Author Archives: BH&J

Average returns distort retirement income assumptions

This post continues a series of thoughts on investment returns and misleading aspects of average annual returns. The articles started with my Tacoma News Tribune column June 4 and extended to include this post about cost basis returns.

Here, we look at how the sequence of investment returns becomes much more important when an investor has shifted to withdrawing assets rather than accumulating a retirement nest egg.

When you are accumulating assets, the order of annual returns doesn’t matter. Take the S&P 500 return of the past 10 years and apply it to an investment in any order you like.

2003

28.50%

2008

-37.02%

2004

10.74%

2009

26.49%

2005

4.77%

2010

14.91%

2006

15.64%

2011

1.97%

2007

5.39%

2012

15.82%

For example, if you start with $500,000 and apply the annual returns in sequential order, reverse order or any random mix, you will end 2012 with a balance of $982,188.30.

However, you cannot use the average annual return over this period and get the same result. The average annual return over this 10-year period is 8.72%. If you apply annual 8.72% compounded growth to the initial $500,000 you would have an ending balance of $1,153,624 – a positive difference of $171,436.

If you evaluate an investment by reviewing the average annual return, you can be easily led astray of reality. Even more problematic, if you apply an average annual return assumption to a retirement income projection, you could receive wildly misguided output.

The order of returns becomes much more important in the withdrawal years.

Consider this variation of the earlier example.

Start with a nest egg balance of $500,000 and take out $25,000 (5%) at the start of each year. For simplicity’s sake we won’t consider adjusting the withdrawals upward each year to offset inflation. Since you need the $25,000 for year one, the balance left invested is $475,000.

If we use the average annual return assumption, the balance at the end of 2012 is $721,159. Even though we removed $25,000 per year ($250,000 total), our ending balance increased nicely due to the assumed 8.72% annual return that was achieved from 2003-2012.

Now, not only is the average annual return misleading, but the sequence of those returns becomes important. If we do the math with the actual order that was experienced, at the end of 2012, the account balance is $611,575 – almost $110,000 less.

If we reverse the order of returns, the ending balance is $565,801.

What if we move that ugly -37.02% return from 2008 up to the first year of the assumed retirement (2003 in this case)? Even though the average return over the 10-year period remains the same, the order is detrimental to long-term financial security. After 10 years, the account balance has dropped to $440,976 – 39% less than the projected balance if simply applying the average annual return each year.

Return sequence A Return sequence B Return sequence C Return sequence D
8.72% return each year Actual order of S&P 500 returns 2003-2012 Reverse order of S&P 500 returns 2003-2012 Negative return first (2008’s -37.02 switches places with 2003 return)
End balance End balance End balance End balance
$721,159 $611,575 $565,801 $440,976

Stretch these examples out over 20+ years – more reflective of a full retirement – and you will see that even if you achieve the same average annual return over time, it’s possible that one order of returns could run out of money while a different sequence could more than offset the annual withdrawals with exceptional growth.

KEY TAKEAWAYS

  • Average annual returns are not a good proxy for the actual investor experience.
  • Using retirement calculators that rely on a simple average annual return assumption can be problematic. It’s important to use sophisticated enough analysis to generate many variations of return patterns. This way you can understand a range of possible asset projections and determine a probability that your money will last longer than you do.
  • This example uses an investment only in the S&P 500 Index of large U.S. stocks. It is not a globally diversified portfolio and is not reflective of an investment strategy that we would recommend, either while accumulating assets or withdrawing from them.
  • A globally diversified portfolio may have lower returns over time but also could be expected to experience less downside risk. This type of portfolio would not be expected to continue growing at the rate demonstrated here while withdrawals were also being made.

Have you determined how much money you’ll need to retire without too much concern about the impact of market returns?

How have you projected future account growth and the impact of withdrawals?

~ Gary Brooks, CFP® — Brooks, Hughes & Jones, Partners in Wealth Management – Tacoma, WA

www.BHJadvisors.com

 

Past performance is not indicative of future investment results.
The S&P 500 is an index of 500 U.S. stocks selected by a committee and meant to reflect the large-cap U.S. stock market.
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Cost basis returns understate performance

Continuing the theme of my June 4 column in the Tacoma News Tribune, here’s another element of evaluating investment returns that can be confusing:

In some cases, particularly with mutual funds that own bonds and pay out regular income, you could see performance reports that show investment gains while in actuality, you’ve invested more in the fund than it is currently worth.

This is sometimes a function of measuring your cost basis return. In taxable brokerage accounts (non-IRAs) your monthly statement identifies the month-end market value of a position as well as the cost basis. The basis is the total amount you have invested in the fund over time adding together the initial contribution, any subsequent contributions or withdrawals and any reinvestment of income paid out by the fund.

Here’s a simplified example of how a fund company could report positive performance while you actually have a capital loss (higher cost basis than current market value).

Imagine you make investment of $10,000 on the first day of year. You buy 1,000 shares at $10 each. The fund pays out income of $50 per month. That income is reinvested in five new shares each month, all purchased at $10. At the end of the year, you have 1,060 shares at $10 each for a total market value of $10,600.

The price return/capital appreciation of the fund for the year was zero. The share price started at $10 and ended at $10. The total return (price change plus income paid out) was 6% (you earned $600 on a $10,000 investment), in this case all income. Given this math, it’s possible for the price of the investment to go down but still have a positive total return. Imagine that the fund dropped to $9.90 per share at the end of the year. The 1,060 shares would be worth $10,494. The total return would be 4.94% (6% income return reduced by the -1% price return).

Now if this investment is in a taxable account (not a retirement account) you would also have a cost basis return that differs from the average annual return.

Going back to the example above, the fund produced a 6% return increasing in value from $10,000 to $10,600. Even though this $600 is new money to you, by reinvesting it in new shares of the fund, this amount is added to your cost basis which is now also $10,600. You are even with what you have contributed to the account. There was no growth in price per share but the fund can report a 6% total return.

Complicating this scenario is the fact that this is a taxable account. The $600 of income received was fully reinvested but you are responsible for paying tax on this income, reducing the after-tax return. This is one reason why it’s usually preferable to hold bond funds in a tax-deferred account like an IRA instead of in a taxable account.

This is also an example of how income is nice to have in a portfolio but ultimately the total return of capital appreciation plus income is more important where portfolio growth is required.

~ Gary Brooks, CFP® — Brooks, Hughes & Jones, Partners in Wealth Management – Tacoma, WA

www.BHJadvisors.com

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How will the next generation manage wealth?

Reading the May edition of Registered Rep magazine, a couple nuggets of recent research caught my eye.

  • “Six out of 10 wealthy people believe that their children are not well prepared to handle an inheritance.”  – U.S Trust Insights on Wealth and Worth
  • “Lifetime value of what baby boomers stand to inherit: $8.4 trillion.” – Boston College, “Inheritance and Wealth Transfer to Baby Boomers”

Over the next few decades a lot of baby boomers will inherit from their parents. Some will inherit large sums. Many of these people won’t be prepared to manage these assets intelligently.

From our perspective managing an inheritance is no easy task. Most individuals have no formal training in wealth management. There is no school which combines classes in personal investing, estate and legal asset protection tactics, advanced accounting and asset protection tactics with training on how to work with other members of the family to manage, and sometimes give away, wealth.

Most baby boomers who have inherited know that they can hire professionals to help them with the various aspects of this responsibility. Accountants can do their taxes and recommend tax management strategies, attorneys can create wills and other asset protection devices, financial advisors can help manage the assets, etc.

The issue that most people have is coordinating all of these professionals to make sure that they are working together to provide the best solution for their situation.

In our experience, many advisors can offer excellent financial advice from their perspective, but that advice looks less useful when it is reviewed against the overall objective of the client.

We think that people who have inherited assets should ask the following questions when considering the management of this money:

  • What is the long-term goal for these assets?
  • What is the hierarchy for wealth management decisions? For instance, for some, wealth protection is much more important than reducing taxes.
  • Who will make decisions about these goals and how will they be made?

Once they have the answers to these questions, they need to determine if they are comfortable managing their investments themselves or if they should work to find a person who can help them coordinate the management of experts with the goal of better managing this process.

~ Allyn Hughes, CFP®, CLU®, ChFC® — Brooks, Hughes & Jones, Partners in Wealth Management – Tacoma, WA

www.BHJadvisors.com

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Personal finance trends – the good and bad

Positive developments in 2013

1)      Lower expense ratios on many Exchange Traded Funds (ETFs). Last year, Schwab started the trend of lowering ongoing management fees on their ETFs and eliminating the transaction costs to buy and sell these products on the Schwab platform. This move attracted the attention of competitors and now many ETFs are cheaper to own than ever before. These products allow the broadest diversification across entire market segments at the lowest possible cost.

2)      The government has increased the contribution limits for retirement accounts for the first time since 2008. Annual IRA contributions were bumped up by $500 to $5,500 for people 49 and under and $6,500 for 50 and over investors. Employer retirement plan contributions also increased. Individuals under 50 can contribute $17,500. The over-50 catch up contribution can add another $5,500 to get to $23,000 total.

3)      Congress adopted higher federal estate tax thresholds ($5.25 million per person and $10.5 million per couple in 2013) than expected by most pundits. This effectively eliminates the prospect of paying federal estate tax for 99.86% of estates according to the Tax Policy Center. It also provided much more clarity for estate planning professionals who work with high net worth individuals on estate planning issues. Many states still have lower estate tax thresholds, however. For example, in Washington state the limit is $2 million. If a person dies with an estate value of $1,999,999 no state estate tax is due. But reach $2,000,001 and an estate tax return and payment are necessary.

4)      Investors have returned to markets. According to Leuthold Group, through April 24, net cash flow into mutual funds was at its strongest pace ever with year-to-date positive cash flow $223 billion.

Trends that concern us:

1)      Regarding that cash flow, the point of concern is that $106 billion of the incoming investments have gone to bond mutual funds. We think bonds will be severely challenged to generate meaningful returns over the next several years. Combine the premium many bonds are trading at with current low yields and the fact that total return could turn negative when interest rates rise and particularly U.S. government bonds will struggle to post returns anything like the past decade. By comparison, $22 billion of new investments have entered U.S. stock funds so far this year.

2)      The low interest rate policy set by the Federal Reserve Board. This policy has lowered the borrowing costs for the U.S. Government, but it has also changed the way that we all invest. Bond investors who are searching for yield are taking considerably more investment risk with their fixed income portfolios than ever before. When the Fed finally increases interest rates, three things may happen: inflation could increase dramatically, bond default rates may rise, and returns for bonds could turn negative as investors seek newer bonds at different increasing interest rates.

3)      Less affordable long-term care insurance. A few trends are becoming clearer for the LTC marketplace. A) most residents of nursing homes are women, b) Most baby boomers don’t have long-term care insurance because they either feel that it is too expensive or they don’t think that they will ever need it, C) Rates paid for LTC policies are becoming gender based, and although they have stabilized somewhat in the past year, the combination of the continuation of the low interest rate policies by the federal government and higher claims rates by women will force LTC prices to continue to grow at higher rates than inflation.

~ Allyn Hughes, CFP® — Brooks, Hughes & Jones – Partners in Wealth Management, Tacoma, WA

www.BHJadvisors.com

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Expanding the dictionary to deal with bond challenges

Calvert, a mutual fund company that specializes in socially responsible investments, has trademarked a new financial term – Thincome™. “Thin” and “Income” are combined to create a word which describes what is now happening to income-oriented investors. Namely, that low interest rates have made it difficult for the average retiree to live on the income that is paid by bonds, savings accounts and other fixed income investment options that they hold.

Over the past few years many retirees have had to fundamentally change their investment allocations to try to overcome Thincome. The Federal Reserve’s commitment to a very low interest rate environment has forced investors to take a couple steps up the ladder of risk in order to receive the same income they had become accustomed to with more conservative investments. Many investors have moved money into international and emerging markets bonds which pay higher rates. Some have increased exposure to higher yielding “junk” bonds which have also provided more attractive returns. They have increased the duration and maturity of the bonds in their portfolio to increase yields.

These steps can reasonably be expected to increase income and total return from bonds, but it’s important that investors understand that this Thincome environment has led to our new contribution to the investment dictionary – Riskcrease. Riskcrease is the increase in risk that Thincome investors have taken on in search of higher yields.

The problem with Riskcrease is most investors are unsure how much additional risk they have taken on by making these changes to their fixed income investments. Five years ago, their fixed income portfolios were probably fairly conservatively managed. Now, many of these fixed income portfolios are subject to a broader range of risks than before.

We suggest that investors understand the specific risks of each of their fixed income holdings to properly address both Thincome and Riskcrease.

~ Brooks, Hughes & Jones — Partners in Wealth Management — Tacoma, WA

www.BHJadvisors.com

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Questions to ask before making a charitable donation

More than 1.5 million not-for-profits organizations in the U.S. are registered with the IRS as charitable 501(c)(3) entities according to the NCCS Business Master File. In 2010 these nonprofits paid 9.3% of all of the wages paid in the U.S. and had revenues of $1.51 trillion (source: The Nonprofit Almanac, 2012).

Each 501(c)(3) organization has its own mission, leadership and primary funders. Some of these are national organizations that attract large amounts of donations and are very financially secure. Others are “bootstrap” organizations that support a very specific (and often very local) cause. Many of these are close to being financially bankrupt and don’t have the resources necessary to achieve the objectives that their creators have developed for them.

According to the Current Population Survey, completed in September 2010, over 25% of Americans volunteer each year.

Deciding which charitable organization to support with your time, treasure or talents can be a difficult choice. We find that most folks manage their charitable giving in a few different ways.

Some work on the boards or as volunteers of one or more organizations and tend to focus both their time and their money to help support those entities.

Others support a religious organization that is important to them. Sometimes they tithe. Other times they make consistent donations of time and money.

Still others try to spread their charitable dollars around. They often support both local and national organizations that either have asked them for a donation, or that provide a service that they think is valuable.

Finally, quite a few support both local and national charitable objectives by participating in fraternal organizations like Lions, Rotary and Masons.

There is no right way to support an organization.  

In our experience relatively few people have a specific plan to support charities. They tend to make contributions that are proportional to their level of emotional investment in the objectives of the charity. They worry less about how specifically their money will be spent.

Making good decisions about philanthropy

We look at philanthropy the same way we look at investments. We try to understand how the charitable organization is managed, determine what its goals are and better understand how the contribution will be used.

Here are the three questions that we ask when making a donation: 

  • How financially healthy is the charity? To determine this go on to the web and download IRS Form 990 for the charity. The IRS requires each charitable organization to complete form 990 each year. It contains a lot of useful information—the charity’s goals, its income and expenses for the previous year, its leadership and board members and the expenses associated with managing the assets of the charity.
  •  How has the charity spent its donation in the past? The easiest way to determine this is to ask the executive director or lead fundraiser for the charity about how donations have been spent. Were they used to pay the overhead of the management and the fundraisers at the organization? Were they used to fund one or more specific programs? Try to determine the efficiency level of the fundraising efforts for the entity.
  •  How (likely) will my donation be spent? We always try to figure out if a donation will be spent on a specific expense associated with achieving the charity’s mission or if the money will go toward an endowment fund that the charity manages.

Spending the time to get the answers to these three questions will give you a much better idea of the strengths and weaknesses of a charity so you are comfortable that your money is being spent wisely.

~ Allyn Hughes, CFP®, ChFC®, CLU® — Brooks, Hughes & Jones, Partners in Wealth Management – Tacoma, WA

www.BHJadvisors.com

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Fracking, natural gas and the economics of energy

Richard Vodra, is a lawyer and Certified Financial Planner™ and the president of Worldview Two Planning of McLean, VA. He recently published an article “Is Fracking a ‘Happy Solution’ to our Energy Needs? In this article he brings up a variety of issues that the U.S. faces with the production of natural gas from fracking. Fracking involves injecting steam and other chemicals into shale or sand deposits deep underground to extract oil products and natural gas.

Vodra’s primary points:

1)      The price of natural gas in the U.S. is currently too low. On Friday, February 22, 2013, the spot March 13, 2013 contract price was $3.28 per thousand cubic feet of natural gas. One barrel of crude oil has about the same energy content as 6000 cubic feet of natural gas. The spot price for a barrel of West Texas crude oil for the April 13, 2013 contract was $93.13. The equivalent price of natural gas was $19.68. No natural gas producer can make money at this rate as break-even price for producing natural gas is thought to be between $6 and $8 per thousand cubic feet

2)      The cost to drill a natural gas well is too high. According to Vodra, a typical fracking oil well in Texas now costs over $10 million to drill, compared to less than $1 million for a conventional oil well.

3)      It takes too much energy to get the gas out. Traditional (oil) wells have a ratio of energy returned on energy invested (EROEI) of 10- or 20-to-one, or an energy cost factor of 5 to 10%. The EROEI with fracking is in the range of 5- or 10-to-one, or a cost factor of 10 to 20%. This cost factor is too high to be sustainable.

4)      Fracking uses millions of gallons of water per well, most of which is unusable thereafter because it is too polluted. There is competition for water rights between oil companies on one hand and farmers and ranchers on the other.

5)      Fracking might be making the earth less stable. Earthquakes in areas that don’t commonly have them, including Ohio and Oklahoma, have been linked to fracking activities nearby.

6)      The life of a fracking well ends quickly. A conventional well’s production declines at about 5-8% per year, and it can remain productive for decades. By contrast, the first-year decline in shale wells is over 60%, and about 90% of a well’s production occurs in the first five years. That creates a “drilling treadmill,” as new wells are needed simply to replace production from wells drilled a few years before.

The leaders of many public utilities across the U.S. are betting that the costs of natural gas will remain low. They are re-thinking their decisions to run coal fired power plants and older nuclear power plants and are often choosing to shut them down because they are either too expensive to run, or they don’t meet stricter environmental regulations. Many of these will be replaced by cleaner burning natural gas plants that are today much cheaper to run.

Given the list of the six key concerns about natural gas listed above, we wonder how long the pricing advantage of natural gas can last for U.S. consumers and what will happen to the largest users of natural gas when the costs for equal amounts of oil and natural gas are more equivalent?

Additionally, the National Geographic cover story in the March 2013 issue also looks at fracking, specifically in North Dakota, and examines at what cost the fuel supply is being expanded.

~ Allyn Hughes, CFP®, ChFC®, CLU® — Brooks, Hughes & Jones, Partners in Wealth Management – Tacoma, WA

www.BHJadvisors.com

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Financial fitness from the viewpoint of personal fitness

This post was provoked by a comment I read in a financial industry publication from Stuart Ritter of T. Rowe Price’s retirement services division.

Ritter said “saving 3% for retirement is like going to the gym for six minutes.” Acknowledging low rates of savings for many retirement plan participants, Ritter’s contention is that just as 30 minutes of exercise should be a minimum daily routine, savings for retirement should also be done at five times his example. Instead of saving 3% of annual salary, most people should save 15%.

I think Ritter’s quote goes a bit too far. There are some people who couldn’t manage a decent quality of life (even without living beyond their means) if they deferred 15% of their income into retirement savings. An important thing to consider when determining how much to save for retirement is how much of the heavy lifting you want to rely on investment markets to do and how much of it can you do by managing a prudent financial life that pays yourself first via retirement savings.

If you are saving just 3% of annual income, investment markets will be forced to do much more of the heavy lifting to get you to a point where you can come reasonably close to replacing your earned income in retirement by combining Social Security and withdrawals from investment accounts.

For the dwindling few (mostly government employees) who will receive an employer-funded stream of pension income in retirement, saving just 3% of income in addition to the pension may actually be adequate for living lean in retirement. For the majority, it won’t – especially if the savings is not invested in aggressively enough over the long-term to generate a meaningful rate of return.

Consider if at age 30 – possibly after paying off student loans and saving for a down payment on a home, a couple (or even a single wage earner) make $80,000 per year and their income grows at 2.5% per year. If they saved 3% of income in a pre-tax employer retirement plan and earned a 7% average annual investment return for 35 years, retiring at 65, they would have $473,846 of savings. This balance, assuming it continued to earn 7% returns for 30 years of retirement could reasonably be expected to generate approximately $1,400 per month of inflation-adjusted after-tax income to age 95. Add that to the average Social Security benefit and the couple (or individual) has to learn to live on a lot less than while they were working.

I think a more prudent minimum retirement savings is 10% of annual income. Apply the same scenario as before with 10% savings (perhaps through both personal and employer match contributions) and the balance after 35 years is $1,457,633 pre-tax. It would have about a 70% probability of supporting  $4,400 per month of after-tax spending for 30 years to age 95.

Of course, many people can’t afford to save 10% of their annual income early in their career but they expect to increase their contributions over time. What if someone upped their retirement plan contribution by 1% every two years. They start at 3% for two years, then 4% for two years and so on until they reach 15% of their income for the final 10 years of their career. Would they ever catch up to the person who saved 10% throughout? No. Even though they would have contributed approximately $58,000 more dollars to the retirement plan, saving much more during the peak earnings years, they would end up a bit less than $200,000 behind the consistent 10% saver. This is due to the missed opportunity to have more money growing and compounding returns in the early years.

While saving just 3% of income for retirement won’t sustain the same standard of living as pre-retirement, saving 15% throughout a career could be oversaving for some people, sacrificing a little bit too much today for the opportunity to use it in retirement.

The most important point is to take the time (or hire an independent financial advisor) to determine what amount of savings you will likely need to live on in retirement. This will inform your level of needed savings throughout the remainder of your working life and also be a guide for the appropriate investment strategy.

  • What can you do to increase your rate of savings in retirement plans?
  • Do you know how much money you need to save today to replace your income in retirement?

~ Gary Brooks, CFP® – Brooks, Hughes & Jones – Partners in Wealth Management – Tacoma, WA

www.BHJadvisors.com

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