 WSJ poll shows what its readers invest in for income, beyond conservative bonds: dividend-paying stocks (47%), high-yield bonds (19%), REITs (15%), energy MLPs (12%), and emerging markets bond funds (7%). A separate December 2012 survey by the WSJ asked financial advisors, mutual fund experts, and academics what they felt were the best books about investment basics: [1] A Random Walk Down Wall Street by Burton Malkeil [2] The Investor’s Manifesto by William Bernstein [3] Unconventional Success by David Swensen [4] The Little Book of Common Sense Investing by John Bogle [5] The Intelligent Investor by Benjamin Graham [6] Warren Buffet’s annual letters (free at BerkshireHathaway.com) [7] The Investment Answer by Daniel Goldie and Gordon Murray [8] Winning the Loser’s Game by Charles Ellis [9] Risk Less and Prosper by Zvi Bodie and Rachelle Taqqu QUARTERLY UPDATES

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Financial Planning

6.7

MEDICARE 2013 Medicare Parts A and B cover hospitalization and doctor visits for most people age 65 and older. A supplemental plan called Medigap covers the 20% of costs not covered by Part B. For 2012, the typical Part B monthly premium is $100, down from $115 in 2011. Part B premiums ranged from $40 to $220 a month (those with incomes > $214K). Starting in 2013, the Medicare payroll tax will increase from $1.45% to $2.35 on incomes above $200,000 for individuals ($250K for married couples). Under the Affordable Care Act, Medicare benefits increased and now include the following: free annual checkups and preventive care and large discounts on prescription drugs for Medicare recipients who are part of the “donut hole.”

Lowering Costs There is an annual Medicare enrollment period that ends each year in early December. This is a good time to reevaluate Medicare coverage, especially for those who are paying high fees. Only about 15% of Medicare recipients review their coverage each year. There are several types of coverage that could be subject to change: [1] instead of using Medicare Parts B and D, your client may consider a Medigap policy (Part C), [2] there are 10 different drug plans under Part D, and [3] Medicare premiums are based on each year’s modified adjusted gross income (MAGI). A chart listing the brackets and premiums can be found in the Social Security Administration’s publication, Medicare Premiums: Rules for Higher-Income Beneficiaries. Capital gains and the conversion of a traditional IRA into a Roth IRA are not counted when MAGI is computed for Medicare premium purposes.

LONG-TERM CARE COSTS The average monthly cost of a room in an assisted-living facility ranges from $3,000– $4,000 in most states, including California, Texas, and Florida. The states with the least expensive costs are Arkansas ($2,355) and North Dakota ($2,617); those with the most expensive are New Hampshire ($5,086) and Maine ($4,881). None of these dollar figures include the following monthly charges (source: WSJ):

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Financial Planning

6.8

Service

Average monthly cost

Medication management

$347

Dressing assistance

$236

Bathing assistance

$181

Other personal care

$504

The phrase “long-term care” includes a range of health and daily-living services that may be in the patient’s home or a facility. A number of these services do not include roundthe-clock skilled-nursing care. The price of a private room at a nursing home averages $248 a day. The table below shows the average monthly rate for a room in an assistedliving facility, with different levels of services (source: MetLife).

2012 Average Monthly Rate for Assisted-Living Facility Room < 5 Services

6–9 Services

10+ Services

Alzheimer’s*

$2,750

$3,490

$3,790

$4,810

Base rate

* Alzheimer’s/dementia care

Strategies to Reduce LTC Costs One strategy is to buy an immediate annuity that makes monthly payments for a specified number of years. This allows other assets to grow, thereby possibly protecting the estate or surviving spouse. The real benefit of this strategy is that the annuity payments are not counted when qualifying for Medicaid. The state has the first claim on any remaining annuity payments once the patient dies. Families of wartime veterans may receive up to $2,020 a month from the Department of Veterans Affairs for those that qualify; single vets and surviving spouses may qualify for smaller monthly payments. A less-expensive alternative to an assisted-living facility is an independent-living apartment. For the most part, these structures are merely age-restricted apartments. In recent years, many have added transportation, meals, and concierge services. Unlike continuing-care retirement communities, independent-living apartments do not require an upfront lump sum.

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Financial Planning

6.9

Home health care is often the most desirable option. For those who do not need 24-hour care, a person can be hired for ~$20 an hour for housekeeping, meal preparation, dressing, bathing, and other hands-on assistance. Medicare’s Home Health Compare tool allows you to search for local agencies offering such services. An agency tacks on ~25%, so consider hiring a caregiver on your own. Adult-day service provides social, health, and therapeutic services in a group setting for those who have functional or cognitive problems. Some offer a high level of medical care and charge an average daily rate of $80. Respite care programs allow an older person to check into an assisted-living facility for a weekend or longer when a family caregiver needs to take a vacation or break. This option can help a family delay using a more expensive option.

LTC Costs for Women Starting in 2013, women will be paying as much as 40% more than men for long-term care insurance issued by Genworth Financial, the nation’s largest long-term care insurer. Some large insurers, such as Prudential and MetLife, stopped selling long-term care (LTC) policies a few years ago. The price increase for women is likely modest to severe in all but two states: Montana and Colorado (both require insurers to use unisex rates). For example, a 55-year-old woman buying $3,000-a-month coverage for three years (with a 3% annual CPI adjustment) will pay $2,000 a year in 2013; a man the same age will be paying $1,466 a year. Married couples can get a discount since their ages are “blended.” Same-sex and unmarried couples can also qualify for a discount. In order to rein in risk, many insurers have tougher applications; blood samples are often taken to verify nicotine and drug use. Insurers frequently phone interview applicants under the age of 69 in order to test their memory skills. Some insurers also want to see if there are any indications of cardiovascular disease or stroke, the insurer’s biggest concerns after cognitive issues.

INVESTOR IGNORANCE A 2009 study by the National Financial Capacity found that 48% of those surveyed believed that owning a single stock was less risky than owning a mutual fund. Only 36% of adults surveyed knew that at 20% annual compounding, money would double in less than five years. In another survey, just 37% of respondents said they compared credit card interest rates when shopping for a credit card; only half shopped for auto loans.

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Financial Planning

6.10

PORTFOLIO REBALANCING The Vanguard Balanced Index Fund constantly maintains a 60/40 (stock/bond) mix; the equity portion is invested in the broad U.S. stock market, while the fixed-income part mimics the Barclays Aggregate Bond Index. For the 10-year period of 2002–2011, the fund averaged 7.04% a year, while a 60/40 mix that was never rebalanced returned 6.82% annually. The annualized difference (0.22%) between these two returns becomes even smaller once the impact of taxes are taken into account (from two sources: periodic rebalancing and the tax inefficiency of the bond portion). According to 1990 Nobel Prize winner William Sharpe, a retired Stanford finance professor, “I don’t think there have been enough major cycles to say definitively that [rebalancing] will be a good thing in the future.” William Bernstein, investment manager of Efficient Frontier Advisors, believes that there is no reason to think that balancing monthly or on another frequent schedule is any better than doing it annually. He believes that rebalancing even once every two to three years is fine.

BUYING A HOME An often-cited guide to home affordability is the “28/36 rule.” This guideline states that < 28% of pretax household income should be spent for mortgage payments (principal plus interest), property taxes, and home insurance. For example, if a couple grosses $100,000 a year, total annual housing costs should not be greater than $28,000 ($2,334 a month). Total household debt should not exceed 36% of pretax income.

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Economics

7.1

7.ENERGY

COST COMPARISON

The table below shows the 2017 projected cost per megawatt hour of electricity, according to the Energy Information Administration.

Source

Cost

Source

Cost

Natural Gas

$66

Advanced Nuclear

$98

Hydro

$89

Biomass

$111

Wind

$96

Solar Photovoltaic

$153

Conventional Coal

$98

Solar Thermal

$153

Geothermal

$98

GLOBAL GDP [$72 TRILLION FOR 2012] The table below shows global GDP for 2012, according to the IMF.

2012 Global GPD Country or Region

% of Total

U.S.

22%

Euro area

18%

China

11%

Rest of the world

49%

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Economics

7.2

NATURAL GAS According to energy economist Philip Verleger, “The U.S. is going to be the low-cost industrialized country for energy” (October 2012). Since 2008, U.S. oil production has increased by 20%. Natural gas prices peaked at $12 per million BTUs during the middle of 2008 and was $3.50 by the middle of October 2012. The U.S. government estimates that natural gas prices will stay below $5 for another decade. Natural gas now represents 31% of the total U.S. electric power generation (vs. 37% for coal). German, French, and Japanese companies pay three times as much for natural gas as U.S. corporations. Domestic manufacturers are now seeing gas bills that are 60–70% lower than what they were paying in 2008. Major users of natural gas are fertilizer, aluminum, chemical, metal (up to 20% of their overall costs), and glass manufacturers.

GLOBAL IPOS A December 2012 study by Dealogic shows the U.S. still greatly leads every other country when it comes to raising cash from IPOs:

2012 Cash Raised from Initial Public Offerings (IPOs) [through December 12, 2012, in billions] U.S. ($47)

Mexico ($7)

China ($14)

U.K. ($5)

Japan ($12)

Singapore ($4)

Malaysia ($8)

Netherlands ($3)

Hong Kong ($7)

Germany ($3)

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Economics

7.3

DOWNSIZING A T. Rowe Price survey of investors ages 21 to 50 lists five top financial goals: saving for retirement (72%), maintaining or improving current lifestyle (50%), creating or adding an emergency fund (36%), paying off debt (34%), and saving for a child’s college expenses (27%). According to Demand Institute, > 40% of Americans ages 50 to 64 expect to move in the next five years. A study by Boston College’s Center for Retirement Research, those that move due to circumstances such as a job loss or divorce do not gain much financially when they downsized. These movers plowed almost all of their home equity back into their new homes, freeing up an average of just $26,000. A growing number of older adults are carrying mortgage debt than in the past; the amount of debt is also higher.

Percentage of Families with Mortgage Debt [1989 vs. 2010] Age

1989

2010

< 35

34%

33%

35–44

58%

58%

45–54

59%

60%

55–64

37%

53%

65–74

21%

40%

75+

6%

23%

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Economics

7.4

Median Mortgage Debt [1989 vs. 2010] Age

1989

2010

< 35

$73,000

$120,000

35–44

$66,000

$140,000

45–54

$42,000

$115,000

55–64

$33,000

$97,000

65–74

$14,000

$68,000

75+

$10,000

$51,000

Among homeowners age 60+ who recently told researchers of the University of Michigan Health and Retirement Study that they had “more things than they need,” over 75% stated that the sheer volume of their possessions made them “somewhat” or “very” reluctant to move. Among older Americans, a large majority settled within 20 miles of their previous homes according to a 2009 Boston College study.

Average New Home Size in U.S. Year

Sq. Ft.

Year

Sq. Ft.

1973

1,660

2000

2,266

1980

1,740

2005

2,434

1985

1,785

2007

2,521

1990

2,080

2010

2,392

1995

2,100

2015*

2,150

* Projected

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Quarterly Updates - 2012 (Q4 v1.2)  

The following 36 pages are a summary of relevant information from the fourth quarter of 2012.

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