ibf - updates - 2009 (q3 v1.1)

Copyright © 2009 by Institute of Business & Finance. All rights reserved. v1.1

QUARTERLY UPDATES

Q3 2009

Quarterly Updates

Table of Contents

ECONOMICS

PREDICTING THE END OF A RECESSION 1.1

FOREIGN DEBT LEVELS 1.2

MUTUAL FUNDS

FOCUSED FUNDS 2.1

ACTIVE VS. PASSIVE MANAGEMENT: 2009 2.1

ETF UPDATE 2.2

LEVERAGED ETFS 2.3

INVERSE AND INVERSE LEVERAGED ETFS 2.4

ETF WEB RESOURCES 2.5

EMERGING MARKET SMALL CAP FUNDS 2.6

MUTUAL FUND MERGERS 2.6

STABLE-VALUE FUNDS 2.6

FRONTIER FUNDS 2.7

2008 FUND RETURNS 2.7

MONEY MARKET FUND COMPOSITION 2.7

MERGED MUTUAL FUNDS 2.8

FUNDS THAT EMPHASIZE DIVIDENDS 2.8

MONEY MARKET FUND CONSIDERATIONS 2.9

CONCENTRATED FUNDS 2.9

GREEN FUNDS 2.10

USER-FRIENDLY PROSPECTUS 2.10

FINANCIAL PLANNING

EARNINGS, REBOUNDS AND CHASING RETURNS 3.1

CREDIT-RATING FIRMS 3.1

FAT TAIL INVESTING 3.2

CREDIT SCORES 3.3

IMPROVING A CREDIT SCORE 3.4

RETURNS FOR IVY LEAGUE SCHOOLS 3.4

EDUCATION VS. HEALTH CARE COSTS 3.5

FINANCIAL PLANNING (CONT.)

MANAGED FUTURES 3.5

SAFETY OF LIFE INSURANCE COMPANIES 3.6

COMMODITY STUDIES 3.7

LASTING IMPACT OF LOSSES 3.8

MONTE CARLO SIMULATION 3.9

HARVARD ENDOWMENT FUND RETURNS 3.9

REASONS TO DIVERSIFY 3.10

MONEY MANAGER RANKINGS 3.11

ANNUITIES

ANNUITY SALES 4.1

STOCKS AND BONDS

BEAR MARKET BENEFITS 5.1

STOCKS VS. BONDS 5.1

MARKET CAP FOR S&P 500 STOCKS 5.2

INDEXED CDS 5.2

HISTORICAL P/E RATIO 5.3

SECURITIES LENDING 5.3

I BOND PAYMENTS 5.4

HOW BOND FUNDS LET INVESTORS DOWN 5.4

RETIREMENT

FUNERAL SHOPPING 6.1

MAXIMIZING SOCIAL SECURITY BENEFITS 6.1

ROTH CONVERSIONS 6.1

REVERSING A ROTH IRA CONVERSION 6.2

DISABILITY INSURANCE 6.2

REAL ESTATE

HOUSING DECLINES 7.1

HISTORY OF AMERICAN HOME OWNERSHIP 7.1

REIT DEBT 7.2

REAL ESTATE FUND UPDATE 7.3

HOUSING MARKET UPDATE (FALL 2009) 7.3

EXPENSIVE U.S. HOUSING MARKETS 7.4

REVERSE MORTGAGES 7.4

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ECONOMICS

ECONOMICS 1.1

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IBF | GRADUATE SERIES

1.PREDICTING THE END OF A RECESSION

The nonprofit group, National Bureau of Economic Research (NBER) defines a recession

as “a significant decline in economic activity spread across the economy, lasting more

than a few months” (note: the most recent recession began in December 2007). It is

generally believed that the six-member NBER Business Cycle Dating Committee will

wait until the U.S. economy has improved to the point when GDP was restored to its

former peak (before declaring the end of a recession).

Even though unemployment figures are often considered a lagging indicator, a number of

experts (e.g., Northwestern University economist Robert Gordon) feel the four-week

moving average is a very reliable signal; the cresting of this average typically means a

recession is within six weeks of its end. However, a recovery can begin even if jobs are

slow to come back—if households are confident enough to increase spending in

anticipation of better times.

In every recession, the economy breaks some rule. Listed below are seven widely used

gauges of economic recovery (listed in no particular order):

[1] University of Michigan consumer expectations—this index is based on how well off

households say they and the country are.

[2] Retail sales—a rise in consumer spending.

[3] Single-family housing starts, annualized—the number of homes construction is

started each month.

[4] Spread between Treasury and corporate bonds—a drop in Baa-rated corporate bond

yields relative to 10-year Treasury notes shows investors are less fretful about extending

credit to companies (making it easier for them to expand).

[5] Purchasing Managers’ Index—based on a survey of purchasing managers; shows how

well the manufacturing sector is doing.

[6] Orders for nondefense capital goods-excluding aircraft—company orders for big

ticket equipment.

[7] Initial jobless claims, four-week average—in the past, when the number of Americans

filing new claims for unemployment peaked, the economy soon began to recover.

ECONOMICS 1.2

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FOREIGN DEBT LEVELS

The table below shows debt as a percentage of 2008 GDP for a select group of countries

(source: Eurostast).

Foreign Debt as a % of GDP

Country Debt % Country Debt %

Spain 40% France 68%

U.K. 52% Italy 106%

Germany 66% Euro zone 70%

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MUTUAL FUNDS

MUTUAL FUNDS 2.1

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2.FOCUSED FUNDS

According to focused fund manager Charlie Bobrinskoy (Ariel Focused Fund), a fund

that typically holds just 20-30 stocks, “it is hard to find 100 great investment

opportunities; why put your money into your 100th

or 50th

best idea, when you can put it

into your 6th

or 19th

best?”

The average stock fund has roughly 170 holdings; the typical focused fund owns just

25 different equities. Those who advocate focused funds point out that an overly

diversified fund can mimic an index fund, but at a much higher cost. Since focused fund

managers have little room for error, they tend to emphasize in-depth stock research and

tend to buy securities selling at a deep discount. For your clients, the challenge of owning

a focused fund is they often require more patience than most investors realistically have.

Focused funds tend to have low turnover rates.

ACTIVE VS. PASSIVE MANAGEMENT: 2009

For the five-year period ending June 30th

, 2009, an S&P study showed that at least 75%

of all bond fund managers lagged behind their respective bond index; the sole

exception was emerging market debt funds. For mortgage-backed securities funds, 98%

underperformed their index; 92% in the case of long-term investment-grade bond funds.

On an asset-weighted basis, index returns beat actively managed fund returns in all

13 fixed-income categories over one and three years, and 11 of 13 categories over

five years. Only emerging market debt and global income funds beat their indexes over

five years. In the case of equity funds, 60% of the large group underperformed their

respective indexes.

The S&P study, as well as other recent studies, shows that when there is less information

about companies, such as small caps or foreign issues, or less liquid markets, such as real

estate or emerging market bonds, active management can provide an edge. A 2009 study

by FundQuest looked at the returns of thousands of actively managed funds from the start

of 1994 through the end of 2008. The study showed that more than 75% of active

managers of foreign small and mid cap growth funds beat their benchmark index. By contrast, fewer than 25% of inter-mediate-term government bond funds beat their

index.

MUTUAL FUNDS 2.2

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What is always missing from the ongoing debate of active versus passive management is

the value of using a broker. If an advisor can steer the client away from some fund that

was up 125% last year (and ends up with a -57% loss by the end of this year), provides a

strategy to permanently reduce taxes or gives ideas as to how a portfolio can be insured

or properly structured, any ongoing fees are a bargain.

ETF UPDATE

As of September 2009, over $670 billion was invested in ETFs. The biggest players in

the ETF marketplace are shown in the table below. Fidelity has just one ETF and T.

Rowe Price has no plans to offer any ETFs. The 10 largest ETF funds account for

roughly 40% of total ETF assets; just 10 ETFs account for nearly two-thirds of average

daily ETF trading volume. There were 846 ETFs and 36 sponsors as of September 2009.

The average ETF has an expense ratio of 0.6%, up from 0.4% at the end of 2005, largely

due to the offering of more complex products. About a dozen ETFs have assets of more

than $10 billion; these large funds have bid-ask spreads of less than 0.09%.

ETF Sponsors—September 2009

Sponsor Assets Sponsor Assets

Barclays $317 billion ProShares $26 billion

State Street $152 billion Van Eck Global $8 billion

Vanguard $66 billion Bank of NY Mellon $7 billion

Invesco PowerShares $37 billion U.S. Commodity Funds $7 billion

Commodity ETFs came into existence in 2003 and represent about 9% of the ETF

universe. During August of 2009, the U.S. Natural Gas Fund (UNG) was trading at a

16% premium to gas futures while PowerShares DB Oil Fund, which tracks crude oil

futures, was trading at a 0.3% premium.

Small ETFs can have substantial bid-ask spreads. A few have spreads of more than 13%;

nearly 200 ETFs have spreads of over 0.5%.

MUTUAL FUNDS 2.3

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Actively Managed

It took the ETF industry almost 10 years to get regulatory approval for actively managed

funds (e.g., PowerShares Active Alpha series, Grail American Beacon Large Cap Value,

RiverPark series, PIMCO, State Street and Vanguard).

In addition to looking at relative performance and market expectations, consider the

following to decide whether index funds or actively managed funds (or both) make sense

for you. Consider index funds if: [1] You lack the time or desire to research and monitor

funds. [2] You are content to match the overall market, not beat it. [3] You want lower-

cost funds. Index funds typically have lower expense ratios. [4] You are investing in a

taxable account. Index funds are typically more tax-efficient than active funds.

Consider actively managed funds if: [1] You have time and interest to research and

monitor funds. [2] You want to beat the market. Long term, top funds may outperform

their indexes (though active funds can underperform as well). [3] You want more

downside protection. Some active managers strategically increase cash holdings in times

of distress. [4] You are looking for broader diversification. In categories such as bonds,

active funds may provide more diversification.

LEVERAGED ETFS

For the first half of 2009, some pairs of ETFs designed to profit from opposite moves in

markets had both either risen or fallen. ProShares Ultra Real Estate, which aims to

double the daily performance of the Dow Jones U.S. Real Estate Index, was down 46%.

ProShares UltraShort Real Estate, designed to deliver twice the inverse of the index’s

daily rise or fall, lost 64% over the same period (while the index fell 12%).

Exchange-traded funds that use leverage often have returns that do not match their

objective. For example, the S&P 500 dropped 38.5% in 2008, but the double-leveraged

S&P 500 short fund (UltraShort S&P 500 ProShares), rose 61%, not 77%. The ProShares

fund designed to return twice the opposite of the Dow Jones U.S. Real Estate Index was

down 50% for 2008 while the index was also down 43% (note: based on the ETF’s

description, the index should have gained about 86%, less its expense ratio, any loan

interest and trading costs).

Where the confusion (and faulty math) comes in is the wording of leveraged funds’

objectives. Typically, these funds are designed to have two or three times the returns of

their underlying index; in the case of “short” funds, the return is expected to be 2-3 times

the opposite of what the index experiences. However, in both cases (long and short), such

math is based on the index’s daily move—not its cumulative move over a week, month,

quarter, year or some other extended period of time.

MUTUAL FUNDS 2.4

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For example, suppose you have a 2X “long” ETF with a beginning NAV of $100 and a

corresponding index that also happens to have a starting point of $100. The index goes up

5% the first day (from 100 to 105) and then drops 10% the next day (from 105 down to

94.5). While your client might think the corresponding ETF should fall 11% from its

peak (5.5% loss x 2), the ETF actually will fall 12%. Here is why: for the first day, the

2X fund goes from $100 to $110; the second day it drops from $110 to $88 (a 20% loss).

The disparity becomes even greater over an extended period.

For example, on October 10th

, 2008 you had a client who had $100,000 into an S&P 500

index fund and wanted to offset this position by putting $50,000 in the UltraShort S&P

500 ProShares (a 2X ETF). Two months later, despite large market swings, the S&P 500

was virtually unchanged from its October 10th

starting date. The “2X short” ETF fund

experienced a cumulative return of -24% (a $12,000 loss from the original $50,000).

INVERSE AND INVERSE LEVERAGED ETFS

The performance results shown in the table below are for the first three quarters of 2009

plus the first day of October (when the market dropped 2%—a plus for all of the funds

listed below). The “Should Be” column shows what the loss should have been (e.g., if the

DJIA were up 8% for the year, a DJIA short fund should be -8%; a 2X DJIA should be -

16%). The “Actual” column shows the actual return of the fund. As you can see, actual

losses have been far greater than what should have been—using simple math (note: all

ETFs have an expense ratio and brokerage fees which should, rightfully, narrow the gap

between “Should Be” and “Actual.”

There are three reasons for the differences between the “Should Be” and “Actual”

returns: [1] ETF expense ratio, [2] cost of margining (in some cases) and [3]

magnification of consequences when index moves in opposite direction hoped for (e.g., if

X drops 40%, it will take a gain of >60% to get back to even).

MUTUAL FUNDS 2.5

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ETF Short Funds

ETF (symbol) Benchmark Should Be Actual

UltraShort S&P 500 (SDS) S&P 500 (2x) -28% -40%

Short S&P 500 (SH) S&P 500 -14% -20%

Inverse 2x S&P 500 (RSW) S&P 500 (2x) -28% -44%

Short Dow 30 (DOG) DJIA -8% -15%

UltraShort Dow 30 (DXD) DJIA (2x) -17% -32%

Large Cap Bear 3x Shares (BGZ) Russell 1000 (3x) -48% -60%

UltraShort SmallCap 600 (SDD) S&P SmallCap 600 (3x) -31% -47%

UltraShort Russell 2000 (TWM) Russell 2000 (2x) -37% -52%

Small Cap Bear 3x Shares (TZA) Russell 2000 (3x) -56% -72%

UltraShort Russell 2000 Growth

(SKK)

Russell 2000 Growth

(2x)

-37% -62%

Short MSCI EAFE (EFZ) MSCI EAFE -17% -26%

UltraShort MSCI EAFE (EFU) MSCI EAFE (2x) -34% -50%

ETF WEB RESOURCES

Cumulative investments in ETFs represent about 5% of what is invested in mutual funds.

Funds have been around for more than 80 years; the first U.S. ETF was launched in 1993.

Listed below are free web sites designed for ETF advisors and investors.

morningstar.com/goto/etfs: perhaps the most comprehensive ETF internet resource.

finance.yahoo.com/etf: basic knowledge plus a large number of data tables.

marketwatch.com/tools/etfs/html-homeasp: includes snapshot of the day’s biggest

gainers, losers and most actively traded; site also features profiles and fund details as well

as searches based on a wide range of criteria.

indexuniverse.com: a mix of research, analysis and breaking news; this site is geared

more toward sophisticated advisors and investors.

etftrends.com: this site was started by Tom Lydon (a well-known ETF writer) in 2005

and generates 8-10 articles a day.

MUTUAL FUNDS 2.6

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etfguide.com: launched in 2003 by two former financial advisors, this site provides

news, commentary and research plus weekly picks and pans.

etfdb.com: portfolio constructor by using one screen at a time; the site caters to long-

term as well as active traders.

EMERGING MARKET SMALL CAP FUNDS

As of September 2009, there were just 10 emerging market small cap funds (e.g.,

Templeton, Wasatch and Matthews) and just one such ETF (SPDR S&P Emerging

Markets Small Cap ETF).

MUTUAL FUND MERGERS

Over the past couple of years, 300-400 mutual funds merged with other funds. Fund

families tend to merge funds that are poor performers into other funds. Another reason

can be expenses; very small funds cost more to manage.

STABLE-VALUE FUNDS

Stable-value funds typically invest in highly rated corporate debt and highly-rated

structured securities, such as asset-backed securities, commercial mortgage-backed

securities and residential mortgage-backed securities. The goal is to deliver returns that

are 1-2% higher than a money market fund.

The funds back up these bonds with contracts, known as wrappers, from banks, insurers

or other financial companies. The protection provided by these wrappers cost a fund

0.15-0.20% of its assets per year. A key measure of a stable-value fund’s financial health

is the ratio of its actual market value of its underlying holdings to its book value. The

ratio was 99% at the end of 2008, 95% in the early part of 2009 and 98% in August of

2009.

MUTUAL FUNDS 2.7

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FRONTIER FUNDS

Frontier markets are generally those that do not make it to “emerging” status because

they are too small, illiquid or otherwise inaccessible. Such traits can make their price

movements dramatic. While commodities are a driver in many frontier markets, so

are long-term domestic growth prospects. The long-term story is likely to a

convergence of incomes, technology, living standards and labor costs.

The MSCI Frontier Markets index, which contains 25 countries, peaking in January 2008,

then dropped 69% by early March 2009. From the bottom hit in March 2009, the index

rose 51% by the beginning of June 2009. For this 2008-2009 period, the correlation

between frontier markets, the S&P 500 and the MSCI Emerging Markets index was

extremely high.

2008 FUND RETURNS

The best performing domestic equity fund earned 0.4% for 2008; the second-best

performer posted a loss of -2.6% (vs. -34% for the Dow and -38% for the S&P).

At the beginning of 2008, there were just 14 stock and balanced funds that had

beaten the S&P 500 for nine years in a row. By the end of 2008, there was just one

fund (a “lifestyle” fund of stocks and bonds—Manning & Napier Pro-Blend Maximum

Term Securities) that had done better than the S&P for each of the past 10 years (-35%

vs. -38%).

MONEY MARKET FUND COMPOSITION

Money market funds can put as much as 5% of assets in securities with the second-

highest credit rating, known as A2/P2. As of the end of June 2009, 96% of eligible

commercial paper in money market funds was tier one and the 4% balance tier two.

According to the SEC, only a modest percentage of all money market funds hold any tier

two paper.

MUTUAL FUNDS 2.8

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MERGED MUTUAL FUNDS

During 2008, 208 mutual funds merged; for the first half of 2009, there were 208 such

mergers. Fund mergers occur for one or more reasons: [1] to eliminate duplicate

offerings, [2] to get rid of poor historical returns and [3] to save money. A mutual fund

typically becomes profitable once its asset base is $50 million or more. Many large fund

companies are only interested in overseeing funds that have assets of at least $500

million.

FUNDS THAT EMPHASIZE DIVIDENDS

For 2008, the typical dividend-focused fund lost about 25%, while the S&P 500 dropped

about 38%. Fund managers believe that while the ranks of companies that pay good

dividends have thinned, dividend growth eventually will rebound along with the

economy. The appeal of dividend funds is straightforward: [1] dividend preferential tax

rate of 0% or 15%, [2] rising dividends provide some inflation protection and [3]

dividend rates can be very competitive to CD and short-term bond rates. When

considering dividend-enhanced mutual funds, keep in mind that fund strategies differ.

Equity income funds emphasize a high level of income by buying stocks of companies

such as utilities as well as other industries wherein investors expect lower growth or a

possible future dividend cut. Other funds, which focus on “dividend growth” or “dividend

building,” are looking for companies whose dividends may not be high now, but are

expected to grow in the future. These funds sometimes yield 2-3% less than an equity-

income-type fund. Examples of dividend-oriented funds include Thornburg Investment

Income Builder, T. Rowe Price Dividend Growth, Franklin Rising Dividends, Eaton

Vance Dividend Builder and Vanguard Dividend Growth.

MUTUAL FUNDS 2.9

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MONEY MARKET FUND CONSIDERATIONS

As of October 2009, the average money market fund had a seven-day yield of just 0.05%

(source: iMoneynet Inc.). From the middle of 1999 through the first three quarters of

2009, the typical taxable money market fund’s yield ranged from just under 6% (early

2001) to well under 1% (middle of 2009). Over the same period, inflation ranged from a -

2% (second and third quarter of 2009) to about 5.5% (third quarter of 2008). From the

middle of 2002 until toward the end of 2006, the average money market fund’s return

was less than inflation by an average of 1%.

According to Lipper data, the average short-term investment-grade bond fund beat the

average taxable money market fund over the 10 years through mid-September 2009

(3.8% vs. 2.6% annualized). But short-term funds actually trailed money funds over the

past three and five years. Although short and ultra-short funds are often a favored choice

for liquidity and yield, advisors cannot assume all offerings are safe—Schwab YieldPlus

lost 35% in 2008 and was down 10% for the first three quarters of 2009.

CONCENTRATED FUNDS

Based on Morningstar data, there were 300 funds with 40 or fewer stocks, excluding

funds of funds and index funds, out of a universe of 4,800 equity funds as of the end of

the 2009 third quarter. According to Morningstar’s data on volatility and performance:

[1] as a group, concentrated funds have not consistently outperformed or underperformed

funds with more diverse holdings and [2] on average, concentrated funds are not more

volatile than diversified funds. Most stock funds adopt “the safety-in-numbers”

approach, with an average of about 180 stocks. A Morningstar study of returns from 1992

through 2006 fund that volatility was fairly close between the least and the most

concentrated funds, as measured by standard deviation.

MUTUAL FUNDS 2.10

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GREEN FUNDS

In many ways, “green” investing is a subset of socially responsible investing, where fund

managers typically use a set of screens to weed out stocks of companies that do not meet

certain criteria, usually relating to environmental, social and corporate-governance issues.

There are three dozen dedicated green mutual funds and ETFs. These sectors can be quite

volatile, as illustrated by the bankruptcy of multiple ethanol and biofuel producers as well

as struggles among small solar-power companies. Examples of green portfolios

include: Claymore/MAC Global Solar Energy Index, Market Vectors Solar Energy,

PowerShares WilderHill Clean Energy, New Alternatives, Winslow Green Growth, Pax

World Global Green, Portfolio 21, Northern Global Sustainability Index, Alger Green,

Green Century Balanced and PowerShares Water Resources.

USER-FRIENDLY PROSPECTUS

Starting in 2010, mutual funds must provide brief summaries describing a fund’s

investment objectives and strategies, risks, costs and performance. Also required to be

included in the summary is information on the fund’s investment advisers and portfolio

managers, procedures for buying and selling funds, compensation to brokers and tax

implications. Funds have the option of including these summaries as early as March

2009.

Your clients will be able to find the summaries at the front of a fund’s prospectus. Fund

companies can provide investors with just a printed copy of the summary, provided they

post it and the full prospectus online and make printed copies available upon request

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FINANCIAL PLANNING

FINANCIAL PLANNING 3.1

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3.EARNINGS, REBOUNDS AND CHASING RETURNS

From March 9th

to August 29th

, 2009, the DJIA was up 46%. For its entire 113-year

history, only six rebounds in the Dow have been bigger and faster. The Dow had a 46%

gain in the 117 days ending April 30th

, 1930; it then lost almost 51% over the next year

(meaning a $10,000 investment increased to $14,650 and then dropped to $7,179).

Another 47% upswing in 1971 led to a choppy decline of 37%. In March 2009, stocks

traded as low as 11.7 times their average earnings for the previous 10-year period,

adjusted for inflation. The long-term average is 16.3 times earnings.

Research consistently shows investors chase past performance, buying whatever has

made the most money for other people. What is not commonly understood is that

investors also chase their own past performance, buying more of whatever they

themselves have made the most money on. Research by Harvard economist David

Laibson shows 401(k) participants tend to add significantly to whichever funds they

already own that have gone up the most.

In the classic book, “The Intelligent Investor,” Benjamin Graham wrote, “The investor

with a portfolio of sound stocks should expect their prices to fluctuate and should neither

be concerned by sizable declines nor become excited by sizable advances.” According to

Graham’s definition, if one cannot exercise that kind of emotional control, then they are

not an investor.

CREDIT-RATING FIRMS

The SEC designates 10 credit-rating firms as “nationally recognized.” The title is

important because many companies require the use of a nationally recognized credit rater

when relying on a rating. The big three firms, Standard & Poor’s (McGraw-Hill),

Moody’s and Fitch (Fimalac SA), are paid by debt issuers for ratings; other firms are

funded by subscriber fees. Critics feel firms paid by issuers, such as the big three, create a

conflict of interest.


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FAT TAIL INVESTING

For the 2008 calendar year, a 60/40 portfolio (60% stocks and 40% bonds) lost about

20% (note: the typical balanced fund was down 27% while the S&P was off 37%).

Standard portfolio construction tools assume that such a loss occurs once every 111

years. A number of brokerage firms believe conventional assumptions about market behavior

substantially underestimate risk. New Wall Street tools assume market returns fall along

a “fat-tailed” distribution (as opposed to the traditional “skinny-tailed” standard deviation

distribution). Mathematician Benoit Mandelbrot recognized the relevance of fat-tailed

distributions (meaning extreme returns are more likely than conventional wisdom

has dictated) in the 1960s. These modeling tools were never widely used, partly because

the math was so complex.

During the middle of 2009, Morningstar’s Ibbotson Associates unit began to include fat-

tailed assumptions into its Monte Carlo assumptions, which estimate the odds of reaching

retirement financial goals. The new assumptions present risk quite differently. Under a

fat-tailed distribution, a 60/40 portfolio should experience a loss of 20% once every 40

years (vs. once every 111 years under a normal (“skinny-tailed”) distribution, assuming a

bell-curve-type distribution (note: the validity of standard deviation is highly

questionable if there is not a bell curve distribution—which there is not, according to

critics of standard deviation).

Fat-tailed assumptions can lead to conservative portfolios by cushioning the downside

while sharply curtailing the upside. Nobel Prize winner Harry Markowitz pioneered

standard deviation as a risk measurement tool for investors. A criticism of his analysis is

standard deviation gives equal weight to upside and downward movements—yet, most

investors fear losses much more than they value gains. According to PIMCO’s Mr.

Bhansali, “comprehensive measures of risk fail you in many cases when you need them

the most.”


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CREDIT SCORES

Your clients actually have several different credit scores. FICO, developed by Fair Isaac

Corporation, ranges from 300 to 850 and varies depending on which credit bureau is

reporting the FICO score and the kind of lender that is requesting a score. Three credit

bureaus, Equifax, Experian and TransUnion, each sell their own proprietary scores.

Credit scores are misunderstood, for example: [1] they do not reflect a client’s whole

financial picture, just a snapshot of their debt at a point in time; [2] it is irrelevant

whether there is a balance due, but it does matter if payments are made on time; [3] the

score bought by someone may not be the score seen by lenders and [4] credit inquiries

can show up on a report, even if client is not applying for new credit.

FICO Credit Score

Factor and Weight Explanation

Payment history [35%] Payment history—bills paid on time

and if not, frequency of late payments.

Amount owed [30%] How much is owed on each account

and how much of each credit limit is used.

Credit history [15%] How old is each account.

New credit [10%] Number of new accounts or queries.

Types of credit [10%] Kinds of debt.

A credit score does not reflect income, employment history or assets. It does not show

whether rent or utilities are paid on time. Credit bureaus have no idea whether or not

someone pays a bill in full or carries a balance each month. All they know is the amount

owed on the most recent statement. The biggest concern is how much available credit is

being used. Generally, keep credit use to less than half the credit limit to minimize the

impact on your credit score.

About 30% of a FICO score is based on “credit utilization” (amount owed), a broad term

that includes how much of each credit card limit has been used, how much one has

borrowed as a percentage of total available credit and how big the dollar balances are; the

most important factor of a FICO score (35% of total) is whether or not bills were paid on

time. One late payment can ding a score for up to a year; very late payments can impact a

score for 2-3 years—collections and bankruptcies can affect a score for up to seven years.


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Closed accounts in good standing will stay on your credit history for a decade. A credit

history can go back 30 years. Preserving credit history can be a plus. If you do not

formally close an account (but instead let the issuer close it for lack of activity), the

longer the account stays open, thereby adding to your credit history.

Credit scores are not affected by “soft inquiries” such as being pre-approved for a card or

when a credit card company is keeping tabs on your credit. However, in other instances,

someone checking your credit, even though you are not applying for a loan, can knock 15

points off a score. Shopping around for a car, education or mortgage loan only counts as

one inquiry as long as it is all done within a few weeks. Your clients can see all factors

used to determine a score (but not their credit score) for each of the three major reporting

agencies for free, once a year, by going to AnnualCreditReport.com.

IMPROVING A CREDIT SCORE

There are three main crediting reporting agencies, Experian, Equifax and TransUnion.

Reporting agencies are more concerned with how revolving credit (e.g., credit cards) is

handled than installment debt (e.g., car loan and mortgage). Listed below are five ways to

improve a credit score.

1. pay bills on time; payment history counts for ~35% of a credit score.

2. lengthen credit history; ~15% of a credit score is based on history.

3. keep credit balances low (25% of available credit if possible); ~30% of a score.

4. minimize credit score requests; ~10% of a score.

5. ask credit reporting agencies to stop unsolicited credit offers.

RETURNS FOR IVY LEAGUE SCHOOLS

The returns earned by Ivy League schools such as Harvard and Yale have become

legendary in recent years. The stated reason for their success has been a higher-than-

normal allocation to “nontraditional” asset categories such as emerging market equity and

debt, energy and commodities. For example, as of the middle of 2008, Yale had just 10%

allocated to U.S. stocks but 29% to real assets.


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Most individual investors do not qualify for hedge fund, private equity or venture capital

partnerships that make up a large part of university endowments. At Yale, 25% of the

endowment was in “absolute return” vehicles such as hedge funds and another 20% in

private equity. However, during the 2008 meltdown, a number of endowment managers

learned the downside of illiquidity. Exit doors for most private equity and venture capital

funds slammed shut. Existing positions stopped yielding cash flow and demands were

made to investors for additional capital. A number of investors in these illiquid positions

were forced to sell during a weak market to fund cash needs and also to meet prior

commitments to these and other investment funds. For the fiscal year ending June 2009,

the University of Pennsylvania was expecting to post a 16% drop, Harvard was

anticipating a 30% decline and Yale a 25% loss.

EDUCATION VS. HEALTH CARE COSTS

According to the chief economist at Moody’s Economy.com, over the 10-year period

ending December 31st, 2008, education costs rose 5.9% annually versus 4.2% for health

care costs. Over this same period, wages and income rose 3.7% per year. As a side note,

The Federal Reserve pointed out that U.S. household net worth dropped by $11 trillion in

2008. This 18% decline equaled the combined GDP of Germany, Japan and the U.K.

MANAGED FUTURES

The Barclays CTA Index was up 4% for 2008 and gained an average of 12.2% since

1980, losing money in only three of those calendar years (1980 through 2008). Academic

research shows commodity futures have kept pace with inflation and rivaled returns of

stocks, with the feature of tending to go up whenever stocks or bonds go down. Despite

these appealing features, there are several negatives to futures funds:

[1] Many commodity trading advisors (CTAs) charge a 2% annual fee plus 20% of any

“new net profit” plus client may have to pay up to 6% “introducing broker” fee (after all,

the broker or advisor needs to be compensated) in order to get into the futures fund.

[2] Historical figures of CTAs are tainted—they include return results only from those

managers who choose to report their returns to industry databases (few, if any, lesser-

known advisors are going to report bad numbers).

[3] Correlation coefficients with other classes could increase—this often occurs when a

new investment idea is embraced by the financial services industry.


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SAFETY OF LIFE INSURANCE COMPANIES

An A.M. Best study spanning 1977 to 2007 found that just 0.06% of insurers with an

A++ or A+ grade were impaired one year later, compared to 2.0% of B and B- carriers

and 6% of C and C- insurers. Fitch, Moody’s and S&P each have seven variations of an

A rating; 47% of insurers have some type of A rating from Fitch, 81% from S&P and

89% from Moody’s. A.M. Best has four different types of A ratings. B grades are even

more spread out. Fitch, Moody’s and S&P each use nine versions of B, defined as

everything from “good,” “adequate,” “marginal,” “weak,” “questionable,” and “poor.”

The table below, based on 2,100 ratings awarded to 809 life insurance companies in early

2009, shows what percentage of the insurers rated received a rating of “excellent.”

Percentage of Insurers Rated “Excellent”

Rating Agency # of Insurers Rated % Rated “Excellent”

Standard & Poor’s 282 81%

A.M. Best 598 66%

Moody’s 140 55%

Fitch 452 47%

TheStreet.com 625 11%

According to information analyzed by Money Lab and Consumer Reports, “Moody’s and

S&P say their rating scales are not necessarily directly comparable with other agencies’

because of differences in data, rating criteria and scoring models.” Fitch says its B+

rating is comparable to Best’s C++. TheStreet.com (formally Weiss Ratings) says its C-

equals Best’s B++, S&P’s A+, Moody’s Baa3 and Fitch’s A-. TheStreet.com is the only

agency that does not accept payment from any companies it rates. Its research is financed

by the sale of guidebooks and reports to investment advisors and libraries. By contrast,

100% of Best’s and Moody’s ratings are paid for by insurers. Fitch and S&P ratings are

hybrids; insurers sponsored 44% of Fitch’s ratings and 82% from S&P.

Generally, financial strength ratings are based on analysis of an insurer’s balance sheet,

capital and reserve ratios and other financial vital signs. The data is mostly from reports

insurers file with state regulators plus market data from independent sources. All five of

the major services use this objective data in their proprietary “quantitative” analysis

models.


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Analysis from TheStreet.com ends with the analysis described above. The other four

agencies meet with an insurer’s management team and learn about the company’s plans.

These meetings add an element of subjectivity and create a potential conflict when the

insurer pays the rating agency.

COMMODITY STUDIES

Roger Ibbotson and Peng Chen (also of Ibbotson & Associates) completed a research

paper in 2003-2004 that attempted to discern where hedge fund returns came from.

According to Chen (May 2009 interview in Wealth Manager magazine), “two-thirds of

the returns are tied to the stock market…We found that hedge funds compared to other

money managers are probably a better place to generate alpha, and we still believe that.”

One of the earliest academic pieces on commodities was a 2004 Yale University article

by Gorton and Rouwenhorst titled, “Facts and Fantasies about Commodity Futures.”

Using an equally weighted index of 34 different commodity futures for the period July

1959 to March 2004, the authors concluded, “In addition to offering high returns, the

historic risk of an investment in commodity futures has been relatively low—especially if

evaluated in terms of its contribution to a portfolio of stocks and bonds.”

A March 2004 study commissioned by PIMCO and conducted by Ibboton (“Strategic

Asset Allocation and Commodities”) was also quite positive about the use of

commodities, “in addition to impressive historical returns, commodities had the lowest

average correlation to other asset classes; yet, the positive correlation to inflation

supports the idea commodities result in real inflation-adjusted returns.”

In September 2006, Harry Kat at City University in London published, “Is the Case for

Investing in Commodities Really that Obvious?” Kat believed investors and advisors had

a too simplistic approach to supply and demand. According to Kat, “Supply and demand

relationships in commodity markets are extremely complex and completely different for

different markets; even experts are known to get it very wrong at times.” Kt noted that

the 2004 Gorton and Rouwenhorst study (see above) only looked at one specific

portfolio—a different portfolio could easily have produced very different results. The

Gorton and Rouwenhorst study did not “account for the high degree of heterogeneity in

commodities.” Kat also cites a 2006 paper by Erb and Harvey (“What Every Investor

Should Know About Commodities”) that pointed out commodities do not offer investors

a consistent risk premium.


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Earlier inflated claims about commodity returns are less frequent, partially due to an in-

depth study of historical returns of individual commodities and criteria used to produce

commodity indices. Opinion is still quite divided over the degree of protection

commodities add to a portfolio as well as their reliability as a hedge against

inflation. The table below shows correlation coefficients for asset classes over a three-

year period ending December 31st, 2008.

Correlation Coefficients [2006 thru 2008]

TIPS REITs

Commodities

T-bills

Foreign

Stocks

Foreign

Bonds

TIPS --

REITs 0.4 --

Commodities 0.4 0.3 --

T-bills 0.2 0.2 0.2 --

Foreign Stocks 0.4 0.6 0.6 0.2 --

Foreign Bonds 0.7 0.3 0.2 0.1 0.4 --

LASTING IMPACT OF LOSSES

The table below shows the impact of a portfolio loss of -10% up to -50% and the number

of subsequent years needed to recover (assuming positive returns ranging from 2% to

10%).

Recovery Time After a Loss

Subsequent

Return

Degree of Portfolio Loss

-10% -20% -30% -40% -50%

4% 2.7 years 5.5 years 9.0 years 12.7 years 17.2 years



10% 1 year 2.2 years 3.5 years 5.2 years 7.0 years

For retired investors, a loss can be particularly painful if periodic withdrawals are being

made. Basic studies show that the sequence of annual returns has no impact on ending

value, but this is certainly not the case if there are periodic withdrawals. A market drop,

coupled with an income withdrawal can compound any such loss.


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MONTE CARLO SIMULATION

A number of financial advisors have become skeptical about the validity of Monte Carlo

simulation: “I take whatever probability of failure that comes out of the simulation and

add 20%” (William J. Bernstein, author of The Four Pillars of Investing). Other critics

point out that there are no standard assumptions used; Monte Carlo software programs

frequently use different assumptions about interest rates, inflation and volatility.

A major criticism of this simulation is that its validity is based on an asset’s return being

a bell-shaped curve. While a bell-curve model indicates that there is almost no chance of

a greater than 13% monthly decline in the S&P 500, such declines have happened at least

10 times since 1926 (e.g., -16.8% in October 2008, but not another such drop until

October 1987 when the market returned -21.5%).

HARVARD ENDOWMENT FUND RETURNS

For the fiscal year ending June 30th

, 2009, the median loss for the typical large

endowment fund was -18%, versus 27% for Harvard (for the category “real assets,”

which includes commodities and real estate, the annual loss was almost 40%). Harvard’s

endowment managed pointed out the fund’s annual return over the previous 10 fiscal

years averaged 8.9%.


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REASONS TO DIVERSIFY

The table below shows seven asset categories and the best-performing category for each

of the past 25 years (shown in boldface type).

Total Returns: 1984-2008

S&P

500

Small

Stocks

EAFE

Index

Emerging

Markets

U.S.

Bonds

Foreign

Bonds Cash

1984 6.3% -7.3% 7.9% --- 15.1% --- 9.8%

1985 31.7% 31.0% 56.7% --- 22.1% 27.2% 7.7%

1986 18.7% 5.7% 69.9% --- 15.3% 23.0% 6.2%

1987 5.2% -8.8% 24.9% --- 2.8% 18.4% 5.5%

1988 16.6% 25.0% 27.9% 40.4% 7.9% 4.4% 6.3%

1989 31.6% 16.3% 12.0% 65.0% 14.5% 4.3% 8.4%

1990 -3.3% -19.5% -22.7% -10.6 9.0% 11.2% 7.8%

1991 30.4% 46.0% 14.0% 59.9% 16.0% 16.0% 5.6%

1992 7.6% 18.4% -11.0% 11.4% 7.4% 5.8% 3.5%

1993 10.1% 18.9% 34.9% 74.8% 9.7% 11.1% 2.9%

1994 1.3% -1.8% 6.6% -7.3% -2.9% 0.2% 3.9%

1995 37.5% 28.4% 9.9% -5.2% 18.5% 19.7% 5.6%

1996 22.9% 16.5% 6.7% 6.0% 3.6% 4.9% 5.2%

1997 33.3% 22.4% 2.0% -11.6% 9.6% 3.8% 5.3%

1998 28.6% -2.5% 14.5% -25.3% 8.7% 13.7% 4.9%

1999 21.0% 21.3%% 30.9% 66.4% 0.8% -5.2% 4.7%

2000 -9.1% -3.0% 15.1% 30.6% 11.6% 3.2% 5.9%

2001 -11.9% 2.5% 19.5% -2.4% 8.4% 1.6% 3.8%

2002 -22.1% -20.5% 14.7% -6.0% 10.3% 16.5% 1.6%

2003 28.7% 47.2% 41.4% 56.3% 4.1% 12.5% 1.0%

2004 10.9% 18.3% 21.4% 25.9% 4.3% 9.3% 1.2%

2005 4.9% 4.5% 17.1% 34.5% 2.4% -4.5% 3.0%

2006 15.8% 18.4% 27.2% 32.6% 4.3% 6.6% 4.8%

2007 5.5% -1.6% 17.1% 39.8% 7.0% 9.5% 4.7%

2008 -37.0% -33.8% -45.2% -53.2% 5.2% 4.8% 1.7%


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MONEY MANAGER RANKINGS

The table below shows the 10 biggest asset managers at the end of 2008. Barclays was

acquired by BlackRock in late 2009 (meaning Blackrock was the largest money

management company at the end of 2009); asset numbers represent billions of U.S.

dollars (source: Pensions & Investments).

12-31-08 Largest Money Managers

Manager Market Total Assets

Barclays Global Investors U.K. $1.52b

Allianz Group Germany 1.47b

State Street Global U.S. $1.44b

Fidelity Investments U.S. $1.39b

AXA Group France $1.38b

BlackRock U.S. $1.31b

Deutsche Bank Germany $1.15b

Vanguard Group U.S. $1.14b

J.P. Morgan Chase U.S. $1.14b

Capital Group U.S. $0.98b

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ANNUITIES

Annuities 4.1

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4.ANNUITY SALES

New Variable Annuity Sales

[ranking and market share percentage: 1st Quarter 2009]

Rank / Insurer % Rank / Insurer %

[1] MetLife 13% [11] AIG 4%

[2] TIAA-CREF 12% [12] Pacific Life 3%

[3] AXA Financial 10% [13] Nationwide Life 3%

[4] Prudential Financial 7% [14] Hartford Life 2%

[5] John Hancock Life 7% [15] U.S. units of Aegon 2%

[6] U.S. units of ING 6% [16] Sun Life of Canada 2%

[7] Lincoln National 6% [17] Fidelity Investments 2%

[8] Jackson National 5% [18] Ohio National Life 1%

[9] Ameriprise Financial 4% [19] Mass Mutual Life 1%

[10] Allianz Life 4% [20] Thrivent Financial 1%

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STOCKS AND BONDS

Stocks and Bonds 5.1

QUARTERLY UPDATES


5.BEAR MARKET BENEFITS

Ask your clients, “Would you rather start investing during a bull or bear market? A 2009

T. Rowe Price study shows that those who began to systematically invest in equities

during past severe bear markets were significantly better off 30 years later than investors

who began during bull markets.

The study looked at four hypothetical investors who each invested $500 per month into a

retirement account that mimicked the S&P 500 over a 30-year period (dividends

reinvested). One investor started in 1929, one in 1950, another in 1970 and the fourth

investor began in 1979. The two bear market investors who began making contributions

in 1929 and 1970 started just before two of the worst market declines in modern history.

From 1929 through 1938, the S&P averaged -0.9% per year; +5.9% per year during the

1970s. Each of these investors made contributions that totaled $60,000 ($500 x 12

months x 10 years). By the end of 1938, the first bear market investor had $88,255; the

second bear market investor had $86,047 by the end of 1979.

The two bull market investors, who also had cumulative investors of $60,000, ended up

with $152,359 (1950-1959) and $137,370 (1979 through 1988), a 19.4% and 16.3%

annualized S&P 500 return. Despite the initial advantage the two bull market investors

experienced, cumulative returns at the end of 30 years (the initial 10 years cited above

plus 20 more years) favored the bear market investors because they acquired more shares

during the bear market periods.

Even though the 1930s marked the beginning of the worst 30-year period for stocks,

the S&P 500 averaged an annualized 8.5% from 1929 to 1958. Over this 30-year

period, the market was up 960%. The other bear market investor (who started in 1970

had a 30-year total return of 1,753%). In contrast, the two bull market investors (who

began in 1950 and 1979) each earned less than 400% over 30 years.

STOCKS VS. BONDS

Over the past half century, the best year for stocks was 1975 (+37% for the S&P 500); the

worst year was 2008 (-37%). By contrast, the best year for bonds was 1982 (+36%),

while the worst year was 1999 (-6%). The Reuters/Jefferies CRB Index, the oldest global

commodities index had annualized returns of 8.6% for the 10 years ending 12/31/2008.

Over the past 200 years, stocks have beaten bonds by 2.5 percentage points a year, with

half of that advantage occurring 1949-1965, according to Rob Arnett of Research

Affiliates.


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MARKET CAP FOR S&P 500 STOCKS

At the end of 2008, Standard & Poor’s lowered market capitalization guidelines used for

a number of its indexes. The cut-off capitalization for a stock to be considered in the S&P

500 is now $3 billion or greater; $750 million to $3.3 billion for the S&P MidCap 400

and $200 million to $1 billion for the S&P SmallCap 600.

INDEXED CDS

Indexed CDs have been around for two decades, with annual sales in the $2-3 billion

range. The investment is issued by banks and typically sold by financial planners and

brokers. Investors who cash out early can lose money.

During the third quarter of 2009, Barclays Bank offered an indexed CD based on

the S&P 500 with a five-year term. The CD owner will earn up to 50% of the S&P

500’s gain; if the S&P 500 has a cumulative loss over the five-year period, the

investor gets back 100% of principal.

Some indexed CDs have what are called “barriers” or “knock out rates.” These terms,

found in the CD contract, can limit the investor’s return. For example, suppose your

client bought a CD tied to the S&P 500 with a 60% “barrier.” If the S&P had a

cumulative gain that ever exceeded 60%, the investor would end up getting back just

principal. If the term of the contract was five years, this means that if the S&P was up a

total of 60.01% after 19 months, the client would have to wait another 41 months to get

back his principal (there would be no gain since the barrier was breached at some time

during the contract’s term).

Besides carefully reading the CD contract, the advisor needs to discern how the

underlying index’s value is measured as the market goes up and down. Some CDs used

average quarterly or annual returns; others use a more straightforward “point to point”

method. Some indexed CDs base their returns on two or more indexes.

Indexed CDs are not tax efficient and are best owned in a sheltered account. The investor

is taxed each year on “phantom” income, which in the case of an indexed CD is generally

a small predetermined amount listed in the CD’s disclosure statement. Indexed CDs are

generally FDIC insured (principal and interest) up to $250,000 per account.


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HISTORICAL P/E RATIO

According to Morgan Stanley, since 1984, the S&P 500 has had an average trailing p/e

ratio of 16.9; from the beginning of 2007 through the third quarter of 2009, the p/e has

ranged from just under 11 (toward the end of 2009) to about 15 (middle of 2007). Based

on a “forward” p/e (12 month forecast), the p/e was 14.7 as of the end of September

2009, just below the 25-year average (1984-2009) of 14.9.

Surprisingly, low expected earnings per share (EPS) usually translate into higher stock

returns. The Ned Davis Research table below covers the period from the beginning of

1980 through February 2009. As you can see, when expected EPS is high, returns have

suffered.

Expected EPS Growth S&P 500 Gain Per Year

> 14.2% -3.4%

4.2% to 14.2% 6.5%

< 4.2% 11.7%

Buy/hold 6.8%

SECURITIES LENDING

Securities lending allows a fund to make money on its stocks and bonds, without having

to sell them, by lending them out and earning interest. Borrowers post cash collateral of

102-105 cents on the dollar. According to Data Explorers, securities lending generated

about $1.4 billion in gross income for the U.S. mutual fund industry in 2008. The lending

firms earn more by taking the interest payments and reinvesting them. It is estimated that

securities lending can add up to 1/4th

of 1% of a funds annual return; in the case of small

stock funds, the “bonus money” can add a full percentage point.

Some fund managers, acting as lending agent, keep 50-100% of the income generated

from the lending. Other firms, such as T. Rowe Price and Vanguard rebate 100% of all

securities lending money back to the funds that generated it.

Revenue bonds are secured by a public service or enterprise, such as a water or sewer

utility. For core, essential services, revenues for these types of bonds have generally

remained strong. While history is not a perfect future guide, consider:


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I BOND PAYMENTS

Series I Savings Bonds (I bonds) investors will earn 0% for the first months of 2010, the

first time this has happened since 1998. I bonds, which all have a maturity of 30 years,

are comprised of two parts: a fixed rate (set at 0.10% by the Treasury for new issues that

are purchased during the middle of 2009 and last for the bond’s life, and the inflation rate

as measured by the CPI. For the September 2008 to March 2009 period, the inflation rate

was an annually adjusted -5.6%. The interest rate credited to I bonds cannot fall below

zero (source: www.savings-bond-advisor.com and Bankrate.com).

HOW BOND FUNDS LET INVESTORS DOWN

In theory, bond funds should be a haven from bear markets in stocks. The most widely

used investment-grade bond market benchmark, the Barclays Capital Aggregate Index

(formally the Lehman Aggregate) gained 5.2% in 2008. But what about the first five

months of 2009?

For the first five months of 2009, the average intermediate-term bond fund lost 4.7%;

excluding the top 5% performers (-3.5%), funds in the bottom 95% lost an average of

20.7%. The reasons the losses were so steep was many intermediate-term bond funds

held risky bonds. The Barclays (Lehman) index is only comprised of investment-grade

debt issues. Since 1999, there has only been one year (2003) when the average fund

topped the index.

http://www.savings-bond-advisor.com/

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RETIREMENT

Retirement 6.1

QUARTERLY UPDATES


6.FUNERAL SHOPPING

The Federal Trade Commission spells out your clients’ rights involving funerals on its

Web site (ftc.gov and type “funerals” in the search box). Advisors should recommend

their clients compare prices from at least two funeral homes. Another useful site is the

nonprofit Funeral Consumers Alliance (100 local chapters). AARP has detailed articles

on how to shop for a funeral and burial arrangements.

MAXIMIZING SOCIAL SECURITY BENEFITS

If someone needs extra money between the ages of 62 and 70 and the only choice is

either taking Social Security benefits or tapping tax-deferred retirement accounts, the

decision may largely depend upon what can be earned in the tax-deferred accounts. The

higher the return, the more sense it makes to take Social Security benefits either early or

at one’s normal retirement age. Generally, if the tax-deferred return is above 5%, taking

Social Security is the better option.

Roth IRA withdrawals are not included as income when determining the taxation of

Social Security benefits. However, taxable money withdrawn from a traditional IRA or

other tax-deferred account is included.

ROTH CONVERSIONS

As of January 1st, 2010, individuals may convert their traditional IRA into a Roth IRA,

regardless of how much money they earn. Before 2010, those with modified adjusted

gross incomes of $120,000 ($176,000 if a joint return) could not make the conversion.

Taxpayers can either report the conversion amount as income for the year of conversion

or spread out the tax liability over the subsequent two years—if the conversion is done in

2010. For example a $50,000 conversion made in 2010 could either be reported as

$50,000 of additional income for 2010 or $25,000 of income for 2011 and $25,000 for

2012. If a conversion is made any year other than 2010, taxes must be paid for the year of

conversion. Generally, it does not make financial sense to make a Roth conversion if the

tax liability is paid from money inside the traditional IRA.

Retirement 6.2

QUARTERLY UPDATES


REVERSING A ROTH IRA CONVERSION

You may have clients who converted a traditional IRA into a Roth IRA and subsequently

experienced a moderate-to-severe market loss in the newly created Roth IRA. Such an

event would result in an ordinary income tax liability on the converted amount even

though the client later experienced a drop in value. By reversing a Roth IRA conversion,

you can help the client eliminate any inflated conversion tax bill.

Your clients have until October 15th

(of the year of conversion) to reverse the

conversion. The deadline is applicable whether or not the taxpayer extended the filing

date of their tax return to October 15th

. When a traditional IRA is converted, the IRA

custodian or trustee reports such information on IRS Form 1099-R.

When a traditional IRA is converted into a Roth, the taxpayer pays ordinary income taxes

on the entire amount converted—but such tax liability assumes the investor converted all

traditional IRA accounts. If your client holds multiple IRAs, the taxable percentage is

based on the total balance of all traditional IRAs. If a converted account is reversed (the

IRS uses the term “recharacterization”), the tax hit disappears. A taxpayer must wait at

least 30 days after conversion before the reversal (recharacterization) can occur.

DISABILITY INSURANCE

According to the U.S. Commerce Department, one in seven workers can expect to be

disabled for five years or more before they retire; one in five will suffer a disability

lasting a year or more, according to the National Association of Insurance

Commissioners. Three in 10 workers who enter the work force today will become

disabled before retiring. Of the more than 6.8 million workers receiving Social Security

Disability benefits (which average $1,000 a month), half are under age 50. To qualify for

such Social Security insurance, one must be disabled for five calendar months and have a

disability expected to last for a total of at least 12 months or otherwise end in death. The

disabled person must also be unemployable at any occupation, not just his or her own line

of work.

The National Safety Council gauges that 90% of disability accidents and injuries are not

work-related and, therefore, not covered by workers compensation. One disability

reinsurer (JHA) believes 90% of disabilities are caused by illness, vascular problems,

musculoskeletal conditions and cancer are among the medical causes of most disabilities,

with pregnancy an additional factor for women.

Retirement 6.3

QUARTERLY UPDATES


According to Harvard University, medical disability led to nearly half of the 1.5 million

bankruptcy filings in 2001. An earlier study by the Housing and Home Finance Agency

found that 48% of home foreclosures were the result of disability while just 3% resulted

from the homeowner’s death.

Top 6 Causes of Long-Term Disability

[source: JHA Disability Fact Book, 2008]

Musculoskeletal 27% Cancer 10%

Circulatory System 13% All Other 9%

Nervous System Disorder 12% Injury / Poisoning 13%

Top 6 Causes of Short-Term Disability

[source: JHA Disability Fact Book, 2008]

Musculoskeletal 22% Pregnancy (complicated) 8%

Injury / Poisoning 13% Cancer 8%

Pregnancy (normal) 12% All Other 8%

Types of Disability

There are two types of disability income (DI): short- and long-term. Short-term DI

insurance typically pays a percentage of salary for 13-52 weeks after a short waiting

(elimination) period, such as one day for an accident and eight days for an illness. Long-

term DI kicks in after the short-term policy has expired. The percentage of salary

payments is generally in the 50-67% range. The checklist below can help your client

compare different disability policies (source: American Council of Life Insurers).

[1] How is disability defined? Some benefits are based on any occupation while others

are based on own occupation (a more expensive policy).

[2] How will benefits be paid? Some policies make payments if you can only do part of

your job; others pay benefits if you are unable to work full time.

[3] What is the policy’s elimination period? Almost all policies have a waiting period

before benefits commence.

[4] Are benefits paid if the disability results in less income? Some policies will pay the

difference between what you are earning now versus pre-disability.

Retirement 6.4

QUARTERLY UPDATES


[5] Is there a return-to-work or rehabilitation provision? Some policies help pay for

training or work environment modification.

[6] Is there a new waiting period if there is a reoccurring disability? If there is a relapse

within a specified period after returning to work, most policies will not require an

additional waiting period.

[7] Is there a cost-of-living adjustment (COLA)? A COLA provision ensures increased

payments in the future (but policy premiums are much higher).

[8] What about mental illness or substance abuse? Policies usually limit payments for

such disabilities to two years unless institutionalization is required.

[9] Is the policy non-cancellable and/or guaranteed renewable? A non-cancellable policy

means premiums can never be decreased. Guaranteed renewable means premiums can

only increase for the entire class, not a specific individual. Both of these types of policies

can usually be renewed until age 65 and cannot be cancelled as long as premiums are

paid.

QUARTERLY UPDATES


QUARTERLY UPDATES

REAL ESTATE

Retirement 7.1

QUARTERLY UPDATES


7.HOUSING DECLINES

The table below show percentage decline in home prices by city from the June 2006 peak

through June of 2009 (source: S&P/Case-Shiller); 32% of all mortgages have negative

equity, meaning property is worth less than its out-standing debt (source: 1st American

CoreLogic).

Housing Percent Decline [6-2006 through 6-2009]

City Decline City Decline

Las Vegas - 54% Washington D.C. - 31%

Miami - 48% Chicago - 25%

San Francisco - 43% New York - 21%

Los Angeles - 41% Boston - 14%

San Diego - 41% Denver - 9%

HISTORY OF AMERICAN HOME OWNERSHIP

From 1900, when the U.S. census first started gathering data on home ownership, through

1940, fewer than half of all Americans owned their own homes. Home ownership

actually fell in three of the first four decades of the 20th

century. But from that point

forward (with the exception of the 1980s, when interest rates were extremely high), the

percentage of Americans living in owner-occupied homes steadily increased. Today,

more than two-thirds of Americans own their own homes. Among whites, more than 75%

are homeowners today. We are a nation of homeowners and home speculators because of

Uncle Sam.

Before the Great Depression, the government played a minuscule role in housing (the

1913 federal tax code allowed a deduction for home mortgage interest payments). Until

the 20th

century, holding a mortgage came with a stigma—you were a debtor. Mortgages

were also hard to come by. Lenders typically required 50% or more of the purchase price

as a down payment. Interest rates were high and terms were short, usually 3-5 years.

Home ownership was largely divided between the wealthy (who paid cash) and working

class folks who built their own homes because they could not afford a mortgage. The

Depression changed every-thing. Between 1928, the last year of the boom, and 1933, new

housing starts fell 95%. Half of all mortgages were in default.

Retirement 7.2

QUARTERLY UPDATES


Herbert Hoover signed the Federal Home Loan Bank Act of 1932, laying the groundwork

for massive federal intervention in the housing market. In 1933, Roosevelt created the

Home Owners’ Loan Corporation to provide low interest loans to help out foreclosed

homeowners. In 1934, F.D.R. created the Federal Housing Administration, which set

standards for home construction, initiated 25- and 30-year mortgages and cut interest

rates. In 1938, his administration created the Federal National Mortgage Association

(Fannie Mae), which created the secondary market for mortgages. In 1944, the federal

government extended generous mortgage assistance to returning veterans.

Easy credit, underwritten by federal housing programs, boosted homeownership rates; by

1950, 55% of Americans owned a home. By 1970, the figure had risen to 63%. It became

cheaper to own than rent. Federal intervention also unleashed vast amounts of capital that

turned home construction and real estate into critical economic sectors. By the late 1950s,

for the first time, the census bureau began collecting data on new housing starts.

During the 1960s and 1970s, those who had been excluded from the postwar housing

boom were aided by the newly created Department of Housing and Urban Development,

which expanded ownership to minorities. The 1976 Community Reinvestment Act forced

banks to channel resources to underserved neighborhoods. Activists successfully pushed

Fannie Mae to underwrite loans to buyers once considered too risky for conventional

loans.

During the late 1990s and the first years of the new century, the dream of home-

ownership turned hallucinogenic. The Clinton and Bush administrations engaged in the

biggest promotion of homeownership in decades. Both pushed for public-private

partnerships, with HUD and government-sponsored financiers such as Fannie Mae. New

tools, including securitization of mortgages and subprime lending, made it possible for

even more Americans to live the dream.

REIT DEBT

In recent years, equity REITs pursued higher leverage to boost profits. The greater the

debt, the higher the risk; companies with less debt are less volatile. From 1996 through

the first quarter of 2009, REIT leverage as a percentage of asset value went from 40% to

75%. Debt as a percentage of net operating income went from a ratio of 4-1 to just over

6-1.

Retirement 7.3

QUARTERLY UPDATES


Milton Cooper, often credited with starting the modern REIT era when he took retail

landlord Kimco Realty public in 1991, stated, “Very little can go wrong with 25% debt;

I’d love to see the (REIT) industry not get seduced by leverage.” Public Storage’s

leverage was 27% during the first part of 2009. Analysis by Green Street showed that of

the 29 major REITs studied, Public Storage had the best track record, delivering an

average annual return of 15% to investors over the 15 years ending December 31st, 2008.

Green Street found that during those 15 years, every one percentage point increase in

leverage was accompanied by a 0.4% decrease in annual returns for equity REITs in

general.

REAL ESTATE FUND UPDATE

As of the middle of 2009, the biggest real estate funds were Vanguard REIT Index,

Fidelity Real Estate Investment, T. Rowe Price Real Estate, DFA Real Estate Securities

and Russell Real Estate Securities. The largest real estate mutual funds own a wide

variety of commercial real estate such as office space, storage facilities, shopping malls,

medical and industrial buildings. The funds own shares of big, publicly traded REITs

such as Simon Property Group, Public Storage Equity Residential, Vornado Realty Trust

and AvalonBay Communities. The largest real estate ETFs include: iShares Dow Jones

U.S. Real Estate Index, iShares Cohen & Steers Realty Majors Index, SPDR Dow Jones

REIT and Vanguard REIT ETF.

Some advisors view equity REITs almost like a bond holding, since the category has

historically provided a high dividend stream. Other advisors feel the category’s 1.5 beta

makes it a riskier-than-normal consideration.

HOUSING MARKET UPDATE (FALL 2009)

Based on the 10- and 20-city S&P/Case-Shiller Home Price Indices, housing prices

peaked in June or July 2006. From their peak to April 2009, these two indexes were down

34% and 33% respectively. As of September 2009, S&P estimated that there were still

about one-third more existing homes for sale than average.

Retirement 7.4

QUARTERLY UPDATES


EXPENSIVE U.S. HOUSING MARKETS

The table below shows the most expensive housing markets in the nation, based on the

average price paid for a 2,200-square-foot, four-bedroom home for the first three quarters

of 2009. For the second year in a row, La Jolla topped the list; the lowest price similar

home sold for $113,000 and was located in Grayling, Michigan (source: Coldwell Banker

Real Estate).

2009 Most Expensive U.S. Housing Markets

Market Change From 2008 Average Price

La Jolla (San Diego), CA +17% $2,125,000

Beverly Hills, CA +11% $1,982,000

Greenwich, Conn. -15% $1,519,000

Palo Alto, CA -14% $1,490,000

Santa Monica, CA -12% $1,461,000

San Francisco, CA -10% $1,363,000

Boston -10% $1,338,000

Newport Beach, CA -15% $1,316,000

Palos Verdes, CA -4% $1,237,000

San Mateo, CA -20% $1,090,000

REVERSE MORTGAGES

As of February 2009, the maximum home value that seniors can borrow against for a

reverse mortgage increased from $417,000 to $625,500. Congress also passed a 2% cap

on the first $200,000 and 1% on any amount over that, with fees not to exceed $6,000.

Other upfront costs include an insurance premium and closing costs.

ibf - updates - 2009 (q3 v1.1)

Documents

mutual funds focused

bond funds

green funds

concentrated funds

frontier funds

merged mutual funds

money market fund composition

stablevalue funds