re-evaluating risk and finding income in todays economy presented by: marta nystrom nystrom &...

Re-Evaluating Risk andRe-Evaluating Risk andFinding Income Finding Income

in Today’s Economyin Today’s Economy

Presented by:

Marta Nystrom

Nystrom & Associates

Copyright 2009 Nystrom & Assoc

What We’re Covering Today

• The Risk in:– Treasuries– Bonds– Mutual Funds and Exchange Traded Funds

• Finding Income in this Economy:– Bonds versus bond funds– Master Limited Partnerships– Options Strategies– Fixed rate annuities– Annuity Lifetime Income Riders– Medical Arbitrage Strategies

Copyright 2009 Nystrom & Associates

3/5/2009 ALERT: New Bull Market or Bear Market Rally Imminent !!!


The Relationship Between Price and Yield

If interest rates increase during the term of your bond, the money invested will be earning less interest than it could elsewhere.

● As interest rates rise, the value of your Treasury or any bond will decline in the resale market for the same reason.


2 Ways to Lose Money in Treasuries and Bonds

When you purchase at a low rate of interest due to excessive demand

When you sell at a low resale rate due to excessive selling


The Downside of Treasuries…

In December 2008, world wide investors fled to long term US Treasury bonds. They hoped to obtain yields better than the near-zero (and occasionally negative) yields on short-term Treasury bills. The plan backfired, however, and instead of locking in 4-4.5% coupon yields, buyers paid such a significant premium that they ended up getting the lowest Treasury bond yield in history: a mere 2.52% on a 30 year Treasury bond.

The problem then compounded when the value of these long term bonds plummeted (due to heavy selling by bond holders), delivering a market loss to these bond holders of 12.85%. The decline occurred over a short six weeks. The net loss was the equivalent of more than five years of interest in just six weeks. (12.85=2.52=5.3 years)


“On Wednesday, the Fed said it would buy up to $300 billion in longer-term Treasuries over the next six months "to help improve conditions in private credit markets.“

…The prospect of a 10-ton buyer entering the market sparked an enormous jump in the price of the 10-year Treasury notes. Its yield, which moves in the opposite direction, plunged to 2.5 percent on Wednesday from 3 percent Tuesday.

…William Poole, former president of the St. Louis Fed, worries that by loading up its balance sheet with so many long-term Treasury and mortgage securities, the Fed is reducing the flexibility it says it needs to adapt to rapidly changing conditions.

"I believe this is an unfortunate and dangerous policy the Fed is getting into," he said during a talk to the CFA Society of San Francisco last week…”

Kathleen PenderSan Francisco Chronicle

March 22, 2009

But The Situation Has Improved, Right?


Corporate Bonds

Secured or unsecured debt issued by a company to raise money.– Repayment is contingent upon the company’s

claims-paying ability.– Most corporations are experiencing reduced

profits or losses.


Municipal bonds

Repayment is based upon the claims-paying ability of municipalities.– 2 Types:

GO (General obligation) Bonds Money to repay bonds comes from property taxes, income

taxes, license fees, and sales tax revenue. How are these revenue sources faring in this economy?

Revenue Bonds Payable from the specific earnings and net lease

payments of revenue-producing facilities How are these revenue sources faring?


But Muni’s Can Be Insured

Municipal bond issuers can insure their securities’ principal and interest payments by buying insurance from the MBIA, AMBAC, CGIC, or FGIC and others

“Many cities, states and other entities that issue municipal bonds - to finance schools, roads and other public projects - are facing lower revenue as a result of the slowing economy, which could affect their ability to repay their bonds.

Investors who bought munis that offered insurance if the issuer defaulted thought they were getting an extra layer of protection. But now the companies that issued these insurance policies are having their credit ratings cut.

These ratings downgrades have caused the value of insured bonds to decline relative to uninsured bonds and have increased risk and uncertainty in the muni market.”

SF Gate June 12, 2008


The Safety of Mutual Funds & ETF’s

From Wikipedia:– Diversification in finance is a risk management

technique, related to hedging, that mixes a wide variety of investments within a portfolio. It is the spreading out investments to reduce risks.

Because the fluctuations of a single security have less impact on a diverse portfolio, diversification (mitigates) the risk from any one investment.


Mutual Funds & ETF’s Versus Individual Stocks

“This is not a time to brag about the stock market performance of our prior year's list of the Platinum 400, the Best Big Companies in America. Thanks to the current bear

market and the severe economic downturn, only 22 of the

400 companies on the list managed to produce a positive price change over the past year…”

Forbes.com Brian Zajac, 12.22.08


A Secular Bear Market


What to Do Now?

• Trailing Stops

• Absolute return portfolios• Shift to income producing portfolio until the market full corrects


Absolute Return Portfolios

“Buy and Hold” is “buy and hope.”– John Mauldin study of markets from 1900-2008 broken into

20 year blocks of time No 20 year period gave a 10% or better compounded ROR. 1942-1961 gave a compounded ROR of 9.9%. Every other high ROR period included the 1990’s.

Only the 1990s gave a compounded ROR > 20% Absolute return strategies aim to produce a positive

absolute return regardless of the directions of financial markets.

– Should incorporate an exit strategy, preferable to BOTH the upside and the downside.


Absolute Returns Portfolios

Keep one eye on returns and the other on risk.– Evaluate based upon “draw down,” i.e. peak to valley versus volatility as a

measure of risk.– S&P closed at 1557 on 10/1/07; on 3/17/09 closed at 783. Represents a

decline of 49%. Fees and Trading Expenses Typically Perform Better In Bear and Volatile Markets; Worse in Bull

Markets– It is extremely difficult to know when one is in a bear/bull market until well

into it, therefore adopting any strategy based on bull or bear market conditions may lead to unfavorable results

Tax Ramifications– Short term trades mean short term capital gains and losses– Tax deferred accounts versus taxable accounts


Shifting To An Income Portfolio

• Bonds versus Bond Funds

• Master Limited Partnerships

• CD’s versus Fixed Interest Annuities

• Options Strategies

• Lifetime Income Riders

• Medical Arbitrage Strategies


Bonds versus Bond Funds

Remember the teeter totter – bond holders must be agile in this economy.

Average maturity – Why does it matter? Turnover – What is it? Does it help or hurt? Bond funds might be more liquid but what do fund

managers do with the money flowing in and only low interest rate bonds to purchase?

– Strategy, track record, manager’s experience, closed end or open end


Master Limited Partnerships (MLP’s)

Yields of between 5-11% on average They must generate 90% of their income from activities relating

to real estate, natural resources (timber, mining, energy), or commodities.

They pay no income tax, so your dividends are taxed as ordinary income.

Because they pay out such a high level of their income, they can become more easily strapped for cash and subject to the whims of the credit markets.

May not be appropriate for retirement accounts due to Unrelated Business Income Tax (UBIT) on amounts over $1000.

Must be shopped extremely carefully.


CD’s versus Fixed Interest Annuities

CD’s are issued by banks and brokerage firms. Annuities are issued by life insurance companies. 3/30/09 CD rates for 3 year term averaged between 2.7% -2.9% with high quality

institutions 3/30/09 CD rates for 5 year term averaged between 3.3% - 3.5% with high quality

institutions– CD’s MAY be insured through FDIC. Only place your money with a highly rated

company and understand the early surrender terms.– Withdraw the interest to increase cash flow.

3/30/09 Fixed annuity rate for 3 year term 4.6% with “A” rated company 3/30/09 Fixed annuity rate for 5 year term 5.0% with “A” rated company

– Annuities are not insured through FDIC. They may be insured through a carrier’s reinsurance policy or through each state’s insurance guaranty fund.

– Only place your money with a highly rated company and understand the early surrender terms.

– Withdraw the interest to increase cash flow.– Check with your tax advisor to understand the tax ramifications of annuity

deferrals and the tax ramifications when money is removed from an annuity after having been deferred.


Options Strategies

Basic Terms: Option Writer vs Seller, Strike Price, Expiration Date

You must set up an options trading account with your brokerage firm and be approved to trade options.

– Approval is determined at different risk levels. – Beginner traders usually limited to level 1 or level 2, which typically

includes covered calls and may or may not include selling puts. – The use of options may be considered higher risk and may be limited to

more experienced and/or affluent investors. Not the same as having a Margin Account. These strategies are not beginner strategies, but are viewed as

a strategies to hedge and conserve portfolios. Selling covered calls (and often puts) are generally allowed inside retirement accounts as they are considered appropriately conservative by the IRS.


Put Option Example

You determine that XYZ Company would be a good holding, and you have sufficient funds in your account to purchase 100 shares of XYZ.

XYZ is currently selling at $24/share and it’s 52 week low is $19/share.

You SELL or WRITE a put option on XYZ for $20/share with an expiration of June, 2009.

You RECEIVE a premium of $100 (or $1/share before transaction fees). This lowers your cost on XYZ to $19/share.

Two possible outcomes by end of June:– XYZ is trading higher than $20/share and your option expires. You

keep the $100 and can repeat this strategy.– XYZ is trading at or below $20/share and your option is “assigned.”

You have now purchased XYZ at $20/share AND you keep the $100 premium.


Call Option Example

You own 100 shares of XYZ. You bought XYZ a couple years ago at $23/share. It went up to $34/share and is now back down to $24/share.

You SELL or WRITE a call option on XYZ at a strike price of $27 with a June expiration. You receive $80 in premium.

There are 3 possible outcomes:– XYZ’s price goes up to but doesn’t make it to $27. The option

expires worthless and you keep the $80. You can repeat the covered call sale.

– XYZ’s price goes down below $24/share. You could “unwind” the transaction or just ride it out. You keep the $80 and can repeat the covered call sale.

– XYZ’s price goes above $27. You must sell it at $27. You keep the $80 premium, but you have given up the difference between the $27 strike price and the market price.


Lifetime Benefit Income Riders

Annuity product– Provided by life insurance companies– Check financial health of the company– Understand fees and surrender charges– Work with an independent; complex products that come in a variety of

“flavors” Variable versus fixed annuities

– Typically higher fees in variable annuities, including life insurance fees– Understand HOW the life insurance works in variable plans– Variable products can go down in value; fixed products cannot– Variable products may offer more upside potential, depending upon market

conditions Offers lifetime income without annuitization Probably best suits the age 55-70 age bracket

NOTE: Annuities may be highly illiquid and may have long surrender periods. Most restrict the amount of money that may be removed prior to the end of the surrender period. The GIBR annuities (above) are meant to be held permanently in order to obtain maximum benefit.


How GIBR Annuities Work

Account Value Side Grows at rate determined by

various strategies. If variable annuity, could go down in value.

Fees usually deducted from this side of annuity.

This side is what beneficiaries would inherit if any left after income stream taken on Income Account.

Income Account Side Grows at rate set by contract Grows tax-deferred until

funds are removed After deferral period, allows

you to take income stream at set rate even after account value funds are exhausted

If account value funds are exhausted, beneficiaries receive nothing


Arbitrage Strategies

Arbitrage (as defined by Webster): “The Purchase Of A Security, Commodity, or Foreign Exchange In One Market And Immediate Resale In Another Market To Profit From Price Discrepancies.”

The Arbitrage Strategies That I’m Going To Share With You Today Are Unique, And Will Only Be Suitable In Certain Situations. I’m Going To Explain These Concepts Through Several Examples:


Arbitrage Strategy #1

Potentially Increase Income


James Is A 67 Year Old With Two Homes. Neither Has A Mortgage.

James’ Also Has $150,000 In CD’s And Would Like Some Additional Income That Won’t Vary.

He Is Currently Making 2.5% On His CD’s For An Annual Income of $3,750, All Of Which Is Taxable As Ordinary Income. James Is In A 25% Income

Bracket.


James Learns That He Can Take Out A Fixed Rate 30 Year Mortgage at 5.25%.

He Takes Out a $120,000 Mortgage At Fixed Rate of 5.25%, Which Has An Annual Payment of

$7,951.68.

How Can James Increase His Income And Improve His Tax Situation?


Step 2…

James Then Takes $80,000 From His $150,000 In CD’s And Combines It With The $120,000 From The Mortgage To Put Into A Lifetime Income Contract Of $200,000.

This Creates An Annual Cash Flow of $16,848*.

After The Mortgage Payment Of $7,951, James Has $8,896 Remaining.

*Incomes Generated By Lifetime Income Contracts Will Vary Depending Upon A Number Of Different Factors.


Step 3…

James Wishes To Replace The Money Taken From The Mortgage In The Event That He Doesn’t Live For 30 More Years.

He Purchases A $120,000 Life Policy With A No-Lapse Guarantee For An Annual Premium Of $2,544. He Pays For The Premium With The Income Received From The Lifetime Income Contract.

James’ Income After Making The Premium Payments On The Policy is $6,352.


James’ Situation James’ Situation BeforeBefore Implementing This Strategy:Implementing This Strategy:

Gross Income From $2,000 $80,000 CD Interest @ 2.5%Insurance Premium $0Mortgage Payment $0Net Income $1,500*

*Assumes a 25% income tax.NOTE: Your situation may be different than that illustrated here.


Here’s What James’ Situation May Look Like Here’s What James’ Situation May Look Like AfterAfter Implementing This Strategy: Implementing This Strategy:

Gross Income From Lifetime $16,848 Income Contract*Tax Liability In 25% Tax Bracket $ 632 Based Upon Favorable Tax Treatment of Lifetime Income ContractMortgage Payment $ 7,951Insurance Premium $ 2,544Net Income $ 5,721

* Lifetime Income Contract Based On A Rated Age Of 75.

James Receives Some Additional Tax Benefits On The Mortgage Interest Deduction.


Pro’s And Con’s Of James’ Situation

James has increased his net income by approximately $4200/year.

But he has decreased his CD holdings by $80,000. James has received some income tax advantages from the tax

laws on lifetime income contract and the mortgage interest deduction.

Mortgage interest deductions could be erased by changes to the tax laws.

James has replaced the value of the mortgage through life insurance, but not the value of the $80,000.

– The mortgage will be paid off in 30 years, provided James lives that long. At that time, there will still be $120,000 in life insurance if James elects to keep it in force.


How Does James Find Out If This Strategy Is Feasible Given His Situation?

As Part Of A Feasibility Study James Gets Quotes On:

● A Medically Underwritten Immediate Annuity ● A New Life Insurance Policy


Arbitrage Example #2


Potential Problem!Taxes On Your IRA

Presently Scheduled Estate Tax RatePresently Scheduled Estate Tax Rate

2009

2010

2011

45%

Repealed

55%

$3,500,000

$1,000,000

Estate TaxEstate Tax

IRD TaxIRD Tax

45%45%

19%19%


As An IRA Grows, So Do The Potential Taxes. Here’s What A 5% Growth Rate In An Ira Would Look Like And What The Corresponding Tax Bill Would Look Like If the Ira Owner Took a Full Withdrawal. The Assumed Combined Tax Rate Is 25%

Year IRA BalanceTax Due on Full

WithdrawalAfter Tax Balance

1 $500,000 $93,750 $375,0002 $530,000 $99,375 $397,5003 $561,800 $105,338 $421,3504 $595,508 $111,658 $446,6315 $631,238 $118,357 $473,4296 $669,113 $125,459 $501,8357 $709,260 $132,986 $531,9458 $751,815 $140,965 $563,8619 $796,924 $149,423 $597,693

10 $844,739 $158,389 $633,555


Arbitrage Strategy #2IRA Arbitrage

Larry is a Married 64 Year Old Man (Wife is Brenda, age 63). Larry Has An

IRA Account With A Value Of $600,000.

He’d Like To Be Able To Improve His Income Situation, Reduce Taxes, And

Also Be Able To Leave As Much Money As Possible To His Heirs.


IRA Arbitrage Option #1

Larry Is Uninsurable, But Brenda Was Offered Life Coverage From Almost Every Carrier Shopped With Offers Ranging From Preferred

to Table C. Larry Decides To Place $500,000 Of The IRA Account Into A Lifetime Income Account For Brenda That Will Pay An Annual

Income Of $45,702$45,702 For The Rest Of Her Life.

If Larry And Brenda Are In A Combined Tax Bracket Of 28%, The After-Tax Annual Payment From The Lifetime Income Account Will

Be $32,905.$32,905.

*Annual Income Based on a Standard ‘Card Rate’ for age 63 with an offset of plus one .


Of The Annual After-tax Income Payment That They Receive Of $32,905 Brenda Is Going To Use $9,175

To Pay The Premium On A Life Insurance Policy With A Death Benefit Of $500,000

To Replace The Value Of Larry’s IRA.

This Leaves $23,730 Per Year After Tax For Larry And Brenda To Use To Meet Living Expenses Or Whatever

They May Want To Use The Money For.


That’s A Net Return to Larry and Brenda After Taxes of

4.74% And A Taxable Equivalent of 6.85%.

Larry And Brenda Would Need to Get A 6.58% On Their

Qualified Retirement Account In Order To Net 4.74% After Taxes.

If The Life Insurance Is Owned In A Trust (Preferably With Dynastic Provisions) The Entire Death Benefit Would Be Income And Estate Tax Exempt.


If Larry Decided To Keep That $500,000 In If Larry Decided To Keep That $500,000 In His IRA, Lived Another 20 Years And His IRA, Lived Another 20 Years And Received A 5% Fixed Rate Of Return, Here’s Received A 5% Fixed Rate Of Return, Here’s What His Heirs Might Receive Upon His What His Heirs Might Receive Upon His DeathDeath

$500,000$500,000

$661,229$661,229

Family Family $231,430$231,430

IRS $429,799IRS $429,799

Includes Estate Includes Estate & Income Tax& Income Tax

This Is A Hypothetical Illustration And Doesn’t Represent Any Specific Product.


How Does Larry Find Out If This Solution Is Feasible Given His Situation?

As part of a feasibility study, both Larry and Brenda get quotes on:– A Medically Underwritten Immediate Annuity– A New Life Insurance Policy.


Additional Points on Arbitrage Strategies

A lifetime income contract will cease upon the death of the annuitant. In order to replace the value, a life insurance policy must be purchased and maintained.

Every situation is different. A thorough review of assets, exposure to estate taxes, objectives of the client, income sources, and health situation are required to see if an arbitrage strategy would benefit you.

Because arbitrage strategies cannot be “unwound,” such a decision to enter into such a strategy must be carefully considered.

Arbitrage strategies result in commission compensation for the representative as well as the company doing the feasibility studies.


Adding Dynastic Trust Elements to the Arbitrage Strategies

Let’s Look At The Family Of Commodore Cornelius Vanderbilt Who Died With A

Fortune Of $105,000,000 That He Left Largely To His Oldest Son William In The Year 1877.

*Source: www.nnp.org


Years Later In January 1883, William Was Worth $194,000,000.

William Did A Good Job Managing The Assets Left To Him By His Father.

Years Later, In 1885, William H. Vanderbilt Died With A Net Worth Of

$200,000,000.


William Left Half His Fortune To His Sons, Cornelius And William K, Bringing Their Fortunes To $50,000,000 Each

And The Remaining $100,000,000 Was Divided Among All Of His Children.

Of All William H’s Children, Frederick, Who Inherited Only $10 Million, Did The Best Financially.

At Frederick’s Death In 1938, He Was Worth

$78 Million.

Federal Estate Taxes Consumed Over Half His Estate.Federal Estate Taxes Consumed Over Half His Estate.


According To Arthur T. Vanderbilt II, Author Of “Fortune’s Children: Fall Of

The House Of Vanderbilt,”

When 120 Of Commodore Cornelius Vanderbilt’s Descendents Gathered For A

Reunion In 1973 – There Was Not A There Was Not A Millionaire Among Them.Millionaire Among Them.

The Succeeding Generations Of Vanderbilts Didn’t Do As Well.


Only % Of Family Assets On

Average Survive To The 4th Generation.

*Source: Family Firm Institute, Brookline, Massachusetts


How a Trust with Dynastic Provisions Might Benefit Your Estate Plan

Eliminate Estate Taxes on Your Life Insurance Death Benefit

Divorce Protect Your Estate Creditor Protect Your Estate Lawsuit Protect Your Estate Allow future businesses and assets similar

protection Preserve Your Estate for Future Generations

– For up to 120 years in NM; up to 350 years or in perpetuity in some other states


How Do You Set Up a Trust with Dynastic Provisions?

If your attorney isn’t familiar with this type of trust, you can work with your attorney in conjunction with another attorney who

specializes in such trusts.Unless your estate attorney is unwilling to work

with you on this, you do NOT need to “dump” your estate attorney.

NOTE: The cost of establishing a trust with dynastic provisions could be higher than that of an ordinary Revocable Living Trust. It is a specialized field of estate law.


Where Do You Go From Here?

• What Is Your Risk Tolerance And Time Horizon?• What Are Your Objectives?

– Income? Tax Reduction? Estate Planning?

• What Is Your Outlook On The Economy And The Market?– Bull? Bear? Fence Sitter?

• What Strategies Appeal To You?– Bonds? Income Portfolios? Absolute Return Portfolios? Arbitrage Strategies?

• Get Personal Guidance, Make Your Plan And Implement It

re-evaluating risk and finding income in todays economy presented by: marta nystrom nystrom &...

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