As Detroit Goes…

You’ve probably read that the city of Detroit has filed for bankruptcy protection. If you’re like most Americans, you assumed that this is because the city has been declining, economically for decades. And indeed it’s true that America’s 18th largest city, once the 4th largest, has seen its population fall by 1.3 million people, leading to a 40% aggregate drop in tax revenue despite property taxes that are now twice the national average. Detroit’s unemployment rate is more than double the U.S. average–a situation which is unlikely to slow the exodus.

But Detroit’s fiscal problems actually have little to do with its woeful economy. The problem lies in the assumptions that the city made about future returns in its investment portfolio–the portfolio that funds all city pensions and retirement benefits. With the benefit of hindsight, it is clear that these assumptions were disastrously off-kilter. Recent estimates say that the discrepancy between what the city has promised to its current and retired employees, and the money the city has to pay for those promises, could be anywhere between $3.5 billion and $9 billion dollars.

Here’s the punchline: the calculations that Detroit’s municipal authorities relied on to say that they were perfectly solvent follow generally accepted actuarial principles. Many other cities and states appear to be making the same mistake, and it’s perfectly legal.

Without getting too deeply into the complicated math, the bottom line is that the city has been assuming that its portfolios would generate a steady return of between 7% and 7.5% at least since the turn of the century. In 2011, as the city’s financial picture worsened, its pension fund managers increased their projections of future investment returns to 8%, which made the pension system seem potentially better-funded in future years.

Why is this a problem? If you’ve ever happened to glance at your own portfolio statements, you may have noticed that no conservatively-managed investment portfolio has earned anything close to 7% a year since 2000. But Detroit’s actuarial team accounted for that by “smoothing” the projections–a fancy way of saying that they assumed higher returns in the future would offset the lower returns they’d experienced.

These assumptions had two highly-desirable results: they allowed the city to make much smaller contributions to the pension fund than would have been necessary with more realistic investment projections, and they allowed the city to promise future retirement (income and healthcare) benefits that were much more expensive than the city could actually afford.

The problem is that Detroit is not alone.

It doesn’t take a rocket scientist to notice, as a writer did recently at The Economist magazine, that the New York City public school system account statements show a yearly return on teacher annuities that is six percentage points higher than the highest going rate on bank savings accounts. New Jersey recently cut its investment projections to 7.9 percent, a mere ten basis points less than Detroit. Over the past ten years, the giant California pension, Calpers, has been using various smoothing techniques to give its municipalities the illusion of greater solvency. Some states and cities, when they post job listings for staff actuaries, require that the potential hires hew to the generally-accepted principles. No sober doses of reality will be sought or tolerated.

Why hasn’t anybody blown the whistle on this long-term overstatement of returns and understatement of liabilities? Who benefits from putting that whistle to their lips? The city employees, whose monthly statements show returns and benefits that are orders of magnitude higher than they could get in the open market? The city officials, who would then have to deal with the scandal of underfunding and have to make huge tax dollar commitments to catch up, often with money they don’t have? The municipal bondholders, who are clipping coupons and whistling in the dark, hoping they’ll be paid off before somebody tells them, as Detroit bondholders are now being told, that their investment is worth pennies on the dollar?

Taxpayers, who could be on the hook for billions of dollars worth of promises that the state constitution and city charter declare must be kept?

In fact, the New York Times recently reported that the Society of Actuaries itself is revisiting its generally accepted principles, fearing a black eye for the profession. The debate could lead to a policy that favors more realistic investment assumptions, while officials running for office may have uncovered the next scandal that could shoo them into office.

Either way, you can expect to hear more about bankrupt cities and municipalities, and the next headline probably won’t be about a city whose population has been declining since the Eisenhower Administration. How far and how deep this readjustment will go, how much has been overstated across millions of workers and hundreds of thousands of retired municipal workers, is a potentially alarming mystery.

Sources:

http://www.realclearmarkets.com/articles/2013/07/24/the_real_message_behind_detroits_decline_100499.html

http://www.irishtimes.com/business/economy/detroit-bankruptcy-filing-comes-after-long-financial-decline-1.1469526

http://www.economist.com/blogs/democracyinamerica/2013/07/detroit-s-bankruptcy

http://dealbook.nytimes.com/2013/07/19/detroit-gap-reveals-industry-dispute-on-pension-math/?ref=marywilliamswalsh

This article was written by Bob Veres and re-printed with his permission.

Income Seeking Investor? Fair Warning

With interest rates historically low, many investors are seeking non-traditional means to generate income from their investment portfolios. Often people find comfort in investments that provide interest and dividends because it is based on the rule of thumb that one shouldn’t touch the principal. The financial media has latched on to the subject – it is not hard to find stories on a daily basis on the virtues of income investing.

And that makes me nervous. Investment styles that are currently in vogue tend to attract people that fail to consider the risks. From what I’ve seen, I have the feeling people have a false sense of security. Here are some things that the investor seeking income should consider:

-Dividend paying stocks usually go down in value on the date the stockholder is entitled to their dividend. In reality the thought of not touching the principal is an illusion.

-Focusing on dividend paying stocks pays no attention to dividend paying stocks of the future. Great companies usually do not initially pay dividends. Only when their business matures and growth slows do they begin these payouts.

-There is no documented research that proves dividend-paying stocks weather downturns in the stock market better than non-dividend paying stocks.

-Only 40% of the domestic stock universe pays dividends and a majority of these stocks fall in only a handful of business sectors. You are giving up a lot of diversification.

-If a bond or bond fund is carrying a higher yield, there is a reason for that – it’s called risk. Bonds that have longer maturities are more likely to fall in value when interest rates go up. Some bonds have higher risk of default. Other investment vehicles such as closed end funds borrow money at lower rates to buy higher yielding bonds. Some bonds go overseas and are subject to currency or sovereign debt risk. Municipalities can fail as well – all you have to do is look at the credit default swap rates of municipal bond insurers to see the risk is real. There is no free lunch here.

-How bad can it get if interest rates were to rise? If we have a sudden 2% jump in interest rates within a 12 month period, I estimate an owner of a 20 Year U.S. Treasury Bond will see the value of the bond go down by about 18%.

-If and when interest rates should rise, I fear the same herd of people flooding in will turn the other way and may cause a mass capitulation. If these yields begin to look lousy as compared to prevailing interest rates, people may hit the exits all at once and we could have an acute decline in these types of securities.

-Capital gains are more tax efficient. When one sells a security, some of the gains come back as cost basis and is not taxable. All of a dividend or interest payment is taxable. Also you control when to take a capital gain while you have no control on when to receive a dividend or interest payment.

In the end, dividends and interest shouldn’t be shunned. I only fear that investors have placed too much myopia on the subject than is warranted. Rather than income, seeking a total return approach which include capital gains will not only provide better after tax returns over the long haul, but it will do this with a lot less risk. We’ve gone through a secular bull market for income investors for over thirty years. If and when the secular cycle ends, I fear that many people will be in for a rude awakening.

Big Mistake: Failing to Update Beneficiaries

I make a point of reminding my clients to review their beneficiary designations on their employer based retirement plans, life insurance, IRA’s and accounts with transfer on death assignments. The same could be said of beneficiaries outlined in their wills (you have a will, don’t you?). I was happy to see that the February 2013 issue of Consumer Reports listing this as the number one mistake in their article, 7 Money Stumbles to Avoid.

Why is this so important? It’s because huge unintended consequences could happen if you fail to review this on a periodic basis. For example:

• Many people have trust arrangements set up within their estate planning but many people fail to change the beneficiary designations on accounts when the trust is established, potentially ruining the whole estate planning strategy they wanted to employ.

• It is not uncommon for former spouses to still be listed as beneficiaries on an individual’s life insurance or retirement plans.

• If you have an ERISA based retirement plan like a 401(k) or 403(b) and remarry, did you know your new spouse is automatically your 100% primary beneficiary? This may be the intent of the person, but it may not necessarily be that way if children from a former marriage are involved. And by the way, prenuptial agreements don’t work here.

• I’ve seen parents still listed as beneficiaries even though their child has long been married and has a family of their own that they need to financially support.

• Listing an estate as a beneficiary of a retirement account can have the unintended consequence of having the funds disbursed (and taxed) even if the beneficiaries didn’t need the funds and would opt to defer the receipt of these funds (and the tax consequences) to a later date.

• Having a child who has special needs lose their government assistance because they were improperly named as a direct beneficiary rather than a special needs trust.

• Not only beneficiaries, but the designation of guardians for your children, executors and trustees are good to review as well within your estate planning documents.

On an annual basis, it’s a good exercise to go through this to make sure that all of this is still aligned with your goals. And I would confirm any beneficiary designations directly with the financial service firm that you are working with rather than assuming they have the latest paperwork that you filed on hand. In the end, this is a very simple exercise that can save your family a lot of grief later down the line.

Open Enrollment for Medicare Part C & D

For those eligible for Medicare it’s time to shop around as the open enrollment period for Medicare Advantage (Part C) and Medicare Prescription Drug Coverage (Part D) started October 15th and runs through December 7th.

Why shop around? Like any other insurance policy that renews annually, it’s important to see if your current options still best fit your needs. For example, what may have been the most efficiently priced policy last year could be significantly higher this year. Pricing for most Medicare Advantage Plans are expected to increase moderately this coming this year. However many Medicare Part D Plans are expecting double digit increases in premiums. Second, your current plans provisions and benefits may have changed and may not best fit your needs anymore. Finally, you may have had a change in your personal circumstances where another option may be more efficient. When shopping around for Medicare Advantage, just make sure that any new plan that you are considering has your primary care physician, specialists and care facilities that you are likely to use are on the plans network of providers.

The best place to start shopping is the Medicare Plan Finder on the Medicare website. Before shopping, it is recommended that you have your list of prescription drugs you take and the dosage. Plug in Medicare number and drugs and it will produce a list of available options and detail so you can determine what plan is the best fit for you. One on one advice, the State Health Insurance Assistance Program offers Medicare counseling services.

In the end, it pays to be proactive as it could prevent disappointment in the quality of coverage you receive and it may save you hundreds of dollars each year.

Time to Check Your Credit Report: Experian

Four months ago, I suggested you request a free credit report from Equifax. In order to take full advantage of your free credit reports, I suggest that you request a free report every 4 months from the different credit agencies. This time I’m detailing the process to request a free credit report from Experian

Here are the steps necessary:

1. go to https://www.annualcreditreport.com/cra/index.jsp
2. select your state and click “request report”
3. fill in your personal information, security characters from picture, and click “continue”
4. select Experian and click “next”
5. click “next” again
6. enter last four digits of your social security number and click “submit”
7. choose extras if you want to pay, I never do, click “annual credit report” at the bottom in gray.
8. check “I have read and agree to Experian’s Terms & Conditions, etc” if you accept them, click “Submit”
9. answer the “identity verification” questions and click continue.
10. click “print report” in upper right section of page.
11. print report

If you find there is something amiss, contact that agency immediately. You can contact Experian at 866-397-3742. In 4 months I will remind you to get another report from TransUnion.

Butchers, Brokers, Dieticians and Fiduciaries

In the world of healthcare, representatives of pharmaceutical and medical device firms do not administer advice directly to patients. This avoids the inherent conflicts of interest as representatives have a natural incentive to sell as much of their product and this could influence the advice in a manner that it is not in the best interest of the patient. Unfortunately I wish I could say the same for the financial care field.

The financial service industry doesn’t always require the same level of care – it can differ from firm to firm. Some financial service firms recommend products that they create or holdings they have on inventory that they don’t deem worth holding onto anymore. Some are required to act in your best interest first while others only have to determine if a product is suitable. A recent New York Times Editorial by former Goldman Sach executive Greg Smith and the Fox News report “Citigroups Embarrassing E-mails” sheds some appalling light on how the financial customer could be adversely affected in some cases.

What can you do? The first thing that you can do is understand the difference between a fiduciary arrangement and a brokerage engagement in a financial service engagement. A great whiteboard video showing the difference was produced by Hightower Securities which compares brokers to butchers and fiduciaries to dieticians. In simple terms, you don’t want to ask a butcher if a certain cut of meat is healthy for you.

If you then believe that your financial service advice you receive should be held to a fiduciary standard, I recommend going to The Committee for The Fiduciary Standard website a pull up their Fiduciary Oath. I would print this and provide this to your current or prospective financial adviser to sign. If they sign this, it doesn’t eliminate all potential conflicts of interest, but it requires disclosure of material items and that the adviser acts in your best interest. If they refuse to sign it, at least you know the type of engagement you have and you can make the decision to continue the engagement or move on.

Finally there is a debate going on in Washington concerning the subject as some parties don’t feel a fiduciary obligation is necessary or is too onerous and would prefer things to remain “as is” or to create a watered down definition. Unfortunately many of our elected officials haven’t expressed an interest and/or expertise on the subject. If you feel this is important, I recommend that you forward the above whiteboard demonstration to your representatives.

Time to Check Your Credit Report: Equifax

Four months ago, I suggested you request a free credit report from TransUnion. In order to take full advantage of your free credit reports, I suggest that you request a free report every 4 months, rotating among the different credit agencies each time. This time I’m detailing the process to request a free credit report from Equifax:
Here are the steps necessary:
1. go to www.annualcreditreport.com
2. select your state and click “request report”
3. fill in your personal information, security characters from picture, and click “continue”
4. select Equifax and click “next”
5. click “next” again
6. confirm personal information and click “continue”
7. answer credit questions and click “continue”
8. choose extras if you want to pay, I never do, click “no thanks, I do not want to see my credit score”
9. click “yes” to answer 1. requesting your credit report online free for 30 days. click “no” for the rest
10. Fill in information to open an account, opt out of privacy if you want to opt out, accept agreement terms if you accept them, click “Submit”
11. click “view and print my report”

I click “print report” to get a copy for my records. This way you can compare them with previous reports you’ve received. If you find there is something amiss, contact that agency immediately.

You can contact Equifax at 866-585-9451. In 4 months I will remind you to get your report from Experian. Make sure to double check the information against accounts on this report. Finally, please forward this to anyone you think might benefit from the knowledge.

Time to Check Your TransUnion Credit Report

To protect yourself against identity theft, I recommend that you periodically check your credit reports. Every year you are entitled to a free credit report from each of the three credit reporting bureaus (TransUnion, Equifax and Experian). To take advantage of the free credit reports and monitor your credit in the shortest amount of intervals, I recommend getting your credit report once every four months, rotating this between the credit bureaus accordingly. About four months ago I wrote a blog about how to obtain your credit report from Experian. This time I will provide instructions on how to check your credit report from TransUnion. Here is the process:

1. Go to www.annualcreditreport.com
2. Select your state and click “request report”
3. Fill in your personal information, security characters from picture, and click “continue”
4. Select TransUnion and click “next”
5. Click “next” again
6. Once at the TransUnion site, follow the prompts (skip all the extras they try to sell you unless you want your credit score)
7. Answer the verification questions
8. View and print report

Check your report and contact the agency immediately if you find a problem. I will send you a note in 4 months to remind you to obtain your Equifax report.

Time to Fund Your Retirement Account

The two biggest factors influencing how much money you will accumulate for your goals is time and the amount that you will save over this time; this far outpaces the influence investment returns have on portfolio values. For those saving for their retirement goals, the recent market decline provides a great opportunity to fully fund your retirement accounts for 2011. Rather than waiting until the tax deadline in April of 2012 to fund their Roth or Traditional IRA now may be a more opportune time to take care of this.

For those who participate in an employer sponsored retirement plan and want to maximize their contributions, this is a good time to determine if you are on target. Not only to optimize contributions for this year, but also to determine what deferral percentage you will need to maximize contributions for next year. This month, the IRS will announce if any changes will be made as employee contribution limits are adjusted over time with inflation. We haven’t had any changes over the past couple of years so I suspect that we will see some sort of increase for 2012.

Also for those who participate in an employer provided plan where the employer has matching contributions, in most cases you want to make sure you stretch out your employee deferrals throughout the year. By doing so, it optimizes the dollar amount of the employer match. Often times I will see people maximize their employee deferrals way before year end. They think they are doing the right thing, but unfortunately they end up leaving employer provided money on the table. Employees who are subject to large bonuses and/or commission have the most trouble with this as it’s hard to predict incoming earnings. Some employers are now offering programs where they will assume you are making deferrals throughout the year – providing a full match even if you maximize your contributions before year end. You usually have to sign up for this so I would take advantage of this if your employer offers this.

Finally, don’t forget about Roth Conversions. In an off-hand way, the taxes that are paid from the conversion could be considered an additional contribution. Again, with the recent drop in the market, this makes this strategy more attractive and if the market continues to drop throughout next year, you always can re-characterize the conversion before October 15th. Roth conversions usually only makes sense if you have the cash outside the IRA to pay the tax. Just keep in mind that conversions don’t make sense in all scenarios so be careful and fully think this through before executing.

Meeting goals in a low return environment requires one to save more – simple but true. In the long run it’s a lot better to employ strategies that you can control rather than relying on things outside our control (like the financial markets). If any of my clients would like to fully fund their retirement accounts or explore their options, please feel free to call or e-mail.

Time to Refinance Again?

For those who hold a current mortgage, just a quick note that interest rates for conventional fixed rate mortgages have dropped again to historically low levels. As a result you should compare your current mortgage with other alternatives available to see if it makes sense to refinance.

How can you tell if it makes sense to refinance? The way I approach this is to determine the net present value of the current mortgage payments over the remaining lifetime of the loan. Then I calculate the net present value of the mortgage payments if you refinanced. If you pay the closing costs out of pocket (these are costs outside of escrow items such as insurance and real estate taxes that you would need to pay anyway in the future), then you add this dollar value to the net present value of the refinanced mortgage payment. Whatever payment has the lowest net present value is the option that you should choose. Of course if it favors the refinance, but the difference is not material in nature, then it may not be worth the time and aggravation to refinance.

The traps I tend to find is when people only take the closing costs and divide it by the monthly savings to determine a breakeven point to make the decision on whether to refinance. This isn’t a trap by itself, but it is a trap if they extend their mortgage and fail to take into account the extension of payments beyond their current mortgage that they now have to pay. Also it doesn’t tend to pay off if you plan to move within five years.