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jayesh n. tribhuvan (2 comments, 1808 words in story) Full Story By jayeshtribhuvan, Section DiariesPosted on Sun Nov 05, 2006 at 05:08:54 AM EST
Long-term investment & planning concepts
Long-term investment & planning concepts Community Watch
By djain128, Section Diaries
El Toro | 04-20-02| 11:11 AM| Total Replies: 23 This post was initially written as a response for a new investor on a Morningstar forum and was previously titled "Getting started for the new investor" but the scope has since been greatly expanded and includes many additional planning and retirement topics. This revision has several new sections along with updated and more extensive use of web links to pertinent material. I'd especially like to thank the Morningstar community members who have contributed to the content, format and review of the material. This post contains the following 21 parts:
I.... Building a solid financial foundation (New section) Investors unfamiliar with any of the investment terminology used in this document should refer to one of the following on-line glossaries for a definition:
# Vanguard Site Glossary New investors should seriously consider reading an introductory book like "Mutual Funds for Dummies" by Eric Tyson and/or Vanguard's free introductory booklets "Investment Planner" and "Facts on Funds" that can be downloaded from their website. Suggested reading for more advanced investors would include:
# "Bogle on Mutual Funds" by John Bogle Additional on-line information about mutual fund investing and asset allocation can be found at Vanguard University, Morningstar University and MaxFunds University. Another web site for good unbiased mutual fund information and educational material is the Mutual Fund Education Alliance. Remember; it's your money and your choice!
Hope this helps & best wishes,
Replies # 1 - # 20 of 23
1. Part I - Build a solid financial foundation The secret to financial security and wealth accumulation is risk and debt management, which entails being adequately insured, paying off credit card debts and living within your means by establishing a budget and adhering to it. Everyone's situation is different but financial planners typically recommend the establishment of an emergency fund of 3 to 12 months of monthly living expenses depending on the likelihood of finding employment within that period of time should you suddenly become unemployed. Maintaining an emergency fund is an essential first step of investing because it ensures you'll NOT have to sell equities or other assets during down periods of the markets. The degree of liquidity of said money has been the subject of on-going debate. However, such money should never be invested in the equity markets given the volatility and unpredictable nature of such investments. Some of the acceptable alternatives, which can be used in combinations for such money, are:
# Money market account with checking The Roth IRA was reluctantly included as an alternative because contributions can be withdrawn tax-free at any time unless of course the tax law changes. However, using the Roth IRA in this fashion should ONLY be considered by those that are fully funding other qualified retirement plans, such as 457, 401K and 403B plans, which represent their main retirement savings while desiring to maintain large amounts of liquid assets. The advantage of using a Roth IRA for a portion of said money is that of tax efficiency and more reasonable investment choices such as TIPS and other types of Bond funds. EE Bonds and I-Bonds can serve a dual role in an investment plan, which is that of an emergency fund in the early accumulation phase and later receive preferential tax treatment if used to fund educational expenses. Another important criteria of a successful long-term financial plan is that of establishing and maintaining a good credit rating, knowing your credit score and the factors that affect your FICO Credit Score. Information pertinent to your credit report can be obtained from the following credit bureaus:
Equifax Credit Information Service
Experian (formerly TRW Credit Data)
Trans Union Corp and on-line at myFICO.COM After establishing an emergency fund of appropriate size, new investors should then determine their risk tolerance prior to investing. The development of an asset allocation and long-term plan, which can be adhered to in both good and bad markets, is much more important than the specific funds chosen! Investors with a long-term plan and the discipline to adhere to said plan have a much higher likelihood of success than investors without plans. Having a plan and adhering to it helps isolate an investor emotionally from the "greed and fear" cycles most markets experience. An old but appropriate cliché is: "It's not the investor's plan that fails but that the investor fails to plan" It's NOT timing the market but time in the market that builds wealth through the miracle of compound interest. For example, assuming a 10% annual rate of return, a twenty year old investing $2K in a retirement account for ten years and then never investing another penny will amass more money for retirement than a thirty year old investing $2k every year for the rest of their life. Individuals saving for retirement should maximize contributions to tax advantaged accounts with the usual order of contributions being:
# Qualified Retirement Plan (QRP) to the employer's matching amount Lastly, be tax wise as it's NOT what you make but what you keep that matters!
2. Part II - Insurance & financial security The most valuable asset each of us has is that of our earning power which should therefore probably be insured. As it may be several decades before either disability or life insurance benefits are needed, research the financial strength of the insurance providers by using a good unbiased rating service, such as:
# Standard & Poor's prior to purchasing the policy. If you are turned down for life or disability insurance, verify the correctness of your medical records at the Medical Insurance Bureau at 617-426-3660. Disability insurance and what to look for Most disability insurers, including Social Security, have a waiting period before benefits commence. For most workers, Social Security Disability Insurance will replace but a portion of the income for a disabled participant and ONLY for those totally incapacitated and unable to work in any fashion. An estimate of disability benefits can be found in the PEBES mailed annually or can be obtained by calling Social Security at 800-772-1213 and requesting form SSA-7004. Anyone NOT covered by an employer's long-term disability plan should at least consider getting a disability policy from a private insurer to augment SSDI coverage. Attributes of a disability policy are:
# Definition of disability The most critical factors when choosing a disability policy are the definition of disability and criteria that trigger coverage. Life insurance should be used to mitigate risk and NOT as an investment. In addition to the safety net provided by Social Security survivors' benefits, anyone with dependents should insure against the family's loss of their earning power via adequate life insurance, with the amount of insurance being derived from the number of years of income replacement. As you age, Net worth increases and dependent children mature, therefore the amount and length of time needed for income replacement decreases. Because of the declining nature of this insurance need, a cost effective alternative may be to use a decreasing term policy for a specified period in combination with a permanent low load policy. Life insurance is available in a variety of options such as: TERM life (least expensive)
# Annual renewable - guaranteed renewable without on-going medical exams Quotes for inexpensive Term life policies can be obtained at:
SelectQuote or 800-670-3214 Permanent or cash value life
# Whole life - lifetime fixed premiums Anyone contemplating permanent insurance should consider using insurers that offer low load insurance directly to the public, such as:
Ameritas Life or 800-555-4655
3. Part III - Understanding Risk vs. Reward One of the most critical decisions confronting a new investor is that of determining his or her own tolerance for risk and understanding risk. Portfolio diversification can help reduce but not eliminate risk. New investors would be wise to read the Morningstar series "An Investment Risk Primer" to better understand the risks of investing. Some of the risks that confront investors are:
# Loss of capital (market risk) After years of a bull market in domestic equities, many investors became complacent and reduced or abandoned their less risky and less volatile assets in the hopes of instant wealth. Investors who became excessively aggressive were punished through large capital losses in their portfolios during the sharp market drop and found that they needed to reassess their asset allocation decisions. Therefore, serious consideration should be given to using one or more of the on-line asset allocation planners, such as MSN MoneyCentral Risk Tolerance Quiz or the Vanguard's Investor Questionnaire, to aid in the determination of the correct stock/bond/cash investment mix which can be adhered to, even during down markets. An important step when developing an investment plan is to analyze your goals and long-term employment situation carefully and then determine what rate of return will be needed to meet your objectives. An investor's circumstances, willingness or need to assume risk to market volatility may dictate that they assume a portfolio of lesser return than others in their age bracket having a higher risk tolerance or need to take risk. One way to determine an appropriate stock/bond asset allocation that takes into consideration your personal circumstances is to use one of the many on-line planners available on the web such Fidelity's Asset Allocation Planner or the M* Goal Planner. Caveat: The various on-line planners should be viewed as optimistic projections of expected accumulated wealth because:
# most do NOT use an age-adjusted asset allocation For planning purposes, it's imperative to use realistic expected rates of return. Rate of Return Estimates for Bonds, Stocks, REITs, GDP & Inflation
Index ------------------------------ ROR Risk*
Risk is the standard deviation of annual returns.
A portfolio's return is NOT determined by what funds are chosen but by the asset allocation of the portfolio. Asset allocation differences between portfolios typically account for as much as 90% of the variations in returns. Vanguard's "Investment Planner" booklet provides the following comparison data based on 1926-2000 returns for various stock/bond allocations.
Stock
with equities represented by the S&P 500.
Remember; higher risk portfolios do NOT guarantee higher returns!
4. Part IV - Establishment of accumulation goals
To establish realistic accumulation goals for retirement, it's imperative to analyze and understand all sources of income available during retirement:
# Pensions
Social Security benefits are calculated from a worker's earnings history with full benefits dependent upon date of birth but can commence as early as age 62 at a reduced rate. An estimate of your benefits can be found in the Personal Earnings and Benefits Estimate Statement (PEBES) mailed annually or can be obtained by calling the Social Security Administration at 1-800-772-1213 and requesting form SSA-7004.
Information on Social Security can be found at:
# Benefits overview
A serious consideration when determining your accumulation goal is:
Will the social security system remain solvent and/or how will benefits change?
Currently, the approximate percentage of pre-retirement income replaced by the Social Security benefits is:
Final | Income
Inflation can gradually erode the purchasing power of a portfolio without your being aware of it. The table below represents the amount needed to have equivalent projected purchasing power assuming various levels of inflation over time.
yr% 3.0% 3.5% 4.0%
Therefore, time horizon and inflation affect the accumulations needed to maintain a standard of living during retirement.
A long-term plan should utilize reasonable macro-economic assumptions. If you live in a state where salary reductions for retirement contributions are subject to state and local taxes during working years, retirement distributions may be exempt from those taxes during retirement years, thus making this a concern if relocation is a consideration during retirement. The example below utilizes the following assumptions:
3.0% inflation
The social security system remains solvent with minimal changes
15.0% salary reduction for retirement contribution * Prospective retirees should utilize parameters specific to their situation and contribution limits. EXAMPLE: Assuming a 3% COLA, a couple of age 50 earning $65K will have a combined estimated salary of about $100K at age 65. Their final combined salary, less appropriate reductions, should be used in determining the retirement accumulations needed to maintain their standard of living during retirement. Other expenses projected to be eliminated prior to retirement (mortgage expenses) will reduce the annual withdrawal and should be taken into consideration. Click here for an income worksheet for retirees.
$100.0K Combined pre-retirement salary Note: Special care should be given by couples with respect to reducing final pre-retirement income by their combined estimated Social Security benefits because, at the death of the first spouse, the surviving spouse will lose that portion of the income stream resulting from the deceased spouse's benefit. The Trinity study, which analyzed portfolio survivability using various rates of withdrawal, concluded that a 4% inflation adjusted withdrawal rate has a high probability of surviving withdrawals during retirement for most portfolios. Therefore, the minimum goal for retirement savings for the above couple should be $1.15M, calculated by dividing $46K/0.04. An on-line retirement calculator can be found at SmartMoney. A "Rule of Thumb" formula to estimate target accumulations by age for tracking purposes for retiring at age 65 is:
Target= (Age - 25)salary
5. Part V - Development of an investment plan
The single most important endeavor investors undertake is the establishment of a long-term investment plan consisting of:
# Goals and objectives
Once an asset allocation is determined, the investor can begin the development of the portfolio. Investors should use as few funds as possible in the creation of a diversified portfolio to allow ease of management. Index funds make excellent core holdings within a portfolio, providing exposure to several asset classes and investment styles. For example, a Total Stock Market fund as a core holding provides exposure to domestic small, mid and large cap stocks as well as growth and value styles. However, a Total Stock Market fund may not offer the assets classes in the desired proportions. A better methodology might be to use a combination of an S&P 500 and extended market (Wilshire 4500) fund to allow better control of your asset allocation within the U.S. stock market. Investors using only TSM allow the market to determine their asset allocation rather than making the investment decision themselves in accordance with their plan. Many decisions made during the fund selection process include:
# Load vs. no-load funds
When possible, an investor should choose lower expense funds as expenses do matter and affect the portfolio's long-term rate of return. When the option exists, highly tax efficient assets like stocks, index funds, I-Bonds and tax-managed funds should be held in taxable accounts. Tax inefficient assets like TIPS, bonds, taxable fixed income instruments and REIT funds should be held in tax-deferred accounts. Actively managed funds should also be held in tax-deferred accounts as these funds can generate large capital gains distributions. A highly diversified portfolio could contain the following asset classes maintained in accordance to your age-adjusted risk tolerance:
# Domestic stocks (Small, Mid & Large Cap)
An investor's risk tolerance will (to some extent) dictate their exposure and allocation to various asset classes. For example, because of the increased volatility of small cap stocks, many investors maintain their large cap to small cap ratio in the 2:1 to 3:1 range during their accumulation years, but switch to a ratio of as much as 3:1 to 5:1 range during retirement.
When evaluating funds for inclusion in a portfolio, attributes to consider are:
# Fund expenses
Lastly, the rebalancing process, which restores a portfolio back to its original risk profile, should be done annually or when one of the asset classes is out of the acceptable allocation range as per the investment plan. When possible, rebalancing activity should be restricted to tax deferred accounts due to tax implications or accomplished with new monies. The rebalancing process forces an investor to adhere to the "buy low and sell high" philosophy by selling a portion of the better performing and possibly over-valued asset classes and adding to under-performing assets classes at possibly bargain prices. This will capture and retain unexpected gains and take advantage of unexpected declines by moving money back into under-performing asset classes closer to market bottoms.
6. Part VI -Age adjusted asset allocation & ROR
Past performance can only be used as a guide on how best to invest for expected future returns. Asset classes drift in and out of favor over time and your best bet is to own a highly diversified portfolio of all asset classes in appropriate proportions, depending on your "age-adjusted" risk tolerance. You can review the historic returns for various equity asset classes at
Callan Associates
An old but appropriate cliché:
Past performance is no guarantee of future results!
When determining the rate of return necessary to meet your objectives, the investor should consider inflation, fund expenses and taxes as the three worst enemies of success. The latter two can be controlled through planning and choice. But inflation will sneak up gradually and eventually decimate the spending power of your portfolio without your being aware of it. The Moral: Beware and be aware of inflation!
The following table represents hypothetical well-diversified "age-adjusted" portfolios for demonstration purposes ONLY, along with the annual expected rate of return (ROR) for each:
..........................Portfolio Objectives..............
US Large Cap..... 40.0% .. 35.0% .. 30.0% .. 25.0% .. 10.0%
Volatility & Risk. Very .. High .. Moderate . Low ... Very
RISK PROFILE \ AGE
Again, these are hypothetical "age-adjusted" portfolios and should only be used as a guide for designing a portfolio that meets your age and risk profile in accordance to your long-term plan. A larger percentage of stock exposure may be appropriate for investors in the early accumulation phase of their plan However, a long-term investment plan should provide for a moderation in risk as you age because your ability to take risk is reduced or as you near your objective because the need to take risk is diminished.
7. Part VII - FUND selection process
When the rate or return analysis and asset allocation decisions are complete, the investor can then contemplate selecting funds for the portfolio. Constructing a portfolio from funds that track different indices will minimize stock overlap and maximize diversification. For demonstration purposes ONLY, the asset class table below will be restricted to Vanguard funds for simplicity.
Asset Class..... Symbol | tracking Index
Domestic equity funds are differentiated by investment style such as: growth, value or blend as well as by size as follows:
Size | Median mrkt cap
Small & mid cap equities have historically provided slightly higher returns but with more volatility. Frank Armstrong's Asset Class Investing Series recommends having a value-biased portfolio.
When considering bond funds for inclusion in a portfolio, it should be noted that bond fund volatility is influenced most by average duration and credit quality of the bonds it holds. The value of a bond fund moves inversely to changes in interest rates. As interest rates rise, the value of bonds falls and vice versa. In general, for each 1% change in interest rates, there is a corresponding inverse 1% change in the value of a bond fund for each year of average duration. Therefore, short-term bond funds are less volatile than intermediate or long-term bond funds. Historically, there has been a high correlation between prevailing interest rates and the rate of inflation. However, Treasury Inflation-Protected Securities & Inflation-Linked Bonds, commonly referred to as TIPS & I-Bonds, react differently than traditional bonds to changes in inflation, as part of the their return is linked to inflation and therefore provides an inflation hedge.
International equity and bond fund returns are more closely correlated to economic conditions in their local economies. International investing also exposes an investor to political and currency risks. Emerging market and Int'l small cap equities have a lower correlation to domestic equities than Int'l large caps because of the large cap's reliance on exports to the global economy. However, before investing in an Emerging Market or Int'l small cap fund, an investor must decide whether they are adequately compensated via higher expected returns and lower correlation to more than offset the increased risks and higher fund expenses.
Numerous tools are available on the Morningstar website to aid the investor in distilling the voluminous amounts of information during the fund selection process. The "Fund selector" tool will select by criteria such as:
# load vs. no-load
Funds identified for possible inclusion into the portfolio should undergo further scrutiny during the final selection process. The "Quotes&Quicktakes" tool allows investors to do in-depth research and analysis on a fund-by-fund basis and provides fund data such as:
# multi-year annualized returns
as well as other pertinent data to be analyzed during the final fund selection process. In addition, every fund or asset class will typically have a tracking index which represents its benchmark for comparison purposes. When comparing funds, only compare funds with like characteristics that track the same index and use the same investment style such as growth or value investing. If more than one fund for an asset class is identified during the selection process, the investor can use the "Fund comparison" tool to decide which fund would be the better choice for inclusion into the portfolio. There are thousands of funds from which to choose so the use of appropriate tools can expedite this process.
8. Part VIII - Fund analysis in portfolio design
A premise of Modern Portfolio Theory (MPT) is that including asset classes having a low correlation to existing portfolio assets can reduce risk and lower volatility. Dr. Paul Kaplan, Director of Quantitative Research at Morningstar, was gracious enough to provide the following data in response to a query in the "Improving Your Portfolio" forum.
............................ Correlation With ......
A fund-by-fund correlation for Vanguard funds can be found here.
Morningstar provides many other statistics that can be useful in evaluating funds for inclusion in a portfolio. Data that reflects operating costs, valuation, volatility, correlation and size worth considering are: expense ratio, P/E and P/B, Std. Dev., R-squared and median market cap.
A comprehensive fund-by-fund analysis should be done for each asset class to be considered for inclusion in a portfolio. For demonstration purposes only, the following analysis is limited to evaluating the fundamentals of Int'l equities with respect to portfolio diversification. Int'l equities trade on the fundamentals of their local economies and therefore have a lower correlation to domestic equities. A few of the Int'l funds available for possible inclusion in a portfolio are:
Median
OAKEX | 0.4B| 1.79 | .36 | 62 | 17. | 2.4 | Oakmark Intl Sml
VEIEX | 6.1B| 0.58 | .57 | 488 | 18. | 3.2 | Vangrd Emrg Mrkt * denotes load funds The above table is divided into three distinct asset classes: Int'l large cap, Int'l small/mid cap and emerging markets. Emerging markets and Int'l small cap funds have a lower correlation to domestic equities than Int'l large caps and are, therefore, better portfolio diversifiers. However, before investing in an Emerging markets or Int'l small cap fund, an investor must decide whether they are adequately compensated via higher expected returns and lower correlation to more than offset the increased risks and higher fund expenses. Of the five Int'l large cap funds analyzed, the TIAA-CREF Int'l fund (TIINX) provides a low cost, low correlation alternative having good diversification with 999 equities. Investors preferring a more value-oriented fund could choose Harbor Int'l due to the lower P/E and P/B statistics or Vanguard Int'l Growth because of it's lower expense ratio. Investors preferring a fund with a broad market cap exposure can do further analysis by comparing the market cap composition of the available choices:
------| VWIGX | TIINX | ARTIX | FDIVX | HAINX then decide which fund best meets their criteria. Of the four Int'l small/mid cap funds analyzed, most have considerably higher expense ratios than the Int'l large cap funds. Acorn Int'l would be the better choice of the four because it has the lowest expense ratio. Investors preferring a more value-oriented fund would chose Oakmark Int'l due to the lower P/E and P/B statistics.
9. Part IX - Portfolio analysis & examples When the fund analysis process is complete, the investor can do the portfolio analysis step which is to enter the chosen funds into the "Instant X-ray" tool in the desired proportions, according to the investment plan. Characteristics of the portfolio easily gleaned from the data displayed include:
# asset allocation By evaluating each asset class individually, such as domestic equity funds, the investor will ensure that the desired proportion of each asset sub-class or category has been attained. For example, when evaluating the chosen domestic stock funds, such as the S&P 500 Index used in combination with an extended market fund, closely examine the Style Box for proper diversification (with the four corners being most important), making alterations as necessary until satisfied. Then begin analyzing the other asset classes of the portfolio. The following simple portfolios, for illustration purposes ONLY, demonstrate the usefulness of the data provided by the "Instant X-ray" tool. A hypothetical simple but aggressive three fund Vanguard portfolio for a young investor with very high risk tolerance during their early accumulation phase might be:
% | Fund | Description Entering the above portfolio into the "Instant X-ray" tool yields the following style box diversification:
Style Box Size The above simple three-fund portfolio can be improved by including a small percentage of the Vanguard REIT index, Vanguard Emerging markets and Acorn Int'l because of the very low correlation of these funds to the S&P 500 index. Acorn Int'l was chosen because Vanguard does NOT offer an Int'l small cap fund.
% | Fund | Description which yields the following style box diversification:
Style Box Size The addition of VGSIX, VEIEX & ACINX to the portfolio provides additional exposure to the small/mid cap asset classes and enhances the value bias of the portfolio. A hypothetical TIAA-CREF portfolio comparable to the three fund Vanguard portfolio would be:
% | Fund | Description which yields the following style box diversification:
Style Box Size The ONLY problem with the TIAA-CREF fund family regarding a highly diversified portfolio is that TIAA-CREF equity funds provide minimal exposure to the domestic small/mid cap asset class which is easily observed in the above Style box. However, this shortcoming can be easily overcome by including an appropriate small/mid cap fund from another fund family. The above hypothetical portfolios should ONLY be considered by the most aggressive young investors during their early accumulation phase, having a very high tolerance to risk and market volatility. Investors with a lower risk tolerance would add an appropriate portion of bond funds to their portfolio to reduce risk and volatility. Morningstar analysis tools
Goal planner
10. Part X - Effects of taxation on NetWorth This illustration is limited to investments in taxable accounts to show how taxes affect wealth accumulation. Investor A invests $100K in a REIT index, which pays out dividends, and Investor B invests $100K in a Total stock market equity index. The following illustration compares the taxation and net worth of the two individuals after twenty years with no further invests. According to IRS Publication 17 Table 17-1 pg. 114 which states: Changes for years after 2000.
* Beginning in the year 2001, the 10% maximum capital gains rate will be lowered to 8% for "qualified 5-year gain." Individuals in the 15% tax bracket are eligible for the new lower 8% capital gains rate starting this tax year for qualified assets held at least 5 years and taxpayers in the 28% or higher tax bracket will NOT be eligible for the lower 18% capital gains tax rate until the 1/1/2006 for assets purchased after 1/1/01. In any event, the maximum Long Term Capital gains tax rate is 20%! New investments must be held for 5 years to qualify for the new lower LTCG tax rate Assumptions:
28% tax bracket
REIT Equity Taxes due 0 59683 NetWorth 289806 371887 Conclusion: The tax conscious investor has accumulated $82K in additional Net worth through tax savings and tax-deferred growth of their assets. Additionally, should investor B die, heirs will get a stepped-up cost basis and NOT owe any taxes on the deferred accumulations. Investors should consider inflation, fund expenses and taxes as the three worst enemies of success. The latter two can be controlled through planning and choice. Expenses and taxes do matter and affect the portfolio's long-term rate of return!
11. Part XI - Funding educational expenses Funding college expenses represents a major but worthwhile investment as individuals with college degrees on average make upwards of 80% more than individuals with H.S diplomas. The most commonly used alternatives for reducing overall costs of college expenses are:
# Grants & scholarships Financial aid is available to fund a portion of educational expenses by filing a Free Application for Federal Student Aid, or FAFSA, which is used by states and many colleges to award needs-based aid. Financial aid offices use formulas that analyze a family's financial circumstances, such as income, family size and assets, in determining the family's ability to fund expenses, commonly referred to as the "Expected Family Contribution" (EFC). Many on-line calculators are available for calculating a family's EFC. Families should plan carefully with respect to what assets are placed in a child's name as such assets reduce eligibility for financial aid. Strategies for maximizing eligibility for financial aid should be considered. The Tax Relief Act of 1997 provided numerous educational tax incentives documented in Publication 970 with the most notable being:
# Hope Scholarship, pg 4 Section 529 plans provide the most liberal mechanism for saving for educational expenses with higher annual contribution limits and fewer restrictions. However, assets in Section 529 plans may reduce eligibility for financial aid because gains withdrawn from 529 plans are treated as beneficiary income. It should be noted that the comparative ratings differ for each state sponsored plan, which ultimately has control over the asset allocation and investment manager along with non-resident eligibility. In general, asset allocations for funds contributed to such plans automatically adjust to a more conservative investment portfolio as the beneficiary approaches college age. Some of the Section 529 plan benefits are:
# assets grow tax deferred Prior to making a final decision, the above items should be double-checked with the chosen state's plan as 529 plan options differ from state to state. Two low cost providers of Section 529 plans are Vanguard, which manages plans for Iowa and Utah, and TIAA-CREF, which manages twelve state programs: California, Connecticut, Idaho, Kentucky, Michigan, Minnesota, Mississippi, Missouri, New York, Oklahoma, Tennessee, and Vermont. Information on funding college expenses:
Guide to Financial Aid
12. Part XII-Retirement withdrawal considerations There are no certainties with respect to retirement other than more accumulations is better as are lower withdrawal rates. IRS Publication 590 contains information and rules governing Individual Retirement Arrangements, referred to as IRAs, complete with life expectancy tables for one or two people. Retirement is typically funded partly through systematic withdrawals from qualified plans. Terms frequently used in retirement discussions are:
* Recalculation method - distributions recalculated annually on life expectancy NOTE: Substantial penalties result when inadequate amounts are taken after RBD Articles on retirement investing
# Making it Last Forever Retirement planning tools
# new MRD calculator Early retirement considerations Early retirement is fraught with peril and should ONLY be considered after fully understanding the risks associated with such a decision which are:
# Inflation The IRS permits penalty free withdrawal from qualified employer plans for anyone separating from service after attaining age 55. Additionally, IRS code section 72(t) allows for penalty free withdrawals from IRAs and other qualified plans prior to age 59 1/2 through distributions which are part of a series of Substantially Equal Periodic Payments, referred to as SEPP, made at least annually for the life expectancy of an individual or the joint life expectancy of an individual and a designated beneficiary. These distributions must continue for the greater of 5 years or until age 59 1/2, which ever is longer, and are essentially fixed for the entire withdrawal period regardless of inflation. The three accepted SEPP withdrawal calculation methods are:
# Annual recalculation - calculated annually using minimum distribution rules The amortization and annuity factor methods require the use of a reasonable interest rate in the range of 80% to 120% of the Applicable Federal Rates, which the IRS has deemed acceptable. An on-line 72(t) calculator can be used to compute the distributions via any of the three methods. Another good web resource for learning more about 72(t) withdrawals is 72t.net. Withdrawal strategies There have been many studies performed on sustainable withdrawal rates using various asset allocations some of which are:
Trinity study on portfolio survivability These studies conclude that a 4% withdrawal rate has a high probability of surviving withdrawals during retirement using a 50/50 stock/bond asset allocation. Portfolio survivability at various withdrawal rates is very dependent upon the chosen asset allocation. A "Rule of Thumb" percentage for sustainable withdrawal rates by age is: 3.5+((age-55)/10) Common withdrawal strategies are: Fixed income - withdrawal of a fixed amount each year irrespective of inflation Inflation adjusted - annually adjusted withdrawal according to the prior year's inflation rate irrespective of portfolio performance which could suffer the perils of higher withdrawal rates Endowment Principle or Fixed % - adjust the annual dollar amount withdrawn relative to the value of the portfolio at year end. In theory, retirement funds will last indefinitely using this method, which provides a fluctuating income stream irrespective of inflation
13. Part XIII - Dynamic risk adjusting portfolio This portfolio management strategy should NOT be used by investors during the accumulation phase of retirement investing! Retirees should consider what initial Rate of Return (ROR) is required from their portfolio as that represents their need to take risk with respect to exposure in the equity markets. It's also generally accepted that as one ages it's desirable to reduce exposure to equities and thereby reduce portfolio volatility and likewise risk. After the required ROR for the portfolio is determined, the retiree can then develop a diversified asset allocation having a high likelihood of generating the necessary ROR. Using said asset allocation and the value of the portfolio, determine the fixed "$" exposure to the various equity asset classes as components of the portfolio. From that point in time on, that fixed "$" amount represents the exposure to the various equity markets during retirement. For example, if an initial 8.0% ROR is required, the following hypothetical asset allocation represents a portfolio with a high likelihood of generating the desired ROR assuming an inflation rate of 3.0%.
-- Asset class -------- Nominal ROR Asset | Asset Here's the dynamic risk & age-adjusted portfolio management strategy for a hypothetical age 65 retiree starting with a $1M portfolio using an initial 60/40 stock/bond allocation maintaining a fixed "$" amount of equity exposure while utilizing a 4.5% inflation adjusted withdrawal.
.................. Fixed .. Inflation Portfolio Portfolio It should be noted that other withdrawal strategies, such as the endowment principle, also work well using this methodology. Using the above ROR assumptions, which are fairly conservative, this scenario implements the desired behavior, which is to systemically decrease equity exposure as you age. Strict discipline and periodic rebalancing is necessary to maintain the fixed"$" amount of equity exposure. This methodology enforces the "buy low and sell high" philosophy by reducing equity exposure as a percentage of your portfolio during periods of extreme market valuations and increasing equity exposure as a percentage of your portfolio after steep market declines. Retirees desiring a lower initial equity exposure should reduce their withdrawal rate accordingly and determine if this scenario works for their chosen asset allocation and withdrawal rate.
14. Part XIV -Annuity basics Who should consider annuities? A question to ask: Is an annuity right for me?. Investors fearful of out-living their assets should consider an annuity for a portion of their assets in exchange for a guaranteed lifetime income. An annuity can be a viable estate-planning tool for families with modest estates. However, it is recommended that a qualified estate planner and Elder Law Attorney be consulted prior to annuitizing assets are per the following article on Annuities and Medicaid. Types of annuities
# Deferred - allows for tax deferred growth of accumulations The types of investments within an annuity contract are:
# Fixed - provides a fixed return Annuity Payout options The criteria determining the amount of the annuity payment is
# Actuarial life expectancy Tailor An Income Stream To Fit Your Needs The above criteria can be used in the following combinations:
# Single life Use of period certain and inflation-adjusted options result in lower initial payments. Annuity Fees & Expenses
# Surrender charges Shopping for an annuity Questions to ask before buying! Research the financial strength of the insurance company prior to purchasing an annuity because annuity payments may stretch over several decades. Therefore, the use of good unbiased rating services, such as Standard & Poor's or A.M.Best, to evaluate the financial strength of the chosen company is recommended. For immediate annuities, shop around to get quotes from several high-quality providers because the payout amounts can be substantially different between companies. For Variable Annuities, consider low cost providers like TIAA-CREF and Vanguard. An unbiased summary of the Pros&Cons of annuities can be found at AAII. Alternatives to Variable Annuities:
# Contributing maximum to QRPs, IRA & ROTH IRA Pros
# Simplicity Cons
# Inflation risk Reference material
FAQs
15. Part XV - Long-Term Care Planning A common misperception is that Medicare provides long-term care coverage, when in fact, it provides only very limited coverage for skilled nursing and home care coverage and ONLY under certain conditions for less than 100 days. The annual cost of long-term nursing home care now averages more than $40,000 and varies greatly between states and type of care required with state-by-state average LTC costs available at LTCQ.net. State insurance departments typically have consumer affairs divisions to help answer questions. Insurance companies offer Long-Term Care policies to cover medical assistance expenses required by individuals unable to care for themselves. These services are usually provided pursuant to a plan of care prescribed by a licensed health care practitioner for services not covered by MediCare and other health insurance products. Consumers unfamiliar with any of the terminology should refer to GE Financial's LTC Glossary or E.F. Moody's LTC Glossary for a definition. An overview of articles on Long-Term Care information can be found at Health Insurance Association of America and Long-term care insurance library. Another good source for basic information about when to buy LTC, how much coverage and LTC policy features can be found at insure.com. Tips on Buying Long-Term Care Insurance The most crucial factor when choosing a long-term care policy should be the criteria that trigger benefits, which are the conditions that must exist before receiving coverage. The best policies allow you to receive benefits if you suffer from a cognitive impairment such as Alzheimer's disease. However, some policies require an acute medical condition and a hospital stay that requires skilled nursing care before your benefits commence. Most policies require that conditions must exist such that the individual need "substantial" assistance with 2 or 3 ADLs (Activities of Daily Living). Whether or NOT you need LTC insurance depends largely on the size of the estate. Families with a relatively large estate may choose to self-insure against long-term care expenses while Medicaid will most likely cover families having minimal estates. However, families with modest estates are most at risk of impoverishing a surviving spouse as a result of long-term care costs and should consider consulting an estate planner and/or purchasing some amount of LTC coverage. If you can afford the LTC premiums and have assets you want to protect against long-term care costs, you should seriously consider purchasing some amount of long-term care insurance. LTC policy premiums can be controlled by judiciously choosing the waiting period, benefits period and maximum daily benefit but it is advisable to get policy premium cost estimates from several high-quality insurance providers such as GE financial, TIAA-CREF, UNUM, CNA, John Hancock and others. Another good source for price quotes is from an insurance broker site such as LTCQ.net or QuoteSmith.com. It is highly recommended you research the financial strength of the insurance provider prior to purchasing a policy, as it may be several decades before the benefits are needed. Therefore, the use of good un-biased rating services, such as Standard & Poor's or A.M.Best Insurance rating service, to evaluate the financial strength of the chosen insurance provider should be considered. LTC policy benefits & riders Information on LTC Features&benefits and LTC products and policy riders can be found at GE Financial and Insure.com. Some of the more notable features and riders to consider are:
# Maximum Daily Benefit
16. Part XVI - Reverse Mortgage as income A Reverse Mortgage is a financial product available to senior homeowners that can be used to supplement retirement income. Unfortunately Reverse Mortgages are complex financial products that are frequently misunderstood and therefore under utilized. Consumers unfamiliar with any terms in this material should consult a Reverse Mortgage Glossary for a definition. AARP has extensive information on what to consider when Exploring Reverse Mortgages and a 68-page pamphlet titled "Home made money". Borrowers should consider using federally insured loans to help avoid Reverse Mortgage fraud. As with any contract, make sure you understand the terms prior to signing! Who should consider a Reverse Mortgage? Reverse Mortgages are designed for seniors over age 62 who Posted on Sat Feb 11, 2006 at 03:39:47 PM EST
The Real Cost of Housing
Part-1 ( Introduction ) Many of us, Indians dream buying beautiful homes for living. That is ultimate dream for many Indian families, no matter where they live. Let it be India, US or any part of the world. Parents, friends and other well wishers always encourage to buy, no matter what the price of the house is. Simply it can be described as 'obsession' ! Only those who have gone through the process of buying a home will vouch how emotional it was when they tour the site or the house they plan to buy. Any one will tell you one spouse falling in love is enough to convince the other one to go for it. Who cares about Real Estate market ? Bull, Bear or Bubble ?? when it comes to housing we need it so badly we forget about everything we learn, approach the issue emotionally and could not empower ourselves to run the numbers one last time. And all of us can remember all the details related to house purchase, taking time off to visit the house, bargain with seller, doing the paper work, taking friends to show the house and ask for suggestions, shopping for upgrades and soft furnishing and the list goes on.. you know what I am saying ! Can we deny we were not emotional ? The carpet upgrade may only cost 1K$, but we nodded our head for 2.5K$, why ? What else one can do ? Man, we can earn money, can we get a home like this later ? I am not a real estate agent and I am not going to help you in deciding what house to buy or how much to spend for an upgrade. You are expert in that matter and you know your locale very well and its prices. So, no help from me on house selection. The objective of the article is to show the math involved in computing the cost of the house at buying time, holding period and selling time. If you are r2ier you have plans to sell the house and there is an exit time for this project. Also there is a cost associated with it. Most of the time, we are told by media, books and friends, buying house is for sure great deal and renting is throwing the money "down the drain". Have you heard this before ? You bet ! Some of you might have told that to your friends who are living in apartments, and encouraged them to throw in their towel and buy. By the way, one of my friend used to say "people living in houses pay rent to the banks". ( Needless to say where he lives ! ). Is he right ? Well, I am going to show not only renting is about throwing money but most of the time housing also is throwing the money down the drain, in some cases, it is throwing the whole bank down the drain ! ( I can see some smile among people who rent and frown among house owners. I will show you how. Just hang on ! ) Enough of introductions and let us get on with business ! Let us pretend buying house is like a buying a business. Media and friends call it as an investment, right ? So, why not approach it as a clever investor analyzing the deal ? That means we have to pack our emotions and keep it aside. I know it is difficult but we will try. Part-2 ( Assumptions ) First, you should know, from purely business point of view, house is a liability and not an asset. You may not like it, but that is correct. An asset produce income or appreciate and provide positive cash flow. Stocks, bonds, REIT stocks do, houses don't. I hear some voices from California and Massachusetts and other coastal towns not agreeing with me. Some of these places are with housing bubbles and they have seen double digit appreciation, and believe that will last for ever. They may not agree with us when we call house as a liability. We will address that. In some situations house is not a liability. House can be considered assets if you don't live in them and leave it for rental or use it to generate income. If you are running business from home instead of renting a place, then you treat your home as an asset. Let us focus on our own home, where we plan to live and not rent it out. Now let us look at the cash flow. Part-3 ( At time of Purchase ) Let us see one by one cash flow out elements and understand how to compute them. Cash flow out: At time of Purchase:
Initial down payment : Most common mistake I have seen people working out the cost tend to ignore this initial investment. If you take a loan, you use others money and you pay rent for using that money ( a.k.a mortgage interest). Now if you have money and if you don't take the loan, you have a loss of income. By investing your money on appreciating asset, you would have gained. Now by redirecting the money from the market to your home, you have stopped the income generation. This is a loss. Now look this from the lending bank's point of view. You approach them for housing loan. They have this money they plan to finance another project. By giving this money to you, they expect to gain steady monthly income. This is the first reason for them to lend you money. Apply the same principle on your own money which you plan to pay down as initial payment. I usually use 6% rate for returns expected from this investment. I assume the investors will not invest all the money in stock market but in a combination of stocks and bonds, hence 6%.
In this case 20% of $250K = $50K. The closing costs and Initial furnishing costs are to be added like below. { Those interested in computing this in excel = -FV(rate,years,0,PresentValue,1) } Closing costs : Closing costs are usually vary between 1-3%. In some cases where you agree to get finance from the buyer, they waive the closing cost. Initial upgrade costs : If you are buying new house, some of us don't like the tiles or carpets used by the builder and want an upgrade. Every one know that is where the builder has his profits made. When you ask him about upgrade, do you notice how he is trying to hide his smile ? Furnishing costs : You bought the house and it needs decoration, window drapers, sofa, dinning, and other furniture to go with. Charge them on Plastic ! All these costs are incurred at the time of purchase and you can consider them as your initial costs.
At time of Purchase As we did earlier let us compute the future value of this down payment and expenses. This comes to $109,689. Now let us review the monthly cash flow and their costs. Cash flow out:
* Initial down payment Cash flow in:
* House Price Appreciation Next, I will take figures of a typical house in our neighborhood and explain these numbers. With this exercise in detail you should be able to compute your own house costs like a pro.
Home Buy Inputs Part-4 ( Monthly cash flow ) Let us see monthly cash flow and cost of this cash flow. Monthly Cash flow out:
* Mortgage Payments - Principle For taking the loan, mortgage payments are due monthly. These payments are by design spread out equally across the loan period. This helps the house owner to assess their ability to service loan payments and plan them in advance. In the beginning most of the payments go towards the interest and very little towards the principle. In our example here, I have considered 10 years holding period. The reason I have chosen 10 years is, this is about people who plan to return to India and hence they will not hold this house for ever like local Americans would do. We all know the lesser the holding period, it is more difficult to break even the housing costs. Taking a lesser period will heavily discourage the home buyers. So, that is not fair. Most of the house buyers plan to hold a house for 7-10 years ( even though they don't eventually, national average for holding period for Americans is about 7 years ), I have taken the upper limit of this period. There is also another reason for 10 years period, most of the houses will lose the tax advantages in that period. That is after 10 years most of the house payments are not big enough to claim itemized deduction. Since tax advantages is used as one of the selling point for house ownership, I want to maximize that advantage to the house owners. Let us first look at the Mortgage payments, both principle and interest for the entire holding period.
Year Yearly Loan Payments Mort Interest Towards Principle % Mort There is a total of $136,259 paid towards mortgage payments, $34,918 is adjusted towards principle and remaining $101,351 goes towards interest payments, or about 74% of the payments you made in those 10 years period is given away. This is the cost of the loan. For every $4 you paid, $1 went for the principle and rest is your cost. $845 per month is the "rental for the money you borrowed", if renting is down the drain, consider this as such. What about tax deduction ? Does it not reduce the cost ? Not as much as you think, I will explain that in a minute. Before doing that let us take another major cost of home ownership. The property taxes. The property taxes differ from county to county. This may also include city taxes, school taxes etc., The property taxes also assessed differently from state to state. In some states, the property taxes are computed based on the last sale price and is applicable for the entire holding period. In some states, the property taxes is assessed as a percentage of the property value and the property value is assessed every year. Most of the states follow the later policy since it helps them to collect higher revenue year on year, it does not matter if you can really sell the house in the market for the assessed value. There are several occasions the house owner has to go the city council to ask for re-assessment, hoping to get their house value reduced. There are lawyers and accountants to help in this matter for a fee and they produce documents to show why the house is not valued that much. It is irony that most of the house owner buy the property and try to maintain it very well to keep the house value appreciate and on the other hand have to work hard to show the opposite. Taxes can make you nuts ! In our example, I have taken 2.1% as the rate for property taxes. Use the rate applicable to your situation to arrive at the costs. In year-1, the property tax is $5,205 and in year-10, the property tax is $8,075 due to price appreciation. The total property tax payments for the entire holding period is $65,468. Now there are couple of other costs like home insurance and maintenance expenses. In our assumption, the total insurance payments come to $8,750. ( And no insurance incident assumed, otherwise the expense go up and also the premium ). Quote: Insurance is the only thing you never hesitate to buy and pray that you will never use it. Assuming the house you bought is in good condition and you don't need any major repairs or upgrade, your maintenance cost will be lower. Most experts recommend 1% of the house value to be set aside for repairs. On our 250K property, it will be 2.5K per year and 25K for the 10 year holding period. If you are renting the property these expenses like insurance and maintenance costs are deductible, otherwise not. Let us summarize monthly cash out flow for 10 years:
* Mortgage Payments = 136,269 |
