Annuities Now Allowed in Target Date Funds

Posted on December 10, 2014 | AAII Journal

Deferred annuities are now to be held by target date funds within qualified defined-contribution plans, such as 401(k) plans. The inclusion of annuities allows target date funds to provide lifetime income to employers holding such funds.

Target date funds alter their allocations by their date. Far-dated funds use an aggressive allocation strategy and the allocations gradually grow more conservative as a target date fund approaches its target date. The changes are designed to match the investment needs of various age groups.

Currently, widely available target date funds do not have an age restriction. This presents a difficulty for insurers, because it makes pricing an annuity contract difficult. Insurers prefer a restricted age group for making actuarial assumptions. By restricting specific target date funds to older employees, however, a retirement plan would run afoul of the discrimination clause in the tax code. The tax code bans qualified plans from discriminating “in favor of highly compensated employees.” To the extent that older employees have higher salaries than younger employees, restricting access to investors within a specific age group by a target date fund could cause problems.

The tax code does allow the Internal Revenue Service some flexibility in establishing guidelines for qualified plans, and the agency used this flexibility to create a special rule. Target date funds in qualified plans can now restrict the age of their shareholders if certain conditions are met. The series of target date funds offered within a qualified plan must all have the same manager and use the same generally accepted investment theories. The target date funds available to older employees can include deferred annuities, as long as those contracts don’t provide a guaranteed lifetime withdrawal benefit (GLWB) or a guaranteed minimum withdrawal benefit (GMWB). Fees and expenses must be determined in a consistent manner and the target date funds can only hold the employer’s securities if such securities are publicly traded.

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Selecting a Valuation Method to Determine a Stock’s Worth

Posted on December 9, 2014 | AAII Journal

Investing is about earning a financial return. Valuation is at the heart of investing—you need to find a stock selling at an attractive price relative to its intrinsic or underlying value, otherwise your prospects for a financial return are poor.

Wait, you say, that sounds like value investing and I am a growth investor. We feel this dichotomy is unnecessary. All investing is about identifying companies for which we expect to earn a handsome financial return. Why would we want to buy companies selling above their intrinsic value? We might be willing to buy them if the current price is equal to the intrinsic value, as a fair financial return would be expected. However, ideally we would prefer to find companies where the current price is well below intrinsic value. Whether you are a value investor or a growth investor, you are likely concerned about the price you are paying relative to intrinsic value (including the company’s growth prospects). All investors should therefore assess the value of the company using some valuation method and compare that value to the current market price. Doing otherwise is to speculate, not invest.

All valuation methodologies are not created equal and no single method applies to all companies or works in all market conditions. Some valuation methodologies are more appropriate in certain circumstances and not in others. In this article, we examine different valuation methodologies and provide guidance for selecting the method most appropriate in particular circumstances.

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The Individual Investor’s Guide to Personal Tax Planning 2014

Posted on December 5, 2014 | AAII Journal

We start this year’s tax guide with some good news: You may have a smaller federal tax bill in 2015.

The Internal Revenue Service (IRS) adjusted several line items to account for inflation. This indexing increases the dollar amounts defining each tax bracket and the dollar amounts for various exemptions and deductions. The net result is that less of your income may be taxed. Plus, if you are just above the breakpoint for a tax bracket this year, the adjustments could potentially put you into a lower tax bracket in 2015.

The amount of any federal tax savings will vary by taxpayer. Some of you may actually pay more, particularly if your income is higher in 2015 or if there are certain exemptions or deductions that you no longer qualify for. A new penalty for not having health insurance is now in effect as well. Still, many taxpayers will get a savings next year. Wolters Kluwer, CCH estimates that a married couple with total taxable income of $100,000 will pay $125.50 less in income taxes in 2015 than they will on the same income in 2014, assuming they file a joint return. An unmarried person with income of $50,000 will pay $62.50 less in 2015 than he or she will in 2014. Keep in mind that these are just estimates. The numbers also exclude the impact of state and local taxes.

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Christine Benz’s checklist for rolling over your 401(k)

Posted on October 22, 2014 | AAII Journal

If you are changing jobs or are close to retirement, you will be considering what to do with your 401(k) plan assets. Even if you ultimately decide to leave your investments in your former employer’s plan, you should investigate your options to ensure you are making the best choice. Morningstar’s Christine Benz created a checklist of steps to take.

Check your account value: Account balances above $5,000 open the door to many options, including leaving it with your former employer (if the plan allows you to do so) or rolling it into an IRA or your new employer’s 401(k). If your account balance is below $5,000, your former employer can legally remove you from its plan. Balances below $1,000 can be cashed out.

Determine whether you want to stay within the 401(k) confines: This decision will be partially determined by your former and/or current plans’ guidelines. If you are allowed to do so, you will need to weigh the pros and cons. Employer retirement plans offer some protections and can give you access to fund options not available outside the 401(k) structure. Alternatively, moving your account outside of the 401(k) structure gives you more choices.

When making this decision, compare the costs and fund selection of the 401(k) plan(s) against the options available to you through an individual brokerage or mutual fund account. If you like the 401(k) structure and have the option of either staying with your former employer’s plan or moving it to your new employer’s plan, you will need to compare and contrast the two. Also, look at your options for rolling over to an IRA account, which can be held at the brokerage firm or mutual fund company of your choosing.

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Weight by Fundamentals, Not by Price

Posted on October 15, 2014 | AAII Journal

Robert “Rob” Arnott is the chairman and chief executive officer of Research Affiliates. He has published many research papers, served as the editor in chief for the Financial Analysts Journal and pioneered several unconventional strategies, including the Fundamental Index approach. We spoke recently about his quantitative approach to managing stock portfolios.
—Charles Rotblut

Charles Rotblut (CR): Given your background in quantitative analysis, what suggestions could you give individual investors regarding stock characteristics and ratios that lead to better returns?
Robert Arnott (RA): The characteristics that historically produce the best returns are value measures. A higher yield does deliver a higher return and a lower price-earnings ratio delivers a higher return. One of my favorites is a lower price-to-sales ratio. While largely ignored, it does deliver a higher return.

To me, the more important opportunities are not so much in individual stocks as they are in portfolio construction. Typically when you buy a stock, the size of your investment in that stock drifts up and down with price—the higher the price, the higher the weight of the stock in your portfolio. That’s also the Achilles’ heel of market-capitalization-weighted index funds. So reweighting the portfolio to mirror the economic footprint of the business—something we call the Fundamental Index approach—weights companies by the fundamental size of the business and not by the popularity or price of the stock. This turns out to add a lot of value, partially because you’re trading against the market. As the stock’s price soars, if the underlying fundamentals aren’t soaring, if the company isn’t actually getting bigger, then a Fundamental Index portfolio will prompt you to sell some of what you own.

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Real Returns Favor Holding Stocks

Posted on October 7, 2014 | AAII Journal

Charles Rotblut (CR): You have a reputation for being bullish on the stock market, but from reading “Stocks for the Long Run,” it sounds like you’re more focused on the ability of stocks to prevent the loss of purchasing power than making a call on the direction of the market. Is that correct?

Jeremy Siegel (JS): My book emphasizes that the long-run return on stocks is between 6.5% and 7% per year after inflation (Figure 1). This return has been very stable in the long run. Over time stocks are good hedges against inflation, so they keep up with inflation and purchasing power, but even aside from that their returns are excellent compared to fixed-income assets. They dominate fixed-income assets, and particularly in today’s low interest rate environment I think the margin by which stocks will outperform bonds is even greater than it historically has been.

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Figure 1. Total Returns on U.S. Stocks, Bonds,
Bills, Gold and the Dollar, 1802–2013



Managing Cash Flow in Retirement

Posted on September 24, 2014 | AAII Journal

Combining a year’s worth of cash with a long-term investment portfolio protects immediate needs while still enabling the portfolio to grow.

Given the headwinds of inflation, return sequence, and a low return environment, what’s an investor to do?

The traditional income portfolio (i.e., one that provides annual cash flow from dividends and interest) will not work for a number of reasons. First, the current level of interest rates and dividend yields has no relationship to what would be an appropriate retirement portfolio allocation. For example, the current yield on a 20-year A-rated corporate bond is about 3.9% and the yield on the S&P 500 index is 1.8%. For a client looking to achieve a 4% cash flow, that means his portfolio allocation would have to be 100% bonds. Of course, this would be a short-lived solution, as over time the purchasing power of the nominal return from bonds would be eroded annually by inflation. Plus, the investor’s income is variable as interest rates change. Not to mention that how the investor feels and the economic reality of the value of his or her portfolio move in opposite directions, exacerbating the situation. When rates are down, portfolio income decreases and the investor feels poor, even though the portfolio value would actually be increasing. When interest rates rise, portfolio income goes up and the investor feels richer, even though the reality is his or her bond portfolio value is dropping.

A viable solution must provide consistent real cash flow in a volatile, long-term low return market environment. It was with this in mind that we created the Evensky & Katz two-bucket approach back in the early 1980s. Here’s how it works.

An investor’s nest egg is bifurcated into separate portfolios: the Cash Flow Reserve (CFR) portfolio and the Investment Portfolio (IP). When originally designed, the CFR was funded with two years of cash flow needs; subsequent research at Texas Tech University determined that a one-year reserve was optimal. Figure 1 visually describes the strategy.

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Figure 1. Evensky & Katz Portfolio Approach



An Inside Look at Exchange-Traded Funds

Posted on September 22, 2014 | AAII Journal

Exchange-traded funds (ETFs) have been one of the most successful financial innovations in recent years.

Since the introduction of ETFs in the early 1990s, demand for these funds has grown markedly in the United States, as both institutional and individual investors have increasingly found their features appealing.

In the past decade alone, total net assets of ETFs have increased nearly twelvefold, from $151 billion at year-end 2003 to $1.8 trillion as of June 2014, as shown in Figure 1.

With the increase in demand, sponsors have offered more ETFs with a greater variety of investment objectives.

Like mutual funds, ETFs are a way for investors to participate in the stock, bond and commodity markets; achieve a diversified portfolio; and gain access to a broad array of investment strategies.

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Figure 1. Total Net Assets and Number of ETFs
figure 1



Stress Hormone Alters Tolerances for Financial Risk

Posted on September 19, 2014 | AAII Journal

A sustained increase in the stress hormone cortisol leads to both a reduced tolerance for risk and an increased preference for perceived safer, but lower-return outcomes. This physiological response to stress may be a contributing cause to financial market instability, particularly during times of increased uncertainty.

A team of British and Australian researchers reached these conclusions after conducting a study on participants using a combination of cortisol dosing and computerized lottery games. The study was designed to measure risk preferences under placebo-treated, acutely elevated cortisol and chronically elevated cortisol conditions. Though the researchers had previously tested cortisol levels on London traders, this experiment allow them to test responses under controlled conditions.

The researchers focused on cortisol because long-term exposure to raised levels can impair behavioral flexibility and promote anxiety, depression and learned helplessness. The researchers said the effects associated with long-term exposure to elevated cortisol “could be expected to discourage risk taking.”

First, they looked at the average utility curve. The flatter the utility curve is, the less marginal benefit is derived from each incremental increase in the amount of benefit. In other words, a flatter utility curve implies that a person is less willing to incur greater risk in order to reap bigger potential rewards. Participants receiving acute doses of cortisol showed no significant difference in risk aversion than the control (placebo) group did. Participants with chronically elevated cortisol had a “large” increase in risk aversion, however.

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Allocate by Market Weight (And Adjust for Personal Circumstances)

Posted on September 16, 2014 | AAII Journal

Charles Rotblut (CR): I’d like to discuss allocation, starting with rebalancing. A lot of people either psychologically have a problem doing it or just won’t do it. What are your thoughts?

William Sharpe (WS): I think, by and large, people probably shouldn’t do it. In particular, rebalancing by selling winners and buying losers. Basically, if you’re going to sell your winners and buy your losers, then you have to trade with someone. And that person has to take the other side of the trades. If you’re smart doing that, then the other person must be dumb to trade with you. So the questions are: Why is that a good thing to do, and what’s the matter with the other person for trading with you?

We can’t all rebalance, because rebalancing to pre-selected proportions means selling relative winners and buying relative losers. Since we can’t all do that, the question is: If this is the obvious thing to do, with whom are you going to trade? Who is it? And why should the other person trade with you? In an efficient, sensible or informed market, such rebalancing will not be a good strategy.

I would like to see a very-low-cost index fund that buys proportionate shares of all the traded stocks and bonds in the world. Unfortunately, there are none at present. It would be good if there were one or more used by a great many investors as their main investment vehicle. While such a fund is not available, you can construct one from existing index funds, but then you have to monitor the current world values of the components—for example, the value of all the U.S. bonds for the U.S. bond index fund, the value of all the non-U.S. bonds for that fund and the value of all the world stocks for that fund. I’ve talked to my friends in the index fund business, and thus far nobody seems to be interested in producing that. It is a huge hole and individual investors could really use such a fund.

CR: What about adaptive allocation? I know you’ve written about the subject.

WS: Here is a simple way to think about this. Assume that at the moment stock values are 60% of the total value of bonds and stocks, that bond values are 40% and that you just want to have the risk and return of the average investor. Then you should invest 60% in stocks, 40% in bonds. And now, let’s say, stocks go up and bonds go down, so the market values are now 70%/30%. If you want to continue to be the average investor, you should have 70%/30% proportions. But when you look at your portfolio values, you are likely to find that they are already close to 70%/30%. And you didn’t have to do anything. This won’t be exactly the case due to new security issues and things of that sort, so you might have make some minor adjustments, probably when reinvesting dividends and bond payments. But the trades will be small. The idea is to have a policy that indicates what proportions you want when the market proportions are, say 60%/40%, and then keep your relative risk constant as market values change (Figure 1). The formula that I suggest for adaptive asset allocation works from this basic policy and indicates the proportions that you should have as market proportions change.

In the simplest case where you just want to take the risk of the average investor, the formula just says that your policy should be to hold the same proportions as the market. If you want to have a policy of being more risky than the average investor, then you have to look at the formula. But it’s a very easy formula.

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Figure 1. How Adaptive Allocation Works




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