Doesn’t sound like a bad deal, right? A guaranteed 8% return, $56,000 of income every year for as long as you live, and a 5.5% bonus, or $24,145 (5.5% of $439k) just for investing. These were the benefits of the annuity as the investor understood them. Additionally, the investor understood that the investment came with a surrender period, meaning if he withdrew his investment during the first ten years he would suffer significant penalties – as much as 12%! However, since the investor didn’t intend to withdraw his investments for 10 years, until he was 66 and retired, he didn’t see this as an issue. So, had the investor discovered the holy grail of investments?

After a long struggle with the annuity salesman, I was able to review the details of this product. The investment was a fixed annuity with a rider, or add-on, attached called a guaranteed lifetime withdrawal benefit. The first thing the potential investor was initially unaware of is that this rider came with an additional cost of .95% per year. Yet, it is the rider guaranteeing the 8% return and 5.5% bonus. Without the rider, the return of the annuity would simply fluctuate up and down with fixed-income rates.  The current rate on these products is around 3%.

For investors who purchased the guaranteed lifetime withdrawal benefit, their annuities would have two values going forward. First, the contract value would be the amount of their original investment and would fluctuate up and down with fixed-income rates, as if the rider wasn’t purchased. This value could actually be withdrawn anytime in one lump sum (minus any applicable surrender charges – which again could be up to 12%).

The second value would be known as the income base value.  This is the value to which the 5.5% one-time bonus and 8% annual guarantee would be applied. What was unclear to the investor is that this income base value is an imaginary figure and can never actually be withdrawn. This imaginary figure is simply a value used to calculate annual benefits later down the line. What was also unclear to the investor is that while the income base value does grow by a flat 8% rate during the accumulation stage, the value stops growing once distributions begin. Further, while the investor had heard a lot about the guaranteed rate of return, he was unfamiliar with the withdrawal rate, which is the percentage of the income base value that he can receive in payments each year. In this circumstance, if the investor began taking distributions when he retired at age 66, he would be able to withdraw 5.6% of the income base value every year for the rest of his life. Once the investor passes away, there will be no more annual payments and no residual value.

Clearly, there was more to this annuity than the investor was aware. Given these additional considerations, was it still a good deal? If the client invested $439,000 into the annuity the income base value would provide an additional 5.5% bonus right off the bat, bringing the income base value to $463k. At that point, the income base value would grow by 8% each year until the investor retired in 10 years, making the income base value $1 million dollars when the individual retired at age 66. At this point, the client would begin taking distributions so the income base value would no longer grow. Further, the investor would be paid 5.6% of the income base value, or $56,000, every year for the rest of his life.

This may still sound like a decent deal, but suppose the individual actually had access to the $1 million dollar income base value and simply put the lump sum under his mattress while paying himself the same $56,000 ever year. Even though the million dollars would not be growing at all, the investor could continue to pay himself this annual amount for 17.85 years, or until he was nearly 84 years of age, before running out of money. Unfortunately, the average life expectancy for a 66-year old male is only 16.48 years, or until the age of 82½. Thus, even if the investor lived 1½ years longer than expected, the annual rate of return on the income base value from age 66 to age 84 is guaranteed to be 0%. In other words, the guaranteed income base value guaranteed 10 years of 8% growth followed by 18 years of 0% growth. Over the entire 28 year investment period, the investor would receive an annualized return of approximately 2.98%. Not exactly what the investor had expected. Additionally, after accounting for inflation, the purchasing power of the $56,000 annual payment would decline year-over-year. This would essentially reduce the investor’s income each and every year.

Since payments continue for the life of the investor, the longer the client lives the better the return. However, even if the investor lived to age 100 and received $56,000 every year for 34 years, the implied rate of return during the withdrawal period would be 4.23%, far from the 8% the investor was expecting.

The one benefit of the annuity is that it GUARANTEES a return, and as we just established, that return is around 2.98% assuming the investor has an average life expectancy. For investors who simply can’t handle seeing their investments lose money, this may have a value. However, I would argue a similar or superior return could be generated with a simple fixed annuity with no expensive, hard-to-understand riders attached.

Investors who hate risk but can tolerate a minimal amount of loss in their portfolio on rare occasions might consider a conservative, diversified asset allocation such as a 15% stock, 85% bond portfolio. Over the last 42 years, a diversified portfolio with this asset allocation has had a positive annual return 36 times and a negative return 6 times. Further, the most the portfolio ever declined in one year was (3.34%). However the average annualized return of this portfolio over the 42 year period was 9.46%. Clearly, for an investor who can handle minimal investment declines, this appears to be a far superior strategy when compared to the annuity with a guaranteed benefits rider. Further, the investor’s money is completely liquid with this strategy. Money can be withdrawn in a giant lump sum with no penalties anytime the investor desires. Again, this is never possible with the income base value.

Clearly, annuities are incredibly complex investments. Unfortunately, they are meant to be so. Frequently, annuity salespeople rely on investors not understanding the entirety of the annuity contract to complete a sale. If you’re ever introduced to an annuity or other investment vehicle that sounds too good to be true, be sure to read the fine print in the investment contract. If you need additional help, seek the advice of a fee-only Certified Financial Planner® who acts as a fiduciary. These financial planning professionals are not paid a commission for selling financial products, and are more likely to give you an honest, unbiased opinion of the product you’re considering.

I was surprised when the client called me shortly after I sent the email. The client instructed that he did not wish to have his assets immediately liquidated. This was opposite the instructions I had received via fax. It also quickly became clear that the client was interested in my opinion of the annuity he was considering and was anxious to examine any analysis on the product I could provide. At this point, it became evident that the financial advisor who was selling the annuity to the client had written the letter I had received, and that the communication didn’t represent the wishes of the client. My belief is that the advisor had painted an unrealistically positive analysis of the product he was recommending and was attempting to ensure the client didn’t have the opportunity to get an unbiased opinion of the annuity. STRIKE ONE for the advisor.

After my conversation with the client, I typed the name of the financial advisor promoting the annuity into Google. The first item that came up was a complaint filed against the advisor by the Utah Insurance Department. The plaintiff was found to have a recording of the advisor making statements such as “there is no risk” associated with an investment, which the State found to be illegal and deceptive. The advisor was also found guilty of having clients sign various incomplete documents associated with annuity applications, with blank spaces yet to be completed. As a result, the advisor was fined, placed on probation for 12 months, and required to take additional courses on ethics. STRIKE TWO for the advisor. (I know baseball requires three strikes, but this strike alone should be enough for investors to look elsewhere for financial advice.)

Ultimately, the client determined it would be in his best interest to have a three-way conversation between himself, the advisor promoting the annuity, and me. I agreed that such a meeting would be beneficial and invited the discussion to take place in my office. However, I stated that I would need a copy of the annuity contract he was considering beforehand in order to complete my due diligence. I needed the contract in advance because annuities are so complicated (purposefully so) that it takes even a well-trained, fee-only Certified Financial Planner several hours to read and understand the pertinent information and determine if it may be a good fit for a client. The client agreed and immediately asked the advisor to fax or email me the relevant information.

One week later, and the morning of the appointment, I informed the client that I had never received the information (despite multiple requests), and that it wouldn’t be beneficial to conduct the meeting until I had a chance to review the material. The client agreed and the meeting was cancelled. However, the annuity salesman showed up at my office at the time of the scheduled appointment informing me that the client was still planning on attending. I asked why I had not been provided with a copy of the relevant material in advance; the advisor replied he was out of the office during the last week. Essentially, the advisor was contending that he never had the opportunity to fax or email me a simple Microsoft Word document. Yet, the advisor had conducted multiple conversations with the client during the week. In today’s era of computers, fax machines, and smart phones, I find it hard to believe that the advisor (or any of his work associates) never had the opportunity to send me a simple email during a week when he was in clear communication with the client. My strong belief is that the advisor simply didn’t want to allow anyone the opportunity to determine that he had not adequately represented both the pros and cons of the product. STRIKE THREE for the advisor; he’s out! However, the saga continues.

As the advisor had arrived at my office before the client, I suggested I take the contract and read as much as possible before the client arrived so that we could have a productive conversation. However, the advisor would not allow me time to read the contract or even permit me to hold the document despite my multiple requests to do so. STRIKE FOUR.

In an attempt to educate myself as best I could before the arrival of the client, I agreed to let the advisor “walk me through” the material he had brought. As a result, the advisor placed the document on my table, pointed out the guaranteed rate of return and quickly flipped the page. He then pointed out the bonus return that was applied to new contracts and again quickly flipped the page. Finally, he pointed out the annuity contract’s income schedule and quickly turned the page. Clearly, the benefits of the annuity were being pointed out while the details – or fine print – were being avoided. STRIKE FIVE.

At this point, I communicated to the advisor that this exercise was not helping me develop my understanding of the annuity, and that I needed to read the contract. To this, the advisor stated “I’m the annuity expert in the room; you should allow me to explain the product to you.” At this point it became clear that the advisor was not going to allow me an opportunity to review the product, and as a result, any conversation involving the two of us and the client would not be an educated discussion about financial planning and what was best for the client. I refused to continue the conversation and asked the advisor to leave my office, stating that the client was interested in my opinion of the annuity and that he should leave the contract with me so I could inform the client of my opinion and of questions that should be asked. Again, the advisor refused to let me look at the contract and would not leave it with me. STRIKE SIX.

The client ultimately required the advisor to return to my office and leave a copy of the material he had brought to the meeting.  After several hours of reviewing the contract, I discovered the annuity included several major drawbacks that had not been clearly communicated to the client; as a result, I found it was not a particularly attractive investment.  For a comparison of how the advisor had presented the annuity with how the annuity actually functioned, click here.

How can one be confident they can trust their financial advisor and avoid individuals like this? Unfortunately, the term “financial advisor” has become vastly overused and is frequently quite misleading. When is the last time someone introduced themselves to you as an insurance salesman, annuity salesman, or stock broker? Those terms don’t exist anymore because all those professions now refer to themselves as “financial advisors.” These individuals can be wolves in sheep’s clothing. If you meet with an annuity salesman who calls himself a “financial advisor,” he is going to recommend an annuity 100% of the time, regardless of what is in your best interest.

The key is to find a fee-only Certified Financial Planner® who acts as a fiduciary. Fee-only means the advisor is only paid by the client, and never collects commissions from selling products. This will ensure the advisor is recommending a product that is a great fit for you rather than simply selling a product in order to collect a large commission. A Certified Financial Planner® (CFP) is an individual who has completed the gold standard of education in the financial planning industry and is well educated in every aspect of financial planning, ranging from investments, to retirement planning, to taxes, to insurance, to estate planning. Finally, a fiduciary is someone who is legally obligated to act in the client’s best interests, similar to a doctor, attorney, or accountant.  Surprisingly, most “financial advisors” are not fiduciaries.  In fact, over one million people in the US refer to themselves as “financial advisors,” but less than 1% are fee-only CFPs acting as a fiduciary.¹

When looking for a trustworthy financial advisor, do your homework. The National Association of Personal Financial Advisors (NAPFA), located at www.napfa.org, is a great place to start. NAPFA is the nationwide association for fee-only financial planners. Further, insert your advisor’s name into Google to ensure no complaints have been filed against the person. It’s worth the effort – being sold a product that is not in your best interest will cramp your retirement efforts for decades.

The advisors at Net Worth Advisory Group are fee-only CFPs® acting as fiduciaries, and always happy to provide a second, unbiased opinion of any investment you may be considering.

¹As measured by the percentage of financial planners who are NAPFA members.

Avoiding the Issue

According to a recent study conducted by John Hancock, six out of seven people agree that it is irresponsible not to plan for your own long-term care needs. Unfortunately, the issue is not so much awareness but avoidance. Three out of four people who completed the survey state it is difficult to admit they might need long-term care, and the same proportion state that they have so many other concerns that addressing this risk is not a priority.

Medicaid’s Impact

The same John Hancock survey asked respondents who do not have long-term care insurance how they would pay for care if needed. The most frequent answer was qualifying for Medicaid. Yet, most experts agree this is a risky strategy because Medicaid programs are already overburdened and will most likely be even more overwhelmed when the wave of boomers reaches the high-incidence years for needing long-term care. Moreover, this solution is not ideal because the options for care under Medicaid are limited and generally not what most people desire.

What About Your Spouse?

It’s important for people to realize that the people with the largest financial burden resulting from the need for long-term care is often not the recipient of care, but their spouse or other family members. It’s common for a retirement nest egg to be consumed paying for additional health care, leaving no money for the surviving spouse.

Planning Options

Fortunately, the potential financial burden that might arise from needing long-term care can be negated with proper planning. Of course, obtaining long-term care insurance can often be an appropriate solution. While this insurance can be expensive, it can accomplish several key objectives. First, it reduces the need to deplete a nest egg and risk spousal impoverishment. Second, it helps assure more choices and options if care is needed as opposed to being restricted to Medicaid-approved places and levels of care. Third, it reduces the chance that people will spend their final years burdening their children as they are more likely to be able to afford their own care. Finally, it increases the likelihood that people will be able to pass their assets on to their heirs rather than spending money for care facilities.

Be aware that people should research the option of long-term care insurance while they are in their 50s because the cost is lower and their insurability is higher than for people in their 60s. For instance, a 4-year care benefit will cost approximately $3k per year if purchased at age 50, $4k per year if purchased at age 60, and $5k per year if purchased at age 65.

Is Your Nest Egg Big Enough?

The other approach is to self-insure. Of course, with this approach individuals choose not to purchase long-term care insurance and trust that their nest egg is large enough to cover the expenses of a nursing home if such care is needed. An analysis of an individual’s capacity to self-insure can be quite useful. At Net Worth Advisory Group, we perform retirement projections for our clients to determine whether they will be able to maintain their standard of living after leaving the workforce. These projections account for the level of annual spending desired by the client, all sources of income such as Social Security, pensions, and rental income, and consider the retirement nest egg accumulated. To determine a client’s ability to self-insure, we take these retirement projections and add the potential expense of needing five years of long-term care and then determine the standard of living that the surviving spouse could expect in such an event. If both spouses agree that the survivor’s standard of living under these circumstances is acceptable, then the client is likely capable of self-insuring.

There’s no doubt the impact of long-term care cannot be ignored. Determining your ability to self-insure is a great first step in dealing with this issue. Of course, Net Worth Advisory Group delivers this service, so let me know if this is something that interests you. If your financial circumstances don’t allow you the flexibility to self-insure, looking into long-term care insurance options could prove to be a wise investment; remember, the earlier this is done the more cost effective it may be.

¹ John Hancock Study

1. Do you know what tax rate you pay on your income? People may know they are in the 15%, 25%, 28%, 33%, or 35% marginal tax bracket, but don’t realize this isn’t the percentage of their income that they pay to the federal government. A marginal tax bracket is the tax rate applied to the last dollar an individual earned during the year. However, previously-earned dollars were likely taxed at a lower rate. To calculate your effective tax rate, divide line 61 on your 2011 Form 1040 (total tax) by line 22 (total income). This will tell you what percentage of every dollar you earned throughout the year was paid to the federal government.

2. Line 8a is the amount of taxable interest generated during the year. This type of income is usually generated by bank savings accounts or money market accounts. If this figure is too high, you likely have too much of your portfolio invested in cash or have an unnecessarily high emergency reserve fund. Either way, you may be better off shifting some of those funds toward investments that are geared for long-term growth.

3. Line 13 is the amount of capital gains or losses generated by your investments during the year. If this figure is high, it likely means you sold some investments that had experienced significant growth and you may want to review your investment strategy to make sure you intended to. Additionally, remember that capital gains can be offset by capital losses. If a large gain was recognized, it may have been worthwhile to review your investment portfolio looking for losses that could have been recognized to negate the realized gain, thus reducing your tax bill.

4. Line 15a covers IRA distributions. If there is a number here, you may want to look at line 58 to ensure that a penalty wasn’t applied for taking money out of a retirement account before age 59.5. Also, be aware that IRA rollovers don’t count as distributions, so if a rollover was done properly a number should not appear here. Further, while converting a Traditional IRA to a Roth IRA is not a distribution that would appear on line 15a, a taxable amount should appear in line 15b.

5. You may find it interesting to check line 20a and 20b to see how much of your Social Security income is taxable. If you have income from other sources, as much as 85% of your benefit could be taxed.

6. Lines 23 through 35 consist of various deductions you might claim. Review all of these items to ensure you are claiming all the deductions allowed, which will help lower your taxable income.

7. Line 40 clarifies whether you are itemizing deductions or claiming a standard deduction. You should always know whether you have enough deductions to itemize. Itemized (or Schedule A) deductions include some medical expenses, state and local taxes, home mortgage insurance, gifts to charity, casualty and theft losses, and certain job and miscellaneous expenses. Remember, if you aren’t already itemizing, additional Schedule A deductions may not provide an additional tax benefit (unless they push you over the standard deduction amount. In 2012, the standard deduction is $11,900 for married couples and $5,950 for singles).

8. Compare line 7 (total wages) with line 61 (total tax). If you’re paying too much of your wages in taxes, you probably aren’t maximizing contributions to a 401(k) or other retirement compensation plan. Maximizing retirement plan contributions will reduce your taxes and enhance your retirement planning efforts.

9. Lines 62 and 63 are the total amounts withheld from paychecks and the amount of estimated tax payments made during the year. How do these amounts compare with the total tax due on line 61? If not enough money was withheld you could have a large tax bill due at the end of the year and even face a penalty if the gap between taxes due and payments received is too big. However, paying more in taxes than is due is not ideal either. While some enjoy receiving a large refund at the end of the year, there is an opportunity cost to this approach; receiving a large refund means you provided the federal government with an interest-free loan. Wouldn’t you rather keep that extra amount during the year, invest it, and generate a return?

As you can see, reviewing your federal income tax return can provide insights such as whether you should contribute more to your retirement accounts, look for more deductions (such as purchasing a home), change your asset allocation, and more. Ask your tax professional if you have questions on these subjects.

Bonus: President Obama’s Tax Return

Curious whether President Obama has his financial ducks in a row? Click here to view his 2010 tax return. While some lines are slightly different than the 2011 version of IRS From 1040, you’ll get the point. You can see from line 22 that total income was $1,795,614, which would put him in the 35% marginal tax bracket. You can also see on line 60 that his total tax bill was $453,770, meaning his effective tax rate is about 25%. He has only a small amount of his income coming from taxable interest on line 8a, so the majority of his money is likely invested in more long-term assets. He claimed a capital loss of $3,000 on line 13, so he is likely harvesting his investment losses to offset his gains. On line 28 we see $49,000 were contributed to qualified retirement plans (he most likely contributed the maximum amount allowed to a SEP). On line 40 we see he had an incredible $373,289 in itemized deductions. Finally, on line 73, we see he over-contributed $12,334 in taxes during the year – probably reasonable given his large tax bill. Overall, as you would expect, it looks like the President handled his finances relatively efficiently over the course of 2010.

When people are considering their options for taking Social Security they often overlook some strategies available to them. In fact, there are actually 20 different possible benefit choices, and an individual should consider each strategy in full before making their final decision. Sometimes utilizing the correct approach can amount to over a million dollars in additional lifetime benefits. Three strategies are often overlooked or never considered; claiming and suspending, restricting Social Security, and investing the benefit amount. Let’s review the three scenarios:

Claim and Suspend

Consider the example of Sam and Sally Sample, ages (66) and (62). To maximize their Social Security benefits it makes the most sense for Sam to utilize the claim and suspend strategy. Once he reaches his full retirement age (66), he can file for his benefits and immediately suspend them.  By suspending his benefit he will receive an 8% annual benefit increase until he reaches age (70).  However, because Sam filed for benefits at (66), Sally (62) has the ability to collect a spousal benefits based on Sam’s full retirement age benefit.  At age (70) Sam will receive the maximum payout for his Social Security. See the table below.

Restricting Social Security

Let’s now consider the restricted application strategy.  In this case, Sally takes her Social Security now at the earliest age of eligibility (62) to start her own benefit based on her work history.  When Sam reaches full retirement age (66) he will elect to restrict his application with the Social Security Administration, which enables him to receive a 100% spousal benefit (50% of Sally’s benefit). Once Sam reaches age (70) he files for his own personal worker benefit at the higher amount which has been earning delayed retirement credits increasing 8% per year. See the table below.

Reinvestment the Benefits

Sam and Sally are in a great position; they have a pension which will cover their immediate monthly expense during retirement. Even though they do not need Social Security to cover their living expenses, they should still consider the option of taking their benefits early.

In this situation it makes the most sense for them to take Social Security as early as possible and invest their benefit. Even though they will be receiving a reduced benefit, by investing early it will be able to compound for a longer period of time. See the table below representing a 6% return.

Table Comparison

The table below displays a side-by-side comparison of each option and its total lifetime benefit amount. Be sure to receive an in-depth assessment of your Social Security options when you are selecting your benefit method.

Conclusion

Getting the most out of your Social Security should be at the forefront of your mind as you get ready to transition from the workplace to retirement. You have been paying into Social Security all your life; make sure you receive the benefit that you deserve. While we only considered three possible strategies, be sure you consider each of your 20 options before making a million dollar decision.  The ages of each spouse and their benefit amounts have a tremendous impact on which Social Security strategy is most profitable.  Net Worth Advisory Group’s Social Security Maximizer considers each of these factors, along with your financial plan, to determine which Social Security option is best for you.

Since the status of Social Security when this young lady retires in more than 40 years is uncertain, my advice was to take control of her own retirement planning and not rely on the government. Of course, any benefit that Social Security provides will be a welcome supplement, but it may be wise for young individuals to take full responsibility for ensuring their retirement income needs are met.

To illustrate the importance of saving, I asked this woman how much money she currently spends each month. After including rent, a car payment, and all other expenses, we found that she needed about $3,000 per month – or $36,000 per year – to cover her costs. First and foremost, we calculated the impact of inflation on her retirement planning. Assuming a 3% annual inflation rate (which has been about average over the last 100 years) we determined that in 40 years, when she is 65 years old, she will need $9,786 per month – or $117,433 per year – to maintain her current standard of living. As you might expect, the impact of inflation alone was enough to catch her attention.

We then discussed how long she expects to live. Of course, we agreed that running out of money was the last thing she wanted to happen, so she wanted to ensure she has enough funds to support her through 30 years of retirement, from age 65 to 95. Keeping in mind that we wanted to be confident that her funds would last, we assumed she would have a relatively conservative portfolio during retirement and selected a nominal (pre-inflation) 6% rate of return on her investments. Given a 6% return and an inflation rate of 3%, we calculated that the real (inflation-adjusted) rate of return on her investments would be 2.91% (calculated as such: (1.06/1.03) – 1)). Thus, if she wanted to have the ability to spend an inflation-adjusted $117,433 per year between ages 65 to 95, and her investments were earning a real return of 2.91% over this time period, she would need to have $2,328,748 saved when reaching age 65. Again, as you can imagine, this figure raised some eyebrows as well.

Finally, I asked what this woman needs to save over the next 40 years to accumulate a nest egg of $2,328,748 by the time she retires. Since she can afford to take a little more risk with her portfolio because she has 40 years until retiring, we assumed her portfolio could obtain a nominal rate of return of 8% during the accumulation phase. Still, even assuming an 8% return and knowing she has 40 years to save, we calculated that she will need to save $8,989 each and every year in order to accumulate the nest egg she seeks.

Naturally, the young lady was concerned about this rather large savings figure that would be required in order to enjoy what seemed like a relatively basic standard of living during retirement. I used this opportunity to illustrate the importance of taking advantage of any employer match provided through her company retirement plan. Of course, if an employer provides a 100% match on employee contributions to a 401k plan, this could cut the amount of savings required by the young woman by as much as half. I also reminded her that most people’s ability to save increases as their career progresses because earnings tend to increase while consumer debt and student loans tend to decrease.

However, it was vital that the young woman understood the importance of beginning to save as early as possible. To illustrate this point, we preformed the same calculation assuming she waited 10 years, or until she was 35, to begin saving. To accumulate the same nest egg of $2,328,748 at age 65, she would need to save $20,556 each and every year between 35 and 65. Conversely, if she had started to save five years early at age 20, she would have only needed to save $6,025 per year. Clearly, every lost year increases the amount of necessary savings dramatically.

In reality, very few 25-year-olds can contribute $8,989 per year to retirement accounts.  However, the lesson is to save early and save often, and that taking full advantage of any employer match offered within an employer’s retirement plan goes a long way. Any small amount contributed early drastically reduces the retirement saving burden later in one’s career.

Finally, remember that meeting with my client’s children to provide a similar lesson is a service I’m happy to provide. Please take advantage of this offer if you feel it can benefit your loved ones.

Low interest rates may have spurred the economy somewhat, but they have been devastating for retired people who have a low tolerance for risk.  Investors and their advisors are turning toward alternatives that pay higher returns, but these vehicles necessarily carry higher risk. Among these alternatives, some investors are considering the purchase of stocks that pay reliable dividends.

Critics of dividend-paying stocks argue that companies paying dividends are weak because they should be investing their cash back into the company to foster growth.  These critics would clearly be in the growth stock camp, where capital gains are expected to provide the bulk of investment returns.  Proponents of dividend-paying stocks feel that companies sharing their profits with shareholders reward investors and capture their loyalty.

How important have dividends been over long periods of time?  One study examined the components of total equity returns of U.S. stocks from 1802 to 2002.  Over this 200-year period, dividends accounted for 5.8% of the 7.9% of total annualized returns.¹ Another study of global stocks from 1900 to 2005 found that the real return across seventeen countries averaged about 5%, while the average dividend yield was 4.5%.² In other words, dividends provided 90% of the return.

Studies also show that dividend-paying stocks hold up much better than their non-dividend paying counterparts during bear markets. The two above research papers, as well as many others, support the tenet that dividend-paying stocks have provided higher cumulative returns with lower levels of volatility than non-dividend paying stocks.

It is important that investors don’t fall into the trap of buying stocks merely because they have high dividend yields.  The unwary investor could purchase financially unstable companies such as banks that hold debt with questionable value. Other companies may temporarily pay a high dividend to maintain a positive image with its shareholders, even though current and future earnings will not support the dividend payments.  To minimize risk, investors must consider the financial strength of companies through an in-depth screening process.

In response to client requests, one of Net Worth Advisory Group’s recent research projects created a portfolio of dividend-paying stocks in large, financially-stable companies that have relatively high dividend yields. Two portfolios of dividend-paying stocks were used as a basis for our research:  1), The SPDR Standard & Poors Dividend exchange traded fund (SDY); and 2), the Dividend Yield Folio at Folio Investments.

The SPDR S&P Dividend exchange-traded fund (ETF) consists of 60 stocks and seeks to closely match the returns and characteristics of the S&P High Yield Dividend Aristocrats Index. Folio Investments created the Dividend Yield Folio by choosing the largest 100 companies with the highest overall dividend, adjusted for market capitalization, utilizing the principles of fundamental investment analysis.

Of the 160 total stocks analyzed, 80 passed our rigorous filtering process.  As a consequence, we appropriately named the group of 80 companies the “Dividend 80” portfolio. To create our model, we allocated funds evenly among the eighty stocks — thus each stock represents 1.25% of the portfolio. Statistics over the last ten years produced results that supported the independent research we have cited in this article.

A Morningstar Principia® portfolio snapshot shows that the Dividend 80 portfolio would have significantly out-performed the S&P 500 over the last one-year, three-year, five-year, and ten-year periods.  During the last ten years, the S&P 500 experienced its largest twelve-month loss of -44.85% between March 1, 2008 and February 28, 2009.  The Dividend 80 portfolio would have lost -33.26% in the same twelve-month period.

Another test shows that during a shorter, five-year period from 2/21/2007 through 2/17/2012, the Dividend 80 portfolio would have produced a total return of 27.80%. During this same period, the S&P 500 Index including dividends had a total return of 4.05%, and the SPDR S&P Dividend exchange-traded fund had a return of 7.41%.

We are concerned when any investment method becomes too popular.  If investors were to pile into dividend-paying stocks, their prices would increase and yields would decline. We don’t believe the market is close to that point yet, but the possibility of such a trend deserves our vigilance.

Whereas dividend-paying stocks don’t offer the security of savings accounts or CDs, they have an important role to play as one of the sectors in a well-allocated investment portfolio.  Investing in dividend stocks is accompanied by higher market risk, but investors with a twenty to thirty-year investment horizon should be willing to accept some market risk in order to combat inflation.

Please let me know if you are interested in learning more about the “Dividend 80” folio.

Footnotes:

1. Robert D. Arnott, “Dividends and the Three Dwarfs.”  Editor’s Corner, Financial Analysis Journal, 2003.
2. “The Worldwide Equity Premium:  A Smaller Puzzle” by Elroy Dimson, Paul March and Mike Staunton, 2006.

Past performance is not a guarantee of future returns.  Dividend yields can change over time.  Dividend paying stocks are subject to fluctuations in market value.  The Dividend 80 Portfolio is only available only on the custodial platform at Folio Investments.

As noted by the Employee Benefit Research Institute, only 29% of today’s retires have more than $100,000 saved and invested for their future. By contrast, 54% have less than $24,999. What do you need to do to ensure you end up on the right side of this spectrum? Saving 15% of your gross income, save early, and save often.

At Net Worth Advisory Group, we believe peoples ability to adequately pass this “chalkboard test” is crucial to their long-term success. Saving for retirement requires a different investment approach than does ensuring that resources are available and secure over a short period. How can investors be confident they are taking appropriate actions if they aren’t sure how they chose their investments?

Net Worth Advisory Group ensures that our clients are capable of passing the “chalkboard test.” This four-step process is how we recommend investors design their investment portfolios:

Step One: Asset Allocation – Stocks, Bonds, and Cash

This is the most important investment decision you’ll make because it has the largest impact on both risk and return. A simple approach to determine an appropriate mix of stocks vs. bonds is based on age (for example, take the number 110 and subtract the investor’s age; the answer equals the percentage of a portfolio to invest in stocks). An asset allocation based on age makes a portfolio more conservative at the appropriate time by reducing the allocation to stocks as retirement nears. Additionally, be sure to consider the risk associated with the asset allocation you choose. Examine how such an allocation performed during historical bear markets and be sure you can endure that degree of short-term loss.

The “bucket approach” is a more involved asset allocation strategy that considers spending needs. For more information on this strategy, view the second article in this month’s newsletter or click here.

Step Two: Diversification Across Different Asset Classes

A baseball team prepares by placing nine players across the field because they never know where the ball will be hit. Similarly, diversification of investments is important because we never know which asset classes will do well and which won’t.

Diversification lowers risk because it reduces the volatility of a portfolio. It creates ‘zig-zag’ relationships between asset classes so that when one investment is down, another will be up. These relationships are created by diversifying across asset category (stocks vs. bonds), size (large, mid and small cap), style (growth vs. value), and geography (U.S. vs. international).

The 2000’s are referred to as “the lost decade” for the S&P 500, but a diversified portfolio vastly outperformed the market as a whole. For instance, most stock categories lost nearly 40% in 2008, but government bonds gained 23%. Further, when the tech bubble burst in the early 2000’s, most growth stocks suffered but value stocks made huge profits. Clearly, diversification enables gains during bull markets while minimizing losses during market pullbacks.

Step Three: Selecting the Best Investments

If you decide to buy mutual funds, then you want to have criteria for how to select the best fund managers. Here are some of the standards Net Worth Advisory Group uses:

1. Determine the asset category, such as large cap growth or small cap value.
2. Find funds that outperform their peers.  Look for funds that performed in the top 25% of their asset category over one, three, five, and ten year time periods.
3. Choose managers that have at least ten years of experience.
4. Look for low expenses. Total fees, covering your financial advisor, investments, and transaction costs should be no more than 2%.
5. Make sure the fund outperforms its benchmark index (S&P 500 for large cap, Russell 2000 for small cap, etc.).

*Note: Net Worth Advisory Group often identifies the top mutual funds in each asset category and then purchases the individual stocks owned by those funds. This strategy is more cost effective and allows more control over the tax implications.

Step Four: Maintain, Review, Rebalance

Every six months you should tune-up your investment portfolio. Your allocation will get out of alignment over time because some assets will appreciate faster than others. When this happens you should rebalance to make sure you’re allocated properly and not taking extra risk. Always consider tax consequences and costs associated with rebalancing your accounts.   

You should also review the performance of your investments to see if they’re still meeting the criteria you set. If a fund isn’t keeping up with its peers, then flag it and give it a chance to redeem itself. If flagged funds continue to underperform, then replace them with funds that meet your criteria.

As you conduct your routine checkups, make sure you maintain sound investment behavior. Don’t panic when you see the market experiencing a pullback. Remember, when you built your portfolio you accepted a certain amount of risk. If you used the bucket approach to determine your allocation then the money invested in stocks is for the long-term, so expect some short-term uncertainty. Stay the course and make minor adjustments when necessary.

Summary

This four-step strategy is the foundation of the static portion of client portfolios at Net Worth Advisory Group. This strategy can be supplemented by various tactical strategies, which you can learn more about by speaking with our advisors.

Our clients understand the investment strategies they are utilizing and can be confident they are appropriately pursing their retirement goals. If you or your financial advisor isn’t following a clearly defined strategy that you could express on a chalkboard, contact Net Worth Advisory Group for a portfolio upgrade to ensure your approach matches your goals.

Proper asset allocation ensures the portfolio represents the investor’s risk tolerance. If too much of the nest egg is held in stocks and the market tanks, the investor is more likely to panic and sell. In doing this, the investor buys high and sells low.

Picture three buckets. The first bucket should contain money that will be withdrawn from the portfolio within three years. The second bucket contains funds that will be used in four to ten years. And finally, the third bucket holds money that will not be needed during the next ten years.

The money in the first bucket should be invested in liquid, cash-type investments such as money market or savings accounts. This is short-term money which should not be exposed to market fluctuations.

The second bucket, holding intermediate-term money, should be invested in bonds. Although bonds fluctuate in value, they are not as volatile as stocks. However, bond returns are usually a significant improvement on cash-type investments. Constructing a bond ladder by purchasing bonds that mature each year will refill the cash bucket once a year.

The long-term money in bucket three is invested in stocks. This ten-year money is the growth portion of a portfolio and will fluctuate with the market. An investor doesn’t need to worry about a down year in the market because these stocks will not be sold for at least seven years, which is plenty of time for the market to recover. In fact, it took the U.S. stock market seven years to recover from the Great Depression. Thus, an investor utilizing this strategy would have survived the worst investment climate in history without selling assets at a loss.

This strategy provides a consistent source of income when it is needed. Money from the cash bucket can be used to meet living expenses, a bond will mature each year to replenish the cash bucket, and stock positions can occasionally be sold to replenish the bond portfolio. If the market has a poor year, stocks can be held for an extended period to avoid selling during a down market. This strategy will increase the probability that funds will be available to meet any planned expenses ranging from retirement, to business expenditures, to college tuition.

The market pullback of 2008 forced many investors to sell investments at an undesirable time. Speak to your financial professional about developing an asset allocation that represents your risk tolerance and provides sufficient liquidity to prevent having to sell your nest egg at a loss.