Posts in Retirement Planning

OpenCircle’s Fixed Income Methodology

August 24th, 2016 Posted by Investment Strategy, Retirement Planning, Saving 0 thoughts on “OpenCircle’s Fixed Income Methodology”

For a deeper understanding of how we approach fixed-income investments based on academic evidence, this analysis will help. Learn how we balance credit risk, interest rate risk, and reinvestment risk. To discuss further, please call us at 203-985-0448.

The Role of Fixed Income

OpenCircle’s fixed income philosophy starts with the premise that most portfolios contain elements of equities in addition to fixed income. Both asset classes have their specific roles to play: equity for capital appreciation and fixed income as a portfolio stabilizer and a diversifier of portfolio risk. It is important for both asset classes to maintain their clearly defined roles throughout the life of the portfolio. For fixed income, this means ensuring the fixed income portfolio is not stretched in search of additional yield by assuming imprudent risks. Purchasing low-credit-quality bonds or bonds in risky market sectors are strategies that fall into the risk-stretching category.



Academic Evidence

There are three primary risks within the fixed income markets: 1) credit risk, 2) interest rate risk and 3) reinvestment risk. We will discuss in detail these risks and how our approach to fixed income can combat them.

Credit Risk

Credit risk is the risk that a fixed income security will not pay all principal and interest. Arguably, any security that is not a Treasury bond (or a bond issued by another highly rated government entity) has some measure of default risk. The primary way to assess the reward of bearing credit risk is to look at the credit premium, which is measured by comparing the returns between investment-grade corporate bonds and their Treasury counterparts. One difficultly with measuring the credit premium is that high-quality data only goes back to the late 1980s, unlike most other market data that can be traced to the 1920s. Despite this relatively short period of data, we can still draw some interesting conclusions.

From 1989–2015, the investment-grade credit premium averaged only 0.43 percent per year, with volatility around 6.6 percent and a Sharpe Ratio (a measure of risk-adjusted returns) of only 0.07.

This last figure compares rather unfavorably to the Sharpe Ratio of 0.40 for the equity risk premium (stocks – bonds) over that same time period, making the equity markets much more advantageous from a risk/return perspective. Lastly, the investment-grade credit premium has a positive correlation to the equity markets, meaning they both tend to underperform or outperform at the same time. This makes investment-grade corporate bonds less effective as a portfolio diversifier.

Investment-grade bonds are only half of the credit spectrum in the fixed income markets. To properly evaluate the full credit spectrum, the high-yield credit premium must also be measured. From 1989–2015, the high-yield credit premium averaged 2.9 percent per year. While this premium looks enticing on the surface, it comes at a price in the form of much greater volatility of 16.3 percent. Factoring in the increased volatility, the Sharpe Ratio for the high-yield credit premium drops to only 0.18, which is still well below the equity risk premium of 0.40. More alarming, the high-yield credit premium is the correlation to the equity markets, which is very high at 0.61.

Due to their low Sharpe Ratios and high correlations to equities, we avoid both investment-grade and high-yield corporate bonds.

Interest Rate Risk

This is the risk that a fixed income investment’s value will change due to a change in the level of interest rates. Longer-term bonds are more sensitive to interest rate risk than their shorter-term counterparts. Longer-term bonds do carry higher yields to compensate investors for accepting more interest rate risk. The question then becomes how far out should an investor go on the yield curve to get the proper balance between yield and interest rate risk?

The first thing we want to look at is the term premium, which examines whether interest rate risk has been rewarded. Traditionally, the term premium has been measured as the difference in returns between short-term Treasury bills and the five-year Treasury note. From 1927–2015, the term premium averaged 1.9 percent with a Sharpe Ratio of 0.37. The risk-adjusted return of 0.37 compares very favorably to the equity risk premium of 0.40 over that same time period, indicating that extending to the intermediate portion of the curve is an attractive option. Another important piece of data to note is that the term premium has zero correlation to the equity premium, making it an ideal diversifier.

Much like the credit premium, we also need to look at the full yield curve and examine term premium for the long-maturity portion of the curve. This is best examined by comparing the returns on long-term Treasury bonds and the five-year Treasury note. Over that same 1927–2015 period, the longer-term premium was only 0.7 percent, which is well below the 1.9 percent premium for the intermediate portion of the curve. The risk adjusted returns as measured by the Sharpe Ratio are also significantly less at 0.12 versus 0.37 for the intermediate-term premium. This data clearly shows that extending to longer-maturity securities has not been rewarded historically.

Based on this evidence, we invest in short- to intermediate-term bond portfolios in an attempt to capture the term premium. We avoid long-term bonds and their lower risk-adjusted returns.

Reinvestment Risk

This is the risk that future interest and principal payments, when received and reinvested, will earn less than the prevailing market interest rate. Traditionally, bonds with long maturities will have less reinvestment risk because they lock in the rate of interest earned on principal for a longer period of time.

Our Fixed Income Philosophy

The next logical question: How do we most effectively balance these risks associated with fixed income? The most effective way to combat these risks is through the use of a well-constructed bond ladder. A bond ladder is a portfolio of fixed income securities with equal weights that come due in varying maturities. For example, if a client had $1 million to invest in fixed income and wanted to create a 1–10-year bond ladder, he or she would purchase bonds in $100,000 increments in each year from 1–10 years.

A bond ladder is such an effective tool because it is able to strike a balance between both reinvestment and interest rate risk while also helping mitigate credit risk. Credit risk is the easiest of the three risks to hedge because it is the most straightforward. This risk can easily and effectively be reduced in a portfolio by limiting fixed income purchases to only high-quality bonds.

Reinvestment risk and interest rate risk are much harder to hedge as they compete with each other. For example, the most effective way to reduce interest rate risk is to buy only short maturities in the portfolio. Unfortunately, this strategy greatly increases reinvestment risk because principal and interest will need to be reinvested often. On the opposite end of the spectrum, purchasing longer-term bonds would be the most effective solution to fully hedge against reinvestment risk because that would lock in the yield on the portfolio for a greater period of time. The downside is these long-term maturities would increase the interest rate risk in the portfolio. A bond ladder balances these risks. The short-term maturities help protect the portfolio against interest rate risk while the intermediate-term maturities help reduce reinvestment risk. The ladder strikes a balance between these two risks by lowering the overall volatility of the portfolio while diversifying equity risk.

Although not a portfolio risk, per se, asset location is another important consideration when investing in the fixed income markets. Asset location is the process of determining what asset classes to place in tax-advantages accounts (Roth IRAs, IRAs and other retirement plan accounts) versus taxable accounts (joint accounts, individual accounts, etc.). The logic here is simple: If possible, strategies with high effective tax rates should be sheltered in tax-advantaged accounts. Fixed income fits this definition because the bulk of the return is generated from coupon interest, which is taxable at a client’s marginal tax bracket. Because of this, fixed income is sheltered in tax-advantaged accounts as much as possible.

Constructing Fixed Income Ladders

Now, let’s discuss how bond ladders are constructed. To deliver the best after-tax returns, we build customized fixed income ladders with targeted durations between three and five years using the most optimal mix of taxable, tax-exempt and inflation-protected securities. The duration and mix of securities is all predicated on the asset location and tax status of each individual client as no two portfolios are constructed the same.

Distinguishing Features

A pure, academically based philosophy relying on peer-reviewed literature:

  • Optimize risk-adjusted rates of returns.
  • Do not incur expenses attempting to “beat the market” by forecasting interest rate movements or selecting mispriced securities.
  • Minimize costs by reducing price markups and avoiding costly infrastructure expenses of an active portfolio management approach.
  • Maximize after-tax returns by strategically locating tax-efficient assets in taxable accounts and tax-inefficient assets in tax-advantaged accounts and tax-loss harvesting year-round.

True customization based on a client’s individual circumstances:

  • A thorough discovery process uncovers a client’s needs and objectives, including financial objectives, risk tolerances, current and future income needs, tax status, health status, gifting requirements, and philanthropic desires.
  • Create a written fixed income investment plan tailored to each investor.
  • A comprehensive approach considers assets across all investable accounts.

Diversified instrument implementation:

  • Employ both taxable and tax-exempt securities to provide the best after-tax yield.
  • Use TIPS to hedge against unexpected higher inflation.
  • Use both individual securities as well as bond funds when appropriate.

Portfolio maintenance:

  • Screen portfolios daily for any changes in credit quality.
  • Monitor portfolios weekly for upcoming maturities and redemptions.
  • Monitor portfolios for 18 other material events that could affect credit quality.


Women and Investing: Facts, Myths, and Financial Self-Care

August 11th, 2016 Posted by Budgeting, Family Finances, Investment Strategy, Investor Behavior, Life Planning, Marriage and Finances, Retirement Planning 0 thoughts on “Women and Investing: Facts, Myths, and Financial Self-Care”

Women control $5 trillion in investable assets in the United States, and the potential for future growth is enormous. Today, women represent more than 51 percent of the workforce and are starting businesses at twice the rate of men. On the flip side, men’s retirement account balances average more than 50 percent higher than women’s. The gender retirement gap is further compounded by the fact that women tend to live an estimated five to six years longer than men.

The data shows that, on their own, many older women have less money saved to draw from, as well as higher expenses. All too often, this dangerous combination results in financial insecurity. It’s imperative to understand why this gender retirement gap exists, and what can be done about it.

  • The Gender Pay Gap: Statistically, for every dollar men take home, women earn 79¢. That means women will make an estimated $530,000 less over their lifetimes, thus also reducing the amount of money they have to invest. We need to address this inequity as a society, but in the meantime, women in the workforce should not shy away from asking for a raise.
  • Family Responsibility: Many women take more time off work than their male counterparts to raise children or care for elderly parents. Not working outside the home means more than just losing a paycheck. It also means having less disposable income to invest in the long term and may translate into lower Social Security benefits.
  • Cost of Living: Life as a woman actually costs more. For starters, think wardrobe and personal care. And while there may be little we can do to reduce some of these costs, there are still ways to combat this problem. For instance, women often end up paying more for items such as mortgages and cars. By vigilantly researching the best loan rates available, women can negotiate from a stronger position and potentially reduce excessive costs over a lifetime.
  • The Gender Investment Gap: Although women actually save more of their disposable income than men, they tend to invest less of it, leaving a lot of their money in cash or low-yield savings accounts. But when women put together personal plans to bridge the gender investment gap, it can have dramatic, positive consequences for their financial lives. Before we explore ways to move forward in a positive direction, let’s talk about why women often show hesitancy when investing. It’s likely that they’re buying into one or more of the many myths about women and money.

Negative stereotypes and myths about women and finance:

  • Men are better investors than women. Not so. Research shows that when women invest, they tend to be highly successful, outperforming men. Not to mention that funds managed by women consistently outperform their alternatives.
  • Women are too risk averse to invest successfully. True, many women are risk averse. But wait. Can’t caution in investing actually be a virtue that helps you better weigh your options and avoid making poor or rash decisions? Yes – so long as you keep in mind that some risk must be taken in order to realize the returns needed to grow your wealth. This shouldn’t present a problem for women, or any investors, when the connection between their values, goals, financial plan and investments is clear and all are in alignment.
  • Women don’t have enough financial education to make a financial plan. Although this myth represents a gross generalization, there’s no denying that everyone could benefit from getting a better financial education. Not having one, however, has never stopped men from investing.

Moving ahead with saving and investing as a form of self-care:

  • Budget: Try to think of budgeting as less about numbers and more about personal awareness. It’s a check-in to see whether you are spending on the things that matter to you most. Set boundaries that ultimately will set you free to create and pursue the life you desire.
  • Save: Putting aside money is actually a way of caring for your future self. The rule of thumb is to save 15-20 percent of your income, but if you can’t do that, save as much as you realistically think you can. Just as you go in for regular health check-ups, do frequent check-ins on your financial well-being. Ask yourself if there isn’t more you can do to protect your financial welfare.
  • Invest: The need to invest can be compared to our need for exercise. We exercise to fight the corrosive power of aging and maintain our health. We invest to fight the corrosive power of inflation and maintain our financial health. Your savings should be invested, rather than kept in a money market fund with low interest rates. Otherwise, inflation will erode the value of your assets.
  • Insure Yourself: It’s a little-known but important statistic that 80 percent of men die married while 80 percent of women die single. Life insurance and long term care insurance should be seriously considered in women’s financial planning.
  • Take Responsibility: You would never cede big decisions in your life to other people, like who to vote for or how to take care of your kids or aging parents, so make sure that you are also participating in financial planning. It is highly likely that, someday, you will be the only one responsible anyway. A study performed by the National Center for Women and Retirement Research estimates that 90 percent of all women – single, divorced or widowed — will be in charge of financial matters at some point in their lives.

To create the best possible future for yourself, start planning for and investing in your future today. We would be happy to have an exploratory, no-obligation conversation with you. Feel free to give us a call at OpenCircle, 203-985-0448.

Teacup Pigs and Your Retirement: John Oliver’s Segment on 401(k) Plans

June 15th, 2016 Posted by 401(k), Investment Strategy, NAPFA, Politics, Retirement Planning 0 thoughts on “Teacup Pigs and Your Retirement: John Oliver’s Segment on 401(k) Plans”

For those of you who enjoy John Oliver’s straight-shooting and hysterically funny slant on the world and are concerned about getting unbiased advice from a fiduciary advisor on your retirement funds, do yourself a favor and watch his June 12th show. As a fiduciary myself who implements passive, low-cost investment approaches for 401(k) plans and clients in general, I can tell you that Oliver’s segment on retirement advice is right on the mark. Work with a fiduciary who is legally obligated to put your interests ahead of their own, get a full accounting of fees (beware 12-b1 fees, broker fees, internal fund fees), and keep aggregate costs low. Also I would add to his list the following: make sure your plan participants are being individually helped and educated based on their situation, protect yourself as plan sponsor by having the fiduciary advisor take responsibility in writing to serve as section 3(21) fiduciary to the plan, and use only index funds or low-cost asset class mutual funds–the ones we use are from Vanguard or Dimensional Fund Advisors. And please spread the word!!!!

[Strong language advisory]


Also read my April 7th blog for even more reasons to want the Department of Labor to succeed in their efforts to bring fair treatment and transparency to retirement fund management.

$17 Billion in retirement funds have been wasted in hidden broker fees

Our Mixed Up, Messed Up Relationship with Investment Risk

June 14th, 2016 Posted by Investor Behavior, Retirement Planning 0 thoughts on “Our Mixed Up, Messed Up Relationship with Investment Risk”

Whether it’s the recent destruction wrought by Canada’s Fort McMurray oil sands wildfire, a potential June “Brexit” from the European Union, or uncertainty surrounding this year’s US presidential election, there is plenty of risk to go around as we swing into another busy summer.

Is investing riskier than usual these days? In our experience, probably not. If there is such a thing as “normal” in this world of ours, risk is certainly part of it. And, investors often love and hate risk in a mixed up, messed up relationship. How so? Let us count the ways.

One: We Underestimate Risk.

It’s one thing when we imagine risk and its potential impact on our lives and our investments. It’s quite another when it really happens.

In investing, underestimating risk can trick you into believing that you can tolerate far more of it than you actually can. As financial columnist Chuck Jaffe has wryly observed: “[A] common mindset is ‘I can accept risks; I just don’t want to lose any money.’”

Unfortunately, we can’t have it both ways. When risk comes home to roost, if you panic and sell, it’s usually at a substantial loss. If you manage to hold firm despite your doubts, you may be okay in the end, but it might inflict more emotional distress than is necessary for achieving your financial goals. Who needs that?

Two: We Overestimate Risk.

On the flip side, we also see investors overestimate risk and its sibling, uncertainty. We humans tend to be loss-averse, which means we’ll exaggerate and go well out of our way to avoid financial risk – even when it means sacrificing a greater likelihood for potential reward.

This summer already is destined to deliver plenty of uncertain outcomes. On the political front, there are stark contrasts found among the US presidential candidates. For better or worse, whichever candidate prevails is likely to set the tone for the country if not the world. Overseas, the uncertainty surrounding the June 23 Brexit vote, which will decide whether Britain should remain in the European Union, could also impact financial markets in significant ways. Then there are the usual suspects, such as oil prices, continued Middle Eastern unrest, and so on.

We don’t mean to downplay the real influence world events can have on your personal and financial well-being. But the markets tend to price in the ebbs and flows of unfolding news far more quickly than you can trade on them with consistent profitability. So it’s a problem if you overestimate the lasting impact that this form of risk is expected to have on your individual investments.

Three: We Misunderstand Risk.

Especially when colored by our risk-averse, fight-or-flight instincts, it may seem important to react to current financial challenges by taking some sort of action – and fast.

Instead, once you’ve built a globally diversified, carefully allocated portfolio that reflects your personal goals and risk tolerances, you’re usually better off disregarding both the good and bad news that is unfolding in real time. This makes more sense when you understand the role that investment risks play in helping or hindering your overall investment experience. There are two, broadly different kinds of risks that investors face.

Avoidable Concentrated Risks – Concentrated risks are the kind we’ve been describing so far – the ones that wreak targeted havoc on particular stocks, bonds or sectors. In the science of investing, concentrated risks are considered avoidable. They still happen, but you can dramatically minimize their impact on your investments by diversifying your holdings widely and globally. That way, if some of your holdings are affected by a concentrated risk, you are much better positioned to offset the damage done with other, unaffected holdings.

Unavoidable Market Risks – At their highest level, market risks are those you face by investing in capital markets in any way, shape or form. If you stuff your cash in a safety deposit box, it will still be there the next time you visit it. (Its spending power may be eroded due to inflation, but that’s yet another kind of risk, for discussion on a different day.) Invest in the market and, presto, you’re exposed to market-wide risk that cannot be “diversified away.”

Four: We Mistreat Risk.

It’s a delicate balance – neither overestimating the impact of avoidable, concentrated risks nor underestimating the far-reaching market risks involved. Either miscalculation can cause you to panic and sell out or sit out of the market, thus missing out on its long-term growth.

In contrast, those who stay invested when market risks are on the rise are better positioned to be compensated for their loyalty with higher expected returns.

In many ways, managing your investments is about managing the risks involved. Properly employed, investment risk can be a powerful ally in your quest to build personal wealth. Position it as a foe, and it can become an equally powerful force against you. Friend or foe, don’t be surprised when it routinely challenges your investment resolve.

Respect and manage return-generating market risks. Avoid responding to toxic, concentrated risks. These are the steps toward a healthy relationship with financial risks and rewards.

[Photo credit: Flickr user Jared Zimmerman]

21st Century Retirement

April 19th, 2016 Posted by 401(k), Investment Strategy, Life Planning, Retirement Planning, Saving 0 thoughts on “21st Century Retirement”

Retirement is traditionally defined as “leaving one’s job and ceasing to work.” But the definition is changing in the 21st century. Economic, workforce, and societal trends are causing a fundamental shift in the way that individuals view and prepare for retirement.  Five primary factors are shaping the realities of the “new retirement”:

  1. Longer life expectancy

As we know, life expectancy has increased dramatically since the early 1900’s. Pre-retirees are facing the possibility of a retirement that could span one-third of their lives. They are wondering how they will spend their time, and they are concerned about how they will afford it.

  1. A growing need for self-reliance

We’ve all heard the slogan, “If it is to be, it’s up to me.” Increasingly, this is the attitude required for everyone planning for retirement. The concept of employment-funded pensions fully covering the costs of retirement is fading into the past. Building financial security for the future is becoming much more the responsibility of each individual.

  1. Preference for active lifestyles

Those looking ahead to retirement expect this stage of life to be a time for new activities and pursuits. The results of several studies indicate that today’s pre-retirees are more likely than previous generations to view retirement as an opportunity to start a new career and engage in other meaningful endeavors. They are also embracing the belief that physical activities will improve their quality of life.

  1. Expectation of post-retirement work

The idea of retirement can no longer be defined as leaving the workforce. Many members of the Baby Boomer Generation plan to continue working, while trying new and varied careers.  Their main reasons for working include the necessity for additional income, a desire to stay active, and the need to feel productive.

  1. Looking beyond financial matters

Individuals and retirement planning professionals are increasingly recognizing that a successful and satisfying retirement experience depends on more than a healthy nest egg. Retirement is a major life transition that deserves planning and preparation in all areas of life. Issues to explore can include potential changes in lifestyle and social interaction, physical activities, special health requirements, and satisfying employment. Important considerations can involve deciding where to live and how to fulfill any remaining life goals.

Changes in the world around us are occurring at an increasing rate. Meanwhile, many of us are living longer than our predecessors could have imagined. The result is that we must be ever more adaptable to the opportunities that life presents to us. The key to adapting is to anticipate change and try to prepare for it. The challenges of that can be daunting without the guidance of experienced professionals. There is no need to go it alone. We can help. To learn more, please give us a call at 203-985-0448.

$17 Billion in retirement funds have been wasted in hidden broker fees

April 7th, 2016 Posted by 401(k), Investment Vehicles, Politics, Retirement Planning, Saving 0 thoughts on “$17 Billion in retirement funds have been wasted in hidden broker fees”

On April 6, the Department of Labor (DOL) published the final version of the conflict of interest rule it proposed in April 2015. The new regulations require those who advise on retirement savings plans to adhere to the “fiduciary standard” that our firm has long held dear.

Given the complexity of finance, many customers are simply unaware of hidden fees that may eating into their savings. $17 Billion in retirement funds have been wasted in hidden broker fees. As a Registered Investment Advisor, we are held to a fiduciary standard, and have been transparent about our fees since day one.

Because we’ve always been fiduciaries, these regulations won’t affect our relationship with our clients, but it’s a big win for individuals saving for retirement through their employer-sponsored retirement plans or through Individual Retirement Accounts (IRAs).

The new regulation should provide extra transparency and peace of mind in a relationship retirement savers usually don’t have control over (who their employer chooses to manage their retirement plan). We hope to see the rule result in better investments offered (and better advice given) to retirement plan participants across the country.

We anticipate you’ll be curious about what the ruling means to you, so we have answered a few big questions below:

Why was this regulation proposed?

The DOL fiduciary rule was proposed to better protect people who are saving for retirement as a result of changes in the investment environment. Over the last 40 years, the availability and importance of self-managed investments, such as IRAs and participant-directed retirement plans, has increased. At the same time, the number and complexity of investment products in the marketplace has grown, as well as the creative and sometimes questionable way they are packaged and sold.

Due to this changing landscape, the DOL has issued new conflict of interest rules that apply to retirement plan advisors and IRAs. The DOL believes that requiring all advisors who work with retirement plans to operate under a fiduciary standard will prevent advisor conflicts of interest estimated to lower participants’ returns by 1 percent a year and result in approximately $17 billion lost annually.

Why was there so much opposition to this regulation?

Broker-dealers are generally only required to meet the suitability standard in making investment recommendations rather than operating under the fiduciary standard. The suitability standard required broker-dealers only to recommend a product “suitable” to meet clients’ goals; the fiduciary standard requires an advisor to act in a client’s best interest. The DOL rule changes will require broker-dealers to act as fiduciaries for retirement plan and IRA purposes, affecting the compensation arrangements available to them.

What’s changed? What’s different from before?

The rule requires those advisors who work with retirement plans to do only what’s in the best interest of their clients and to disclose any conflicts of interest. Recommendations that previously would not have resulted in a prohibited transaction may now run afoul of the rules that bar financial conflicts of interest. In its final form, the rule defines who is considered a fiduciary investment advisor. Broker-dealers, insurance agents and others that act as investment advice fiduciaries can continue to receive a variety of common forms of compensation (such as commissions) as long as they are willing to adhere to standards aimed at ensuring that their advice is impartial and in the best interest of their clients.

Who will this rule affect? How?

For clients or participants in 401(k) plans, the new regulation should provide extra transparency and peace of mind in a relationship retirement savers usually don’t have control over (who their employer chooses to manage their retirement plan). We hope to see the rule result in better investments offered (and better advice given) to retirement plan participants.

On the advisor side, the main impact falls on broker-dealers. Broker-dealers frequently receive compensation that varies based on the investment options they recommend, and they will now have to comply with prohibited transaction rules designed around a best-interest fiduciary standard.

Registered Investment Advisors (RIAs) such as our firm, who already are considered retirement plan fiduciaries, do not receive compensation that varies by investment, so the impact will be minimal.

When will the new regulation take effect?

Compliance with the rule will be required beginning in April 2017 (one year after the final rule is published in the Federal Register). Exemptions will be available at that time with a “phased” implementation approach designed to give financial institutions and advisors time to prepare.

Investing for Retirement Income Part III: Total-Return Investing

March 24th, 2016 Posted by Investment Strategy, Investment Vehicles, Investor Behavior, Retirement Planning, Saving, Stock Options 0 thoughts on “Investing for Retirement Income Part III: Total-Return Investing”

As we’ve discussed in the first two parts of this three-part series, we do not recommend turning to dividend-yielding stocks or high-yield (“junk”) bonds to buttress your retirement income, even in low-yield environments. So what do we recommend? Today we’ll answer that question by describing total-return investing.

Part III: Total-Return Investing for Solid Construction

There are three essential variables that determine the total return on nearly any given investment:

  1. Interest or dividends paid out or reinvested along the way
  2. The increase or decrease in underlying share value: how much you paid per share versus how much those shares are worth now
  3. The damage done by taxes and other expenses

Total-Return Investing, Defined

Instead of seeking to isolate and maximize interest or dividend income – i.e., only one of three possible sources for strengthening your retirement income – total-return investing looks for the best balance among all three, as they apply to your unique financial circumstances. Which strategy is expected to give you the highest total return for the amount of market risk you’re willing to bear? Which is expected to deliver the most bang for your buck, in whatever form it may come?

If you’re thinking this seems like common sense, you’re on the right track. Last we checked, money is money. In the end, who wouldn’t want to choose the outcome that is expected to yield the biggest pot given the necessary risks involved? Why would it matter whether that pot gets filled by dividends, interest, increased share value, or cost savings from tax-wise tactics?

In “Total-return investing: An enduring solution for low yields,” The Vanguard Group describes the strategy as follows: “Many investors focus on the yield or income generated from their investments as the foundation for what they have available to spend. … The challenge today, and going forward, is that yields for most investments are historically low. … We conclude that moving from an income or ‘yield’ focus to a total-return approach may be the better solution.”

And yet, many investors continue to favor generating retirement cash-flow in ways that put them at higher risk for overspending on taxes, chipping away at their net worth and weakening the longevity of their portfolio.

We’re not saying you should entirely avoid dividend-yielding stocks or modestly higher-yielding bonds. With total-return investing, these securities often still play an important role. But they do so in the appropriate context of your wider portfolio management. Let’s take a look at that next.

The Related Role of Portfolio Management

The tool for implementing total-return investing is portfolio-wide investment management. Decades of evidence-based inquiry informs us that there are three ways to manage your portfolio (the sum of your investment parts) to pursue higher expected returns; more stable preservation of existing assets; or, usually, a bit of both. The most powerful strategies in this pursuit include:

  1. Asset allocation – Tilting your investments toward or away from asset classes that are expected to deliver higher returns … but with higher risk to your wealth as the tradeoff
  2. Diversification – Managing for market risks by spreading your holdings across multiple asset classes in domestic and international markets alike
  3. Asset location – Minimizing taxes by placing tax-inefficient holdings in tax-favored accounts, and tax-efficient holdings in taxable accounts

By focusing on these key strategies as the horses that drive the proverbial cart, we can best manage a portfolio’s expected returns. This, in turn, helps us best position the portfolio to generate an efficient cash flow when the time comes.

Your Essential Take-Home

Bottom line, there is no such thing as a crystal ball that will guarantee financial success or a happily-ever-after retirement. But we believe that total-return investing offers the best odds for achieving your retirement-spending goals – more so than pursuing isolated tactics such as chasing dividends or high-yielding bonds without considering their portfolio-wide role.

With that in mind, the next time the market is huffing and puffing and threatening to blow your retirement down, we suggest you throw another log on the fire that fuels your total return investment strategy, shore up your solidly built portfolio, and depend on the structured strength to keep that wolf at bay. Better yet, be in touch with us to lend you a hand.

Investing For Retirement Income Part II: High Yield Bonds

March 17th, 2016 Posted by Investment Strategy, Investment Vehicles, Investor Behavior, Retirement Planning, Saving, Stock Options 0 thoughts on “Investing For Retirement Income Part II: High Yield Bonds”

Part II: High-Yield Bonds – Sticks and Stones Can Break You

In Part I of our three-part series on investing for retirement income in low-rate environments, we explained why we don’t advise bulking up on dividend-yielding stocks as a reliable way to generate retirement cash flow. Like the Three Little Pigs’ straw house, dividend-yielding stocks can disappoint you by exhibiting inherent risks just when you most need dependability instead.

Another popular tactic is to move your retirement reserves into high-yield, low-quality bonds. Here we explain why we don’t typically recommend this approach either.

Part II: High-Yield Bonds – Sticks and Stones Can Break You

We can see why it would be appealing to try to have your bonds pull double-duty when interest rates are low: protecting what you’ve invested and delivering higher yields. The problem is, the more you try to position your fixed income to fulfill two essentially incompatible roles at once, the more likely you will underperform at both.

Risk and Return: The Same, Old Story (Sort of)

In investing and many other walks of life, there’s nothing to be gained when nothing has been ventured. This relationship between risk and expected return is one of the strongest forces driving capital markets. But decades of academic inquiry help us understand that the risks involved when investing in a bond – any bond – are inherently different from those associated with investing in stocks. These subtle differences make a big difference when it comes to combining stocks and bonds into an effective total portfolio.

Because a company’s stock represents an ownership stake, your greatest rewards come when a company’s expected worth continues to improve, so you can eventually sell your stake for more than you paid for it, and/or receive “profit-sharing” dividends along the way. Your biggest risk is that the opposite may occur instead.

A bond is not an ownership stake; it’s a loan with interest, which defines its two biggest risks:

  1. Bond defaults – If all goes well, you get your principal back when the loan comes due. But if the borrower defaults on the loan, you can lose your nest egg entirely.
  2. Market movement – You would like your bond’s interest rate to remain better than, or at least comparable to those available from other, similarly structured bonds. Otherwise, if rates increase, you’re left locked into relatively lower payments until your bond comes due.

As such, two factors contribute to your bond portfolio’s risks and expected returns:

  1. Credit premium – Bonds with low credit ratings (“junk” or “high-yield” bonds) are more likely to go into default. To attract your investment dollars despite the higher risk, they typically offer higher yields.
  2. Term premium – The longer your money is out on loan, the more time there is for the market to shift out from under you, leaving you locked into a lower rate. That’s why bonds with longer terms typically offer higher yields than bonds that come due quickly.

Bond Market Risks and Returns

If you’re connecting the dots we’ve drawn, you may be one step ahead of us in realizing that, just like any other investment, bonds don’t offer higher expected returns without also exposing you to higher risks. So, just as we do with your stock holdings, we must identify the best balance between seeking higher bond yields while keeping a lid on the credit and term risks involved.

With stocks – Taking on added stock market risk has rewarded stalwart investors over time. The evidence is compelling that it will continue to do so moving forward (assuming you adopt a well-planned, “buy, hold and rebalance” approach as a patient, long-term investor).

With bonds – Taking on extra bond market risk is not expected to add more value than could be had by building an appropriately allocated stock portfolio. Moreover, it is expected to detract from your bond holding’s primary role as a stabilizing force in your total portfolio … and it often does so just when you most want to depend on that cushioning stability.

For example, in “Five Myths of Bond Investing,” Wall Street Journal columnist Jason Zweig dispels the myth that “investors who need income must own ‘bond alternatives’” (such as high-yield bonds). He cites our own BAM ALLIANCE Director of Research Larry Swedroe, who observes that “popular bond alternatives … provide extra income in good times – but won’t act like bonds during bad times.”

The Monevator piece (“brief guide to the point of bonds”) we referenced in Part I offers a similar perspective: “[B]onds are meant to be the counter-weight to shares in a portfolio. They are the stabilising influence that tempers the turbulence. Equities are from Mars and bonds are from Venus, if you will. … [Use] Equities to deliver growth, and domestic government bonds to reduce risk.”

Your Essential Take-Home

Given these insights, logic dictates:

If you must accept higher risks in search of higher returns, take those risks on the equity (stock) side of your portfolio; use high-quality fixed income (bonds) to offset the risks.

As we’ve been hinting throughout this series, there is one more critical component to investing for retirement income. Beyond optimizing your bond portfolio with the right kind of bonds (high-quality, short- to mid-term), and avoiding chasing dividend stocks for their pay-offs, among the most important steps you can take with your retirement income is to adopt a portfolio-wide approach to money management, instead of viewing your income and principal as two isolated islands of assets. We’ll explore this subject in Part III.

Investing for Retirement Income: Straw, Sticks or Bricks?

March 9th, 2016 Posted by Investment Strategy, Investment Vehicles, Investor Behavior, Retirement Planning, Saving, Stock Options 0 thoughts on “Investing for Retirement Income: Straw, Sticks or Bricks?”

Part I: Dividend-Yielding Stocks – A Straw Strategy

If ever there were an appropriate analogy for how to invest for retirement, it would be the classic fable of The Three Little Pigs. As you may recall, those three little pigs tried three different structures to protect against the Big Bad Wolf. Similarly, there are at least three kinds of “building materials” that investors typically employ as they try to prevent today’s low interest rates from consuming their sources for retirement income:

  1. Dividend-yielding stocks
  2. High-yield bonds
  3. Total-return investing

In this three-part series, we’ll explore each of these common strategies and explain why the evidence supports building and preserving your retirement reserve through total-return investing. The approach may require a bit more prep work and a little extra explanation, but like solid brick, we believe it offers the most durable and dependable protection when those hungry wolves are huffing and puffing at your retirement-planning door.

Part I: Dividend-Yielding Stocks – A Straw Strategy

We understand why bulking up on dividend-yielding stocks can seem like a tempting way to enhance your retirement income, especially when interest rates are low. You buy into select stocks that have been spinning off dependable dividends at prescribed times. The dividend payments appear to leave your principal intact, while promising better income than a low-yielding short-term government bond has to offer.

Safe, easy money … or so the fable goes. Unfortunately, the reasoning doesn’t hold up as well upon evidence-based inspection. Let’s dive in and take a closer look at that income stream you’re hoping to generate from dividend-yielding stocks.

Dividends Don’t Grow on Trees.

It’s common for investors to mentally account for a dividend payout as if it’s found money that leaves their principal untouched. In reality, a company’s dividends have to come from somewhere. That “somewhere” is either the company’s profits or its capital reserves.

This push-pull relationship between stockholder dividends and company capital has been rigorously studied and empirically assessed. In the 1960s, Nobel laureates Merton Miller and Franco Modigliani published a landmark study on the subject, “Dividend Policy, Growth, and the Valuation of Shares.” In “Capital Ideas”, Peter Bernstein explains one of the study’s key findings: “Stockholders like to receive cash dividends. But dividends paid today shrink the assets of the company and reduce its future earning power.”

Here’s how the MoneySense article, “The income illusion,” explained it: “[I]f a company pays you a $1,000 cash dividend, it must be worth $1,000 less than it was before. That’s why you’ll often see a company’s share price decline a few days before an announced dividend is paid.”

Dividend Income Incurs a Capital Price.

So, yes, you can find stocks or stock funds whose dividend payments are expected to provide a higher income stream than you can earn from an essentially risk-free government bond. But it’s important to be aware of the trade-offs involved.

As described above, rather than thinking about a stock’s dividends and its share value as mutually exclusive sources of return – income versus principal – it’s better to think of them as an interconnected seesaw of income and principal. The combined balance represents the holding’s total worth to you. (If you’re reading closely, you may notice that we’ve just foreshadowed our future discussion about adopting a total-return outlook in your investment strategy.)

“Safe” Stocks? Not so Fast.

In addition, dividend-yielding stocks may not be as sturdy or as appropriate as you might think for generating a reliable retirement cash flow. Even if those stocks have dependably delivered their dividends in the past, assuming they are as secure as a government bond is like assuming that a Big Bad Wolf is harmless because he hasn’t bitten you yet.

The evidence is clear, and it has been for decades: Stocks are a riskier investment than bonds. This in turn has contributed to their higher expected long-term returns, to compensate investors who agree to take on that extra risk.

Dividend stocks may offer a slightly more consistent cash flow than their non-dividend counterparts, but at the end of the day, they are still stocks, with the usual stock risks and expected returns. As the Monevator “brief guide to the point of bonds” describes, “The key to (most) bonds is they aim to pay you a fixed income until a certain date, at which point you get your initial money back. That is very different to equities, which offer no such certainty of income or capital returns.”

In “The Dividend-Fund Dilemma,” Wall Street Journal’s financial columnist Jason Zweig explains it similarly: “When you buy a Treasury, you collect interest and get your money back (not counting inflation) when the bond matures. When you buy a dividend-paying stock, you collect a quarterly payment – but that certainly doesn’t mean the stock price will be stable.”

Nor is there any guarantee that the dividends will flow forever. Zweig described a lesson that many investors learned the hard way during the Great Recession: “In 2007, 29% of the S&P 500’s dividend income came from banks and other financial stocks, according to Howard Silverblatt, senior index analyst at Standard & Poor’s. That didn’t end well. Many banks that had been paying steady income to shareholders suspended their dividends – or even went bust. Their investors suffered.”

Your Essential Take-Home

Our capital markets rarely offer a free ride. If you’re taking stock dividend income today, you’re likely paying for it in the form of lower share value moving forward. And if you’re invested in the stock market, you are exposing your nest egg to all the usual risks (and expected returns) that comes with that exposure. That’s how markets work.

The fixed income bond markets offer their share of risks as well, but in a different form, which tends to make them a better choice for helping you dampen your total risk exposure as you pursue expected market returns. Stretching for high-yield, higher-risk bond income begins to shift your bond holdings away from their most appropriate role in your total portfolio … which will be the subject of our next piece in this three-part series.

[Photo credit: Flickr Akash Malhotra]

Family Wealth Planning Conversations

February 22nd, 2016 Posted by Budgeting, College Planning, Estate Planning, Family Finances, Homes and Mortgages, Life Planning, Loans and Debt, Marriage and Finances, Retirement Planning, Saving 0 thoughts on “Family Wealth Planning Conversations”

What Are Family Wealth Planning Conversations (And Why Have Them)?

Whether gathering for annual reunions, sharing childhood memories, or simply being there for one another during difficult times, family traditions nourish our most satisfying relationships. An important tradition that we at OpenCircle foster with our clients focuses on family wealth planning. We facilitate conversations that engage every family member, each of them contributing their talents and interests to achieving their collective and personal lifetime goals.

That does not mean that everyone must participate equally. As we work with families, one individual often emerges as the spokesperson or steward for the group. That’s fine … if the role is based on a mutual and deliberately planned arrangement. If it is instead based on unspoken assumptions or force of habit, a family’s wealth planning may benefit from a fresh conversation.

Even if a family is in full agreement on who is best suited to champion its interests, there’s always life’s many “what ifs.” Are others in the family adequately prepared to assume the stewardship role when and if it is required of them? Might they have unexpressed questions or concerns that are best addressed well before that day may arrive? Carving out time to hold candid conversations is where it all begins.

How We Guide Our Clients in Family Conversations

To launch a family wealth planning conversation with a client, we invite them and their family to meet with us at their convenience. (A face-to-face meeting is optimal, but we can harness technology to hold a meeting online if necessary.) We guide them in exploring key considerations such as:

  • How would each of them define their roles in their family’s wealth planning?
  • Are all of them satisfied with their current roles?
  • Do all family members have the essential information, should they be required to increase their participation? (For example, do they know how to reach us?)
  • Are there other questions, suggestions or family wealth dynamics they would like to explore, either immediately or over time?
  • How can we best assist each of them in these and other areas?

We help families find broader and deeper perspective in this area of their lives. Even though specific family members may never have joined us in prior meetings, we encourage them to be included at this time. They may well discover insights about one another that could strengthen both their financial conversations as well as their overall family dynamics.

Regardless of who may be “in charge” of a family’s wealth, every individual is equally dependent on the outcome of the efforts. Enabling a forum for everyone’s voice to be heard is another way OpenCircle helps our clients achieve their greatest life goals, keeping their family’s wealth fresh and meaningful over time. If you would like more information, please give us a call at 203-985-0448.

[Photo credit: Flickr user Luke Lehrfeld]