Asset Allocation Age

Many financial planners determine portfolio allocation based solely on the client’s chronological age. This may not be the best approach.

Most financial planners use some version of age based investment strategy. Client needs are different. The investment strategy for a 30 year old will be different than those of a 70 year old. The reasons are simple. An older person has less time to make up losses than a younger person. The older the investor, the less risk that investor should take.

A Simple, but Effective Approach

Many financial planners use an asset allocation model known as “Your Age in Bonds.” Very simply, whatever a person’s age is, that is the allocation in they should have in bonds. For example, for a 50-year old investor, the target for bonds and cash would be 50% of the portfolio value. The remainder of the portfolio should be in foreign and domestic stocks. The allocation is reviewed annually and adjustments made as the investor ages.

As simple as this concept is, it may not be practical for every person’s portfolio. Different people have different needs and their chronological age may not be the best way to determine portfolio allocation.
Age Contrasts

Everyone’s needs are different. A 30-year old is typically working, may be investing in the company 401(k) and has minimum saving. Market gyrations will have little impact on their net worth. They have many years of working and many opportunities to build a savings. So a 70/30 allocation in stocks and bonds would be a good start.

There is no such thing as a typical 55-year old investor. Some have accumulated significant wealth while other have few asset and significant debts. Some have 401(k)s, other’s have pension plans and some are relying on their own saving for retirement.

Family status is diversified also. Some have small families, no family or a large extended family. Some may have aging parent. While the “Your Age in Bonds” is a good asset allocation model, it cannot be applied to every investor.

Rather than use an investor’s chronological age as the primary yardstick, it makes more sense to use the investor’s allocation age to guide asset allocation. A person’s allocation age may be higher or lower than their chronological age. The allocation age takes individual life situations into account.

An example: Say a 65-year old couple has accumulated $2 million in liquid assets. They have two grown children who do not need financial support. The couple spends about $100,000 a year of which about $60,000 comes from pensions and social security. The balance of $40,000 comes from their savings account. A 35/65 stock/bond allocation would not be appropriate for this couple.

One approach would be to divide their assets into two portfolios. One portfolio of $1 million would be 35/65 stocks/bonds mix allocated to meet the income needs of the couple. The remaining $1 million is not likely to be needed by the couple and will pass to their children. So the second portfolio should be asset allocated to match their children’s age. Their average age is 35 so an appropriate allocation for this portfolio would be 65/35 which is the recipient’s allocation age. Instead of splitting the portfolio, the $2 million portfolio could be asset allocated as a 50/50 mix of stocks/bonds which is the couple’s asset allocation age.

Tale of Two Women

Assume a 55-year old woman is barely getting by. She has a small amount in her 401(k), has some housing debt and is caring for her aging parents. This person would have an asset allocation age of about 70 because she has a high cash flow risk. She is financially vulnerable and cannot afford to lose any sizable amount of her savings.

A second 55-year old woman has a pension plan, no housing debt and a large Roth account. Plus she expects to inherit a sizable estate from her parents. Her allocation age would be about 40 as she has no cash flow risk and no foreseen liabilities.

Two women, same age, but at vastly different asset allocation ages. The first woman should have at least 70% in bonds due to her financial situation. The second woman may have 60% in stocks and 40% in bonds because she is in much better financial shape and can tolerate more risk.

Chorological age is a good place to start with asset allocation. But the ultimate asset allocation is based on your asset allocation age which may higher, or lower than your chorological age.

David Snellen
Registered Investment Advisor
USA Living Financial Group
954-302-3628

IRA to Roth Re-Characterization

The benefits of a Roth IRA can be summarized as tax-free income, no required distribution and ability to pass the account tax-free to heirs. The earnings on the contribution are returned to you tax-free and no penalty if you’re over 59 1/2 and otherwise meet the requirements for a qualified distribution. You can withdraw your contribution at any time without penalty. Unfortunately, households with a modified adjusted gross income of $100,000 or more were unable to have a Roth account. This about to change.

The ability to re-characterize an IRA to a Roth has always been available to people below the $100,000 gross income level. You will have a tax liability on the conversion amount which is due by April 15th of the following year. You will also have to wait five years and be over the age of 59 ½ before you can access the principal and growth tax/penalty-free.

What has changed is beginning January 1, 2010, any household at any income level can convert a traditional IRA to a Roth IRA. You will have to pay taxes on the conversion at your current rate. For example, if you are at the 25% tax level, on a $100,000 conversation you will be taxed $25,000. But if you convert in 2010, you’ll have the opportunity to recognize half the income in 2010 and the other half in 2011. In other words, you will have two years to pay the taxes on the conversion. The five year and 59 ½ rule will apply to the conversion.

Considerations

For many people, this is a great one-time opportunity to create future tax-free distributions. However, the conversion is not for everyone. Things to consider:

If you expect your tax rate to decline in the future, then it would make sense to forgo the conversation and just pay the tax on the IRA distribution. The closer you are to retirement and to taking withdrawals, the stronger this argument becomes. There is no guarantee however that your tax rate or tax liability will decline in the future even with a reduced income. With huge government spending, the deficit is growing rapidly which means some taxes will, in the future, be going up. Or the government could reduce the allowable deductions we now enjoy. Either way, the end result will effectively increase your tax rate. Most financial analysts expectitax rates to increase at some point in the future.

You should have the money available to pay the tax without raiding the IRA to do so. Using the IRA to pay the taxes is self-defeating. This may subject you to a 10% penalty and you would lose the tax-free growth on the money sheltered within the account. The need to pay the tax sooner and in much larger lumps is the major disadvantage of the IRA to Roth conversion. Fortunately, the conversion is not an all or nothing proposition. You can convert some of the IRA assets to a Roth while leaving the balance in the IRA. In other words, you can convert the amount for which you have the money on hand to pay the tax, not the entire IRA amount.

One idea would be to increase your payroll withholdings beginning in January 2010 and running through December 2011. Work with your CPA to estimate the total tax overpayment and then use that amount to pay the conversion tax. Remember you have two years to pay the tax, but the conversion goes to work for you immediately.

The government may attempt to touch Roth accounts. The end result is the government could realize a huge influx of income (taxes) over the next two years at the expense of future administrations. Future administrations may attempt to recoup some of the ‘lost’ revenue by taxing Roth withdrawals. This is not likely as it would be double taxation but they could remove the tax-free ability to pass the account onto your heirs. Or they could decide to tax the Roth earning. This would be an unpopular decision but there may be other creative ways the government could tap the Roth accounts. Although possible, I don’t think the government will attempt to touch Roth accounts in the foreseeable future.

The Best Approach

The best overall approach may be to transfer as must as you can afford into your Roth in 2010 and leave the balance in your IRA. You can always re-characterize portions of your IRA to your Roth at a future time if your gross income is less than $100,000. The only 2010 urgency is the removal of the gross income restriction and having the ability to spread the tax liability over a two year period. And then again, the government may extend the program or a modified version into 2011 and beyond.

All IRA to Roth re-characterizations are taxable events and will have to meet the five-year rule before the distributions will be tax-free. If you have a number of years before retirement, this can be a good retirement planning. If you’re already over 59 ½, you can take IRA distributions now, pay the tax and place the distribution in your Roth.

The Divide and Conquer Strategy

For most people, a partial IRA conversion is the best option because of the tax liability involved. Fortunately, creative planning can help you get the most mileage from a partial conversion. If you place the full conversion into a single Roth account, the tax effects of losses and gains are proportional to the account. But if you split the IRA conversion into multiple Roth accounts each with a single asset class, then you can use re-characterizations to take maximum advantage of the tax break. This strategy is available to you every year.

A Step by Step Example

Assumptions: You are in the 25% tax bracket and have $200,000 in an IRA. You have $5,000 in cash which you are willing to use to pay the tax on the conversion.

Step 1. January 2010: Convert the $100,000 in the IRA into five separate Roth accounts with each with $20,000 and invested in a single asset class. Asset classes could be high yield bonds, emerging markets, REITs, domestic small caps and foreign stocks. This is a temporary allocation and other asset classes could be used. The idea to achieve hyper-returns from one or more asset classes.

Step 2. April 15, 2011: Pay the $5,000 tax but file for an automatic extension on the return. This will give you until October 15, 2011 to file the final return.

Step 3. October 1, 2011: Review each Roth account and decide which one to keep. Then re-characterize the other four back to the IRA before October 15, 2011. The end result is you paid the $5,000 tax on the conversion, enjoyed 21 months of earnings and started the clock on tax-free withdrawals in January 2010.

What if all five Roth accounts decline in value? Simple, just re-characterize all five back to the IRA, file the tax return and get a refund of the $5,000. After 31 days, or at the beginning of the year after the original conversion, whichever comes later, you can once again re-characterize the traditional IRA to Roth IRAs, but with a lower tax liability. This strategy will provide you with a lot of tax planning flexibility.

Piles of Paperwork

The above strategy will require accurate record keeping. You will need to track the IRA and Roth accounts very carefully and document the money movement. Avoid using a single Roth account as the proportional allocations will be difficult to track.

If you want to push back portions of a combined Roth, the custodian will have to determine the amount of the portion conversion and any net income (or loss) allocable to the conversion. If the Roths are combined, you may be required to make up any losses. This is self-defeating so the easiest solution is to create separate Roth accounts.

The Roth you decide to keep should be re-allocated to a more effective diversification. After the five year waiting period, this Roth can be merged into the ‘master’ Roth without penalty.

The Divide and Conquer strategy can be used every year. The ideal situation would be to have five Roth accounts in the pipeline with one “graduating” each January and merged into the master Roth. Use remaining IRA amounts to create five more Roths. In December of the same year, pick the one you like best and send the rest back to the IRA. Repeat in January.

You can see the importance of accurate paperwork because you will be tracking up to 10 Roth accounts and the IRA account. With separate Roth accounts for each year, the paperwork trail will be easier to manage.

Summary

The upcoming Roth IRA conversion can be a golden opportunity for the right person. But it’s not for everyone. Feel free to contact me and I can help you with the pros and cons for your specific situation.

David Snellen
Registered Investment Advisor
USA Living Financial Group
954-302-3628

Navigating the Bond Market

(Written September 2009)

Bonds are fixed income investments. In other worldsbond (purchased individually or via ETF or mutual fuis a debt security. In effect, you are loaning money togovernment, a municipality or a company in the expectation of receiving monthly, quarterly or semi-annually interest payments, in addition to return of the principal.

Bonds are subject to their own set of investment risks including reinvestment risk, interest rate risk and purchasing power (inflation) risk. These risks affect all forms of corporate, government and municipal bond issues. Government bonds however are not subject to default risk, that is, the risk that a creditor may seize the underlying collateral of a bond (if any) and sell it to recoup the principal. Also, government bonds do not have credit risk which is the risk that the issuer cannot make interest and principal payments.

The credit risk of a bond issuer can be determined by reviewing the credit rating assigned by the bond rating agencies, most notably the private firms of Standard & Poor’s and Moody’s. Both firms rate a corporate bond issue as either Investment Grade or Non-Investment Grade (Speculative) grade. The grade assigned is a judgment call so it is recommend you (or your investment advisor) do your own due diligence on the issuer.

An alternative to individual bonds are bond ETF or mutual funds. A bond ETF/Mutual funds is a portfolio of individual bonds that have similar credit ratings. For example, the Dodge & Cox Income fund (DODIX) has an Average Credit Quality of AA (high grade) and Yield of 5.72%. On the other hand the Vanguard High-Yield Corporate mutual fund (VWEHX) has an Average Credit Quality of BB (Speculative) with a Yield of 8.40%.

You will notice with these two examples that the less the quality of the bond, the higher the yield. This is because for a lesser creditworthy company to sell its bonds, it must offer an interest rate high enough to attract a buyer. Contrast the two examples with the iShares Barclay 1-3 Year Treasury ETF (SHY) with a yield of 3.16% but no credit risk.

Bonds should be a portion of every investor’s portfolio regardless of age. The only variables being level of acceptable risk and percentage of portfolio. As the investor ages, shifting toward a larger allocation of bonds along with a move toward less risk in the bond allocation is necessary.

Bond Options

Municipals Bonds – Issued by state and city governments who use the money to build schools, sewers or other high ticket items. Most municipal bonds are free from federal income taxes and state tax (if the investor lives in the state that issued the bond. Because of the tax advantage, munis have historically offered much lower yields than Treasury bonds. The SPDR Barclays Capital Municipal Bond (TFI – 3.88%), Fidelity Municipal Income (FHIGX – 4.31%) and Vanguard Interm-Term Tx-Ex (VWITX – 4.00%) are three funds in this classification.

Government agency bonds – Ginnie Mae, Fannie Mae and Freddie Mac issue bonds backed by the payments from mortgages. Since the federal takeover of Fannie and Freddie, their bonds are effectively guaranteed. Ginnie Maes are also government backed. The yields tend to be higher than Treasurys. The Vanguard GNMA (VFIIX - 4.61%), Payden GNMA (PYGNX – 4.88%), Fidelity Ginnie Mae (FGMNX – 4.65%) and other funds can provide exposure.

Treasury bonds and TIPS – The interest and principal are guaranteed by the government. The downside is the safety is paid for with lower yields. The yields on Treasury Inflation Protected Securities (TIPS) are designed to float with the inflation rate. iShares Barclay TIPS Bond (TIP – 4.68%) and SPDR Barclays Capital TIPS (IPE – 3.38%) are two ETFs that invest in TIPS.

High-grade corporate bonds – Corporate bonds generally have higher yields when compared to Treasurys. They are not risk-free but the bondholders are ahead of stockholders if the company runs into financial trouble. RidgeWorth Investment Grade Bond (STGIX – 4.28%) and iShares Barclays MBS Bond (MBB – 3.85%) are two plays in these bonds.

High-yield bonds – Often called ‘junk bonds’, these riskier cousins of high-grade corporates are issued by companies that have to pay higher interest rates to attract investors. These funds can be tempting because of the high yields, but remember they are paying higher yields for a reason. Two funds in this agenda are SPDR Barclays Capital High Yiled Bond (JNK – 13.25%) and T. Rowe Price High-Yield (PRHYX – 8.32%).

As with any investment, always read the prospectus and make sure you understand all the fees and expenses associated with a bond or bond fund purchases. High fees may cut into your returns.

Written by David Snellen
© 2009 USA Living Financial Group

Disclosure:
David Snellen and/or his clients may have a position in one or more of the quoted funds/ETFs.
All stated yields are as of July 15, 2009
Due to the market volatility of the past year, the yields shown may not represent a true picture of the yields available with this class of bonds.

Is the Worst Over?

(Written November 2009)

The stock and bond markets are indicating that we may have seen the bottom of this economic cycle. The markets are reacting to indication that the stimulus efforts may be working. Bad economic news comes less often and in many cases the numbers are improving. But is the worst over?

With the sharp rallies off the March 9th lows, the summer and fall seem to be giving way to a more somber view of a potential recovery.

Consumers continue to cope with near double digit unemployment and the ongoing recession while trying to salvage what they can of retirement and investment accounts. The U.S. auto industry operates as a former shell of itself, but manufacturing overall is showing some signs of stabilization. Banks and financial institutions still face pressures but posted substantial earnings recovery.

Economic data remains mixed and often contradictory. One must have faith in the ability of the U.S. economy to return to sustainable growth.

The tough part is the not knowing which way the economy and consequentially the stock market will move and over what length of time. No one has a crystal ball, but now being warier and wiser, we can look toward what’s on the horizon.

How It All Started

It’s hard to pinpoint the beginning of the financial crisis. The first signs appeared in late 2006 and 2007 when sub-prime mortgage lenders started going under. The government recognizes the problem and in 2007 began a series of moves to shortstop the growing number of mortgage defaults.

Through the fall of 2007 and into 2008, the government was actively injecting money into the banking system while simultaneously lowering the interest rate.

The Bank of America’s Jan 2008 purchase of Countrywide Financial, the country’s largest sub-prime lender, made BoA the nation’s largest mortgage lender. While mortgage defaults were in the news, this event put the issue on the front page and highlight for most Americans the seriousness of the mortgage defaults.

Then beginning in Jan 2008, banks began to fail. One in January, another one in March followed by two in May. JPMorgan Chase & Co. acquired The Bear Sterns Corporation in March 2008 at a fire sale price. And then the failure of Indymac Bank, on July 12th, 2008.

Many believe it was the failure of Indymac Bank that started the banking dominos to start falling. The failure of Indymac is widely blamed on Senator Chuck Schumer (D) New York who purposely leaked an internal memo on June 26th, 2008 calling into question Indymac Bank’s viability. The discloser resulted in an eleven day run on Indymac resulting in the withdraw of more than $1.3 billion dollars.

John Reich, the director of The Office of Thrift Supervision at that time directly placed the blame for the bank’s failure on the comments made in Senator Schumer’s letter. Indymac Bank was not a poster child of how to run a bank and may well have failed at a later date. And maybe not. We will never know. But at the time Indymac was the most expensive bank failure ever.

Blood was in the water and the Wall Street sharks began to circle Fannie Mae and Freddie Mac. Short sellers, who profit when the price of a stock falls, attacked these financial giants along with other large banks driving their stock price into the ground. One name that stands out is George Soro, the billionaire who broke the bank of England in late 1992 with his shorting the sterling. Soro takes major short positions in US and European stocks, the dollar and 10-year Treasuries. The book he published in April 2008 along with his many appearances on financial shows and written commentary help his positions become big winners.

And then came September 2008, the most harrowing month of all. Fannie Mae and Freddie Mac are placed under government control. Bank of America takes over Merrill Lynch and Lehman Brothers files for Chapter 11 bankruptcy. The consumer starts noticing things were not right and stopped spending which sent demand into a free fall. Washington Mutual Bank failed in September and twelve more would fail before the end of the year.

The U.S. stock market bottoms on March 9th, 2009 down 56.78% from the October 2007 high.

Getting Our Bearing

So where do we go from here? No one knows for sure except we do know that the business cycle and the economy move in a constant pattern of up and down cycles. If the pattern holds true then we should be looking at a gradual if uneven recovery. This will ultimately lead to yet another sump. Like waves on the ocean, you cannot prevent naturally occurring events.

But the one thing we did learn is that the world economies are much interwoven. The U.S. sells raw material and finished products to other countries who in turn sell us raw materials and their finished products. The U.S. is not likely to experience sustained consistent growth without the same occurring in other countries.

What we want to do is avoid overacting to the latest sentiment. Many investors now want a more actively managed portfolio which implies that somehow one can foresee which way the market will move. The best evidence that market timing is a bad idea is the market’s recent behavior. Very few people predicted the crisis. Of those who did, most have been predicting it for years. Peter Lynch famously said, “Far more money has been lost by investors preparing for corrections or anticipating corrections than has been lost in the corrections themselves.

The Road Ahead

There are investment strategies to consider going forward. The first step is to look at your overall investment portfolio within the context of a financial plan. We shouldn’t be focusing on individual investments or the hot sectors.

We do want to hedge the potential inflation risk by considering precious metals and high yield bonds. Diversification is a technique to help reduce risk, but there is no guarantee that diversification will protect against a loss. When the boat is sinking it doesn’t matter which seat you are in. You will still get wet.

We shouldn’t depend solely on the U.S. economy to drive our portfolio. Having a position in specialty sectors like emerging markets, consumer stables, science and technology in additional to the U.S. overall market will help to ensure your portfolio has a chance of growth.

In this era of American economy, investors chart their courses. Consumers set aside more savings. Workers value their jobs more than ever. The greatest cause for optimism may be that we’re grinding through this recession. This is a good thing.

Written by David Snellen.
© 2009 USA Living.com, Inc.

Managing Volatility with a Ladder

(Written October 2009)

During the past decade, income focused investors have faced a remarkable period of interest-rate volatility. In the past 10 years ending in 2008, the Federal Reserve adjusted the federal funds target rate, which influences the interest rates that consumers pay and bondholders earn, 41 times.

One way to help manage interest-rate risk and cash flow from income focused investment is to construct an investment ladder. This allows the investor to benefit when the rates are high and to help minimize the effect when rates are low. Implementing a ladder investment strategy is easy and can be done with bonds, CDs or annuities.

Step by Step Using Bonds

Bonds, which are debt obligations of the issuer, are issued with maturity dates ranging from a couple of years to 30 years or more. Interest payments are generally every six months with the face value of the bond due at maturity. The interest rate paid by bonds is established when the bond is issued. If interest rates later rise, the issuer will pay a below market interest rate. Conversely, if interest rates fall, the issuer is straddled with paying an above market rate interest rate.

Although the interest paid by the issuer will remain constant, the principal value of a bond may fluctuate with market conditions. Bonds redeemed prior to maturity may be worth more or less than their original cost. Investors seeking to achieve higher yields may also face a higher degree of risk. The interest earned may also be taxable at both the state and federal level.

To set up a six-year bond ladder, you would purchase five different bonds with maturity dates of two, three, four, five and six years, respectively. If these are new issue bonds, you will earn an interest rate close to the prevailing market rate. When the first bond matures after two years, you purchase a new six-year bond to keep the ladder intact. Each year when the bond matures, you simply purchase a new six year bond. If interest rates have risen, you benefit from having cash available to invest in a new bond at the higher rate. If interest rates have fallen, only a portion of the portfolio is subject to the lower rate.

An alternative to buying individual bonds is to invest in a bond mutual fund or ETF. Interest is paid monthly instead of semi-annually and you don’t have to worry about reinvestment interest rates.

Using Annuities

Annuities come is many flavors ranging from simple savings annuities to complex variable annuities. The ones we are interested in for an annuity ladder are the short term, no fee and no commission savings annuity. This type of annuity is available from several insurance companies. They can be purchased for various time periods ranging from two to ten years or more and generally have a minimum investment amount with $20,000 to $50,000 being common. These annuities offer a fixed rate of return for a fixed period and the purchaser has no market risk.

For example, in mid September 2009, a simple $100,000 2-year saving annuity contract can be purchased earning 1.75%. A $100,000 5-year saving annuity will earn 3.65%. You can buy this directly from the company with no fees, no commission or salesperson involved. You simply give them a check for $100,000 and in two years they give you back a check for about $103,560. The 5-year annuity would earn about $20,000. Unlike bonds and CDs, the tax on the interest earned on an annuity is deferred.

Constructing an annuity ladder is similar to that of a bond ladder, but you may be limited to the term lengths offered by a single company. For example, some companies offer 2, 5 and 10 year saving annuities. Others offer may offer 3, 5, 7 and 10 year terms.

The interest rate paid on an annuity contract is also influenced by the Federal Funds Target Rate. Like bonds, you will want to keep the ladder short with five to six years probably being the limit. To construct a two-year annuity ladder, purchase a two-year annuity this year and one year later purchase another two-year annuity. When the first one comes due, you may be able to do a 1031 exchange into another two-year annuity which may be paying a higher rate of guaranteed return. The 1031 exchange will allow you to defer the tax on the interest earned.

If a company allows for a three-year annuity contract, the ladder is constructed over a three year period. Or you could build a five year ladder by buying a five-year contract every year for five years. The longer the ladder the more stability the annuity ladder will offer but may subject you to interest rate risk.

Using CDs

Constructing a CD ladder is very similar to the bond and annuity ladder but with more choices. Term lengths on CDs range from three months to five years. In mid-September 2009, the highest rate available on a one-year CD is 2.15% APY.

To construct the CD ladder, buy five separate CDs with maturity dates of 1, 2, 3, 4 and 5 years. As the first one matures reinvest in a new five-year CD. Unlike annuities, you will pay the tax on the interest earned each year even if the money earned will not be received until the CD matures.

With CDs it pays to shop around. You may purchase the CD from practically any bank located anywhere within the USA. Interest rates vary widely between banks with a high today of 2.15% APY down to a low of 1.25% APY. You can find current rates on www.bankrate.com. It may also pay to call the bank directly to request quotes or check the bank’s Web site.

There is no trick to CD laddering. Only due diligence is required in order to minimize risks. You may pay a surrender charge if you cash in a CD before its maturity.

Income investing using a ladder strategy can help provide stability during periods of interest-rate volatility. Remember to read all the fine print before purchasing.

Where to Use a Ladder

All three ladders will create taxable income so it would be wise to consider which investment vehicle: a Traditional IRA, Roth IRA or Saving Account would be the most appropriate. The Roth IRA would by far be the best location because all income is receive tax free after you reach 59 ½. It would not make sense to place an annuity ladder in a Traditional IRA. An IRA already has deferred tax status. It’s a duplication of effort. Both the bond and CD ladder would fit nicely in any of the three investment vehicles.

Written by David Snellen
© 2009 USA Living Financial Group

Create a Personal Pension Plan

(Written August 2009)

“If you ask what is the single most important key to longevity, I would have to say it is avoiding worry, stress and tension. And if you didn’t ask me, I’d still have to say it.” – George Burns

A steady stream of income will go a long way toward eliminating worry, stress and tension in one’s life. The catch however, is how to create a no stress stream of income.

Many people have pensions earned while working for a larger corporation or a government entity. Others choose to buy an immediate annuity. This involves giving an insurance company a sum of money in exchange for a defined period of income. The defined period could be for a short term like 10 or 20 years or for life.

For those of us who do not have a pension and choose to not give up control of our money, one option is to create a personal pension plan. A personal pension is not something you buy, it’s an investing strategy. And if planned properly the income from the personal pension can be tax free!

An individual investor has three choices for saving money. They are tax deferred, tax free and taxable accounts. Tax deferred accounts include IRAs and deferred annuities. There are significant differences between an IRA and a deferred annuity. An IRA is funded with pretax money and the invested amount along with the earnings is taxed upon withdrawal. A deferred annuity is funded with post tax dollars, but the earnings are tax deferred until withdrawal. Tax free accounts are Roth IRAs. With a Roth IRA, the invested money is taxed in the year earned but the growth is not taxed. Both tax deferred and tax free accounts have age limitations and other withdrawal consideration. Consult with your tax professional. The taxable accounts include bank savings account, CDs, money markets, checking accounts and similar type accounts.

How to Create a Personal Pension Plan

During the working years maximize your savings in a 401(k), IRA or Roth account. If you have the 401(k) option, try to invest at least 10-15% of your income. At a minimum, invest at least enough to meet the company’s matching contribution.

If you don’t have the 401(k) option, then your saving choice should probably be a Roth account. You can invest up to $5,000 ($6,000 for 50 & older) this year. You pay tax on the money this year but future earnings can be withdrawn tax free after reaching the age of 59½.

The tax free earnings are significant. For example, a single $5,000 deposit growing at 8% a year for 20 years will create over $18,000 of tax free income. Another example. Investing $5,000/year for 20 years at an average annual growth of 8% will grow to over $205,500. Upon reaching age 59½, this $205,500 could be invested in a combination of government and corporate bonds earning an average return of 6%. This amounts to about $1,025 of tax free income each month. Not bad for a personal pension in which the principal isn’t touched and you don’t have to retire to get it.

Portfolio Organization

When creating a personal pension look at the tax deferred, tax free and taxable categories as a holistic portfolio with distinct parts but coordinated to work together. IRA assets can be withdrawn upon reaching the age of 59½ and reinvested in the Roth account. Or the IRAs asset can be re-characterized into the Roth IRA at any time. Both the withdrawal and re-characterization are taxable events. The Roth account is invested for growth and to create a tax free cash flow. See your tax professional to discuss the re-characterization option.

Portfolio Diversification

An investment portfolio should consist of three distinct allocations of stock funds, bond funds and cash. This applies to 401(k), IRAs, Roth IRA and investment saving accounts. This approach allows for growth and cash accumulation. Stock funds include investments in US and foreign stocks. Stock funds are volatile but over time will be the heavy lifers in a portfolio. Bond funds are the monthly income generators and investors have many choices from high yield corporate bond funds to Government issued bonds both foreign and domestic. Cash has a zero correlation with stocks and bonds and works very well to reduce the portfolio volatility. The allocation percentage is variable and should be discussed with your investment advisor.

Creating growth involves moving a portion of the stock equities capital appreciation into the bond allocation. The remaining portion and any dividends allow for growth in the stock equities. This is taking some of the profits and placing it in a lower risk investment while allowing for growth. Adding equity profits to the bond allocation will increase the monthly income generated by these funds. The bonds can retain the monthly dividends or put them in the cash account.

The cash can be used to adjust the portfolio allocation or possibly flow into another account. For example, the IRA cash could flow into the Roth IRA via re-characterization. Roth IRA cash account being fed by bond funds could create a tax free monthly cash deposit into a money market or checking account. See you tax professional to discuss the tax issues with IRA re-characterization

Creating a personal pension is possible but requires planning and a saving strategy. When is the best time to start planning for a personal pension plan? Today.
© 2009 David Snellen - USA Living Financial Group

Top Five List - Feb 20, 2009

A review of the Top Five best performing securities by asset class contains no real surprises or change from the weeks before. The ranking uses the Sharpe ratio as the primary sort. Download the complete list at 2009-02-20 Top Five.


Summary: All asset classes are showing similar patterns of trending upward from the lows of 6 to 12 months. The annualized 4 week average return is -3.4%, 3 month is -0.4%, 6 month is -27.0%, 9 month is -30.9% with the 1 year is -22.8%. This ripple should roll through the periods so we should expect relatively better (i.e. less negative) returns in the outer periods. The 4 week decline may indicate a forthcoming further dip. Government bond funds currently provide the best risk adjusted investments, followed by Corporate Quality bonds, then Precious Metals and Municipal Bonds.

Asset Allocation - The Vanguard LifeStrategy (VASIX) is on top, but that's no real victory as this fund and the other four have all posted negative returns for the trailing 12 months.

Bear Market - These funds short the market and have been top performers since last spring. The iShares Short Treasury (SHV) is on top becasue of its low standard deviation compared to its mean. UltraShort Russell 1000 Value had the best Geometric Average at 46.%. The Short DOW 30 (DOG), UltraShort Financials (SKF) and UltriShort S&P 500 (SDS) follow.

Commodity - PowerShares DB Commodity Idx (DBC) is on top, but all five have negative 12 month trailing returns. Interesting, International Coal Corp. (ICO) which is a stock is second on the list. (Disclosure: I have a position in this stock.) All the commodity funds have standard deviations greater than 23.5.

Communications - Fidelity funds own this asset class. The top three, Select Wireless (FWRLX), Select Telecommunications (FSTCX) & Telecommunications (FTUAX), posted positive returns for the trailing 4 Week & 3 Month period.

Comsumer - Fidelity has four of the top five in this class but all have negative returns for the 12 month trailing periods. Fidelity Select Chemicals (FSCHX) is followed by Consumer Staples (FDAGX), Select Leasure (FDLSX), Vanguard Consumer Staples (VDC) and Fidelity Select Industrial Equip (FSCGX).

Corporate High-Yield Bond - Vanguard (VWEHX) is on top followed by Ishares (HYG), American Funds (AHITX), PowerShares (PHB) and USAA High Yield (USHYX). This class has positive returns for the 3 month trailing period but the 4 week perod returned to negative returns.

Corporate Bonds - This class is holding up well considering the credit issues. All five funds are showing positive trailing returns and the individual standard deviations are less than the individual means. On top is FPA New Income (FPNIX) followed by four of the Vanguard funds. The Short-Term ETF (BSV), Short-Term Index (VBISX), Total Bond Market (VBMFX) and the Total Bond ETF equivalent (BND).

Diversified Emerging Market - This class has positive returns for the 3 month trailing which is in sharp contrast to the -40.0% to -50.0% trailing 6 month period. The 4 week period is averaging about 0% returns. This may be a class worth watching. On top is iShares Chile (ECH), followed by iShares Brazil (EWZ), Fidelity Latin America (FLTAX), BLDRS Emerging Markets (ADRE) and American New World (NEWFX).

Financials - Negative for the 12 month trailing periods. Standard deviations are less than the negative means which means no anticpated positive returns anytime soon. Fidelity Select Brokeage (FSLBX) tops the list.

Foreign Corporate Bonds - Has positive 3 month trailing returns and standard deviations exceed the means. PowerShares Emerging Mkts (PCY) is on top floowed by Templeton Global Bond (TPINX).

Foreign Large Cap -No life here. All negative for trailing 12 month periods.

Foreign Mid Cap - Three of the five funds have life spans of less than 12 months. Third Avenue Intl (TAVIX) is on top followed by Vanguard Intl Explorer (VINEX).

Foreign Small Cap - Only three funds in this class and all three are negative for the trailing 12 months.

Global Real Estate - Negative 12 month trailing returns across the board, high negative means and Sharpe ratio ranging from -2.6 to -3.1.

Government Bonds - Positive 12 month trailing but clearing trending downward. This class may go 4 week negative following 3 of the 5 funds which already have. On top is SPDR Interm term (ITE) and it has a -1.0% 4 week return. Vanguard GNMA (VFIIX) has a 0% 4 week return which contrasts with the 3.0% 3 month, 5.0% 6 month, 5.0% 9 month and 14.0 % 1 year return.

Healthcare - The Biotech ETF (BBH) is on top and the only one of group with a positive geometric average. Fidelity Biotech (FBTAX) is distant second.

Inflation Protected Bonds - All five are showing positive 4 week and 3 month returns although the 4 week is less than the 3 month. Across the board relatively stable with group standard deviations around 5.0. On top is Blackrock IP (BPLBX) then SPDR TIPS (IPE), Vanguard IP (VIPSX), iShares TIPS (TIP) and Fidelity IP (FIPAX).

Large Cap Equity - All dead with the CGM Mutual (LOMMX) being less dead than the others. The CGM Focus (CGMFX) (Disclosure: I have a position in this fund) and Rydex S&P Equal (RYE) have -7.0% means with standard deviations of around 21.8%. The fourth entry is the John Deere stock (DE) is has been really beaten up followed by Van Kampen Growth (ACPAX).

Mid Cap Equity - As a whole worst than the large cap class. On top is Fidelity Select IT (FBSOX).

Municipal Bonds - All positive returns for 12 month trailing. Low standard deviations, means between -0.8 to 1.9 and Sharpe above 0.0. Leading is Fidelity Advisor Sh Int Muni (FASHX) then Vanguard Int Term (VWITX) and iShares Muni Bond (MUB).

Natural Resources - Potash Corp (POT) well ahead of the other four. However, this stock is a wild bet with an annual standard deviation of 55.2%. It has a 1 year return of 51% with a 9 month return of -57%, a 6 month returns of -52% then 3 month of 20% and a 4 week return of 21%. A wild ride.

Pacific/Asia - All five showing life in the 3 month period but back to around 0% for the 4 week period. Better considering the 6 monh to 1 year where -27% to - 47% is the norm. Overall class average is less than the Diversified Emerging Market class. The China funds own four of the five slots. On top is iShares China (FXI) then Templeton China (TCWAX), SPDR China (GXC), Matthews Asia Pacific (MAPIX) and iShares Hong Kong (EWH).

Precious Metals - Gold has pushed these funds skyward with double digits for the top three entries. Leading is SPDR Gold (GLD) with annuallized Geometric Avg of 16%. Then PowerShares Gold (DGL) at 14%, ProwerShares Prec Metals (DBP) with 13%. iShares Silver (SLV) and Market Vectors Gold (GDX) both had single digit returns at 6% and 5% respectively.

Real Estate - Vanguard REIT (VGSIX) is on top but this is no great achievement. As a group Real Estate ranks with the Financials in value. Real Estate posted trailing returns in the range of -11% to -69%.

Small Cap Equity - 4 week and 3 mon ranging from 2% to -7% is better than 6 months to 1 year which varied between -16% to -47%. Four week is down from 3 month.

Technology - Slightly better than Small Caps. iShares Biotech (IBB) had a 5% 3 month followed by a -1% 4 week return.

Utilities - Worst than Technology and on par with Financials and Real Estate.

World Stock - Lowest of the 29 asset classes.

Analysis by USA-Living Financial Group. Past performance is NOT an indicator of future performance.