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|Portfolio Building |Week 8 |

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From last week: 8. Costs kill.

Mutual Funds

Municipals

Based on: Text Chapter 6 Pages 143-177 skipping 154-166 The Four Examples…

Because we are all different in our financial position, our needs (wants), family constellations, marital status, age, and on and on; we will find there is no one-size fits all solution. Each of us will implement our portfolio differently; using the same principals and rules.

8.1 Portfolio Building

The author advises two things in the first paragraph:

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1. Save as much as you can your whole life.

2. Consider an immediate fixed annuity in retirement.

Remember he is writing for an audience of all ages, not for those already in retirement. We do need to save, if we can, simply because life is uncertain and plans do not always work out. The more we can save, even now, the better we can be prepared. Recall in week 4 we discussed the third step in implementing our portfolio plan. To grow, stay level or deplete our assets.

Here is where each of us must choose to save, stay even or spend down our assets. Like the author, I recommend saving your whole life – if you are able.

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We will talk only about Immediate Fixed Annuities here as the general topic of annuities could fill several Olli classes. If you remain interested in this vehicle after this introduction I urge you in the strongest possible terms to only buy them through a financial planner you can trust. There be sharks in these waters, matey!

The immediate annuity is relatively straightforward: It allows you to convert an immediate payment into monthly, quarterly or annual income for life. Most immediate annuities are fixed, which simply means they pay an amount that's established at the outset. They are issued by an insurance company and purchased from a broker or bank with a lump sum and begin making payments within a short period – as soon as a month after purchase.

Typically, immediate annuities provide a significantly higher level of sustainable income than you'd be able to produce from your investment portfolio, assuming you stick to the convention of withdrawing no more than 4% of your nest egg per year.

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For example, a 65-year-old man who buys an immediate annuity today will receive some 8.4% a year of the amount he invested in the annuity.

The extra income is the result of the requirement that you surrender your principal to the insurer. Each payment consists not just of interest, but also of a portion of your principal, prorated over your remaining life expectancy.

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The payments are guaranteed to continue for the rest of your life. But when you die, they stop -- regardless of whether you've recouped the amount you paid for the annuity. Basically, you can buy a pension!

If you are willing to settle for a lower income, you can buy features designed to overcome some of the drawbacks of a traditional annuity.

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With one, for instance, your heirs will receive a set number of years of income if you don't live to collect it. (First, though, check whether buying a life-insurance policy would be cheaper.) Another raises payments by 2% or more annually to keep up with inflation -- a key feature, given the way inflation can erode purchasing power.

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Sturgeon’s Law, coined by the science fiction writer Theodore Sturgeon, states, “95 per cent of everything you hear or read is crap.” This is undoubtedly true of annuities in general.

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2010: $1,000,000 fixed immediate yields

• $75,000 for a 65 year old individual.

• $62,500 for joint survivor option

• 20 year guarantee, 20% reduction

• Variable, CPI adjustment up to 10% per year, $57,400 for joint survivor couple

Disadvantages:

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• inconsistent with a bequest motive,

• it gives the annuitant an inflexible path of consumption,

• it can involve high transactions costs, and

• it can be tax inefficient.

It’s gone or 20 year option! Couple a year later finds they have a few years to live. No spending down to fill their bucket list.

Sales commissions and fees and expenses!

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Taxes: partial annuitization of retirement accounts does not reduce the required minimum distributions (RMDs) you must take. If you annuitize 50% of your IRA, you still have to take RMDs on the other half. The income from the part you turned into an annuity will be larger than the RMD would have been, so you pay more tax than if you hadn’t annuitized. Also, the year you convert a portion of your IRA to an annuity, you must make an RMD on the full amount.

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If Social Security plus any pension you receive won't cover your monthly budget, many economists recommend buying an annuity for an amount that bridges the gap. We will see how this might fit into a portfolio plan later.

Immediate fixed annuities can be a substitute for bonds. They are a way to provide guaranteed income; with the “loss”, actually the spending, of the principle. This may be one way to spend down a portion, but not all of your assets. If you live long enough, you do well.

Of course, these days, trusting your future to an insurer -- even a top-rated one -- requires a leap of faith. But in the event of an insurer's insolvency, the insurer is taken over by the North Carolina Life and Health Insurance Guarantee Association which provides at least $300,000 in coverage for the guaranteed portions of annuity contracts held at an insolvent company. Policy holders come first as the defunct insurer’s assets are distributed so you can get more. The safest bet is to limit your exposure to any one insurer to $300,000. (As of 2015)

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Social Security – When to take…

Examples: If your retirement age is 66 (born after 1943) and you take social security at the earliest, age 62, your benefits are reduced by 30%! If you wait beyond age 66, your benefit credit increases by 8% per year until age 70. (a maximum credit of 32%)

The author recommends waiting as long as possible to collect Social Security. The gain in eventual income in waiting as long as possible is significant. Good advice, if you can wait. But, obviously each of us will begin collecting when our situation requires the income.

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(If you wait to take SS at 70 not 62 you “catch up” by age 78 after which you receive double payment.

If you take SS at 70 rather than 66, you again catch up at 78 after which you receive 35% more each year.)

The author doesn’t care much for ETF index funds as opposed to indexed mutual funds to build a portfolio. I believe in the next edition, if there is one, this will change.

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Since he wrote the book in early 2010 several new ETF offerings should change his mind. Vanguard and Charles Schwab have developed a family of indexed ETFs with low operating costs and no transaction charge for purchase or sale! Fidelity “index” funds “invest “80% in the underlying index, the rest in futures or options or whatever>

Recall the chart from last week.

Refer to chart Online Fee Comparison for ETFs (as of August 2017)

The first expense ratio in each column is from August 2012. The second boldface expense ratio is from this August. So while our author only recommends Vanguard because it is not publicly traded; Schwab ETFs have not gone away but have improved or grown. But he appears to have made the call on iShares being bought by Blackrock. Fidelity has recently begun to offer core? Index? Funds as well as using iShares 90+ ETFs (no commission charges). But , they are not true index funds. The expense ratios verify this. True index funds have the lowest cost and the best risk mitigation over time.

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Why are low operating expenses and no transaction charges so much better? Two reasons. The first is that we will see we can rebalance our portfolio largely without transaction costs – more on that later. Secondly, because cost averaging can be a useful tool to execute our investment plans. If we need to. And we can do so at no cost for the buys and sells.

For young people building a portfolio, value and dollar cost averaging are essential tools. For us, we may not have the luxury of using them. Since they are most useful when working and building a retirement portfolio, I will skip them for now. Time permitting, I will discuss them later and explain how they can be useful.

Let me address taxes briefly. Each of us faces a different tax situation. It is beyond my pay grade to offer tax advice. If you have taxable accounts and need to reduce your tax burden, you may want to use municipal bond funds. We will look at a simple example next week. If you have a lot of taxable income, you may need professional help.

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Rebalancing:The author recommends rebalancing every two or three years. This seems to work well as it prevents reacting to market conditions. Tax considerations should be considered in deciding on a rebalance schedule. Tax protected accounts can be rebalanced every year. Rebalancing will be the hardest thing you do in implementing your investment plan. Harder than budgeting!

8.2 Investment Plan & Portfolio Tool

Let’s look at how we can implement all this fine information our author had provided.

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As discussed in week 4, when the time comes to implement your investment plan, you will need to complete four steps:

1. Estimate your expenses. (done, I hope)

2. Determine your sources of non-investment income. (Social Security, Pension, Trust Account) (This should be easy.)

3. Decide if you will save each year, retain your portfolio at its current level, or spend down some of it over the remainder of your life. (Can always start with 2 or 3% Savings)

4. Determine the composition of your portfolio to generate the necessary additional income.

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It’s time to start talking about how to construct a portfolio of asset classes suited to your personal needs. We will talk about 3 ways to do this. The first one enables you to do this for yourself. It requires you to do all the work: but, it results in the most highly customized portfolio at the lowest cost and hence highest income return. The second is paying professionals to do it for you – expensive. The third is to use programmed robo-advisors, also costly and both these two have additional drawbacks. To start with the do-it-yourself approach, here is a tool that may help. Here is the paper version for those of you who are adverse to spreadsheets and computers. At our website you can download an excel spreadsheet version that will do most of the calculations for you. It has a different and a more simple set of instructions included.

Distribute the “Income Estimating Tool” hardcopy and manual versions.

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You can make more paper copies of the manual version for your use and keep this original.

At our website you can download excel spreadsheets, save the originals and rename copies to use. We will see shortly why you want to do this.

When you begin to enter numbers in your excel copy, save it as a new name so as to preserve your original.

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EXPECTED returns are NOMINAL – repeat previous remarks on personal inflation if needed.

The asset classes chosen for the tool are the ones I believe are most appropriate for retired investors seeking income. You can add, change, delete as you wish.

You are encouraged to keep two versions, one with annual expected cash flow returns and one with the long term percentages. That is dividends and interest payments only ignoring dividend growth and rebalancing gains. Examples should make this clear.

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How many asset classes? Here there is a tradeoff: More asset classes mean

• more diversification and risk mitigation

• more work to find sound bond funds

• more work to rebalance

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What vehicles in each asset class? Stock fund i.e. equities – Index Funds ONLY.

Bond funds we will cover in detail next week, how to find good funds for these asset classes.

First, the big picture – later you will drill down into the details.

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These examples are for illustration – THEY ARE NOT RECOMMENDATIONS.

The tool has been reduced in size and scope for illustration on our screen. It works exactly like the full blown tool on our website. Here it is.

Switch to Investment Tool Income Spreadsheet

See example 1 on your handout…

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Work through the these examples using the abbreviated spreadsheet tool…

We will assume a 30/70 stock/bond allocation.

We can use the tool to estimate the income we will receive in a given year. We use the actual returns of dividends and interest paid by each fund in our asset classes. Get to EX.2 We are now at EX2 on your handout.

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Example 3 is the long run view including expected capital gains. Note the Equities have larger expected returns. Here is the long run view.

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These percentages are over a long term – decades. While they may be the best estimate of expected returns, actual returns will vary greatly. They are best used as a gauge of risk. The higher the return the higher the risk, the more volatile is the price of the asset class.

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How to Rebalance….

1. Set a fixed date a year or two in advance.

2. Calculate your current expected allocations using the tool.

3. Sell those asset classes that are over your percent allocation to bring them in line.

4. Buy those that have fallen and are below your intended allocation.

Numbers 3 and 4 are HARD to do psychologically, but are the essence of a buy low sell high strategy. This requires discipline.

Then show the example of rebalancing using the abbreviated spreadsheet. Start with EX 2. Invest $50,000.

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A year or two has gone by…

We now sell the asset classes that have gone up and buy more of those that haven’t gone up as much or have gone down! To arrive at our same allocation after the markets have changed.

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This is the cure for chasing what’s hot and ending up with what’s not. It’s practically easy and wise; but emotionally very hard.

Return to slides.

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As Hamlet said, we would “rather bear those ills we have than fly to others that we know not of.”

For the next two classes: Download the tool and explore it and how it works. I expect you to come loaded with questions next week. We will examine how to find funds for income producing asset classes. We will also look at having someone do the portfolio building for you and how to pick financial advisors.

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