Wednesday, December 15, 2010

Puttin' It In & Takin' It Out - Avoiding 'Premature Distribution' - Part II

Takin’ It Out - Avoiding ‘Premature Distribution’

(Preamble or Pre-ambulatory?)

Distribution requires a mind shift from accumulation.
Distribution connotes a dilution – a lessening. And in a culture wired for ‘more, more, more’ (despite more, now, better typically becoming less, worse, later), dispersal indicates a weakening, a reduction, a thinning out – over.
In professional rasslin’, the wrestler, whether baby face (hero) or heel (villain) seeks to get ‘over’ with the crowd. But in personal financial planning, distribution signifies implies and or predicts to some – they no longer can cut the mustard, they are no longer productive even worse useless having to (particularly in retirement) depend on their passive assets rather than their active effort, exertion and talents.
Thus, takin’ it out seems to too many to be a lessening of oneself, a dependency, a loss of importance. They are uncomfortable with distribution despite the assets being the fruits of their active labors (save inheritance). And worse, they fear and often become dependent on the assets identified as themselves forgetting it was their own adaptability and resourcefulness (save inheritance – the lucky sperm club) that with their God given talents and efforts secured the assets and the current currency in the first place! As identification and belief in the assets rises, belief in oneself seems to diminish with the excuse, ‘I’m older now.”
The underlying fear of distribution is, ‘I don’t want to outlive my assets (as I can’t earn them back if necessary and I’ll wind up eating Little Friskies at 16th & Larimer rubbing my gloves hands without finger covering over a sterno can fire.)
I’m not making this up.
Personal Financial Life Planning aside – this scenario – is not uncommon and if I may break character a minute – defies our self professed faith in God and ourselves.
Of course, all bets are off with the continuation of the Obama Administration after 2012 (back in character).

The above doesn’t apply to accumulation distribution cycle for your kids education (though if you think about it, the 300% over inflation higher education cost is personal financial ebola crowding out and or delaying the workfree retirement due to those whining collectivist Scholar Barons on the Honor Dole (tenure)). Nor does the same the cycle apply to a slow down income prior to retirement (assuming it is less than 10 years). But when one is ‘no longer cutting the mustard’ the sense of self becomes tested when the paycheck is no longer coming in and one depends is into distribution – takin’ it out – instead of accumulation

If one is not in touch with the above ‘I am my assets – the growth of my net ‘worth’iness therefore I am’ regardless of distribution methods described below (qualified by the previous blogs) they will be ‘worth’less.
Takin’ it out isn’t costing you ‘an arm and a leg’ (unless there is a divorce lawyer on the other end of your limbs).

The foregoing said, there are other qualifications, considerations & cautions which have been mentioned in previous blogs which you may wish to revisit prior to selecting your method(s) of distribution:

1. The Flaw of Averages & The Sequence of Rates of Return
2. Monte Carlo Probability Analysis
3. Your Investment Policy Statement

4. Exhausting taxable accounts prior to non taxable accounts (IRAs, 401ks, profits sharing) prior to age 70 UNLESS there is required distribution method considerations by law which shifts you into a much higher bracket (and surcharge for medicare!)
5. Rule #1: the closer one is towards distribution from accumulation the greater the liquidity of the investments especially where the payoff is of a short time horizon for distribution (i.e. 4 years for college though in Colorado only 17% graduate in 4 years due to the competency of the arrogant Scholar Barons on the Honor Dole.)
6. Rule #2: the closer one is towards distribution from accumulation the lower the volatility (beta etc.) of the investments in the portfolio for the objective especially where the need for distribution from these assets is within a short time frame (less than 3 years typically) subject to the method chosen below.
7. Where you end up depends on where you start (Go back to previous blogs!)

For all the methods below, regardless, I would suggest

1. RR&R: Recycling, Replenishing & Rebalancing: recycling all distributions, dividends, interest, gains into your money market accounts for living expenses & replenishing and rebalancing per the method & allocation chosen, & your investment policy statement
2. Have at least 1 year if not 2 or 3 of living expenses in money markets to minimize the fright (and stupidity) of selling in panic in a volatile down market. (Yes, your rate of return will decline. However, the savings on your insurances should be added to your rate of return in all fairness.) REMEMBER JOSEPH’s DREAM INTERPRETATION OF THE 7 FATTED COWS AND 7 EMACIATED COWS- (Storing 7 years of grain. The emaciated cows ate the fatted cows and gained no weight - THE FIRST ATKINS DIET – DOW & COWS)

DECUMULATION Methods: To minimize the risk of “pre-mature distribution”

· 4.4% & Variations
· Buckets (‘Kick The Bucket?’)
· 100 less your Age (and variations)
· Layering

4.4% & Variations

Fee only financial planner, Bill Bengen’s extensive research shows that 4.4% can be withdrawn yearly + inflation for a 30 year period with a 80%+ probability of success. That said, at the end of the period, there is nothing left for inheritance. Thus, it is, constructively, almost a do it yourself variable annuity approach without the double and triple dipping fees from insurers. The allocation is typically 65%-70% in equity and 30%-35% in bonds. For Bill Bengen’s variations – look him up on the web.
Fee only planner Michael Kitces (The Kitces Report) assuming at least 60% equity (market) exposure, tweaks the Bengen research with a P/E (price to earnings of the overall market as variable allowing increases (plus inflation) and or decreases in the withdrawal rate:

Kitches Rules for Adjusting Safe Withdrawal Rate
P/E Safe Withdrawal Rate Impact
Above 20 P/E Safe withdrawal rate of 4.5%
P/E between 12-20 Increase safe withdrawal rate 0.5% to 5.0%
P/E below 12 Increase safe withdrawal rate to 1.0% to 5.5%

Why increase by 1.0% to 5.5% when the market is down (P/E 12 implies the market is down and a value)? Because the odds are historically at this low valuation the market will increase while when the market is at a P/E of 20 or more the probabilities of increase are much lower. So the portfolio can take a larger withdrawal when the market is down (which seems counter intuitive) because the remainder of the portfolio should increase in valuation to more than counteract the withdrawal.

The Slices Variation – (Death by a 1000 Slices?)

The withdrawal rate in this method is typically modified per age period/ phase below:

· Age 65-75 ((Higher))Expenses plus inflation)
· Age 75-85 (Expenses plus ½ inflation rate)
· Beyond age 85 (Assumes lower expenses plus inflation)

Given escalating health care escalating costs without restraint in Obamacare (my own AARP Aetna Essentials is going up 72% - so much for Obamacare’s costs will be restrained), adding 30 million people in demand with a shrinking supply of health care professional while, in the immortal words of comedian Timmy Rogers ‘everybody wants to go to heaven, but nobody wants to die,.’ this is my second favorite distribution method. My favorite: almost anything else.

The 5 Year Moving Average:

Other planners use a 5 year moving average – which for most individuals is in the inevitable words of “HD” – “too much trouble”

The Buckets/Tranche Approach (‘Kicking The Bucket?’)

In this distribution approach, you match your investments time horizon and goal. Essentially, one is corresponding assets to the time horizon of the liability/claim (like an insurer). Example: (in all cases the amount is modified by the pension and or social security amounts estimated during the particular tranche/bucket)

Period Investments
1-5 years CDs, short term annuity – less social security
And pension payouts
6-10th year Intermediate bonds, REITs
11-15th year Bond funds, balanced mutual funds
15-20th year Equity mutual funds

My Preference: The Eclectic Layering for ENOUGH

Overriding Factors

1. 4.5% a year + inflation but no more than 3% inflation increase
2. Add 0.5% when P/E is 12 or below and no inflation adjustment (regardless the inflation rate) when P/E 20 and above
3. No inflation adjustment when market is down year to year
4. Recycle all dividends, interest, and distributions (capital gains etc.) back into one’s money market account (to replenish and or distribute to meet the goal set for living expenses)
5. Rebalance per the layers below – once a year
6. The above is subject to your Investment Policy Statement, yearly Monte Carlo analysis and recalculation of goal.

Layer 1 – Emergency & Stupidity

Joseph in response to his 7 fatten and 7 emaciated cow dreams (representing 7 good years and 7 bad years), stored 7 years of gain to weather the potential (and realized) famine. And Egypt got rich when the famine hit because Joseph had the grain.
No grain – pain (which goes against the grain).
While I am not suggesting 7 years of cash or gold (gold bugs – you can’t eat gold – and ps in 1982 or 1983 gold was $850 given a 3% average inflation conservatively – gold to be even would have to $1945 today wise guys – if anything silver would be the better hedge historically at a 16:1 ratio with gold – gold to silver is now 80+:1) – 2 to 3 years of cash (money markets) makes some sense (subject to my thoughts on leveraged etf ‘insurance protection’ later)
Why? As stated in previous blogs, volatility kills investment and therefore goals. From a probability standpoint 2- 3 years is typically the worst of in a terrible market. (However, this is no guarantee remember the Black Swan of 2008 – and the swan dive.) So while your heart rate is racing with 500 point down days – having two years emergency should minimize you from selling at the bottom.
(Forget market timing – study after study has shown this is a loser’s game over time).
While you are at -consider a year of food from Emergency Essentials or some other reputable food storage company etc. (I am not a Morman or MOREmon just a Dogged Jew.)
PS There is an unrecognized added rate of return benefit in that you can take larger deductibles on your health, home, auto etc policies reducing these policies’ cost.

Layer 2 – Longevity Income to Reduce Fear of Outliving Your Assets

This layer is NOT about rate of return, Moreons!! And this layer is subject to inflation risk. But this layer is about not outliving your income or at least a substantial part of it. This layer is for a ‘floor of income’ not ‘if come.’

· Long term care insurance
· Pre or post nuptial agreement
· Asset protection trust (?)

You need long term care coverage sufficient to offset capital depletion due to home health care costs and or nursing home and air tight pre or post nuptial agreements . For those who think they can self insure the long term care risk – remember this: the odds of a fire wiping out your home is 1 in 435 whereas the chance a 60 year old will need some assistance with care in his lifetime is 70% and 40% he or she will stay in a nursing home someday. (Please kill me first). The average cost of one year in a nursing home facility in 2030 will be $178,510 – probably what it costs in New York or Boston now.
So, you’ll insure your house with a 1 in 435 chance of it burning down but not transfer the risk of $178,000 with a 40% probability?
And, as to the reframe, my spouse will take care – oh, please. Studies show this fantasy strains 37% of the marriages. Go lie on the floor right now, and have your spouse pick you up 8 times. Think of that week in and week out – at best you won’t need Jennie Craig.
Wouldn’t it be better to bifurcate – have you spouse to ‘care about you’ and a trained professional (preferably good with their hands gentleman) to ‘care for you?’
With 50% divorce rate of first marriages and 70% rate of second ones – why would you be without a pre or post nuptial agreement given the capital depletion a divorce can cause?
And while outside the scope of this essay, given our litigious society and significant assets, might you not consider an asset protection trust to minimize lawsuit potential capital depletion?

After calculating the present value of your income needs for life after tax after inflation risk adjusted (see prior blogs) – this is the amount you need at the basic living need level to be funded by this layer. (If there is income from layer one, reverse annuitizing one’s home, social security and or pensions that are not Ponzi schemes and underfunded – the amount of the goal to be funded by this layer is reduced.)
Of course, the question becomes do you count on anticipated social security benefits given the multi trillion dollar underfunding and the trend towards making social security more of a welfare program which will entail cutting back benefits especially at the higher end? The second question is the potential value of a stream of income from reverse annuitizing one’s home typically after the age of 70 for a lifetime income to partially offset the need at this level especially with declining housing values.
The above said – here are some of the tools for this level’s funding:
· immediate annuities (spread the purchase in installments over 5 years)
· ladder bonds to match income needs and timing and or bond funds\
· ‘balance mutual funds’ which are part bond and higher yielding stocks
· extractive mineral and or pipeline master limited partnerships traded as stocks
· utility mutual funds/etfs
· income real estate investment trusts
· mutual funds whose object is stocks with increasing dividends.

Layer 3 Discretionary – 70% of Remainder

I recall a story told to me by a former Fortune 500 President relative to his company’s estimated earnings for the quarter. When he inquired of his accounting firm as to the projected earnings, the partner in charge of the account stated, ‘what would you like them to be.’
Accounting for earnings is fiction and bookstores should rearrange their shelves to put accounting texts with Patterson, Grisham and The Secret.
Accordingly, I have a bias against growth stocks which typically trade with projected earnings (based on accounting) and prefer value oriented mutual funds, and mutual funds disguised as stocks both domestic and foreign (Berkshire Hathaway is an example).
Value oriented investments typically do better in down markets and not as well in up markets but when all is said and done – overall outperform growth funds without the big roller coaster effect.
My second bias is (Focused Diversification): – I believe a good analyst – fund manager can really only know maybe 15 stocks. Therefore, I prefer value oriented focused funds but only in the context of focused diversification.
Focus diversification – what have I been training to be a Starbucks Barista, an Obama’s teleprompter and a Cass Sunstein hand puppet?
The concept is to have 3 or more value oriented focused funds (typically each fund has 50%-70% of the holdings in 10 stocks) which buying one alone doesn’t diversify but buying at least 3 ‘focus funds’ gives one ‘diversification.’ Examples: Fairholme and Sequoia (which I do own)
Added to this ‘focused/concentrated diversification’ should an international value fund (focused or not).

Again all interest, dividends, distributions and capital gains are recycled into level 2 or level 1. Additions can be made to a desired a longer emergency fund term though the offset is to balance the longer emergency funding without sacrificing the resource level to maintain one’s Enough goal.

Level 4 Hedging -30% of Remainder

Everybody wants to go to heaven, but nobody wants to die
Comedian Timmy Rodgers

Health Mutual Funds & ETFs
Conventionally, Health industry funds are not considered a ‘hedge.’ Yet, as long as everybody wants to go to heaven and nobody wants to die and as Stalin said, ’10,000 deaths is a statistic, one death (mine – fill in your initials) is a tragedy,’ we will spend, Obama or not, on that last breath as long as there is hope. (‘Hope,’ per Ambrose Bierce, ‘is deferred disappointment.’
Thus, a Health ETFs or mutual funds are ‘a hedge’ as life is an ‘addiction.’

Energy Funds, ETFs etc
We want the energy to live and need energy for our standard of living. (This is despite Watermelon Democrats -Green on the outside – Red lefty on the inside - who have houses costing $3000 a month in heating bills while being against wind farms in Martha’s Vineyard that might hinder ‘their view.’) In any event, when there is no wind – who you gonna call – Ghostbusters – nope – natural gas – oil. Methane combustion from Barney Frank may be large, long and even silent but still not enough to get those wind turbines going when there are no gusts even from blowhards. IYE and VDE are examples of energy ETFs. Also consider for this inflation hedge and yield (in layer 2) pipeline master limited partnerships (examples: PAA, EPD).

Commodities & Leveraged Short Funds
While asset categories that go contrary or less positive (negative correlation or less positive correlation to the market) have basically bit the dust in the global economy, there is still negative correlation with yes – commodities and leveraged ‘short’ ETFs. The concept here is not commodity speculation but smoothing the rate of return – the ups and downs of the entire portfolio. Examples: Rogers (RJI), DBA, VAW, and PCRIX. Leveraged ‘short’ ETFs are new. For example, to protect against the downside of the market there are ETFs like for SDS that when the S&P goes down “1” it goes up “2” – 200% leverage.. However, when the S&P goes up 1, SDS should fall 2 – the 200% leverage working in reverse. ETFs like SDS should also be considered to protect one’s emergency fund buying for example a 50% position of 1 year’s emergency so that if there is a drastic decline in market and currency – you may have replaced 1 years’ worth of the fund (remember the 200% leverage). In this context, the leveraged short ETF is an insurance premium not a speculation.

Gold & Silver
(As for Gold see previous comments – but if one is to do gold or silver – consider the ETFs GLD & SLV or coins with denomination value as well as high gold or silver content to give a floor to the value of this hedge to inflation. )

Given the monetization of the currency, should the ‘sh*t hits the fan scenario’ occur, this calls for the hedge strategy of seeds and bullets. For seeds, an ETF of agricultural commodities like DBA as well as Smith & Wesson, Ruger and or OLN (the only semi pure play in bullets) are examples. The position in DBA supplements the year of food. For bullets and training – NRA Instructors are plentiful to instruct you and your family not only in shooting but for handgun and shotgun strategizing for self defense in your house to protect you and your dogs. (Note: employing the human shield strategy involving one’s spouse which would lower the present value of your Enough need in layer 2).

Taking It Out Distribution vs Whipping It Out Distribution

As a general rule of thumb, after all is said and done – qualified by not compromising the goal, take out 4.4% or 4.5% a year plus inflation up to 3% but in year after the decline in value of the enough amount, do not take out the additional inflation bump until the amount necessary to fund the present goal is restored. Per Kitces’ research only bump the 4.5% to 5% when the P/E of the market is 12 or lower.. And yes, you can make the case of three different enough tranches – early retirement, mid retirement, and Lawence Welk time (living on much less) leading to higher withdrawal rates earlier, but the 4.4- 4.5% rule is easy and has worked in the past (though no guarantees).

More is ‘managing assets and lives in relative external comparison (Dow Jones, S&P, coveting, envy --).
In contrast, Enough is managing goals internally: aligning personal resources with life goals and missions – healing financial anxiety, putting money in it’s place to transcend to your significance especially in your preservation and distribution phase of this earthly existence.

Saturday, December 4, 2010

Puttin’ It In & Takin’ It Out Part I: Puttin’ It In

Okay, if you’ve gotten this far (doubtful), know specifically each of your personal financial planning life goals specifically (not hopes, wishes and dreams – dry or otherwise), and there is a deficit overall today to achieving the goal (and the assumptions of the goal are not to be changed), the question becomes how to make payment in to make up the deficit to the objective?
Some believe they can time the market.
As Tony Soprano would say, ‘Furr get about it.’
Studies show for example:

· In the ‘90’s the S&P 500 was up 15%-16% but if you missed the top 10-15 days you were up 5% per year
· If you were invested in all 2516 days in the S&P Stock Index from 1997-2006 you made (before taxes and fees) 8.4% a year. If you missed the 10 best days you averaged 2.2% a year
· In a series of studies from 1994 to 2002, scholars have show that from 1926 to 1993 you had a
0000000000000000000000000000022883557% chance of correctly timing the stock market just 50% of the time

(Besides if you or I could time the market, I wouldn’t be writing and you wouldn’t be reading this – and that’s a 99%+ probability)
So now, given your investment policy statement with predetermined allocations per objective via retrofitting etc., you are either going to change assumptions (amount of the goal after tax, assumed inflation, after tax rate of return, delaying the start of the objective or duration) or you are going to have to fund the objective.
Now the question is not into what investment (see previous section) as that has been determined but how and when – or puttin’ it in (payment) and sequence risk. (Takin’ it out – withdrawal etc and sequence risk will be in Part II)

Think of sequence risk this way. How successful is a guy trying to go to second base when he hasn’t even gone to first on a date let alone cross home plate? How much lovin’ is there without the huggin’ first?
So are you going to go on whim (the ‘loin quiver factor’ as one recovering MOREon called it), all in a (lump sum), or have a sequential formula for puttin’ it in – in periodic payments? If the latter:

· Do I put it in annually, quarterly or monthly etc?
· Is there some other trigger for regular investment? (i.e. the market is selling on a price to earning ratio of 12 would mean a higher monthly payment than when the market is selling at 20 times price to earnings modifying by X% the amount paid in.)

When accumulating I prefer putting it in – in equal amounts (unless transactions costs make it prohibitive)- monthly but no less frequently than quarterly. This is referred to as Dollar Cost Averaging (aka Constant Dollar Plan). Some prefer to put in equal amount of shares on a regular basis which is called Share Cost Averaging. Some prefer value averaging (which is really asset allocation rebalancing on a more frequent basis). The point is – neither you nor I can time the market. If you could, you wouldn’t be reading this commentary and I wouldn’t be writing it. You want to roll the dice, go to Vegas or get remarried without a prenuptial.
Yet, here of some of the but, but, butts I’ve heard for NOW, NOW, NOW

· I’ve got the money – let’s invest it NOW (“Impatience” – money burning a hole in your pocket)
· The inheritance with biblical guilt: I just got this inheritance from my Iron Fist & Velvet Glove Dad and even though I’m just a lucky sperm club member I don’t want to waste ‘the talents’ given to my ‘stewardship’. NOW (Stewardship is the tip off to being a guilt ridden liberal tight fisted with their own money – inherited – but generous with other people’s money).
· The market is getting away from us, so let’s ‘deploy’ NOW (really, is that how you will feel when the market is down 600 points in one day?)
· I’m getting bubkis on money markets NOW
· So I put it in (monthly, quarterly), then I have to rebalance yearly, too much trouble (just do it all NOW)

If you want NOW – join the National Organization of Women
NOW is a Nag – double entendre intended.
NOW becomes HOW NOW Brown Portfolio and I ain’t talking UPS logistics.
NOW originates from the impatient entitlement of ‘give me, buy me, take me’ which itself stems from MORE (itself derived from the palliative for fear of physical extinction: Acquisition).
NOW is the cousin once removed of More – favoring puttin’ it all in immediately without even a kiss or hug.
And remember e.e. cummings statement with slight adjustment, “more, more, more, what are we all MOREticians?”