On the surface, annuities seem like a simple investment. The investment generally entails paying an insurance company a lump sum with the expectation that, at some point, the insurance company will begin making a string of payments to you from that lump sum plus any investment growth. While the fundamental idea of an annuity is fairly straightforward – you invest your lump sum and we’ll give you a stream of income – as with most financial products designed by Wall Street, annuities can become extremely complex.

The simplest type of annuity is a fixed annuity, which earns a fixed rate of interest and can be converted to a stream of payments at the investor’s request. Slightly more complex are variable annuities, which allow the purchaser to invest in “sub-accounts”, which are mutual fund-like investments into which funds can be directed. Finally, many annuities offer various add-on options, or riders, including  guaranteed lifetime withdrawal amounts, minimum guaranteed growth and so on.

As you might expect, the more complex an annuity, the greater its cost and it’s helpful to understand the various layers of cost involved. The main expenses that every annuity includes are the M&E charges.  The M&E, or mortality and expense charge is a fee which pays for the insurance guarantee, commissions, selling and administrative costs of the annuity. If you opt for a variable annuity, you’ll also pay a fee to the managers of any sub-accounts you use. Finally, those add-on options, or riders, that many annuities now tout come with yet another additional fee.

When you add it all up, it’s not unusual for the total cost of an annuity to exceed 2%, and 3% isn’t unheard of for a variable annuity in which a rider or riders were added. Further, if you try to cash out of many annuities before a specified amount of time has lapsed, and the annuity company will often levy a surrender penalty. Compare all those costs to a cost of less than 1% for a carefully chosen portfolio of mutual funds, and it’s clear that before investing in annuity, an investor should clearly understand the total cost and confirm that for the investor’s particular situation, the annuity makes more sense than a traditional portfolio.

The weather has turned pleasant here in Atlanta in the last week or so, and that has coincided with the beginning of what may be a systematic approach to European debt problems. Still, as with most political issues, the ultimate outcome is uncertain. While that uncertainty continues to exist, expect to see further market volatility.

With that as preamble, I thought it would be useful to revisit the question in the first article below of what would trigger the unwinding of defensive positions in portfolios. One key to understanding our thought process is that we try to quantify likely market returns as opposed to relying on vague ideas of what the market might do.

In the financial planning tip of the month, we delve into two pending legislative issues that will likely impact most investors. For both issues, industry associations we believe represent consumers well are on one side of the issue, while deep pocketed institutional interests are on the other. Finally, in the question of the month we cover market futures, and how they are used to predict where the markets might open on a day-to-day basis.

As always, please feel free to send any thoughts or questions our way.

Best regards,
Micah Porter, CFA, CFP®

One of the key points I’ve reiterated over the last several investment commentaries is that we remain defensively positioned due to the ongoing risks in the market and the broader economy. Given that one of these risks – the European debt crisis – has recently flared again, I think it’s worthwhile to revisit how risk and defensive positioning are related.

Typically, the reason investors take on more risk is the expectation of greater return. Thus, another way of stating the idea in the paragraph above is that the additional return we expect to receive in the near term isn’t great enough to entice us to take on more risk. While this might sound like a subjective judgement, we try to make it less so through relying on an objective, repeatable process. More specifically, we use research that involves scenario analysis to estimate returns on various asset classes. The most recent scenario analysis produced by Advisor Intelligence, one of our research sources generated the following:

As you can see (click image to enlarge), the estimated returns under most scenarios for equities over the next 5 years are fairly lackluster. Absent a sharp market drop or economic data that indicate a shift towards the most favorable scenario, there’s not a good incentive to move from the underweighting we currently have in equities. To put it another way, were investor unease to lead to a market drop of 20% or so in the U.S., we would expect the market to return an additional 4% per year over the next 5 years assuming the economic fundamentals hadn’t changed. Thus, even in a subpar recovery, we would expect returns of over 9%, which would provide us sufficient incentive to take on a bit more risk.

While the returns estimated above aren’t great, they are in line with what we’d expect given a halting recovery. As we’ve maintained for some time, given that this is a debt-driven downturn, recovery simply takes longer. On the bright side, though, there is some evidence that market valuations are now fairly reasonable (see articles here, and here). If that proves to be the case, over the longer term, we should expect healthy returns as we work through ongoing economic issues and enter into a growth phase again.

Financial Planning Tip – Legislation that Impacts Investors

Micah Porter, CFA, CFP®

I don’t often discuss political topics when it comes to financial planning tips, but in rare instances, Congress considers legislation that can have a direct impact on your long-term financial health. In this particular case, there are two issues before Congress that fall into this category.

The first regards whether or not all who offer investment advice should be held to the same legal standard. Currently, registered investment advisors (RIAs) like Minerva are regulated by the SEC or the states and held to a fiduciary standard. This is a strict standard, and requires that we act in our clients’ best interests at all times. The other, more common standard within the planning industry is the suitability standard, and most brokers and non-RIAs adhere to this standard.

To understand the difference in the two standards, consider a hypothetical investment recommendation. The RIA, subject to a fiduciary standard, would have to recommend what he or she felt was the best investment for the client, while the broker would simply be required to recommend a suitable investment. In the latter instance, a bond fund paying a high commission but having a poor performance might well be suitable, but it clearly would not be the best recommendation. If, on the other hand, the RIA subject to the fiduciary standard made such a recommendation, he or she could be found liable for violating that standard.

As part of the Financial Reform bill, there was consideration as to whether a fiduciary standard should be extended to all advisors. The jury is still out on whether that will happen, but there is strong conservative opposition to a uniform fiduciary standard. Further, the second issue is that FINRA, which currently oversees brokers subject to the suitability standard, is making a strong push to regulate RIAs as well. A number of industry associations, including NAPFA, the Financial Planning Association and the Certified Financial Planning Board of Standards are against this move. Given that FINRA is funded by the brokerage industry and has no history of regulating based on a clear standard – and instead regulated via very specific, costly and cumbersome rules – it’s easy to understand why FINRA would not be the optimal choice.

The bottom line is that we feel it is clearly in the best interest of investors to implement a uniform fiduciary standard across the industry. Further, we feel that the states and the SEC are the appropriate, neutral regulators of registered investment advisors. While there are deep-pocketed interests who have the ears of many in Congress, constituent feedback can help shape the ultimate decisions that are made, so feel free to let your Congressman know how you feel.

More in-depth information on both of these topics is available at the Certified Financial Planner Board of Standards website here.

Question of the Month – Why Don’t More Advisors Recommend Gold?

Micah Porter, CFA, CFP®

One of the daily rituals in the financial press is to look to the futures market in the early hours before the stock market opens. The reason they do this is that futures offer a good indication of how the market will likely perform once it opens. But what are futures, and how accurate are they?

A future is an agreement to trade a specified amount of an asset at a specific future time and date. In this particular instance, the asset being traded is the index itself. These trades take place throughout the night and into the early morning, and the movement of the futures price during these hours is considered indicative of the likely movement of the market when it opens. Thus, if futures prices move upward, the market is expected to move upward when it opens and vice versa.

The predictive accuracy of futures often only extends to the first few minutes after the market opens, but even so, for traders who watch the market on a minute-to-minute basis, the information is still useful.

As an example, the chart below on the left hand side depicts the S&P 500 on September 6th and 7th. You’ll note that the market “gapped up” from the 6th to the 7th, and if you had been following the futures chart on the right, you would have anticipated this movement. Futures trended up throughout the period from the close of the market on the 6th to the opening on the 7th, and the market opened up as anticipated.

An Update on Recent Economic Challenges and Market Volatility
Micah Porter, CFA, CFP®

If you didn’t catch much news last week and saw the chart just below, you would probably assume the market was fairly quiet. The actual story, of course, was quite different.

Volatility spiked last week to an extent we haven’t seen since 2009, with market moves in excess of 4% the norm for the week. While the good news is that the markets ended the week slightly higher than they began, it’s still worth exploring the causes behind the volatility and what they might presage for the coming months.

It can be difficult to pin down the cause of market drivers, but last week’s primary movers were likely concerns about the European debt crisis coupled with weak economic data, particularly in the U.S. The issue in Europe has been ongoing, but when that was coupled with revisions to U.S. GDP data that showed the downturn was far worse than originally thought, and the recent recovery has been weaker, the markets moved decidedly lower.

The European Central Bank has moved to support Italy and Spain by buying their bonds, and that has bought some respite in those markets. However, at some point political leaders will have to weigh in if the continent is to ultimately contain the crisis. As for the U.S., although the recovery may well give way to recession, there has been some positive economic data including retail sales that continue to hold up quite well and decreasing initial jobless claims. Further, the Fed’s recent announcement regarding maintaining low interest rates through 2013 should provide a tail wind to both the economy and the markets.

So, last week’s volatility was likely both driven by real underlying economic concerns and an overreaction on the part of many market participants. Yes, the chance of a recession is higher than it was, but no, the data wasn’t indicative of a sea change in expectations. As I outlined in my most recent note, if future volatility drives the markets sharply down again, we’ll likely use the opportunity to add selectively to equity stakes as such sharp drops often lead to bargains.

Financial Planning Tip – Refinancing Your Mortgage

Micah Porter, CFA, CFP®

Although it can be difficult to remember in the face of constant media coverage about the difficulties facing the economy, such a tepid recovery does offer a few upsides. Given the recent softness in economic data, the Fed recently stated interest rates would remain low through 2013. As a result, mortgage rates across the board dropped as well. 30 year rates hit their lows for the year, and 15 year mortgages neared all-time lows.

• If you are carrying a fixed mortgage, now might be a good time to consider refinancing. If you decide to do so, keep the following points in mind:
• If you’re moving from one mortgage of the same type to another – 30 year fixed to 30 year fixed, for example – typically, it will only pay to do so if the interest rate of the new loan is at least one percent lower than the existing loan.
• Try to stay below the jumbo rate if possible, as it is higher than the interest rate on conventional loans. One obvious way to do this is to put more cash down, but another method for remaining below the jumbo limit is to split your mortgage into a first and second mortgage.
• The shorter the mortgage term, the lower the interest rate, so it might be possible for you to move to a shorter term mortgage without a substantial increase in your payments. Moving from a 30 year mortgage to a 15 year mortgage, for example, means that you not only pay a lower interest rate, but you pay less interest because the loan is paid off sooner as well.
• Even if you don’t think you would qualify to refinance because your property has dropped in value, it’s worth your time to check into the possibility. There are still government programs in effect that will backstop your loan, which means lenders will make loans with less equity than would normally be the case.

Although the Fed indicated interest rates would remain low through 2013, there’s no guarantee that mortgage rates will remain at their current lows. Thus, if you think refinancing might make sense for you, we’d advise checking into it in the near future.

Question of the Month – Why Don’t More Advisors Recommend Gold?

Micah Porter, CFA, CFP®

Whenever we hit tough sledding economically, gold rises in popularity as an investment. The most recent downturn was – and is – no exception, as ads for buying gold are everywhere and stores that buy gold have sprung up overnight. Gold is the ultimate bunker investment, and it’s where some investors turn when concerns rise about the global economy. So why don’t more advisors recommend gold?

The primary reason is that over the long run, returns of gold have not been great. Even though gold prices can rise sharply during economic turmoil, they can decline just as sharply. We took a look at the returns of gold for rolling 30 year periods beginning in 1929 and compared those returns to that of a portfolio invested equally in both stocks and bonds. The end results were eye opening, as the balanced portfolio bested gold’s return 84% of the time. Furthermore, the average return of the balanced portfolio over the 30 years was 1230% versus 461% for gold.

For those who are apt to choose a timing approach to investing in gold, it’s useful to take a look at how quickly gold prices fell in 1980, which was the last time we saw a large run-up in prices. As the chart to the left shows, gold can fall in price just as quickly as it rises and timing has the challenges associated with market timing of other investments. Further, unlike most other investments, gold pays neither interest nor dividends while you hold it, which can be problematic if you’re invested during an extended stretch when the price moves little.

For a substitute to gold, understand why you were considering gold in the first place. If it was a question of safety, U.S. Treasuries and very high grade corporate bonds can provide that safety. For inflation protection, Treasury Inflation Protected Securities are one option, as are stocks and real estate. Finally, if you’re seeking diversification, a broader basket of commodities – including gold – can offer a counterweight to the market although in times of extreme economic stress, such an investment is likely to decline in value as well.

All of the foregoing isn’t to say that gold has no place in any portfolio, as it can be a useful investment. However, it’s worth remembering that there are both downsides and challenges to investing that the goldbugs generally fail to mention.

In the most recent quarterly commentary, I noted that the vote on raising the debt ceiling could begin as soon as this past weekend. Unfortunately, that didn’t happen. Instead, talks between the House of Representatives and the White House broke off on Thursday evening. That’s unfortunate, as the deal they were discussing purportedly targeted deficit reduction of nearly $4 trillion over the next decade and included a number of positives, including new revenues and expense reduction in entitlement spending. Each side had to give a bit, but by targeting revenues and expenses, neither would have to be drastically changed.

Ultimately, Speaker Boehner explained that he walked away from the deal because he couldn’t abide a White House request to raise targeted revenues from $800 billion to $1.2 trillion. Subsequent talks between congressional leaders yielded little progress and as a result, both the House and the Senate are pursuing their own bills. Boehner has indicated that he will pursue an increase that requires two steps and two votes – one now and one in 6 months. This strikes us as a bad idea for the economy. To understand why at the most basic level, imagine lending money to someone who tells you that he’ll honor his debt to you now and may continue to do so in 6 months, but he’ll get back to you on that one.

Odds remain high that Congress will ultimately present a bill to President Obama to raise the debt ceiling. However, even absent default, we can’t help but wonder if some damage has already been done. While the debt ceiling increase has been subject to protest votes before, we can’t recall a time in which the increase itself was subject to such legislative wrangling. Further, the idea that over 80 members of the House Tea Party caucus would sign a letter stating flatly they would not vote to increase the limit – in effect stating that they would not honor the government’s financial obligations – is something that to our knowledge has never been done before. Finally, the ratings agencies have indicated that absent a long -term agreement encompassing deficit reduction of a minimum of $3 trillion, a downgrade is a real possibility. With the so-called grand bargain now off the table, it’s unlikely a deal will be forthcoming offering that level of cuts.

The upshot of the foregoing is that we still think it very likely the debt ceiling will be raised, but without a bill that offers greater reduction than now being discussed it seems a downgrade is quite possible. Given that the economy is already facing a faltering recovery, higher interest costs could very well force us back into recession and any immediate austerity as a result of the deal would worsen the situation. Based on these downside risks, we continue to position portfolios defensively, and as we outlined in the commentary, most bond funds have greatly reduced exposure to treasuries.

As to the debt ceiling talks, given the legislative calendar, the House will have to approve legislation this week in order for a bill to ultimately reach the President’s desk by the August 2nd deadline. Thus, we should know in the next few days if the debt ceiling will be raised and what form the ultimate solution will likely take. We will send out more of our thoughts on the topic in the coming week.

David and Susan are in a strong financial position, but the recent decision to adopt has led them to the decision to have a comprehensive plan done. Both David and Susan earn high incomes, and David works as a consultant while Susan splits time between research at a medical university and practicing at the university clinic.

David’s position requires a good deal of travel, and although he has no desire to retire early, he would like to find a less stressful job in his early 50s. Both David and Susan plan to continue working full time once the adoption is complete, and they may hire a nanny or consider daycare for the children. They have fundamental goals in planning: to  adequately fund retirement and to fund education for the children. They want to ensure they are making optimal financial decisions and they would like to have the framework of a plan within which to make those decisions.

Plan Outcome

Given their high savings rate and low spending rate compared to their income, David and Susan are in a strong position. Nevertheless, their position can be strengthened by increasing their stock allocation slightly and by purchasing additional term life insurance to provide income to the surviving spouse in the event of premature death. We also recommend funding 529 plans to cover the educational goals, and we look closely at their various insurance coverages and methods they might use to minimize their tax liabilities.

Note that David recently became eligible for a deferred compensation plan that’s reserved for firm partners. However, the details of the plan are being finalized, and thus we have not included it here. Given its likely materiality, we would update the plan to include the deferred compensation once details are finalized.

Plan Cost

David and Susan’s plan cost $1900, based on 10 hours of work at $190 per hour. In addition, they have requested portfolio design and the fee for that is 0.25% of the portfolio value, or $1125 for a $450,000 portfolio. Should they decide they want to work with Minerva on a retainer basis, the portfolio design fee will be applied to the first quarter’s retainer fee.

Sample Plan #2 Narrative Sample Plan #2

Sarah is a doctor who works for a healthcare provider associated with a large university. She is single and in her late 30s, and although her income has increased substantially since she completed medical school, her spending hasn’t followed suit. Thus, she is in the fortunate position of having substantial disposable income and the matching contributions from her employer to her retirement plans is generous.

She would like to retire in her mid-50’s, although she could put retirement off for a bit if necessary. In addition to contributing the maximum allowable amount to her retirement plans, she is also spending $15,000 each on paying down medical school debt and establishing an emergency fund. Sarah is seeking advice on whether or not her retirement goal is realistic, how best to achieve it and how she should invest.

Plan Outcome

Sarah is close to being on track, but she is more likely to be able to fully fund her retirement if she pushes it back to her late 50’s. Furthermore, her investments are a bit too conservative given her overall risk tolerance and return needs, so we recommend increasing her equity exposure. Lastly, she may want to consider additional disability insurance if it is available so that she can continue to meet her savings goals even in the event of long-term incapacity.

Plan Cost

Sarah’s plan cost $1,330, based on 7 hours of work required at $190 per hour. This cost included all work necessary to complete the plan, plus 2 client meetings to review the initial draft plan as well as the final plan, and subsequent support to answer any questions Sarah had as she worked to implement the plan.

Sample Plan Narrative Sample Plan

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Double-Dip or Just a Soft Patch?
Micah Porter, CFA, CFP®

Over the last few weeks, a spate of economic data has been released that paints a picture of a decelerating economy. Predictably, some have seized on this data to claim that we’re now headed towards a double-dip recession. While that could certainly happen, at this point it doesn’t look as if it’s in the offing.

Since the recovery began, we’ve proposed growth would be moderate and more subject to ebbs and flows than would be the case were this a strong recovery. We based this on the fact that the downturn was driven by the bursting of the credit bubble, and recoveries that follow credit bubbles tend to be tepid and economies require a good deal of time – typically 6 to 8 years – to regain their footing. Academics Carmen Reinhart and Kenneth Rogoff detailed much of this in their book This Time is Different, which culled lessons learned from studying 8 centuries of financial crises.

When recoveries are tepid, headwinds can have a material impact, and in the case of the last few months, two primary headwinds have been rising oil prices (and hence rising prices at the pump) and supply chain interruptions due to the earthquake in Japan. The supply chain interruptions are unquestionably temporary, and most economists believe rising oil and gas prices will prove temporary as well – though the possibility that this won’t happen is certainly a threat to the recovery.

All of the foregoing – along with the widely-held believe that Congress will raise the debt ceiling as I detail below – is why what we’re seeing is likely a temporary slowdown and not the beginning of a double-dip. The business sector is in apparent agreement as well, as surveys show the intent to add to payrolls continues to be positive even in the face of softer economic data. Clearly, there are no guarantees that we won’t experience a double-dip, but based on the data we’re seeing now, it seems unlikely.

Financial Planning Tip – When to Pay Down a Loan

Micah Porter, CFA, CFP®

A balloon loan recently matured on a friend’s car, and her intention was to pay the note.  She weathered a barrage of calls trying to entice her to buy a new car. When she  arrived at the dealership, she ran a gauntlet of sales people offering fantastic deals, and finally met the finance manager with checkbook in hand. She was committed to paying down the loan until the finance manager told her that they could offer a loan for 48 months with a rate under 2% and the ability to prepay at any time. Based on my advice, she put her checkbook away, as the deal was too good to pass up.

So when does it make sense to take a loan versus paying it down? There are a couple of possible scenarios:

• When you have other loans on which the interest rate is higher – generally, you want to pay down your higher interest loans first. One key here is to remember that most of the time mortgages are tax deductible, so if, for example, you’re comparing your second mortgage to another loan that’s not tax deductible, you need to determine the effective rate paid on your second mortgage.
• When you need liquidity – if you don’t have an emergency fund or if your cash needs over the near term are uncertain, it may make sense not to pay off a loan (or roll what’s owed into a very low interest loan). You don’t want to find yourself in a position in which you’ve exhausted your cash by paying down a loan and have a sudden need for cash.

If you decide not to pay down the loan, there are a couple of key points to making the approach work for you:

• Be very careful about taking out a new loan if it has any sort of pre-payment penalty or upfront cost. Both could drive the cost of the loan up, and if that’s the case, it likely won’t make sense.
• Don’t spend the cash you held back on things that aren’t in your plan. If you didn’t pay down the loan because you have higher interest loans, use the cash to pay those down. If you held onto the cash because of a potential liquidity need, only use it for that need – not for something else because you suddenly find yourself with a “windfall”. If the need for liquidity goes away, pay down the loan.
• If it’s a car loan, don’t add any options – just roll over the existing balance. Car dealers will present you with an array of options – most of which revolve around an extended warranty – which they will add to the loan’s principal. Generally, these services cost more than they save you, so odds are you’ll lose in the long run.

There are certainly times when holding on to cash in lieu of paying down a loan makes sense, but you need to make sure you’re very clear on the details of the loan and you have the discipline to use any resulting cash according to plan.

Question of the Month – What is the Debt Ceiling and How Does it Impact Investors?

Micah Porter, CFA, CFP®

Established in 1917, the debt ceiling is a statutory limit on the amount the U.S. government can borrow.  According to National Journal the ceiling was raised 10 times in the last decade alone. It’s worth noting that the debt ceiling will have to be increased because of budgets that were already approved – that we’ve come to this point is no surprise to legislators who only recently approved the 2011 budget.

Posturing about not raising the ceiling is typical. Legislators in the past, particularly those from the out party, often vote against raising the ceiling, secure in the knowledge that the vote to raise the ceiling will ultimately pass. This year, however, House Republicans have made more of an issue about raising the ceiling than usual, claiming that without substantial cuts, they’ll refuse to raise the ceiling. While there is a constituency within the party that would likely favor refusing to raise the ceiling, it’s far more likely that the monied interests within the party would do whatever possible to prevent this from happening.

Failing to raise the debt ceiling would result in having to curtail or delay payments on a host of items including social security, medicare, and debt payments. It would also be the first non-technical default in U.S. history. While few would argue that the U.S. is unable to pay its debts, it would be the first time that our nation proved itself unwilling to do so, even if just for a brief while. The cost of credit would undoubtedly increase as our sterling credit rating was impacted. Higher borrowing rates could easily reverse the current recovery and set us up for much higher debt payments down the line – quite possibly offsetting much of the spending cuts currently demanded by the House majority.

Recently, legislative leaders have been making more positive comments about the progress of the debt ceiling talks. With that in mind and given the host of reasons that failing to raise the debt ceiling doesn’t make sense, it seems highly likely the ceiling will be raised before damage is done to our nation’s credit worthiness.

Best regards,

Micah Porter, CFA, CFP®

The total cost of financial advice includes a number of items we’ve discussed in the last few posts. For clients who work with us those costs include:

• The hourly cost of the plan
• Cost for specific investment recommendations
• The ongoing costs of the investments

Not all financial advisors charge a separate fee for the plan AND for the investment recommendations. As I mentioned in a previous post, advisors who sell commissionable products may not charge a fee for either the plan or the investment recommendation.

Getting a “free” plan and investment recommendations may not be a good deal, however, as the ongoing fees for the investments will, over time, very likely dwarf the upfront cost of a plan. As an example, let’s take a look at a hypothetical investor who has $500,000 to invest and has the opportunity to work with two planners as described below:

Planner A – works on a fee-only basis and charges for both the plan and specific investment recommendations. However, the funds recommended have a lower expense ratio as they do not have to recoup commission costs.

Planner B - charges a reduced fee for the plan and charges nothing for investment recommendations, but does receive a commission from the funds recommended. Thus, these funds have a higher ongoing expense ratio to recoup costs.

For our hypothetical client, here’s how the costs stack up: