Social Security 5: File and Suspend for Soon-to-Be Widowed Homemakers (2009-03-30)

by David John Marotta and Matthew Illian

Our own death or the death of a loved one can be difficult to face. But mortality is one of the most critical factors to consider when making decisions about your Social Security. If you have little earnings of your own and your spouse is in failing health, there is a unique way to maximize benefits.

Don't dismiss this scenario out of hand. It is much more common than you might think. For example, David's grandfather died at age 72 and his grandmother lived until she was six months shy of 100. Men on average are slightly older than their spouses with significantly higher incomes. And we know they tend to die at a much younger age than their wives. When that happens, the difference between the best and worst Social Security choices can be worth over $90,000.

Healthy spouses with little earnings of their own should always encourage their partners to delay filing for Social Security. What changes in this special case is what they should do concerning their own filing.

Take the case of James and Betty Butterworth. James is four years older than his wife. Betty worked to help put James through law school, and then he started his own estate planning firm. She raised their five children and served on the boards of three local charities. Despite her lifetime of achievements, Betty is not eligible for Social Security benefits because to qualify requires earnings in at least 40 quarters.

James has just turned 66 and Betty is 62. Their plan was to file for Social Security when James turned 70, which would increase their annual income by more than 46% compared to filing when James is 66 (full retirement age). When James is 70, Betty will start receiving half of her husband's benefits until her husband dies, and then she will inherit his full payment as the survivor. Normally this is the best option, but then the Butterworths' circumstances take an unfortunate turn.

Betty is healthy, but James has just been diagnosed with cancer and probably will only live another five years. Assuming her husband dies in five years at age 71, Betty will begin receiving his full survivor benefit earlier than is typical for a spouse. In this situation, Betty only expects to receive one year of spousal benefits before jumping up to the survivor benefit. This would mean she would receive just a year of half spousal benefits (when she is age 66 and James is 70) before getting full benefits.

But there is a way for Betty to start receiving spousal benefits at age 62 and still inherit all of the increased benefits from her husband's delayed filing.

The Senior Citizens' Freedom to Work Act of 2000 provides an option that can boost total benefits payments for the Butterworths by as much as 10% over the second best choice. This new option is called "File and Suspend." It works this way: When James reaches his full retirement age of 66, he files for Social Security but suspends receiving any benefits.

Now that James has filed, Betty is entitled to apply for spousal benefits when she is 62. She will collect an extra four years of spousal benefits by using this strategy.

By suspending, James continues to earn delayed retirement credits of 8% a year. These delayed retirement credits allow his benefits to grow from 100% of full benefits when he is 66 to 132% of full benefits when he turns 70. And Betty will inherit this amount after he dies.

Betty is not able to step up to a higher benefit when her spouse files at age 70 because she is already receiving spousal benefits. But she will soon inherit a large survivor benefit, and those early years of spousal benefits really add up. James would have to live to at least 75 before Betty would have benefited from delaying her own filing.

Sadly, James loses his battle with cancer a year earlier than expected. He dies at age 70 and Betty inherits his stepped-up survivor benefit. But because they used the file and suspend option, Betty receives an additional $37,582. If she had waited until James turned 70 to file, she would not have received any spousal benefit.

In summary, the primary earner should often delay taking Social Security when the spouse's income has been significantly smaller in order to increase the survivor's benefits. And if the primary earner's health is questionable, consider file and suspend to allow the spouse to collect additional years of spousal benefits.

 

from http://www.emarotta.com/article.php?ID=330

Social Security 4: File, Repay and Refile to Get an Interest-Free Loan (2009-03-23)

by David John Marotta and Matthew Illian

About half of retirees file for Social Security benefits early at age 62. By doing so, they receive only 75% of their full retirement benefits. And unless they die prematurely, they could lose out on more than $250,000 they might have received otherwise. So for many people, filing early is the worst possible decision.

Retirees who delay filing for Social Security until age 70 receive annual payments equal to 132% of full retirement benefits. If you don't mind some added risk, you can combine these file-early and file-late strategies by filing, repaying and then refiling.

To refile, you must repay everything you have received in benefits after you submit the Request for Withdrawal of Application, which also allows for a refund of the taxes you have paid. You can use this opportunity to file, repay and then refile in at least three ways.

First, if you have made the mistake of filing early, you can repay what you have received and then refile at your full or delayed retirement age. This ability to undo your selection will raise your monthly payment by 33% at full retirement age and by 76% at age 70. Some people who were expecting to retire at age 62 may want to repay their benefits because they are still working full time and being penalized on their work benefits.

Here's the second way this method is worth considering. You simply use it to gain a tax-free loan from the government. The only difference between filing late and filing early, repaying and then refiling is an eight-year interest-free income stream of payments from the government.

Refiling at age 70 can offer the best of both worlds. If you die before age 70, you have enjoyed benefits you would not have received otherwise. If you live to age 70, you will have succeeded in getting an interest-free loan from the government.

Consider the case of Leland Rockefeller again. If he files early, he will receive a monthly benefit of $1,742. Between age 62 and age 70, he could receive interest income. Even at just a 4% return, Leland could earn an additional $28,402 of interest before repaying and refiling at age 70. After refiling he will start receiving increased benefits in the amount of $3,066. The survivor benefit for his wife Candy will nearly double. The break-even point will come the year Leland turns 79. The benefits will continue beyond his death for as long as Candy draws a survivor's check.

But filing, repaying and then refiling does have a downside. Significant risks must be considered.

For example, Leland might die at age 69 before being able to repay and refile, having received only seven years of early payments. If Leland was single, his filing early at least would have resulted in getting some money. But because he is married, his young widow Candy could get stuck receiving his reduced benefits simply because he didn't live long enough to repay and refile.

This is not a trivial concern. Any threat to repaying means you might be saddled with one of the worst filing methods and miss one of the best. Before filing early with the intention of repaying and refiling, you must consider the worst case scenario: what will happen if you never get the chance to repay and refile. If Leland and Candy's Social Security benefits were both equally high, Candy would not be hurt too much by Leland filing early and then dying before he had a chance to refile.

Another danger of the refiling scenario is that when it comes time, you may not have the money. If you've invested poorly or spent the money, you may be shackled with reduced benefits for the rest of your life. Given the tendency of most retirees to file early because they can't wait to start spending their Social Security checks, the danger of not having the money when it comes time to repay is too risky for many households.

The potential benefit of filing and repaying is greatly reduced if you continue working beyond age 62. When you take Social Security, any income over $14,600 reduces your benefits by $0.50 for every $1 above that limit you receive as wages. It also doesn't work if you are trying to use the time between age 62 and 70 as low-income years to convert some traditional IRAs into Roth IRAs and thus minimize taxes during retirement.

Finally, a third reason to consider this file, repay and refile strategy is to gain an inflation-adjusted income stream starting at age 70. Repaying Social Security is a better return on your money than any commercial annuity you could buy. In the case of Leland, repaying his Social Security will provide him the benefits of a joint and survivor annuity at nearly half the price of commercial annuities offered through an insurance company.

The Withdrawal of Application asks you to explain why you are withdrawing your initial benefit application. You can simply respond that it's better for you financially or you are now working. About 100,000 people file a Withdrawal of Application each year.

Although filing early and then repaying can be risky, it is the least dangerous for a husband and wife whose benefits are roughly equal. In this case, either partner dying before refiling won't jeopardize the other's benefits. Additionally, both should have stopped receiving any income when the first one reaches age 62. This most commonly happens when spouses are the same age. Also, they should be fairly well off with no temptation to spend what they receive, and they should invest in stable vehicles, such as CDs that mature the year they turn 70.

Although this option of refiling is both riskier and more complicated than the more traditional choices, it can boost your benefit by an additional 3%. For the faint of heart, however, simply filing late provides 97% of the benefit with little of the risk. It also opens up the possibilities of working until age 70 or using those years to take advantage of Roth conversions.

 

from http://www.emarotta.com/article.php?ID=329

Social Security 3: Delay Filing for Younger Wives and Homemakers (2009-03-16)

by David John Marotta and Matthew Illian

Most retirees believe their only choices for Social Security are to file early or to file when they reach full retirement age. Furthermore, married couples make the mistake of only calculating benefits on each person's personal life expectancy. If you are married, look at joint mortality. With a little planning, you can boost your benefits significantly.

Social Security options are complex for married couples. Each spouse qualifies for three different types of benefits. Option 1: They can file for their personal benefit based on their own record of earnings. Option 2: They may file for spousal benefits based on half of their spouse's earnings. With each of these options, they have three choices: file early, file at full retirement age or delay filing and receive up to 132% of full retirement benefits.

Option 3 is for retirees who meet requirements for a survivor's benefits after their spouse predeceases them, based on their spouse's earnings record. Don't overlook this survivor's benefit when you are deciding when to file. Computing how long you must live to take advantage of late filing requires including the projection for survivor's benefits and considering the likelihood that each spouse might be the first to die.

For any couple in a situation where one should take the other's spousal benefits, joint longevity as well as the difference between their ages affects the filing options significantly. There may be many more years to collect survivor's benefits than personal benefits. Because women typically live longer and are more likely to have earned lower personal benefits, many men delay their benefits until age 70. Their wives thus inherit a larger benefit to use through possibly long years as a widow, a wonderful way to protect a loved one from running out of money.

For example, consider Leland and Candy Rockefeller. Candy met Leland in her tai chi class at the country club. Leland's wife had passed away two years earlier, and Candy was just beginning to think about marriage. They fell in love over a couple of bento boxes after class. She'd always wanted to see Tokyo, and he owned a penthouse suite on Shibuya Street. They honeymooned in the Far East.

Despite their age difference, they have been happily married for seven years. Leland is now 62 and considering filing for Social Security; Candy is 25 years younger. Second marriage has kept Leland in good shape, but the men in his family did not live to old age. He may not need the money either way, but he is tempted to take early benefits and get as much as possible while the system is still viable.

Candy, in contrast, has youth on her side. She enjoys excellent health and exercises regularly. And the women in her family have had impressively long lives.

When Leland dies, Candy can begin receiving a survivor's benefit as earlier as age 60. If he files early, she will receive a monthly benefit equal to $1,661 in today's dollars, but if Leland waits until age 70, she will receive a monthly benefit of $2,192. Her many years of receiving benefits far outweigh the possibility that Leland will die too young to enjoy his increased benefits. Clearly he should wait until age 70 before he files for Social Security.

Even if Leland dies at age 70 and does not receive a dime of benefits, so long as Candy lives past 76, it will have been worth it. Candy finds it enormously reassuring to know that even if she lives to be 100 she will have received $1,052,160, or 11% more benefits, because of Leland's wisdom in waiting to file. And if Leland lives to an average life expectancy of 81 and Candy lives to age 84, which is typical for women in retirement, they will collect $182,664 more because of Leland's delayed filing.

Healthy spouses with little earnings of their own should always consider encouraging their partners to delay filing for Social Security. Having little, if any, benefit accrued on their own work record, they will need to rely on their spousal and survivor's income benefits. This is a situation that homemakers and younger wives share. Only in a situation where both the spouses have a shortened life expectancy does it benefit a couple to file early. Delaying your filing for Social Security also allows you to earn additional income and save money without penalizing your benefits.

Another reason to delay filing is to gain a measure of longevity insurance. Dying young never jeopardizes a retirement plan financially. It's only when you live a long time that you risk running out of money. Filing late increases the money you will receive. And if you live a long life, the benefit of a later filing increases the longer you live.

Anyone who delays filing for Social Security should also consider another choice: filing, repaying and then refiling. This option is both riskier and more complicated, but it can boost your benefit by an additional 3%. We discuss this scenario in next week's column.

Too many impatient retirees take Social Security as soon as possible and miss out on thousands of dollars. Run the numbers and consider all your options before you make the decision when to file.

 

from http://www.emarotta.com/article.php?ID=328

Social Security 2: File Early If You Plan to Die Young (2009-03-09)

by David John Marotta and Matthew Illian

Social Security may be a Ponzi scheme, but it differs in one important way. Those who get paid early won't have to give the money back. Perhaps this explains why many people choose to start taking payments as soon as possible.

About half of all Americans file early for Social Security at age 62. In addition to their concern that promised payments may dry up in the future, many other factors motivate them. Some are behavioral finance mistakes, but others are legitimate.

Filing early exacts a steep price. Your Social Security benefits are permanently cut to 25% less than the amount calculated at full retirement. In 2009, full retirement benefits require waiting until age 66. So filing at age 62 translates to several years of early payments followed by getting 25% less for the rest of your life. Waiting beyond age 66 means getting extra benefits above the full retirement amount. Waiting until age 70 results in receiving 132% of full retirement benefits. People who file early receive about 44% less Social Security income over their lifetime than those who wait until age 70 when the maximum benefit is available.

Consider the case of aging rock star Capitan Danger. After decades of free love and rocking on, he finally began working steadily after he reached 50. By recording soundtracks for video games, he now has more than 10 years (40 quarters) of on-the-books income that has qualified him for Social Security benefits at age 62. At this point Danger has to decide if he wants to take retirement benefits early or wait until as late as age 70 to receive the highest benefit.

Studies show that if we refrain from smoking, exercise regularly, only drink alcohol moderately, and eat five servings of fruit and vegetables a day, we will enjoy an average of 14 additional years of life compared with people who adopt none of these behaviors.

Capitan Danger adopted none of those behaviors.

Although the average 62-year-old might live another 19 years, Capitan Danger will be lucky to survive more than 5 years. His body is beat up from his heroin addiction in the 1970s, and alcohol abuse has damaged his liver. And of course he doesn't ever pay much attention to the future consequences of anything.

Capitan Danger should file early for Social Security benefits. He can make his decision independently. Although he has known the love of many women, he never married any of them. One of the characteristics he seeks in a partner is her ability to support his lifestyle. Accordingly, his current girlfriend is years from retiring and earns more than he does anyway. She certainly won't need or be eligible to claim his Social Security benefits when he dies.

During retirement the Capitan has a disincentive to work. He must not earn more than $14,160 in 2009. Any overage will be taxed at 50%. That's fine with Danger because working too hard cramps his musical style.

He would have received a monthly benefit of $1,562 if he had waited until age 70. Beginning at 62, however, Danger will only get $887. By starting his Social Security payments early, he will realize $95,823 in today's dollars by age 70. It takes a while for the larger benefit that comes from delaying filing to overcome the immediate windfall of starting early.

Danger's break-even point is at age 80. He will receive the greatest benefit from filing early if he dies exactly at age 70. After that, no benefit will accrue in delaying his retirement income. He will no longer receive the delayed retirement credits that increase his benefit 8% in addition to the cost-of-living adjustment for each year he waits. If the Capitan lives to 82, he will have lost $20,016 by taking benefits early. At age 90, he will be $84,750 behind, and by age 95 his present hedonism will have cost him $125,209.

Sadly, Danger's hard living catches up with him and he dies at age 69, having used his extra retirement money as deposits on costumes and venues for a failed reunion tour of The Thankful Corpse, his former band.

People with shorter life expectancies and singles who will not be passing their benefit along to a surviving spouse are the best candidates for filing early for Social Security. Others are better off looking at other options. Women obviously tend to live longer than men. But Social Security does not discriminate by gender, so single men have an actuarial incentive to file before single women. Both minorities and poor people typically live shorter lives, which is also an incentive to file early.

You can see how critical it is to plan carefully before you file for Social Security. Because of all these moving variables, maximizing benefits changes every year as the age to file and receive full benefits keeps advancing upward. And it changes with every retiree's specific situation. But in each case, analysis begins with an estimate of projected benefits for both you and your spouse.

If you do not have a copy of the benefits estimate that Social Security sends out annually, you can request it at <a href="http://www.ssa.gov/estimator" targer=_blank>www.ssa.gov/estimator</a> and then print the results. Or call the Social Security Administration at 800-772-1213. You can also get a copy of "Retirement Benefits" (Publication No. 05-10035) online.

On March 11 from 7 to 8:30 pm, the nonprofit NAPFA Consumer Education Foundation is giving a seminar, "Everything You Need to Consider Before Filing for Social Security," at the Northside Library Meeting Room in the Albemarle Square Shopping Center. Financial advisors Matt Illian and Frank McCraw will be presenting. For more information, visit <a href="http://www.napfafoundation.org/NAPFAfoundation_Charlottesville.htm" target=_blank>http://www.napfafoundation.org/NAPFAfoundation_Charlottesville.htm</a> or e-mail <script language="JavaScript">eval(unescape('%64%6F%63%75%6D%65%6E%74%2E%77%72%69%74%65%28%27%3C%61%20%68%72%65%66%3D%22%6D%61%69%6C%74%6F%3A%43%68%61%72%6C%6F%74%74%65%73%76%69%6C%6C%65%40%6E%61%70%66%61%66%6F%75%6E%64%61%74%69%6F%6E%2E%6F%72%67%22%3E%43%68%61%72%6C%6F%74%74%65%73%76%69%6C%6C%65%40%6E%61%70%66%61%66%6F%75%6E%64%61%74%69%6F%6E%2E%6F%72%67%3C%2F%61%3E%27%29'))</script>.

 

from http://www.emarotta.com/article.php?ID=327

Social Security 1: Planning Is Crucial (2009-03-02)

by David John Marotta and Matthew Illian

Social Security benefits can represent a big stack of cash. A typical monthly benefit of $2,200 has a present value well over $500,000. Consider all your Social Security options carefully to avoid making a costly mistake.

Like all government law, Social Security is not a simple piece of legislation. Since the Social Security Act became law in 1935, hundreds of amendments have added to the complexity. To make the best decision, you must consider health, income before retirement, income during retirement and taxes.

Retirees cannot rely on commonly held beliefs. Don't assume that simplistic rules such as "Always file for early benefits" or "You need to stop working to receive benefits" are correct. There are specific cases that break every rule of thumb. And these one-size-fits-all answers leave many retirees failing to maximize the benefits they have earned.

At least four methods are used when electing how to take Social Security. And if you are married, the two of you can mix and match these in more than 16 different ways. Each one results in a different cash flow. By using the cash flows and the time value of money, you can determine which method will result in the highest net present value and offer you the best maximum value.

These methods differ significantly. They depend on your historical earnings, marital or divorce status, continued work in retirement, longevity and rates of return. The choice may be worth $250,000 of income or more. Filing options include "early filing," "standard filing," "delayed filing," "file and suspend," and many combinations of these options for married couples. It is certainly worth careful study and analysis of each one. Yet a majority of Americans make their choice impulsively and emotionally.

The decision is even more critical for women. For 42% of single women older than 62, Social Security is their sole source of income. Women on average outlive men. Thus planning for retirement is much easier for men, who tend to have more assets and die young. Widows are twice as likely to live under the poverty line as men who have lost their wives. And the poverty rate for elderly single women is 23% compared with just 5% for retired couples.

Couples must take their joint longevity into account before either one files for benefits. The person with the longer life expectancy will inherit either a wise or a foolish decision that will last a lifetime. Given that a husband's benefits are often higher and the wife's life expectancy longer, each case needs to be analyzed carefully.

Unfortunately, many people file after considering only one or two options in isolation. The Social Security Administration's new online filing system enables quick decision making. People can easily submit their request without any professional advice or planning.

Before filing, then, you obviously should be informed about all the options. To begin, you need to know your personal Social Security earnings and the projected benefits for both you and your spouse. You can request an estimate at <a href="http://www.ssa.gov/estimator" target=_blank>www.ssa.gov/estimator</a> and then print the results. Or call the Social Security Administration at 800-772-1213. You can also get a copy of "Retirement Benefits" (Publication No. 05-10035) online.

Social Security planning is crucial for everyone. People with significant assets should carefully consider both the lifetime benefits and tax consequences of Social Security in light of their overall portfolio strategy. For the less well off, Social Security benefits will dictate their retirement lifestyle. Proper planning could well determine what they can afford to eat.

To help you understand your options before locking in the wrong choice, attend the nonprofit NAPFA Consumer Education Foundation seminar, "Everything You Need to Consider Before Filing for Social Security," on March 11. This free presentation will be held at the Northside Library meeting room in the Albemarle Square Shopping Center from 7 to 8:30 pm. Financial advisors Matt Illian and Frank McCraw are leading the seminar. For more information, visit <a href="http://www.napfafoundation.org/NAPFAfoundation_Charlottesville.htm" target=_blank>http://www.napfafoundation.org/NAPFAfoundation_Charlottesville.htm</a>. Or e-mail <script language="JavaScript">eval(unescape('%64%6F%63%75%6D%65%6E%74%2E%77%72%69%74%65%28%27%3C%61%20%68%72%65%66%3D%22%6D%61%69%6C%74%6F%3A%63%68%61%72%6C%6F%74%74%65%73%76%69%6C%6C%65%40%6E%61%70%66%61%66%6F%75%6E%64%61%74%69%6F%6E%2E%6F%72%67%22%3E%63%68%61%72%6C%6F%74%74%65%73%76%69%6C%6C%65%40%6E%61%70%66%61%66%6F%75%6E%64%61%74%69%6F%6E%2E%6F%72%67%3C%2F%61%3E%27%29'))</script>.

 

from http://www.emarotta.com/article.php?ID=326

Government-Provided Economic Security Is an Illusion (2009-02-23)

by David John Marotta

The various congressional bailouts have been touted as essential to the nation's economic security. So long as the notion of economic security remains vague and abstract, it has wide support. But anyone who examines the details should realize this so-called security threatens our freedom and stability.

Security can be understood in two different ways. The first is having enough to eat, a place to live and clothes to wear. We all can agree that in our affluent society we can afford to provide every citizen some minimum standard of living so those falling on hard times may be given a hand back up.

The second way to understand security is the assurance that whatever salary or assets you have earned, including your current position and rank in society relative to others, are yours to keep. Often this second type of security is overlaid with a moral judgment that the people benefiting from this support are more deserving than the rest of society.

With today's level of productivity we can provide the first type of security without endangering freedom or promoting corruption and preferential treatment. Even so there is still serious debate about this support. We should question if government is the best vehicle to deliver it or if private charities do a better job. With increasing globalization, we should also ask the moral question if our safety net should provide a level of support well above 95% of the world's population.

Nevertheless, security of this first type generally protects people against calamities they would naturally want to avoid under any circumstances. It helps them preserve their health, ability to work and the possibility of regaining a foothold if needed. In other words, it gives them a safety net, not a hammock.

The second type of economic security is much more of a threat to freedom and certainly more prone to corruption. Under this type of security, society tries to protect certain sectors of society from the natural and regular fluctuations of economic activity by subsidizing some or all of their losses from failed ventures. Some automakers get money, and others do not. Some banks are subsidized, and others are allowed to fail.

This form of economic security is ultimately designed to protect certain classes from loss of either their annual income or their accumulated wealth. In a free-market economy, people spend their money on those goods and services they believe are the most valuable. They are free not to spend money on things they deem less valuable. The behavior of consumers is an objective way to measure the value placed on particular goods and services.

Any supplement of the value that people are actually willing to pay for goods and services can only be based on subjective bias away from the fair market value. It may correspond to some perception of effort and intentions, but it will still be subjective bias, trumping an objective willingness to pay freely.

To understand these two kinds of economic security, consider that people are more willing for the government to bail out the consequences ensuing from a large disaster than a personal tragedy. The more people who are killed or inconvenienced, the easier it is to garner public support, even though a family is no less devastated by a single fatality in a car accident or a lightning strike. Helping people in need is always a kind and gracious act when freely given. But making it an entitlement of public policy is not.

Again, I'm not talking about efforts to help rescue families subject to the misfortunes of market forces by providing basic needs. I'm questioning the wisdom of bailing out the industries themselves so those who are employed keep their middle- and upper-class lifestyles. Ensuring security in some sectors of the economy comes at the expense of other sectors. Securing one sector against market fluctuations destabilizes all the other sectors, causing the latter to bear the brunt or needlessly fail themselves.

When a few receive the largess of a specifically targeted bailout, the rest of society is left to pay the consequences. The cost of the resources bestowed on the privileged drives up the cost for everyone else. The tax revenues directed toward the enfranchised are often taken from those of lesser means. And the trillions spent devalue the accumulated savings of those who received no government boon.

This problem is not simply that the free market gives people an incentive to do their best. Rather, the bailout removes any yardstick by which they can even judge what is best. The bailout changes a private mistake into a public crime. When private businesses fail, it need not be a public matter. The business goes under because of poor management, and the assets are sold or distributed as part of the company's liquidation. If there are fewer banks in town, I am not hurt. If one car company stops production there will still be competition to sell me a new car. But if the government guarantees the enterprise, then it becomes a crime against society for the company to fail. Failure now becomes a political scandal.

There must be charges of mismanagement. There must be an inquiry. Those responsible must be held accountable. Those innocently injured must be made whole. And all of this must be accomplished by government.

It doesn't matter that other companies, perhaps even in the same industry, were well managed. They will not receive support. And worse, they will experience an unfair disadvantage in the marketplace when their direct competitors are subsidized. To every grant of security bestowed on one group, every other group grows more unstable and finds its freedom compromised.

Government spending is often taken to have a wholly positive effect on the economy. It is assumed that as the money is spent, jobs are created, companies become profitable and the money received in taxes is spent again, creating a higher gross domestic product and a higher tax base. Such thinking is obviously false. No family can spend their way out of debt or financial troubles. Neither can society as a whole.

If the government had allowed the money to remain in the hands of the taxpayers, they too would have been able to spend the money, creating jobs and empowering the economy. Although you can argue that governmental choices are superior to the choices that individuals might make, you can't argue with the fact that individuals, free to make their own choice, would have chosen to spend their money differently.

In free markets, transactions are voluntary. They do not continue unless both parties believe they are better off making them rather than not. But government policies are not voluntary. They can continue indefinitely even if they impoverish society as a whole. Government doesn't have any productivity of its own. It can simply take money from some and give to others. And because government's pie is fixed, if it guarantees a set portion to one group of constituents, it inevitably diminishes the share apportioned to everyone else.

As a result, security becomes a political privilege and more difficult to achieve. We can only look to politicians to provide it. As a scarce and thus more valuable commodity, security soon overshadows other measures of success. Controlled areas of the economy cause other sectors to fail in an increasing spiral. And when they do not succeed, it is perceived as a failure of the free markets. Unregulated parts of the economy won't be able to take risks. And both the risk of failure and the potential windfall profits are then viewed as moral failings.

Put another way, the very engine of entrepreneurial capitalism is increasingly implicated as the problem. Lack of regulation is blamed until security is imposed on more parts of the economy. It doesn't matter that government intervention in the free markets provoked the failure. Government causes the problem in the first place and then gains sweeping powers as society relies on it to solve the crisis.

Unquestionably, both the Bush administration and the Congress dominated by Democrats are to blame for poor bailout legislation packages. We need a new political paradigm, one humble enough to acknowledge that regulation caused many of the crises we are currently facing. Intervention is prone to all that is worst in Washington special-interest lobbying. And intervention disrupts much of the equilibrium in the markets and makes security less likely. We must recognize that attempts to impose security are apt to destabilize rather than ensure people's security.

 

from http://www.emarotta.com/article.php?ID=325

Safeguard #6: Recognize and avoid financial hooks (2009-02-16)

by David John Marotta

To safeguard your money, you must be able to extricate yourself from any bad investment quickly. Of course, the companies that sell mistakes don't want you to be able to do that, so they use financial hooks to hold your money captive.

Any financial product with a surrender value significantly different from the net asset value has financial hooks. For example, take the different classes of mutual funds from the giant American Funds: Growth Fund of America.

Shares come in five different sales classes. Class A shares have an expense ratio of 0.65% in fees and expenses. Additionally, there may be a front-end load of 5.75%.

If you invest in class B, there is no upfront sales charge. But if you sell shares before you have owned them for seven years, you must pay a sales charge that starts at 5%. And while you are holding class B shares, the expense ratio is 1.39%.

Class B shares are the most gut wrenching. If investors have been holding them for nearly three years, they are still hit with a 4% redemption if they sell them early. It doesn't matter if they should sell large-cap U.S. stocks and diversify into another asset class. It doesn't matter that the company has already collected 4.17% in ongoing expense ratios.

Investors are still faced with the decision of holding the fund another four years, at an ongoing expense of 5.56%, or selling the fund and paying a contingent deferred sales charge of 4.00%. The angst of these kinds of hooks in their investments deters many people from selling, even though they know diversification is critical to their portfolio.

In this example, because the fund has been held just under three years, waiting a few months until the third anniversary lowers the redemption charge to 3%, probably the wisest decision. There is an obvious 3% hook if you sell, and a hidden 5.56% hook if you hold the investment.

Class C shares have a contingent deferred sales charge of 1.00% in the first year and an even higher expense ratio of 1.44%. Needless to say, we don't recommend A, B or C shares. These are all loaded shares, meaning they are laden with sales charges.

Fee-only financial planners recommend two classes of shares at American Funds that are no load. The F1 class has no front- or back-end sales charges and an expense ratio of only 0.63%. The F2 class is used in retirement plans and eliminates the 12b-1 marketing fee. It has the lowest expense ratio, only 0.43%. A fair comparison can be made between C shares with an expense ratio of 1.44% and F1 shares with an expense ratio of 0.63%. The savings of F1 shares is 0.81%.

Mutual fund salespeople claim this difference is less than the 1% of assets under management that many fee-only financial planners charge. But you are not getting any real value for a mutual fund sales charge. A different way of looking at it is that fee-only financial planners could earn 81% of their fee simply by reducing your expense ratios. Given an 81% discount, that would make their comprehensive financial planning available at a cost of the other 19% of their fee.

Our example only looked at the five different share classes of Growth Fund of America. A fee-only financial planner has the entire world of investment options to choose from and may find better selections available at even lower expense ratios.

B shares are just one example of the many investment choices with financial hooks. Whole life insurance also has a surrender value significantly lower than its fair market value. And annuities are sold with financial hooks that can lock your money up for several years.

Private equity investments require even longer commitments of capital. Once you are invested, it is very difficult to get your money out until the fund liquidates many years later. During those years you may not even know if your investment was a good one.

Because no public pricing exists for private equities, they continue to be priced to investors at their initial cost. That cost, minus fees, expenses and write-offs, typically produces a negative return over the first half of the investment. Private equity also may require you to commit to additional investments through the life of the investment. So not only is your initial investment held captive, but you must keep a sizable chunk of cash liquid to pay the private equity's capital calls. Finally, the fees are charged on the basis of this committed capital, not just the amount you have already invested.

It was these capital calls that recently hurt the investment strategy of the University of Virginia endowment. Having had significant investments in private equity, after the drop in their regular investments, much of the remainder will be needed to satisfy capital calls on their private equity. The result will be a much higher than desirable portion of the endowment in private equity investments.

Private equity may be acceptable for an endowment with an infinite time horizon, but it is not for average investors who want access to their money during retirement.

Hedge funds are poor investments for similar reasons. They typically require your investment to be committed for years, called a lockup period. During that time, managers not only take 1% to 2% of assets annually, but they also collect 20% of returns, both realized and unrealized. These extra fees are collected any time the fund exceeds its high-water mark.

This compensation scheme is ripe for abuse. Many of the hedge funds that opened after the fall of 2002 hit their high-water marks in the summer of 2008. When the markets are behaving themselves, hedge fund managers enjoy the ride up, gaining 20% of the profits of markets trending upward. During this time, your money is held captive during the lock-up period, and redemptions are not allowed.

If a typical fund charges 2% plus 20% of profits, and gains average 10% to 12% because the markets generally go up, the average fees being paid are in excess of 4%. You might imagine that would be enough money to keep hedge fund managers loyal to their captive customers, but it is not.

But when the market winds blow south, fund managers defect. Many hedge funds are now closing. There is no sense running a fund that is 50% below its high-water mark. Without the incentive of proximity to the high-water mark and a good chance of making 20% of the profits, many hedge funds are not interested in merely serving the client.

So hedge funds can hold your money captive when they are making high fees and abandon you and start a new fund after a significant market correction. This explains why hedge fund companies often have several different hedge funds, each with a different inception date. They can drop those that have poor returns and advertise those with good returns.

As a result, the average life of a hedge fund is only three years. Every three years a market downturn provides the incentive for hedge fund managers to close the current fund and reboot to a lower high-water mark. Three years is also the average lockup period after which disappointed investors can finally get their money out.

To add insult to injury, hedge funds are unregulated, which means the reporting of a hedge fund's return is completely voluntary. There is a hedge fund index that aggregates these voluntarily reported returns, but the number isn't reliable. Hedge funds with poor returns don't report, and hedge funds that fold and go out of business stop being included.

Unrealistically high reporting of returns to attract customers, a three-year lockup period and exorbitantly high fees sounds like a way to make money for the fund but certainly not for the average investor.

My final example of financial hooks involves captive trustee accounts. Sometimes estate trusts are established in legal documents that name a bank or other financial institution as the trustee with no method to change that trustee. The banks call these "captive" accounts for a good reason. Beneficiaries cannot take their business elsewhere and may have to suffer poor service or high fees.

Banks may charge fees as high as 4.5% while better service options are available for a fraction of a percent. A bank here in Charlottesville pushed one of our clients to get their estate documents drawn up by an attorney who charged the client thousands of dollars and then wrote the bank in as the trustee in the estate's legal documents.

I've learned through experience that the more financial hooks keep you captive to a particular financial services company, the poorer the service. And without a way to extricate your investment, you are stuck receiving inferior returns for years. It's a simple but powerful lesson: Avoid anything that puts financial hooks on your investments.



from http://www.emarotta.com/article.php?ID=324

Safeguard #5: Understand Your Investment Strategy (2009-02-09)

by David John Marotta

I often write about the importance of a financial advisor being a fiduciary and the responsibilities accompanying that legal obligation. But clients also have their part to play in financial planning. Certain responsibilities cannot be delegated to others. Understanding and maintaining your role in the process is critical to safeguarding your money and consequently your financial freedom.

Advisors are coaches, not players. They motivate and assist their clients in completing all the actions necessary to implement the plan and thus achieve their financial goals. Most clients have a vague list of worries that reflect more anxiety and frustration than direction. A good coach on your team can make a big difference in the outcome of the game, but the contest is still ultimately in the hands of the players. Your active participation is necessary to secure your financial future and cannot be delegated.

As fiduciaries, we strive to act as you would if you had our time and expertise. But without you taking a real role in the process, we would be unable to gather the information and resources needed to help you set and meet reasonable and realistic goals. Without committed participation, the process of assisting clients to meet their stated financial goals can end up frustrating both parties.

This scenario is very different from dealing with brokers or agents, who may only be interested in satisfying the suitability rule in order to sell their products and services. Without the burden of acting in their clients' best interests, they may be personable to work with, but wealth management isn't just about the relationship. It is about reaching your goals, and sometimes the most effective coach can't be your best friend too.

The best advisors are quantitative and analytical. They may buy you lunch or send you a birthday card, but their genuine strengths lie elsewhere. Expert advisors have substantial knowledge and offer sophisticated services.

To extend the sports metaphor, if a fiduciary advisor is a coach, then brokers and agents are there just to sell you equipment. But a shin-guard salesperson isn't going to help you play a better game of soccer. Personality can be an effective sales tactic because salespeople know you are most likely to say "yes" to someone you like. In contrast, a good coach is not your buddy but rather someone who asks things of you. But he or she is also going to support you with a winning team and help you interact with that team to score goals.

A player can't sit back in the bleachers like a fan and cheer the team on. When you as the client are not interested in understanding enough of the investment strategy to play your position, you won't be able to achieve your goals.

Don't trust any investment strategy you don't understand, and don't trust any advisor who won't or can't take the time to explain exactly why and how he or she operates. An advisor's investment philosophy is the most important and valuable resource you are purchasing. If you don't trust your advisor's knowledge and techniques, you shouldn't entrust your financial future with them. In other words, don't invest in anything with anyone that you either do not understand or with whom you feel uncomfortable.

"Distressed emerging market risk arbitrage" may be a surefire way to make loads of money, but if you don't understand the process and feel at ease being part of the team that executes that move on the field, you would be better off sitting on the bench and investing in Treasury bills.

Note that I am not advocating "invest in what you know," which is called familiarity bias and can cause your portfolio to be inadequately diversified. Only investing in what you know may help you avoid some crazy investment schemes, but the resulting concentration can be dangerous in other ways.

Instead, the better rule of thumb is "know what you are investing in," which requires active participation by both you and your advisor. It is best to have an advisor who is a patient and skilled teacher or mentor at heart. And to be a good coach, your advisor should be willing to contradict you when it will help you better meet your goals. At the end of the day, your coach will still be your coach, but you should also be a better player as a result of the relationship.

With a good advisor, your investment approach should be simple and straightforward enough that you understand why the approach is being taken and how it is being implemented. It should never be a black box where you put your money in the top, let the advisor crank the handle and hope the return that comes out the bottom is good enough to meet your goals.

The box should be sufficiently transparent so you know these three simple pieces of information. You know how others are making money off your investments, you know what your investments are composed of and you know how and by what measure your portfolio will be monitored and reviewed.

Sales pitches are notorious for trying to confuse investors about the real composition, execution and compensation structure of the underlying investment. They generally ask investors not to worry about the details and to trust the reputation of brainy academics or else look at the pictures in the glossy four-color brochures instead.

Don't be fooled and don't be foolish. Understanding your investment strategy is critical to safeguarding your investments against reckless schemes. With a good coach and mentor, you can become a better team player and help your family achieve both their financial goals and peace of mind.

 

from http://www.emarotta.com/article.php?ID=323

Safeguard #4: Buy Investments That Trend Upward (2009-02-02)

by David John Marotta

Crazy volatile markets push people toward irrational investment schemes. Methods to safeguard our investments won't prevent loss, but ideally they will prevent us from putting our money in investments where we should have known better. Let me give you an example.

There's always a way to make money in the markets. I'm going to tell you how you could have made a lot of money last year. Some investors used this technique to capture huge gains in 2008 while most investors were losing their shirts. What was their secret? Halfway through the year they bet oil prices would drop.

As oil approached $147 a barrel and everyone else thought it was going to $200 a barrel, these wily investors sold it short. That is, they bet on oil going down. Because they were right, their investment earned sizable returns.

They accomplished this feat by purchasing "put options," the right but not the obligation to sell a certain number of barrels of oil for a certain price for a specified period of time. If the price of a barrel of oil drops significantly, as it did, they could sell their put options for a profit.

Does this scenario sound enticing? Do you find yourself wishing you had your investments in oil puts last year? Envy and regret are powerful motivators in the investing world. But you must tame these emotions if you are going to learn how to safeguard your money.

Just because some investors made significant gains in commodity futures doesn't mean that is where you should have been invested. Most of the time when you purchase a put option, the underlying commodity does not drop significantly in price and your put option expires as worthless.

On average, commodity prices rise rather than fall. If you stop and think for a minute, you could assume that commodity prices would at least increase along with inflation every year. They rise reflecting inflation and they fluctuate along with the supply and demand of economic expansion and contraction.

If a commodity rises an average of 5% just for inflation, most of the time investments in commodity puts will lose money. You can purchase put options at various prices, but they all have to overcome strong tailwinds to move backward. The commodity has to drop more than inflation plus the price of the option itself just to break even and start making money. Just because they sometimes make money doesn't make them a good bet.

Imagine you are standing next to the roulette wheel in a Las Vegas casino trying to decide which bet you want to make. You can either bet on red or black, but you are getting confused because the last spin came up green: zero.

Just because the ball happened to land in zero the last turn doesn't mean zero is a good bet. On average, it is a losing bet. In fact, on average, so are red and black. Never invest in something that on average is a losing bet. Never invest in something that on average goes down. You don't want to be a gambler in Las Vegas at all.

Instead you want to be the house.

The house loses lots of bets. In fact, the house loses more bets than investors do over a year in the stock market. The house edge is small, but on average the house wins a steady stream of gains.

Any investment that, on average, doesn't go up shouldn't be an asset class in your portfolio. There are a lot of so-called investments that fit this description. They are best described not as "investments" but as "speculations." I concede there is a place in specific portfolios to invest in something that doesn't go up on average. But this situation is the exception, not the rule, and these decisions are warranted most commonly because of a large investment that needs to be protected. In this case, what you are really buying is "insurance," not an "investment."

Here's another way to look at short investments. If the markets appreciate 10% per year, then investments against the market lose 10% per year. Predicting market drops with such accuracy as to overcome a 10% headwind plus the transaction costs of shorting the market is difficult, to say the least.

And whereas investments that are long in the market can only drop a finite amount (to zero), short investments can lose an infinite amount because there is no limit to how much a stock can rise.

Gold is another example of an investment that on average does not appreciate in value.

Jeremy Siegel, author of "Stocks for the Long Run," analyzed investments over the past 200 years. Gold, on average, maintains its value over time. If you bought a dollar's worth of gold 200 years ago, after adjusting for inflation, it would be still be worth about $1 today.

Although gold generally holds its purchasing value, it still fluctuates wildly based on other factors of supply and demand. While it does so, the part of these movements that is not just random noise is simply an inverse reaction to the value of the dollar.

Over the long term, gold holds its purchasing power, but it has not for almost three decades. In January 1980, gold reached its high of $850 an ounce. The following year my wife and I became engaged and chose modest wedding rings that were still very expensive. Note that $850 in 1980 had the same buying power as $2,191 in today's dollars. Gold trading at $850 an ounce then was like gold trading at more than twice its current price. In other words, those people who purchased gold in 1980 have lost more than half their buying power during a 28-year investment. Even considering the October 2008 stock market drop, the tailwind of appreciation pushed stock investments to significant gains over the past 28 years. That tailwind is a powerful force for investment growth.

Investments that bet on stock market corrections are more dangerous than the market itself. Perhaps they should come with the following warning: "The stock market can go up as well as down!"

Holding investments for the long term makes sense because millions of people are working in thousands of publicly traded companies on your side of the investment. Your interest is congruent with theirs, and their very livelihood depends on your investment making a profit.

So look for great well-financed companies that deliver products or services of real value in order to make the trend of the investment upward. If the investment bets against that trend or simply holds its value, it should not be a major component in your allocation. There may be a place for options like insurance, but these are rare. As a rule of thumb, put your money only in investments that on average go up.

 

from http://www.emarotta.com/article.php?ID=322

Safeguard #3: Insist on Publicly Pricaed and Traded Investments (2009-01-26)

by David John Marotta

To protect our money, several safeguards are advisable. They aren't always necessary, but they are certainly safer than the alternative. One of these safeguards is to insist on investing only in liquid assets. Investors undervalue liquidity 99.9% of the time. You need to be in the other 0.1%.

Liquidity refers to the ability of an asset to be easily sold without losing value in the process. Imagine starting with a pile of money, buying the asset, holding it a week and then trying to sell it again. If you get back a much smaller amount of money, the asset is illiquid.

Because illiquid investments are hard to price, it's also difficult to compute what return you've received. I analyzed a real estate investment for a couple who had held it for 20 years. It was valued at $60,000 and paying a $6,000 return every year. I kid you not. It was paying a 10% dividend.

The investment had been illiquid for a long time, but now the general partners were offering to buy out any investors who wanted to sell. Alternatively, they were putting together another real estate deal in which you could invest additional money. Finally, if for some strange reason you liked your current investment but did not want to invest any additional money, you could neither sell your share of the old deal nor invest more money in the new deal.

The couple thought they had received a great rate of return. And believing no investment could be better than a 10% dividend, they were ready to sink more money into a similar investment.

Again, even with perfect hindsight, it is often difficult to recognize if illiquid investments have been a good investment because you may not be able easily to compute what return you've received.

In a simple analysis, it looked like a $60,000 investment was now paying a 10% rate of return. And so it was, but only after two decades of a zero percent return. Shares in the investment were not actually worth $60,000 because they were not traded in a public market. Without such a market to value the shares, their worth was at least questionable.

The fact that the general partners were now finally willing to pay $60,000 for the shares only meant they were worth at least $60,000. The fact that they were purchased for $60,000 some 20 years ago and were now paying a $6,000 annual dividend meant they were probably worth a lot more.

Even at a small 8% annual rate of return, the couple's $60,000 investment should have grown to at least $279,600. Perhaps the investment was indeed worth over a quarter of a million. Maybe that explained why the general partners were willing to pay $60,000 for the investment.

Assuming the investment has achieved an 8% return, the dividend is paltry. If the investment is really worth that much, the $6,000 dividend is only a 2.15% return, not a 10% return as previously supposed. Because of the illiquidity of the investment, nothing about it is attractive. The truth lies somewhere between these two extremes: the investment having absolutely no appreciation in 20 years and currently paying a 10% dividend and the investment having a decent 8% return over 20 years but only paying a 2.15% dividend. The illiquidity of the investment obscures the real return.

And that's the problem with investments that aren't publicly priced and traded. Because your investment can't be converted into cash, even after two decades you may still not be able to evaluate it. In this case we were able to determine that the investment wasn't worth selling for $60,000. The stream of $6,000 annual income was worth more than that. But it also was a mistake to invest any additional money in similar investments.

This situation illustrates a common dilemma with illiquid investments. Because they aren't easily sold, they often are not worth selling. Therefore it isn't worth buying them in the first place. That is the definition of illiquid: not worth buying and not worth selling.

Liquidity is a continuum. On one end, cash defines liquidity. Many investments, such as stocks, exchange traded funds and mutual funds, are so publicly priced and traded that their price is published in the Wall Street Journal every day. These are sufficiently liquid and can be realized in a matter of days. Holdings that have well-established public markets with adequate volume make buying and selling easy.

Even individual bonds fall in the middle of the spectrum. If you buy an individual bond this week and then try to sell it next week, it will lose some of its value. Bonds, unlike stocks, do not have a smooth and liquid market. You have to put a bond out for bid and then decide if you will accept the best price you are offered.

So even for bonds, it is best to structure your portfolio to hold them until maturity when the bonds pay back their principal. In the recent credit crunch, bonds that fell from investment grade to junk status were suddenly extremely difficult to sell. As a result, the price you could get for them dropped more sharply than it might have otherwise.

Real estate is another illiquid asset. Flipping real estate for a profit is usually not possible. Sales commissions and closing costs consume over 6% of the sales price. It has to be an extraordinary real estate market if you can buy a house one week and sell it for a 6% profit a few weeks later. Starting with a 6% loss because of illiquidity costs is a steep headwind to overcome quickly.

Moving further toward the other end of the spectrum are investments that are even more difficult to buy or sell. These have even higher spreads between their purchase and sale price, and even more return must be made just to overcome the spread between the bid and ask prices.

Real estate, hedge funds and private equity deals belong in this category. Some purposefully lock up your money and prohibit sales for several years. For others, something like a market exists for them but with very little volume. Finally, they may have capital calls where not only can't you sell, but you are required to invest more money in them. They all may have the allure of exclusivity, but they lack liquidity. Here is the critical question: "When you go to spend your money, will it be easily available?"

You need your money to be there when you want it. Therefore, use liquidity as one way of avoiding investments you should not be making in the first place. Remember, it is to the advantage of agents who sell such investments that their products remain illiquid. Therefore avoid going to them for so-called free advice as well. Even a negative return in the markets is better than no return of your investment.

 

from http://www.emarotta.com/article.php?ID=321

Safeguard #2: Walk Away from "Too Good to Be True" (2009-01-19)

by David John Marotta

In addition to the all-important fiduciary requirement, you should insist on several other investment safeguards. Safeguard #1: Do not allow your financial advisor to have custody of your investments. The second safeguard: Avoid any investment opportunity that sounds too good to be true.

I learned this principle in a practical way from my father when I was 13 years old. One of my brothers had a friend whose father was doubling his money in an investment company that was importing Portuguese wine. They were selling it for more than twice what they had paid for it and making money hand over fist.

But they needed cash to buy the wine. After having the wine shipped from Portugal and distributing it around the Washington, D.C., area, they were paying 50% interest. Because orders had already been taken, it was touted as a sure thing. My father, George Marotta, was asked to invest in the next shipment.

His response was right to the point. He just said, "It sounds too good to be true." That was it. No looking into the matter, trying to determine where the catch was. He simply refused to waste his time on it.

My brother wanted to take the money my parents had saved for him and invest it in the Portuguese wine deal. Why not, he reasoned. It was guaranteed, wasn't it?

Again my father refused to allow my brother to invest anything. He explained that they couldn't be making 50% interest every six months. There had to be a hidden difficulty or complication.

Six weeks later the scandal broke on the front page of the Washington Post. There was no wine. Families lost their life savings and their children's college funds. It was all a Ponzi scheme. They were paying early investors with the money taken in by subsequent investors. Without any real returns, all Ponzi schemes eventually run their course and then implode.

Nothing really changes. For many people, greed can block common sense. This natural but deadly impulse is one you must learn to overcome.

Shortly after my father's wisdom was vindicated, it was suggested he give his sons some practical experience in investing by finding a good pick for us, some penny stock that was going to two pennies without very much risk.

My father again replied wisely, "If I knew a penny stock that was going to two pennies without any risk, I would invest our life savings and double our money. Such an investment doesn't exist."

Here's the hard lesson: There is no such thing as a sure thing, and if something sounds too good to be true, it is.

I used to analyze offers to find the proverbial catch. I would scrutinize the small print and find where they were going to make their money. Curiosity drove me to know, and in the process I learned a great deal about the dishonest methods companies use to separate fools from their money: bait and switch, allure of exclusivity, guarantee or your money back, limited time horizon and automatic charges.

And then there were the handful that really sounded too good to be true. And it struck me that they were blatantly lying. Nothing could be found in their literature to determine where the snag was because they simply were not telling the truth. And that is part of the lesson to be learned. You don't need to know where and how they are lying. But if it sounds too good to be true, it probably is.

Madoff Securities was recently caught in the largest Ponzi scheme in history. For years, Bernie Madoff collected assets with returns that seemed amazing. Hedge funds fronted for his investments, putting their own private label on his $50 billion scam.

Madoff was known as the guy who never seemed to lose money. It was implied he was subsidizing down months in the markets, a common rationale around Ponzi schemes. There has to be some reason given in a Ponzi scheme for the total lack of volatility, and the rationale commonly offered is that the company eats its losses during down months.

But it is a securities fraud to misrepresent either an investment's returns or the volatility of those returns. We are always reminding our clients and our readers that the markets are inherently volatile. Despite this tendency, they have also been profitable, even taking into account the significant drop in 2008. You should expect to see and understand the risk you are taking. Don't be mesmerized either by the promise of a high return or a sure thing. Even Treasury bills carry the inherent risk that you will lose your buying power to inflation.

Although the preceding may sound cynical and paranoid, many posing as financial advisors really do try to separate you from your money. Fortunately, only a few do it fraudulently. Others may do it legally in small amounts through hidden fees over a long period of time. Both may be actively calculating how to maximize their portion and minimize yours and how to hide how much they are keeping and the real return you are receiving.

So the challenge for investors seeking financial advice is clear. Where is the moral high ground? How can investors avoid as much as possible the conflict of interests inherent in many compensation schemes and find an advisor who simply helps clients meet their goals?

The National Association of Personal Financial Advisors (<a href="http://www.napfa.org" target=_blank>www.napfa.org</a>), created in 1983, is an industry association of firms that provide independent financial advice. Their compensation is not clouded by the purchase or sale of a financial product.

You have a right to be proactive and ask the right questions. It is up to you to know how your advisor is compensated and how your investment return is calculated. And if past returns sound too good to be true, don't believe them. Visit <a href="http://www.napfa.org/tips_tools" target=_blank>http://www.napfa.org/tips_tools</a> to learn more and become a truly savvy, and safe, investor.

 

from http://www.emarotta.com/article.php?ID=320

Safeguard #1: Do Not Allow Your Advisor to Have Custody of Your Investments (2009-01-12)

by David John Marotta

I was recently asked if investors should trust their financial advisors. And my short answer, you may be surprised to hear, was no.

Given all the greed and deceit revealed last year in the world of financial services, this question of trust could not be more timely.

If your advisor is not a fiduciary, he or she has no legal obligation to act in your best interest. Only about 7% of those working in financial services are fiduciaries, so the odds are your advisor is probably not.

Simply put, the term "fiduciary" applies to those who have the legal responsibility to manage other people's money. Fiduciaries are required by law to act in the best interests of their clients, beneficiaries or retirement plan participants.

Both the National Association of Personal Financial Advisors (<a href="http://www.napfa.org" target=_blank>www.napfa.org</a>) and the Center for Fiduciary Studies (<a href="http://www.fi360.com" target=_blank>http://www.fi360.com</a>) require its members to sign and uphold a fiduciary oath. In contrast, brokers and agents are not fiduciaries and often must disclose the following in writing: "Your account is a brokerage account and not an advisory account." And "Our interests may not always be the same as yours."

Being a fiduciary is the bright white line that separates those who sit on your side of the table and legally must act in your best interests and those who sit on the other side of the table and have no such obligation.

In addition to the all-important fiduciary requirement are several other safeguards that you should insist on. Foremost among them is that your financial advisor should not also have custody of your investments.

Custody refers to the entity that is legally responsible for holding your investments and keeping them safe. In the old days, custody literally meant keeping the paper certificates secure. In contrast, a contemporary custodian offers a range of services that investors commonly take for granted.

When securities are bought or sold, the custodian delivers or receives ownership of the shares in exchange for the agreed amount of money. This process, called "settlement," usually takes one to three days after the purchase or sale.

At one time the physical certificates had to be transferred. But U.S. legislation in 1975 enabled markets to use the Depository Trust Company (DTC), a unified central securities depository. Holding securities electronically or in "street name" makes it easier to transfer and keep track of them. Now the certificates do not move physically. Instead they are transferred via book entry settlement between securities account holders called "members" or "participants."

While the securities are being held for you, your custodian provides asset services, which amounts to exercising rights and obligations on your behalf.

Custodians collect all the dividends and interest accrued by the investment. They relay any corporate information or actions that affect your investments and provide a standard and streamlined way for you to receive information, exercise rights or vote proxies.

Having a financial advisor who does not have custody of your assets gives you an extra layer of accountability and oversight. Fiduciaries review potential custodians to determine the best one to house their clients' assets. They analyze the fees and expenses charged in exchange for the services offered. Then fiduciaries keep an eye on the chosen custodian on behalf of their clients.

With a hedge fund or private equity, there is much less accountability. No one--except the individual investor--is watching to see if fees and expenses are reasonable. If the managers of a private equity pay themselves well, their salary is simply an added expense.

The safeguards and monitoring of advisor and custodian work mutually. The custodian sends its own set of statements, a way for you as the investor to double-check what your financial advisor is telling you. Being defrauded is much less likely when you are receiving independent statements.

The custodian also prices your investments, ensuring that everything is really worth what your advisor says it is. When advisors provide their own valuations, they might use the opportunity to manipulate client investments.

Imagine a hedge fund or private equity investment where contributions and redemptions must be requested ahead of time. If net investment flows are into the fund, illiquid assets can be priced high so that investors buy fewer shares. But when net investment flows withdraw money from the fund they can be priced lower, so investors receive less money. If management is also invested in the fund, they can do the exact opposite when moving their own contributions and withdrawals to maximize their profits and minimize that of other investors.

It is even more frustrating when your investments are unknowingly leveraged in nontransparent hedge funds or private equity. Much of your investment may be used as collateral against speculative investments in the hopes of a profit great enough to break high-water marks and justify bonus fees. You may or may not understand these investments. Nor may you understand if they are in your best interest or only in the best interest of your advisor. Using a reputable third-party custodian can help ensure that reporting about your investments is transparent.

Not having custody of your investments may limit some of your advisor's services. So be it. Your advisor can help you with the paperwork to transfer money in or out of your investments but should not handle the money itself. Always make the check out directly to the custodian, never to your advisor.

You can give your advisor limited power of attorney to makes trades on your behalf and take out a fee, but your custodian should both watch out for excessive fees and make withdrawals by your advisor impossible. Your advisor may be able to transfer money between your accounts but only between those you own completely.

Do not allow your advisor to pay bills on your behalf. If paying bills is required, use a third-party service and ask your advisor to make sure it is reputable and honest.

As fiduciaries, we put all of these safeguards into practice to help secure our clients' investments. We instigate these because part of being a fiduciary means avoiding conflicts of interest and implementing secure practices. By separating your custodian and your advisor, you'll have peace of mind, knowing that the fees you are paying are reasonable and your assets are secure.

 

from http://www.emarotta.com/article.php?ID=319

Compute Your Net Worth Once a Year (2009-01-05)

by David John Marotta

Last year's markets took a heavy toll on your financial plan. You may have been on track at the beginning of the year, but now you must reevaluate. The storm has blown you miles off course, and not making any adjustments is destined to end in a shipwreck.

Everything in the financial markets has changed: energy, financials, real estate, bonds, equities, even the dollar. If you are within 20 years of retirement (age 45 to 65), it's critical to get your retirement planning updated. Computing your net worth annually is like taking a sextant reading to chart your course toward financial security.

Net worth gives you a snapshot of how much money would be left if you converted everything you owned into cash and paid off all your debts. Compute your net worth by creating four lists.

Liquid assets: An asset is something you own that has significant value. A liquid asset can be sold in a matter of days. Include personal bank accounts (checking, savings and money market), certificates of deposit, bonds, mutual funds, stocks and exchange-traded funds. Use values as of December 31 of the previous year so all of your amounts are calculated on the same day.

Nonliquid assets: Nonliquid assets are those things you own that incur a penalty when they are sold. Include the value of your retirement accounts (IRAs, 401ks, 403bs, SEPs, profit-sharing plans and pension plans). Add real estate investments as well as the market value of your home. Use the assessed value.

Other nonliquid assets may include proprietorships, partnerships or company stock in a firm that is not publicly traded. Add the cash value of any life (nonterm) insurance. Some people include jewelry, collectibles, cars and boats in this category. Although these items often have a high retail value, their true worth is often a small fraction of their initial cost. I do not recommend including personal property.

Immediate liabilities: List what you owe to creditors. Immediate liabilities include credit card debt, car loans, student loans, other loans and any bill or debt that must be paid within two years.

Long-term debt: For most people, long-term debt is primarily their home mortgage, but it may encompass other real estate or business loans.

The first time you gather all of this information will be challenging, but it gets much easier each subsequent year. By keeping an annual record of your net worth, you're creating a valuable financial planning tool.

Next compute three additional values. For your total assets, add your liquid and nonliquid categories; for your total liabilities, add your immediate liabilities and long-term debt; and finally, for your net worth, simply subtract your total liabilities from your total assets.

Use these net worth numbers to compute other values useful for reaching your financial goals. For example, your emergency reserve (liquid assets minus immediate liabilities) should be at least half your annual income. Any extra can be invested more aggressively for appreciation. Your debt load ratio (total liabilities divided by total assets) should be under 35%, with your home mortgage comprising most of your debt.

If you are trying hard to pay off your mortgage ahead of schedule instead of making a huge effort to save and invest, your attempts are laudable but mistaken. The quickest path to wealth includes holding a home mortgage you could pay off but you choose not to in order to take advantage of the tax benefits. The rich leverage wisely and invest.

A net worth statement helps you measure your progress toward retirement. At age 65 you can only withdraw 4.36% of your portfolio to maintain your lifestyle. In other words, to keep the same standard of living, you will need about 23 times what you spend annually.

Take your net worth and divide it by your annual take-home pay. The result shows you how many times your annual standard of living you have amassed in savings. If you are younger than 40, the number probably comes to less than five, which is adequate for now.

Progress toward retirement is not linear. This equation, determined by quadratic regression, estimates how much of your current net worth you should have saved given your age. It gives you a benchmark for determining if you are on track to retire by age 65:

Savings should equal 0.0125 x^2 - 0.5746x + 7.4668, where x is your age in years.

The result should be between zero and 23. That number tells you how many times your current annual income you should be worth. The formula is most accurate between ages 45 and 65.

By age 45, you should be worth about seven times your annual spending. More sophisticated retirement planning includes the difference between taxable, tax-deferred and Roth accounts as well as Social Security guesses and defined benefit plans, but the method described here will approximate your progress. This table shows by what age you should have saved different multiples of your annual spending.

If your net worth is higher, congratulations! You may be able to retire earlier than 65. For every 1 unit you are over, you could consider retiring about a year earlier. Conversely, for every 1 unit you are under your age's benchmark, you may have to work an additional year beyond 65.

Between ages 40 and 50, your net worth should increase by 1 unit of your annual spending every two years. That means your current net worth divided by your take-home pay should be 1 unit greater than it was two years ago. And if you are between age 50 and 65, your net worth should have increased this year by one times your take-home pay.

Want to retire younger? Try lowering your standard of living. Most retirees spend about 70% of the gross salary they earned while working. If you can live off 50% of your take-home pay, it's not as essential to save as much.

Need to catch up? Save more than 15% of your take-home-pay. Determine how far you are behind and what additional percentage you can save each year. For example, at age 30, you should be worth 1.5 times your annual income. If your numbers don't match that ideal, an additional 0.3 times your annual income will help you get there. You could save an additional 10% of your income (for a total of 25%) for three years. If that's too much, try saving 20% (an additional 5%) for six years.

Money makes money. By the time you reach your 40s, you should have enough investments to be earning about half of your annual spending each year. Early in life what you save is most important for building wealth, but as you approach age 40 what you earn on your investments becomes critical. While you are young, the best advice a professional can offer is to "save." As you amass significant wealth, it is more pressing to "manage" well what you already have.

All financial planning begins with a clear understanding of your net worth. A PDF template on our website (<a href="http://www.emarotta.com/budget" target=_blank>www.emarotta.com/budget</a>) can help you compute and keep track of your net worth each year. Contact us or visit our website to download a free copy.

 

from http://www.emarotta.com/article.php?ID=318

Financial Resolutions for the New Year (2008-12-29)

by David John Marotta

Every year many of us make New Year's resolutions and then can't follow through because we claim we're too busy. The most common priority--if another hour can be found in the day--is to spend more time with family and friends. The second one on the list is to find time for physical fitness. But given two extra hours, far too many of us just work that much longer on our backlog of pressing responsibilities.

This year, however, is different. Financial planning concerns very likely threaten to consume your life and ruin all your other New Year's resolutions. The tsunami of 2008 left your finances beached in a tree, and a plan to get back on track in order to meet your goals is imperative. You can't afford to spend time with family and friends and make it to the gym unless you have someone on your team watching out for your finances. Few of us are disciplined enough to accomplish what we need to do without help.

If you are young, you may not have had that much saved relative to your annual spending anyway. But if you are older than 40, what you save each year is small compared with what you already have invested. So growing that money is critical. And for both young and old alike, for every seven years you delay saving and investing, you cut in half the lifestyle you might enjoy in retirement.

Here are some suggestions. First, ask the right questions and stay the course until you've found the answers. Goals that are shared are ten times more likely to be acted on. Don't wait until you have everything set up to seek out accountability.

Second, make those goals concrete and then document them. Set your savings goals as a specific annual percentage of your adjusted gross income (AGI). We recommend saving at least 10% of your AGI in tax-free retirement accounts and another 5% toward retirement in taxable investments. If you are behind on your savings (over age 40 with less than five times your AGI in investments), you may want to save more in order to catch up.

Third, craft the best strategy to implement your goals, including prioritizing the appropriate retirement vehicles. We recommend investing just enough to get the entire match that your company's 401(k) plan offers first and then funding your Roth IRA accounts next. After these two, make certain you have enough nonretirement savings. By prioritizing your investment vehicles, you are deliberately putting your money into accounts that combine the greatest number of asset allocation choices with the lowest possible fees. Many company 401(k) accounts have such high fees and poor choices that they frustrate investors.

Fourth, automate your plan. Automating putting money in an employer-defined contribution plan is easy. Automating a taxable savings plan is just as painless. Most brokers offer an automatic money link between your investment account and your checking account. They also offer a monthly automatic transfer between the two accounts.

Finally, monitor your plan and rebalance your portfolio regularly. I recommend doing this halfway through the year after your June 30 statement.

Your plan must be comprehensive. Investment management may be at the core, but it is not the most critical element. Managing your investments must be done in the context of sound financial planning that you and an advisor monitor and review regularly. Financial planning includes retirement projections, figuring out how much to save and setting reasonable spending rates in retirement.

But an even more important element than financial planning is a comprehensive wealth management plan, which should include reasonable and appropriate insurance and liability coverage.

Perhaps the most critical component of wealth management in the new year will be tax management. With the potential for tax rates to fluctuate even more than the stock market, the value of tax management has never been greater. In addition to positioning your family's wealth to take advantage of all the possibilities, from Roth conversion to municipal bonds, you also will need help to contend with the plethora of changes in estate planning laws over the next few years.

Investment management, financial planning, wealth management and estate planning underline the need for integrated life planning. You can learn to enjoy life more, and find time for family and exercise, if you delegate the financial, tax and legal issues to trustworthy advisors.

A skilled financial advisor can help you realize the benefit of saving and investing with a minimal amount of work. But be aware that salespeople cannot be objective in helping you determine what to purchase when they have a vested interest in selling you a product. To find a fee-only financial advisor, call the National Association of Personal Financial Advisors (NAPFA) at 1-888-FEE-ONLY (1-888-333-6659) for a list of members in your area or visit their website at <a href="http://www.napfa.org" target=_blank>www.napfa.org</a>.

 

 

from http://www.emarotta.com/article.php?ID=317

A Christmas Sermon (2008-12-22)

by David John Marotta

Christians celebrate the birth of Jesus on Christmas Day. But for too many of us, it's the season that unravels the careful financial planning of the previous 11 months. So this year, instead of trading your financial goals for a mountain of gifts and debt, take a moment to contemplate how a spiritual perspective can help you put your wealth in perspective.

In Christianity, my religious tradition, we are only stewards of our wealth. We are entrusted to use it wisely to meet the responsibilities we've been given. Thus our money belongs to God, and we must first ask ourselves, "What does God want us to do with his money?"

You may find a spiritual perspective on wealth either strange or presumptuous. But for all of us, money is an unconscious placeholder for what we value. The way each family uses money expresses their beliefs. Even when someone uses money hedonistically, it reveals their worldview. More commonly, our use of money negotiates a plethora of competing values such as education and recreation, security and travel, or children's needs and parents' needs.

Every spiritual tradition promotes certain actions and ideals as beautiful, virtuous and true and discourages others as ugly, sinful and false. Having a spiritual view of wealth management, whether based on the Judeo-Christian, Buddhist, Baha'i, or any other faith, helps us purposefully apply our values and use money to meet our goals.

The wisdom we gain from our spiritual traditions challenges us to consider our wealth from a new perspective. In the Christian tradition, the words directly attributed to Jesus, often marked in red in the Bible, have the highest authority. But whatever your religious faith, consider the words of Jesus as a prophet and spiritual leader. In the gospel of Matthew (23:23), Jesus says, "You give a tenth of your spices--mint, dill and cumin. But you have neglected the more important matters of the law--justice, mercy and faithfulness."

Giving a tenth of your income each year, or tithing, is a noble endeavor. Many people use this percentage as a benchmark of their generosity, but Jesus offers us a greater challenge and an important warning. He cites three values that are particularly germane when dealing with our perspectives toward wealth management: justice, mercy and faithfulness.

Justice, the first virtue, is acting fairly. The notion of justice seems to be instilled universally in the human mind and heart. We all recognize injustice, especially against ourselves! But the truth of justice is that all people, regardless of their wealth, have equal value in the eyes of God. Although most believe this to be true in the abstract, wealth can make people act otherwise.

We tend to treat those with power and wealth with more respect and deference than those without. And if we have acquired wealth, we may think ourselves better than others for having done so. But being more productive does not make us more valuable. True justice values every person. And its opposite is pride, believing ourselves better than others because we have wealth, status and power.

In the Christmas story, the wise men come bearing gifts for the baby Jesus. They bring him gold because he is a king. Some have cynically mocked the golden rule, misquoting, "He who has the gold makes the rules." The gift from the magi reminds us that Jesus has the gold, and with him as king, justice rules. Wealth need not make us prideful, and we can treat others with equity and humility.

Mercy, the second virtue that Jesus mentions, translates as kindness toward those in need. Mercy is also a universal virtue. Few would argue against being tenderhearted and compassionate. Although the goodness of mercy is universal, unfortunately the practice is not. Statistics show that the more money people possess, the smaller percentage they give to charity.

If mercy is the virtue, greed is the vice. Making progress toward our financial goals need not blind us to those struggling behind us. Part of our careful planning and budgeting should include cheerfully helping those charities and individuals in need. Jesus emphasizes that becoming generous and merciful is even more important than giving a fixed percentage of our income.

Frankincense, the second gift of the wise men, was used to offer prayers to God. It reminds us to have faith that a power greater than ourselves cares for us. Every person among us needs mercy.

The third virtue, faithfulness, involves a covenant relationship with God to trust ultimately in the spiritual, not the material. If we are not vigilant, the many things we buy with money can become the center of our lives. We can find ourselves literally worshipping material goods.

In his book "Mere Christianity," C.S. Lewis warns, "One of the dangers of having a lot of money is that you may be quite satisfied with the kinds of happiness money can give and so fail to realize your need for God. If everything seems to come simply by signing checks, you may forget that you are at every moment totally dependent on God."

The Old Testament law in Deuteronomy 8:11-18 makes this temptation even clearer: "Be careful that you do not forget the Lord your God. Otherwise, when you eat and are satisfied, when you build fine houses and settle down, and when your herds and flocks grow large and your silver and gold increase and all you have is multiplied, then your heart will become proud and you may say to yourself, 'My power and the strength of my hands have produced this wealth for me.' But remember the Lord your God, for it is he who gives you the ability to produce wealth, and so confirms his covenant."

The opposite of faithfulness is fear. We fear that God has forsaken us or is indifferent to our struggles. But fear can paralyze us. And if we do not take risks, we are unable to live and enjoy fully the life God has given us.

The final gift of the magi was myrrh, a bitter gum used in death and burial. In the Christian tradition, it reminds us that even at Jesus' birth, his death on our behalf is foreshadowed. As the apostle Paul writes in the letter to the Romans (8:32-34), "If God is for us, who is against us? He who did not spare His own Son, but delivered Him over for us all, how will He not also with Him freely give us all things? God is the one who justifies; Christ Jesus is He who died, yes, rather who was raised, who is at the right hand of God, He intercedes for us."

If God is for us, we can trust him, and take courage no matter how dark the future may appear. Look to integrate finances with your spiritual traditions to reflect the best of your values and live life holistically.

Seek to avoid pride, greed and fear is a common mantra in investment management. Jesus substitutes the positive virtues: justice, mercy and faithfulness. Don't think more highly of yourself if you have money. Be generous to those in need and trust that God cares for you. Remember these principles this Christmas season, and you will remember the one whose birth we celebrate.

 

from http://www.emarotta.com/article.php?ID=316