Portfolio Endurance

The need for retirement planning doesn’t end with the onset of retirement. A new retiree’s focus shifts from building wealth to managing and preserving it. One major challenge is to make the investment portfolio supply cash flow for the duration of life — and through different economic and market conditions.

Experts have studied portfolio longevity or endurance to help retired investors reduce the odds of depleting their wealth too soon. The studies evaluate how a portfolio might endure under the stress of changing markets and spending levels. The resulting models estimate portfolio survival in terms of statistical probabilities.1 While the technical details are beyond the scope of this article, the general conclusions are more intuitive.

Three main factors drive portfolio endurance: asset mix, spending level, and investment time frame. Certain aspects of these factors are within an investor’s control while others are not. Let’s briefly consider them.

Asset Mix
Asset mix describes the ratio of stocks to bonds in a portfolio. This determines risk exposure and expected performance, and is one of the most important decisions investors of all ages can make. Historically, stocks have outperformed bonds and outpaced inflation over time. This return premium reflects the higher risk of owning stocks. Consequently, the larger the equity allocation, the greater a portfolio’s expected return—and risk.

Keep in mind that risk and return go together. A higher allocation to equities increases the risk of experiencing periods of poor returns during retirement. But if you can handle the risk, having more equity exposure in a portfolio enhances its return potential. Growth can bring higher cash flow, inflation protection, and portfolio endurance over time. This is why most advisors believe that most investors should have an equity component in their portfolios, with actual weighting depending on one’s time frame, risk tolerance, and spending flexibility.

Spending Level
Portfolio withdrawal is typically described in terms of a specified dollar amount (e.g., $50,000 per year) or a percent of annual portfolio value (e.g., 5% of assets each year). Neither method is ideal, however—and for different reasons. Briefly consider each one:

· Specified dollar amount: withdrawing a fixed amount each year and adjusting it for inflation can provide a stable income stream and preserve your living standard over time. But the portfolio may survive only if future withdrawals represent a small proportion of the portfolio’s value. One academic study quantified this amount. It found that a retiree with at least a 60% stock allocation can withdraw up to 4% of initial portfolio value (adjusted for inflation each year), and enjoy a high probability of never running out of wealth. Choosing a higher withdrawal amount is not likely to be sustainable, especially if the portfolio faces an extended period of negative returns.

· Percent of annual portfolio value: withdrawing a fixed percentage of assets based on annual asset value makes it unlikely that you will deplete retirement assets because a sudden drop in market value would be accompanied by a proportional decline in spending. But this method can produce wide swings in your living standard when investment returns are volatile.

Retirees who need relatively consistent cash flow may want to combine these two methods. One way is to withdraw cash flow according to a rule that combines past spending (e.g., an average of the past thirty-six months of cash flow) with a payout rate applied to current portfolio value. You can weight these factors to favor your preference for either more stable cash flow or a greater chance of portfolio survival. In effect, you are customizing your withdrawals to smooth out consumption while responding to actual investment performance.

Investment Time Frame
Investment time horizon may be the hardest to estimate, especially if it is the same as your lifespan. In this case, you can only guess how long your portfolio must support spending. If you plan to bequeath assets, your investment time frame may extend beyond your lifetime. This may influence your risk and spending decisions as well.

Time frame forces a tradeoff between the short and long term. Retirees with a longer investment time horizon might choose a higher exposure to equities. But they may have to offset this risk by being more flexible about spending over time. Elderly retirees and others with a short time horizon may choose a less risky allocation or a higher payout rate, although they can experience rising spending levels, too. In any case, retirees should think carefully about equity exposure and avoid taking more risk than they can afford.

Considerations
Planning involves assumptions about the future—assumptions that may not pan out. Although you cannot avoid making assumptions, you can ask whether they are realistic and consider how your lifestyle might change if future economic and financial conditions are much different than projected. For instance, you may assume an average return based on historical performance. But there is no certainty that future portfolio returns will resemble the past, regardless of time frame. Moreover, short-term results may vary drastically, which could force hard financial choices. Investors should think in terms of probability, not history.

Managing asset mix, payout, and time horizon inevitably involves tradeoffs. Exhibit 1 below illustrates the dynamics. For example, a bond-dominated portfolio with a lower expected return may suit investors with a shorter time horizon, or require them to accept a lower payout rate to increase the odds of portfolio survival. A portfolio with a higher allocation to equities may be appropriate for someone with a long time horizon or a strong desire for a high payout rate, but a higher assumption of risk also results in greater uncertainty about future wealth. Retirees who take this route must be able to handle the risk emotionally, and they should be ready to adjust their lifestyle in response to market downturns. In fact, investor flexibility plays a role in all of the tradeoffs.

Exhibit 1: Basic Tradeoffs in Portfolio Survival



Finally, although you cannot fully control these and other factors involved in portfolio endurance in retirement, having more wealth can improve the odds of having a less stressful financial life. A more substantial nest egg might enable you to take fewer risks, enjoy a higher sustainable spending rate, or extend the productive life of your portfolio.

The Amusement Park of Jim Cramer

Jim Cramer is the epitome of "financial pornography". Jim Cramer’s predictions sometimes swing dramatically from optimistic to pessimistic, and back again, over short periods. His army of viewers, a strong 600,000, watch to get their dreams filled with hot air or for just mere entertainment, who knows. One thing is for sure, he knows how to lure viewers in the same way a casino does. Moreover, the show exploits the innocence of investor psychology. In the same manner a casino prevents outside light entering the gambling floor in attempt to control a gambler's internal clock, Jim Cramer's show has fabricated the same fanatical experience.

(CLICK TO ENLARGE)



From the color red to loud alarms Jim Cramer fascinates his viewers with psychological tricks. Who wouldn't be entertained by a circus act? The graphic above gives a list of triggers to look out for - in Mad Money and the investing world in general. Jim Cramer's effect on investors perfectly displays Nobel Laureate, Daniel Kahneman's findings on behavioral biases. A portion of Mr. Kahneman's research concluded that humans are not wired for long-term investment decisions because we tend to try and make create patterns out of random events. Furthermore, our perception flaws our judgment about decisions. Casinos, game shows, and now Jim Cramer play on the psychology of humans.

Mr. Cramer makes hundreds of buy-hold-sell recommendations on individual stocks each month via his show. What have his results been? According to CXO Advisory, his Accuracy Rating is 47%, meaning you would be better off flipping a coin in order to make a decision than listen to the entertainer. You'd be better off spending your time watching Sportscenter.

The Best 529 Plan Goes to... West Virginia!

By Arianna Capital

Saving for college can be quite an endeavor. Luckily, this article will aide anyone looking to pursue a college degree. There are several options like the Coverdell ESA, UGMA/UTMA, or the 529 plan. We will focus on the 529 plan today.

A Little Bit About 529s
Nearly every state has a 529 named for the IRS code that brought them about. The funds can grow tax free if used to pay for higher education qualified expenses. They can also be used to pay for thousands of post-secondary education across the globe. However, not all 529s are the same.

The West Virginia Award
After scouring the nation for the best option to help our clients save for their kids' future payments we found a diamond in the rough - West Virginia 529. It is special for several reasons. First of all it has low fees. This is an extremely important factor when searching for investment options. Secondly, West Virginia offers DFA funds. In previous posts we have written about the academia and science behind these funds. They don't try to offer the next best flavor of the month. Instead, they control what they can control in taxes and fees, and they let markets work for an expected return for providing financial capital. I have yet to come across better funds. Third, they are very simple to use. We all have busy lives. It may happen that we forget to rebalance the portfolio, or the child gets closer to college-age. Enter the age-based portfolio option, like that offered by West Virginia, which automatically does all of this for us.

Other Tips
When selecting a 529 plan there are three other things you need to watch out for.
1. Always buy a direct plan. Advisor sold plan only create wealth for the advisor. West Virginia makes it so easy that an advisor is really not necessary here.
2. Look for a state tax break. If your state gives a tax deduction or credit for contributions, look at home first. If the fees aren’t too much higher than West Virginia's, the value of the tax deduction or credit may outweigh the higher fees. In Texas, this is a mute point.
3. Consider an age-based option. This aids the values of simplicity and diversification.

Investing in 529's is a wonderful idea when planning for college to achieve tax-advantages returns. Make sure you choose carefully and watch out for costs and emotional decision making.

The Flaws of Variable Annuities

Ever walked the streets of New York City? Did you experience the snake-oil salesman luring you in with their fake Rolex watches and designer purses? Sounds familiar to the variable annuity market thanks to commissions of 5% or more.

Historically, variable annuities have gone from bust to boom. It seems as if variable annuity providers are in an "arm-race" to construct and sell the sleaziest, most deceiving product. Perfect timing uh? A 100-year event, like the market fall of 2008, can sure get people thinking differently about the complex, costly alien-like products. After all, an astonishing $33 billion in variable annuities was sold across the distribution channels in the fourth quarter of 2009. If only individuals knew what they were getting themselves into.

First, a primer. A variable annuity is basically a tax-deferred investment vehicle that comes with an insurance contract, usually designed to protect you from a loss in capital. Thanks to the insurance wrapper, earnings inside the annuity grow tax-deferred, and the account isn't subject to annual contribution limits like those on other tax-favored vehicles like IRAs and 401(k)s. Typically you can choose from a menu of mutual funds, which in the variable annuity world are known as "subaccounts." Withdrawals made after age 59 1/2 are taxed as income. Earlier withdrawals are subject to tax and a 10% penalty.

Variable annuities can be immediate or deferred. With a deferred annuity the account grows until you decide it's time to make withdrawals. And when that time comes (which should be after age 59 1/2, or you owe an early withdrawal penalty) you can either annuitize your payments (which will provide regular payments over a set amount of time) or you can withdraw money as you see fit.

So, what's the catch? The average expense on a variable annuity subaccount (including fund expenses and insurance costs) is typically one percent more than the average mutual fund expense ratio. Additionally, many variable annuities extract ongoing fees for administration and maintenance on the contract. An annual commission is also usually withdrawn from the account as well.

Proponents of variable annuities may point out the advantages of a death benefit. The death benefit basically guarantees that your account will hold a certain value should you die before the annuity payments begin. With basic accounts, this typically means that your beneficiary will at least receive the total amount invested — even if the account has lost money. For an added fee, this figure can be periodically "stepped-up" or earn a small amount of interest. (If you opt not to annuitize, then the death benefit typically expires at a certain age, often around 75 years old.)

Investors who bought annuities and then happened to pass away within the next two months probably got their money's worth. But considering the fact that over the long term the stock market will deliver positive returns, most folks need this insurance about as much as a duck needs a paddle to swim. While all variable annuities come with a standard death benefit, the average price for additional death benefits is 0.43%, according to Morningstar. On $1 million, if this $4,300 was used to buy a life insurance policy independent of an annuity, a healthy 50-year old man could definitely hold a policy of greater than $2 million, making the benefits of a death benefit a mute point.

Want to get your money back quickly once you invest? Tough luck. The surrender fees typically apply for 5 to 10 years. Withdrawing your funds before this time frame will result in huge fees. The surrender fees usually tier down as the years pass, but getting dinged by a 1% surrender fee in the last years can really eat into your assets. Not only that, but withdrawal before age 59 1/2 will result in a 10% penalty fee.

Gains in variable annuities are taxed at ordinary income tax rates. For most investors, that's a whole lot higher than the long-term capital gains tax rate they pay on their long-term mutual fund gains. And the tax difference can easily eat up the advantage of an annuity's tax-free compounding. Residents of some states may pay even more taxes on non-qualified variable annuity accounts. Some states also add a tax for variable annuities purchased within a qualified account, like a IRA.

Variable annuities continue to be a poor solution for a variety of factors. Some of which are not mentioned, such as estate planning issues and investment options, entailing higher expense ratios and underperfoming funds. Bottom line, ask the seller of a variable annuity how we much they will be compensated and from whom. If a conflict of interest exists, usually the solution wasn't designed with your best interests in mind.

How Might a Nobel Laureate Advise You?

By Arianna Capital

Nobel laureates have made lasting contributions to the financial industry. This documentary covers areas of theory, practice, and implementation - ending on a topic that will help investors for years to come. Please welcome this unique opportunity to hear from five recipients of the Nobel prize and learn how this can impact your investment experience of tomorrow.

Dimensional Fund Advisors and the American Finance Association present a new documentary that compares the work and ideas of five recipients of the Nobel Prize in Economics. A brief history of their theories and experiences culminates in a host of insights for today's investors.

Wallstreet and Their 'Special Interests'...

By Jay Franklin

“Wall Street is a place where anything that can be sold will be sold”
– Warren Buffett

“You are just a buyer of Wall Street’s dreck” – Robert Soros

“They [structured products] are horrible investments for retail investors…Simple portfolios of bonds, stocks or the S&P 500 will beat structured products 99.5 percent of the time because of the heavy profit built into the pricing”
- Craig McCann, former SEC economist and founder of Securities Litigation & Consulting Group

Credit to Eduardo A. Repetto and Inmoo Lee of Dimensional

Over the years, Arianna Capital has had the chance to view the portfolios of many different prospects and clients (before they actually became clients). We have seen the underbelly of Wall Street at its very worst, complete with penny stocks, C-Class shares of hyperactive mutual funds, triple inverse Russell 2000 ETFs…well you get the idea. Lately however, there has been one type of product that has been showing up more often than we are comfortable with, structured products. Granted, the name sounds as innocuous as it is vague. To briefly explain, the structured products marketed to retail investors promise either the straight return or a multiple of the return of an index (usually the S&P 500) up to a certain level (say 15%) with partial protection on the downside (e.g., for the first 10% of negative return you are fully protected but for each percentage point drop beyond 10% you lose a percentage point). They are typically designed by the whiz kid quants of Wall Street, the same geniuses who gave us the Synthetic collateralized debt obligations and other monstrosities that nearly took down the whole economy. At first glance, structured products may look very enticing; after all, they offer you some upside and a little protection on the downside. What could be so bad about that? Plenty.

Perhaps the very first principle of investing is that there is no such thing as return without risk. No free lunches. In a similar vein to the First Law of Thermodynamics, risk can never be obliterated; it can only be transferred from one party to another. If your broker is offering you a product that promises partial upside of the market with downside protection, you can be absolutely sure that the party that has agreed to take on the downside risk on your behalf is being paid to bear that risk, so the question you should naturally ask is, “Who is paying this party to take on my risk?” The answer, of course, lies in the mirror, but the costs are not transparent. The cost may show up at the end as a much lower return than what would have been received in a boring index fund.

One of the key points to understand about structured products is that they are constructed out of positions in options (both long and short), Treasuries, and sometimes positions in the underlying index itself. The issuer of the structured product, after collecting your payment, will buy these building blocks at a lower price and pocket the difference as immediate profit, after paying your broker his commission. These products are often designed to help the issuers unwind positions that they have due to trades with other institutions. This brings us to a very important point: Structured products carry default risk of the issuing company. Buyers of Lehman Principal Protected Notes have had to swallow this bitter pill. So even though structured products may appear to provide market-based returns, investors in these products are staking their nest egg on the fortunes of one company. Bad idea! An additional problem with structured products is liquidity.

Like all the other products that come out of the “too big to fail” companies of Wall Street, they are not designed in the best interest of investors, and that alone should be reason enough to steer clear. The complex payoff structures of these products are extremely unlikely to meet the needs of any investor, and they have no special magic that allows them to offer higher expected returns with lower risk. Arianna Capital has consistently counseled investors not to be buyers of Wall Street’s dreck. Rather than incurring the hidden costs and risks of structured products, they should favor transparent, risk-appropriate, low cost portfolios of index funds.

Government Intervention and Stock Returns

By Arianna Capital

This is a really cool five minute video that explains how the past can give us an insight into the future. It also attempts to debunk the hype about government intervention being negative for stock market returns and your portfolio.

Video - By Weston Wellington
Should equity investors be alarmed by the prospect of greater government intervention in the US economy?