December 2008 Newsletter

Avoid the Bernie Madoffs in the world![i]

[1] Thanks to Tom Posey, of Posey Capital Management for help with this portion.

The buzz on Wall Street is still the Bernard Madoff Ponzi scheme, which appears to have vaporized $50 billion.

What did he do? He allegedly collected money to invest from clients, made up false statements to show that they were doing well, and used new clients' money to pay interest and withdrawals to existing clients.

The majorities of his clients were thought to be very sophisticated, but didn't see this coming. Could they have? Let's look at three key safety tips that would have prevented this from happening.

1. Stick to stocks, bonds, ETFs, and mutual funds that are publicly traded and listed on major exchanges like the New York Stock Exchange. They are valued independently at least daily, if not minute-by-minute, while the exchange is open. You can check their reported returns against your own portfolio. If you can't look up the prices and performance in the newspaper or on the Internet - that's a red flag - ask a lot more questions.

2. Be sure your advisor uses an independent account custodian. Madoff held his client assets, managed them, and priced them, too. See the conflicts of interest? Investment performance can look better if the prices reported to clients are manipulated, which is allegedly how Madoff showed winning year after winning year despite market turmoil. At Creative Financial Design, our client assets are held by an independent third party, Charles Schwab. We have no input on investment pricing and that separation is a very good thing. The only power we have over those accounts is to make trades and deduct fees. Clients also get an independent statement directly from Charles Schwab each month.

3. Check on insurance. Our clients benefit from fraud insurance. The first part is the Securities Investor Protection Corporation (SIPC) coverage for $500,000 per account. Then Charles Schwab buys additional coverage from Lloyd’s of London that provides protection of securities and cash up to an aggregate of $600 million, and is limited to a combined return to any customer from a Trustee, SIPC and Lloyd’s of $150 million, including cash of up to $1 million. Fraud insurance does not protect against market declines, but it does protect against theft of securities and/or related fraudulent transactions.

If an investment sounds too good to be true, it probably is. Reportedly, Madoff claimed consistent monthly returns of 0% to 2% (annual returns of 10-12%) with little volatility and no annual losses. This claim of making money in up-markets while not participating in declines is impossible.

My final Madoff thought is this: I have seen this same type of Ponzi scheme pulled off in Lansing and Flint three times. The first time I was in competition with the gentleman who pulled it off. He got the business and the customer got the shaft.

Which type of planning advice do you want in 2009?[i]

The following is my overview of a white paper by Dave Loeper, CEO of Wealth Capital Management in Richmond, VA. Dave was one of the very early adopters of the Monte Carlo modeling technology in building portfolios and communicating volatility more meaningfully to clients.

Dave is attempting to calculate the benefit of a financial planner who tends your investment portfolio, and constantly rebalancing back, not just to the original tolerances, but to the equity exposure you would need in order to achieve your goals. This exposure is a moving target; in times like these, when the markets have put many of you behind your retirement goals, there would need to be a higher allocation to equities. Other times, when you are ahead of the game, the planner would give you a reasonable chance of success with fewer equities. The net effect is to broaden clients’ exposure during down markets, when there is an expected recovery, and reduce clients’ exposure as they achieve their goals and effectively take them out of the way of whatever bear market might set them back.

The paper runs to 40 pages, so I'll offer a quick summary of the high points. If you would like to see the total paper, let me know and I will send it to you.

Dave's central thesis is that advisors should manage client wealth instead of client returns, and that they should make their asset allocation decisions on an ongoing basis based on their evaluation of where a client is relative to his/her funding goals. In many cases, he says, clients are already overfunded, and should not be heavily weighted in equities; the advisor should lock in their achievement of the goal. Clients who are underfunded should be encouraged to save and invest more money in the markets, to freeze spending and/or raise the allocation to equities. The asset allocation decisions are based on each client's funded status, with the full recognition that we don't know what the markets will do in any given year or decade.

The test Dave chose is a woman who happened to be widowed in 1926. She needs to generate $5,000 a year in real (inflation-adjusted) income (about $50,000 in today's dollars), from the proceeds of a $100,000 life insurance policy left to her by her deceased husband. As it happens, she will live to the year 2006; as Dave puts it, her blood pressure runs out when she turns age 100.

At the moment the life insurance settlement is paid out, the universe splits into five different branches, and in each branch the woman works with a different money manager.

1. The first checks out the widow's risk tolerance and creates an asset allocation which will run more or less constantly throughout her life.
2. The second adopts a target-date equity allocation which Dave sets as 100 minus the widow's age--starting at 80% and dropping from there.
3. A third manager decides to put the entire portfolio into stocks.
4. The fourth sets a long-term asset allocation and then manages to beat it by 1.5% a year.
5. The fifth runs a Monte Carlo analysis with historical inputs, and decides to set the portfolio at an allocation which produces an 82% confidence rate of reaching the widow's stated long-term goal. Each year, this manager will re-run the analysis, and over the next 100 years, he will be required to make nine changes to the allocations--all in the first 20 years of her life. A table in the white paper shows these changes, but basically the percentages shift from 80% equities in the first two years to 45% in 1928, to 30% in 1929, to 80% in 1930 (we're now in catchup mode), to 100% in 1931, back to 30% in 1938, back to 45% in 1942, to 60% in 1943, and then back down to 30% in 1945, when the portfolio appears highly likely to meet the widow's funding goals.
   
   

Overall, advisor 1 maintains a stock allocation of 38%, and achieves a compound return of 8.29% each year.

Advisor 2 is gradually lowering exposure, but over 80 years, he/she has an average stock allocation of 41% and a slightly higher compounded return of 8.42%.

The third manager, who owns nothing but stocks (I won't calculate the average annual stock exposure for you) generates an impressive 10.36% rate of return.

The fourth manager has the same average allocation as the first one, but because he can beat this index each year, he manages to achieve a 9.8% compounded yearly return.

The wealth manager has an average annual allocation of 38% and a very low 30% allocation for all of the Post-WWII years, and manages to generate 8.58%, compounded, a year.

You might think that the terminal wealth of the portfolios can be sorted neatly according to the compounded annual return, but that wouldn't take into account the sequence issue; the sequence of returns matters greatly to overall wealth.

Now here's the punch line: If the widow continues to take her inflation-adjusted income out of the portfolios:

1. In the universe of the first manager she will be broke at age 51.

2. She spends her last dime at age 50 in the universe of manager two.

3. She runs out of money at age 55 with manager three.

4. The fourth manager, who can consistently beat the market, fares much better; the widow dies leaving an inheritance of $1,072,678.

5. The fifth manager? With him watching over the portfolio, adjusting the stock allocations up a bit when the market is down, down a bit when the market has taken her closer to her funding goals, she dies with $4,878,522 in her portfolio.

His allocations never produced superior returns in any one year, never beat the indices, but it did manage to capture a bit more of the upside, a bit less of the downside, and basically iced down the portfolio when the widow had essentially achieved her funding goal. Of course, the other managers contributed to their own defeat, by continuing to invest aggressively when they could have taken the widow's risk off the table, and by refusing to become more aggressive themselves when the funding goal was slipping out of their reach.

I think the results would have been much more dramatic if Dave had assumed that the widow had earned some income during this 80-year time period and managed to save a bit more and increase funding during times when the portfolio returns had threatened her funding goals. This, of course, is the kind of flexibility that pre-retired clients have and, in fact, the opportunity that clients have at this very moment, when more money could be deployed when virtually every asset class is on sale, often at screaming bargains.

Do you know the difference between an Elderly Lady and an Old Woman? Money!

Goodbye 2008![1]

[1] Thanks to Bob Veres, The National Association of Personal Financial Advisors (NAPFA) and Bob’s readers for helping us all communicated better with our clients during these troubled times.

We certainly live in interesting times. We did foresee, in the fall of 2006, the financial and economic turmoil that has resulted from difficulties in the real estate, credit and derivative markets. That is why the majority of our clients are now holding cash and short term bonds. However, we did not foresee the extent to which things would fall apart. Since October 2007, the world seems to have been turned on its head. The pessimistic outlook so commonly held today will not be reversed until there are reasons to be optimistic. Capitalism depends on confidence. Without it, transactions cannot take place. And confidence is in very short supply today.

It is our belief that the current decline in the stock market is being driven by two other types of sellers as well: Those who are forced to sell to meet cash needs or liquidation requests, and those investors who are driven to sell out of fear or a sense of panic. Forced or panicked sellers are not selling with economic justification. Therefore, they push prices down to such an extent that they actually set the stage for a significant price recovery. The majority of investors buy high and sell low! Yes, you read that correctly.

Although there are no guarantees, those of you who took our advice are now ready to buy really low and participate in what could be the greatest worldwide investment recovery in 78 years. No one is sure when this recovery will start or long it will last. We just need to be patient. Financially, we know you can do it. Emotionally, we know you can too; you just may need our help.

For now, we want you to lead your lives in as normal a fashion as possible. None of us knows how long our stay on this earth will be. We encourage you to continue to spend money on things or services that increase the quality of your life or the lives of loved ones within reasonable spending limits. However, if we have cautioned you about your spending level being higher than what would be prudent given your portfolio size, recent investment declines will only magnify the importance of a spending reduction.

It is very important for all of us to be mentally prepared for additional bad economic news as the nation and the world work through this. There will be no quick solutions. As dark as it is, it could, and probably will, get worse. If the markets decline from here, they will only increase the potential of your future profits. That is if you don’t spend your money before it gets a chance to once again work for you.

Many of you grew up in small towns or cities, and you may remember that some of the most beautiful springs followed some of the harshest winters. I can tell you with certainty, after having watched the market for 35 years, that spring is coming. We have been given one day at a time, so I cannot predict with accuracy when spring will bloom, but I can tell you that it will arrive. At that point, this harsh winter will become a memory.

Finally, with all that is going on today when you are done with this newsletter, pass it on to someone you think would benefit from it, be they family, friends or business associates.

Thank you in advance for your courage and patience during these difficult times. We take nothing for granted, and are honored by your decision to retain us as your trusted financial counsel.

Ted Feight

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Focus on Fiduciary

Do you know that only certain financial professionals are subject to a “Fiduciary Standard”. A Fiduciary Standard means an advisor is putting their client’s interests first. In no way do they urge their clients to invest in vehicles that are in the advisor’s best interests.

fi•du•ci•ar•y – A financial advisor held to a Fiduciary Standard occupies a position of special trust and confidence when working with a client. As a Fiduciary, the financial advisor is required to act with undivided loyalty to the client. This includes disclosure of how the financial advisor is to be compensated and any corresponding conflicts of interest.

Theodore J. Feight, CFP® firmly believes this is the strongest definition of Fiduciary available because of the basic requirements of Trust, Loyalty, and Disclosure.

Trust – Someone who does not completely trust their financial advisor can never be fully confident that they are receiving the best possible advice from the best possible advisor. Without trust, can confidence really be achieved?

Loyalty – An advisor who is loyal to only their clients will not be swayed by outside forces to recommend investments with higher commissions or payouts. Without loyalty, can people ever be sure their own interests are being looked after?

Disclosure – People must know, and understand, how their financial advisor is being compensated for the advice they are providing and whether or not any conflicts exist that may cause a problem with that advisor’s ability to provide truly independent advice. Without disclosure, can prudent advice be provided?

It’s hard to find the perfect financial professional who will meet your needs. You deserve an advisor who is competent, qualified, knowledgeable, and is compensated in a manner that minimizes conflicts of interest. But, more importantly, the advisor must be held to a Fiduciary Standard, meaning they will always put your interests first. You want to always be sure the advisor is working for you – not for themselves.

Registered Investment Advisors (RIAs) are held to a Fiduciary Standard. By law, a Fiduciary will act solely in the best interest of the client. They must fully disclose any conflict, or potential conflict, to the client prior to and throughout a business engagement. Fiduciaries will also adopt a Code of Ethics and will fully disclose how they are compensated.

You must be careful to read and understand the disclaimers on marketing and advertising materials offered by a professional. Recent regulations put forth by the Securities and Exchange Commission (SEC) now require brokers and other professionals who are not considered fiduciaries to add the following disclosure:

“Your account is a brokerage account and not an advisory account. Our interests may not always be the same as yours. Please ask us questions to make sure you understand your rights and our obligations to you, including the extent of our obligations to disclose conflicts of interest and to act in your best interest. We are paid both by you and, sometimes, by people who compensate us based on what you buy. Therefore, our profits, and our salespersons’ compensation, may vary by product and over time.”

If this disclaimer appears, you should ask questions, obtain complete disclosure, and determine if the relationship with the financial professional is in your best interests.

Do you know what physicians, lawyers and CPAs have in common? They all hold to a Fiduciary Standard to put your interest first. Look to a Financial Planner who will put your interest first.

The complexity of retirement distributions:

It won't be long before a lot of people are taking distributions from a myriad complexity of retirement plans, taxable accounts, Traditional IRAs and Roth IRAs, and they should be looking for guidance on where the money should come from first. There is little research and even less agreement on how this should be done.

We are developing a decision matrix which takes a lot of things into account before you can decide where to take your initial distributions. For example: Stocks or funds with a high tax basis might be more attractive to liquidate than IRA assets, but stocks or funds with a low tax basis might be profitably held until the first spouse dies, giving the second spouse a step-up in basis that can really enhance tax-efficiency going forward.

Tax-inefficient investments like taxable bonds are most profitably stashed in the IRA. But as you liquidate the IRA, you are also reducing your capacity to deploy those tax-inefficient investments where they belong. So you have to keep an eye on your IRA "capacity" in relation to the percentage of taxable bonds in the portfolio.

How you leave any leftover assets to heirs at death is another consideration. If the next generation of beneficiaries is quite young, then leaving a stretch-out IRA might be more efficient than leaving assets from the taxable account. However, we are not optimistic, given our current budget deficit, that Congress will maintain our current tax rates, and that money inside a retirement plan is more subject than outside money to the government's taxing whims. This would argue for taking money out of the IRA first, while the getting is good.

If there are estate tax liquidity issues, then it might be beneficial to avoid depleting the taxable accounts, since those assets would receive a step-up in basis, and no income taxes would have to be paid by the heirs to get this money. Withdrawing money from a traditional IRA to pay estate taxes would trigger additional income tax payments.

We look at distributing (rather than reinvesting) dividends and capital gains distributions from the taxable accounts, and considers whether clients have capital loss carry-forwards and/or realized capital losses for the current year (which would suggest taking capital gains from the taxable account sufficient to offset the losses). Beyond that, how important is creditor protection? (IRA assets are less vulnerable.) And are the heirs capable of managing a stretch IRA? Is there a high possibility that they would liquidate it in a few years, rather than stretching out the distributions and taking full advantage of the deferral?

There are two points here: First, that the source and sequence of retirement income distributions is a seriously complex planning issue, with too many variables to yield a pat, simple, one-sentence rule-of-thumb answer. Second: we may not have yet defined all the variables or outlined how they interact with each other.

Ted Feight, CFP®

April 2006

The media is touting the first quarter of 2006 as the great quarter in this decade. It was a good quarter with the DJIA up 5.77%, S&P 500 up 9.68% and the NASDAQ up 17.03%. But what makes it seem so good is that there has not been a first quarter in any year since 1998 that all three of these stock market indexes were positive.

So should you get excited and run out and put all your money into the stock market. Probably not, according to the following:

1. Have you ever heard the saying buy low and sell high? Well the stock market indexes are currently at all time highs.
2. If you look you can find a chart called the Average Presidential Cycle. The one I have takes each week of the DJIA, for each week in every United States President’s four-year term since 1897 and averages them together in a four year chart. That chart clearly shows that during the second year in a presidential cycle the DJIA starts out up, then goes flat to down until the last part of the year. Then the DJIA goes up for some time. This chart does not give guarantees, so don’t take it as one.
3. The two year and ten year interest rates have been inverted for 34 days this year. “So what?” you say. An inverted yield curve is when short-term interest rates are higher than long-term interest rates. This is usually measured by using the 2-year treasury rates in comparison with the 10-year treasury rates and/or the 3-month treasury rates in comparison to the 10-year treasury rates. When the short-term rates are higher than the long-term rates, it is called an inverted yield curve. This usually means that the country will go into a recession within the next two to four quarters. The yield curve has predicted essentially every U.S. recession since 1950 (1969, 1973 - 1974, 1980, 1981 - 1982, 1990, 2001 - 2002) with only one false signal, which preceded the credit crunch and slowdown in production in 1967. To be a credible signal, the curve must stay inverted for 30 days and the 3-month and 10-year treasury rates do the best job of predicting this.

So what do you do? Find your self a good Certified Financial Planner™ to help you answer that question. Ad lives are for aminitures and your monitory future is too important to play around with.

Nov 7th 2005

It was my fault. I took some time off to go hunting, even though I knew that there was a good chance the world would fall apart. And this is what happened: A horrible mudslide in Central America, parts of India and Pakistan devastated by one of the deadliest earthquakes in history, a new tropical storm swirled up ominously in the Gulf, Mount Everest inexplicably lost 12 feet in height and a tornado in the Midwest . For those of you who are hiding under your beds, you can safely come out again; I'm back in my office.

While hunting, I did have a saw fall out of a tree and try to cut my nose off, another saw cut through a branch and attack my left hand (3 stitches) and a small tree I was pruning jumped up and it tried to take my head off. Hunting is dangerous.

This is the time of year that we start planning what we want to do during the next year. We try to pre-set client appointments, find a financial planning theme for the coming year and improvements our systems to better help our clients. No matter how much planning we do, nature will usually throw a monkey wrench into things along the way. Yet having a plan often helps us to get better results.

Very often the financial planning theme will be different for each client, as almost each client is in a different stage of his or her financial planning life. Often, the times we pick for appointments will not fit into the client’s schedule. That is OK. We can and will work around these small setbacks. The real joy will come next year at this time, when we see the results of the planning we do now.

June 24th 2005

From time to time I sit back and look at where we have been and how I see it relating to where we are. Although not a complete match, I see us now in a period of time like 1974, 1984 and 1994. In 1974 the oil problems were hitting their second crisis period in 3 years and the markets looked bleak. In 1984 we were in the middle of the S&L crisis, high interest rates and the markets looked bleak. In 1994 we had just had a war in the Middle East , oil prices were up, interest rates were being raised and the markets looked bleak. Today, we have a war in the Middle East , oil prices are hitting their second crisis period in 3 years and the markets look bleak.

During each period you heard people say, “In the future the stock markets will not be able to give us the returns we had in the past.” In the 1970s oil drove the stock markets up during the last half of the decade. In the 1980s computers and lower interest rates drove the stock markets up during the last half of the decade. In the 1990s the internet and lower interest rates drove the stock markets up during the last half of the decade. All of these decades started the boom in the latter half of the decade. They were driven by things we did not even know existed before the decade began.

Well, guess where we are today. I see the markets ready for another new driver that many people do not see coming. Do you see what it is?

June 05. 2005

Retirement in the 21st Century is't like it use to be.

There are several stages in retirement.

1. The early stage (the go-go years).
2. A stage where people can no longer do all the tasks of daily living (the slow go years).
3. Finally the nursing home stage (the no-go years).

During the early retirement, individuals have the most flexibility and can enjoy life the most: they can continue to work full time or part time, they do some things themselves rather than hire someone More importantly, during this time the amount of assets at that time has the biggest effect on sustainable withdrawal and life expectancy is the most difficult to determine. You should tend to be conservative in withdrawal rates during that period. During early retirement the client can enjoy his spending the most, but the trick is to not have the spending be too high or there won't be enough left for the no-go years.

With depression era people, the problem usually is not spending enough of their money. Many planners seem to have the issue of urging these clients to spend more, because depression era people believe they will never have enough. The baby boomer generation is another story. They have not ever had to go without or wonder where their next dollar would come from. They all spend too much, to early in retirement and on many things they really do not need.

I want my clients to understand the trade-off.

June 05, 2005

Currently the economy is growing faster than it is creating jobs. Put another way, companies are accomplishing more and more with technology rather than people. There is a disconnect between job creation and GNP growth which begs the questions:

How will we provide a living to additional people with an economy that creates jobless growth?

How will you protect your assets in an economy that is doing this?

June 05, 2005

It appears that the stock markets liked the information coming out of the Federal Reserve today. There are no guarantees with investments, but it appears the markets want to rally.

May 05, 2005

We need to help people gain insight into the future and how it will impact on them. We need to help people to work on their own personal strategic planning processes so they can move forward and realize their goals whether they be short- or long- term. We need to do this without getting caught up in the short-term smoke screen thrown up by the media. Live and work for the future, not the past or the present.