TIPS: Not Attractive Yet

Posted On April 10, 2017 By Scott Stratton, CFP(R), CFA In Portfolio Management /

I love TIPS, but I’m going to tell you why you should not own them today. Treasury Inflation Protected Securities (TIPS) are government bonds, backed by the US Treasury. They pay two ways: a fixed interest rate (coupon) paid every six months, and an adjustment to your principal based on the Consumer Price Index (CPI-U). The dollar amount of interest increases when CPI goes up.

TIPS are considered by many to be a nearly “ideal” investment. Most traditional bonds have a set face value of $1,000, which creates inflation risk. The $1,000 you will get back 10 years from now will not have the same purchasing power as $1,000 does today. This inflation risk is nullified by TIPS. And it doesn’t even matter what inflation is: whether it is 1% or 10%, your purchasing power will be preserved by TIPS. It’s a remarkable benefit which makes TIPS “safer” at preserving wealth than a CD or savings account, while carrying none of the market risk of stocks.

At my previous firm, we had tens of millions of dollars invested in TIPS as a core fixed income holding. At my urging, we sold almost all of these bonds between 2012 and 2013. Why? As interest rates fell, the prices of TIPS skyrocketed. Yields on TIPS became negative; investors were willing to pay so much for these bonds that they were guaranteed to not keep up with inflation. Our clients had made a handsome profit in TIPS, but would have made less than inflation if we continued to hold. So we sold the TIPS and moved into other types of bonds.

The yield on TIPS are determined by auction, and the Treasury presently issues 5-year, 10-year, and 30-year TIPS. Institutional investors compare TIPS yield to fixed rate Treasury Bonds. For example, the most recent 10-Year TIPS auction on March 31, 2017 produced a yield of 0.466% (plus inflation). Compared this to the current yield on a fixed 10-Year note of about 2.3% and you get an inflation expectation of 1.8% over the next 10 years.

For big banks, this creates arbitrage opportunities if they think that the market inflation expectations are wrong. This arbitrage mechanism means that the rate on TIPS will likely be tied closely to regular Treasury Interest Rates.

For investors, if you think that we were going to have extreme inflation over the next 10 years, you would prefer to invest in the TIPS rather than the 2.3% fixed rate 10-Year note. But that is speculation, and I am not interested in speculating on inflation rates, thinking that we know more than all of Wall Street.

However, the forces which drove down interest rates and gave us a reason to sell our TIPS at high prices appear to be reversing. The Federal Reserve has started to raise interest rates, which may mean that last summer’s 1.6% 10-Year yield was the top of a 30-year bond Bull Market. As interest rates rise, the price of existing bonds will drop. And that will be painful for holders of 10 year and especially 30 year bonds, including TIPS.

Back when you could buy TIPS and earn 2%, 3% or more above inflation, that was a compelling return for a very low risk bond. Today, the yields on TIPS are less than 0.5% on the 5 and 10 year TIPS and below 1% on the 30 year TIPS. In 2 of the 3 auctions in 2016, the yields on the 5-year TIPS were negative. These rates are simply too low to include in our portfolios. Add in the risk of rising interest rates (= falling bond prices), and the appeal of 10 and 30 year TIPS are gone for me.

There is an alternative to TIPS which do not carry the risk of rising rates: I-Series Savings Bonds. Like TIPS, I-Bonds are linked to CPI-U and also carry a fixed rate of return. You purchase and redeem I-Bonds through TreasuryDirect.gov. They are issued as 30-year bonds, but you can redeem them anytime after 1 year (3 months interest penalty if redeemed in the first 5 years). Since you can redeem them directly with the government, you don’t have to worry about market losses caused by rising interest rates. If there are better alternatives in 5 years, you could simply cash out your I-Bonds and take your money elsewhere.

I-Bonds would be a logical alternative to TIPS, except for two big problems: 1) The current fixed rate is zero. Since 2010, it has been zero for most of the time, briefly reaching only 0.10% or 0.20%. 2) Each taxpayer is limited to buying $10,000 of I-Bonds a year and you cannot own them in an IRA or brokerage account. Still, if the fixed rate on I-Bonds were the same as TIPS, I would buy those first, before buying any TIPS.

There may come a time when it will be attractive to buy I-Bonds or TIPS. For now, interest rates are too low and inflation is not an immediate risk. Still, there are many appealing benefits to these bonds. While preserving purchasing power is the primary difference to other bonds, from a portfolio construction standpoint, there are other benefits, including extremely low default risk, relatively low volatility, and much lower correlation to equities than corporate bonds.

Today, I think we can get a higher return by taking on some credit risk versus government bonds, whose interest rates have been held down by central banks. It has been nearly 10 years now since the peak of the mortgage/financial crisis, but we are just now starting to emerge from a global Zero Interest Rate Policy. That unwinding will take many years and will have a big impact on fixed income for years to come.

Robots and The Future of Work

Posted On April 3, 2017 By Scott Stratton, CFP(R), CFA In Financial Planning /

Technology will change work in ways we can only begin to imagine. Self-driving cars and trucks, for example, could eliminate 4 million transportation jobs in the next 10 or 20 years in the US alone. But it’s not just blue collar jobs which will be replaced. In medicine, we will increasingly see hospitals turning to artificial intelligence for diagnoses and incredibly precise robots for surgical procedures. It’s not that we won’t have human doctors, just that many of the tasks that they currently spend hours on every week could be done by computers with better accuracy, more consistency, and lower cost.

In finance, Blackrock, one of the world’s largest asset managers, announced last week they would be reducing the number of actively managed funds they offer, to focus more on quantitative investing using computer models. Rather than using human research and analysis, they are finding that computers may be better stock pickers, especially after costs are considered.

Jobs in manufacturing today are more likely lost to automation than to outsourcing to another country with a lower cost of labor. In almost every industry, fewer workers will be needed, and eventually we will even have robots designing, building, and repairing other robots.

With human workers being replaced by robots, Bill Gates has proposed taxing robots for the economic value of their productivity, rather than taxing humans based on their income. (Gates’ comments appeared in the Wall Street Journal, Forbes, and elsewhere this month.) This would help address the loss of tax revenue as companies employ fewer humans to create the same or higher economic output.

A frequently discussed use of a “robot tax” would be to create a universal living wage for all people, to help offset the loss of income from automation. It’s a novel idea.

It will be interesting to see what jobs will look like 25 and 50 years from now. Change is inevitable. Just as Henry Ford made horse drawn buggies obsolete, today’s technologies will inevitably cause some industries to go away. Instead of trying to save jobs in manufacturing, trucking, or coal mining, we might be smarter to not stand in the path of progress, and focus on being a leader in technology, automation, and clean energy.

Those are challenges for countries. I see two distinct challenges for individuals:

1) Are you in a profession which could be replaced by automation or new technology? If so, can you adapt while maintaining or improving your current income? Can you keep from becoming obsolete in a rapidly changing economy? Smart workers will manage their careers and proactively change jobs before it is forced upon them.

2) Your financial security will depend on your savings. Social Security is projected to be bankrupt by 2034 (when I turn 62, just my luck…), and many municipal and corporate pensions are significantly underfunded. It’s easy to bemoan that we deserve what was promised to us, but that doesn’t change the math: people are living longer, the ratio of workers to retirees has fallen dramatically, and the money simply isn’t there. What seemed feasible in 1950 or 1980 we know doesn’t work with 2017’s demographics.

There is no easy fix to just keep these programs as they are today without enormous tax increases. There will be cuts to retirement programs, whether that occurs through increasing the retirement age, reducing benefits, etc. I believe they will continue to exist, just perhaps not in their current form. People who will derive the bulk of their retirement income from Social Security are at the greatest risk of poverty.

It may seem depressing to think about how the future may displace workers, but technological progress is going to be net positive for society. We will reduce mundane and dangerous jobs, lower costs of goods and services, and increase our total wealth and consumption. And people who say that we don’t make anything anymore aren’t considering the impact and future benefits that are going to come from US leaders like Apple, Tesla, Google, and hundreds of other medical, software, and energy innovations. Work will change – for the better.

How to Help Your Millennial Children With Money

Posted On March 27, 2017 By Scott Stratton, CFP(R), CFA In Financial Planning /

Your kids are recently out of college and starting to make their way in the world. They have a mountain of student loans, an underpaying job, and are just making ends meet. How can you help them become prosperous? Should you help them financially?

Today’s recent grads face a tougher job market and a longer career path than previous generations. The cost of a college education has become staggering. Long gone are the times when you could put yourself through college by working a summer job or waiting tables on the weekends. Those jobs aren’t going to cover the $50,000 tuition bills at a private university today. Even students who work through college can finish with $40,000, $60,000, $80,000 or more in debt.

I’ve also seen parents go too far and give their children million dollar homes, creating unreasonable expectations and a total lack of drive and ambition. Why work if you’re just going to be given whatever you need? Parents risk having adult children who don’t value money and have no interest in developing their own financial success.

There are, I think, a number of creative ways to help your children financially without simply writing them a blank check. Parents want to prevent their children from falling on their faces, but we have to remember that challenges often teach us the most important lessons. Children often copy their parents’ money habits, and not talking about money isn’t going to help your kids become responsible adults. Here are ways to help.

1) Rent to Roth. If your kids are going to move back home after college, consider charging a nominal amount for rent, based on what they can afford. If that’s only $200 or $300 a month, fine. Then, take that money and put it into a Roth IRA in their name. Give them the account after they move out.

There is an enormous benefit to starting early for retirement saving. If they save $3,600 at age 23 and 24 ($300 a month), and earn 8%, they’d have over $175,000 at age 65 just from those two years! But they have to not touch this money – to leave it invested and not spend it on student loans, or a car, or a house, or a wedding. It’s got to be off limits!

2) Give them this book. It is a gem. It’s short and they could read it in one afternoon. If they read it, they will know more about money than 99% of their peers. (And if they don’t read it, you’re only out $12.)

3) Mom and Dad’s Matching Program. Rather than making an outright gift of cash and hoping they use those funds wisely, offer to match their funds for goals like student loans, buying a used car, or funding an investment account like a 401(k) or IRA. This at least requires that they also contribute towards their financial goals rather than making everything a free-bee. Support financial needs which will make them more self-sufficient, rather than inadvertently making them more dependent on their parents for living expenses. Ask if this support is empowering or enabling?

4) Sign them up for my Wealth Builder Program, which is specifically designed for their needs. I will work one on one with them on their financial goals, including loan repayment, risk management, savings strategies, and investing. They get advice from their own fiduciary, which they may accept more readily than advice from a parent! Your cost is $200 a month. Alternatively, if you’re working with another financial advisor, ask if they will include your adult children as part of your household, but meet with them separately.

5) Encourage Entrepreneurship. Working families think that an education is the key to financial success. And to some extent, it is. But wealthy families know that owning a business is the real path to financial independence. Consider how you can encourage, support, and invest in your children starting a business.

Just remember before sinking your whole nest egg into their yoga studio (or whatever) that 80% of new businesses disappear in less than 5 years. If you are going to commit money to an idea, then it should be a sensible investment – either equity in the business or a loan with specific terms – and not a gift. It must be in line with your own investment strategies and not represent a substantial change to your risk profile.

An estimated two-thirds of parents are financially supporting their children over the age of 21. While this may be a new reality, it is also wreaking havoc with many parents’ finances and their ability to save for retirement. In some cases, we also need to be candid about what the parents can or cannot afford and what these sacrifices may mean for the parents’ finances. This is where a financial planner can provide an independent, objective point of view to make sure that your generosity is not going to jeopardize your own goals or become a permanent need for support.

10 Ways to Wreck Your Portfolio

Posted On March 19, 2017 By Scott Stratton, CFP(R), CFA In Behavioral Finance, Portfolio Management /

Over the years, I’ve seen hundreds of portfolios and 401(k) accounts, and observed investors make tons of mistakes. Admittedly, I have made many of these errors on my own as well, just to double check! Here’s your chance to learn from others’ losses. But, if you still insist that you want to ruin your rate of return, go ahead and make these 10 mistakes…

1) Rely on Past Performance. You invest with winners, not losers! Just find the top performing fund offered by your 401(k) and put all your money in there. That’s why they say past performance is a guarantee of future returns, or something like that.

2) Don’t diversify. Have you seen that Chinese Small-Cap BioTech fund? Why invest in the whole market when you can bet on one tiny, minuscule sliver?

3) Ignore the fact that 80% of actively managed funds under perform their benchmark over five years. You’re going to pick funds from the other 20%. Indexing is for people who are willing to settle for average.

4) Put as much money as possible into your company stock. It’s beat the S&P 500 for X number of years, therefore you’d be stupid to ever take your money out of company stock or to cash in your options. And since you work there, you know more about this investment than anyone. Just like the employees at Nortel, Worldcom, and Enron.

5) To avoid paying taxes, don’t sell your winners. Don’t rebalance or sell overvalued shares. Later, if the stock is down 40% you can pat yourself on the back: “Thank God I didn’t sell when it was up and have to pay 15% tax on my gains. I dodged that bullet!”

6) Never sell your losers either. The loss isn’t real until you sell, and the most important thing is to protect your ego. If you hold on, eventually, you should get your money back. So what if another fund returns 60% while you are waiting for yours to rebound 30%? (Says the guy who has old General Motors shares that are worthless from when the company filed for bankruptcy and wiped out their stockholders.)

7) Do it yourself. Don’t use funds or ETFs, pick individual stocks yourself! It will be fun and easy. Just look at all those smiling people on the commercials for online brokers, they’re getting rich from their kitchen tables! Anyone can beat those fancy investment managers with their extensive training, huge research departments, and decades of experience. And if you spend all day watching your portfolio, it magically grows faster!

8) You know when to get in and out of the market. It’s not market timing if you know what you’re doing. When the market is down, it’s a bad market, so don’t buy then. Wait until the market goes back up before you make your purchases. You should toss out a detailed 20-year financial plan if your gut tells you. And by gut, of course, we mean CNBC, Fox News, or whatever you watched in the preceding 48 hours.

9) When the market is down, your funds are horrible, the managers incompetent, and the market is rigged. When your portfolio is up, it’s because of your brilliant mind for finance. You are investing for decades, but if your portfolio doesn’t go up every single quarter something is horribly wrong with your approach. Change everything you own when this happens.

10) All the good investments are reserved for the wealthy. You can only become rich by investing in complicated, non-transparent private placements or limited partnerships in oil, real estate, leasing, or something you cannot explain in less than three minutes. And it’s rude to ask how much these programs charge, that’s so gauche. On a related note, you should always buy penny stocks that you hear about through an email.

I know no one really wants to wreck their portfolio, but from my vantage point, a lot of our investment pains appear self-inflicted. I can help you avoid these ten mistakes and many, many others. Even more important than avoiding errors, together we can create a financial plan and investment program that will be tailored to your goals, rather than focusing on what the market might do this month or this year.

Professional advice. Comprehensive financial planning. Evidence-based investment management. Ongoing evaluation, monitoring, and adjustment. Those are our tools to help investors succeed. That doesn’t mean that there won’t be years when the market is down, but it does mean we will be better prepared and much less likely to make the mistakes which can make things worse.

The Rate of Return of Life Insurance

Posted On March 19, 2017 By Scott Stratton, CFP(R), CFA In Financial Planning /

Life insurance is a necessity for many families to protect them from the unexpected potential loss of income that could occur with a loss of life. For young families, term insurance is an excellent vehicle to address this risk.

As we get older, we hopefully have generated some wealth and we will have fewer future expenses. At some point, your kids will be out of college, you may have paid off your house, and accumulated a nice size retirement account. Each year, your need for life insurance is reduced, and eventually, you may be able to self-insure the risk of an unexpected death.

Still, I know that many pre-retirees like the idea of having a permanent life insurance policy to leave money for their spouse, heirs, or charity. Unlike a Term policy, “permanent” life insurance may provide a specified death benefit for as long as you keep the policy in force. Obviously, a permanent policy is much more expensive than term insurance. But is it a good rate of return?

It depends on how long you live! The longer you live, the more premiums you pay, and the longer your heirs have to wait to receive a fixed payout. Therefore the return is lower. Here’s an example.

For a 60 year old male in good health, you might pay $8,000 a year for a $500,000 policy. Even if you live for another 25 years, that means your heirs would receive $500,000 and you only paid $200,000 in premiums. That must be a good return, right? Let’s take a look:

$500,000 future payout, cost is $8,000 a year.
Rate of Return

10 Years	32.1%
15 Years	16.5%
20 Years	9.9%
25 Years	6.5%
30 Years	4.4%

I would say the return is excellent if you live for 20 years or less. If you live for 30 years or more, you may have more total wealth if instead of purchasing insurance, you had simply kept your $8,000 a year invested. Historically, it has not been very difficult to beat 4.4% over 30 years. So as a long-term investment, I don’t like life insurance. Which brings us back to the primary purpose of life insurance in my mind: to protect against the danger of pre-mature death.

To be fair, the rate of return on insurance is generous because so many policies lapse. When that happens, insurers will have received years of premiums and never have to pay out a death benefit. Other policy holders will borrow from their policies, causing them to deplete and never payout. I believe the majority of people who start a permanent policy will never receive a death benefit because of their own choices.

I should add that getting the best price on a life insurance policy is no easy task. Underwriting for a permanent policy will be rigorous, looking at your health, weight, blood tests, family and occupational history and more. Now, if your premium was higher than $8,000 a year for this hypothetical policy, the rates of return above would obviously be much lower.

My recommendation for most people: get term to cover you until your kids are out of college. For many people, that will be the only life insurance policy they will ever need. There are some good uses for permanent insurance, such as for business succession or estate planning. But it’s not the vehicle financial planners prefer for long-term wealth accumulation.

How to Give Away Money

Posted On March 5, 2017 By Scott Stratton, CFP(R), CFA In Financial Planning /

It shouldn’t be difficult to give money away, but there are many ways we can help improve outcomes for families who have more than enough assets to last a lifetime. While estate planning is important, let’s make your money go further and have a greater impact by creating a giving plan for while you are alive.

If you are philanthropically inclined, have a favorite charity, or just want your children or grandchildren to benefit from your blessings, we can help you plan how to best distribute your money, minimize taxes, and safeguard your future. Here are seven tips to get started.

1) Put yourself first. It should go without saying that you should not give away a significant amount of your wealth if there is any question as to whether you have sufficient funds to last a lifetime. With increasing longevity and rising costs of healthcare, it is not difficult to burn through a million or two over a 25-year retirement.

We begin with a retirement analysis that includes your philanthropic goals, and evaluates the likelihood your funds will cover your lifetime. The more guaranteed sources of income you have – Social Security, Pensions, Annuities, etc. – the more we can distribute other capital without worries of loss of income. The purchase of an Annuity can give you the confidence to disburse cash during your lifetime without fear of market risk, sequence of returns, or longevity.

We generally do not recommend that retirees aim to impoverish themselves to qualify for Medicaid. States have a 60-month look-back period that determines if you have given away money. In some cases, Medicaid planning may make sense, but we prefer to plan for abundance.

2) Understand the Gift Tax Annual Exclusion. Each year, you can give $14,000 (2017) to any person under the gift tax exclusion. This is well known, but most people don’t understand that you do not necessarily have to pay a tax if you exceed this amount; rather you are required to file a gift tax return, and your gift (over $14,000) reduces your lifetime gift and estate tax exemption, currently $5.49 million per individual.

Although most estates will not exceed these levels, we do know that there are many politicians in Washington who want to lower the estate exemption. So it’s difficult to predict what the exemption will be in 10 or 20 years. The easiest approach is to stay under the $14,000 annual exclusion. Remember that a couple may, combined, give $28,000 to an individual or $56,000 to another couple, such as a daughter and son-in-law.

Additionally, there are medical and educational exceptions to the gift tax. You can pay college tuition or medical bills for anyone, and those amounts are not subject to a gift tax. The best approach is to pay those bills directly to the providers, and not write a check to the recipient, to avoid any implication of a gift.

3) Give now, rather than leave everything in your will. By making donations and gifts today, you can:

receive a tax deduction for charitable giving. If you’re in the 28% tax bracket, giving $10,000 a year now could save you $2,800 on your taxes.
see your gifts make a difference for your family, causes, and institutions immediately. Your gifts may be more helpful to your children today rather than when they are 55 or 65.
discover how those monies will be spent, and learn who will be responsible with a large sum of money. Leaving a large inheritance through a will sometimes backfires, causing reckless spending. Starting a gifting program early may identify these issues and provide planning and education, or identify the need for trustees who can help ensure money is used prudently.
avoid the fights, misunderstandings, and vastly expensive lawsuits that so frequently occur with large estates. Don’t cause future problems for your spouse or children by leaving them a mess or a distribution that creates anger and divisions. This is so common and yet most parents think it will never happen to their family.

4) Give appreciated securities to charity rather than cash. You can donate shares of stock, mutual funds, or other assets to charity and avoid paying capital gains tax on the gains on those investments. Besides avoiding capital gains, you also get to deduct the full value as a charitable donation, as eligible. The charity will sell the donated securities immediately, but not owe any taxes to Uncle Sam. It’s a great way to be more efficient in your charitable giving. It saves you taxes, which ultimately means you will have more money to donate and do good.

5) Leave money to charity through your IRA rather than through your will. If you leave a $500,000 IRA to an individual, they will owe income taxes on any distribution, which could eat up $200,000 of the account, or more, if you have state income taxes. If you leave the same IRA to a charity, they will pay no taxes on the account, and would receive the full $500,000 immediately.

Instead, leave a taxable brokerage account to your children; they will receive a step-up in cost basis on those investments and therefore will likely have little or no capital gains on the sale of those assets. Your kids will be so much better off receiving taxable assets rather than the same number of dollars from your IRA.

Change your mind? If you write a charity into your will, and later want to change the amount or name a different charity, you will have to get a whole new will. But if you use your IRA for your charitable bequests, all you have to do is update the IRA beneficiary form, which is quick and free.

6) 529 plan for Grandchildren. Want to help your grandchildren be successful in life, pursue their career goals, and not be saddled with crippling student loans? Consider 529 college savings plans, which will get assets out of your taxable estate and enable tax-free withdrawals for qualified higher educational expenses.

If one beneficiary does not need the account, you can change the beneficiary to another person. You can retain control of this money, while creating a legacy for the future success of your grandchildren, great-grandchildren, or beyond.

Given a choice of having money in a taxable account or a tax-free account, you’d probably prefer the tax-free option, so I am baffled why more wealthy grandparents are not using 529 plans. The younger your grandchildren are, the longer time you will receive tax-free growth. Start early.

7) Insurance. Retirees can protect their ability to fund their giving goals by purchasing long-term care insurance. This can help ensure they do not deplete their assets or have to choose between adequate care and fulfilling their other financial goals.

If you intend to leave $1 million to your alma mater, church, or other organization, it may make sense to purchase a permanent life insurance policy specifically for that goal. Then you can preserve your other assets for your spouse or children while guaranteeing your gift to that institution. Or you could do the reverse – give money annually to charity and leave life insurance to your children or a trust. Individuals receive life insurance proceeds tax-free.

We’ve only just scratched the surface of what is possible to enable you to most efficiently disburse your money and assets. There are a lot of pitfalls that could be avoided with rigorous planning. Many of these strategies will benefit you over a long period of time, which means you’d be smarter to start these at age 58 rather than 78. Don’t procrastinate! Living the Good Life means that abundance finds joy in seeing the benefits our giving can have on the world.

Do Top Performing Funds Persist?

Posted On February 27, 2017 By Scott Stratton, CFP(R), CFA In Portfolio Management /

How do you pick the funds for your 401(k)? I know a lot of people will look at the most recent performance chart and put their money into the funds with the best recent returns. After all, you’d want to be in the top funds, not the worst funds, right? You’d want to invest with the managers who have the most skill, based on their results.

We’ve all heard that “past performance is no guarantee of future results”, and yet our behavior often suggests that we actually believe the opposite: if a fund has out-performed for 1, 3, or 5 years, we believe it is due to manager skill and the fund is indeed more likely to continue to out-perform than other funds.

But is that true? Do better performing funds continue to stay at the top? We know the answer to this question, thanks to the people at S&P Dow Jones Indices, who twice a year publish their Persistence Scorecard (link).

Looking at the entire universe of actively managed mutual funds, they rank fund performance by quartiles, with the 1st quartile being the top performing 25% of funds, and the 4th quartile being the bottom 25% of funds.

Let’s consider the “Five Year Transition Matrix”, which ranks funds over five years and then follows how they perform in the subsequent five year period. For the most recent Persistence Scorecard, published in December 2016, this looks at funds’ five-year performance in September 2011, and then how they ranked five years later in September 2016.

Here’s how the top quartile of all domestic funds fared in the subsequent 5-year period:
20.09% remained in the top quartile
18.93% fell to the second quartile
20.56% fell to the third quartile
27.80% fell to the bottom quartile
10.75% were merged or liquidated, and did not exist five years later

The sad thing is that if you picked a fund in the top quartile, there was only a 20% chance that your fund remained in the top quartile for the next five years. But there was a more than 38% chance that your top performing fund became a worst performing fund or was shut down completely in the next five years.

Another interesting statistic: the percentage of large cap funds that stayed in the top half for five years in a row was 4.47%. If you simply did a coin flip, you’d expect this number to be 6.25%. The number of funds that stayed in the top half is slightly worse than random.

The Persistence Scorecard is a pretty big blow to the notion of picking a fund based on its past performance. And it’s significant evidence that we should not be making investment choices based on Morningstar ratings or advertisements touting funds which were top performers.

Should you do the opposite? I wish it was as simple as buying the bottom-performing funds, but they don’t fare any better. Funds in the bottom quartile had a similarly random distribution into the other three quartiles, but had a much higher chance of being merged or liquidated.

There are a couple of possible explanations for funds’ lack of persistence:

Styles can go out of favor; a “value” manager may out-perform in one period and not the following period. Hence a seemingly perpetual rotation of leaders.
Successful managers may attract large amounts of capital, making them less agile and less likely to out-perform.
There may be more randomness and luck to managers’ returns, rather than skill, than they would like to have us believe.

Unfortunately, the S&P data shows that for whatever reason, there is little evidence for persistence. Investors need a more sophisticated investment approach than picking the funds which had the best performance. The Persistence Scorecard highlights why performance chasing doesn’t work for investors: yesterday’s winners are often tomorrow’s losers.

What to do then? We focus on creating a target asset allocation, using a core of low-cost, tax efficient index ETFs and a satellite component of assets with attractive fundamentals. What we don’t do is change funds every year because another fund performed better than ours. That kind of activity has the potential for being highly damaging to your long-term returns.

I hope you will take the time to read the Persistence Scorecard. It will give you actual data to understand better why we say past performance is no guarantee of future results.

Is Your Pension Insured?

Posted On February 19, 2017 By Scott Stratton, CFP(R), CFA In Financial Planning /

Pensions offer what may be the ideal source of retirement income. If you are fortunate enough to be vested into a Pension Plan, consider yourself lucky. You should ask, though, What would happen to your pension if the plan were to terminate or fail?

If you are a participant in a private sector pension, check if your plan is covered by the Pension Benefit Guaranty Corporation here. The PBGC is a federal agency that was chartered to protect pension plan participants; it’s funded through required employer contributions and receives no tax dollars.

Even if your pension is insured, there are limits on the amount of coverage available through the PBGC. If a plan terminates and you are vested, but not yet retired and receiving benefits, you would be covered only for your currently vested benefits and would not receive any further credit for future work.

This is important: you need to understand whether your Pension Estimate is based on past contributions, or an estimate based on the assumption you are going to work to age 65 or other future date. The PBGC will only cover vested benefits and a plan termination will halt the accrual of future benefits.

If you are retired and already receiving benefits, the PBGC has limits on the monthly benefit they cover. If a plan terminates and is taken over by the PBGC, you could see your monthly benefit drop by a significant amount.

The limit of benefits available through the PBGC depends on four things:

Whether your plan was a single-employer plan or a mutliemployer plan.
Your age at retirement.
The number of years you were a participant in the plan.
Whether your benefit is a single-life annuity or a joint and survivor benefit.

For single-employer plans, the limit of the PBGC coverage is capped based on your age and the year the plan was terminated. For example, if you are 65 years old and your plan were to terminate in 2017, your PBGC benefit would be capped to $5,369.32 a month for a single-life benefit or $4,832.39 for a Joint and 50% Survivor Annuity. Link: PBGC Monthly Maximum Tables.

The PBGC benefits for single-employer plans are generally quite strong. However, if your pension benefit is above the monthly guaranty amount, and the plan were to fail, your benefit would be reduced to the PBGC maximum.

This can happen! Years ago, I met an airline pilot who retired at the mandatory age of 60 and started his six-figure pension thinking he was set for life. After 9/11, his former employer went bankrupt and his pension was slashed to around $3,000 a month. They hadn’t saved very well because they were planning on the generous pension. The reduction to his monthly pension check was devastating.

If your pension offers a lump-sum payout upon retirement, we can determine the limit of your PBGC coverage and investigate the funded status of your pension plan. If your plan is in critical status, or your company has a credit rating below investment grade, you will seriously want to consider the lump sum, if your payment exceeds the limits of PBGC coverage.

The PBGC coverage for multiemployer pension plans is unfortunately much, much lower than for single-employer plans. If you are a participant in a multiemployer plan, your maximum coverage under the PBGC is based on the number of years of service. This is regardless of how your plan may calculate benefits.

PBGC formula for multiemployer plans:
100% of the first $11 of monthly benefits,
Plus 75% of the next $33 of monthly benefits,
Times the number of years of service.

The maximum monthly benefit under the PBGC then is $35.75 times the number of credited years of service. For example, if you were a participant for 30 years, your maximum benefit would be $1072.50 a month, or $12,870 a year. And in order to get $35.75 from the PBGC, you’d have to be receiving at least $44 from the pension. In other words, to get the PBGC benefit of $12,870 a year, your pension benefit amount would need to be at least $15,840.

The amounts for Multiemployer plans are not indexed for inflation and do not receive Cost of Living Adjustments. Link: Multiemployer Benefit Guarantees.

The PBGC only covers private sector pension plans. Participants in a federal, state, or municipal government plan do not have any separate insurance or guaranty. And there are significant problems with funding in municipal pension plans. Here in Dallas, there is a billion dollar short-fall in the Police and Fire pension plan. Recent problems have prompted a stampede for the exits, as members retire early so they can take a lump sum payment. All of which is further driving the plan over the edge.

There are lots of municipal pension plans that are ticking time-bombs. It’s not clear to me that the public has the willingness to accept increased taxes so we can cover generous employee retirement plans. It seems inevitable that there will be some plans which will be forced to reduce the benefits they have promised.

All of which means that investors need to have multiple legs on their retirement plan: pension, Social Security, investment accounts including IRAs, and other sources of income. If you try to have a plan that rests entirely on one leg, you are potentially asking for trouble.

Can You Be Too Conservative?

Posted On February 13, 2017 By Scott Stratton, CFP(R), CFA In Retirement Planning /

As you approach retirement, you are probably thinking quite a bit about making your investment portfolio more conservative. We generally recommend that investors start dialing back their risk five years before retirement.

However, it is possible to be too conservative. Retirement is not an single date, but a long period of sustained withdrawals. We typically think in terms of a 30-year time horizon, which is not unrealistic for a 60 to 65-year old couple, given increasing longevity today.

The old rule of thumb was to subtract your age from 100 to determine your allocation to stocks. For example, a 65-year old would have 35% in stocks and 65% in bonds. Unfortunately, this old rule of thumb doesn’t work for today’s longer life expectancies.

Researchers analyzing the “4% rule” used for retirement income planning, typically find that optimal allocation for surviving a 30-year distribution period has been roughly 50 to 60 percent stocks. For most new retirees, we generally suggest dialing back only to 50/50 or 60/40 in recognition that the portfolio still needs to grow.

We still need growth in a retirement portfolio to help you preserve purchasing power as inflation erodes the value of your money. At 3% inflation, your cost of living will double every 24 years. So if you are retiring today and thinking that you just need $40,000 a year, you should be expecting that need to increase to $80,000 or more, to maintain your standard of living.

Another reason retirees should not be overly conservative: interest rates are very low today. Bonds had a much better return over the past 30 years than they will over the next 30 years. That’s not even a prediction, it’s just a fact. When we use projected returns rather than historical returns in our Monte Carlo simulations, it suggests that bond-heavy allocations are not as likely to succeed as they were for previous retirees. See: What Do Low Interest Rates Mean For Your Retirement?

The other side of today’s low interest rates is that some investors are reaching for yield and investing in much lower-quality junk bonds. While retirees often focus heavily on income producing investments, financial planners and academic researchers prefer a “total return” approach, looking at both income and capital gains.

We don’t want to take high risks with the bond portion of our portfolios, because we want bonds to provide stability in the years when the stock market is down. High Yield bonds have a high correlation to equities and can have significant drops at exactly the same time as equities.

We manage to a specific, target asset allocation and rebalance annually to stay at that level of risk. That gets our focus away from stock picking and looking at the primary source of risk: your overall asset allocation of stocks, bonds, and other investments. While no one can predict the future, a disciplined approach can help avoid mistakes that will compound your losses when market volatility does occur.

Diversification and Regret

Posted On February 6, 2017 By Scott Stratton, CFP(R), CFA In Behavioral Finance, Portfolio Management / 1 Comment

Diversification is one of the key principles of portfolio management. It can reduce idiosyncratic risks of individual stocks or sectors and can give a smoother performance trajectory, or as financial analysts prefer to say, a “superior risk-adjusted return” over time. Everyone sees the wisdom of not putting all your eggs in one basket, but the reality is that diversification can sometimes be frustrating, too.

Being diversified means holding many different types of investments: stocks and bonds, domestic and international stocks, large cap and small cap, traditional and alternative assets. Not all of those assets are going to perform well at the same time. This leads to a behavioral phenomenon called Tracking Error Regret, which some investors may be feeling today.

When their portfolio lags a popular benchmark, such as the Dow Jones Industrials or the S&P 500, Investors often regret being diversified and think that they should get out of their poorly performing funds and concentrate in those funds which have done better. (Learn about the benchmarks we use here.)

It’s understandable to want to boost performance, but we have to remember that past performance is no guarantee of future results. Many people receive a snapshot from their 401(k) listing their available funds with columns showing annualized performance. Consider these two funds:

	3-year	5-year	10-year	Expense Ratio
S&P 500 ETF (SPY)	11.10%	13.55%	6.88%	0.10%
Emerging Markets ETF (VWO)	2.83%	-0.07%	2.24%	0.15%

Source: Morningstar, as of 2/06/2017

Looking at the performance, there is a clear hands-down winner, right? And if you have owned the Emerging Markets fund, wouldn’t you want to switch to the “better” fund?

These types of charts are so dangerous to investors because they reinforce Performance Chasing and for diversified investors, cause Tracking Error Regret. Instead of looking backwards at what worked over the past 10 years, let’s look at the Fundamentals, at how much these stocks cost today. The same two funds:

	Price/Earnings	Price/Book	Dividend Yield	Cash Flow Growth
S&P 500 ETF (SPY)	18.66	2.65	2.21%	0.33%
Emerging Markets ETF (VWO)	12.34	1.51	3.37%	5.09%

Source: Morningstar, as of 2/06/2017

Now this chart tells a very different story. Emerging Market Stocks (EM) cost about one-third less than US stocks, based on earnings or book value. EM has a 50% higher dividend yield and these companies are growing their cash flow by 5% a year, versus only 0.33% a year for US companies.

I look at the fundamentals when determining portfolio weightings, not past performance. If you only looked at the performance chart, you’d miss seeing that EM stocks are cheap today and US stocks are more expensive. That is no guarantee that EM will beat the S&P 500 over the next 12 months, but it is a pretty good reason to stay diversified and not think that today’s winners are bound to continue their streak forever.

Performance chasing often means buying something which has become expensive, frequently near the top. That’s why I almost never recommend sector funds or single country funds (think Biotech or Korea); the investment decision is too often based on recent performance and those types of funds tend to make us less diversified rather than more diversified.

Staying diversified means that you will own some positions which are not performing as well as others in your portfolio. When the S&P 500 is having a great year, a diversified portfolio often lags that benchmark. But, when the S&P 500 is down 37% like it was in 2008, you may be glad that you own some bonds and other assets.

We use broadly diversified ETFs and mutual funds, with a willingness to rebalance and buy those positions when they are down. We have a value bent to our weightings and are willing to own assets like Emerging Markets, even if they haven’t been among the top performers in recent years. Staying diversified and focusing on the long-term plan means that you have to ignore Tracking Error Regret and Performance Chasing. Just remember that you can’t drive a car forward by looking in the rear-view mirror.