Retirement Watch

Having the Last Word

2009-11-05T21:49:00Z

Most estate plans are missing a key ingredient. Many estate planners don’t recommend it, and it isn't even mentioned in many estate planning discussions. One reason might be that, despite its importance, the document is not legally binding on anyone.

This document can clear up a lot of issues. It can save time and money in processing the estate, answer many questions of loved ones, and prevent the heirs from going to court. The document also can make clear one's final wishes in many areas that are not covered in wills and trusts.

The document often is called a letter of final instructions. That is a bit of a misnomer, because properly done it is more than a letter. It should be several documents contained in a three-ring notebook or other device that makes it easy to update the papers yet keep them together.

The letter of instructions is your last word on a number of issues. It also is a practical guide to handling your estate and managing the property. It can provide advice and guidance. Preparing a letter of instructions also is an excellent way to help do your planning and uncover forgotten information. Let's take a look at the details.

Contacts. Your executor will need to contact your estate planning attorney, accountant or tax preparer, life insurance agent, and any other financial professional who helped you. There also might be investment managers and employers or former employers who are paying benefits. Also include personal contacts: friends, relatives, organizational leaders. Include the name, address, telephone number, and e-mail address of each.

Where to look. Unfortunately, in many cases much of an executor's time is spent looking — for documents, account statements, contact information, personal items, or long-forgotten assets. May you know where everything is (though you probably don't). Make things easy and inexpensive for your executor by leaving behind an inventory of assets that includes where the assets and any documents related to them can be found. If you keep valuables in a safe deposit box or safe, be sure to note this and how the executor can gain entry. Let the executor know where you keep receipts, canceled checks, and any other supporting documents.

How it is divided. Your will, beneficiary designations, trusts and other documents legally determine who gets what. But you can make a plain English explanation of the division in your letter. You might explain why things are divided as they are — especially if you think someone might be surprised, disappointed, or have questions.

If you own a business, be sure to get periodic valuations and asset inventories. The business might own assets your heirs might not be aware of. You should provide separate detailed information about the business, its assets, its operations, and suggested actions to take with it.

You probably have several credit cards and belong to one or more associations, societies, or other groups that offer membership benefits. The benefits might include some kind of life insurance, disability insurance, or medical insurance. Take the time to review your benefits and list them somewhere. Provide full information, such as the brochure received from the provider. Your executor can make claims and boost your estate.

All of these lists can be included as separate statements that are attached to the letter or included in a separate divider in the binder. Also include in the binder copies of recent tax returns for you and your business along with your will and any other estate planning documents. Of course, a copy of your will and any trusts should be included. Recent copies of statements from any financial accounts and employee benefits also should be attached.

In most states, your instructions on funeral arrangements and some other matters are not legally binding even if included in the will. You also don't want to update the will each time a new idea occurs to you. These items can be included in the letter of instructions or notebook. Here are topics to consider:

* Burial, organ donation, and similar preferences. Naturally, if arrangements have been made in advance, these should be explained.

* A suggested obituary or items to include in an obituary.

* Preferences for the funeral, memorial service or other ceremony. You can be as detailed or general as you would like.

* The disposition of special collections or assets, pets, and memorabilia.

* Care for dependents who are incapacitated or for minor children or grandchildren.

Every estate planner with any experience has stories about searches for assets or disputes over seemingly minor matters. You can avoid being part of one of these stories by leaving a letter of instructions.

A letter of instructions has the benefit of being easy to update. You don't need to incur lawyer's fees or have a signature witnessed. Sit down once a year, review it, and determine what needs to be updated. After the revisions, make some copies. Your lawyer and executor each should have a copy, and there should be one in your desk drawer or other place you keep documents.

Preparing a letter of final instructions can provide benefits now. The letter ensures that your financial affairs and documents are organized. It probably will cause you to throw away unneeded items and carefully consider some items that have been put off or neglected. The process will cause you to do things that should have been done some time ago. Make it easy by not trying to do the entire project at once. Break it into manageable pieces and give each the attention it deserves.

When You Don’t Prepare

Without a letter of instructions and good organization, the heirs are forced to engage in the old-fashioned property and document search. Sometimes it is comical. Sometimes things get ugly. Always a lot of time and effort is wasted.

Estate planners tell stories of important documents that never are found and of other documents that are found in the most unlikely places. Cash, jewelry, and other property are found hidden in the backs of closets, in attics, or under floorboards. Sometimes evidence of real estate or stocks is found stuffed where they are discovered only by accident.

When heirs remember seeing property, such as jewelry, or hearing the loved one talk about real estate, suspicions are aroused when the property or documents are not found during the estate settlement process. The results can include accusations, lawsuits, and broken relationships.

Don’t leave your heirs in this position. Prepare a proper letter of instructions and supporting documents. In the process, you probably will re-learn things about the estate you forgot and also realize that some important papers need to be replaced.

Bob Carlson is editor of the monthly newsletter Retirement Watch and the web site www.RetirementWatch.com. He also is author of the books The New Rules of Retirement and Invest Like a Fox…Not Like a Hedgehog.

My Hedge Fund Portfolio Keeps Moving Ahead

2009-10-29T14:42:00Z

Hedge funds continue to make headlines, and most of them are not good. The big insider-trading case involved a hedge fund firm, and news stories indicate the investment process of the firm was to get an “information edge” that apparently included insider information on a regular basis. Forbes magazine had an article asking “How Dirty Are Hedge Funds?” Its answer was “filthy.”

The latest evidence for Forbes was an academic paper that concluded 21% of hedge funds lie about their legal and regulatory problems and 28% issue either incorrect or unverifiable information about other topics.

You can receive the benefits hedge funds are supposed to have without the high fees, lack of liquidity, uncertainty about investment strategies, and other disadvantages of hedge funds. My portfolio of mutual funds that have hedge fund qualities persists in meeting or surpassing my goals. The portfolio is delivering higher returns than the S&P 500 with less risk. It took a hit in the last half of 2008, but it did not fall as much as the indexes and most portfolios. It lost 13.25% for the last three months of 2008 and 18.49% for all of 2008. Though disappointing, the losses were far less than for the S&P 500.

In the rally, it bounced back faster, widening its long-term return above the S&P 500. It was up 9.88% for the three months ended September 30, 2009, and 4.79% for the prior 12 months. Its performance is ahead of the S&P 500 for all periods but the latest three months, and the portfolio has far less risk and volatility.

My “hedge fund” portfolio is composed of mutual funds that use strategies similar to those followed by the better hedge funds. The strategies include distressed asset investing, deep value investing, and tactical asset allocation. We also have funds that can hedge and leverage their portfolios and funds with "go anywhere" investment strategies. Most can raise cash when they perceive market risks to be high. The portfolio also has special assets such as high yield bonds, international bonds, and real estate investment trusts. What these funds have in common is investment strategies that differ greatly from the conventional approach of only buying stocks or bonds that closely resemble a given market index.

The differences these funds have from each other also are important. Over time different investment strategies have their good and bad returns during different periods. In academic terms, they have low correlations with each other. When a group of funds that are not correlated with each other are put together, they form a portfolio that has much smoother, steadier returns than a traditional portfolio. For example, over 10 years the hedge fund portfolio has about half the volatility as the S&P 500.

Another advantage of the portfolio is its low correlation with the S&P 500. That means our returns and net worth are not closely tied to the returns of the market indexes. While the returns from the stock market indexes have been flat or close to it for the last 10 years, the hedge fund portfolio has returned 8.68% annualized.

The quarter ending Sept. 30 was consistent with the portfolio’s history. Our return was less than the S&P 500 for the quarter, which is not surprising. Because of its diversification, the portfolio trails the stock indexes when there are strong bull rallies. The rest of the time, the portfolio’s returns equal or exceed those of the indexes.

This is a buy and hold portfolio. Because the funds are uncorrelated with each other, there is no reason to make adjustments for the market cycle. The fund managers do that for us. The only changes I make are when there are changes in the funds or when I discover a fund that will enhance the portfolio. For example, Schwab Hedged Equity changed its name and ticker and modified its strategy. Instead of keeping the new version, I recommended selling it and spreading the proceeds among the other funds.

The portfolio includes some non-traditional balanced funds such as Oakmark Equity & Income and FPA Crescent. Among the other funds are Hussman Strategic Growth, PIMCO All Assets, Wintergreen, and Berwyn Income.

The mutual fund “hedge fund” portfolio delivers what traditional hedge funds are supposed to. The portfolio’s fluctuations have a low correlation to the stock market indexes, but the returns equal or exceed those of stocks over the long term. It has the reasonable expenses of no-load mutual funds and their daily liquidity. Even the wealthy who meet the minimum income and net worth requirements for traditional hedge fund investing probably would be better off with this mutual fund portfolio.

The Multi-State Estate Plan

2009-10-23T00:30:00Z

Readers with homes or other property in more than one state need to give special attention to their estate plans. Each state has different rules and requirements, and your estate might have to run probate proceedings in each state. There is more work involved for either you or your executor or both.

There are lawyers who advise drafting separate wills and other estate planning documents for each state involved. You shouldn't need to do that much work. The estate plan, however, does need to recognize that multiple states are involved and make appropriate adjustments.

An estate generally must go through the probate process in order for title to the assets to be transferred to the beneficiaries. Real estate is probated in the estate where it is located. Personal property is probated in the deceased's state of residence, even if he or she dies in another state.

Occasionally there is a dispute over a person's state of residence, but that doesn't happen often. When you have houses in more than one state, part of your estate plan should be to clearly establish one state as the legal residence to avoid a dispute over your residence.

When there will be probate in more than one state, the same will can be submitted in probate proceedings in the different states. Each state, however, sets its own qualifications for wills, trusts, powers of attorney, medical directives, and other documents. Some have more requirements than others. For example, some states require only two witnesses to a will while others require three. Louisiana, because it is based on French law, has its own peculiar rules.

Estate planning attorneys, especially when they know that a person spends a significant time in more than one state, will draft a will so that it is valid in every state except Louisiana. The documents are written to comply with the state that has the toughest requirements. Be sure your estate planner knows where your different assets are located and where your time is spent. The planner then should ensure the will is valid at least in the relevant states.

The same strategy should be used with trusts. A trust is resident in and controlled by the law of the state where the trustee is located. A trust should be written, however, so the trustee or the location can be changed. To avoid problems with those changes, a trust should be written to be valid in as many states as possible.

Another way to deal with the potential of estate proceedings in more than one state is to plan your estate to avoid the cost and inconvenience of having the estate probated in two or more states.

One way to minimize probate is to create a revocable trust. The trust can hold a few key assets, such as real estate that is held outside the state of primary residence. Or it can hold title to all your assets. Anything owned in a trust does not have to be probated. The trust agreement should state how a successor trustee is determined and how the assets are managed and distributed. A will still would be needed for assets not held in the trust, but assets in the trust would avoid probate.

Another option to avoid probate for real estate is to own it through a partnership, LLC or trust. The partnership or LLC interests are personal property and could be probated with the rest of your personal property. The real estate would avoid probate.

Another way to avoid the probate problem is to establish joint title with right of survivorship for major properties. There are pitfalls to this, as I have discussed in past issues of Retirement Watch and don’t have space for here, but it might be an appropriate strategy for married couples whose estates are small enough to avoid estate taxes.

Your other estate documents also should be drafted to comply with the requirements of all states you frequent. These could include the general power of attorney, financial power of attorney, health care power of attorney or proxy, health care advanced directive, and living will. The health care documents should be drafted to comply in as many states as possible, because the governing law will be the state in which you need the medical care.

With a financial power of attorney, the key is to make the document acceptable to the financial institutions holding your accounts. Most institutions require that the power be filed with them in advance, and many will acknowledge only powers using their own forms or approved by their attorneys before they are needed.

Spending time or owning assets in multiple states adds a few complications to an estate plan. An experienced estate planner who has all the information can smooth out the complications and make the estate administration process easier. With a little work, you can avoid having probate cost extra time and money.

Why Estate Planning Details are Important

2009-10-16T14:24:00Z

In this post we discuss two key issues that don’t draw much attention but are keys to the success or failure of your wealth transfer plans. They probably are not what you’d expect. Meeting a plan’s goals often does not hinge on the “headline issues” of trusts, family limited partnerships, and the like. The nitty gritty details are more important, such as stating who pays debts and taxes, ensuring the estate has enough cash, and choosing executors and trustees. I regularly remind my readers of the details requiring attention and provide recommendations.

Here are a couple of issues that don’t get much attention but deserve more of your time.

A recent court case shows what happens when details are overlooked.

A man owned a farm, sold it, and incurred capital gains taxes. He died before the year ended and before paying the taxes on the sale or filing his tax return for the year. His oldest son was named executor of the estate. It turned out a younger son was a joint owner with right of survivorship with his father of the farm and inherited the rights to the farm's checking account after it was sold. The checking account held the sale proceeds, minus mortgage repayments.

Because the farm and its checking account were held as joint owners with right of survivorship, the younger son automatically became sole owner of the farm business and its assets when the father died. The older son as executor oversaw the probate estate and had control of those assets. But the farm assets never were part of the probate estate, and the executor never had an interest in or control over the farm assets.

Yet, the estate and its executor are responsible for all taxes of the estate and the deceased. In this case, the executor was liable for the father's final income tax return and the taxes due under it. The IRS assessed the executor for the capital gains taxes from the sale of the farm. The executor went to court to challenge this, saying his brother should pay the taxes since he had the money.

The court said it had no choice but to rule for the IRS. The executor is responsible for paying the taxes on the deceased's final income tax return. The brother who served as executor could sue the other brother for the money, but he first had to pay the IRS the money.

Here we have a division within a family and an estate without cash to pay its bills, because the father either didn’t seek advice or received bad advice. The father did not pay estimated taxes that included capital gains taxes on the sale of the farm, and he did not ensure the estate had money to pay the taxes and other bills. He might not have been aware the farm would be included in the taxable estate though the executor had no rights to it.

Several key details were neglected that should be part of every estate plan. Estimate the cash flow for the estate. Be sure there are enough liquid assets to pay its obligations. The will should state who is responsible for paying taxes on the assets. Otherwise, one group of beneficiaries could pay taxes on assets received by another group of beneficiaries.

Otherwise, your estate could end up fighting with the IRS, and your family members fighting with each other. (U.S. v. Guyton, No. 3:07-cv-00273, D.C. Fla, May 7, 2009)

Giving Gifts — and a Lecture

Grandparents are filling only half their roles these days. They are providing financial help to their grandchildren. In fact, they increased their financial aid as the economy worsened. Unfortunately, they are providing financial aid without much advice.

About 63% of grandparents say they provided some form of financial assistance to their grandchildren over the last five years, according to a survey for the MetLife Mature Market Institute, an affiliated organization of MetLife Inc., the insurance company. The assistance over the five years averaged $8,661. The survey was of adults over age 45 who have grandchildren under age 25. About 40% of the gifts went toward "general financial support," while 26% was for educational expenses and 21% was to help grandchildren through major life events. Because of the declining economy, about 26% of grandparents said they increased support for grandchildren.

Despite the generosity with wealth, most grandparents are not generous with their advice and wisdom. About 68% of the grandparents said they provided no financial guidance to their grandchildren. Lower-income grandparents are more likely to give advice, with 83% of those earning $35,000 or less saying they warn their grandchildren to avoid large debts and to maintain financial security. Only 65% of those with incomes between $50,000 and $74,999 talked about finances with their grandchildren.

It is admirable that so many grandparents are willing to give now to help their grandchildren receive educations and establish a firm financial foundation. But it is a mistake to give money or other wealth without some guidance, or ensuring the grandchildren receive good advice elsewhere. Financial literacy is taught in very few schools. Most high school graduates lack basic financial skills such as balancing a checkbook and understanding a mortgage or other debt instrument. If the parents try to provide lessons, the grandchildren are likely to ignore them.

Grandparents are more likely to be listened to, and they can provide a lot of hard-earned wisdom. Grandparents can teach with authority principles such as avoiding debt, starting to save and invest early in life, living within one's income, working hard, and saving both for a rainy day and for specific goals.

Debt management is probably the lesson most grandchildren could benefit from. Their parents, like most of their generation, probably never learned the lessons of how to use credit wisely. Also, the credit picture is much more complicated than it used to be, with many different kinds of debt available but objective information about the credit hard to find.

Grandparents should not give only wealth. They should give lectures and advice. Even a simple request that the grandchild read a basic book, such as The Richest Man in Babylon by George Clason, as a condition of receiving a gift can go a long way. The book is both entertaining and enlightening for most people, regardless of age. But the best advice would be direct from you.

Articles with helpful discussions on my members web site discuss compound returns, mutual funds for small investors, and financial lessons youngsters need to know. Share this and other advice with your grandchildren so they will remember it when key decisions have to be made. It also will make your financial gifts more valuable, making it more likely your wealth is well-used.

Year-End Tax Planning is Different This Year

2009-10-09T15:24:00Z

Year-end tax planning will be unique and tricky this year. The usual year-end strategies are complicated by the potential for significant tax increases over the next couple of years and the lack of details we have today. In addition, the incentive to convert traditional IRAs into Roth IRAs in 2010 provides a fresh wrinkle, which is discussed in previous posts. Yet, the right moves in the next few months could save you a lot of money. It is worth the time to begin year-end planning now.

The key to year-end tax planning is to try to examine at least two years together. This allows you to reduce total taxes. Otherwise, if you look at one year at a time you are likely to simply shift the tax bill from one year to another, or even to inadvertently raise the bill one year by reducing it in another year. So, consider this year and next year together. That won't be easy, because of the lack of detail about those likely future tax increases. Yet, we can make reasonable assumptions.

Year-end tax planning involves four broad, basic strategies. Income can be accelerated into the current year or deferred into next year. Likewise, deductions can be accelerated into this year or deferred into next year. These are the basic rules:

* If you think your tax rate is likely to rise next year, you want to accelerate income into this year and defer deductions into next year.

* If you think tax rates might decline, defer income to next year and accelerate deductions into this year.

* If you think deductions might be restricted next year, accelerate some deductible expenses into this year.

* If you think deductions might be increased next year, defer until next year some expenses that might be deductible.

There are other situations when you might want to shift income or deductions. A minority of taxpayers itemize deductions these days. The rest use the standard deduction, because their total itemized deductions are less than the standard. Careful shifting of deductions can allow you to itemize deductions every other year and reduce overall taxes. The standard deduction for 2009 is $11,400 for married filing jointly and $5,700 for single taxpayers. It is increased each year for inflation, with the next year's amounts usually announced in December. You can use the 2009 number for planning.

Here are some ways to move deductions to qualify for itemizing.

State and local taxes, whether income taxes or property taxes, generally are itemized deductions. You might be able to mail a Jan. 2010 payment in late Dec. 2009, or hold a Dec. 2009 payment until Jan. 2010. If you have a mortgage, doing the same with monthly payments can shift a month's interest payments from one year to another, giving you 13 months of interest deductions in one year. Charitable gifts generally are flexible payments. You can bunch more of them in one year to increase itemized deductions.

Medical expenses are deductible only to the extent they exceed 7.5% of adjusted gross income, and only if deductions are itemized. Few people have enough medical expenses to deduct them. You might be able to make them deductible by incurring elective medical expenses in one year instead of spreading them over two.

Remember, the provision for making charitable contributions from an IRA was extended through the end of 2009. Normally when a charitable contribution is made from an IRA it is treated as a distribution and included in gross income. You receive a charitable contribution deduction if you itemize expenses. But in 2009 those age 70½ or older can have charitable contributions made directly by their IRA custodians to a charity. There is no deduction for the contribution, but it also is not treated as a distribution and not included in gross income. This contribution is limited to $100,000 annually.

In addition to the regular income tax, you need to pay attention to the alternative minimum tax (AMT). More and more middle income Americans, especially retirees, are falling under this second tax system originally intended for the wealthy. You compute taxes under both the regular system and the AMT, and pay the higher tax. High itemized deductions (other than charitable contributions) and personal exemptions can trigger the AMT. Large capital gains also trigger the AMT. New retirees frequently fall under the AMT because their incomes decline while their itemized deductions remain the same.

When estimating your regular income tax for the year, also estimate the AMT. Then, before making any changes in income or deductions to reduce the regular income tax see how they would change the AMT.

Home improvements are a special consideration this year, because Congress enacted additional tax credits for many energy-efficient improvements for 2009 and 2010. The credits can be substantial, but the qualifying improvements also can be expensive. You have to decide if the credits plus potential energy savings are worth the additional cost of the qualifying improvements. Check the IRS web site at www.irs.gov for updates and details about the available credits and how to qualify for them.

Don't forget to check your tax prepayments. They are likely to be off this year for more taxpayers because of the new withholding tables under the Making Work Pay tax credit from the stimulus law. If your estimated tax payments and withholding are not high enough, increase payments. Even better, if you receive wages, IRA distributions, annuity payments, or other payments from which you can ask for withholding, have the additional taxes withheld. You are more likely to avoid penalties by increasing withholding than by increasing your last estimated tax payment or two.

Income can be deferred or accelerated by changing distributions from IRAs and annuities and timing sales of investment assets. Of course, if you still are working you might be able to work with your employer on the timing of bonuses and raises.

Taxpayers age 70½ and over do not have to worry about taking required minimum distributions from IRAs and other qualified retirement plans for 2009. But unless Congress changes the law this fall, RMDs will be restored in 2010. You might consider taking some distribution from the IRA this year to reduce next year's RMD, especially if this year will have a lower tax rate or higher deductions than next year. Taking a distribution in 2009 will reduce 2010’s RMD, because RMDs are based on the IRA’s value of Dec. 31 of the previous year. So reducing the Dec. 31, 2009 IRA balance reduces the 2010 RMD.

Take a look at your investment portfolio. If you were fortunate enough to buy stocks or other risky investments near their lows in March through a taxable account, you have sizeable gains now. Be careful about when to cash in those gains. If you sell them before owning them more than one year, the gains are short-term and taxed as ordinary income, with a top rate of 35%. You can save a lot of money by waiting for the one year period to pass and take them as long-term capital gains, if the gains hold up long enough.

If you still have losses from the bear market, continue pruning them to save taxes. Capital losses offset gains dollar for dollar. Up to $3,000 of any additional losses can be deducted against other income. Unused losses can be carried forward indefinitely to future years until used.

You can sell an investment to take a deductible loss, and then later buy back the investment. With stocks, bonds, mutual funds, and other securities you need to wait more than 30 days before re-buying the same or a substantially identical investment. If you don't wait long enough, the loss can’t be deducted for this year but is added to the basis of the new investment.

Consider making charitable contributions with your securities instead of cash, but do it the right way. You deduct the fair market value of long-term capital gains property that is contributed to charity. Give such long-term capital gains property. You won't any owe any taxes on the gain and can deduct the full market value. If your securities are showing a loss, sell them, deduct the loss, and give the cash proceeds.

When It Pays to Mix Annuities and IRAs

2009-10-02T14:25:00Z

Most of the time it’s not a good idea to combine an IRA with an annuity. The IRA already has tax deferral, so why take on the costs and limitations of an annuity? But there are a couple of times when it may make sense to mix an annuities with an IRA. We take a look at two such situations.

Managing RMDs

When it is time to take distributions from an IRA, there are two goals of most IRA owners. One goal is to make the income last at least a lifetime, hopefully leaving something for a spouse or younger heirs.

The other goal is compute the required minimum distributions (RMDs) due after age 70½ so penalties are avoided.

The two goals can conflict. RMDs increase the risk of depleting the IRA early. That’s why a goal of many IRA owners is to minimize RMDs.

One way around this conflict is to purchase an immediate annuity about the time RMDs must begin. An immediate annuity begins distributions within a year of purchase and pays the same amount every year for a guaranteed period. Most people purchase an annuity that makes payments for life or for the joint life of the IRA owner and his or her spouse.

The insurer takes care of the RMD compliance, and purchasing an immediate annuity usually is considered to be fulfilling the RMD rules. The IRA owner does not have to worry about computing distributions or consulting the rules.

The annuity comes with the insurer's guarantee that payments will continue for the chosen period. If the insurer has financial difficulties it might not be able to make good on the guarantee. So, it is important to choose an insurer that seems financially secure.

A downside to the annuity is less flexibility. If you have an emergency financial need, your ability to draw additional money from the annuity is limited. With a straight IRA, you can take out as much money as you need above the RMD. Many insurers have loosened distribution rules so that you can take as much as 10% of the annuity balance in a year. The provision increases costs and reduces the annual payouts. It is better to have other assets available outside the IRA to handle unexpected expenses.

Another downside to the annuity is that payments are fixed. They do not increase with inflation, interest rates, or anything else. There are some inflation-indexed annuities available, but they have substantially lower initial payouts. Again, it is good to have assets other than the IRA that can be invested for growth and be available to increase annual spending as costs increase.

The annuity payments can continue to beneficiaries if you select such a payment schedule. That will result in lower payouts during your lifetime, but it ensures something is available to your heirs and the insurer does not profit if you die before life expectancy. The insurer also would manage distributions to beneficiaries. That relieves you of the burden of ensuring they understand how IRA inheritance rules work and can prevent your heirs from spending the entire amount quickly.

Charitable annuity

Taxpayers who are charitably-minded also have a problem with IRAs. The tax advantages of making gifts from the IRA are not great. You can take a distribution from the IRA, include it in gross income, issue a check to the charity, and deduct the contribution. That could result in no taxes, if you itemize deductions on Schedule A and are not in the higher tax brackets for which itemized deductions are reduced.

There is a temporary provision that allows a taxpayer who is at least age 70½ to have up to $100,000 transferred directly from an IRA to a charity. The money is excluded from gross income and no deduction is allowed. But that applies only to a few taxpayers and for a limited time.

One strategy to cope with these problems is the charitable gift annuity. Here is how this strategy works.

The IRA owner takes a distribution from the IRA of any amount, including the entire IRA, which is included in gross income.

The distribution is used to purchase a charitable gift annuity. This is an annuity contract purchased from a public charity. The charity will make regular payments to the owner for life, just as an insurer of a commercial annuity will. The owner can choose from different payment options, such as for life or for the joint life of the owner and a beneficiary.

The amount of the payouts is less than from a commercial annuity. The difference is a gift to the charity, and the owner receives a charitable contribution for the amount of the gift in the year the annuity is purchased.

The amount of the gift is determined from IRS tables that use current interest rates and the owner's age to set the deduction amount. The older the owner is, the greater the deduction. The deduction offsets some of the distribution that was included in gross income. The deduction depends primarily on your age and might offset up to half the distribution.

When payments are received from the annuity, a portion is tax free as a return of your basis or investment in the annuity. The basis is considered to be received pro rata over your life expectancy. Contrast that with when an annuity is purchased directly by the IRA. In that case, all of each distribution is likely to be included in gross income.

The charitable gift annuity strategy should be used only by someone who has charitable intentions. But for such people when the charitable contribution is considered along with the partial tax-free treatment of each payment, the after-tax cash is likely to be comparable to that of simply purchasing an annuity with the IRA.

The promise to make the payments is backed by the charity. If the charity founders financially, it might default on the annuity payments and you would be an unsecured creditor. We have seen a number of smaller charities suffer financially in the bear market or because they invested with con artists such as Bernard Madoff. Take care when determining the charity with which you do business. Favor a long-established charity with a diverse funding base and years of experience with gift annuities. Some charities purchase annuities from commercial insurers to back up their obligations. But you would not have ownership rights in that annuity or be entitled to take title to it if the charity defaults or runs into financial trouble. One popular option is to purchase the annuity from a donor-advised foundation or community foundation. These charities support a number of causes and sometimes give donors input into how their gifts are used.

There is no need to shop around for the best payout. Almost all charities agree to use the same payout formula.

When the annuity owner has other sources of income to pay living expenses, the annuity payments might be used to purchase life insurance. The life insurance can pay estate taxes or increase the inheritance of the heirs. The inheritance would be tax free, so that would leave the heirs with a better after-tax position than if they had inherited the IRA. Combining the charitable gift annuity with life insurance could leave the heirs and charity with more after-tax money than the alternatives.

Annuities are attracting more people because of their security and steady, guaranteed income. Some IRA owners will find that annuities can make retirement easier and be a powerful complement to their IRAs.

Who Will Benefit from Your IRA?

2009-09-25T00:17:00Z

One of the most important decisions about an IRA is naming the beneficiary or beneficiaries. There are many candidates for the biggest mistake made by IRA owners, and a leading contender is the failure to name a beneficiary or naming the wrong beneficiary.

If no beneficiary is named, the estate is the beneficiary. When an estate or another non-individual is a primary beneficiary, the entire IRA must be distributed within five years after the original owner's passing. The estate, as the beneficiary, will owe income taxes on the distributions, in addition to any estate taxes due on the value of the IRA. An IRA owner should never fail to designate at least one qualified individual as primary beneficiary and should never name the estate or other non-individual as a primary or contingent beneficiary. The only exceptions are when there is no interest in allowing heirs to use the tax deferral of the IRA and for certain trust that are allowed to defer distributions.

Since new regulations were issued in 2001 and 2002, the choice of beneficiary is not fixed and does not affect required minimum distributions. The major consideration in naming the beneficiary is: Who should receive the IRA in light of the goals, tax issues, and any other factors that are important to the owner?

After deciding on the primary beneficiary or beneficiaries, the owner also should name contingent beneficiaries. These are people who inherit if the primary beneficiaries are not available or disclaim the inheritance. Naming contingent beneficiaries can be part of a good strategy. The estate executor names the Designated Beneficiary of an IRA by the end of September of the year after the owner passed away. The DB's age determines the required minimum distributions for the IRA. The DB must be on the list of primary or contingent beneficiaries.

Naming contingent beneficiaries allows the executor and heirs to adjust the estate plan if circumstances have changed. Primary beneficiaries who believe it is best for the family that someone else inherit the IRA can disclaim their rights. Disclaimers can continue until the "right person" is available to be named DB. That cannot happen unless contingent beneficiaries are named.

Customized Beneficiary Forms

When naming beneficiaries, it often can be best not to use the Beneficiary Designation forms provided by IRA custodians. A number of estate planners draft their own forms and have them reviewed and approved by the custodians.

One value to a custom beneficiary form is it allows the owner to name more than one primary beneficiary and leave them unequal shares, something that often is difficult or not possible with standard forms. A custom form ensures that the form lists all the beneficiaries the owner wants named. Another benefit to a custom form is, if there are disclaimers or premature deaths of beneficiaries, contingent beneficiaries will succeed primary beneficiaries in the desired order and not in an order dictated by the IRA custodian.

While a standard form might work for many people, those with multiple beneficiaries or less-than-standard situations should consider having their estate planners draft custom forms and file them with the IRA custodian.

The IRA owner also should consider who would receive the share of a beneficiary who dies prematurely — either before inheriting a share of the IRA or after distributions to heirs begin. Should the share go to the children of the beneficiary, or should it be shared by the other primary beneficiaries? Or should it go to a different contingent beneficiary?

The choice is up to the IRA owner, but it has to be stated in the designation form. Otherwise, most IRA custodians have a default position they implement absent instructions from the IRA owner. State law also might establish a default position. The IRA owner should consider the issue and make the choice clear in the designation form.

Another issue: Suppose a beneficiary or contingent beneficiary is young or cannot be trusted to handle the IRA properly. Then, it might be appropriate to name a trust as the beneficiary of the IRA. Naming a trust also is appropriate when the intended beneficiary has special needs.

A trust that is an IRA beneficiary must have precise terms in order to take advantage of the IRA’s tax deferral. With the wrong trust terms, the IRA balance must be distributed and taxed on an accelerated schedule. The help of an experienced estate planner is needed to set up the trust properly.

Splitting IRAs

When there are multiple objects of affection, one option is to name them as joint primary beneficiaries. An alternative is for the IRA owner to split the IRA into separate IRAs, naming a separate beneficiary and a group of contingent beneficiaries for each. IRS regulations allow beneficiaries who jointly inherit an IRA to split it. Yet, not all beneficiaries know about this right or are able to agree to execute it. The owner might find it wise to split the IRA now rather than leaving that to the estate administration process.

I frequently emphasize that an estate owner who plans to leave something to charity should consider using the IRA to do so. Unlike other beneficiaries, the charity will fully benefit from the IRA. Charities are tax-exempt. A charity can withdraw the entire IRA balance and not owe income taxes on it. In addition, naming a charity as beneficiary avoids the estate tax. The IRA is included in the estate, but there is an offsetting charitable contribution deduction for the amount left to the charity.

Because non-charitable heirs benefit more by receiving non-IRA assets, leaving the IRA to a charity can be a good deal for all involved. When the estate owner plans to leave part of the estate to charity and there are enough non-IRA assets for other beneficiaries, the owner should consider leaving all or part of the IRA to charity while leaving the other assets to non-charitable beneficiaries.

When considering IRA beneficiaries as part of an estate plan, there are a couple of other strategies I frequently recommend that you should consider as alternatives.

One strategy is to avoid all this by emptying your IRA early. Distribute all or most of the IRA, pay the taxes, and invest the after-tax amount. That gives you more flexibility over how to give away the balance and probably gives the heirs a larger after-tax amount in the long term. This can be appropriate for someone with a large IRA and other income or assets to maintain the standard of living. It also is best if you expect the after-tax account to have 10 years or more to growth and compound before money is withdrawn.

Another strategy is to convert the traditional IRA into a Roth IRA. This does not avoid the choice of beneficiary, but it makes the distributions tax free. Keep in mind it costs money to convert to a Roth IRA.

I have discussed the details of both of these strategies in past issues of Retirement Watch and in my book, The New Rules of Retirement.

Designating IRA beneficiaries is a neglected step in many estates. Take care to designate beneficiaries with care and use a custom beneficiary designation form if necessary. Taking these steps can increase the after-tax wealth of your heirs by tens of thousands of dollars. A will or living trust has no influence on who inherits your IRA or other qualified retirement account. Only the beneficiary designation form counts. Make your designations carefully, update them as needed, keep copies of all forms, and be sure the executor knows where the forms are.

Avoiding Estate Planning Mistakes

2009-09-17T19:40:00Z

The success or failure of an estate plan often depends on small details. Amid all the big picture issues (taxes, trusts, gifts, business interests), these matters may seem too small to deserve much time. Don’t have that attitude. It could cost you and your heirs.

Don’t make these very common estate planning mistakes.

* Overlooking non-probate assets. These assets are excluded from the “probate estate” and avoid the probate process, so their disposition is not covered by the will. (They likely are included in the gross estate for tax purposes.) They are covered by law or by contract. These assets include IRAs, employer retirement plans, life insurance, and annuities. Living trusts and all the assets in them also avoid probate.

Retirement plans, annuities, and life insurance have beneficiary designations that must be completed, either as a section of the account application or contract or in a separate document. For each of these non-probate assets, the custodian or account sponsor looks only at the forms in its records. Whoever is listed as beneficiary gets the asset. Often, a beneficiary designation form was completed many years ago, perhaps before the owner was married or had children. In the ensuing years, the owner’s marital or family situation could change. Yet, many people forget about their designation forms and do not update them.

Every estate owner should keep a copy of all beneficiary designation forms and review them every couple of years. More frequent updates are necessary as family situations, goals, and objects of affection change.

A related mistake is not to name contingent beneficiaries. These are needed because a beneficiary might pre-decease the owner or otherwise be unable to inherit. Another reason to have contingent beneficiaries is the primary beneficiaries might realize that due to changed circumstances it would be better for all concerned if someone else inherits the asset. The named beneficiary (or beneficiaries) could file a document known as a disclaimer, refusing the inheritance. The account then would go to the next contingent beneficiary.

* Many people set up living trusts but neglect to fully implement them or update them as needed.

One often overlooked detail with living trusts is that ownership of assets must be transferred to them. Only the assets legally owned by the trust avoid probate and are controlled by the trust’s terms. Too many people do not do the work of transferring the legal title of homes, vehicles, and financial accounts to their trusts, making the trusts useless.

It also is important to check with financial institutions to determine if they need a copy of the trust on file. A number of financial institutions are hesitant to recognize succession clauses in a living trust unless a copy of the trust agreement was filed with them in advance or they have other proof of the initial trustee's intent before transferring power over the accounts.

As with a will, there also might be a need to change trustees and beneficiaries. There should be successor clauses for beneficiaries and trustees that automatically make changes in certain circumstances. The clauses should be carefully written, updated as needed, and the successors made aware of the situation.

* A financial power of attorney is essential to every estate plan. Most estate plans focus on one's demise, but the possibility of disability also must be considered. Someone should have legal authority to manage the finances during a period of disability. If plans haven't been made, loved ones must go to court to have someone appointed. At that point, the owner has no control over the choice.

One reason to get started on the POA is that most financial institutions require that a copy of their own POA form be signed and on record to be effective. They might not accept the form drafted by an attorney or might delay its acceptance for some time. They also might not accept a form that is not filed with them until the principal is disabled.

* There are other details that are part of a complete estate plan. Parents of minor children should designate guardians in case of the demise of both parents. An estate owner also should create a beneficiary book that contains most important financial documents, plus descriptions and locations of other assets and records. There also should be instructions for the estate executor and those who inherit special assets. Funeral, memorial service, and burial instructions can be suggested by the estate owner and should be included in the book. I have discussed all these issues in more detail in regular issues of my newsletter, Retirement Watch.

Over the years estate planning has become synonymous with tax planning. There are other issues that are as least as important as taxes. A goal of estate planning is to manage assets and transfer them as efficiently as possible to the objects of one’s affection. Reducing taxes is part of that process, but there are other aspects that also affect how much of the assets reach loved ones and how efficiently that transfer occurs.

You and Uncle Sam Can Help the Grandkids Buy a Home

2009-09-10T16:35:00Z

Home prices are down, and inventories of unsold homes are high in many areas. These are buyer’s markets. That makes this an ideal time to buy a home, or to help a grandchild buy that first home or move up to a larger home. Even better, there is a tax incentive that leverages the help you provide to buy a first home.

Despite the decline in prices, buying a home still is a struggle for many young people. Relatively high interest rates, high property taxes, and tighter lending standards do not help. Helping with a home purchase is a gift that is not likely to be squandered — if the young person makes a significant contribution from his or her own assets. The home also is likely to appreciate at least with inflation over time, and that future appreciation is out of your estate. Helping to buy a home also can free up some of the young person’s income to fund retirement and the education of his or her own children.

To increase the buyer’s cash flow, the government established a first-time home buyer’s credit that is good for homes purchased before Dec. 1, 2009. The credit is up to $8,000 and probably is the main reason for what good news we have seen in residential homes in recent months. For more details about the first-time homebuyers credit, click here.

A home purchase can be assisted without a large gift. Some parents and grandparents help with the closing costs. These can be significant in some areas, because they include various taxes and fees. Others provide all or most of the down payment, after ensuring that the young person will be able to afford the mortgage payments.

The tax law provides several ways a parent or grandparent can help a young person buy a home without triggering high gift or estate taxes.

The tax basics are that gifts are not taxable income to the recipient. Everyone can give up to $13,000 annually to any person without incurring gift taxes. This is the annual gift tax exemption. You can make these gifts to as many different people as you want each year. A married couple can jointly give up to $26,000 annually to a person gift tax free.

Each person also has a lifetime gift tax exemption for $1 million of gifts. Gifts that exceed the annual gift tax exempt amount reduce the lifetime exemption. Any amount of the lifetime gift tax exemption that is used also reduces the estate tax exemption by the same amount.

The gift tax exemptions are the foundations of strategies to help children and grandchildren. Now, let’s look at six specific strategies to consider.

 Perhaps the easiest strategy, at least initially, is to co-sign the mortgage. This amounts to lending your credit rating to the youngster and requires no cash. It is not considered a gift for tax purposes.

Looking down the road, this approach might not be as trouble-free as setting it up is. If the young person stops paying the mortgage, you are on the hook for the payments and there could be gift and income tax consequences for that. Then, you would have to decide whether to make the payments indefinitely; buy the grandchild out of the home; or sue for payment, foreclose, evict the grandchild, and sell the house. Also, the young person's failure to make any payments can adversely affect your credit rating.

 A straightforward gift of cash is the cleanest and most-used strategy. You can give an amount equal to closing costs or the down payment, or a larger amount. These days many lenders will require a gift letter. They want buyers to have their own equity in the home before lending. If part of the down payment came from a gift, the lender might require a letter stating that it was a genuine gift with no strings attached or expectation of repayment.

 Periodically, equity sharing is popular. This effectively is a form of joint ownership, though the home is the principal residence of only one owner. Equity sharing’s appeal is that the grandparents or parents can join in the appreciation or have more control over the situation. Some grandparents need the equity interest to feel financially secure.

Equity sharing gets complicated and requires the assistance of an experienced tax professional. There are many ways the arrangement can be structured, and each has different tax effects. Issues include how much of the down payment each person will contribute; how much of the monthly mortgage and real estate taxes each will pay; and how much rent the child or grandchild might pay to the other owner. Without rent, there is an annual gift from the nonresident owner to the other owner, and that could be taxable. Responsibility must be determined for other expenses, such as maintenance and insurance. A formula for sharing appreciation also is needed.

Because of the complications, setting up an equity sharing arrangement should incur professional fees, and those reduce the amount you can give.

 A low-interest loan can work in situations when you need or want the money in the future and are confident the young person will be able to repay the loan. The young person has use of the money at no interest or below-market interest. You lose only the earnings the money would have earned, if the loan is repaid.

Low-interest loans have no tax consequences if you stay within a safe harbor. One safe harbor is the total low-interest loans to an individual do not exceed $10,000. Another safe harbor is for gift loans between individuals when the total gift loans to that borrower by the lender are less than $100,000 and the borrower has net annual investment income of $1,000 or less. If the investment income is higher, then there will be imputed interest payments between borrower and lender as discussed below, but only to the extent net investment income exceeds $1,000.

If you don't qualify for a safe harbor, then a market interest rate will be imputed. You'll be treated as though interest payments were made at that rate, and those imputed interest payments will be included in gross income. The borrower might be able to take deductions for the imputed interest. Check with a tax advisor about the imputed rates and the details of the safe harbors before making a low interest loan.

Of course, making a loan has many of the same problems as co-signing. If the loan is not repaid, you have to decide which actions to take.

A no-interest loan can be a strategy for avoiding the gift tax exemption limits by making a loan that exceeds the annual exemption but is under the gift loan safe harbor.

Some people make gifts beyond the loan amount that are used to pay the loan or the imputed interest. Each year after the loan, cash gifts up to the annual gift tax exemption are made to the young person and used to make principal or interest payments to the lender.

You want to make a real, enforceable loan. You need to draw up a loan agreement with a payment schedule and should record it against the title to the property. If you do not have documentation, the IRS might treat the transaction as a gift instead of a loan.

 Another option is to buy the house yourself. This is helpful when the youngster does not have a credit history that merits a third party loan. Then, you have several options. You can rent to the young person with an option to buy. Or you can sell to the young person and finance the sale yourself with terms that are affordable to the young person. Another option is to make gifts of equity in annual installments that qualify for the annual gift tax exclusion. Over time, as the young person's credit rating and income improve, he or she might be able to obtain a loan from a third party and buy the home from you.

The advantages of this strategy are that the young person might get in the habit of making regular payments and also taking care of the property. The disadvantages are that the opposite might occur. The payments might not be made and the house neglected. Then, you have to decide which actions to take. The potential for problems is one reason to ensure the arrangement is recorded in legal documents that are filed as required.

 Annual gifts to help pay a mortgage are another simple strategy. You make gifts that qualify for the annual exemption. That frees up the young person's income to fund retirement or his or her children’s education or to pay other expenses. The potential downside is that the young person will become dependent on your annual gifts, and those gifts might have to stop or be reduced at some point. Also, the young person might waste the money in some way instead of using it to build financial strength.

What about triggering jealously among other children? Many wills provide that a child's inheritance will be reduced by any significant lifetime gifts, so over time the children are treated equally.

There are many ways to help a young person take advantage of the weak housing markets around the country. Pick one that best fits your finances and goals.

How to Revise Your Retirement Plan

2009-09-03T17:25:00Z

Despite the rally in stocks and other risky assets since March 9, many portfolios are still damaged from the events of the last few years. For those who are retired or near retirement, one step you have to take after such an event is to re-evaluate your retirement plan, especially your spending. Specifically you have to check the rate at which you plan to withdraw money from your retirement portfolio and decide if it needs to be adjusted to reduce the risk of running out of money.

Financial planners spend a lot of time contemplating the safe or sustainable withdrawal rate. This is the percentage of the portfolio you can withdraw the first year, increase the dollar amount by inflation each subsequent year, and have a high probability the portfolio will at least 30 years. The biggest risk to a retirement portfolio is a bear market or a long-term flat market in the early years of retirement. The second biggest risk is to withdraw money at an unsustainable rate.

Numerous studies indicate that to be safe, the first year withdrawal rate should be between 3% and 4% of the portfolio. The most commonly-cited sustainable rate is 3.6%. This assumes you invest at least 50% of the portfolio in stocks or assets that earn similar returns. If you invest a lower percentage in growth assets, the sustainable withdrawal rate is lower.

If you are fortunate enough to retire at the beginning of a bull market, a higher withdrawal rate is safe. But you won't know until after a few years of retirement the type of market that coincided with the beginning of your retirement.

Whatever withdrawal rate you choose the first year, the rate needs to be re-evaluated periodically. Even the 3.6% withdrawal rate does not allow a portfolio to last 30 years 100% of the time. There still is a risk of running out of money.

When portfolio returns are disappointing, you need to re-evaluate the plan to be sure you aren’t on track to run out of money. Bear markets are followed by bull markets, eventually. The key is to be sure the combination of the bear market and your spending does not bring the portfolio balance so low the subsequent bull market gains are not enough to sustain the portfolio through retirement.

If you retired a few years ago and still have a portfolio that is worth more than your starting portfolio, you probably are in good shape. The research shows you should be able to continue your planned withdrawal schedule with a very low probability of outliving your money. You might want to reduce spending a bit for the next few years to be on the safe side, but drastic measures are not needed unless there is another significant downward leg to for your portfolio.

What if you now have less money than when you first retired? In that case, you need to consider changes. We will review some potential changes shortly. First, let's look at more objective benchmarks of your spending rate.

One way to evaluate your spending rate is to assume an immediate single-premium lifetime annuity is purchased with your entire retirement portfolio. Is the annual payout from that annuity similar to the amount you are withdrawing now? If you are withdrawing significantly more than the annuity payment, you likely will have a problem sustaining the withdrawal rate unless investment returns increase. Insurance companies spend a lot of resources calculating life expectancies and determining how much they can pay a person and still make a profit. If your withdrawals are significantly higher than what the insurers are paying, then you are assuming a significantly higher investment return or shorter life expectancy than the insurers. Keep in mind if you have a spouse you intend to provide for, the portfolio likely will have to last longer than for a single life annuity. Check annuity payout rates at web sites such as www.ImmediateAnnuities.com

Another objective warning sign is a withdrawal rate approaching 10%. Surveys continue to show that many people think they safely can withdraw 8% to 10% annually. Research does not back that up, except in strong bull markets.

Here’s another quantitative measure.

One study found a strong correlation between the safe withdrawal rate for the next 30 years and the current price/earnings ratio of the S&P 500. The higher the P/E ratio, the lower the safe withdrawal rate is for the next 30 years. P/E ratios tend to be high at bull market peaks, followed by years of below-average returns.

A simple rule is that when the P/E ratio is above the historic average, the safe withdrawal rate is on the low side. When the P/E ratio is low, withdrawal rates can be higher. When the P/E ratio is below 12, a withdrawal rate of 6% or more generally is safe. At extreme bear market bottoms, a rate of 10% can be sustained going forward. Right now, the P/E ratio is around the historic average and not near historic lows.

If your portfolio has declined and you are concerned how long it will last at the current spending rate, there are steps you should consider. One or more of these steps should put you back on the right track.

Drop the inflation bump. The studies of the safe withdrawal rate all assume that after the first year the amount taken from the portfolio each year increases with inflation. A simple step is to stop the inflation increase for a while. With consumer prices falling, that makes sense anyway.

Use a market-based formula. Instead of a formula that steadily increases spending, have spending rise and fall with the portfolio, though not by as much. One simple formula is to set your withdrawal rate, but apply it to the average account value at the end of each of the last five years.

Another option is what I call the Yale Endowment formula. Each year 70% of the distribution is the initial spending amount plus inflation. The other 30% is a fixed percentage of the portfolio's value. More details of the formula are in my book The New Rules of Retirement.

These formulas smooth distributions. They have the disadvantage of automatically reducing spending when the portfolio declines, but that makes the portfolio last longer. They also have the advantages of increasing spending as investment returns improve, and the cuts are not as drastic as the portfolio’s changes.

The safety fund system. Another approach I have recommended is to create a safety fund at the start of retirement. You put an amount equal to the estimated spending for two to five years in safe investments such as money market funds and certificates of deposit. The rest of your portfolio is invested for the long-term. You take money from the safety fund to pay expenses. At the end of the year you rebalance the long-term portfolio by replenishing the safety fund.

The advantage of the safety fund approach is that you do not feel pressured to sell investments after a steep decline, because you know there is enough money in safe assets to get through the two to five year period. Those who do not have large enough portfolios to create a safety fund should consider purchasing an immediate annuity with a portion of their portfolios. Because of low interest rates now is not an optimum time to put a lot of money in an immediate annuity, but as rates rise it is a good long-term strategy.

Change allocations and strategies. Retirees whose past investment strategies have let them down should consider changes. Some portfolios were too heavily weighted to equities instead of being diversified (though there were few asset classes that did not lose money in 2008). Other investors could benefit by shifting from buy-and-hold to the more active strategies of our Managed Portfolios.

Most retirees are able to vary spending. They can postpone travel, spend less on restaurants and entertainment, and replace cars and other items less often. Spending adjustments are the best way to get a retirement portfolio and spending back on track.

When secular bear markets strike early in retirement and put the longevity of your portfolio at risk, adjustments are needed. First, adjust spending. You can reduce it for only a year or two or consider making a permanent change to the spending formula. Second, reconsider your investment policy. Do not give up on growth or risk or take too much risk, but be sure your strategy fits today’s markets.

Ensuring the Medical Care You Want

2009-08-26T21:18:00Z

The debate over health care reform has brought an important issue into the headlines. The public debate is not very enlightening, but it serves a good purpose if it causes more people to include one or more important health care documents in their estate plans. Everyone needs one or more of these documents, regardless of the value of the estate. Even if you are not ready to put the rest of the plan into place, the health care documents should be prepared and executed.

One problem with many plans is that they do not have any health care documents. An equally serious problem is that people have the wrong documents or do not understand the limits of the documents they have. For example, most people do not realize that in a high percentage of cases the health care documents are ignored.

Let's look at the different documents. You will learn which are best for you and how to increase the probability that your wishes will be followed.

The living will is the best known health care document. It is simple to execute. Most states officially recognize living wills and have authorized sample forms that are easy to download from the Internet and complete. You can locate them through www.caringinfo.org.

The idea behind a living will is that you do not want certain types or levels of care (often called "heroic measures") in certain circumstances. The simplest living will states: "If I have a terminal condition, and there is no hope of recovery, I do not want my life prolonged by artificial means."

Such simple statements are difficult to apply in practice. Medical professionals can disagree over whether someone has no hope of improvement, is terminally ill, or is brain dead. Even when the experts agree, the family members might disagree on either the medical condition or on whether to continue treatment. Some living wills prohibit artificial means of life support, but there is disagreement over whether some forms of care (such as feeding and hydration tubes) meet that definition. They might be considered steps taken to keep the person comfortable.

In addition, you might have one situation or set of circumstances in mind when considering the wording of the living will. When presented with a different set of circumstances, you might reach a different conclusion of the preferred course of action.

To avoid these problems, many estate planners now write custom living wills. Detailed questionnaires of sixty pages or more reveal how a client wants to be treated or not treated in different situations, and those views are reflected in the living will.

Even this does not avoid problems. The questionnaires still cannot cover all possible scenarios and eliminate gray areas or difficult decisions, leaving decision makers uncertain of what to do. Also, technology and medical knowledge change. Conditions that could not be treated a few years ago can be treated now. As with the simple living will, there can be disagreements over the facts such as the diagnosis, probability of improvement, and whether a person is in a vegetative state.

Perhaps most important, living wills simply aren't effective. The medical professionals often do not see the documents until after treatment decisions are made. Some ignore the documents, because they fear that surviving family members will sue for failure to treat. In addition, a doctor can interpret a document to approve treatment in a circumstance when others interpret it to withhold treatment. Even if a doctor believes the living will prescribes non-treatment in a situation, treatment still is likely to be given at the request of one or more key family members.

Another simple document is the do not resuscitate/hospitalize order. DNR and DNH orders are common among older people who are in frail condition, especially those in nursing homes. Medical researchers say CPR rarely helps these individuals recover and often makes their passings violent and painful. Regarding hospitalization, some people believe that additional treatment for new ailments or developments will not prolong their lives or improve their quality of life. These people opt to be kept comfortable in their residences. They are declining CPR or hospitalization or both in advance by executing DNR and DNH orders.

The documents should be kept in the individual's medical chart, and any medical personnel who regularly treat the individual should be made aware of it. Again, some doctors will ignore these documents out of fear or being sued for failure to treat.

A third document is the health care proxy or power of attorney.

This is similar to the financial power of attorney that should be in every estate plan. The document appoints one or more people to make medical decisions when the person appointing the proxy is unable to. State laws on these documents vary, but most states do recognize the health care power of attorney. It is far more effective than the other health care documents, because it does not rely on interpretations of language drafted in advance that might not apply to the current situation. Instead, one or more people are appointed to discuss the facts with medical personnel and make decisions.

The person appointed the proxy should be someone who is likely to be available when medical decisions are needed. You probably do not want to appoint someone who does not live near by, travels a lot, or is not easy to get in touch with.

Some advisors recommend naming more than one proxy. This takes the life-and-death-decision making burden off one person. It also ensures a more complete discussion and consideration of all the factors. When more than one person is appointed, you might want to require that all agree before treatment can be withheld. Some people appoint only family members; others believe at least one proxy should be a non-family member who knows the family.

Another document you should have is the HIPAA authorization. This authorizes medical providers to release information to the named persons without violating the privacy provisions of the Health Insurance Portability and Accountability Act of 1996. Without this document some medical professionals will not share information about your medical situation, even with family members or holders of proxies.

The latest innovation is to combine the essentials of these documents into one called an advanced health care directive. In addition to combining the living will and power of attorney, the directive can include detailed explanations of your philosophy and preferences in different situations.

The document also can include information such as how you want to be made comfortable and be treated, including non-medical directives. For example, you can give instructions regarding music, grooming, fresh flowers, and other aspects of your environment.

Sample all-in-one documents are available, as Five Wishes, from Aging with Dignity (www.agingwith-dignity.org; 888-5-WISHES). Other versions are available from MyHealthDirective.com. These organizations charge modest fees for the documents and say they have versions for each state.

Whichever document or documents you select, all your doctors should have copies and know how to get in touch with decision makers. You also might want to discuss your philosophy with your care providers so they understand how to interpret the documents. Each proxy or decision maker also should have a copy, and key family members should have copies.

Be sure your estate planner knows if you travel regularly to another state or states. You want to be sure documents will be enforceable there as well as in your home state. You also should be aware that most states allow a doctor or hospital to refuse to follow the instructions for reasons of conscience.

Most of us need help in thinking about these difficult treatment decisions, whether for ourselves or others. A useful guide is a booklet written by the former chaplain at a nursing home. The booklet discusses the pros and cons of different choices and includes summaries of the scientific research of different treatments. You probably could benefit from Hard Choices for Loving People, by Hank Dunn (A&A Publishers, Inc., P.O. Box 1098, Herndon, VA 20172-1098; $4.00); www.hardchoices.com. A PDF version can be downloaded free. You also can check the sources below for additional thoughts and samples of documents.

Help with Health Care Directives

General sources:

Aging with Dignity: www.AgingWithDignity.org; 888-5-WISHES

MyHealthDirective: www.MyHealthDirective.com

National Hospice & Palliative Care Organization: www.nhpco.org; 800-658-8898

Your state attorney general's office

American Bar Association: Tool Kit for Health Care Advance Planning and Common Legal Myths About Advance Medical Directives. www.abanet.org/aging

Software:

Quicken WillMaker Plus

Kiplinger WillPower from H&R Block.

Web sites:

Legacywriter.com

LawDepot.com

Nolo.com

Pay Off Debt or Continue Owing in Retirement?

2009-08-21T14:13:00Z

Paying off the mortgage used to be part of the American dream and a prerequisite to retirement. Then, times changed. Debt management and the use of leverage spread from businesses to personal finance. It was not unusual for people to enter retirement with mortgages and other debt with no plans to become debt free. Some did not hesitate to increase debt during retirement.

Now, the pendulum seems to be swinging the other way. The financial crisis and economic downturn are causing Americans in general to deleverage. They are reducing debt and increasing saving.

What is the best approach? Should you try to pay off the mortgage as soon as possible or use debt as a financial tool?

The first factor to consider is subjective. Some people are not comfortable with debt, especially in retirement when they no longer have steady working income. They want to be debt free as soon as they can and will sleep soundly knowing that they do not owe substantial sums to anyone. If that describes you, paying off the mortgage probably should be a priority even if the numbers we will discuss shortly show it might be better to carry some debt.

Another factor to consider is the level of your cash or liquid asset reserves. Emergencies arise from time to time. Everyone should have cash or liquid assets to be drawn from in case of unplanned expense such as medical expenses or home repairs. It could be risky to use part of your emergency cash reserves to pay off the mortgage. Shortly after the mortgage is paid, there might be an unexpected need for cash. Alternatively, it might be possible to set up a home equity line of credit to be tapped for such emergencies. Before paying off a mortgage, consider how any emergency needs would be covered.

Once those factors are considered, take a hardnosed look at the numbers.

Someone considering paying a mortgage has a source of funds from which to make the payment. The question is: What is the best use of that money?

First, estimate the rate of return you expect to earn from investing that money over the remaining term of the mortgage. A conservative investor might estimate a return of 3% or so from money market funds, certificates of deposit, or conservative bonds. Other investors might estimate a higher return, and aggressive investors might project a return of 7% or more annually. Then, apply your tax rate to the investment return to arrive at the after-tax rate of return.

Next, verify the interest rate on the mortgage. If you itemize deductions, the mortgage interest will be deductible, so determine the after-tax interest rate. The after-tax rate will be less than the stated rate on the mortgage because of the deduction. (Most lenders will provide an estimate of how each future payment will be divided between interest and principal. As a mortgage gets older, more of each payment is applied to principal and less is interest.)

If the after-tax investment return exceeds the after-tax interest rate on the mortgage, you are better off keeping the mortgage and leaving your money invested. You are earning more income on your capital than the mortgage is costing, so it is better to keep the cash invested and pay the mortgage over time.

If the situation is reversed with the mortgage interest rate exceeding the investment return after tax considerations, the best use of the money is to pay the mortgage. You are earning less than the mortgage is costing you, so your wealth is increased over time by paying the mortgage and saving the interest payments.

Example. Suppose your mortgage has an interest rate of 6% and your combined federal and state income tax rate is 40%. The after-tax interest rate is 3.6%. Tax-exempt bonds yield more than that. Investment grade corporate bonds yield around 7%, which is 4.2% after taxes. If you invest the money in either of those vehicles, you are better off doing that and instead of paying down the mortgage. The same would be true if you plan to invest in a diversified portfolio or even primarily in stocks and expect to earn more than 3.6% annually after taxes. Keep in mind, however, that for these investments the rate of return is not guaranteed over the life of the mortgage, and there is a risk of losing principal.

If you invest in money market funds, certificates of deposit, or treasury bonds you probably will be earning less than 3.6% after taxes. Also, if you are bearish about stocks for the duration of the mortgage, you probably are anticipating a return less than 3.6% annually. In those cases, the better use of your capital is to pay the mortgage.

Suppose you already own a home debt free and are considering how to pay for repairs or improvements. Your choices are to take money from the portfolio or borrow against the home. The same analysis should be done. Compare the mortgage interest rate with the portfolio's investment return to decide on the best use of your money.

There are other factors for some people to consider.

If you still are working, the best use of income might be to maximize the contributions to your 401(k), or at least contribute enough to receive the full employer matching contribution. Taxes are deferred on the income contributed to the 401(k), as are taxes on the account's earnings. To the extent the employer makes a matching contribution, the rate of return on the 401(k) contributions is very high.

If the wealth that would be used to pay the mortgage is not in cash or near-cash, transactions might be needed to convert it to cash. Those transactions could trigger taxes. Selling stocks or mutual funds could trigger capital gains taxes, while withdrawals from annuities or IRAs would be taxed at ordinary income rates. The transactions also might push you into a higher tax bracket or even trigger the alternative minimum tax. In effect, you would need a greater amount than the mortgage balance to pay off the mortgage, because of the taxes incurred. The interest rate on the mortgage would have to be substantially higher than your investment return to justify taking the extra money from investments to pay the mortgage and the taxes.

Are the wealthy smarter than other people about using debt? Data from before the crisis show that the percentage of older Americans with mortgages is rising, and wealthy Americans have a disproportionate share of the nation's debt. This could be an indication of what financial advisors call strategic debt—using debt as a tool to increase net worth.

Strategic debt works like this. Suppose you have $500,000 of investments. You want to buy a home for $500,000. You could pay cash for the home and be debt free. Or you could make a down payment of $100,000 and take a mortgage of $400,000. Then, you own a $400,000 investment portfolio and a $500,000 house, controlling $900,000 of assets. The strategy works as long as income is high enough to pay the mortgage and is smart when the portfolio’s return is at least as high as the mortgage interest rate.

But a further probe into the data also shows that a lot of the debt among the wealthy probably is incurred to maintain a lifestyle people really cannot afford. The top 1% by wealth owe much less debt than those just below them on the wealth scale. It appears that a lot of the debt is not so much strategic as it is to stretch a lifestyle to keep up with even wealthier people.

One final factor to consider is prepayment penalties. Some states prohibit them, but in others penalties can be imposed on principal prepayments. This is another cost to factor into the equation.

Deciding whether to keep or eliminate debt is a simple exercise, requiring a few simple calculations. There are web sites that help make the calculations, such as www.mtgprofessor.com.

The Four Goals of Legacy Planning

2009-08-14T00:29:00Z

Perhaps one of the worst effects of high estate taxes is the way tax planning diverts attention from other important estate planning issues. For many years, I have stressed that estate planning is about much more than taxes, but most people believe estate planning and estate tax planning were the same thing. Though wrong, it was understandable when the lifetime estate tax exemption was $600,000. Many "modest millionaires" who considered themselves middle class would be hit by high estate and gift taxes without planning.

Unfortunately, the idea that estate planning is all about tax reduction still is widely held. With the estate tax exemption at $3.5 million and likely to stay there or higher, many people simply are neglecting estate planning. Since estate taxes are not going to be a problem for them, they see no reason to put together a plan.

One way to avoid falling into this trap is to think about legacy planning instead of estate planning. Everyone needs a legacy plan, even those with less than $1 million in assets. With a new estate tax law likely to come down the pike this year and stabilize the tax picture, 2009 is a good time to put together your legacy plan.

Legacy planning has four key goals. Consider these goals and how to accomplish them. Working with an estate planner will be easier and faster when you understand legacy planning this way, and it will make meeting these goals easier and more likely.

Financial security for you and the objects of your affection is a priority of legacy planning.

Though few people realize it, putting yourself first should come be the priority of legacy planning. Establishing a legacy involves giving to or providing things (not necessarily money) for others. Yet, you are best able to give to others when your own standard of living is secure. You won’t be able to give to or provide for others when your own situation is precarious. As the plan is developed, keep returning to the question of whether a strategy would put your standard of living at risk under some circumstances. The sharp decline in asset prices in 2008 brought that home to many people.

Once comfortable with your financial security, establish goals for the ultimate disposition of your wealth. Often, the spouse is the first beneficiary of the wealth. After that, children, grandchildren, and charities are the usual recipients of the wealth. You need to decide who will benefit from your estate, the order in which they will benefit, and the amount or percentage of your wealth they should receive.

After determining who should benefit from the wealth, the next issue is how they will benefit. That issue often is determined by the other goals of legacy planning.

Continuing the management and caretaking of the estate is the next goal. If you are like most people, you have been calling the shots if not doing all the management. Too many estates, regardless of their size, dwindle rapidly after the first owners pass them on. Often the successors did not understand how the assets were to be managed or did not share the values and outlook of the founder.

This issue is particularly important with small businesses. The founding owner must decide who will own the business, who will benefit from its income, and who will manage the business. Those are three separate categories and do not have to consist of the same person or people. A key to successful legacy planning for a business, however, is to have a succession plan in place and to follow it. Succession planning is an issue we have discussed in my newsletter, Retirement Watch from time to time.

Even estates without businesses need to address the issue of the stewardship transition. It could be that the people you want to benefit from the wealth are not likely to manage it well over the long term. In that case, you want to consider trusts and other arrangements that separate management and ownership. It is important to recognize that those who benefit from the assets do not have to be the managers.

Protecting the estate is another key element of the plan. This goal is particularly important to small business owners and professionals. They feel a greater need to protect assets from potential creditors and lawsuits. But others might need asset protection from those sources as well as disgruntled family members, irresponsible family members, and ex-family members in divorces.

There are simple, low-cost vehicles that will protect assets, including different ways to hold title to assets, IRAs, annuities, and umbrella liability insurance. These work for estates of any size. For larger estates, there are vehicles that can be used to protect assets, including trusts and limited partnerships. Your fears, needs, and the various methods can be discussed with your estate planner. The key is to identify the assets you want protected and the potential harms from which you want protection. Surprisingly, the size of the estate often is not a factor. Many estate planners report that the worst fights are over the smaller estates.

The legacy plan must address the potential tax burden. Once you have established who should benefit from the wealth, you want to transfer the wealth to them in the ways with the lowest possible tax bill that meet your other goals. For many estates, that has become easier each year for about a decade, but easier tax reduction probably won't continue after 2009.

One reason many people do not develop estate plans is they do not realize how valuable the estate is and the potential tax burden. There often are "hidden assets" that are included in the taxable estate such as annuities, life insurance, IRAs, and some trusts. Other people "forget" about some of their assets or do not know their true value.

Even when federal estate taxes are not a problem, state inheritance or estate taxes could be. A number of states have these taxes, and some impose taxes on estates or assets with values as low as $250,000.

Income taxes on beneficiaries also need to be considered in the plan. For example, the beneficiaries of IRAs face an income tax burden many people overlook. That burden is one reason it might benefit you or your heirs to empty an IRA early, pay the taxes, and put the IRA assets in a taxable account to compound over the years. If you do not consider income taxes, your beneficiaries could benefit from far less of your wealth than you expected.

Planning a legacy involves far more than reducing estate taxes. It is time to start determining your goals and putting your plan together. Once the new estate tax law is final, push forward with the final details and implementation.

When Should You Buy Long-Term Care Insurance?

2009-07-30T15:15:00Z

Among the more difficult retirement planning decisions are whether or not to buy long-term care insurance and, if so, at what age to purchase it.

In this Memo, we will assume you plan to buy LTCI and will focus on the age at which to buy. There are a raft of trade offs to consider. The annual premiums for the insurance are lower the younger you are when the policy is purchased. But benefits usually are not claimed until a policyholder is in one's late seventies or older. So, an early purchase could result in paying premiums for many years before receiving benefits, making the lifetime cost much higher than a later purchase.

But delaying the purchase has disadvantages. The premiums are higher the older you are at the time of purchase. In addition, a later purchase could mean that a change in one's health results in even higher premiums or even an inability to qualify for purchase. Also, there could be changes in the insurance market that result in higher premiums across the board.

It is difficult for many people to evaluate this decision. Guessing or trying to balance the different unknowns is not a good approach. A good decision framework was developed by Advisor Insurance Resources (AIR), which works with fee-only financial planners to analyze various insurance products for consumers. AIR identified the key factors to consider and quantified their effects using assumptions and historic data.

AIR says there are four key assumptions to consider.

An overlooked assumption is how new products insurers introduce, usually every three to five years, affect the cost. The new policies generally have effective premium increases of about 3% over the previous generation of policies. The increases often are required because the insurers underpriced their past policies and paid higher claims than anticipated. Cost increases also can be indirect, through lower basic benefits instead of higher premiums. Insureds buying the new policies have to choose higher cost riders and options to receive the same coverage as the previous generation’s basic policy.

Another assumption is the benefit limit of the policy. If a policy is purchased later instead of sooner, the benefit amount must be higher to keep pace with inflation of the covered expenses. In other words, $3,000 of monthly coverage today might be the equivalent of $3,800 per month in five years. That translates again into higher premiums for waiting.

The third assumption is what would be done with the money that would have gone to premiums if the policy purchase is deferred. You might want to assume it is invested. AIR assumed a 5% after-tax annual return in its analysis.

Another assumption is how long you will keep paying premiums. The main choices are ages 80 and 90.

Each assumption makes a difference in the results.

Let's look at a few conclusions that can be drawn from the framework developed by AIR, which is available on their web site at www.AdvisorInsuranceResource.com.

If you assume premiums are paid to age 80, at almost any age it is cheaper to buy the policy now instead of five years from now. But it is even cheaper to wait at least 10 years to buy. Cheaper is measured by how much the policy costs over a lifetime.

A major factor in the calculations is your current age, especially if you assume premiums are paid until 90 . If you assume premiums are paid to age 90 and you are younger than 60, it is cheaper to buy either now or 15 years or more from now. After age 60, at every age level it is more expensive to wait to purchase if you pay until 90.

The key variable, which cannot be quantified, is insurability. An accident or decline in your health could make you uninsurable at any time. The ideal strategy, as the numbers show, would be to delay the purchase until just a few years before you need the benefits. But you are unlikely to be able to time the purchase that way, and becoming uninsurable in the meantime would have expensive consequences. You would have to pay for all long-term care yourself, because insurance would not be available.

Another important factor is that, under this analysis, when waiting to purchase pays off a big reason why it does is the assumption that the money that would be spent on premiums is invested to earn an after-tax 5%. The compounded savings offset the higher premiums at later ages. If you do not invest the money that would have gone to premiums or earn a lower return, waiting to purchase LTCI is not the better financial move.

Buying early also eliminates the risk future policies will be less generous. Long-term care insurance still is a fairly new product, and insurers do not have sufficient data to make good projections about the claims they will pay. Many insurers entered the field the last few decades only to drop out after claims far exceeded their estimate. As the Baby Boomers age, if they use long-term care more than the insurers forecast, future policies could be issued with restricted coverage or much higher premiums. Another advantage of an early purchase is eliminating the risk premium increases will be much higher than assumed.

This analysis involves only straight long-term care insurance, not policies that combine LTCI with life insurance or annuities or that guarantee return of premiums. Those features substantially increase the cost and make it hard to analyze and compare policies.

The conclusion you should draw from this analysis is the safest route is to buy coverage sooner rather than later. Otherwise, all the assumptions in favor of delaying the purchase must be accurate for you to come out ahead, and you must be insurable at the later date. The risks to buying early are you pay many years of premiums before making a claim or never make a claim under the policy. This is the same risk you hope will be true for homeowner’s and auto insurance, and long-term care insurance should be viewed the same way.

Hedge Funds for the Rest of Us

2009-07-23T15:41:00Z

Hedge funds used to occupy a small, obscure part of the investment world. They were out of the public eye; few investors even knew about them. Regulators ignored them, as a matter of law.

Gradually hedge funds became more prominent. A few of the pioneers of the business became billionaires, drawing attention to the business. George Soros received a lot of publicity in the 1990s after winning a big bet against the British pound, a move that British officials lambasted and blamed for the fall of the pound.

Hedge funds really took off after the technology stock bubble burst in 2000. While market indexes declined, many hedge funds held their value or made money. That attracted not only media attention but a flood of money from pension funds, endowments, and other sophisticated investors. It seemed that everyone who did well on the trading desk of a Wall Street firm or who had the confidence of a broker formed a hedge fund and raised tens of millions of dollars to invest. Some hedge funds grew to billions of dollars under management, and some hedge fund owners earned $1 billion and more in a year.

While hedge funds in general did not distinguish themselves in the broad market crash of 2008, they have a reputation for beating the S&P 500 long term and generally have done so in 2009 to date.

The problem for most investors is they cannot invest in hedge funds. By law, a hedge fund can accept only certain investors, known as qualified investors. They also are known as sophisticated investors. These investors are pension funds, endowment funds, foundations, and individuals who meet net worth or income requirements. But there are some safe ways for individual investors to reap the rewards of hedge fund investment strategies.

There is no real definition of a hedge fund, though there used to be. Today, a hedge fund is an investment partnership or pool that is not subject to the regulations that apply to mutual funds, investment advisors, or brokers. Hedge funds are subject to only a few regulations. That is why they can accept only certain types of investors. Those who wrote the securities laws reasoned that these sophisticated investors did not need the protection of the securities regulators and could invest with whatever firm they wanted to.

The original hedge fund was an investment vehicle that took both long and short positions in the stock market. A long position is when an investor buys an investment expecting it to appreciate. A short position is when the investor sells short an investment, expecting it to depreciate. The investor also can use futures or options contracts to take long or short positions in an investment. In other words, a hedge fund actually hedged its investments. It would take a long position expecting an investment to increase but also would take a short position that would profit if the long position did not.

Today the term hedge fund applies to a fund’s legal status rather than its investment strategy. Hedge funds today engage in a wide range of investment strategies. Some have very conservative strategies that aim to earn only a little more than money market interest rates. Other hedge funds employ very risky strategies, even using debt or other forms of leverage that magnify gains or losses.

Hedge funds have several features that attracted institutional investors in recent years.

An important characteristic of a hedge fund is that its investment returns have a low correlation with the major stock and bond market indexes. Correlation is the extent to which an investment rises or falls with an index. Some investors call this “beta.” An investment with a beta of 1.0 to a stock market index rises and falls when the index does and by the same percentage. An investment with a beta of 0.0 to the index has no correlation with it. An investment with a beta of -1.0 moves exactly the opposite of the index.

Correlation is important, because an investor might not want his portfolio’s value to be subject to the ups and downs of the stock market. While the long-term average returns are nice, the investor might not be able to withstand the shorter-term declines of 20% and more, sometimes much more. An endowment or foundation must pay income each year to fund its sponsor. A pension fund must pay pension annuities, and the employer’s annual contribution is based on the current value of the fund. An individual might be paying for retirement or some other expense, and cannot plan well with sharp fluctuations in the portfolio’s value. Each of these investors has good reason to seek an investment that does not have a high correlation with the stock market indexes.

An investment with a high long-term return that does not fit the same pattern as the stock market indexes is a good addition to a portfolio.

Hedge fund investors also like that they can build a diverse portfolio of hedge funds that have low correlations with each other. When some funds are up, others are down. This combination of investments with low correlations to each other also smoothes a portfolio’s returns.

Another advantage of hedge funds is they can be less volatile than the stock indexes. While the stock indexes have wild disparate returns from year to year, a number of hedge funds have much steadier return patterns. This is another way of smoothing the portfolio’s annual changes in value.

Investment returns are another appeal of most hedge funds. The ideal hedge fund has long-term returns that are close to those of the stock indexes but has a low correlation with the index and less volatility than the index.

This is all interesting, but what does it mean for you unless you are a qualified investor? There are ways you can benefit from hedge fund strategies.

A few years ago I set out to build a portfolio of no-load mutual funds that have the same characteristics as hedge funds. The return patterns of the funds would have low correlations with the major stock and bond indexes and also with each other. The funds as a group also would have less volatility than the indexes and would have high long-term returns.

Not too long ago, it would have been impossible to put together such a portfolio. Mutual funds had “long only” portfolios. They did not use unusual strategies, sell short, or hedge. They also did not move from one type of asset to another. In general, traditional mutual funds stuck to one type of investment and strategy, and they did not hedge their investments.

Even better, my “hedge fund” mutual funds do not have the high expenses of hedge funds. A typical hedge fund charges annual expenses of 2% of assets plus an incentive fee of 20% of all positive returns. That is how hedge fund managers make high incomes. You do not need to earn high returns to earn a high income if you have a lot of assets under management and take 20% of all positive returns.

I put the hedge fund portfolio together in 2001 and back-tested its performance. The performance since has been consistent with the back-testing and the goals. The portfolio returns more than the S&P 500 with less volatility and a low correlation to the index.

The key to a long-term successful portfolio such as this one is to avoid the large losses of the indexes. While 2008 was a rough one for my “hedge fund” portfolio, it was better than for traditional mutual fund investors and for many well-known hedge funds.

The big picture numbers of the portfolio are impressive. The volatility, as measured by standard deviation, is 10.75 over three years, 8.7 over five years and 7.73 over 10 years. In each case, the volatility is about half that of the S&P 500. (All the data are as of June 30, 2009.)

The portfolio also has a low beta, or correlation, with the S&P 500, though that has increased the last few years. Over three years the beta is 0.52, and it is 0.51 over five years. Over 10 years the beta is 0.36.

Returns are excellent. Alpha is the extent to which the returns exceed those of the benchmark. The portfolio consistently delivers alpha over the S&P 500. Over three years, alpha is 3.01 annually, and it is 2.93 over five years. Over 10 years, annual alpha is 5.88.

The financial crisis of 2007 and 2008 increased the standard deviation and beta, because all assets were negatively affected by the market meltdown and credit squeeze, except treasury bonds. I expect over time those numbers for the shorter periods will become closer to those of the 10-year period, as they were before 2008.

One of my goals for any investment is to avoid big losses. We cannot avoid all losses, but we want to avoid those 40% and 50% draw downs to which the market indexes are subject. The hedge fund portfolio has accomplished this.

Over the one-year period, the portfolio lost 9.12%. That is disappointing, but it is much better than the 26.21% loss of the S&P 500. Over three years the portfolio has a positive return of 0.30% annualized, versus an annualized 8.22% loss for the index. Over 10 years we have a 7.26% positive annualized return instead of the 2.22% annualized loss of the S&P 500.

Normally a portfolio that avoids large losses also misses out on bull markets. That is not the case with this portfolio. The highest returning period of the last 10 years was the three months ending with May 2009. The hedge fund portfolio earned 16.27% during this period. That lags the historic returns the S&P 500 earned during the period, but it is a strong return and coupled with the portfolio’s loss reduction qualities puts the portfolio well ahead of the index. The worst three-month period for the portfolio, not surprisingly, was the period ending November 2008 with a 20.63% loss. The worst 12 months ended February 2009 with a 22.78% loss, and the worst three years ended Feb. 2009 with a 4.43% annualized loss. Losses of that magnitude are disappointing, but they are well above the index and what most investors sustained. The portfolio bounces back with the markets.

The hedge fund portfolio is diversified among not only strategies but also different types of assets. As of June 30, 2009, the portfolio was 7.37% in cash, 37.52% in U.S. stocks, 9.22% in non-U.S. stocks, 43.04% in bonds, and 2.85% in other assets.

The funds in the portfolio are carefully selected for several characteristics. They must be no-load and have reasonable expenses. They also must use strategies commonly used by the best hedge funds instead of typical mutual fund strategies. The funds also must have low correlations with each other and with the major indexes.

The hedge fund portfolio is designed as a buy-and-hold portfolio. Changes are made when newer funds prove themselves after a few years or when an existing fund has a major change, such as its management or fee structure. But generally we depend on the fund managers to move their portfolios among different asset classes instead of doing it ourselves.

The portfolio has a wide variety of mutual funds. There are traditional hedge funds, such as Schwab Hedged Equity. There also are “asset allocation” funds such as Hussman Strategic Growth and PIMCO All Asset. There are some unique balanced funds, such as Oakmark Equity and Income, FPA Crescent, and Berwyn Income. The portfolio also has funds that can invest in almost anything but specialize in distressed asset investing. Finally, we have some funds that invest in long only strategies but do so in assets that offer good diversification, such as real estate investment trusts, high yield bonds, and international bonds.

Investors have been damaged by following conventional investment strategies of buying and holding portfolios of long-only mutual funds that invest in many of the same assets. There are opportunities to achieve true diversification and construct portfolios that deliver better returns than the S&P 500 with less volatility and risk. These results can be achieved using select no-load mutual funds that avoid the high fees and lack of liquidity of traditional hedge funds while employing traditional hedge fund strategies.