Educational Articles

Educational Articles

  • First Things First: Choosing the Right Retirement Plan

    Key Points

    • DB Defined
    • DC Defined
    • Cash Balance Plans
    • Points to Remember


    For employers, the decision to offer workers a retirement plan addresses critical business needs. However, it also raises the question: What type of plan -- defined benefit (DB) or defined contribution (DC) or a combination of both -- best addresses the goals of participants as well as those of the company?

    The following overview provides the fundamental information on the different types of plans and will help you narrow down your search for the best possible retirement plan.

    DB Defined

    What exactly is a DB plan? Essentially, DB plans are the old-fashioned "pension plans" that are funded and managed by employers who bear the responsibility of providing a predetermined retirement benefit for retired employees. The actual dollar amount of benefits to be paid to each retiree by a DB plan is based on a formula (identified in the official plan documentation) and is typically determined by each individual's age, length of service, and level of compensation.

    Because DB plans assume the responsibility for paying a predetermined (i.e., "defined") benefit to retirees, many argue that they represent the best way for employers to help provide true retirement security. DB plans are often perceived as representing better "public policy" because they also tend to be more valued by -- and more generous to -- longer-tenured employees who prefer stability and predictability in their financial lives. However, participants do face the risk of "unfulfilled expectations" that may arise in the event of a job loss, plan termination, or plan underfunding. (The federal Pension Benefit Guaranty Corporation (PBGC) insures DB plans in the event that an employer fails to provide full funding. If a plan terminates without full funding, PBGC will pay the benefits promised by the plan up to certain limits.)

    In general, DB plans are more costly for employers to sponsor than DC plans. They are also more complex to administer. For example, DB plans require employers to pay insurance premiums and hire actuaries. In addition, expenses related to funding DB plans appear on corporate financial statements. And employers must adhere to special regulations if they decide to terminate a DB plan early. By contrast, a DC plan can be terminated much more easily.

    DC Defined

    DC plans can be viewed as the mirror image of DB plans. Instead of being funded, invested, managed, and paid out by employers, DC plans place the responsibility for those decisions and strategies on the shoulders of each individual participant. The employer has no responsibility to provide a predetermined retirement benefit.

    The three most common types of DC plans are 401(k) plans, 403(b) plans, and 457 plans, which are sponsored by companies, nonprofits, and government agencies, respectively.

    In general, DC participants decide how much money to contribute to their individual (and uninsured) accounts and how to manage their investments up to and throughout retirement. In other words, participants bear most of the risks normally associated with investing in securities markets. Consequently, the goal of achieving retirement security with a DC plan can be threatened by bad investment decisions or market volatility.

    DC plans are usually less expensive to administer than DB plans, and future expenses can be easier to predict. Yet it's important to remember that DC plans have the potential to be more expensive for the workers themselves, since participants are often required to pay at least a portion of any administrative, actuarial, and investment fees incurred by the plan.

    Still, research indicates that DC plans are most appreciated by younger workers who place a high priority on being able to control their money and understanding how their retirement plan operates. Part of their appeal is the fact that DC assets are highly portable, meaning that workers can easily transfer balances to other qualified retirement accounts when changing jobs. They can also opt to cash out by taking a lump-sum distribution after separating from service. However, they'll have to pay taxes on their distributions and early withdrawal penalties may apply.

    Some types of DC plans also give employers the option of making tax-deductible matching contributions to participants' accounts, subject to certain limits. While an employer match obviously increases employer costs, it can be a valuable tool for attracting and retaining employees. An employer match may also inspire better financial behavior by participants. For example, one study revealed that 69% of plan participants cited the employer match as the reason they enrolled in their 401(k) plan.1

    DB and DC -- Compare and Contrast

    DB DC
    • completely funded by employer
    • employer is responsible for making up shortfalls
    • insured by the federal Pension Benefit Guaranty Corporation
    • plan costs are shouldered by employer
    • most attractive to older, long-standing employees
    • funded by participant contributions (employer may make matching contributions)
    • employer has no responsibility to provide a predetermined retirement benefit
    • individual participants assume all investment risks
    • uninsured
    • participants often pay a portion of plan administrative costs most attractive to younger, more mobile workers

    Cash Balance Plans

    An increasingly popular type of retirement plan is the cash balance plan, which combines aspects of both DB and DC plans. As in a DC plan, cash balance plan participants have their own accounts and can transfer assets when switching jobs. If the new employer doesn't have a cash balance plan, cash balance plan assets may be rolled into an IRA. Like a DB plan, however, the employer is responsible for all funding of accounts and bears all investment risk. The employer must make sure that participants' accounts have enough money to pay out total contributions plus specified interest, regardless of the performance of plan investments.

    Keep in mind that regardless of the type of retirement plan a company decides to offer, the federal Employee Retirement Income Security Act (ERISA) stipulates that it must be established and managed in the best interests of its participants. So while it certainly makes sense to determine which option best addresses your company's needs, the final decision must ultimately take into account the long-term needs of your workforce.

    Points to Remember

    1. DB plans are funded, invested, and managed by plan sponsors (i.e., employers), whereas DC plans require individual participants to determine the amount of their contribution as well as their investment and distribution strategies.
    2. DB plans are typically more popular with older, long-standing workers, while DC plans are generally favored by younger, more mobile workers who value the ability to control their own accounts.
    3. Cash balance retirement plans have characteristics of both DB and DC plans. As with DB plans, employers are responsible for guaranteeing benefit payments. But as with DC plans, participants have their own accounts and may transfer assets when changing jobs.
    4. Regardless of your business needs, keep in mind that ERISA mandates that each retirement plan must be established and managed in the best interests of its participants.

    1PLANSPONSOR magazine, November 16, 2010.



    Because of the possibility of human or mechanical error by S&P Capital IQ Financial Communications or its sources, neither S&P Capital IQ Financial Communications nor its sources guarantees the accuracy, adequacy, completeness or availability of any information and is not responsible for any errors or omissions or for the results obtained from the use of such information. In no event shall S&P Capital IQ Financial Communications be liable for any indirect, special or consequential damages in connection with subscriber's or others' use of the content.

    © 2013 S&P Capital IQ Financial Communications. All rights reserved.

  • Changing Jobs or Retiring? Don’t Forget Your Retirement Savings!

    Key Points

    • What Is a Distribution?
    • Some Distribution Options
    • A Look at Some of Your Choices
    • Retirees Should Consider Tax Consequences
    • Withholding on Cash Payments
    • The Potential Cost of a Cash Distribution
    • Points to Remember

    Your retirement savings plan offers you several choices when you decide to change jobs or when you retire. This report explains some of the options you may be able to choose from in deciding how you want the money in your plan treated when one of these events occurs.

    What Is a Distribution?

    A distribution is simply defined as a payout of the amount of money that has accumulated in your retirement savings plan. This may include amounts you have contributed, the "vested" portion of any amounts your employer has contributed, plus any earnings on those contributions.

    You will want to think carefully before making any decisions about the money in your retirement plan, as some choices may mean you have to pay more in income taxes on your distribution. It's also a good idea to talk with a tax advisor before picking a distribution election.

    Some Distribution Options

    Keep Money in Employer's Plan: Allows continued tax-deferral of any growth.

    Make a Direct Rollover: Allows continued contributions and tax-deferral of any growth. Avoids potential taxes and penalty fees.

    Take a Cash Distribution: Satisfies immediate need for cash. Substantial taxes and penalty fees may apply.

    A Look at Some of Your Choices

    You may be able to leave your money in the plan; move it to another retirement savings account, such as an IRA, or another employer's retirement savings plan if you're changing jobs; or take a cash distribution.

    Keep Your Money in the Plan: You can leave your savings in your employer's retirement savings plan if your account balance was more than $5,000 when you left, depending on your plan's rules. Minimum distributions must begin after you reach age 70½, however. You'll continue to enjoy tax-deferred compounding of any investment earnings and receive regular financial account statements and performance reports. Although you will no longer be allowed to contribute to the plan, you will still have control over how your money is invested among the plan's investment options. You also may still be able to obtain information from the professionals who manage and administer your account.

    When retiring, you might choose this option if your spouse is still working or if you have other sources of retirement income (such as taxable investment income). If you're starting your own business when you leave the company, keeping your retirement money in your former company's plan may help protect your retirement assets from creditors, should your new venture run into unforeseen trouble.

    Example: Sue, 58, is retiring from her full-time job. Her husband is retiring and the family receives his pension and Social Security benefits, which will cover most of their current living expenses. Sue plans to work part-time at her church after "retirement" and does not expect to need her retirement savings for several more years. After consulting with a tax advisor, Sue decided that keeping her money in the company's retirement plan at least until she turns age 59½ will provide her with the greatest flexibility in the future.

    Move Your Money to Another Retirement Account:You can move your money into another qualified retirement account, such as an Individual Retirement Account (IRA), or, if you're changing jobs, your new employer's retirement savings plan. With a "direct rollover," the money goes directly from your former employer's retirement plan to the IRA or new plan, and you never touch your money. With this method, you continue to defer taxes on the full amount of your plan savings.

    Example: Bill is taking a new job at a different company. He elects to roll over balances from his existing plan into an IRA rather than transfer his assets into his new employer's 401(k) plan. This provides Bill with a much broader choice of investment options.

    Take a Cash Distribution: You can choose to have your money paid to you in one lump sum, or in installments of a fixed amount or over a set number of years, depending on your plan's provisions. However, you may have to pay taxes on a cash distribution and, if you're under age 55 at the time when you leave your job, you may also have to pay a 10% penalty for early withdrawal.

    Retirees Should Consider Tax Consequences

    If you're retiring, you will want to take into consideration whether favorable tax rules apply to your lump-sum distribution. To qualify as a lump-sum distribution, you must receive all the amounts you have in all your retirement plans with a company (including 401(k), profit-sharing, and stock-purchase plans) within a one-year period.

    Potentially favorable tax rules that may apply to a lump-sum distribution include the minimum distribution allowance and 10-year forward income averaging if you were born before January 2, 1936.

    Ten-year forward income averaging: The taxable part of the distribution is taxed at special rates based on levels for single taxpayers in 1986.

    Example: Ron, born in 1935, is retiring in three months. He met with a financial advisor to determine which distribution method would result in the greatest benefit after taxes. His advisor showed him that, under some assumptions about inflation and future rates of return, his best course would be to take a lump-sum distribution and use 10-year forward income averaging. Under other assumptions, he would benefit from leaving his money in the company plan or rolling it over directly into an IRA. There may be other distribution options available. Contact your plan administrator for information on all options available under your plan.

    Withholding on Cash Payments

    If you choose to physically receive part or all of your money (say, $10,000) when you retire or change jobs, this action is considered a cash distribution from your former employer's retirement account. The cash payment is subject to a mandatory tax withholding of 20%, which the old company must pay to the IRS, and possibly a 10% penalty if you are under age 55 at the time you left the company.1

    You can avoid paying taxes and any penalties on a cash distribution if you redeposit your retirement plan money within 60 days to an IRA or your new employer's qualified plan. However, you'll have to make up the 20% withholding from your own pocket in order to avoid taxes and any penalties on that amount. The 20% withholding will be recognized as taxes paid when you file your regular income tax at year end, and any excess amount will be refunded to you as an IRS refund.

    The Potential Cost of a Cash Distribution

    Distribution -20% Tax Withholding1 = Amount in Your Pocket
    $10,000 distribution -$2,000 Tax Withholding = $8,000 in Your Pocket

     If you are under age 55 when you separate from service with your employer, and choose to take a cash distribution, be aware of how it can immediately whittle away the money you've worked so hard to save. You can take a cash distribution and avoid the 10% penalty so long as you roll over the entire $10,000 within 60 days into an IRA or your new employer's qualified plan, even though you actually received only $8,000 after paying the 20% tax withholding. In that case, $2,000 will have to come out of your pocket.1

    As with all retirement and tax planning matters, be sure to consult a qualified tax and financial planning professional to ensure that your planning decisions coincide with your financial goals.

    Points to Remember

    1. A distribution is a payout of realized savings and earnings from a retirement plan. In general, you must begin taking distributions from your account by April 1 of the year following the year in which you turn 70½, unless you are still working for your employer.
    2. Your distribution options include keeping your money in your plan; enacting a direct rollover; or taking a cash distribution.
    3. If you keep your money in your plan you will no longer be able to make contributions, but you still maintain control over the investments and any growth continues to be tax deferred.
    4. In a direct rollover, you have your money moved directly to a qualified plan or IRA without physically receiving a cent. If you are under age 55 at the time of separation from service, a direct rollover may be a good option, as it avoids the hefty taxes and penalties associated with a cash distribution.
    5. Although a cash distribution is perhaps the most enticing option available, consider that you must pay taxes on the money you receive at then-current rates. And if you are under age 55 when you leave your employer, you may have to pay Uncle Sam 10% of your savings in penalties.

    1Additional taxes may be due, depending upon individual's tax bracket.

    Because of the possibility of human or mechanical error by S&P Capital IQ Financial Communications or its sources, neither S&P Capital IQ Financial Communications nor its sources guarantees the accuracy, adequacy, completeness or availability of any information and is not responsible for any errors or omissions or for the results obtained from the use of such information. In no event shall S&P Capital IQ Financial Communications be liable for any indirect, special or consequential damages in connection with subscriber's or others' use of the content.

    © 2013 S&P Capital IQ Financial Communications. All rights reserved.

  • Use Annuities to Plan for Your Future

    Key Points

    • What Are Annuities?
    • Features of Annuities
    • Deferring Taxes May Help Build Value
    • A Choice of Investment Options
    • Balance Costs and Benefits
    • Points to Remember

     
    Annuities are one of the most popular investment products available today. One reason annuities are attractive is that they can help build more value over time. By providing potential growth that is tax deferred, an annuity's investment earnings can accumulate and compound untouched by federal, state, or local income taxes until you begin making withdrawals, which is usually after retirement. Keep in mind that withdrawals made from an annuity before age 59 ½ are taxed as ordinary income and may be subject to a 10% federal penalty tax. In addition, the issuing insurance company may also have its own set of surrender charges for withdrawals taken during the initial years of the contract.

    In addition to tax advantages, annuities also offer a choice of investment options. These may include fixed accounts, which may help protect principal from market risk, and variable investment accounts in stock and bond portfolios, which offer the potential for higher returns.

    Together, these features make annuities attractive to those who seek investments that can help supplement future retirement benefits, and to retirees who want greater control over their income and the flexibility to continue deferring taxes on investment earnings.

    What Are Annuities?

    Annuities are essentially contracts between the purchaser and the issuing insurance company. Until the 1970s, most annuities were sold through insurance companies and offered only a fixed amount to be paid out. Annuities today are sold through banks and insurance companies and are much more flexible. They may include both fixed accounts and potentially higher-returning variable investment options.

    Money is accumulated in an annuity through contributions and investment earnings.

    Features of Annuities*

    • You can make a single contribution or a series of payments over time.
    • You can contribute any amount, regardless of your income level or sources of income.
    • When you begin making withdrawals, you can choose from different payout methods, including a fixed amount for life for you and/or your spouse, or payments to your beneficiaries or heirs.
    • Payout methods include insurance features, which guarantee payment to your designated beneficiaries if you die before withdrawals begin. In most cases this payment does not have to pass through probate.
    *You should fully investigate the insurance company's stability and financial strength through an independent agency, such as Moody's, Standard & Poor's, or A.M. Best Company, before committing to a contract.

     

    Deferring Taxes May Help Build Value

    The power of tax-deferred growth can be substantial compared with a comparable taxable investment. Compared with other tax-deferred accounts, such as IRAs or 401(k)s, you have much greater control over the income generated from your annuity. The same 10% tax penalty that applies to early withdrawals from retirement accounts also applies to annuity withdrawals made before age 59½. In some instances you may be able to defer making withdrawals until several years past retirement. (Check your annuity contract for details.)

    Another important advantage of annuities is that they generally allow unlimited after-tax contributions, whether you have earned income or not, and your contributions can continue even after retirement. At withdrawal, only the investment earnings on your annuity contributions are taxable.

    Here are six ways to help maximize the value of an annuity:

    1. Take advantage of low fees. Fees charged for annuities are similar to those on other investments, but with additional expenses of insuring the total value of premiums paid. In choosing an annuity, you may want to compare both annual expenses and insurance charges as well as sales charges. Many annuities collect a surrender charge if the contract is canceled prematurely. But if you plan to use your annuity as a long-term investment, you'll likely be more concerned with front-end sales loads and annual contract charges than surrender fees.
    2. Choose an annuity that offers a variety of investment options. Many experts suggest that individuals in their 30s or 40s concentrate their long-term investments in stocks, which provide the greatest potential for long-term capital appreciation over time. Of course, these investments also carry higher risk. You might also want to diversify your investments to help reduce investment risk.1 As your lifestyle changes or your financial needs change, you will want the flexibility to rearrange your investments to keep in step. Look for annuities with no-fee exchanges and a variety of investment options.
    3. Dollar cost averaging could potentially boost long-term returns. By investing the same amount at regular intervals, you essentially buy more when prices are low and less when prices are high. This may help smooth out some of the normal fluctuations of the stock markets over the years. Using this strategy, however, does not assure an investment profit or protect against loss in declining markets. Before you consider dollar cost averaging, be sure to review your financial ability to invest during periods of declining prices.
    4. Increase the potential return on aggressive investments. Even though the maximum federal capital gains tax rate is well below the top income tax rates, you may still benefit by deferring taxes on your long-term capital gains until you make withdrawals. Annuities can make your aggressive investments even more rewarding as taxes on both long- and short-term capital gains are deferred.
    5. Enjoy the benefits of diversification.Spreading your money among different types of investments has been shown to lower your investment risk. Annuities offer opportunities to diversify among fixed account and variable investments, thereby reducing your risk while still allowing you to potentially benefit from higher returns.1
    6. Use annuities to pass money along to heirs quickly. Annuities can offer a number of advantages in estate planning. For example, if you designate family members as beneficiaries to the annuity, your loved ones will (in most cases) receive the insurance benefit directly, without having to wait for your estate to be settled. If your spouse is named beneficiary, he or she may even be able to keep the annuity in place and continue tax deferral on any investment earnings.

    A Choice of Investment Options

    With little risk to principal, fixed annuities offer a stated rate of return for a specified period of time. Variable annuities include a variety of investments that may offer higher potential for return but may also fluctuate with market conditions. Variable investment choices can include:
    • Equity portfolio: common stocks
    • Fixed-income portfolio: bonds, preferred stocks
    • Balanced portfolio: stocks and bonds
    • Money market portfolio: bonds and notes
    • Fixed-rate portfolio: no risk to principal; bonds and notes

     

    Balance Costs and Benefits

    An annuity can be an excellent retirement investment vehicle if you are able to forgo use of the money for several years. Annuities also offer unlimited contributions, protection of principal on fixed accounts, and the potential to earn higher rates of return on your investments in variable accounts. Annuities may also entail higher fees and expenses than some other investment vehicles, in part due to the insurance feature annuities provide.

    Although annuities today are flexible investment vehicles that can be used to meet a variety of financial needs, most people don't appreciate their usefulness. If you have been investing in mutual funds, a variable annuity might be the next logical step for a portion of your retirement investment plan.

    Points to Remember

    1. Annuities are available in fixed accounts and variable investment accounts.
    2. An annuity offers a choice of investment options.
    3. Money is accumulated in an annuity through contributions and investment earnings.
    4. An annuity's earnings are tax deferred.
    5. Annuities allow unlimited after-tax contributions.
    6. Your contributions to annuities can continue even after retirement.
    7. Annuities allow you to diversify, thereby reducing your risk, while still allowing you to potentially benefit from higher returns.

    1Diversification does not ensure against loss.

    Because of the possibility of human or mechanical error by S&P Capital IQ Financial Communications or its sources, neither S&P Capital IQ Financial Communications nor its sources guarantees the accuracy, adequacy, completeness or availability of any information and is not responsible for any errors or omissions or for the results obtained from the use of such information. In no event shall S&P Capital IQ Financial Communications be liable for any indirect, special or consequential damages in connection with subscriber's or others' use of the content.

    © 2013 S&P Capital IQ Financial Communications. All rights reserved.

  • Focus on Time in the Market, Not Market Timing

    Key Points

    • What Is Market Timing?
    • Market Timing Has Its Risks
    • The Risk of Missing Out
    • Use Time to Your Advantage
    • Total Annual Return of the S&P 500
    • Regular Evaluations Are Necessary
    • Time Is Your Ally
    • Points to Remember


    Sports commentators often predict the big winners at the start of a season, only to see their forecasts fade away as their chosen teams lose. Similarly, market timers often try to predict big wins in the investment markets, only to be disappointed by the reality of unexpected turns in performance. It's true that market timing sometimes can be beneficial for seasoned investing experts (or for those with a lucky rabbit's foot); however, for those who do not wish to subject their money to such a potentially risky strategy, time -- not timing -- could be the best alternative.

    What Is Market Timing?

    Market timing is an investing strategy in which the investor tries to identify the best times to be in the market and when to get out. Relying heavily on forecasts and market analysis, market timing is often utilized by brokers, financial analysts, and mutual fund portfolio managers to attempt to reap the greatest rewards for their clients.

    Proponents of market timing say that successfully forecasting the ebbs and flows of the market can result in higher returns than other strategies. Their specific tactics for pursuing success can range from what some have termed "pure timers" to "dynamic asset allocators."

    Pure timing requires the investor to determine when to move 100% in or 100% out of one of the three asset classes -- stocks, bonds, and money markets. Investment in a money market fund is neither insured nor guaranteed by the U.S. government, and there can be no guarantee that the fund will maintain a stable $1 share price. The fund's yield will vary. Perhaps the riskiest of market timing strategies, pure timing also calls for nearly 100% accurate forecasting, something nobody can claim.

    On the other hand, dynamic asset allocators shift their portfolio's weights (or redistribute their assets among the various classes) based on expected market movements and the probability of return vs. risk on each asset class. Professional mutual fund managers who manage asset allocation funds often use this strategy in attempting to meet their funds' objectives.

    Market Timing Has Its Risks

    Although professionals may be able to use market timing to reap rewards, one of the biggest risks of this strategy is potentially missing the market's best-performing cycles. This means that an investor, believing the market would go down, removes his investment dollars and places them in more conservative investments. While the money is out of stocks, the market instead enjoys its best-performing month(s). The investor has, therefore, incorrectly timed the market and missed those top months. Perhaps the best move for most individual investors -- especially those striving toward long-term goals -- might be to purchase shares and hold on to them throughout market cycles. This is commonly known as a "buy and hold" investment strategy.

    As seen in the accompanying table, purchasing investments and then withstanding the market's ups and downs can work to your advantage. Though past performance cannot guarantee future results, missing the top 20 months in the 30-year period ended December 31, 2012, would have cost you $13,549 in potential earnings on a $1,000 investment in Standard & Poor's Composite Index of 500 Stocks (S&P 500). Similarly, a $1,000 investment made at the beginning of 1993 and left untouched through 2012 would have grown to $4,852; missing only the top 20 months in that span would have cut your accumulated wealth to $1,064.1

    Though many debate the success of market timing vs. a buy-and-hold strategy, forecasting the market undoubtedly requires the kind of expertise that portfolio managers use on a daily basis. Individual investors might best leave market timing to the experts -- and focus instead on their personal financial goals.

    The Risk of Missing Out

    1983-2012 1993-2012 2003-2012
    [1] Untouched $21,727 $4,852 $1,985
    [2] Miss 10 Top-Performing Months 8,178 2,072 926
    [3] Miss 20 Top-Performing Months 3,810 1,064 577
    Perhaps the most significant risk of market timing is missing out on the market's best-performing cycles. The three columns represent the growth of a $1,000 investment beginning in 1983, 1993, and 2003, and ending December 31, 2012.

    Row 1 shows the investment if left untouched for the entire period shown above; Row 2 shows the investment if it was pulled out during the 10 top-performing months; and Row 3 shows the investment if it was pulled out during the 20 top-performing months.

    Use Time to Your Advantage

    If you're not a professional money manager, your best bet is probably to buy and hold. Through a buy-and-hold strategy, you take advantage of the power of compounding, or the ability of your invested money to make money. Compounding can also help lower risk over time: As your investment grows, the chance of losing the original principal declines.

    Annual Return of the S&P 500

    Source: Standard & Poor's. Based on the total calendar-year returns of the S&P 500 index. (CS000141)

    Regular Evaluations Are Necessary

    Buy and hold, however, doesn't mean ignoring your investments. Remember to give your portfolio regular checkups, as your investment needs will change over time. Most experts say annual reviews are enough to ensure that the investments you select will keep you on track to meeting your goals.

    Normally a young investor will probably begin investing for longer-term goals such as marriage, buying a house, and even retirement. The majority of his portfolio will likely be in stocks and stock funds, as history shows they have offered the best potential for growth over time, even though they have also experienced the widest short-term fluctuations. As the investor ages and gets closer to each goal, he or she will want to rebalance portfolio assets as financial needs warrant.

    This hypothetical investor knows that how much time is available plays an important role when determining asset choice. Most experts agree that a portfolio made up primarily of the "riskier" stock funds (e.g., growth, small-cap) may be best for those saving for goals more than five years away; growth and income funds and bond funds might be the main focus for investors nearing retirement or saving for shorter-term goals; and investors who see a possible need for cash in the near future might consider a portfolio weighted toward money market instruments.2 Remember, though, that even those enjoying retirement should consider the historical inflation-beating benefits of stocks and stock mutual funds, as people often live 20 years or more beyond their last official paycheck.

    Time Is Your Ally

    Clearly, time can be a better ally than timing. The best approach to your portfolio is to arm yourself with all the necessary information, and then take your questions to a financial advisor to help with the final decision making. Above all, remember that both your long- and short-term investment decisions should be based on your financial needs and your ability to accept the risks that go along with each investment. Your financial advisor can help you determine which investments are right for you.

    Points to Remember

    1. Historically, a buy-and-hold strategy has resulted in significantly higher gains over the long run, although past performance is not indicative of future results.
    2. A big risk of market timing is missing out on the best-performing market cycles.
    3. Missing even a few months can substantially affect portfolio earnings.
    4. Market timing strategies -- which range from putting 100% of your assets in or out of one asset class to allocation among a variety of assets -- are based on market performance expectations.
    5. Market timing is best left to professional money managers.
    6. Though buy-and-hold is a smart strategy, regular portfolio checkups are necessary.
    7. Time horizon is particularly important when determining asset choices.
    8. Riskier investments are more appropriate for longer-term goals, and as goals get closer, portfolios should be rebalanced.
    9. Even in retirement, portfolios should contain investments for earnings to keep pace with inflation.
    10. You should consult your financial advisor when making asset allocation decisions.

    1Source: Standard & Poor's. Stocks are represented by Standard & Poor's Composite Index of 500 Stocks, an unmanaged index generally considered representative of the U.S. stock market. Individuals cannot invest in indexes. Past performance is not a guarantee of future results.

    2An investment in a money market fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Although most funds seek to preserve the value of your investment at $1.00 per share, it is possible to lose money by investing in the fund.

    Because of the possibility of human or mechanical error by S&P Capital IQ Financial Communications or its sources, neither S&P Capital IQ Financial Communications nor its sources guarantees the accuracy, adequacy, completeness or availability of any information and is not responsible for any errors or omissions or for the results obtained from the use of such information. In no event shall S&P Capital IQ Financial Communications be liable for any indirect, special or consequential damages in connection with subscriber's or others' use of the content.

    © 2013 S&P Capital IQ Financial Communications. All rights reserved.

  • Fiduciary Responsibility and Market Volatility

    Key Points

    • ERISA: The Letters of the Law
    • Getting the Word Out
    • Points to Remember


    Market volatility is a reality all investors must face at one point or another. However, when market swings are pronounced and occur with greater frequency, plan sponsors may find themselves subject to increasing claims of fiduciary liability. But that doesn't necessarily mean sponsors need to go back to square one and completely reinvent their plans in order to avoid such a scenario.

    Instead, diligent and ongoing adherence to a multifaceted risk-management strategy can help sponsors accomplish two important priorities simultaneously: improving participants' ability to pursue their financial goals for retirement and reducing sponsors' potential exposure to claims of fiduciary malfeasance. To ensure success, however, sponsors must first understand their broad range of fiduciary responsibilities as defined by the Employee Retirement Income Security Act (ERISA), and then systematically review their tactics for achieving compliance.

    ERISA: The Letters of the Law

    ERISA mandates that a plan fiduciary must fulfill four primary responsibilities:

    • To act solely in the interests of plan participants and beneficiaries
    • To do so with the care, skill, and diligence characteristic of a "prudent" person familiar with such matters
    • To diversify plan investments, with exceptions for investments in company stock
    • To comply with the written plan document

    While it's true that participants may feel inspired to action in the event that market volatility significantly reduces the value of plan assets, they must generally demonstrate that the sponsor has breached at least one of those responsibilities in order to prove claims of fiduciary irresponsibility.

    For example, liability concerns could arise if private company information regarding the value of employer stock differs significantly from the assessments of public securities analysts, as was alleged in past high-profile lawsuits filed against plan sponsors such as WorldCom and Enron.

    Implicit in the ERISA guidelines is the need for sponsors to monitor all investment options, not just company stock. But ERISA does not specifically define what type of monitoring practices should be employed.

    However, according to the Foundation for Fiduciary Studies, the current ERISA case law standard suggests that plan fiduciaries should review each investment option at least once per quarter to make sure that it remains a potentially appropriate option for participant contributions. Details of such monitoring procedures should be spelled out in a plan's investment policy documents, but such a review should typically resemble the process employed for investment selection and take into account the following considerations:

    • A comparison of recent and rolling performance data, relative to an appropriate peer group and industry index
    • An assessment of risk-adjusted performance relative to a relevant peer group
    • The significance of changes to a portfolio management team
    • The significance of changes to investment strategy (e.g., has style drift occurred?)
    • Whether investment options offered by the plan complement the plan's stated investment strategy
    • Whether there has been a significant increase or decrease in the plan's fees and/or assets under management

    Of course, these initiatives may prove relatively useless in court if they remain undocumented. For that reason, the individuals or committees responsible for such tasks should make every effort to keep detailed minutes of their discussions and decisions.

    Getting the Word Out

    In addition to "back office" oversight, plan sponsors are also advised to communicate clearly, honestly, and frequently with plan participants. Under normal circumstances, those communications might address a wide array of topics, such as how the plan works, how to calculate a savings goal, and how to arrive at realistic investment expectations, as well as basic educational themes, such as the importance of asset allocation, diversification, and investment risk.

    But when volatility negatively influences the value of specific investment options -- particularly employer stock -- it may be appropriate to issue a message from company management explaining the current situation and reinforcing the need to maintain a long-term, diversified investment strategy.

    Keep in mind, however, that companies cannot give participants more information about a specific security than they would be allowed to give to other shareholders. Also, make sure that participant communications do not contain any information that could be perceived as erroneous, inconsistent, or promissory in nature. If a plan restricts participants' ability to sell company stock, then eliminating or easing such restrictions may be an effective way of encouraging participants to reduce their overall risk profile.

    Finally, it's worth noting that plan sponsors have tried to eliminate some fiduciary responsibility by offering participants direct access to brokerage windows, which are exempt from Department of Labor monitoring requirements. But that strategy is not without its drawbacks: Many participants simply lack the sophistication and resources necessary for self-directed success.

    Points to Remember

    1. In order to minimize their exposure to participant lawsuits and claims of fiduciary irresponsibility, plan sponsors are advised to carefully review their plan's compliance and communications initiatives.
    2. In order to prevail in court, participants typically need to claim that a plan sponsor failed to act in the best interest of participants, failed to provide diversified investment options, or failed to comply with formalized plan procedures and policies.
    3. If possible, sponsors should conduct a comprehensive review of a plan's investment lineup at least once per quarter and document those initiatives.
    4. If a plan offers employer stock as an investment option, the company cannot provide participants with more information about the security than they would offer to other investors. Also, removing or easing restrictions about selling employer-issued stock might help to reduce fiduciary liability.
    Because of the possibility of human or mechanical error by S&P Capital IQ Financial Communications or its sources, neither S&P Capital IQ Financial Communications nor its sources guarantees the accuracy, adequacy, completeness or availability of any information and is not responsible for any errors or omissions or for the results obtained from the use of such information. In no event shall S&P Capital IQ Financial Communications be liable for any indirect, special or consequential damages in connection with subscriber's or others' use of the content.

    © 2013 S&P Capital IQ Financial Communications. All rights reserved.

  • How Many Funds Do You Need?

    Key Points

    • The Purpose of Mutual Funds
    • Why Hold More Than One Fund?
    • Fund Investment Categories
    • How Many Funds Are Right for You?
    • How Many is Too Many?
    • Time to Reevaluate
    • Points to Remember


    When you sit down to evaluate your portfolio, do you have trouble remembering exactly why you bought certain funds in the first place? Do you buy funds randomly, based on recent magazine or newspaper articles? If you answered yes to either of these questions, you may be guilty of fund collecting.

    The Purpose of Mutual Funds

    Mutual funds are pools of securities, which typically offer diversification within one or more asset classes. In general, people invest in mutual funds in order to achieve diversification in their portfolio without the trouble of managing a large number of stocks and bonds. With thousands of mutual funds available today, however, some people have started collecting mutual funds as if they were art. The downside of holding too many similar funds is potentially lower returns on your portfolio.

    Why Hold More Than One Fund?

    The number that is right for you depends on your investment goals, risk tolerance, and the amount of your investment capital. If you have both short- and long-term goals, you will likely want different types of mutual funds for each time frame. The more capital you have to invest, the greater your ability to afford diversification among different asset classes and investment styles.

    Asset allocation is the way you weight investments in your portfolio. There are three main asset classes: stocks, bonds, and money market securities. Each has its own characteristics in terms of value fluctuation, level of market risk, and ability to outpace inflation. Which asset classes you decide to invest in depends on how your investment time frame and goals match up with the risks and return potential of the various asset classes.

    The concept of diversification -- the process of investing in different types of funds or securities in order to reduce risk -- is an important part of asset allocation. Diversifying among different asset classes increases the chance that as one investment is falling in value, another may be rising. A mix of assets will help position your portfolio to benefit during market upswings, while suffering less during downturns. Keep in mind that there is no guarantee that a diversified portfolio will enhance overall returns or outperform a nondiversified portfolio. Diversification does not ensure against market risk.

    If you have sufficient capital, you can also diversify among investment styles to help reduce risk. Active and passive investing are the two most basic investment styles. While active investors believe that managed funds have the ability to outperform the market, passive investors have faith in the long-term success of the market index. Active investors are further divided into the two categories of growth and value. Growth funds typically invest in well-established companies with strong earnings potential. Value funds, on the other hand, invest in companies that have recently fallen out of favor but are expected to bounce back. Many investors prefer to combine investment styles to potentially gain through different market cycles that favor different approaches.

    Fund Investment Categories

    Balanced
    These funds use a mix of stocks, bonds, and money market securities to try to generate moderate growth and income while carrying moderate risk.

    Bond
    Invests in government, Treasury, and municipal bonds to provide revenue and reduce market risk.

    Global
    Invests in foreign securities seeking to balance out single market performance risk. May include a percentage of domestic holdings.

    Growth
    Actively buys and sells stocks in an attempt to generate high returns. May use high-yield bonds or mortgage derivatives. Carries higher market risk than other fund types.

    Index
    Strives to post returns comparable to benchmark index for investment category. Risk varies with asset class.

    Money market1
    Invests in high-quality bonds, commercial paper, and bank notes. Seeks to maintain a stable share price and generate income. Carries a low market risk but lower returns are highly susceptible to inflation risk.

    Small-cap
    Buys and sells stocks of smaller companies in search of high returns. Many of these funds are aggressive growth funds and carry higher risk.

    Large-cap
    These growth funds buy and sell stocks of larger, well-established companies in search of high returns and a lower degree of volatility.

    Value
    Seeks to maintain principal and generate modest income by investing in out-of-favor or undervalued securities. Low annual returns may not outpace inflation.

    1An investment in a money market fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Although the fund seeks to preserve the value of your investment at $1.00 per share, it is possible to lose money by investing in the fund.

    How Many Funds Are Right for You?

    Consider investing in a minimum of three mutual funds. These first funds would likely include a stock fund, a bond fund, and a money market fund. How much you invest in each fund will depend on your investment goals, risk tolerance, and time horizon.

    You might want to consider adding a mix of different types of stock and bond funds to further diversify your portfolio. A long-term investor seeking growth who already holds a domestic large-cap stock fund, for example, could add a small-cap stock fund and an international stock fund without duplicating holdings.

    How Many Is Too Many?

    With so many funds in the market, it is inevitable that there are several funds with similar strategies and performance. These funds invest in the same stocks and follow identical investment styles. If you hold several funds that all use similar investment strategies in your portfolio, you essentially hold the market. You could achieve the same result much more cost-effectively by simply buying an index fund.

    Time to Reevaluate

    Each fund that you invest in should play a specific, defined role in your portfolio. An investment advisor can help you evaluate each fund and its role in your portfolio. If you find yourself surrounded by a sea of similar funds, or can't remember why you bought a fund in the first place, it could be time to pare down your portfolio.

    Points to Remember

    1. People invest in mutual funds in order to achieve diversification without the time and cost of tracking hundreds of individual securities.
    2. There is no ideal number of mutual funds to own.
    3. Before picking a mutual fund, consider your investment goals, time frame, and amount of investment capital.
    4. Diversify among different asset classes to help reduce risk and potentially increase the rate of return of your portfolio.
    5. Owning too many funds means you may be paying for active management when you really hold the market.
    6. Your investment advisor can help you evaluate each fund to determine its role in your portfolio.

    Because of the possibility of human or mechanical error by S&P Capital IQ Financial Communications or its sources, neither S&P Capital IQ Financial Communications nor its sources guarantees the accuracy, adequacy, completeness or availability of any information and is not responsible for any errors or omissions or for the results obtained from the use of such information. In no event shall S&P Capital IQ Financial Communications be liable for any indirect, special or consequential damages in connection with subscriber's or others' use of the content.

    © 2013 S&P Capital IQ Financial Communications. All rights reserved.

  • Quantifying Investment Risk: The Sharpe Ratio

    Key Points

    • Calculating Sharpe Ratios
    • Putting Sharpe Ratios to Work
    • Other Considerations
    • Points to Remember


    Much as coaches use statistics to help them evaluate the performance of their sports team and individual players, plan sponsors can turn to quantitative tools to aid them in selecting investment options and monitoring their performance. One of the most valuable is the Sharpe ratio, a frequently used formula for comparing investments to determine which offer the most return for a given amount of risk. Simply put, the ratio measures risk-adjusted returns.

    The Sharpe ratio is essential for making a fully informed decision -- not just one based on past returns. Risk-adjusted return is a key consideration for fiduciaries in carrying out their responsibility to offer an investment menu that enables participants to assemble portfolios with a wide variety of risk and reward combinations.

    Specifically, the Sharpe ratio measures the amount of return earned per unit of risk. It was devised in the 1960s by William F. Sharpe, a pioneering portfolio theorist, former finance professor at Stanford University and a Nobel Laureate in economics. The ratio -- which can be applied to individual securities, pooled funds such as mutual funds, and portfolios -- is commonly used to rank mutual funds with similar objectives over a given period of time. More versatile than some other risk measurement tools, it can be employed to compare investments from different asset classes.

    Calculating Sharpe Ratios

    Calculating the ratio is straightforward. The formula is:

    Sharpe ratio = (investment's return % - risk-free return %) ÷ investment's standard deviation

    In this formula, risk-free return is usually represented by the yield on a 90-day Treasury bill. Standard deviation, a common measure of volatility, measures the degree to which an investment's returns over a given period -- three years for example -- varied from the investment's average return over that period. The higher the standard deviation, the greater the variation.

    A hypothetical example shows how the Sharpe ratio is determined. If a fund produced an average annual return of 12% over the most recent three years, with a standard deviation of 10, and the T-bill rate averaged 4%, the fund's Sharpe ratio would be .80 (12% - 4% ÷ 10 = .80).

    Putting Sharpe Ratios to Work

    In practice, it's often sufficient to remember this rule of thumb: the higher the Sharpe ratio, the better an investment's returns have been relative to the amount of investment risk the investor has taken. Sharpe ratios can be obtained from fund companies and also from mutual fund rating and ranking services, such as Morningstar, Standard & Poor's, and Lipper.

    The Sharpe ratio has pros and cons. On the plus side, it avoids a drawback of alpha and beta, two related measures of volatility frequently used in fund analysis. Unlike the Sharpe ratio, they measure volatility against an index benchmark, which in practice may not be closely correlated to the fund. The Sharpe ratio uses only the volatility of the investment itself, based on standard deviation of its returns. As a result, it can be used to directly compare equity and fixed-income funds.

    The Sharpe ratio's main disadvantage is that it's just a raw number. As such, it's not meaningful except in comparison with ratios for other investments over the same time period (and, normally, with similar objectives). Another shortcoming: The ratio doesn't take into account non-quantifiable factors that can affect performance, such as prevailing economic and market conditions or a change in fund managers.

    In addition, when comparing investments with negative returns, the calculation can produce a ratio that is counterintuitive -- that is, a fund with a higher standard deviation may have a higher Sharpe ratio than another fund with a lower standard deviation. In such cases, other risk assessments need to be considered.

    Risk Measures at a Glance

    In addition to the Sharpe ratio, here are four measures of risk often used in investment analysis:
    Beta compares an investment's volatility against a benchmark such as the S&P 500. It shows how an investment's historical returns have fluctuated in relation to the broader market represented by the benchmark. For example, a beta of 1.20 would indicate that a fund had fluctuated 20% more than the benchmark, which has a beta of 1.
    Alpha shows the relationship between an investment's historical beta and its current performance. An alpha of 0 indicates the investment performed as expected. A positive alpha means the investment returned more than its beta indicated; a negative alpha signifies that it returned less.
    R-squared(R2) quantifies how much of a fund's performance can be attributed to the performance of a benchmark index. The value of R2 ranges between 0 and 1 and measures the proportion of a fund's variation that is due to variation in the benchmark. For example, for a fund with an R2 of 0.70, 70% of the fund's variation can be attributed to variation in the benchmark.
    Standard deviation reveals the volatility of an investment's returns over time, with a high standard deviation indicating greater historical volatility. Standard deviation can be used to compare any type of security with any other.

    Other Considerations

    In addition, relying on Sharpe ratios based on readily available fund data may not give a sufficiently long-term view of a fund's risk-adjusted performance. In cases where standard deviation is provided only for a fund's most recent three-year period, additional research is required in order to calculate the ratio for longer periods.

    Like other risk assessment tools, the Sharpe ratio is also open to the broad criticism that it can only show how investments have behaved in the past, which, of course, may not be a reliable predictor of future performance.

    While the Sharpe ratio has limitations, it is regarded as a valid statistic for comparing funds and other investment assets. Used as a screening tool, it provides an objective measure of an investment's risk-adjusted past performance. Used in conjunction with well-defined selection criteria and monitoring policies, it can help plan sponsors create and maintain a suitable array of investment choices for the benefit of plan participants.

    Points to Remember

    1. The Sharpe ratio is a statistical tool for comparing the risk-adjusted performance of investments over a given time period.
    2. The ratio is frequently used to rank mutual funds and other pooled funds. It can also be used to compare individual securities and investment portfolios.
    3. The ratio measures how much an investment returned in excess of a risk-free investment per unit of risk taken. The three-month Treasury bill rate is often used to represent the risk-free return, while standard deviation of returns represents risk in the formula for calculating the ratio.
    4. Like other risk measures, the Sharpe ratio has limitations. It cannot predict an investment's future risk-adjusted performance, nor does it shed light on qualitative and external factors, such as a change in fund management, that may affect performance.

    Because of the possibility of human or mechanical error by S&P Capital IQ Financial Communications or its sources, neither S&P Capital IQ Financial Communications nor its sources guarantees the accuracy, adequacy, completeness or availability of any information and is not responsible for any errors or omissions or for the results obtained from the use of such information. In no event shall S&P Capital IQ Financial Communications be liable for any indirect, special or consequential damages in connection with subscriber's or others' use of the content.

    © 2013 S&P Capital IQ Financial Communications. All rights reserved.

  • Now That You're Retired, Maximize Your Retirement Income

    Key Points

    • Factor In the Variables
    • Keep Stocks Working for You
    • A Focus on Yield
    • Now That You're Retired, Maximize Your Retirement Income
    • Your Retirement Distribution
    • Components of Total Return
    • Donate Appreciated Assets to Generate Income
    • Develop a Strategy for Income and Growth
    • Points to Remember


    Those long-awaited Golden Years have arrived and you're enjoying a well-deserved retirement. You've saved and invested wisely to provide a financial cushion, but making the most of your assets now -- maximizing your retirement income -- may require a brand new strategy. Where do you go from here?

    Factor In the Variables

    Investing during retirement can be uncharted terrain for many people. An appointment with your investment professional to reassess your portfolio can be crucial in helping you meet your changing needs. With uncertain variables such as longer life expectancies, the changing rate of inflation, and the possibility that you could outlive your retirement funds, you'll want to be sure your investments will keep up with you and outpace the cost of living.

    Neglecting your investment strategy now could be costly. Inflation is one reason; even at a moderate 3% rate, inflation can substantially cut the purchasing power of your savings over 20 years. Another is that you may find your hard-earned cash dwindling too fast. A balanced portfolio of investments to maximize security while building needed profitability may be crucial to your financial security.

    Keep Stocks Working for You

    Many people believe that retirement means investing everything in low-returning money market accounts1 or certificates of deposit (CDs). While these investments do offer little risk to principal, you should also consider the risks that (1) your assets will not keep pace with inflation and that (2) you may outlive your assets. Although past performance is no guarantee of future results, stocks have historically outpaced inflation by the widest margin and have provided the strongest returns over the long term. So you should consider keeping a portion of your portfolio invested in stocks and stock mutual funds throughout your retirement.2

    A Focus on Yield

    Along with some stock investments, a significant portion of your principal will likely be invested in fixed-income investments to provide a consistent stream of income. Depending on your needs, such investments may include high-quality corporate and government bonds, tax-exempt bonds, and high-yield "junk" bonds.3How much risk (maturity and credit risk) you need to take in these investments depends in part on how much income you need. For example, if you can get by with a 5% annual return, you might be comfortable with high-quality, medium-term, fixed-income investments. But if you need to generate 8% or more on your money, you'll need a longer-term strategy and will likely have to take on more risk.

    You can buy individual government bonds of varying maturities and coupon rates to match your projected cash flow needs. In fact, this is how many insurance companies and banks manage cash flows to minimize interest rate risk. They first estimate a schedule of cash outflows, and then buy securities "maturing" along the same schedule. You can use a similar strategy by buying bonds maturing (principal repaid) in one, two, and three years based on your expected cash needs in those years. You'll earn the stated rate of interest and likely have little risk of loss of principal, since you shouldn't need to sell the bonds before the scheduled due date. The rest of your bond portfolio may be invested in higher-yielding, longer-term investments.

    Now That You're Retired, Maximize Your Retirement Income

    Security Risk Income Growth Potential
    3-Month T-Bill Low Low Lowest
    Commercial Paper Low Low Low
    Dividend-Paying Stock Medium Low Medium
    Intermediate Bond Medium Medium Low
    Corporate Bond Medium Medium Low
    Convertible Stock Medium Medium Low
    High-Yield Bond High High Medium
    Growth Stock High Low High
    International Stock High Low High

    Your Retirement Distribution

    For many people, retirement is also a time to elect a distribution from their company pension and retirement savings plans. Many people may also begin taking distributions from an IRA or annuity at this time.

    Because these distributions often involve complex analysis of income and tax scenarios to determine the best choice for your unique circumstances, it's wise to consult your financial advisor.

    If you have substantial assets that generate more income each year than you spend, consider putting some of your investments in a variable annuity. Your investment earnings will grow and compound tax deferred until withdrawal. However, when you withdraw earnings they are taxed as ordinary income regardless of how long they have accrued in your account. Because these tax rates may be higher than capital gains tax rates, you may want to use variable annuities for your fixed-income investments and your most aggressive stock investments -- those that typically experience high turnover and therefore generate substantial short-term income distributions (which are taxed as ordinary income rather than as long-term capital gains).

    Annuities also allow you to continue making contributions after retirement and to defer withdrawals, often until age 80 or later. Withdrawals from traditional, non-Roth IRAs, however, must begin no later than April 1 following the year you turn 70½. After that, you must make your second withdrawal by December 31 of that year and withdrawals by each of the subsequent December 31 dates.

    Components of Total Return

    Components of Total Return

    While stocks have historically provided income and capital appreciation, the total return of bonds has been composed primarily of interest income. Past performance is not indicative of future results.

    Sources: Standard & Poor's, Barclays Capital, 1983-2012. Stocks are represented by Standard & Poor's Composite Index of 500 Stocks, an unmanaged index of common stocks considered representative of the stock market. Bonds are represented by the Barclays U.S. Aggregate Bond index. Investors cannot invest directly in any index. The performance shown is for illustrative purposes only and is not indicative of the performance of any specific investment. (CS000037)

    Donate Appreciated Assets to Generate Income

    You can donate highly appreciated assets to charity and generate current income along with a tax deduction, using a charitable remainder trust. With the top capital gains tax rate at 15% for most investors, the value of the tax deduction may be less than in previous years but could still provide an advantage to wealthy individuals.

    A charitable remainder trust requires that you donate the asset to a qualified charity or foundation, which will establish a trust. The trustee sells the asset at market value, and then invests the proceeds and pays you annual investment income. You receive a current tax deduction based on the expected remainder value of the asset and your life expectancy. At your death, the trust is paid to the designated charity.

    Develop a Strategy for Income and Growth

    An investment portfolio can work hand-in-hand with retirement accounts, annuities, and trusts to meet your income and growth needs. To help determine what kind of investment vehicles may be appropriate for your particular circumstances (as well as how much of your portfolio should be allocated to each asset class), consider your risk tolerance and your needs for income vs. growth. You also want to consider tax consequences of each option. Your financial advisor can help you find a balance that is appropriate for you. Once you've established a suitable portfolio, you might consider using your fixed-income and money market investments1 -- and any retirement plan and trust distributions -- for your annual expense money. Of course, continuous attention to detail can help keep you ahead of the game -- and well cushioned against the rising cost of living.

    Points to Remember

    1. Inflation continues to eat away at the value of your savings. Stocks offer the best potential for fighting inflation over the long term.
    2. Only a portion of your money is invested for the short term. Today's longer life expectancies mean a component of your portfolio may be invested for 20 or more years.
    3. Income investments include bonds and dividend-paying stocks.
    4. You may have to elect payment options for your company pension and retirement plans. You may also elect to begin withdrawals from your IRAs. Consult your financial advisor.
    5. An annuity can help you shield investment earnings from taxes.
    6. Charitable remainder trusts are vehicles for converting appreciated assets into income.

    1An investment in a money market fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Although most funds seek to preserve the value of your investment at $1.00 per share, it is possible to lose money by investing in a money market fund.

    2Share prices may fall in value as well as increase, and there is no assurance that the full value of an investment in stocks can ever be recovered.

    3Bond values are not guaranteed. A bond's market price may vary significantly from face value. Investors may receive the face value or redemption value of a bond only if it is held to maturity or call date. High-yield bonds present greater risk of default.

    Because of the possibility of human or mechanical error by S&P Capital IQ Financial Communications or its sources, neither S&P Capital IQ Financial Communications nor its sources guarantees the accuracy, adequacy, completeness or availability of any information and is not responsible for any errors or omissions or for the results obtained from the use of such information. In no event shall S&P Capital IQ Financial Communications be liable for any indirect, special or consequential damages in connection with subscriber's or others' use of the content.

    © 2013 S&P Capital IQ Financial Communications. All rights reserved.

  • Make the Most of Your 401(k)

    Key Points

    • What Is a 401(k)?
    • Tax Treatment of 401(k) Plans
    • Matching Contributions
    • Consider the Advantage of Tax Deferral
    • 401(k) Advantages
    • Choosing Investments
    • When You Change Jobs
    • Borrowing From Your Retirement Plan
    • Work With Your Financial Advisor
    • Points to Remember


    As more Americans shoulder the responsibility of funding their own retirement, many rely increasingly on their 401(k) retirement plans to provide the means to meet their investment goals. That's because 401(k) plans offer a variety of attractive features that make investing for the future easy and potentially profitable. Be sure to talk to your employer or plan administrator about the specific features and rules of your plan.

    What Is a 401(k)?

    A 401(k) plan is an employee-funded savings plan for retirement. It takes its name from the section of the Internal Revenue Code that created these plans. 401(k) plans are also known as "qualified defined contribution" retirement plans: qualified because they meet the tax law requirements for favorable tax treatment (described below); and defined contribution because contributions are defined under the terms of the plan, while benefits will vary depending on plan balances and investment returns.

    Tax Treatment of 401(k) Plans

    The 401(k) plan allows you to contribute up to $17,500 of your salary in 2013 to a special account set up by your company. Future contribution limits will be adjusted for inflation. Keep in mind that individual plans may have lower limits on the amount you can contribute. In addition, individuals aged 50 and older who participate in a 401(k) plan can take advantage of so-called "catch up" contributions of an additional $5,500 in 2013.

    401(k) plans now come in two varieties: traditional and Roth-style plans. A traditional 401(k) plan allows you to defer taxes on the portion of your salary contributed to the plan until the funds are withdrawn in retirement, at which point contributions and earnings are taxed as ordinary income. In addition, because the amount of your pre-tax contribution is deducted directly from your paycheck, your taxable income is reduced, which in turn lowers your tax burden.

    The tax treatment of a Roth 401(k) plan is different. Under a Roth plan, contributions are made in after-tax dollars, so there is no immediate tax benefit. However, plan balances grow tax free; you pay no taxes on qualified distributions.

    Both traditional and Roth plans require that distributions be qualified. In general, this means they must be taken after 59½ (or age 55 if you are separating from service from the employer whose plan the distributions are withdrawn), although there are certain exceptions for hardship withdrawals, as defined by the IRS. If a distribution is not qualified, a 10% IRS penalty will apply in addition to ordinary income taxes on all pre-tax contributions and earnings.

    If your plan permits, you can make contributions in excess of the 2013 limit of $17,500 ($23,000 if over age 50), as long as your total contribution is not more than 100% of your pre-tax salary, or $51,000 in 2013, whichever is less. That means if your salary is $100,000, you may be able to contribute up to $51,000 total to your 401(k) plan during 2013. In the case of a traditional 401(k), however, only the first $17,500 ($23,000 if over 50) of your contributions can be made pretax in 2013; contributions over and above that amount must be made after tax and do not reduce your salary for tax purposes.

    Matching Contributions

    Besides its favorable tax treatment, one of the biggest advantages of a 401(k) plan is that employers may match part or all of the contributions you make to your plan. Typically, an employer will match a portion of your contributions, for example, 50% of your first 6%. Under a Roth plan, matching contributions are maintained in a separate tax-deferred account, which, like a traditional 401(k) plan, is taxable when withdrawn.

    Employer contributions may require a "vesting" period before you have full claim to the money and their investment earnings. But keep in mind that if your company matches your contributions, it's like getting extra money on top of your salary.

    401(k) Advantages

    • Tax-deferred contributions and earnings on traditional plans.
    • Tax-free withdrawals for qualified distributions from Roth-style plans.
    • Choice among different asset classes and investment vehicles.
    • Potential for employer-matching contributions.
    • Ability to borrow from your plan under certain circumstances.

    Tax-Deferred Compounding

    The benefit of compounding reveals itself in a tax-advantaged account such as a 401(k) plan. If your $100 monthly contribution accumulates tax-deferred over 30 years, you could grow your retirement nest egg to $150,030. That's a difference of almost $50,000 just because you didn't have to pay taxes up front.1 Of course, you'll have to pay taxes on earnings and deductible contributions to a traditional 401(k) when you withdraw the money. But that will likely be when you are retired and may be in a lower tax bracket.

    Choosing Investments

    Generally, 401(k) plans provide you with several options in which to invest your contributions. Such options may include stocks for growth, bonds for income, or money market investments for protection of principal. 2 This flexibility allows you to spread out your contributions, or diversify, among different types of investments, which can help keep your retirement portfolio from being overly susceptible to different events that could affect the markets.3

    When You Change Jobs

    When you change jobs or retire, you generally have four different options for what to do with your plan balance. You can keep the plan in your former employer's plan, if permitted; you can transfer balances to your new employer's plan; you can roll over the balance into an IRA; or you can take a cash distribution. The first three options generally entail no immediate tax consequences; however, taking a cash distribution will usually trigger 20% withholding, a 10% IRS penalty tax if taken before age 59½, and ordinary income tax on pre-tax contributions and earnings.

    When deciding on which of the first three options to choose, you should consider available investment options and ease of access. Often, rolling over to an IRA provides the greatest flexibility and control, while affording a wide choice of investment alternatives.

    Borrowing From Your Retirement Plan

    One potential advantage of many 401(k) plans is that you can borrow as much as 50% of your vested account balance, up to $50,000. In most cases, if you systematically pay back the loan with interest within five years, there are no penalties assessed to you.

    If you leave the company, however, you may have to pay back the loan in full immediately, depending on your plan's rules. In addition, loans not repaid to the plan within the stated time period are considered withdrawals and will be taxed and penalized accordingly.

    Work With Your Financial Advisor

    A 401(k) plan can become the cornerstone of your personal retirement savings program, providing the foundation for your future financial security. Consult with your plan administrator or financial advisor to help you determine how your employer's 401(k) plan could help make your financial future more secure.

    Points to Remember

    1. A traditional 401(k) plan allows you to defer taxes on part of your salary. A Roth 401(k) accepts after-tax contributions, but allows for tax-free withdrawals in retirement.
    2. Contribution limits are $17,500 in 2013 ($23,000 if age 50 or older). Future contribution limits will be indexed for inflation.
    3. One of the biggest advantages of 401(k)s versus other retirement plans is that employers may match part or all of the contributions you make to your plan.
    4. 401(k) plans provide you with several options in which to invest your contributions.
    5. If you leave your company and take a cash distribution, taxes and penalties will likely apply.
    6. Some 401(k)s allow you to borrow as much as 50% of your vested account balance, up to $50,000.

    1This example is hypothetical in nature and is not indicative of future performance in your retirement plan. Withdrawals prior to age 59½ are subject to a 10% IRS penalty tax.

    2An investment in a money market fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Although the fund seeks to preserve the value of your investment at $1.00 per share, it is possible to lose money by investing in the fund.

    3Diversification and asset allocation do not ensure a profit or protect against a loss in a declining market.

    Because of the possibility of human or mechanical error by S&P Capital IQ Financial Communications or its sources, neither S&P Capital IQ Financial Communications nor its sources guarantees the accuracy, adequacy, completeness or availability of any information and is not responsible for any errors or omissions or for the results obtained from the use of such information. In no event shall S&P Capital IQ Financial Communications be liable for any indirect, special or consequential damages in connection with subscriber's or others' use of the content.

    © 2013 S&P Capital IQ Financial Communications. All rights reserved.

  • Make the Most of Your Traditional IRA

    Key Points

    • What Is a Traditional IRA?
    • Rules on Contribution Limits
    • Tax Treatment of IRAs
    • The Magic of Tax-Deferred Compounding
    • Change Jobs, But Keep Your Retirement Money
    • Withdrawing From Your IRA
    • Consult Your Financial Advisor
    • Points to Remember


    Investors have two options for their individual retirement accounts (IRAs). The first option is a traditional IRA, and the second option is a Roth IRA (named for the account's congressional sponsor), which features -- among other benefits -- the ability to receive tax-free earnings under certain circumstances. In this report, we'll discuss the features of the traditional IRA. You may want to review material outlining the Roth IRA -- or talk to your financial planner -- before you make a decision as to which IRA is right for you.

    What Is a Traditional IRA?

    An individual retirement account allows your investment earnings to grow tax-deferred until withdrawn, typically at retirement. Generally, if you have earned income or receive alimony, you can establish as many IRA accounts as you want prior to the tax year in which you reach age 70½. You may also have an IRA even if you participate in a qualified pension, profit-sharing, or other retirement plan. Your entire contribution may not be deductible on your income tax return, depending on your income and your eligibility for an employer-sponsored retirement plan.

    IRAs offer two distinct advantages in terms of taxes: potential deductibility of contributions and tax deferral on investment earnings.

    Rules on Contribution Limits

    In 2013, the maximum annual contribution is $5,500 (in general, married couples filing jointly can contribute a total of $11,000, even if only one spouse has income). Thereafter, the contribution limit will be adjusted for inflation. Individuals aged 50 and older are now able to take advantage of "catch up" contributions to IRAs. The allowable catch-up contribution is $1,000 per year. Maximum contributions may not exceed earned income.

    In addition, you can open an IRA or make contributions to an existing IRA as late as the deadline for filing a tax return for that year. That means you would have until April 2014 to make your 2013 IRA contribution.

    Tax Treatment of IRAs

    Contributions to a traditional IRA may or may not be deductible from your earned income in a given tax year depending on your situation. Income limits apply if either you or your spouse participates in an employer-sponsored retirement savings plan. Deductibility is phased out over certain ranges of income as follows:

    Traditional IRA Deductibility Phaseout Ranges for 2013*

    $ in Thousands
    Single Filers Joint Filers
    Those covered by an employer-sponsored retirement plan $59-$69 $95-$115
    Those not covered by an employer-sponsored retirement plan, but filing a joint return
    with a spouse who is covered
    N/A $178-$188
    *Based on modified adjusted gross income (MAGI).

    The Magic of Tax-Deferred Compounding

    The ability to make tax-deductible contributions to a traditional IRA can help your current tax situation. But you may want to invest in an IRA whether or not your contributions are deductible. Why? The real advantage of investing in an IRA is tax-deferred compounding of your investment earnings over the long term.

    For example, if you had contributed $100 every month for 30 years to a tax-deferred IRA, then paid 25% tax on your withdrawals at retirement, you could have netted $112,522, assuming an 8% average annual rate of return. However, in an account that's taxed annually at a hypothetical rate of 25%, your total would have been only $100,954 -- almost $12,000 less just because you had to pay taxes up front!1

    Consider the Advantage of Tax Deferral

    As you evaluate the potential benefits of an IRA, consider the advantage of tax deferral. This chart shows the result when a hypothetical $100 monthly investment is made for 30 years in a tax-deferred plan versus the same investment taxed annually at a hypothetical rate of 25%, assuming an 8% average rate of return compounded monthly. If the final tax-deferred amount is withdrawn at retirement and taxed at a hypothetical rate of 25%, it exceeds the taxable final amount by nearly $12,000.

    Change Jobs, But Keep Your Retirement Money

    IRAs can also come in handy when you're about to leave jobs and need to move your 401(k) money. If your former employer requires that you withdraw your retirement money, you can move your distribution safely from your former employer's qualified retirement plan into a rollover IRA and avoid owing current income tax on the distribution.

    If you choose to physically receive part or all of your money and do not replace the entire amount within 60 days, you will be subject to penalty fees and taxes on the amount kept.

    Withdrawing From Your IRA

    Generally, any distribution you receive from an IRA before the day you reach age 59½ is subject to a 10% additional tax imposed by the IRS, in addition to federal and state income tax. Beginning at age 59½, you can withdraw money (of which any deductible contributions and investment earnings are taxable at your then-current income tax rate) from your IRA as desired without additional tax, whether or not you are still employed.

    But, as with any rule, there are exceptions. Distributions before age 59½ are not subject to the additional tax under certain circumstances, including when:

    • You become permanently disabled.
    • You die before age 59½ and distributions are made to your beneficiary or estate after your death.
    • You make withdrawals to pay deductible medical expenses that exceed 7.5% of your adjusted gross income.
    • You make withdrawals for a qualified first-time home purchase (lifetime limit of $10,000).
    • You make withdrawals to pay qualified higher education expenses for yourself, a spouse, children, or grandchildren.

    By April 1 following the year in which you reach age 70½, you must begin withdrawals from your IRA. A great advantage of taking only the required minimum distribution amount is that the balance continues to compound tax-deferred. However, if your distributions in any year after you reach age 70½ are less than the required minimum, you will be subject to an additional tax equal to 50% of the difference.

    Consult Your Financial Advisor

    An IRA can become the cornerstone of your personal retirement savings program, providing the foundation for your financial security. That's why it is so important to start planning today. Consult with your financial advisor to help you determine how an IRA could help make your financial future more secure.

    Points to Remember

    1. If you have earned income or alimony, you can establish as many IRA accounts as you want prior to the tax year in which you reach age 70½. Keep in mind, however, that you may be incurring annual account fees for each account, so maintaining multiple accounts may not be a prudent decision.
    2. Contribution limits are $5,500 or 100% of your earned income, whichever is less. Special "catch up" contributions of $1,000 are also available to individuals who are at least 50 years old.
    3. You can open an IRA or make contributions to an IRA as late as the tax-filing deadline for that year.
    4. Income limits restricting the deductibility of contributions apply if either you or your spouse participate in an employer-sponsored retirement savings plan.
    5. A major advantage of investing in an IRA is tax-deferred compounding of earnings.
    6. By April 1 following the year in which you reach age 70½, you must begin withdrawals from your IRA.
    7. Individuals under the age of 59½ can make penalty-free withdrawals to pay college expenses for themselves, a spouse, children, or grandchildren.

    1This example is hypothetical in nature and is not indicative of future performance in your retirement plans.

    Because of the possibility of human or mechanical error by S&P Capital IQ Financial Communications or its sources, neither S&P Capital IQ Financial Communications nor its sources guarantees the accuracy, adequacy, completeness or availability of any information and is not responsible for any errors or omissions or for the results obtained from the use of such information. In no event shall S&P Capital IQ Financial Communications be liable for any indirect, special or consequential damages in connection with subscriber's or others' use of the content.

    © 2013 S&P Capital IQ Financial Communications. All rights reserved.

  • Close-Up: Defined Contribution Plans for Corporate Sponsors

    Key Points

    • Specific DC Choices -- An Overview
    • Points to Remember


    For an employer who wishes to provide some kind of retirement benefit, a defined contribution (DC) plan delineates a sponsor's obligations to plan participants. It established the sponsor's funding liability as the amount the sponsor sets aside when the benefit is earned rather than an amount the sponsor might be committed to pay at some point in the future. Thus, the DC plan is designed to eliminate the risk of future funding shortfalls in retirement assets.

    In contrast, the ultimate cost of a traditional pension for any given employee cannot be precisely determined until after that employee has received all benefits due under the plan. That lack of future uncertainty may help explain the explosive popularity of DC plans.

    Specific DC Choices - An Overview

    At the highest level, the DC universe has two essential categories -- qualified and nonqualified. Qualified plans are those that meet IRS rules for favorable federal tax treatment. Within IRS limits (which have been set separately for each qualified plan type) contributions are generally income-tax deductible in the year made for both employers and employees. Also, such plans must be offered to all eligible employees. As a general rule, any proceeds from the investment of plan assets accumulate for the eventual gain of the participants, and do so without immediate tax consequences for either the sponsors or the employees. Nonqualified plans operate without explicit tax advantages, but also without IRS-mandated eligibility requirements and ceilings on contributions.

    The principal types of deferred contribution plans are the following:

    • 401(k) Plans. These are becoming the primary vehicle for retirement savings for most employees. Contributions are considered discretionary since the employee generally chooses whether to participate and how much, within IRS guidelines, to contribute. Employer contributions to 401(k) accounts can be varied from year to year as long as plan benefits in any given year are applied uniformly to higher and lower income employees, meeting the nondiscrimination tests of the IRS. Contributions to a 401(k) are generally made with pretax funds; withdrawals of both pretax contributions and investment earnings are generally accounted for as taxable income to the participant. 401(k) plans are available only for employees of taxable, profit-making enterprises. Similar benefits are available to educators and employees of nonprofit entities through 403(b) plans, and for employees of local government entities through 457 plans.
    • Niche DC plan types. There are a number of structures that may be attractive in particular circumstances, but their usage is not widespread. For example, money purchase plans allow more generous employer contributions than most other DC programs, but the payments are mandatory and beneficiaries do not often contribute. Stock bonus and profit sharing plans are likewise funded entirely or mostly by the employer and are generally used as supplements since their contributions can be completely discretionary from year to year.
    • Small Business plan types. Simplified Employee Pension (SEP)-IRAs operate like employer-funded Individual Retirement Accounts. SIMPLE plans are funded by employer contributions and can be augmented by employee pretax contributions.
    • Nonqualified Deferred Compensation Plans. These allow highly compensated employees to accumulate retirement assets commensurate with their income level and help supplement the benefits these employees might receive under a pension or 401(k). Nonqualified plans often require complex trust structures to obtain limited tax advantage for participants and to help manage the risks associated with asset custody and deferred ownership. Nonqualified plan contributions are generally discretionary. In addition, employers can select which employees they wish to benefit.

    A complex web of rules and regulations governs employer-sponsored DC plans -- portions of which originate with the IRS and portions with the Department of Labor.

    Sponsors must exercise fiduciary responsibility over plan administration and asset management, meaning that they must be sure that the same level of care is taken in those areas that a knowledgeable professional would exercise. DC plan sponsors must also segregate all plan assets from their business assets and use suitable independent institutions for trust and custody.

    For help in assessing your current defined contribution offering or to explore options that may be applicable to your situation, please consult a qualified benefits planning professional.

    Points to Remember

    1. A defined contribution (DC) plan offers a plan sponsor immediate closure on the expense exposure in providing retirement benefits, which may help explain the explosive popularity of DC plans.
    2. 401(k) plans, SEP-IRAs, and SIMPLE plans are defined as qualified plans because they meet the IRS requirements for favorable tax treatment of contributions and investment income. Each qualified plan has its own unique rules regarding total yearly contributions.
    3. Supplementary deferred compensation programs are generally not qualified for favorable IRS tax treatment, but they are also exempt from IRS-imposed limits and nondiscrimination requirements.
    4. Employers who sponsor DC plans must exercise fiduciary responsibility, segregate plan assets, and use independent trust and custody services.

    Because of the possibility of human or mechanical error by S&P Capital IQ Financial Communications or its sources, neither S&P Capital IQ Financial Communications nor its sources guarantees the accuracy, adequacy, completeness or availability of any information and is not responsible for any errors or omissions or for the results obtained from the use of such information. In no event shall S&P Capital IQ Financial Communications be liable for any indirect, special or consequential damages in connection with subscriber's or others' use of the content.

    © 2013 S&P Capital IQ Financial Communications. All rights reserved.

  • Longevity Risk and Retirement Income

    Key Points

    • Live Long and Prosper
    • Protecting Your Retirement Paycheck
    • Developing a Diverse Income Strategy
    • Adding Annuities to the Mix
    • Accounting for Growth
    • Points to Remember


    How long might you live in retirement? Think carefully. Your answer could influence whether you have enough money for a comfortable retirement or just scrape by.

    Studies have found that many Americans do not realize that one of the greatest threats to their financial security in retirement is the risk of outliving their money.1 Why the lack of awareness? Because most people just don't understand how long they might live.

    According to pension mortality tables, at least one member of a 65-year-old couple has a 72% chance of living to age 85 and a 45% chance of living to age 90.2 This suggests that many of us will need to plan carefully to ensure that we don't outlast our assets.

    Live Long and Prosper

    The first step in tackling longevity risk is to figure out how much you can realistically afford to withdraw each year from your personal savings and investments. You can tap the expertise of a qualified financial professional to assist you with this task. Or, you can use an online calculator to help you estimate how long your money might last.

    One strategy is to withdraw a conservative 4% to 5% of your principal each year. However, your annual withdrawal amount will depend on a number of factors, including the overall amount of your retirement pot, your estimated length of retirement, annual market conditions and inflation rate, and your financial goals. For example, do you wish to spend down all of your assets or pass along part of your wealth to family or a charity?

    Protecting Your Retirement Paycheck

    No matter what your goals, there are ways to potentially make the most out of your nest egg. The remainder of this article examines how a strategy might play out with assets held in taxable accounts.

    First, you'll likely need ready access to a cash reserve to help pay for daily expenditures. A common rule of thumb is to keep at least 12 months of living expenses in an interest-bearing savings account, though your needs may vary.

    Then, consider refilling your cash reserve bucket on an annual basis by selectively liquidating different longer-term investments, timing gains and losses to offset one another whenever possible.

    Developing a Diverse Income Strategy

    Responding to the current interest rate environment is one way to potentially squeeze more income from your savings and stretch out the money you've accumulated for retirement. For example, if rates are trending upward, you might consider keeping more money in short-term Certificates of Deposits (CDs).3 The opposite strategy may be employed when rates appear to be declining.

    Most retirees need their investments to generate income. Bonds may help fill this need. "Laddering" of bonds can potentially create a steady income stream while helping reduce long-term interest exposure (see illustration).

    Building a Bond Ladder

    "Laddering" bonds is a popular strategy used by income investors. This strategy involves buying an assortment of bonds of different maturities and staggering the maturities over time. In the above example, an investor initially buys bonds with maturities of one, two, and three years. As each bond matures, it is reinvested in another three-year bond to retain the staggered bond ladder. Total yield (income) is potentially higher than if continually reinvested in one-year maturities. Risk is also potentially reduced due to investing in a mix of maturity rates.


     A common way to help temper investment risk is to spread it out by diversifying among different types of securities. A retiree seeking income can use the same strategy by adding dividend-paying equities to his or her portfolio.

    These stocks potentially offer the opportunity for supplemental income by paying part of their earnings to shareholders on a regular basis. Another potential attraction? Qualified stock dividends are currently taxed at a maximum rate of 20%, rather than ordinary federal income tax rates, which currently run as high as 39.6%. Also, keep in mind that investing in an equity-income mutual fund, which generally holds many dividend-paying stocks, may help reduce risk compared with investing in a handful of individual stocks.

    Adding Annuities to the Mix

    One way to potentially provide regular income andaddress longevity risk is to purchase an immediate annuity. In exchange for giving an insurer a specific amount of money, you're guaranteed income for either a specific period of time, or life. Keep in mind, however, that guarantees are backed by the claims-paying ability of the issuing company. There are many types of annuities, so speak with a financial professional to carefully weigh your options, and be sure to examine fees and other charges before buying.4

    The chart shows how adding an annuity could potentially increase the odds that your money will last your lifetime. One tactic is to figure out your annual expenses and determine how much income you'll receive from Social Security and pensions (if any). Then, consider purchasing an annuity that will make up any shortfall. This allows peace of mind, knowing that your regular expenses are covered. Then, you can put your other investments to work pursuing growth.

    Accounting for Growth

    Finally, be cautious about being overly conservative with your investments. Many people may live 30 or more years in retirement. Therefore, your portfolio may need a boost of stocks to outpace inflation over the years.

    These are just a few ideas for developing an adequate income plan during retirement. Consider sitting down with a qualified financial professional to discuss these and other strategies that might be appropriate for your situation.

    Stretching a Retirement Portfolio

    An annuity may potentially help provide stability and longevity to a retiree's income.3 This hypothetical example illustrates how long a $500,000 portfolio would last for someone who retired in 1982, based upon a portfolio comprised of 25% stocks, 25% bonds, and 50% invested in a lifetime annuity, assuming an annual withdrawal rate of $30,000, adjusted for inflation. Returns assume reinvestment of dividends and capital gains if any.
    Sources: Standard & Poor's; Barclays Capital; Bureau of Labor Statistics. Performance is based on the 30-year period ended December 31, 2012. Stocks are represented by the total returns of the S&P 500, which is generally considered representative of the U.S. stock market. Bonds are represented by the total returns of the Barclays U.S. Aggregate Bond Index, generally considered representative of the U.S. bond market. Both are unmanaged indexes. Inflation is represented by the change in the Consumer Price Index. Fixed annuity assumed to earn a 6% annual rate. Individuals cannot invest directly in any index. Past performance does not guarantee future results. Example is hypothetical and for illustrative purposes only. Annuities involve risks and fees. Talk to your financial advisor about their role in your retirement.

    Points to Remember

    1. For many Americans, a great threat to their financial security in retirement is the risk of outliving their money.
    2. The first step in tackling longevity risk is to figure out a sustainable annual withdrawal rate from personal savings and investments.
    3. Next, consider keeping a cash reserve of 12 or more months to help pay for daily expenditures.
    4. Consider diversifying the rest of your taxable portfolio among different savings and investment options, including those with different maturities to account for fluctuating interest rates.
    5. Purchasing an immediate annuity with part of your nest egg can provide regular income and help address longevity risk.
    6. You may need to own some stocks to outpace inflation over the years.
    7. Work with a qualified financial professional to discuss retirement income strategies that might be appropriate for you.

    1Sources: Mercer Human Resource Consulting, April 2004; Journal of Financial Planning, June 2003 (most recent data available).

    2Source: Social Security Administration, Period Life Table (2007, latest available).

    3Certificates of Deposit (CDs) offer a guaranteed rate of return, guaranteed principal and interest, and are generally insured by the Federal Deposit Insurance Corp. (FDIC), but do not necessarily protect against the rising cost of living.

    4Withdrawals from annuities prior to age 59½ are subject to a 10% penalty and all withdrawals are taxed as ordinary income. Issuing companies may also charge surrender charges for some early withdrawals. Neither fixed nor variable annuities are insured by the FDIC, and they are not deposits of -- or endorsed or guaranteed by -- any bank. Investing in variable annuities involves risk, including loss of principal.

    Because of the possibility of human or mechanical error by S&P Capital IQ Financial Communications or its sources, neither S&P Capital IQ Financial Communications nor its sources guarantees the accuracy, adequacy, completeness or availability of any information and is not responsible for any errors or omissions or for the results obtained from the use of such information. In no event shall S&P Capital IQ Financial Communications be liable for any indirect, special or consequential damages in connection with subscriber's or others' use of the content.

    © 2013 S&P Capital IQ Financial Communications. All rights reserved.

  • Asset Reallocation Is Critical for Aging Plan Participants

    Key Points

    • Asset Allocation: A Matter of Age and Objectives
    • The Need to Rebalance
    • Education Is Key to Action
    • Points to Remember


    While it's commendable that participants are staying the course when it comes to their long-term investment strategy, for older workers who are nearing retirement, it is important to conduct a thorough reassessment of their goals, risk tolerance, and income needs. In short, they need to go through the entire planning process from square one.

    Asset Allocation: A Matter of Age and Objectives

    Asset allocation, or the way an investor divides a portfolio among various types of stock, bond, and cash equivalent securities, is vital to investment success. In fact, one landmark study of pension plans found that more than 90% of the variability of a portfolio's performance over time can be attributed to asset allocation.1 The purpose of an asset allocation strategy is to aim for a particular rate of return with a given level of risk. While investment education materials typically offer allocation advice based on broad parameters, asset allocation is a highly customized process that examines three fundamental factors that will evolve throughout an investor's lifetime.

    1. Tolerance for Investment Risk. A good gauge of risk tolerance is how much loss an investor can withstand over a one-year period. In general, industry research suggests that investors with a low risk tolerance can sustain losses of no more than 5% in a year. Investors with a moderate risk tolerance may be able to withstand total losses of 6% to 15%, and those with a high risk tolerance can weather losses between 16% and 25% annually.
    2. Return Needs. This factor is dependent on an individual's investment goals. Is he or she seeking regular income, long-term growth, a combination of the two, or preservation of principal? Historically, investors have looked to bond investments for regular income and stock investments for long-term growth potential. Money market investments seek to preserve principal; they provide little growth over time.2
    3. Investment Horizon. This is the period of time an individual has before he or she needs to begin taking money out of an investment portfolio. In general, a short-term horizon is less than five years. A long-term horizon is five years or more. An investment horizon is an important gauge of how well an individual can withstand an investment's price fluctuations.

    Although the ideal asset allocation will vary from person to person, standard investment wisdom states that as investors age, they may need to gradually shift to a more conservative asset allocation that focuses on retirement income as the primary investment objective. The charts shown below illustrate how allocations may vary according to the investor's time horizon.

    For instance, if an individual has been investing aggressively for retirement for more than 20 years and is now less than 10 years from retiring, protecting what that investment may have earned may become more important. In this case, it may be wise to gradually shift some of the stock allocation into bond and money market holdings. Keep in mind, however, that many financial experts recommend that stocks be included in every portfolio to maintain growth potential.

    Asset Allocation: A Matter of Age and Objectives

    The Need to Rebalance

    If asset allocation is vital to investment success, periodically rebalancing a portfolio to maintain intended allocation percentages is equally important. A participant's allocation can shift when one market outperforms another for an extended period of time, leaving a portfolio with greater exposure to volatility than desired. An allocation imbalance could even diminish return potential. Consider the performance of two portfolios over a recent 10-year period -- one that was actively rebalanced and one that stayed unchanged through up and down market cycles. Assuming the performance of the assets in each portfolio mirrored general market benchmarks, the portfolio that was actively rebalanced would have produced a higher annual rate of return during the period (see chart).3

    Seeing the Difference

    Plan participants can rebalance their investment mix by selling shares of the outperforming asset class to purchase new shares of the underperforming asset class. Alternatively, they could increase their annual contribution amount, if they aren't already contributing the maximum allowed, and apply the new amount to the asset class that has fallen below the target allocation.

    Regular portfolio review and maintenance -- at least once a year -- is key to ensuring that an asset allocation stays balanced and keeps up with a participant's changing investment objectives.

    Education Is Key to Action

    What steps can plan sponsors take to assist plan participants in maintaining an up-to-date asset allocation strategy? Offering education materials around the concepts of asset allocation and portfolio rebalancing are vital first steps. Targeting those messages to plan participants whose account allocations remain stagnant is an even more effective approach. Technology can also play a key role. For instance, consider instituting portfolio management tools that inform participants, via computer models, of the importance of rebalancing and proper asset allocation depending on one's life stage, income, total net worth, and retirement goals. Plan sponsors may also consider offering a lifestyle fund as a default option and/or an automatic rebalancing mechanism that evaluates a participant's account once a year, depending on lifestyle and income factors.

    The ultimate goal for sponsors is to find an approach that works for their employees so that they can get the maximum benefits from their retirement plans even if they lack the confidence or interest to make it happen themselves.

    Points to Remember

    1. Asset allocation is a highly customized process that examines three fundamental factors that will evolve throughout an investor's lifetime: risk tolerance, return needs (i.e., income, long-term growth, preservation of principal), and investment time horizon.
    2. While maintaining an appropriate target asset allocation of stock, bond, and cash investments is critical to long-term investment success, as plan participants age, they need to reassess their planning parameters and make changes as warranted.
    3. General investment wisdom dictates that as investors age, they may need to shift to a more conservative asset allocation that focuses on retirement income as a primary objective.
    4. Changing market conditions and other lifestyle variables make it important to periodically rebalance a retirement plan portfolio to the investor's target allocation. Plan participants should conduct regular (at least annual) reviews throughout their investment lifetime.
    5. Plan sponsors can assist participants in keeping their allocation strategies up-to-date by providing education materials and portfolio management tools that inform participants of the importance of rebalancing and proper asset allocation.

    1Source: Financial Analysts Journal, January 2000.
    2An investment in a money market fund is neither insured nor guaranteed by the U.S. government, and there can be no guarantee that the fund will maintain a stable $1 share price. A fund's yield will vary.
    3Sources: Standard and Poor's; Barclays Capital. For the period from January 1, 2003, to December 31, 2012. In this hypothetical illustration, stocks are represented by the S&P 500 and bonds by the Barclays U.S. Aggregate index. The rebalanced portfolio would have been reset to maintain its 50%/50% target allocation on a quarterly basis. Keep in mind that individuals cannot invest directly in any index, that actual investment performance may vary from benchmarks, and that index performance does not account for the potential impact of taxes and transaction costs. This analysis assumes that all cash proceeds were reinvested at then-prevailing rates of return. Past performance does not guarantee future results.

    Because of the possibility of human or mechanical error by S&P Capital IQ Financial Communications or its sources, neither S&P Capital IQ Financial Communications nor its sources guarantees the accuracy, adequacy, completeness or availability of any information and is not responsible for any errors or omissions or for the results obtained from the use of such information. In no event shall S&P Capital IQ Financial Communications be liable for any indirect, special or consequential damages in connection with subscriber's or others' use of the content.

    © 2013 S&P Capital IQ Financial Communications. All rights reserved.

  • The Roth Individual Retirement Account

    Key Points

    • Rules of the Roth IRA
    • The Traditional IRA vs. the Roth IRA
    • The Traditional IRA
    • Conversion of a Traditional IRA to a Roth IRA
    • Which Is Right for You?
    • Points to Remember


    The Roth IRA presents a potentially attractive alternative to the traditional IRA long favored by many Americans as a cornerstone in their retirement planning efforts. That's because a Roth IRA may allow you to avoid future taxation of your retirement funds by making nondeductible contributions now.

    Rules of the Roth IRA

    Following is a summary of the rules for Roth IRAs:

    Unlike the traditional IRA, contributions to a Roth IRA are nondeductible regardless of your income level or participation in a company-sponsored retirement plan.

    Your total annual contributions to all IRAs are limited to $5,500 in 2013. Individuals who are at least 50 years old by the end of the year are also able to make so-called catch-up contributions to a Roth IRA. The allowable catch-up contribution is $1,000 per year but is not adjusted for inflation. The contribution limit begins to decline or "phase out" for single taxpayers with adjusted gross incomes (AGIs) of more than $112,000 and for married couples filing jointly with AGIs of more than $178,000. Individuals with AGIs in excess of $127,000 ($188,000 for married couples filing jointly) are not eligible for a Roth IRA. Married taxpayers filing separately are not allowed to contribute to a Roth IRA.

    Contribution limits may increase in the years ahead. In the future, the annual contribution limit may be adjusted for inflation.

    Your contributions to a Roth IRA may continue beyond age 70½. You are not required to start taking distributions from a Roth IRA at age 70½, as you are with a traditional IRA, and you can continue to contribute as long as you have earned income. When a Roth IRA owner dies, however, his or her heirs must adhere to the same minimum distribution rules that apply to traditional IRAs.

    Qualified distributions from a Roth IRA are tax free. While your contributions to a Roth IRA are never tax deductible, your distributions may be tax free if you have owned the Roth IRA for at least five years and:

    • You are at least 59½ years old or you qualify for one of several exceptions; or
    • Your withdrawal of up to $10,000 (lifetime limit) is applied to a first-time home purchase; or
    • You die or become permanently disabled.

    You may qualify for the "first-time home purchase" if you have not owned a home for at least two years before the date on the purchase contract or the date when construction started. You, your spouse, or a descendant or ancestor of either may qualify as the buyer.

    The taxable portion of a nonqualified distribution is subject to a 10% tax penalty. If you make withdrawals that do not meet the rules for a qualified distribution, you'll owe taxes on all or a portion of the withdrawal. You must also pay a 10% penalty tax on the taxable portion of the withdrawal.

    Penalty-free withdrawals are permitted for qualified education expenses. If you are under age 59½ but have held the Roth IRA for five years, you may withdraw funds penalty free to pay for qualified education expenses for yourself or family members. You will have to pay income tax on the taxable portion of the distribution, however.

    Retirement plan "rollovers" are permitted. If you are changing jobs or retiring, you can roll over funds from an employer retirement plan, such as a 401(k) account, directly to a Roth IRA. In the past, you could do this only if your workplace retirement account was a Roth-style plan. But since 2008, direct rollovers from a non-Roth plan have been allowed. The rollover is treated as a conversion, with income taxes due on all proceeds.

    The Traditional IRA vs. the Roth IRA

    When deciding whether a traditional IRA or a Roth IRA is best for you, you'll want to compare the after-tax dollars that would be available to you under each option. This will depend on many factors, including your tax bracket, how many years you have until retirement, and when you wish to begin making withdrawals. For many people, a Roth IRA will result in more after-tax income during retirement because qualified withdrawals from a Roth IRA are tax free, while withdrawals from a traditional IRA will be taxed.

    For those whose contributions to a traditional IRA are tax deductible and who are in a higher tax bracket today than they will be in during retirement, a traditional IRA may be the smart choice.

    If you are not eligible to participate in a company-sponsored retirement plan, you can make deductible contributions to a traditional IRA regardless of your income level, up to $5,500 in 2013 (or $6,500 if you are at least 50 years old). Deductible contributions may be reduced or eliminated for individuals who participate in a company-sponsored retirement plan, based on their incomes.

    The Traditional IRA

    The traditional IRA may still provide an advantage over the Roth IRA to those who maximize its benefit. Here's how: You invest the tax savings from your IRA deduction in a traditional account each year and let that account grow along with your IRA. Assuming your tax rate drops in retirement, this could yield more of a tax-adjusted benefit than a Roth IRA.

    Conversion of a Traditional IRA to a Roth IRA

    There are no income limits associated with the conversion of a traditional IRA to a Roth IRA -- anyone can convert, provided they pay the tax bill. Since the investment earnings and capital gains in your regular IRA have not been taxed yet, the government will take its share at the time of the conversion. If you have a nondeductible, traditional IRA, its earnings will be taxed but the amount of your contributions will not. The withdrawal from your traditional IRA will count as income but will not trigger the 10% penalty usually imposed on early withdrawals.

    Which Is Right for You?

    If you have a traditional IRA and are considering converting to a Roth IRA, here are a few factors to consider:

    • A Roth IRA may be more attractive the further you are from retirement. Why? Because the longer your earnings can grow, the more income you may have that is never taxed. On the other hand, if you convert to a Roth IRA close to retirement, your investments may not have much time to compensate for the associated tax bill.
    • If your traditional IRA contributions are nondeductible, you may be better off with a Roth IRA.That's because the distributions of earnings from your traditional, nondeductible IRA will eventually be taxed. The qualified distributions from a Roth IRA will not.
    • Your current and future tax brackets will affect which IRA is best for you. For example, if you are currently in a high tax bracket and expect to be in a much lower tax bracket during retirement, a traditional IRA could be the best option. Why? Because you may be able to claim a deduction on your contributions now and then pay taxes on future distributions at the lower rate later. Keep in mind that some experts say you could still come out ahead with a Roth IRA if you can fund it for at least 12 or 15 years before retirement.

    As you can see, there is no easy answer to the question, "Which IRA is best for me?" As with any major financial decision, careful consultation with a professional is a good idea before you make your choice. In addition to helping you with calculations and projections, a professional is also likely to know what, if any, changes or clarifications have been made to the complex new tax laws. Remember, your retirement could last 20 years or more. How you live tomorrow could depend on the choices you make today.

    The information contained herein is general in nature and is not meant as tax advice. Consult a tax professional as to how this information applies to your situation.

    Points to Remember

    1. Roth IRA contributions are nondeductible, but qualified withdrawals are tax free.
    2. Individual contributions to all IRAs are limited to $5,500 in 2013 ($6,500 for investors who are at least 50 years old). Note that this amount may increase in the years ahead.
    3. You may continue contributions to a Roth IRA after age 70½, and there are no mandatory withdrawals.
    4. You can make penalty-free withdrawals from a Roth IRA before age 59½ for a first-time home purchase or if you die or become permanently disabled.

    Because of the possibility of human or mechanical error by S&P Capital IQ Financial Communications or its sources, neither S&P Capital IQ Financial Communications nor its sources guarantees the accuracy, adequacy, completeness or availability of any information and is not responsible for any errors or omissions or for the results obtained from the use of such information. In no event shall S&P Capital IQ Financial Communications be liable for any indirect, special or consequential damages in connection with subscriber's or others' use of the content.

    © 2013 S&P Capital IQ Financial Communications. All rights reserved.

  • Quantifying Investment Risk: Standard Deviation

    Key Points

    • Standard Deviation Defined
    • Using Standard Deviation to Evaluate Investments
    • Other Measures of Risk
    • Points to Remember


    There are a number of different statistical tools for measuring investment risk. Standard deviation is among the most widely used and is a common gauge of volatility. But standard deviation is a relatively complex calculation, and it pays to understand exactly what it does and does not measure, and how it is best used when evaluating and choosing plan investments.

    Standard Deviation Defined

    Standard deviation is a measurement of the amount of variation in any group of numbers from its mean. It's not just a financial tool, but is one of the most commonly used statistical tools in the sciences. For an investment, standard deviation is a gauge of volatility; the higher the standard deviation, the higher the volatility. To calculate it, you compare the investment's average or mean return over a period of time (typically 36 months) with the average absolute variance from this return. A standard deviation of zero means the investment return rate never varies, such as a federally guaranteed savings account at a bank paying a fixed rate of interest. A very high standard deviation of, say 40%, indicates that the investment varies often and significantly from the mean.

    Historical research has shown that stock and bond returns are random, and therefore fall on a normal bell curve. For such "normal" distributions, about 68% of the time, all values will fall within one standard deviation of the mean; about 95% of the time, all values will fall within two standard deviations of the mean; and about 99.7% of the time, all values will fall within three standard deviations of the mean. Most financial standard deviation statistics are quoted as one standard deviation, or a 68% probability. This means that if the mean is 10% and the standard deviation is 5%, 68% of the time you can expect to find returns between 5% and 15% (95% of the time, you are likely to find returns within 0% and 20%). Standard deviation on a given investment is generally available through fund companies and also from mutual fund rating and ranking services, such as Standard & Poor's, Morningstar, and Lipper.

    A close relative of standard deviation is semi-variance. It measures the average deviation of values above the mean and below the mean, but not with the same magnitude. Some asset return distributions, such as derivatives and swaps for example, tend to be positively or negatively skewed. In such cases, the formulas to find the range of possible returns is not a mirror image for the above-mean as it is for the below mean.

    Using Standard Deviation to Evaluate Investments

    Volatility is an important factor for fiduciaries to consider before selecting investment options for a plan offering. Higher volatility means higher risk, but often higher return potential. Used in conjunction with other risk and criteria (see inset), standard deviation can help you establish a target balance between risk and return potential that provides plan participants a diverse selection of investment options.

    Because standard deviation is an absolute measurement -- it is not calculated based on a benchmark or index -- it allows you to compare the volatility of individual investments, whole portfolios, or entirely different asset classes. For instance, you can compare the relative volatility of bonds versus stocks by looking at standard deviations of the Lehman Aggregate Bond Index and the S&P 500 indices. Or, you can compare the standard deviation of two specific stocks or funds to see which has shown less historical volatility. You should also compare the standard deviation for a given investment with its peers or its benchmark index.

    Following are standard deviations for different benchmarks and assorted investments for the 20 years ended December 31, 2012:1
    S&P 500 Index (domestic equities) 15.12%
    S&P SmallCap 600 Index (small caps) 18.73%
    MSCI EAFE Index (foreign equity) 17.02%
    Long-Term Government Bonds (bonds) 9.77%

    While standard deviation is an excellent measure of volatility, it has its limits, and it is only one gauge of investment risk. For instance, standard deviation makes no distinction between upward and downward volatility. A stock whose price continually rises in leaps and bounds would likely carry a high standard deviation, but would not necessarily be high risk. The ratio is also only meaningful when compared with benchmarks or other investments. While it can help differentiate investments based on their past performance, it takes further analysis to uncover and understand factors that have contributed to this performance. These may include qualitative developments such as a change in a fund's manager or a drift in a fund's investment style. General economic conditions and business trends are other examples of factors that may affect returns.

    Other Measures of Risk

    In addition to standard deviation, here are four measures of risk often used in investment analysis:
    Beta compares an investment's volatility against a benchmark such as the S&P 500. It shows how an investment's historical returns have fluctuated in relation to the broader market represented by the benchmark. For example, a beta of 1.20 would indicate that a fund had fluctuated 20% more than the benchmark, which has a beta of 1.
    Alpha shows the relationship between an investment's historical beta and its current performance. An alpha of 0 indicates the investment performed as expected. A positive alpha means the investment returned more than its beta indicated; a negative alpha signifies that it returned less.
    R-squared (R2) quantifies how much of an investment's performance can be attributed to the performance of a benchmark index. The value of R2 ranges between 0 and 1 and measures the proportion of the investment's variation that is due to variation in the benchmark. For example, for an investment with an R2 of 0.70, 70% of the return variation can be attributed to the benchmark.
    The Sharpe Ratio measures risk-adjusted returns and is used for comparing investments to determine which offer the most return for a given amount of risk. The ratio is calculated by subtracting the return of a risk-free investment (such as the 90-day Treasury bill) from the investment's return and then dividing that result by the standard deviation of the investment's return.

    Points to Remember

    1. Standard deviation is among the most widely used measures of investment risk and is a common gauge of volatility.
    2. To calculate standard deviation, you compare an investment's average return over a period of time (typically 36 months) with the average absolute variance from this return.
    3. Standard deviation on a given investment is generally available through fund companies and mutual fund ranking services, such as Standard & Poor's, Morningstar, and Lipper.
    4. Standard deviation allows you to compare the volatility of individual investments, whole portfolios, or entirely different asset classes, but is also only meaningful when compared with benchmarks or other investments.
    5. Other measures of investment risk include beta, alpha, R-squared, and the Sharpe ratio.

    1Sources: Standard & Poor's, Frank Russell Company, MSCI International, Barclays. Based on rolling 12-month holding periods.

    Because of the possibility of human or mechanical error by S&P Capital IQ Financial Communications or its sources, neither S&P Capital IQ Financial Communications nor its sources guarantees the accuracy, adequacy, completeness or availability of any information and is not responsible for any errors or omissions or for the results obtained from the use of such information. In no event shall S&P Capital IQ Financial Communications be liable for any indirect, special or consequential damages in connection with subscriber's or others' use of the content.

    © 2013 S&P Capital IQ Financial Communications. All rights reserved.

  • Growth vs. Value: Two Approaches to Stock Investing

    Key Points

    • Growth and Value Defined
    • Defining Features of Growth and Value Stocks
    • Growth and Value Are Complementary
    • Growth vs. Value: Compare the Performance
    • Combining Growth and Value
    • Points to Remember


    Growth and value are two fundamental approaches in stock and stock mutual fund investing. Many growth stock mutual fund managers look for stocks of companies that they believe offer strong earnings growth potential, while value fund managers look for stocks that appear undervalued by the marketplace. Some fund managers combine the two approaches.

    Growth and Value Defined

    Growth stocks represent companies that have demonstrated better-than-average gains in earnings in recent years and are expected to continue delivering high levels of profit growth. While earnings of some companies may be depressed during periods of slower economic growth, growth companies may potentially continue to achieve high earnings growth regardless of economic conditions. "Emerging" growth companies are those that have the potential to achieve high earnings growth, but have not established a history of strong earnings growth.

    Value stocks generally have fallen out of favor in the marketplace and are considered bargain-priced compared with book value, replacement value, or liquidation value. Typically, value stocks are priced much lower than stocks of similar companies in the same industry. This lower price may reflect investor reaction to recent company problems, such as disappointing earnings, negative publicity, or legal problems, all of which may raise doubts about the companies' long-term prospects. The value group may also include stocks of new companies that have yet to be recognized by investors.

    The primary measures used to define growth and value stocks are the price-to-earnings ratio (the price of a stock divided by the current year's earnings per share) and the price-to-book ratio (share price divided by book value per share). Growth stocks usually have high price-to-earnings and price-to-book ratios, which means that these stocks are relatively high-priced in comparison with the companies' net asset values. In contrast, value stocks have relatively low price-to-earnings and price-to-book ratios.

    Defining Features of Growth and Value Stocks

    Growth Stocks
    • Higher priced than broader market
    • High earnings growth records
    • More volatile than broader market
    Value Stocks
    • Lower priced than broader market
    • Currently priced below similar companies in industry
    • Carry somewhat less risk than broader market

    Growth and Value Are Complementary

    Following a specific investment style, such as growth or value, provides investment managers with guidelines for choosing stocks. Growth fund managers look for high-quality, successful companies that have posted strong performance and are expected to continue to do well, though there are no guarantees. Investors are willing to pay high price-to-earnings multiples for these stocks in expectation of selling them at even higher prices as the companies continue to grow. The risk in buying a given growth stock is that its lofty price could fall sharply on any negative news about the company, particularly if earnings disappoint Wall Street.

    Value fund managers look for companies that have fallen out of favor but still have good fundamentals. They buy these stocks at bargain prices below the stocks' average historic levels or below the current levels in their industry groups. Many value investors believe that a majority of value stocks are created due to investors' overreacting to negative events. The idea behind value investing is that stocks of good companies will bounce back in time when the true value is recognized by other investors. But this recognition of value may take time to emerge and, in some cases, may never materialize.

    Which strategy -- growth or value -- is likely to produce higher returns over the long term? The battle between growth and value investing has been going on for years, with each side offering statistics to support its arguments. Some studies show that value investing has outperformed growth over extended periods of time on a value-adjusted basis. Value investors argue that a short-term focus can often push stock prices to low levels, which creates great buying opportunities for value investors.

    Growth vs. Value: Compare the Performance

    Growth vs. Value: Compare the Performance
    Both growth and value stocks have taken turns leading and lagging one another during different markets and economic conditions.
    Source: Standard & Poor's. Stocks are represented by the annualized returns of composites of the S&P 500 Growth and Value indexes, which are unmanaged indexes considered representative of growth and value large-cap stocks. Index performance results do not take into account the fees and expenses of the individual investments that are tracked. Results include reinvested dividends. Past performance is no indication of future results. Individuals cannot invest directly in an index. (CS000170)

    Combining Growth and Value

    For many mutual fund investors, however, there may not be an absolute advantage to any single approach to investing over a long period of time. Instead of choosing only one approach, individual investors may strive for the best-possible returns with the minimum risk by combining growth and value investing. This approach allows investors to potentially gain throughout economic cycles in which the general market situations favor either the growth or value investment style. For example, value stocks, often stocks of cyclical industries, tend to do well early in an economic recovery; growth stocks, on the other hand, tend to lead bull markets, which are normally fueled by falling interest rates and increased company earnings. Also, because the two groups of stocks tend not to move in the same direction or to the same extent, investors can enhance return potential and reduce risk by combining the two approaches.

    Points to Remember

    1. Growth and value are two approaches, or "styles," of investing in stocks.
    2. Portfolio managers use an investment style to describe their rules for selecting securities.
    3. Value investors seek stocks that are priced near or below the value of the company's assets. Growth investors seek companies that are growing earnings rapidly.
    4. Because they take time to turn around, value stocks may be more suited to longer-term investors and may carry more risk of price fluctuation than growth stocks.
    5. Individual investors who purchase mutual funds can combine the two investment styles to help lower risk.

    Because of the possibility of human or mechanical error by S&P Capital IQ Financial Communications or its sources, neither S&P Capital IQ Financial Communications nor its sources guarantees the accuracy, adequacy, completeness or availability of any information and is not responsible for any errors or omissions or for the results obtained from the use of such information. In no event shall S&P Capital IQ Financial Communications be liable for any indirect, special or consequential damages in connection with subscriber's or others' use of the content.

    © 2013 S&P Capital IQ Financial Communications. All rights reserved.

  • Understanding Style Drift

    Key Points

    • Get the Drift
    • Keeping Up With Style
    • Four Questions for Portfolio Reviews
    • Monitoring Mechanisms
    • Points to Remember


     Style drift -- when a portfolio manager strays from an investment's stated investment style -- can alter asset allocation, increase investment risk, and contribute to underperformance. One ground-breaking study found that mutual funds that adhered to their stated style from 1991 through 2000 produced better returns than those that did not, even after accounting for expenses and portfolio turnover. What's more, the researchers concluded that managers of style-consistent funds tended to make fewer asset allocation errors and investment selection mistakes than their style-wandering brethren.1

    Because a plan sponsor's fiduciary responsibility includes performing due diligence regarding the appropriateness of the investment options offered within a plan, it's important to monitor investments for style drift.

    Get the Drift

    Because index funds track market benchmarks, they are not usually subject to style drift. However, actively managed funds -- with their aim to beat market indexes -- may stray from a fund's stated investment style for several reasons. Asset bloat is one example. Case in point: If a small-cap fund has been performing extremely well, it may attract substantial amounts of new money. These large inflows can make it difficult for the manager to pinpoint a sufficient number of attractive small-company investment opportunities. One solution? Purchasing shares of larger-cap stocks, which could cause imbalance within the fund's style.

    Another cause: fluctuating market cap. A small-cap stock can experience rapid growth, pushing it into the midcap range. Conversely, a larger-cap stock could lose market share, reducing its market capitalization. A possible result? A fund's style may be skewed. Then there's the problem of sector overweighting. Some managers of growth equity funds overweighted their portfolios with technology stocks during the late 1990s. Consequently, many of those funds suffered when the tech boom eventually ran its course. Yet another factor is human behavior. The manager of a value fund that has underperformed for some time may be tempted to invest in growth stocks to potentially boost returns.

    Although style drift is more common with equity funds, bond funds may also shift focus. For example, during the late 1980s, some managers of investment-grade bond funds began adding riskier high-yield bonds in hopes of gaining an edge. Consequently, return performance suffered when that strategy backfired.

    Keeping Up With Style

    So what can sponsors do to guard against style drift? Creating a set of written guidelines and documenting adherence to those guidelines may help protect them from fiduciary liability claims. Another good idea is to schedule quarterly portfolio reviews based on these standards.
    Consider using a standardized set of questions designed to uncover style drift during this process (see sidebar). As an additional check, some sponsors choose to hire independent financial subadvisors to assist with the review.

    Four Questions for Portfolio Reviews

    1. What is the fund's stated investment style? Check the prospectus for this information and then review reports for consistency over time. Keep back issues of quarterly and annual reports for comparison purposes.
    2. What are the fund's investment holdings? All funds should invest in securities that match their stated style. A small-cap fund that invests in blue-chip giants is cause for pause. Similarly, derivatives appearing in a high-quality bond fund should raise a 'red flag.'
    3. Is performance significantly greater or less than the fund's benchmark? If so, ask the portfolio manager for an explanation.
    4. Has the fund recently changed managers? It's not unusual for style drift to occur with leadership changes. A new manager may choose different investments, which could impact style.

    Monitoring Mechanisms

    Additionally, there are a number of tools available to help ascertain an investment's style purity. Several Web sites contain free, detailed information about funds.

    www.funds-sp.com -- Standard & Poor's uses quantitative and qualitative analysis to rank thousands of mutual funds to help investors evaluate fund performance and consistency within specific categories.

    www.businessweek.com -- BusinessWeek's Mutual Fund Scoreboard runs annually in the magazine, but is updated monthly online. Enter a fund's name or ticker symbol to receive a wealth of information.

    www.morningstar.com -- Morningstar's star ranking system scores similar funds (after adjusting for risk and sales charges) based on performance. Each report also includes a handy at-a-glance style chart.
    There are also sophisticated style analysis software programs available for purchase. Some programs review performance over a given period and compare it with stated objectives, while others weigh a fund's individual holdings against those within the same style category.

    Style drift happens, but it doesn't have to happen to you. Ultimately, it's incumbent upon the plan sponsor to catch the drift before potential problems arise.

    Points to Remember

    1. It is a plan sponsor's fiduciary responsibility to monitor portfolio investments for investment style drift, which can alter asset allocation, increase investment risk, and contribute to underperformance.
    2. Actively managed mutual funds may experience style drift for many reasons, including asset bloat, fluctuating market capitalization, sector overconcentration, and changes in fund management.
    3. Creating a set of written guidelines and documenting adherence to those guidelines through quarterly portfolio reviews may help protect sponsors from fiduciary liability claims.
    4. Plan sponsors can also use Web resources and sophisticated software programs to assist in detecting investment style drift.

    Because of the possibility of human or mechanical error by S&P Capital IQ Financial Communications or its sources, neither S&P Capital IQ Financial Communications nor its sources guarantees the accuracy, adequacy, completeness or availability of any information and is not responsible for any errors or omissions or for the results obtained from the use of such information. In no event shall S&P Capital IQ Financial Communications be liable for any indirect, special or consequential damages in connection with subscriber's or others' use of the content.

    © 2013 S&P Capital IQ Financial Communications. All rights reserved.

  • Establishing an Appropriate Investment Menu

    Key Points

    • ERISA at the Root
    • Making It Right, From the Start
    • An Ongoing Responsibility to Manage the Investment Menu
    • Weeding the Menu
    • Codifying the Logic Behind an Investment Menu
    • Points to Remember


     Employers who sponsor tax-favored retirement savings programs for their employees are more than just dispensers of fringe benefits. They are fiduciaries who have a legal obligation to ensure that the plan is properly equipped to meet the tangible retirement goals of the participants. One important expression of this fiduciary responsibility is the obligation to provide a suitable selection of investment choices in the plan's menu of investment options.

    ERISA at the Root

    The Employees Retirement Income Security Act of 1974, as amended, (ERISA) created the legal foundation for these requirements. ERISA compels employers to clearly define the funding, investment, and custody practices to be used in the plan, and it established the "prudent person" standard for evaluating the appropriateness of the relevant policies, procedures, and services. In other words, the plan must do what a knowledgeable professional in the field might do or be expected to do under the same circumstances.

    In the context of defined-contribution investment management, a plan sponsor has two basic choices. One alternative is to make all investment decisions and assume the risks inherent in asset management. The other is to provide a suitable menu of investment options and allow participants to make their own asset management choices. If this second option is done according to the detailed provisions of ERISA's Section 404(c), it means that the participant will assume the risks of his or her investment decisions.

    A plan investment menu that complies with the terms of Section 404(c) must provide a range of investment portfolios that might be appropriate to the ages, retirement goals, and risk tolerances of all employees. At an absolute minimum, that means a plan must include at least three diversified core investment options, each of which has different risk and return characteristics. The investment choices in this menu must be sufficiently liquid to permit participants to change their investment selections at least once each quarter. And the plan must provide the participant with sufficient information about the performance and composition of the investment options so that the participant has the opportunity to make appropriate choices.

    Making It Right, From the Start

    A typical investment menu may offer a significant number of customized investment vehicles as well as access to a wide array of mutual funds. But despite the appearance of diversity, there is a significant risk that the menu will not fully meet the strictures of Section 404(c). To do so, the customized investment options should be professionally designed to meet specific planning goals, and these options must be clearly identified as to their asset class and investment style composition. The mutual funds that are offered should likewise cover the full range of asset classes needed to create targeted portfolios for diverse retirement horizons and risk tolerances. The industry-standard asset classes include large- mid-, and small-cap domestic stocks; global developed-market stocks; global emerging market stocks; long-, medium-, and short-term bonds; and money market funds. Many stock portfolios are also managed according to styles such as growth, value, and sector. Since diversified portfolios for any planninggoal require assets of several different classes and styles, an appropriate investment menu should be built to provide the needed diversity across all of these categories. Haphazard fund selection focusing on popular or widely known funds introduces the risk that important investment categories might be overlooked and thus unavailable to plan participants.

    Other considerations imposed by Section 404(c) in menu setup include manager selection and due diligence. An ideal menu will include managers who have the potential to outperform their peers after all fund management costs and investment expenses are accounted for. And an ideal menu selection process will include relevant documentation of all investigations and analyses.

    An Ongoing Responsibility to Manage the Investment Menu

    Under ERISA's Section 404(c), the plan sponsor is responsible for ensuring that the actual behavior of fund managers included in the plan's investment options is carefully monitored for consistency and performance. The sponsor should also ensure that any relevant developments are reported to participants in a timely manner. For example, fund managers sometimes change their asset class or style targets as the market climate changes. The plan sponsor should be certain that these instances of drift are identified and reported to participants so that the participants can decide whether to adjust their own portfolio balance if need be. Also, if a fund manager's performance deviates significantly from benchmarks, the sponsor is responsible for ensuring that the divergence is properly explained to participants.

    Weeding the Menu

    There may come a time when it is necessary to remove a fund from an investment menu. The manager may have drifted too far from original style targets, the management team may have been broken up or the fund performance may have begun to lag peers chronically. When a fund is removed from the plan roster, its place should be taken by a fund with similar risk, reward, and style characteristics so as to sustain the diversification blueprint created by the plan's initial design. Whenever a fund is removed, participants should be told that an investment option is being eliminated or replaced by a comparable fund and why this action was taken. This should be done as soon as possible. Participants can then be offered the option of either transferring their assets automatically to the replacement fund or reallocating their portfolios.

    Codifying the Logic Behind an Investment Menu

    Many experts recommend that the steps used to evaluate each investment manager, the rules used to select each investment option, and the procedures for monitoring and amending the investment menu be set forth in a formal investment policy. This policy could also spell out the intended risk and return profiles of each investment option and define the benchmarks to be used for evaluation. And it can spell out the guidelines for manager termination.

    The laws defining a sponsor's obligations under ERISA are changing constantly, and this summary cannot replace professional plan design, implementation, and legal advice. So before taking any action, please consult with an appropriate professional who has expertise in ERISA law. But a plan that broadly adheres to these principals can serve the needs of participants and sponsors alike for a stable, predictable retirement savings program.

    Points to Remember

    1. A plan's investment menu is an expression of its sponsor's fiduciary responsibility.
    2. The menu should provide investment choices that can be used to address a wide variety of risk and reward targets.
    3. Once managers are selected for inclusion in the investment menu, their investing activity should be monitored for appropriate consistency and performance.
    4. Participants should have access to timely and detailed information about their investment options in order to be enabled to make appropriate investment choices.

    Because of the possibility of human or mechanical error by S&P Capital IQ Financial Communications or its sources, neither S&P Capital IQ Financial Communications nor its sources guarantees the accuracy, adequacy, completeness or availability of any information and is not responsible for any errors or omissions or for the results obtained from the use of such information. In no event shall S&P Capital IQ Financial Communications be liable for any indirect, special or consequential damages in connection with subscriber's or others' use of the content.

    © 2013 S&P Capital IQ Financial Communications. All rights reserved.

  • The Risks of Fixed-Income Investments

    Key Points

    • Know Your Risks
    • Special Risks of International Fixed-Income Investments
    • Points to Remember


     Most employer-sponsored retirement plans feature a "core" offering of different funds, suited to different levels of investment risk. A staple among these offerings is usually one or more fixed-income funds, which may hold different types of bonds and asset-backed securities. Yet the choice of which fixed-income fund(s) to include is not an easy one. There are many to select from -- more than 2,500 are available in the U.S. alone.1 -- and fixed-income funds cover a wide array of types, ranging from stable short-term government bond funds to speculative high-yield corporate bond funds. Most important for plan sponsors is the fact that the different types of fixed-income investments can carry dramatically different levels of risk, making some inappropriate for your retirement plan.

    Know Your Risks

    Although equity as an asset class carries higher risk than fixed-income securities, there are many types of fixed-income investments that can be riskier than certain types of stocks. Below is a summary of the principal risks encountered with fixed-income investments and how they apply to different types.

    Credit risk is the risk that the bond issuer or issuers will default. All U.S. Treasury securities are backed by "the full faith and credit" of the U.S. Government and carry negligible credit risk. Keep in mind, however, that although interest income and the principal amount invested in government bonds is guaranteed, the funds that invest in these bonds are not. Government agency securities are not directly issued by the U.S. government and are not necessarily backed by its full faith and credit. However, agency bonds are of generally high quality and have historically run little risk of default. Unlike government bonds, the credit quality of corporate bonds varies widely. Standard & Poor's, Moody's Investors Service, and other independent rating agencies publish credit-quality ratings for most bonds. Ratings run from Aaa (Moody's) or AAA (S&P) through D, based on the issuer's creditworthiness. For bond funds, the combined rating breakdown is available from the fund company.

    For retirement plans, credit risk comes into play for any funds that hold non-U.S. Government bonds, and particularly if the plan features higher-yielding bond funds or offers "balanced" funds that contain corporate bonds. To gauge how exposed a fund may be to credit risk, look at the combined rating breakdown. Bonds issued with a rating BB- or less are considered non-investment-grade (sometimes referred to as "junk" or "high-yield" bonds) and carry higher credit risk.

    Interest rate risk is the risk that bond prices will drop when interest rates rise. Exposure to interest rate risk increases with the length of a bond's or fund's average maturity, as issuers generally pay higher yields on longer-term bonds than on those with shorter maturities, and prices tend to fluctuate more widely. Accordingly, although interest rate risk is applicable to virtually all bond funds, those with shorter average maturities and with higher credit quality are likely to suffer less when interest rates rise.

    A low interest rate environment also exposes bond holders tocall risk, the right of an issuer to redeem a bond before its stated maturity. Issuers typically call bonds when interest rates drop, allowing them to pay off higher-cost debt and issue new bonds at a lower rate. Bonds paying higher yields are most susceptible to call risk. Similarly, falling rates also entailprepayment risk, whereby prices on investments such as mortgage-backed securities are affected by refinancing activity.

    But for retirement plans, it's important to keep in mind the long investment time horizon of most plan participants and the need to maintain a diversified asset allocation. While bonds prices stand to fall as rates increase, they also stand to gain when rates come down again.

    Inflation risk is the danger that the income produced by a bond or bond fund will fall short of the current rate of inflation. The comparatively low returns of high-quality bonds such as U.S. government securities are particularly susceptible to inflation risk, particularly in times of rapid inflation such as during the 1970s. Inflation risk is also more prevalent in funds with long average maturities, which may be locked into lower yielding investments.

    Special Risks of International Fixed-Income Investments

    A key factor to be aware of when considering funds which hold foreign bonds is the role of currency fluctuation. Changes in the value of a foreign country's currency can directly impact the value of bonds issued from the country. For example, if the value of a foreign country's currency rises relative to the U.S. dollar, the earnings from bonds issued there will buy more dollars when received by the investor. There are a number of factors that affect a nation's currency, including interest rates, direct and indirect investment, trade flows, and inflation.

    Different Types of Fixed-Income Investments Carry Different Risks

    U.S. Treasuries Perhaps the lowest risk of all bond investments, these bonds have little credit risk because they are guaranteed by the U.S. government, although they can have high inflation risk.
    Government Agency Securities Next to Treasury bonds, agency and entity bonds are the second-safest bonds in terms of credit risk. But some mortgage-backed issues may carry high interest rate risk.
    Municipal Bonds Municipal bonds carry varying degrees of credit risk, but are generally rated AA or higher. Municipal bonds are generally not held in retirement plans since their federally tax-exempt status offers little benefit to tax-deferred plans.
    Corporate Bonds Credit risk ranges from low to high, depending upon the issuer, but is generally higher than Treasuries, agency securities, and municipal bonds. For callable bonds, call risk is also a consideration, especially when market interest rates are falling.

    Points to Remember

    1. Risk among fixed-income investments varies by type of investment and type of risk.
    2. Although equity as an asset class carries higher risk than fixed-income securities, there are many types of fixed-income investments that can be riskier than certain types of stocks.
    3. Credit risk is the risk that the bond issuer or issuers will default. Credit risk is generally higher for corporate bonds and lowest for U.S. Treasury securities.
    4. Interest rate risk is the risk that bond prices will drop when interest rates rise. Exposure to interest rate risk increases with the length of a bond's or fund's average maturity, as issuers generally pay higher yields on longer-term bonds than on those with shorter maturities, and prices tend to fluctuate more widely.
    5. Inflation risk is the danger that the income produced by a bond or bond fund will fall short of the current rate of inflation. Inflation risk is generally highest for low-yield Treasury securities.
    6. Foreign bonds or bond funds also carry currency risk, or the risk that changes in the value of a foreign country's currency will impact the value of bonds issued from that country.

    1Source: Investment Company Institute, Investment Company Fact Book, May 2012.

    Because of the possibility of human or mechanical error by S&P Capital IQ Financial Communications or its sources, neither S&P Capital IQ Financial Communications nor its sources guarantees the accuracy, adequacy, completeness or availability of any information and is not responsible for any errors or omissions or for the results obtained from the use of such information. In no event shall S&P Capital IQ Financial Communications be liable for any indirect, special or consequential damages in connection with subscriber's or others' use of the content.

    © 2013 S&P Capital IQ Financial Communications. All rights reserved.

  • Using a Rollover IRA to Consolidate Multiple Retirement Assets

    Key Points

    • Rollover IRAs Offer a Wide Range of Benefits
    • Efficient Rollovers Require Careful Planning
    • Special Considerations for Company Stock
    • How much could that cash distribution be worth when you retire?
    • Potential Downsides of IRA Rollovers to Consider
    • Points to Remember


    Your retirement plan assets may be one of the most important legacies you take with you when you move from one job to another. Intended to help provide financial security later in life, these assets need to be managed carefully and invested wisely in order to help ensure that they will be available when eventually required.

    Rollover IRAs Offer a Wide Range of Benefits

    As compared with employer-sponsored retirement accounts, a rollover IRA can provide you with a broad range of investment choices and flexibility for distribution planning. Here's a brief overview that highlights some of the key benefits of a rollover IRA compared with an employer-sponsored plan.

    1. As the IRA account owner, you make the key decisions that affect management and administrative costs, overall level of service, investment direction, and asset allocation. You can develop the precise mixture of investments that best reflects your own personal risk tolerance, investment philosophy, and financial goals. You can create IRAs that access the investment expertise of any available fund complex, and can hire and fire your investment managers by buying or selling their funds. You also control account administration through your choice of IRA custodians.
    2. While you may look forward to a long and healthy career, life's uncertainties may force changes. Internal Revenue Service distribution rules for IRAs generally require IRA account holders to wait until age 59½ to make penalty-free withdrawals, but there are a variety of provisions to address special circumstances. These provisions are often broader and easier to exploit than employer plan hardship rules.
    3. IRA assets can generally be divided among multiple beneficiaries in an estate plan. Each of those beneficiaries can make use of planning structures such as the Stretch IRA concept to maintain tax-advantaged investment management during their lifetimes. Beneficiary distributions from employer-sponsored plans, in contrast, are generally taken in lump sums as cash payments. Also, except in states with explicit community property laws, IRA account holders have sole control over their beneficiary designations.

    Efficient Rollovers Require Careful Planning

    One common goal of planning for a lump-sum distribution is averting unnecessary tax withholding. Under federal tax rules, any lump-sum distribution that is not transferred directly from one retirement account to another is subject to a special withholding of 20%. This withholding will apply as long as the employer's check is made out to you -- even if you plan to place equivalent cash in an IRA immediately. To avert the withholding, you must first set up your rollover IRA, and then request that your employer transfer your assets directly to the custodian of that IRA.

    Keep in mind that the 20% withholding is NOT your ultimate tax liability. If you spend the lump-sum distribution rather than reinvest it in another tax-qualified retirement account, you'll have to declare the full value of the lump sum as income and pay the full tax at filing time -- at a rate of up to 39.6% depending on your eventual tax bracket. In addition, the IRS generally imposes a 10% penalty tax on withdrawals taken before age 59½.

    Also, if you plan to roll over the entire sum, but have the check made out to you rather than your new IRA custodian, your employer will be required to withhold the 20%. In that event, you can get the 20% refunded if you complete the rollover within 60 days. You must deposit the full amount of your distribution in your new IRA, making up the withheld 20% out of other resources. When you file your tax return for the year, you can then include a request for refund of the lump-sum withholding.

    If you have after-tax contributions in your employer plan, you may opt to withdraw them without penalty when you roll over your assets. However, if you wish to leave those funds in your retirement account in order to continue tax deferral, you can include them in your rollover. When you begin regular distributions from your IRA, a prorated portion will be deemed nontaxable to reimburse you for the after-tax contributions.

    The information contained herein is general in nature and is not meant as tax advice. Consult a tax professional as to how this information applies to your situation.

    Special Considerations for Company Stock

    Many firms make some or all of their contributions to employee accounts in the form of company stock, bonds, or other securities. If you have company securities in your account and their current market value includes significant price appreciation, you could benefit from an in-kind distribution for the company securities that is separate from the lump-sum cash-out of other investments' assets.

    An in-kind distribution is delivery of the actual securities rather than their cash value. The potential benefit comes from the fact that any price appreciation that occurred while the securities were held in the 401(k) can be treated as capital gains rather than ordinary income. When you take an in-kind distribution of your employer's securities, you will pay income tax only on the original cost basis of the securities; the balance of the value on the distribution date is categorized as net unrealized appreciation (NUA). When you sell the securities, the NUA is treated as a long-term capital gain. Any gain that might occur after the distribution date is taxed as if you bought the securities on the date of the distribution. (Note that NUA treatment is available only for publicly traded securities.)

    How much could that cash distribution be worth when you retire?

    A retirement nest egg grows most vigorously when investment proceeds are permitted to compound over long time periods. A relatively small amount of money today may become a considerable nest egg when earnings are compounded over a lifetime, as this chart illustrates.

    Source: Standard & Poor's. For illustrative purposes only. Example is hypothetical in nature and is not indicative of any particular investment. Past performance is not indicative of future returns.

    Potential Downsides of IRA Rollovers to Consider

    While there are many advantages to consolidated IRA rollovers, there are some potential drawbacks to keep in mind. Assets greater than $1 million in an IRA may be taken to satisfy your debts in certain personal bankruptcy scenarios. Assets in an employer-sponsored plan cannot be readily taken in many circumstances. Also, you must begin taking distributions from an IRA by April 1 of the year after you reach 70½ whether or not you continue working, but employer-sponsored plans do not require distributions if you continue working past that age.

    Remember, the laws governing retirement assets and taxation are complex. In addition, there are many exceptions and limitations that may apply to your situation. Therefore, you should obtain qualified professional advice before taking any action.

    Points to Remember

    1. Retirement plan assets that are scattered among numerous accounts may be difficult to manage effectively, with hard-to-assess portfolio allocations and risks.
    2. Lump-sum distributions are immediately taxable as ordinary income unless rolled over into another tax-qualified plan within 60 days.
    3. IRAs generally offer more flexibility in estate planning than employer-sponsored plans.
    4. Employer stock can be treated differently from other assets in a lump-sum distribution in order to harvest the benefits of long-term capital gains tax treatment.
    5. IRAs may offer less protection in personal bankruptcy than employer plans.
    Because of the possibility of human or mechanical error by S&P Capital IQ Financial Communications or its sources, neither S&P Capital IQ Financial Communications nor its sources guarantees the accuracy, adequacy, completeness or availability of any information and is not responsible for any errors or omissions or for the results obtained from the use of such information. In no event shall S&P Capital IQ Financial Communications be liable for any indirect, special or consequential damages in connection with subscriber's or others' use of the content.

    © 2013 S&P Capital IQ Financial Communications. All rights reserved.

  • Reducing the Uncertainty of Retirement Projections

    Key Points

    • What Is Stochastic Analysis?
    • Comparing Stochastic Analysis to Simpler Methods
    • Using Stochastic Analysis in the Planning Process
    • Points to Remember


     Much of retirement planning is based on risk tolerance, time horizon, and investment goals. Other unpredictable factors, such as inflation, market volatility, and interest rates are harder if not impossible to plan for, but are just as important to consider during the planning process.


    So how can plan sponsors educate a participant on the impact of unforeseeable variables, such as market volatility, in preparation for retirement?

    What Is Stochastic Analysis?

    Stochastic analysis is one tool that can help participants calculate for the probability of volatility and its possible effect on their portfolios. Although past performance is no guarantee of future results, stochastic analysis can help give your participants a reliable indication of whether their financial plans will meet their retirement funding objectives.

    Stochastic analysis first generates thousands of "what ifs" from the life expectancy and investment parameters. It then calculates the maximum sustainable payout rate and a most likely terminal portfolio value for each permutation. The results are recorded and reported in order of which results were supported in a specified percentage of the trials. The effects of changes in any of the assumed variables -- allocation, withdrawal rate, or return -- can also be shown in order to facilitate plan adjustments.

    Comparing Stochastic Analysis to Simpler Methods

    Before the widespread availability of high-powered desktop computers and sophisticated statistical software, most financial plans were evaluated by means of simple linear analysis. With this technique, a planner would use a single, judiciously chosen return assumption and a maximum foreseeable life expectancy. For those assumptions, the planner could estimate an annuity payout and terminal estate value. Such linear calculations, however, cannot take into account the normal year-to-year variation of returns or the possibility of an overall poor return over the life of the simulation.

    In reality, however, the timing of the variations is critical, as is the overall long-term return achieved. A portfolio that experiences above-average returns early on would be able to sustain considerable downside later and still remain on course. On the other hand, a portfolio that starts out with sub par performance may fall into a hole from which it never recovers. Stochastic analysis will show the participant the whole range of foreseeable results.

    Using Stochastic Analysis in the Planning Process

    Stochastic analysis can be used to determine whether specific retirement income expectations are realistic or to more precisely estimate the resources that might be available for a goal such as retirement funding. It can also be used for broader planning applications such as comparing the benefits of long-term financing versus outright purchase for cash. For example, a home mortgage may provide a nice, tax-deductible loan, but it will also add risk to the participant's overall financial picture. Stochastic analysis allows a participant to help quantify how much risk he or she is actually taking.

    There are some financial planning concerns that stochastic analysis alone cannot address. For example, it may have only limited use in specific asset selection since actual holdings may or may not perform in the same pattern as the investment assumptions and may have higher costs as well. Also, stochastic analysis is intended to account for the randomness of investment returns, but not cyclical events like long-running bull and bear markets. But for participants looking to create blueprints with a high likelihood of financial success, stochastic analysis offers a powerful tool for reducing the areas of uncertainty about outcomes.

    Points to Remember

    1. Stochastic analysis is an analytical technique that runs simulations using random quantities for uncertain variables. It does not predict actual events.
    2. Stochastic analysis can be used by participants to check the viability of their investment strategy. It is not intended to serve as a sole planning tool for retirement savings.
    3. Participants can use stochastic analysis as a reality check of their portfolio during particularly turbulent markets, lifestyle changes or at annual review time.
    4. Encourage participants to stay invested in the market, especially during turbulent times. If a participant strays from his or her retirement goal, an adjustment to his or her asset allocation strategy may be required.

    Because of the possibility of human or mechanical error by S&P Capital IQ Financial Communications or its sources, neither S&P Capital IQ Financial Communications nor its sources guarantees the accuracy, adequacy, completeness or availability of any information and is not responsible for any errors or omissions or for the results obtained from the use of such information. In no event shall S&P Capital IQ Financial Communications be liable for any indirect, special or consequential damages in connection with subscriber's or others' use of the content.

    © 2013 S&P Capital IQ Financial Communications. All rights reserved.

  • Shielding Retirement Assets From Taxes

    Key Points

    • RMD Rules Simplify Things
    • Stretch Out the Tax Bill
    • Strategies for Spouses
    • Strategies for Nonspouse Beneficiaries
    • Talk to the Right People
    • Points to Remember


     As hard as it is to believe, today's tax-advantaged plans -- including individual retirement accounts IRAs, 401(k)s, and rollover IRAs -- have the potential to make many employees millionaires. A 401(k) contribution of $433 per month, at 8% compounded monthly, would be worth more than $1 million after 35 years.1


    These plans are also highly vulnerable to tax losses, if they are not bequeathed properly. For instance, a $1 million IRA inheritance could be whittled to almost nothing under worst-possible circumstances, such as a combination of estate taxes, top income tax brackets, and missed withdrawal deadlines.

    Saving your heirs thousands of tax dollars on your retirement money often hinges on the decisions you make before you retire. Therefore, it's important to take a look now at how to save heirs tax headaches later on.

    RMD Rules Simplify Things

    The IRS rules for calculating the required minimum distribution (RMD) from IRAs and qualified retirement plans provide some longer-term planning advantages.

    For the tax conscious, the premise behind retirement plan distributions is simple -- the longer you are expected to live, the less the IRS requires you to withdraw (and pay taxes on) each year. Because your heirs could inherit this payout schedule along with the assets' tax bill, talk to your tax or financial advisor about how these rules should be applied to best meet your goals and objectives. Keep in mind that if you or your heirs do not withdraw minimum amounts when required, taxes can take half of what should have been withdrawn.

    Stretch Out the Tax Bill

    There are various other ways to make the tax payments on these assets easier for heirs to handle. These are:

    1. Selecting a beneficiary -- If no one is named, your assets could end up in probate and your beneficiaries could be taking distributions faster than they expected. In most cases spousal beneficiaries are ideal, because they have several options that aren't available to other beneficiaries, including the marital deduction for the federal estate tax and the ability to transfer plan assets -- in most cases -- into a rollover IRA.
    2. Consider the options for multiple beneficiaries -- If you want to leave your retirement assets to several younger heirs (such as your children), the IRS has issued "private letter" rulings that suggest that the assets in a stretch IRA may be split into several accounts, each with its own beneficiary. That way, distributions will be based on each beneficiary's age. In addition, the rules provide added flexibility in that beneficiary designations need not be finalized until December 31 of the year following the year of the IRA owner's death for the purposes of determining required distributions. Therefore, an older beneficiary (e.g., a son or daughter of the IRA owner) may be able to either cash out or "disclaim" their portion of the IRA proceeds, potentially leaving the remainder of the IRA proceeds to a younger beneficiary (e.g., a grandchild of the IRA owner). As long as this is done prior to December 31 of the year following the year of the IRA owner's death, distributions will be calculated based on the younger beneficiary's age. Because rules governing use of these strategies are complex, speak with a tax attorney or financial advisor to make sure that correct requirements are followed.
    3. Being generous -- Plan assets given to charity are fully estate tax deductible, and no income tax is due on this gift. You should contact your tax or financial advisor to gain a better understanding of the tax benefits of donating IRA or qualified plan assets to charity.
    4. Consider an irrevocable trust -- Because qualified plan assets qualify for the unlimited marital deduction, spousal beneficiaries may inherit these assets without tax consequences when the assets are left intact as part of the estate. Some estate planning experts have developed strategies using an irrevocable trust. This type of planning is very complex and requires specialized expertise in estate planning.

    Strategies for Spouses

    • Consider a rollover IRA -- With rollover IRAs, you can practice some creative tax planning, such as setting up stretch IRAs for your children or recalculating the distribution schedule for yourself.
    • "Disclaim" IRA assets if you don't need them -- If you are the primary beneficiary of an IRA and your child is the contingent beneficiary, you may be able to disclaim your right to the IRA proceeds. If done so by December 31 of the year following the year after the IRA owner's death, future distributions may be based on your child's age, effectively spreading those distributions out over a longer period of time. Be sure to check with a tax attorney prior to using these strategies.

    Strategies for Nonspouse Beneficiaries

    • With stretch IRAs, don't use your name! -- Under IRS rules, your inherited IRA becomes immediately taxable if you switch the account into your name.
    • Watch the calendar -- The account also becomes immediately taxable if you don't take your first required payout from an inherited IRA by December 31 of the year after the account owner's death.

    Talk to the Right People

    With careful planning, your retirement assets can remain as vital as they had been during your lifetime. Talk with your tax advisor and with those who may bequeath a retirement legacy to you -- such as parents or grandparents -- to see what type of tax planning they've put in place. Opening the doors to this discussion could make your tax burden lighter later on and bring peace of mind to your family.

    Points to Remember

    1. If retirement plan assets aren't bequeathed properly, heirs could lose half of this inheritance to taxes.
    2. The longer your life expectancy is for distribution purposes, the smaller the annual tax bill will be for both you and your heirs.
    3. Some easy ways to make plan distributions more tax efficient for your heirs include opening stretch IRAs, leaving a portion of retirement assets to charity, and transferring assets into an irrevocable trust.
    4. Plan heirs can reduce taxes on inherited plan assets by using rollover IRAs, observing minimum distribution deadlines, and taking special tax deductions, if eligible.
    5. Consult a qualified tax professional to see how the new distribution rules may affect your financial affairs.

    1This example is hypothetical and is not meant to be tax advice. Please contact a tax attorney or financial advisor as to how this information could apply to your situation.

    Because of the possibility of human or mechanical error by S&P Capital IQ Financial Communications or its sources, neither S&P Capital IQ Financial Communications nor its sources guarantees the accuracy, adequacy, completeness or availability of any information and is not responsible for any errors or omissions or for the results obtained from the use of such information. In no event shall S&P Capital IQ Financial Communications be liable for any indirect, special or consequential damages in connection with subscriber's or others' use of the content.

    © 2013 S&P Capital IQ Financial Communications. All rights reserved.

  • Defined Benefit Plans: A Primer for New Sponsors

    Key Points

    • The Modern Defined Benefit Plan -- An Overview
    • Know Your Fiduciary Duties
    • Obtaining Appropriate Professional Support
    • Points to Remember


     To the generations of Americans who came of age before IRA and 401(k) entered the common lexicon, the term "pension" has one simple meaning. It is an employer's promise to pay a retiree a fixed sum on a regular basis for the rest of his or her life. The amount of an employer-paid pension is determined solely by the retiree's earnings while working and length of time on the job. Sometimes, even the retiree's spouse or disabled dependent could count on a lifetime of payments from the plan.


    With the explosion in individualized retirement savings options during the past two decades, the pension concept has been refined; the nomenclature is now "defined benefit retirement plan." For many employees today, the promise of such a benefit -- guaranteed income security for a retirement lifetime -- is still a powerful lure. If you are considering whether to sponsor such a plan, here are some of the issues you will need to consider.

    The Modern Defined-Benefit Plan -- An Overview

    A defined-benefit (DB) plan represents a promise to pay a specified, predetermined amount of money to a retiree periodically for the remainder of his or her life. The amount is computed from a formula you, as plan sponsor, select. This formula should be applied uniformly to all potential participants in the plan, and its terms should be spelled out clearly. Sponsors are required to fund this obligation each year based on the actuarial life expectancy, length of service, and benefit accrual schedule of their plan participants. They are also expected to document the liability each year on their financial reports. As a general rule, a sponsor cannot take away benefits once they are earned. However, a participant may be required to stay on the job for some set period of time before his or her right to benefits becomes vested, and thus irrevocable.

    Assets that are committed to pension benefits are generally held in accounts that are segregated from the general assets of the sponsor. These pension assets are considered property of the plan and are held in trust for the beneficiaries. Thus they are not generally available to meet other business obligations of the sponsor. An independent financial institution typically administers the assets under a trust and custody agreement. While the sponsor may set an investment policy and asset allocation strategy to meet the pension plan's return, risk, and liquidity targets, the day-to-day investment management decisions are generally delegated to professional asset managers selected by the sponsor. Over the lifetime of the plan, sponsors can claim the advantage of any investment earnings in excess of those needed to fund benefits (typically by reducing future sponsor contributions). Sponsors are also liable for any deficits that might emerge when contributions and investment earnings are not sufficient to fully fund payouts.

    Know Your Fiduciary Duties

    When a company offers a pension plan to its employees, the corporation and certain of its designated officials become legally accountable for seeing that the interests of the beneficiaries are always protected. In other words, the company and its officials acquire a fiduciary duty to their plan participants. The complexity of this duty is spelled out in the Employee Retirement Income Security Act of 1974 as amended (ERISA), and the landscape is constantly changing as courts and regulators refine their definitions of key terms. In general, a fiduciary is required to act with care, skill, prudence, and diligence in the interest of plan participants. One key test for fiduciaries is to ensure that all policies in the written plan documents are fairly and consistently executed. Another is to make certain that the plan engages in no transactions that are expressly prohibited by ERISA, such as lending plan funds to the sponsor.

    Obtaining Appropriate Professional Support

    Plan assets should be managed according to the highest professional standards of asset management -- what ERISA calls the "prudent person standard." The portfolio must be properly diversified with investments chosen according to recognized investment styles. The plan cannot generally lend money to or engage in other business dealings directly with the sponsor. Asset managers are often chosen on the basis of their management style through a competitive bidding or consultant-mediated search process.

    The care and safekeeping of plan assets is generally overseen by a commercial bank under a master trust and custody agreement. In addition to the physical safety of any stock and bond certificates, the custodian bank generally settles all securities transactions, collects dividend and interest income, reclaims any withholding taxes, votes proxy ballots, and protects shareholder rights to stock splits and dividends. Plan sponsors themselves are not permitted under ERISA to act as their own custodians.

    Points to Remember

    1. A defined benefit pension is an employer's promise to pay a retired employee a predetermined sum on a periodic basis for the rest of his or her life. The value of the pension is determined by a formula that takes into account the employee's total length of service and earnings.
    2. DB plan funding is controlled by the provisions of ERISA, the basic federal law regulating retirement income plans of all kinds. ERISA requires that a sponsor fund its promised pension benefits each year with payments equal to the present value of the total future benefits earned in that year.
    3. DB assets must be managed professionally according to the highest standards of practice and held in trust at a licensed fiduciary institution.

    Because of the possibility of human or mechanical error by S&P Capital IQ Financial Communications or its sources, neither S&P Capital IQ Financial Communications nor its sources guarantees the accuracy, adequacy, completeness or availability of any information and is not responsible for any errors or omissions or for the results obtained from the use of such information. In no event shall S&P Capital IQ Financial Communications be liable for any indirect, special or consequential damages in connection with subscriber's or others' use of the content.

    © 2013 S&P Capital IQ Financial Communications. All rights reserved.

  • Why Style Matters

    Key Points

    • Large vs. Small Cap
    • Growth vs. Value
    • Domestic/International
    • Active vs. Passive
    • Matching Styles With Plan Offerings
    • Points to Remember


    Retirement plans typically offer a variety of different investments, ranging from conservative money market funds to aggressive growth funds. With the expanded choice of investments that has occurred in recent years, a growing trend has been to offer style-based investment alternatives, permitting participants to specialize or diversify their retirement funds in different investing styles. For plan sponsors, the challenge is to find the right mix of styles -- one that complements the plan's other investment choices while affording a variety of offerings.

    Although there is a wide assortment of investing styles to choose from, the most widely used are based on market capitalization, geographic location, perceived value, and passive/active methodology. Each of these style choices is discussed below.

    Large vs. Small Cap

    Like many other things in life, size matters when investing. Typically, style choices based on market capitalization feature funds invested in small-, medium-, and large-cap companies. During the past 20 years, the highest returns -- on average -- have come from midcap stocks (stocks with market capitalizations between approximately $1 billion and $10 billion). But since these returns tend to run in cycles, there have been periods when large-cap stocks or small-cap stocks have outperformed. Small-cap stocks tend to have the highest price volatility, which translates into higher risk.

    Growth vs. Value

    Growth funds seek companies they expect (on average) to increase earnings by 15% to 25%. Stocks in these companies tend to have high price to earnings ratios (P/E) since investors pay a premium for higher returns. They also pay little or no dividends. The result is that growth stocks tend to be more volatile, and therefore more risky.

    Value funds look for bargains -- cheap stocks that are often out of favor, such as cyclical stocks that are at the low end of their business cycle. A value fund manager is primarily attracted to asset-oriented stocks with low prices compared to underlying book, replacement, or liquidation values. Value stocks also tend to have lower P/E ratios and higher dividend yields. These higher yields tend to cushion value stocks in down markets while certain cyclical stocks will lead the market following a recession.

    Returns on growth stocks and value stocks may not be correlated. This means that an increase or decrease in returns on one style may occur independently of the variations in the other style.

    Domestic/International

    Geographic location also represents a style choice of sorts, in that international stocks carry different risks than domestic stocks and tend to perform differently since their economic fundamentals vary from country to country. International funds vary -- some invest only in stocks of a particular region or country, while others invest broadly across many international markets. Still others -- global funds -- represent a cross between domestic and international funds. In addition to the normal risks of equity investing, international funds carry unique risks such as currency fluctuation and political risks. For this reason, they tend to be more volatile than their domestic counterparts. Nonetheless, international funds can be included in more comprehensive plans where sponsors wish to offer participants ways to hedge against domestic economic and market movements.

    Active vs. Passive

    Increasingly popular among plan investment selections are passive, or index funds. These funds seek to mirror the performance of a particular index such as the S&P 500 or Russell 2000. The theory behind passive funds is that over time, all information available about a company is reflected in that company's current stock price, and it's impossible to predict and profit on future stock prices. Rather than trying to second-guess the market, passive investors buy the entire market via index funds.

    Matching Styles With Plan Offerings

    Which fund styles should you incorporate in your retirement plan? This will depend on your specific plan, how many choices you wish to offer, and what degree of flexibility you wish to afford to plan participants. Most plan offerings include at least some portion of their more aggressive offerings in capitalization-based funds. Often, these are combined with a growth or value style.

    Index funds can also be an attractive alternative because of their low fees. Because indexes are followed so widely, participants need look no further than their local paper to get an idea how their investment is faring.

    But regardless of which styles you choose, a primary consideration should be in providing diversification to participants' retirement portfolios. In order to reduce volatility, many experts encourage diversifying based on investment style. By diversifying between different styles, plan participants can decrease risk and still enjoy high long-term return potential.

    Points to Remember

    1. A growing trend among employer-sponsored retirement plans has been to offer style-based investment alternatives, permitting participants to specialize or diversify their retirement funds in different investing styles.
    2. Capitalization-based styles -- small-, mid-, and large-cap -- carry different levels of risk and volatility and tend to perform differently in different phases of the business cycle.
    3. Growth investors seek companies with high-growth earnings, while value investors seek bargain stocks that may be out of favor, such as cyclical stocks that are at the low end of their business cycle.
    4. International funds carry unique risks, but offer participants ways to hedge against domestic economic and market movements.
    5. Passive funds seek to mirror the performance of a particular index such as the S&P 500 and offer low fees as well as performance accessibility.
    6. Regardless of which styles you choose, a primary consideration should be in providing diversification to participants' retirement portfolios.

    Because of the possibility of human or mechanical error by S&P Capital IQ Financial Communications or its sources, neither S&P Capital IQ Financial Communications nor its sources guarantees the accuracy, adequacy, completeness or availability of any information and is not responsible for any errors or omissions or for the results obtained from the use of such information. In no event shall S&P Capital IQ Financial Communications be liable for any indirect, special or consequential damages in connection with subscriber's or others' use of the content.

    © 2013 S&P Capital IQ Financial Communications. All rights reserved.

  • The Investment Policy Statement — A Firm Foundation for Monitoring and Control

    Key Points

    • What Exactly Is an Investment Policy Statement?
    • Why Have an Investment Policy Statement?
    • What Should Be Included in an Investment Policy Statement?
    • Other Considerations
    • Points to Remember


    As a retirement plan sponsor, you face a number of questions when deciding how your plan will be managed. What types of investment options will you offer in the plan? What are the long-term funding goals? What are the short-term liquidity needs? How will you evaluate funds and managers on an ongoing basis? To answer these and other questions, many plan sponsors create an investment policy statement (IPS), a document which defines investment policy and procedures and often serves as a road map for your plan.

    What Exactly Is an Investment Policy Statement?

    It's a document created by plan sponsors that provides written guidelines for trustees, fiduciaries, and investment managers who make important decisions about the plan. Defining specific parameters for funding objectives, investment selection, risk management, and evaluation procedures, the statement gives employers the tools they need to adequately manage the plan. It also helps define goals and outlines the benchmarks with which to compare investment results.

    Why Have an Investment Policy Statement?

    The purpose of the IPS is to provide the fiduciaries with guidance in discharging certain fiduciary responsibilities -- and may even help protect them in some circumstances. The IPS can also serve to fulfill certain ERISA (Employee Retirement Income Security Act) requirements concerning fund selection, participant investment discretion, and participant communications. Above all, the investment policy statement is critical to establishing broad investment goals and funding requirements, as well as defining exactly how plan funds will be administered.

    What Should Be Included in an Investment Policy Statement?

    While there is no official set of standards specifying exactly what is included in an IPS or how it is organized, typical statements usually contain three fundamental areas: plan description and objectives; investment structure and selection criteria; and ongoing monitoring and evaluation processes.

    Plan description and objectives can be viewed as a plan overview or executive summary of the IPS. This section generally contains such information as the overall plan purpose or objectives, summary plan information (plan name, type, participant eligibility, plan fiscal year, etc.); a summary of plan options available to employees; and a summary of the investment selection process. It may also identify the plan's board or oversight committee and the role of this committee in choosing/monitoring or changing investments (although this can be detailed elsewhere in the document). This section also typically includes a statement of the plan's intention to meet ERISA requirements. Investment structure and selection criteria is the section of the IPS that spells out in detail all matters concerning investment selection including:

    Investment structure: This section defines the number and types of investment options available in the plan. For instance, will there be a core group of funds? Will the plan feature lifestyle or risk-level portfolios? Will plan investment options be tiered among different employees? Will the plan feature an asset allocation approach? Will the plan contain a brokerage fund option? Will the plan feature company stock? How often will plan participants be permitted to change their plan holdings and what restrictions will apply?

    Selection criteria: This section should give working guidelines to fiduciaries or plan administrators as to how to choose an investment management firm or individual investments for the plan. For example, what specific criteria should be taken into consideration (fund performance, management tenure, fees, maximum allowable position, and a host of other information) when choosing a fund? Or, what factors should be considered when gauging the suitability of a particular management firm?

    Selection process: This section identifies the plan oversight committee and its role in selecting/approving investments. Items such as meeting frequency and approval levels should also be addressed here.

    Keep in mind that the more specific the information and guidelines in each section are, the more accurate a guide the IPS will be for present and future fiduciaries.

    Ongoing monitoring and evaluation. This section focuses on the ongoing monitoring of funds and fund managers. Issues such as oversight committee meeting frequency and purpose, periodic realignment of plan holdings, style drift, fund performance assessment, and substitution policies can all be addressed here.

    The nature and frequency of participant communications should also be included in this section. Should there be a regular plan newsletter? How will plan changes be communicated? How often are plan statements sent out? Do you wish to provide online access to employees? These are all questions that you should consider here.

    Other Considerations

    When making the many decisions that are required to put together an IPS, always keep in mind employee needs and preferences, since they are ultimately what will drive plan participation levels. Periodic employee surveys or e-mail bulletin boards are commonly used tools to help gauge employee sentiment. And, before drafting your IPS, you'll want to consult qualified legal counsel. You may also wish to review ERISA regulations. ERISA, along with the Internal Revenue Code, sets the legal framework within which all employer sponsored retirement plans must operate. ERISA section 404c sets forth guidelines for plan sponsors and others regarding educating employees about plans and disclosing plan and investment information.

    Points to Remember

    1. An investment policy statement is a document created by plan sponsors that provides written guidelines for trustees, fiduciaries, and investment managers who make important decisions about the plan.
    2. In addition to providing guidance to plan administrators, an IPS provides some legal protection to fiduciaries and can be used to fulfill certain ERISA requirements.
    3. While there is no official set of standards specifying exactly what is included in an IPS or how it is organized, statements typically contain three fundamental areas: plan description and objectives; investment structure and selection criteria; and ongoing monitoring and evaluation processes.
    4. The more specific the information and guidelines in each section are, the more accurate a guide the IPS will be for present and future fiduciaries.
    5. When putting together an IPS, it's wise to first gauge employee needs and preferences. You'll also want to review ERISA regulations and consult qualified legal counsel.

    Because of the possibility of human or mechanical error by S&P Capital IQ Financial Communications or its sources, neither S&P Capital IQ Financial Communications nor its sources guarantees the accuracy, adequacy, completeness or availability of any information and is not responsible for any errors or omissions or for the results obtained from the use of such information. In no event shall S&P Capital IQ Financial Communications be liable for any indirect, special or consequential damages in connection with subscriber's or others' use of the content.

    © 2013 S&P Capital IQ Financial Communications. All rights reserved.

  • Company Size – Why Market Capitalization Matters

    Key Points

    • Sizing Up Stocks
    • Who'll Lead the Pack Next?
    • Evaluating Risk and Reward Potential
    • Measuring Returns – Using a Proper Index
    • Selecting the Right Combination
    • Points to Remember


     Stocks represent ownership in companies of various sizes. Some may be corporate giants with household names like Microsoft and General Electric. Others may be industry newcomers with revenue and resources a fraction the size of their larger brethren, but with the potential for rapid growth, as well as greater risk.

    Understanding the relationship between company size, return potential, and risk is crucial if you're creating an investment strategy designed to help you pursue long-term financial goals. With that knowledge you'll be better prepared to build a balanced stock portfolio that comprises a mix of market caps.

    Sizing Up Stocks

    Typically, companies are categorized in one of three broad groups based on their size – large-cap, midcap, and small-cap. Cap is short for market capitalization, which is the value of a company on the open market. To calculate a company's market capitalization, multiply its stock's current price by the total number of outstanding shares. For example, if a company issues one million shares of stock trading for $50 each, its market capitalization would be $50 million ($50 times 1,000,000 shares).

    Definitions of the different market-cap categories may differ—from one mutual fund company to another, for instance—but here are some examples:

    • Large-cap company – market value of $10 billion or more.
    • Midcap company – market value between $3 billion and $10 billion.
    • Small-cap company – market value of $3 billion or less.

    Corporations with valuations of less than $1 billion are sometimes referred to as microcap companies. Of course, companies often grow and shrink in size with the passage of time. Microsoft, today one of the world's largest companies, was once run on a shoestring. And given the changing nature of the marketplace, who knows what tomorrow may bring?

    Evaluating Risk and Reward Potential

    Generally, market capitalization corresponds to where a company may be in its business development. So a stock's market cap may have a direct bearing on its risk/reward potential for investors looking to build a diversified portfolio of investments.

    Large-cap stocks are generally issued by mature, well-known companies with long track records of performance. Large-cap stocks known as "blue chips" often have a reputation for producing quality goods and services, and a history of consistent dividend payments and steady growth. Large-cap companies are often dominant players within established industries, and their brand names may be familiar to a national consumer audience. As a result, investments in large-cap stocks may be considered more conservative than investments in small-cap or midcap stocks, potentially posing less risk in exchange for less aggressive growth potential.

    Who'll Lead the Pack Next?

    In recent years, small-cap indexes have outperformed large-cap indexes, although historically, they have taken turns leading the market. This chart ranks them in order of performance, from first place to third. Given the results, it may make sense to establish a diversified portfolio of investments representing different market capitalizations.
    S&P 500 S&P MidCap 400 S&P SmallCap 600
    2003 3 2 1
    2004 3 1 2
    2005 3 1 2
    2006 1 3 2
    2007 2 1 3
    2008 3 2 1
    2009 2 1 3
    2010 3 2 1
    2011 3 2 1
    2012 3 2 1
    Source: Standard & Poor's. Based on average annual total returns for the 10-year period ended December 31, 2012. Large-cap stocks are represented by the S&P 500; midcap stocks by the S&P Midcap 400 Index; and small-cap stocks by the S&P SmallCap 600 Index. Unmanaged indexes do not take into account the fees and expenses associated with investing, and individuals cannot invest directly in any index. Past performance cannot guarantee future results.

     

     Midcap stocks are typically issued by established companies in industries experiencing or expected to experience rapid growth. These medium-sized companies may be in the process of increasing market share and improving overall competitiveness. This stage of growth is likely to determine whether a company eventually lives up to its full potential. Midcap stocks generally fall between large caps and small caps on the risk/return spectrum. Midcaps may offer more growth potential than large caps, and possibly less risk than small caps.

    Small-cap stocks are issued by young companies that generally serve niche markets or emerging industries, such as those in the technology sector. Small caps are considered the most aggressive and risky of the three categories. The relatively limited resources of small companies can potentially make them more susceptible to a business or economic downturn. They may also be vulnerable to the intense competition and uncertainties characteristic of untried, burgeoning markets. On the other hand, small-cap stocks may offer significant growth potential to long-term investors who can tolerate volatile stock price swings in the short term.

    Measuring Returns – Using a Proper Index

    A standard method of gauging the performance of an investment is to measure its returns against those of an index representing similar investments. Like stocks, indexes come in all sizes and shapes. Depending on its objective, an index may represent the performance of a limited number or a wide range of stocks from different sectors, industries, or geographic regions of the country or world. Among the most recognizable "market-cap" index providers are Standard & Poor's and Russell Investment Group.

    To adequately measure how well or poorly an investment is doing, an index must represent equities that are comparable in nature to those under evaluation. It wouldn't be accurate to use a small-cap index to assess the performance of large-cap stock fund or vice versa, for example.

    The Russell 2000 is a prominent index for small-cap stocks, while the Russell 1000 represents large-cap stocks. The S&P 500 is among the best known yardsticks for large-cap stocks. As their names suggest, the S&P MidCap 400 and S&P SmallCap 600 indexes represent midcap and small-cap stocks, respectively. One of the oldest benchmarks, the Dow Jones Industrial Average, represents the performance of 30 of the nation's most revered blue-chip stocks. Although the Dow is frequently referred to by the popular press, it represents only a tiny fraction of the stocks traded daily in the United States.

    Each group of stocks may be influenced differently by current market conditions, underscoring the importance of diversification and the need to compare apples to apples. Individuals cannot invest directly in any index.

    Selecting the Right Combination

    So what does a company's size have to do with your investment strategy? Quite a bit. Over time, large-cap, midcap, and small-cap stocks have tended to take turns leading the market (see table). Each can be affected differently by market or economic developments. That's why many investors diversify, maintaining a mix of market caps in their portfolios. When large caps are declining in value, small caps and midcaps may be on the way up and could potentially help compensate for any losses.

    To build a portfolio with a proper mix of small-cap, midcap, and large-cap stocks, you'll need to evaluate your financial goals, risk tolerance, and time horizon. A diversified portfolio that contains a variety of market caps may help reduce investment risk in any one area and support the pursuit of your long-term financial goals.

    Keep in mind, diversification does not eliminate risk or the risk of potential loss.

    Points to Remember

    1. Company size is often referred to as market capitalization, which is the value of a company on the open market.
    2. Market cap definitions vary, but in general large-cap companies have a cap of $10 billion or more; midcap companies have a cap between $3 billion and $10 billion; and small-cap companies have a cap of $3 billion or less.
    3. A stock's market cap may have a direct bearing on its risk/reward potential.
    4. A diversified portfolio that contains a mix of market caps may help reduce investment risk in any one area and support the pursuit of long-term financial goals.
    5. It's important to use the right index when gauging the performance of an investment in a particular market-cap category.

    Because of the possibility of human or mechanical error by S&P Capital IQ Financial Communications or its sources, neither S&P Capital IQ Financial Communications nor its sources guarantees the accuracy, adequacy, completeness or availability of any information and is not responsible for any errors or omissions or for the results obtained from the use of such information. In no event shall S&P Capital IQ Financial Communications be liable for any indirect, special or consequential damages in connection with subscriber's or others' use of the content.

    © 2013 S&P Capital IQ Financial Communications. All rights reserved.

  • Is Education Enough? Developing a Plan Communication Strategy

    Key Points

    • Basic Guidelines You Should Keep
    • Advice on Advice
    • Points to Remember


     In recent years, plan sponsors have seen participation and contribution levels dwindle in the face of economic uncertainty and a volatile stock market. In this environment, educating participants about the specifics of a plan may not be enough. What is often needed is a more comprehensive communications strategy. But what does such a strategy entail and how do you go about implementing it?

    Basic Guidelines You Should Keep

    There is no one formula for a successful plan communications strategy. Every plan differs from the next, and each has its specific terms and participant priorities. Yet there are certain basic guidelines you should keep in mind when creating any plan communication program:

    1. Set goals, objectives, and time frames. Document broad goals, specific objectives that will contribute to the achievement of each goal, and time frames for each objective. This document -- sometimes called a creative brief -- provides the framework or roadmap for the overall program.
    2. Gauge your audience. Marketing communications professionals utilize a myriad of sophisticated tools -- from direct mail campaigns and telephone surveys to focus groups -- to help them understand their audience better. For an individual plan sponsor, an ideal way to get to know your audience is to interview employees. Identify their needs and concerns, which should drive the type, nature, and frequency of plan communications.
    3. Tailor the message. As the Department of Labor's Working Group on Planning for Retirement found in its year-long study on how Americans plan for retirement, participants must be able to relate to the message in order to understand it. Communications need to be as personally relevant as possible. For example, income tax reduction generally is not a motivating message to low and moderate income earners, but ease of saving and the effects of long-term compounding are. For this reason, the most effective communications programs are also the most easily modified for different audiences. An ongoing educational campaign, for instance, may include an online newsletter that has different content for various age groups.
    4. Keep it simple. Follow the advice preached in most advertising and marketing communications courses -- that is, keep it simple. As William M. Mercer's Michael McCallister testified to the Department of Labor, most plan participants today are "drowning in information, starving for knowledge."
    5. Measure success. This is perhaps the most commonly overlooked step in any communications campaign. Plan sponsors need to measure levels of participation at the onset of a program and then monitor changes throughout its implementation phase. This is again where flexibility becomes important: If participation is not improving, alterations may be needed to better target low-level and non-participants.The Profit Sharing/401(k) Council of America offers a simple worksheet designed to help plan sponsors measure the success of their communications program. It is available online at www.psca.org.
    6. Choose your format. Finally, when developing a communications program, one must consider whether Internet delivery is the best medium. While no on design and quantity. However, once again, this is an area where the communications program professional needs to understand his/her audience in order to reach them in the most effective manner. Unless the entire audience has access to the Internet, even the most creative, targeted, well-conceived communications program will produce limited results.

    Advice on Advice

    In recent years, there has been a growing demand for employers to provide work-based financial advice to their employees on plan investments. At the same time, plan sponsors have agonized over whether providing advice would expose them to increased liability. Although the Department of Labor has cleared the way for investment companies to offer advice to participants via third-party providers, the trend has yet to thoroughly take hold.

    Despite the ongoing debate, most industry observers believe that personalized communication is clearly the best option for employees -- one-on-one advice being the ideal. But for most plan sponsors, this is a cost-prohibitive benefit to extend to any but the most key employees. The next-best option that likely fits most communication budgets may be simplified, personalized recommendations such as asset allocation models that use a series of easy-to-answer questions in an interactive worksheet that takes into consideration an employee's larger financial picture.

    Points to Remember

    1. Plan participant education is necessary, but often not enough to boost plan participation levels.
    2. While there is no one formula for a successful plan communications strategy, there are certain basic guidelines to keep in mind when creating any plan communication program.
    3. A successful program will be tailored to the specific needs and demographics of its audience.
    4. Avoid providing plan participants with too much information; when designing a communications program, remember to keep it simple.
    5. Including investing advice in your communications program can be an attractive, if costly, feature for a plan. Personalized communications and asset allocation worksheets can be a less expensive alternative.

    Because of the possibility of human or mechanical error by S&P Capital IQ Financial Communications or its sources, neither S&P Capital IQ Financial Communications nor its sources guarantees the accuracy, adequacy, completeness or availability of any information and is not responsible for any errors or omissions or for the results obtained from the use of such information. In no event shall S&P Capital IQ Financial Communications be liable for any indirect, special or consequential damages in connection with subscriber's or others' use of the content.

    © 2013 S&P Capital IQ Financial Communications. All rights reserved.

  • A Primer on International Investments

    Key Points

    • International Opportunities
    • Types of International Funds
    • Different Approaches to International Asset Allocation
    • Short- and Long-Term Performance of Foreign Stocks
    • Tax Aspects of Foreign Investments
    • Points to Remember


    International investments may offer investors opportunities to diversify their portfolios while seeking to enhance returns. Because foreign stock and bond markets can potentially move independently from the U.S. financial markets -- when domestic stock prices are falling, other markets may be posting gains, for example -- U.S. investors may help reduce overall portfolio risk by investing abroad. In addition, international investments provide exposure to opportunities that U.S.-only investments overlook, including some of the world's largest companies.

    If you are investing for long-term goals, you may want to include international investments in your portfolio. These investments carry more risks than domestic investments, including currency risk and political risks, and less liquidity. However, when combined with domestic investments in a diversified portfolio, they may potentially help smooth out your overall portfolio volatility. Before deciding whether international investments are right for your goals and risk tolerance, you may want to consult a financial professional.

    International Opportunities

    Individuals may invest directly in stocks of foreign companies by purchasing shares on a foreign stock exchange or by purchasing American Depositary Receipts (ADRs) listed on U.S. exchanges. Managed investments include global, regional, and country-specific mutual funds, and, for high-net-worth investors, separately managed accounts.

    Investing directly in foreign stocks poses several challenges. Industry and company research on potential investments may not be readily available to individuals. In addition, many foreign companies do not follow U.S. accounting standards, making it more difficult for investors to evaluate and compare company financial statements. Direct investors may also need to commit substantial funds in order to build a diversified international portfolio.

    Mutual funds offer professional management and, depending on the fund's objective, immediate diversification among companies in many different countries or industries. In selecting individual securities, fund portfolio managers may draw on the investment firm's proprietary in-house research as well as analysis conducted by independent research firms. Portfolio managers may also meet regularly with the management of companies that they invest in as well as the firm's customers and suppliers in order to gather information about the company's business prospects and assess the strength of its management team.

    Global funds invest in foreign and domestic markets, while international funds invest only in developed foreign markets. Some funds invest only in a single country or region of the world. Emerging market funds focus on investments in smaller, less-developed countries.1 Funds may also be defined by investment style, such as index, growth, or value.

    Unmanaged exchange-traded funds are another option for investors seeking exposure to specific foreign markets. Some ETFs allow investors to purchase shares representing a basket of stocks included in a single country index.2 They offer low transaction costs3, readily available pricing, and the ability to trade on margin or to sell shares short.4


    Types of International Funds

    • Developed Single Country
    • Emerging Single Country
    • Global Equity
    • International Equity
    • International Balanced
    • International Sector
    • Developed Regional
    • Emerging Regional
    • Global Bond
    Source: Standard & Poor's.

    Different Approaches to International Asset Allocation

    Some diversified international mutual funds seek to invest in a variety of national markets using the Morgan Stanley Capital International EAFE index as a benchmark. Portfolio country weightings may reflect those of the EAFE index, which are based on each country's total market capitalization. However, some investment professionals believe that diversification may be enhanced by allocating assets among different industry groups around the world rather than just targeting individual countries: for example, investing in pharmaceutical companies in different countries.6

    What's behind this approach? During the 1990s, the reduction in trade barriers, the formation of the European Monetary Union, and increasing globalization contributed to higher correlations between price movements in different countries. Higher correlations reduce potential diversification benefits. Therefore, some strategists argue, it may potentially be beneficial to invest across industry groups with lower correlations. However, keep in mind that this is just one approach to international investing, and it may not be right for every investor.

    Short- vs. Long-Term Returns of International Stocks

    This chart shows the annual total returns of international stocks during each of the past 25 years compared with the 25-year average annual total return (7.63%). Long-term investors should be aware of the potential for short-term volatility with international investments, but may also want to focus on their long-term potential.
    Source: Standard & Poor's. Foreign stocks are represented by the calendar-year returns of the Morgan Stanley Capital International Europe, Australasia, and Far East (EAFE) Index, an unmanaged index that is generally considered representative of developed foreign markets. Returns include reinvested dividends. Past performance is not a guarantee of future results. Individuals cannot invest directly in any index. The performance shown is for illustrative purposes only and is not indicative of the performance of any specific investment. (CS000174)

    Tax Aspects of International Investments

    Earnings and capital gains on international investments are subject to income taxes assessed by foreign governments as well as U.S. income taxes. If you invest in international funds, you will receive a statement showing the amount of foreign taxes paid on your shares. The United States has tax treaties with many individual countries, which may allow you to claim a credit on your U.S. tax return for taxes paid abroad. If you invest directly in foreign markets, you are responsible for meeting the tax filing requirements in each country in which you invest. Be sure to consult with tax and financial advisors about the suitability of international investments for your portfolio.

    Points to Remember

    1. International investments carry higher risks, including currency risk, political risk, and less liquidity. Combining foreign and domestic investments in a portfolio may potentially help lower volatility compared to a purely domestic portfolio.
    2. With many of the world's largest companies located outside of the U.S., international investments offer individuals unique opportunities to invest in leading companies and industries.
    3. Individuals may invest directly in foreign markets or through mutual funds.
    4. Global funds include both foreign and U.S. securities. International funds invest only in foreign securities. Emerging market funds invest in companies in smaller, less-developed countries.

    1Emerging markets are generally more volatile than the markets of more-developed foreign nations, and therefore you should consider this increased market risk carefully before investing. Investors in international securities may be subject to higher taxation and higher currency risk, as well as less liquidity, compared with investors in domestic securities. Returns are in U.S. dollars and reflect effects of currency fluctuations.

    2ETF prices change throughout the trading day, and the investor may not be able to realize a quoted price. Purchase and sale of ETF shares may involve brokerage trading commissions. These commissions are not typically included in the ETF expense calculations. Returns reported on ETF investments do not reflect the impact of any brokerage commissions incurred in the purchase or sale of ETF shares.

    3The frequent trading of ETFs could significantly increase costs such that they may offset any savings from low fees or costs.

    4You can lose more funds than you deposit in the margin account. The firm can force the sale of securities or other assets in your account(s). The firm can sell your securities or other assets without contacting you. You are not entitled to choose which securities or other assets in your account(s) are liquidated or sold to meet a margin call. The firm can increase its "house" maintenance margin requirements at any time and is not required to provide you advance written notice. You are not entitled to an extension of time on a margin call. "Short selling" is a strategy that involves selling something that you do not already own. Short selling is extremely risky. Be cautious of claims of large profits from short selling. Short selling requires knowledge of securities markets; requires knowledge of a firm's operations; and may result in your paying larger commissions. Short selling on margin may result in losses beyond your initial investment.

    5Diversification does not ensure against loss.

    Because of the possibility of human or mechanical error by S&P Capital IQ Financial Communications or its sources, neither S&P Capital IQ Financial Communications nor its sources guarantees the accuracy, adequacy, completeness or availability of any information and is not responsible for any errors or omissions or for the results obtained from the use of such information. In no event shall S&P Capital IQ Financial Communications be liable for any indirect, special or consequential damages in connection with subscriber's or others' use of the content.

    © 2013 S&P Capital IQ Financial Communications. All rights reserved.

  • Investing in Stocks

    Key Points

    • Public Ownership of a Company
    • Why Stocks?
    • Ways of Categorizing Stock Investments
    • Investing in Stocks
    • Points to Remember


     Once the province of the rich, stock ownership today is widespread, with over half of American households invested in stocks through pension plans, retirement funds or direct ownership. But just what is the stock market and what is involved in investing in stocks?

    Public Ownership of a Company

    Stock represents ownership of a company. If a company is privately held, then its stock may be owned by only a few individuals and is not available for purchase by the public. If a company is publicly held, then its stock can be purchased through stockbrokers by individual investors and institutions alike. Corporations can issue different types of stock, but the most typical is common stock. By investing in stock, you stake a claim in the future of that company and the potential investment return that it may bring. With potential reward, however, you also have all the risks associated with owning a company. If a company is forced to liquidate, it is first obligated to pay its creditors, bondholders, and those who hold preferred stock (a limited issue stock that does not hold voting rights), before those who own common stock.

    As a shareholder of common stock, you have voting rights on issues such as election of a board of directors and other important issues affecting the direction of the company. Shareholders may also receive dividends, which are paid to shareholders from the company's earnings. The amount of the dividend is decided by the board of directors and is based on what portion of earnings needs to be reinvested in the growth of the company and what portion can be distributed to shareholders.

    Why Stocks?

    Stocks carry higher investment risks than bonds or money market investments, but they also have historically realized higher rates of return over longer holding periods (see chart). While past performance doesn't guarantee future results, the higher return potential of stocks can make them ideal investments for long-term investors seeking to build the value of their portfolios or to stay ahead of inflation. Both of these objectives are critical to investors with specific long-term goals in mind, such as saving for retirement.

    In deciding to invest in stocks, investors must weigh the potential risk of loss of principal against the risk of not meeting their investment goals or of losing purchasing power to inflation. Stock investors can also manage risk by:

    • Diversifying among stocks of many different companies. Investing in just one or two stocks is generally much more risky than buying stocks of 15 or 20 companies. By holding stocks of different companies in several industries, you reduce your exposure to a substantial loss due to a price decline in just one stock. Remember, diversification does not eliminate risk.
    • Allocating assets appropriately. Asset allocation refers to how you spread your portfolio among different types of investments -- such as stocks, bonds, and money market investments. An aggressive investor with a long-term horizon might choose to keep 80% of his or her portfolio in stocks, for example, with the remaining 20% in bonds and money market funds.1This adds yet another level of diversification to the portfolio and can further reduce investment risk. Your financial advisor can help you select an asset allocation that is appropriate for your goals and time frame.
    • Staying invested through periods of market turbulence can also help reduce risk of loss as the variability of returns tends to decrease over time.

    Average Rates of Return

    Average Rates of Return

    Consider how various stocks have performed versus other investments over the 30 years ended December 31, 2012.

    Large-cap stocks are represented by the S&P 500 index. Midcap stocks are represented the S&P MidCap 400 index. Small-cap stocks are represented by a composite of the CRSP 6th-10th decile portfolios and the S&P Small Cap 600 index. Foreign stocks are represented by the MSCI EAFE Index. Bonds are represented by the Barclays U.S. Aggregate index. Cash is represented by a composite of yields of 3-month Treasury bills and the Barclays 3-Month Treasury Bills index. Based on average 12-month total returns from 1983-2012, which assumes reinvestment of all investment proceeds. Different investments offer different levels of potential return and market risk. International investors are subject to higher taxation and currency risk, as well as less liquidity, compared with domestic investors. Midcap stocks and small-cap stocks are generally subject to greater price fluctuations than large-cap stocks. Bonds represent a contractual obligation for timely payment of principal and interest. Investors cannot invest directly in any index. Index performance does not represent the performance of any actual investment and does not account for any fees, expenses, and taxes that might be incurred by investors. Past performance does not guarantee future results.(CS000168)

    Ways of Categorizing Stock Investments

    Company Size The market value (capitalization) of a company determines whether it is considered a large-cap, midcap, or small-cap stock.
    Growth Stocks of fast-growing companies (in general, companied expected to increase earnings by 15% or more per year).
    Value Stocks of companies that are priced near or below their intrinsic value (with little growth in earnings assumed) are called value stocks. They may or may not be bargains, however, depending on whether their prices subsequently recover.
    International Developed Stocks of companies headquartered outside the United States in industrialized countries.
    Emerging Market Stocks of companies headquartered in underdeveloped, fast-growing countries.
    Industry Sector Type of industry, such as technology, energy, or cyclicals.

    Investing in Stocks

    Individuals can buy stocks directly or through mutual funds and other pooled investment products. An employee may also have an opportunity to buy stock in his or her company through a company stock purchase plan or retirement plan.

    Many financial analysts believe that most people can best access the stock market by buying shares of mutual funds that invest in stocks. There are thousands of mutual funds available today that invest in a variety of stock market categories and sectors. Mutual funds offer the potential advantages of professional money management, diversification, and liquidity. These advantages are particularly apparent when investing in international and emerging market stocks, which are often less accessible to individual investors. Your financial advisor can help you assess which types of mutual funds may be suitable for your portfolio.

    When it comes to investing in stocks, there's a variety of information available on public companies that may help you understand their financial positions. This information includes:

    Price Range -- The price of a stock is determined according to the rules of supply and demand. Tracking the price over time can give you a partial picture of the company and its recent performance. Daily information in national newspapers includes the high and low price for the stock in the previous 52 weeks.

    Price to Earnings Ratio -- This number, which is derived by dividing the stock price by the company's earnings per share, is used to determine what an investor is paying for the earning power of the company. It is one figure that can be used in comparing the value of several companies even though their prices may be vastly different.

    Dividend Yield -- The dividend yield, determined by dividing the amount of the dividend by the share price, simply indicates what percent return the company is paying its investors. National newspapers report the return on both the initial investment at the time of the first public offering and the return on the current value of the stock. This number can also be used in a comparison of companies.

    Payout Ratio -- This figure represents the percentage of earnings a company is paying out to its investors. It is an indication of whether most of a company's earnings are being paid to its investors or whether they are being reinvested in the growth of the company.

    In addition, a fundamental approach to stock investing considers the following questions: How does the company compare to its competitors in earnings growth and profitability? Are there any outside factors such as government regulations that may affect the entire industry? What is the projected demand for the company's product? Is the industry a cyclical one, i.e., does it move up and down in cycles? What are management's goals and how are they going to achieve them?

    Because of their long-term potential, stocks have a place in nearly every portfolio. Speak with your financial advisor about how you can use equity investing to help meet your financial goals.

    Points to Remember

    1. Stock represents the shares of ownership in a company.
    2. By investing in stock, you stake a claim in the future of that company.
    3. As a shareholder of common stock, you have voting rights.
    4. Shareholders may receive dividends, which may be paid to shareholders from the company's earnings.
    5. Your financial advisor can help you decide which stocks are right for you.

    1This allocation is presented only as an example and is not intended as investment advice. Your own allocation will depend on your specific circumstances.

    Because of the possibility of human or mechanical error by S&P Capital IQ Financial Communications or its sources, neither S&P Capital IQ Financial Communications nor its sources guarantees the accuracy, adequacy, completeness or availability of any information and is not responsible for any errors or omissions or for the results obtained from the use of such information. In no event shall S&P Capital IQ Financial Communications be liable for any indirect, special or consequential damages in connection with subscriber's or others' use of the content.

    © 2013 S&P Capital IQ Financial Communications. All rights reserved.

  • A Look at Mutual Fund Categories

    Key Points

    • Categories for Different Needs
    • Choose Funds That Match Your Goals
    • Watch Your Basket
    • Points to Remember


    With thousands of mutual funds available today, selecting the most suitable ones for your portfolio is a tricky business. Overwhelmed by the sheer number of funds, new investors understandably may be confused. People invest in mutual funds mainly because they don't have time to examine hundreds of individual securities, yet selecting specific mutual funds isn't any easier.

    True, picking the right funds will take some time. But once you have some understanding of the different fund categories -- which determine the kinds of securities that fund managers select for their funds -- the industry's messy and seemingly endless differentiation will clarify itself. You can then devise a mutual fund investment strategy that will work for you, bearing in mind your time horizon and ability to withstand fluctuations in the value of your portfolio.

    Categories for Different Needs

    Despite the fund industry's endless differentiation, equity mutual funds boil down to four large groups: aggressive growth funds, growth funds, growth and income funds and sector funds. Besides those, there are also categories of bond funds, money market funds, and global and international funds. Additionally, there are multiple asset class funds such as balanced, allocation and target-date funds.

    • Aggressive growth andsmall-cap funds are among the most aggressive equity funds. Aimed at maximizing capital gains, these funds invest in companies with the potential for rapid growth (companies in developing industries, small but fast-moving companies, or companies that have fallen on hard times but appear due for a turnaround). Some aggressive growth funds use several investment strategies -- which may include options and futures -- in an effort to achieve superior returns. These funds can be very volatile in the short term, but in the long run they may offer the potential for above-average capital appreciation. Aggressive growth funds are generally more suitable for long-term investors with a time horizon of 10 years or longer.
    • Growth funds also strive for capital appreciation by investing in companies that are positioned for strong earnings growth. Funds in this group vary widely in the amount of risk they take. But in general, they are less risky than aggressive growth funds because they normally invest in well-established companies. Growth funds may entail less volatility than aggressive growth funds, but also less potential for capital appreciation. Neither aggressive growth funds nor growth funds strive for dividend income. In fact, the companies they invest in often do not pay dividends to their shareholders, but reinvest the earnings to fuel future growth.
    • Growth and income funds strive for both dividend income and capital appreciation by investing in companies with solid records of dividend payments and capital gains. Some growth and income funds emphasize growth while others emphasize income. Growth and income funds may be less risky and less volatile than pure growth funds but may also offer less potential for capital appreciation.
    • Balanced funds offer one-stop shopping by combining stocks and bonds in a single portfolio. Balanced funds are more conservative than the previously discussed categories and usually invest in blue-chip stocks and high-quality taxable bonds. They may potentially hold up better in rough markets, because when their stock investments fall, their bonds may do well, and vice versa. Because they offer diversification, balanced funds are often suitable for people with a small amount of cash to invest.
    • Sector funds concentrate on one industry (such as technology, financial services, or consumer goods) or focus on certain commodities (such as gold, gas, or oil). Selected by more experienced investors who are willing to pay close attention to the market, sector funds are less diversified than the broader market and hence are often more volatile.
    • Bond funds can be divided into four broad categories: tax-exempt, taxable, high quality, and high yield. Within these categories, funds are also segmented by maturities, type of issuer, and credit quality of bonds in which they invest.Tax-exempt bond funds buy bonds issued by state and municipal agencies, while taxable bond funds may invest in all other debt securities.High-quality bond funds stick with government and top-rated corporate or municipal bonds that offer relatively lower interest. High-yield bond funds buy lower-rated or non-investment grade corporate or municipal bonds, or "junk bonds," which offer higher interest to compensate for the higher risks that investors take. While bond funds in general are less risky than stock funds, the return on principal is not guaranteed and bond funds have the same interest rate, inflation, and credit risks that are associated with the underlying bonds owned by the fund.
    • Money market funds invest in short-term money market instruments, such as U.S. Treasury bills, commercial paper, certificates of deposit, and repurchase agreements. Striving to maintain a stable share price of $1, money market funds offer maximum safety and liquidity, as well as a yield that's generally higher than that of bank deposits, which unlike money market funds, are FDIC-insured.1
    • Global and international funds can help diversify your assets into a wide array of foreign stocks and bonds. The difference between the two groups is that global funds may buy a mix of U.S. and foreign stocks, whereas international funds invest exclusively overseas. Under the two fund groups, there are regional funds andcountry funds designed to take advantage of specific investment opportunities in the world's developed and emerging countries. In terms of risk ratio, global and international funds vary widely from lower-risk funds that invest in established markets to higher-risk emerging market funds. Be aware that international securities may face additional risks, such as higher taxation, less liquidity, political problems, and currency fluctuations, that do not affect domestic securities.
    • Allocation and target-date funds may be another option for investors looking to simplify their choices. Allocation funds invest in a static mix of stocks, bonds, and money markets based on a particular risk profile. Target-date funds also invest in a mix of asset classes, but that mix changes over time as you approach the target date, typically your expected date of retirement. For example, a 2040 fund might feature a mix of stocks and bonds that gets progressively more conservative as you approach 2040.

    Choose Funds That Match Your Goals

    • Equities
    • Aggressive Growth
    • Small Cap
    • Sector
    • Growth
    • Growth and Income
    • Global
    • International
    • Emerging Market
    • Country/Regional
    • Fixed Income
    • High Yield
    • Mortgage Backed
    • Government Agency
    • Long-Term Government
    • Long-Term Corporate
    • Tax-Exempt
    • Short-Term Bond
    • Money Market
    • Tax-Exempt Money Market
    • International Bond
    • Multiple Asset Class
    • Balanced
    • Allocation
    • Target Date

    Watch Your Basket

    The adage "Don't put all your eggs in one basket" applies to mutual funds as much as any other type of investment. By investing in only one fund category, you may subject your assets to an undue amount of risk. One way to help minimize risk is to practice diversification, or spreading your assets among a variety of funds within different categories.2

    Evaluating Mutual Fund Performance

    1 Year 3 Years 5 Years 10 Years
    Large-Cap Growth 15.34% 9.30% 1.12% 7.12%
    Large-Cap Value 14.57% 9.02% 0.32% 6.67%
    Midcap Growth 14.07% 11.08% 1.73% 8.98%
    Midcap Value 16.60% 10.77% 2.87% 9.14%
    Small-Cap Growth 15.46% 11.88% 3.09% 9.29%
    Small-Cap Value 13.15% 11.74% 2.55% 9.14%
    Foreign Developed 18.29% 3.89% 3.60% 7.92%
    Emerging Market 18.15% 4.26% -2.16% 15.44%
    Long-Term Bond 12.97% 11.84% 8.75% 7.83%
    Short-Term Bond 3.67% 3.21% 3.30% 3.20%
    Money Market -- Taxable

    0.03%

    0.03% 0.46% 1.53%

    This table shows the performance achieved by various mutual fund categories over the past 1-, 3-, 5-, and 10-year time periods ended December 31, 2012.

    Source: Morningstar. Based on the average total returns of all funds tracked by Morningstar within a category that reported performance for the relevant period. Performance shown is for illustrative purposes only and is not indicative of the performance of any specific investment. Past performance does not guarantee future results. Does not take taxes, brokerage fees, or sales charges into account.


     Understanding mutual fund categories is only the first step in mutual fund investing. The next step is to match your goals, time frame, and risk tolerance to appropriate fund categories.

    Points to Remember

    1. Mutual fund categories determine the types of securities that mutual fund managers select for their funds.
    2. Some equity fund categories are aggressive growth, growth, growth and income, balanced, sector, global, and international.
    3. Bond funds include taxable and tax-exempt funds and are also segmented by maturity, issuer, and credit quality.
    4. Investors should match their objectives to a particular category but be cautious about focusing too heavily in any one area.
    5. Diversifying among funds is one way to help minimize risk in your portfolio.

    1An investment in a money market fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Although most funds seek to preserve the value of your investment at $1.00 per share, it is possible to lose money by investing in a fund.

    2Diversification does not ensure against loss.

    Because of the possibility of human or mechanical error by S&P Capital IQ Financial Communications or its sources, neither S&P Capital IQ Financial Communications nor its sources guarantees the accuracy, adequacy, completeness or availability of any information and is not responsible for any errors or omissions or for the results obtained from the use of such information. In no event shall S&P Capital IQ Financial Communications be liable for any indirect, special or consequential damages in connection with subscriber's or others' use of the content.

    © 2013 S&P Capital IQ Financial Communications. All rights reserved.

  • The Impact of Volatility on Retirement Plan Assets

    Key Points

    • What Is Stochastic Analysis?
    • Comparing Stochastic Analysis to Simpler Methods
    • Using Stochastic Analysis in the Planning Process
    • Points to Remember


     Much of retirement planning is based on risk tolerance, time horizon, and investment goals. Other unpredictable factors, such as inflation, market volatility, and interest rates are harder if not impossible to plan for, but are just as important to consider during the planning process.


    So how can plan sponsors educate a participant on the impact of unforeseeable variables, such as market volatility, in preparation for retirement?

    Stochastic analysis is one tool that can help participants calculate for the probability of volatility and its possible effect on their portfolios. Although past performance is no guarantee of future results, stochastic analysis can help give your participants a reliable indication of whether their financial plans will meet their retirement funding objectives.

    What Is Stochastic Analysis?

    Stochastic analysis is a method of calculating the degree of uncertainty in future events. Life expectancy and investment performance cannot be predicted precisely for any given individual situation. Investment statistics and actuarial life expectancy tables, however, can be used to calculate a range of likely results for any given portfolio allocation, withdrawal rate, and investment time horizon.

    Stochastic analysis first generates thousands of "what ifs" from the life expectancy and investment parameters. It then calculates the maximum sustainable payout rate and a most likely terminal portfolio value for each permutation. The results are recorded and reported in order of which results were supported in a specified percentage of the trials. The effects of changes in any of the assumed variables -- allocation, withdrawal rate, or return -- can also be shown in order to facilitate plan adjustments.

    Comparing Stochastic Analysis to Simpler Methods

    Before the widespread availability of high-powered desktop computers and sophisticated statistical software, most financial plans were evaluated by means of simple linear analysis. With this technique, a planner would use a single, judiciously chosen return assumption and a maximum foreseeable life expectancy. For those assumptions, the planner could estimate an annuity payout and terminal estate value. Such linear calculations, however, cannot take into account the normal year-to-year variation of returns or the possibility of an overall poor return over the life of the simulation.

    In reality, however, the timing of the variations is critical, as is the overall long-term return achieved. A portfolio that experiences above-average returns early on would be able to sustain considerable downside later and still remain on course. On the other hand, a portfolio that starts out with subpar performance may fall into a hole from which it never recovers. Stochastic analysis will show the participant the whole range of foreseeable results.

    Using Stochastic Analysis in the Planning Process

    Stochastic analysis can be used to determine whether specific retirement income expectations are realistic or to more precisely estimate the resources that might be available for a goal such as retirement funding. It can also be used for broader planning applications such as comparing the benefits of long-term financing versus outright purchase for cash. For example, a home mortgage may provide a nice, tax-deductible loan, but it will also add risk to the participant's overall financial picture. Stochastic analysis allows a participant to help quantify how much risk he or she is actually taking.

    There are some financial planning concerns that stochastic analysis alone cannot address. For example, it may have only limited use in specific asset selection since actual holdings may or may not perform in the same pattern as the investment assumptions and may have higher costs as well. Also, stochastic analysis is intended to account for the randomness of investment returns, but not cyclical events like long-running bull and bear markets. But for participants looking to create blueprints with a high likelihood of financial success, stochastic analysis offers a powerful tool for reducing the areas of uncertainty about outcomes.

    Points to Remember

    1. Stochastic analysis is an analytical technique that runs simulations using random quantities for uncertain variables. It does not predict actual events.
    2. Stochastic analysis can be used by participants to check the viability of their investment strategy. It is not intended to serve as a sole planning tool for retirement savings.
    3. Participants can use stochastic analysis as a reality check of their portfolio during particularly turbulent markets, lifestyle changes, or at annual review time.
    4. Encourage participants to stay invested in the market, especially during turbulent times. If a participant strays from his or her retirement goal, an adjustment to his or her asset allocation strategy may be required.

    Because of the possibility of human or mechanical error by S&P Capital IQ Financial Communications or its sources, neither S&P Capital IQ Financial Communications nor its sources guarantees the accuracy, adequacy, completeness or availability of any information and is not responsible for any errors or omissions or for the results obtained from the use of such information. In no event shall S&P Capital IQ Financial Communications be liable for any indirect, special or consequential damages in connection with subscriber's or others' use of the content.

    © 2013 S&P Capital IQ Financial Communications. All rights reserved.

  • Quantifying Investment Risk: Beta

    Key Points

    • Calculating and Using Beta
    • Other Measures of Risk
    • Points to Remember


     Beta is a number that measures the volatility of a mutual fund or other security compared to the broader market, represented by a benchmark, such as the S&P 500 index or the Barclays Aggregate Bond Index. In a sense, beta shows whether the security has tended to march to the drumbeat of the market or more to its own drummer.

    Beta is one of a number of risk-measurement tools plan sponsors can use in selecting and monitoring investment options to help ensure that their plan's investment menu is sufficiently diverse to allow participants to construct individual portfolios targeting a wide range of risk and reward targets.

    Calculating and Using Beta

    Calculating beta requires some math, but the resulting number is easy to understand. To determine the beta of a mutual fund, the monthly returns of the fund and its benchmark are plotted on a graph, using the benchmark's return as the X coordinate and the fund's return as the Y coordinate. A best fit line -- one that comes closest to all of the points -- is then drawn, and the slope of the resulting line is measured to determine the fund's beta.

    A beta of 1 indicates a fund has the same volatility as its benchmark; a beta of 2 indicates the fund is twice as volatile as the benchmark; a beta less than 1 indicates the fund is less volatile than the benchmark. In other words, a fund with a high beta has responded strongly to variations in the market, while a fund with a low beta is relatively insensitive to variations in the market.

    Mutual fund betas are typically calculated for 36-month periods and are available from fund companies and fund rating services. While beta reflects past performance and is useful in screening funds with similar investment objectives and styles, it is sometimes employed to help predict future price behavior. For example, an equity fund with a beta of 1.2 might be expected to move 20% more than its benchmark. If that benchmark were the S&P 500 and it moved up 10%, the fund would be expected to go up 12%. If the benchmark declined 10%, the fund should go down 12%. Conversely, an equity fund with a beta of .8 should go up by only 8% when the S&P 500 increases by 10% and decline 8% when the benchmark falls 10%.

    Analyzing funds or other investments with low betas requires special care. While it might seem logical to conclude that a low beta indicates that an investment has low volatility risk in relation to the market, it might just as well mean that the benchmark being compared is not closely correlated to that investment's returns.

    For that reason, beta is best used in conjunction with a related statistic, R-squared. R-squared measures how close all the points on the XY graph are to the best fit line. If all the points on the graph were right on the best fit line, an investment would have an R-squared of 100, indicating a perfect correlation with the benchmark, while an R-squared of 0 would signify absolutely no correlation. Put another way, the lower the R-squared, the less reliable beta is as a measure of an investment's volatility.

    Beta has a close ally in quantitative analysis -- that is alpha. Alpha measures the difference between the return expected from a security, as indicated by its historical beta, with the return it actually produced. For example, a positive alpha means a fund returned more than its beta predicted, while a negative alpha means it returned less. Alpha is sometimes used as an indicator of the value added by a fund manager.

    As with other statistical measures, beta has its limitations. It's important to recognize that beta is a narrow measure of an investment's past performance relative to a market benchmark. Also, keep in mind that beta cannot account for qualitative factors that may affect performance, such as economic conditions, market developments, and changes in a fund's management. Notwithstanding these considerations, beta has a valuable part to play in illuminating differences among investments, which can help you establish a target balance between risk and return potential for your plan's investment menu.

    Other Measures of Risk

    In addition to beta, these four measures of risk are often used in investment analysis:
    Alpha shows the relationship between an investment's historical beta and its current performance. An alpha of 0 indicates the investment performed as expected. A positive alpha means the investment returned more than its beta indicated; a negative alpha signifies that it returned less.
    R-squared (R2)quantifies how much of a fund's performance can be attributed to the performance of a benchmark index. The value of R2ranges between 0 and 1 and measures the proportion of a fund's variation that is due to variation in the benchmark. For example, for a fund with an R2 of 0.70, 70% of the fund's variation can be attributed to variation in the benchmark.
    The Sharpe Ratio measures risk-adjusted returns, and is used for comparing investments to determine which offer the most return for a given amount of risk. The ratio is calculated by subtracting the return of a risk-free investment (such as the 90-day Treasury bill) from the investment's return and then dividing that result by the standard deviation of the investment's return.
    Standard deviation reveals the volatility of an investment's returns over time, with a high standard deviation indicating greater historical volatility. Standard deviation can be used to compare any type of security with any other. It's calculated by comparing an investment's average or mean return over a period of time with the average variance from that return.

    Points to Remember

    1. Beta is a widely used gauge for comparing the volatility of an investment with the broader market represented by a benchmark such as an index.
    2. Monthly returns of the investment and its benchmark are used to calculate beta.
    3. It's often advisable to use beta in conjunction with R-squared, which measures the correlation between an investment and its benchmark.
    4. Beta is also used in computing alpha, which measures the difference between the return expected from a security, as indicated by its historical beta, and the return it actually produced.

    Because of the possibility of human or mechanical error by S&P Capital IQ Financial Communications or its sources, neither S&P Capital IQ Financial Communications nor its sources guarantees the accuracy, adequacy, completeness or availability of any information and is not responsible for any errors or omissions or for the results obtained from the use of such information. In no event shall S&P Capital IQ Financial Communications be liable for any indirect, special or consequential damages in connection with subscriber's or others' use of the content.

    © 2013 S&P Capital IQ Financial Communications. All rights reserved.

  • Nonqualified Retirement Savings Plans

    Key Points

    • Contributions
    • Structure
    • Distributions
    • Points to Remember


     The growth of 401(k) and other qualified employer-sponsored retirement plans has been a boon for those seeking to save for retirement while reducing their current tax bite. But for the growing numbers of individuals earning over $100,000 per year, the benefits of these "qualified" plans can be restricted. Because of limitations set by the Internal Revenue Code, contributions to qualified plans (both employee and employer matches) are capped and decline proportionately as the individual's income rises.

    In response to this dilemma, many companies offer nonqualified plans to certain highly compensated employees. Such plans come in many shapes and sizes: defined benefit excess plans, defined contribution excess plans, voluntary deferred compensation plans, and supplemental executive retirement plans (SERPs). Nonqualified plans are not subject to most of the requirements of the Employee Retirement Income Security Act (ERISA) and are not subject to the contribution limitations imposed by the Code. However, these plans are also not protected by ERISA, and executives who participate in them should be aware of their drawbacks as well as their benefits.

    Contributions

    The first point to keep in mind with nonqualified retirement savings plans is that they are all different. Since they are not subject to most of ERISA's rules, they generally can be tailored to a specific company's -- or individual's -- needs. Accordingly, contribution limits, employer matches, and vesting schedules may differ significantly from plan to plan. And even within the same company, plan specifics may vary from individual to individual. For example, a Senior VP-level plan is likely to differ from the CEO's plan.

    But most nonqualified plans do have certain common features. For one, contribution limits for nonqualified plans have no legal caps and are often significantly higher than for qualified plans. As with qualified plans, contributions to properly designed nonqualified plans are tax deferred; taxes are not paid until funds are distributed. Unlike qualified plans, however, contributions are not technically owned by plan participants until they are paid; fund liabilities -- including employee contributions -- represent an unsecured promise to pay on the part of the employer. This can present issues in the event of a sale of the company or if it goes bankrupt. Depending on the plan's investment structure, an employee may find himself at the end of a line of creditors making dibs on what he thought were "his" plan assets.

    Structure

    In order to qualify for tax-deferral status, nonqualified plans must pass muster with the IRS on two basic principles: constructive receipt and economic benefit. In essence, these fundamental precepts require a plan to be structured in such a way that plan participants do not have unlimited discretion as to when they can receive payments and have not had their benefits funded in some separate arrangement outside of the company's assets -- that is, participants do not own plan assets in any way or have any rights to any specific company property. Also, nonqualified plans may not be "funded" the same way as a 401(k) and other qualified retirement plans are with a separate trust that is specifically dedicated to only the payment of plan benefits. This means that nonqualified plans may only use indirect methods of "funding" for plan benefits.

    Typically, a company provides for plan benefit payments in one of three different ways: "Pay-as-you-go," mutual funds (and other publicly traded investments), and life insurance. Under the "pay-as-you-go" approach, plan benefits are paid directly by the company with available cash. As benefits come due, they are paid and deducted as business expenses. In practice, this structure is seldom used nowadays, as it can pose significant cash flow issues to the sponsoring company and offers little in the way of guarantees that the company will meet its payment obligations in the future.

    In a plan funded by mutual funds (and other publicly traded investments), assets are held directly by the company or in a special type of trust -- a "rabbi trust" (so named because of a 1981 IRS ruling granting tax-deferred status to a trust established by a synagogue for its rabbi) -- which is invested in mutual funds (and other publicly traded investments). A rabbi trust is a trust that holds assets contributed by the company that are intended to be used to pay benefits, but that are treated as property of the company for tax purposes and are subject to the claims of the company's creditors in the event of the company's insolvency or bankruptcy. The company or trust will typically invest in the same mutual funds (and other publicly traded investments) available in the company's qualified plan, thus "mirroring" the qualified plan, and offering participants identical fund selection and weightings. Plans structured with a rabbi trust offer simplicity to plan sponsors and a certain amount of security to plan participants, whose plan benefits are assured even if the company is acquired or management tries to renege on its promises.

    One popular funding mechanism is through corporate-owned life insurance (COLI). In this arrangement, employers fund plans with life insurance. Although COLI-funded plans can be complex, they offer tax-free growth1, can be cost effective, and are attractive to sponsors seeking to match assets with liabilities created by deferred compensation plans.

    Special rules apply to nonqualified plans maintained by tax-exempt organizations.

    Distributions

    Unlike with qualified plans, distribution options under nonqualified plans are determined by the sponsoring company subject to the requirements of Section 409A. A given employer may design and plan to limit your choices on how and when you receive distributions.

    While employee contributions to most plans are typically 100% vested from day one (although not owned until paid), vesting schedules are often imposed for the employer contributions -- earning some nonqualified plans the nickname "the golden handcuffs," in that vesting periods are usually stretched out long enough to encourage the executive to remain with the company sponsoring the plan.

    Most importantly, nonqualified plans must satisfy the requirements of Section 409A of the Internal Revenue Code, which was added to the Code in 2005 and which substantially changed the tax treatment of nonqualified plans. Section 409A sets forth a variety of requirements applicable to nonqualified plans, including rules on distribution options and deferral elections. Failure to comply with the requirements of Section 409A results in the early taxation on nonqualified plan benefits as well as a 20% penalty tax and additional interest payable to the IRS.

    Unlike qualified plans, nonqualified plans do not permit you to roll over plan assets into an IRA or another nonqualified plan when changing jobs. Instead, you must begin receiving payouts -- and pay taxes on them -- in accordance with the plan's terms.

    Points to Remember

    1. Nonqualified retirement plans are primarily offered to executives and other highly compensated employees whose participation and benefits from qualified plans may be significantly restricted.
    2. Nonqualified plans differ significantly from company to company, and from individual to individual within the same company.
    3. Unlike with qualified plans, there are no legal contribution limits for nonqualified plans.
    4. Typically, nonqualified plans are funded in one of three different ways: "Pay-as-you-go," mutual funds (and other publicly traded investments), and life insurance.
    5. Life insurance is a popular and typically cost-effective funding mechanism.
    6. Nonqualified plans do not permit you to roll over plan assets into an IRA or another nonqualified plan when changing jobs. Instead, you must begin receiving payouts -- and pay taxes on them -- in accordance with the plan's terms.

    1Certain taxes may apply if the sponsor company is subject to the alternative minimum tax.

    Because of the possibility of human or mechanical error by S&P Capital IQ Financial Communications or its sources, neither S&P Capital IQ Financial Communications nor its sources guarantees the accuracy, adequacy, completeness or availability of any information and is not responsible for any errors or omissions or for the results obtained from the use of such information. In no event shall S&P Capital IQ Financial Communications be liable for any indirect, special or consequential damages in connection with subscriber's or others' use of the content.

    © 2013 S&P Capital IQ Financial Communications. All rights reserved.

  • Redefining Retirement in the 21st Century

    Key Points

    • Creating a New Life Cycle
    • Plan for the New Retirement
    • Prepare Today for the Retirement of Tomorrow
    • Points to Remember


    When a man retires and time is no longer a matter of urgent importance, his colleagues generally present him with a clock.
    - R.C. Sheriff


    The days may be over when a gold watch is a somewhat ironic and less-than-useful gift for a retiree. If the experts are on target, retirement in the next century will scarcely resemble the conventional image of lazy days spent on cruise ships and golf courses. You might plan to open a business of your own. Or perhaps you'll return to school for that graduate degree you never had the chance to complete. Of course, you'll probably still find time to sit back and put your feet up.

    Creating a New Life Cycle

    At the turn of the 20th century, the average life expectancy was 47 years. Today, the average American newborn can look forward to about 78 years of life. What's more, the average life expectancy for today's 65-year-old has increased to 84, according to the National Center for Health Statistics.

    Creating a New Life Cycle

    What's behind this trend? Some causes are obvious, such as improved health care, both early on in the form of preventative medicine and during the later years of life. Medical advances, including hypertension drugs and hip replacements, allow older Americans to remain active. Healthier lifestyles are also a contributing factor.

    "People are treating their bodies with greater respect," said Dr. Sanford Finkel of the Buehler Center on Aging at Northwestern University. "They're giving up smoking, learning to eat right, and exercising regularly. Inevitably, these trends lead to healthier, longer, more productive lives."

    The result is a new way of thinking about age. In her best-selling book, New Passages, Gail Sheehy argues that the "mid-life passage" generally thought to take place at age 40 now occurs a decade later. The period between ages 45 and 65 is no longer middle and old age, according to Sheehy, but a "second adulthood." Psychologist Ken Dychtwald, chief executive officer of Age Wave Inc., a California-based consulting firm, also sees new lines being drawn. Using his model, ages 25 to 40 represent young adulthood, while ages 40 to 60 comprise a new stage known as "middlescence." Next comes late adulthood (60 to 80), followed by old age (80 to 100), and very old age (100+).

    But perhaps more important than the categories is the effect that longer, healthier lives may have on the traditional life cycle of education, work, and retirement. It will be replaced by a less linear cycle, according to Dychtwald, who predicts short-term retirements, followed by any combination of career shifts, part- or flex-time work, entrepreneurial endeavors, and continuing education peppered with occasional "mini-retirements."

    Today's older American doesn't hesitate to change jobs -- or careers -- in the pursuit of keeping life interesting. This trend should accelerate. According to the most recent available study by the Bureau of Labor Statistics, the percentage of Americans aged 65 years or older who participate in the labor force is expected to increase from about 17% in 2008 to more than 22% by 2018.1

    Plan for the New Retirement

    So what does this redefined retirement mean to you? There is no one answer. In the coming decades, "retirement" will mean something different to each of us. Regardless of your decision, you'll need to design a financial plan suited to your specific vision of the future.

    Retirement Income -- A good starting point might be to examine your sources of retirement income. If you pay attention to the financial press, you've probably come across at least a few commentators who speak in gloom-and-doom terms about the future for American retirees, decrying a lack of savings and warning of the imminent growth of the elderly population.

    True, there is widespread concern about at least one traditional source of income for retirees -- Social Security. Under current conditions, Social Security funds could fall short of needs by 2033, according to the Social Security Administration. But the reality is that Social Security was intended only to supplement other sources of retirement income. In fact, Social Security benefits account for only 37% of the aggregate income of today's retirees, according to the Social Security Administration.

    Even pension plans, once considered a staple of retirement income, only account for 18% of the retirement-income pie. In recent years, employers have been moving from traditional defined benefit plans based on salary and years of service to defined contribution plans, such as 401(k) plans, funded primarily by the employees.

    This shift makes it even more important for individuals to understand their goals and have a well-thought-out financial plan that focuses on the key source of retirement income: personal savings and investments. Given the potential duration and changing nature of retirement, you may want to seek the assistance of a professional financial planner who can help you assess your needs and develop appropriate investment strategies.

    As you move through the various stages of the new retirement, perhaps working at times and resting at others, your plan may require adjustments along the way. A professional advisor can help you monitor your plan and make changes when necessary. Among the factors you'll need to consider:

    Time -- You can project periods of retirement, reeducation, and full employment. Then concentrate on a plan to fund each of the separate periods. The number of years until you retire will influence the types of investments you include in your portfolio. If retirement is a short-term goal, investments that provide liquidity and help preserve your principal may be most suitable. On the other hand, if retirement is many years away, you may be able to include more aggressive investments in your portfolio. You will also need to keep in mind the number of years you may spend in retirement. Thirty years of retirement could soon be commonplace, requiring a larger nest egg than in the past.

    Inflation -- Consider this: An automobile with a price tag of $20,000 today will cost $29,600 in just 10 years, given an inflation rate of just 4%. While lower-risk fixed-income and money market investments2 may play an important role in your investment portfolio, if used alone they may leave you susceptible to the erosive effects of inflation. To help your portfolio keep pace with inflation, you may need to maintain some growth-oriented investments. Over the long-term, stocks have provided returns superior to other asset classes.3 But also keep in mind that stocks generally involve greater short-term volatility.

    Taxes -- Even after you retire, taxes will remain an important factor in your overall financial plan. If you return to work or open a business, for example, your tax bracket could change. In addition, should you move from one state to another, state or local taxes could affect your bottom line. Tax-advantaged investments, such as annuities and tax-free mutual funds, may be effective tools for meeting your retirement goals. Tax deferral offered by 401(k) plans and IRAs may also help your retirement savings grow.

    Prepare Today for the Retirement of Tomorrow

    To ensure that retirement lives up to your expectations, begin establishing your plan as early as possible and consider consulting a professional. With proper planning, you can make retirement whatever you want it to be.

    Points to Remember

    1. As people live longer and healthier lives, retirement begins to take on a whole new look.
    2. You'll need to develop a financial plan suited to your specific vision of the future.
    3. Under current conditions, Social Security funds could fall short of needs by 2033.
    4. You will need to rely on your own personal savings and investments for the majority of your income in retirement.
    5. Keys to determining your financial plan are time, inflation, and taxes.

    1Source: Bureau of Labor Statistics, November 2009. (Most recent available data.)
    2An investment in a money market fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Although the fund seeks to preserve the value of your investment at $1.00 per share, it is possible to lose money by investing in the fund.
    3Past performance is no guarantee of future results.

    Because of the possibility of human or mechanical error by S&P Capital IQ Financial Communications or its sources, neither S&P Capital IQ Financial Communications nor its sources guarantees the accuracy, adequacy, completeness or availability of any information and is not responsible for any errors or omissions or for the results obtained from the use of such information. In no event shall S&P Capital IQ Financial Communications be liable for any indirect, special or consequential damages in connection with subscriber's or others' use of the content.

    © 2013 S&P Capital IQ Financial Communications. All rights reserved.

  • Investing Through Life’s Stages

    Key Points

    • Factors That Affect Your Investment Decisions
    • Growth or Income
    • Time and Risk Tolerance
    • Sample Asset Allocations
    • Sound Strategies for Everyone
    • Investing for Life Stages
    • Discipline and a Financial Advisor Can Help
    • Points to Remember


    Investing is a lifelong process. The sooner you start, the better off you'll be in the long run. It's best to start saving and investing as soon as you start earning money, even if it's only $10 a paycheck. The discipline and skills you learn will benefit you for the rest of your life. But no matter how old you are when you start thinking seriously about saving and investing, it's never too late to begin.

    The first part of a successful lifelong investment strategy is disciplined savings habits. Regardless of whether you are saving for retirement, a new house, or just that extravagant dining room set, you will need to develop rigid savings habits. Regular contributions to savings or investment accounts are often the most productive; and if you can automate them, they are even easier.

    Factors That Affect Your Investment Decisions

    Once you begin saving on a regular basis, you'll soon have to decide how to invest the money you are saving. Regardless of what financial stage of life you are in, you will have to decide what your needs are and how comfortable you are with risk.

    Growth or Income

    What do you need the money for? The answer to this question will help determine whether you want to put your savings into investment products that produce income for you, or that concentrate on growing the value of your investment. For instance, a retirement fund does not need to produce income until you retire, so your investing strategy should focus on growth until you are close to retirement. After you retire, you'll want to draw income from your investment while keeping your principal intact to the extent possible.

    Time and Risk Tolerance

    All investing involves a certain amount of risk. How well you tolerate price fluctuations in your investments will need to be balanced against your required rate of return in determining the amount of risk your investments should carry. An offsetting factor to risk is time. If you plan to hold an investment for a long time, you will probably tolerate more risk because you have the time to make up any losses you may experience early on. For a shorter-term investment, such as saving to buy a house, you probably want to take on less risk and have more liquidity in your investments.

    Sample Asset Allocations

    PORTFOLIO RISK LEVEL
    Low Moderate Aggressive
    % Treasury Bills 30 30 20 10 10 10
    % Bonds 40 30 30 40 30 20
    % Growth Stocks 30 30 40 30 50 70
    % Small Caps 0 0 0 10 0 0
    % International 0 10 10 10 10 0


    Chart illustrates sample portfolio asset allocations: Low Risk (those nearing or in retirement); Moderate Risk (middle-aged investors); Aggressive Risk (younger investors).

    Allocations are presented only as examples and are not intended as investment advice. Please consult a financial advisor if you have any questions about how these examples apply to your situation.

    Sound Strategies for Everyone

    Everyone lives his or her life differently, and everyone has complicated emotions about money, so investment decisions are highly personal and unique to each person. But there are some basic rules that apply to most investors.

    • To provide liquidity for emergencies, you should probably always have a cash reserve in a money market fund1 or traditional savings account or CD, no matter what your life stage.
    • Also, if you can tolerate even a little risk, you should probably always have some portion of your portfolio in stocks to help protect your savings from being devalued due to inflation.
    • Another good idea is scheduling annual reviews of your investments with a financial advisor. This habit will keep you up to date on your investments and help spot potential problems in your investment strategy.
    • Finally, every investment decision should include tax considerations. Investments can be taxable, tax deferred, or tax free. You should be aware of the taxable status of your investments and take that into account when setting up and reviewing an investment strategy.

    Investing for Life Stages

    Although everyone's attitude toward investing and money is different, most investors share some common situations throughout their lives. For instance, where you are in your life cycle certainly affects how you invest for retirement, but what about other life stages that aren't so closely related to age?

    Let's say you're 40 and expecting your first child. You'll need to decide how to balance your finances to account for the additional expenses of a child. Perhaps you'll need to supplement your income with income-producing investments. Moreover, your child will be entering college at about the time you're ready to retire! In these circumstances, your growth and income needs most certainly will change, and maybe your risk tolerance as well.

    The following are some major life events that most of us share, and some investment decisions that you may want to consider:

    When you get your first "real" job:

    • Start a savings account to build a cash reserve.
    • Start a retirement fund and make regular monthly contributions, no matter how small.

    When you get a raise:

    • Increase your contribution to your company-sponsored retirement plan.
    • Invest after-tax dollars in municipal bonds that offer tax-exempt interest.
    • Increase your cash reserves.

    When you get married:

    • Determine your new investment contributions and allocations, taking into account your combined income and expenses.

    When you want to buy your first house:

    • Invest some of your non-retirement savings in a short-term investment specifically for funding your down payment, closing, and moving costs.

    When you have a baby:

    • Increase your cash reserves.
    • Increase your life insurance.
    • Start a college fund.

    When you change jobs:

    • Review your investment strategy and asset allocation to accommodate a new salary and a different benefits package.
    • Consider your distribution options for your company's retirement savings or pension plan. You may want to roll over money into a new plan or IRA.

    When all your children have moved out of the house:

    • Boost your retirement savings contributions.

    When you reach 55:

    • Review your retirement fund asset allocation to accommodate the shorter time frame for your investments.
    • Continue saving for retirement.

    When you retire:

    • Carefully study the options you may have for taking money from your company retirement plan. Discuss your alternatives with your financial advisor.
    • Review your combined potential income after retirement and reallocate your investments to provide the income you need while still providing for some growth in capital to help beat inflation and fund your later years.

    Discipline and a Financial Advisor Can Help

    One of the hardest things about investing is disciplining yourself to save an appropriate portion of your income regularly so that you can meet your investment goals. And if you're not fascinated with investing, it's probably also hard to force yourself to review your financial situation and investment strategy on a regular basis. Establishing a relationship with a trusted financial advisor can go a long way toward helping you practice smart money management over your entire lifetime.

    Points to Remember

    1. The first step in a successful lifelong investment strategy is to develop disciplined savings habits.
    2. Throughout life, you should assess your need for growth or income.
    3. You will have to determine your overall tolerance to risk and regularly reassess your tolerance. Education and a long-range investment goal can help raise your risk tolerance.
    4. An offsetting factor to risk is time.
    5. You should probably always have a cash reserve in a money market fund, traditional savings account, or CD.
    6. You should probably always have some portion of your portfolio in stocks to help protect your investment from being devalued due to inflation.
    7. Increase regular investment contributions when your financial situation improves.
    8. Start separate investment funds for specific purposes, such as a fund for college or the down payment for a house.
    9. Schedule annual reviews of your investments.

    1An investment in a money market fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Although the fund seeks to preserve the value of your investment at $1.00 per share, it is possible to lose money by investing in the fund.

    Because of the possibility of human or mechanical error by S&P Capital IQ Financial Communications or its sources, neither S&P Capital IQ Financial Communications nor its sources guarantees the accuracy, adequacy, completeness or availability of any information and is not responsible for any errors or omissions or for the results obtained from the use of such information. In no event shall S&P Capital IQ Financial Communications be liable for any indirect, special or consequential damages in connection with subscriber's or others' use of the content.

    © 2013 S&P Capital IQ Financial Communications. All rights reserved.

  • Tax Changes: What They Mean to You

    Key Points

    • Reduced Income Taxes
    • Dividends and Capital Gains
    • Rates on Ordinary Income
    • Relief for Parents and Joint Filers
    • Alternative Minimum Tax Exemption
    • Retirement Savings Vehicles
    • Contributing the Max
    • Estate Taxes
    • Education Incentives
    • Take the Next Step: Talk to a Pro
    • Points to Remember


    Federal tax legislation enacted over the past ten years has affected virtually all Americans, with major changes in income tax rates, taxes on dividends and long-term capital gains, estate taxes, retirement savings rules, and education incentives. Although many of these changes were set to sunset after 2012, most were extended or made permant in The American Taxpayer Relief Act of 2012.

    Keep in mind that federal legislation entails myriad details, and the following represents only a summary of the principal provisions.

    Reduced Income Taxes

    The table below lists federal income tax rates for 2103.

     

    Tax Rate Single Married Filing Jointly
    10% $0 - $8,925 $0 - $17,850
    15% $8,925 - $36,250 $17,850 - $72,500
    25% $36,250 - $87,850 $72,500 - $146,400
    28% $87,850 - $183,250 $146,400 - $223,050
    33% $183,250 - $398,350 $223,050 - $398,350
    35% $398,350 - $400,000 $398,350 - $450,000
    39.6% $400,000 or more $450,000 or more

    Dividends and Capital Gains

    Dividend income paid by U.S. and some qualified foreign corporations is now taxed at a top rate of 20%. However, the same taxable income thresholds of $400,000/$450,000 apply when determining the rate investors will pay on long-term capital gains and dividends. Those with incomes that exceed the new limit will pay a higher 20% rate, but most others will pay a lower 15% rate.

    Be aware that some types of dividend income may be taxed at ordinary rates. For example, dividends received from a REIT (real estate investment trust) may not be subject to the lower rate. Check with your tax advisor for the various types of dividend income that are exempt from the new rules.

    Long-term capital gains (gains on assets held more than one year) are also taxed at a top rate of 20%, but as with qualified dividends, only taxpayers in the top bracket pay 20%; others pay a maximum rate of 15%.

    Relief for Parents and Joint Filers

    Parents of children under age 17 can claim a child tax credit of $1,000 per child. The credit begins to phase out for single filers and heads of household with adjusted gross incomes of $75,000 or more, and for married couples filing jointly with incomes of $110,000 or more.

    For married couples who file jointly, the tax legislation attempted to reduce the impact of the so-called marriage penalty: a glitch in the tax rules that results in higher tax bills for some married couples than they'd face if they were single and filing separately. The 15% tax bracket for married taxpayers filing jointly was expanded so that it applies to twice as much income as for single filers. In addition, the standard deduction for joint filers was increased so that it will be double that allowed for single filers.

    Alternative Minimum Tax Exemption

    For married couples filing jointly, the alternative minimum tax exemption is $80,800 in 2013. For single filers, it is $51,900 in 2013.

    The alternative minimum tax is a federal tax system created in 1969 to help ensure that wealthier taxpayers didn't use loopholes to completely avoid paying income taxes. But because the tax was never indexed for inflation, it has increasingly applied to less affluent households.

    Retirement Savings Vehicles

    A number of tax changes benefit those saving and investing for retirement, including:

    Higher Contribution Limits -- The limit on annual contributions to traditional and Roth IRAs is $5,000. For certain employer-sponsored retirement plans -- including 401(k) plans -- the annual contribution limit in 2012 is $17,000. Keep in mind, however, that employers can impose contribution limits that are lower than the government maximum.

    Contributing the Max

    Tax Year 401(k) and 403(b) [traditional and Roth], 457 Plans SIMPLE Plans
    2013 $17,500 $12,000



    Catch-Up Provisions for Those Nearing Retirement
    -- Individuals aged 50 and older can take advantage of "catch up" contributions to IRAs and some qualified employer-sponsored retirement plans. For IRAs, the allowable catch-up contribution is $1,000 per year. Participants in 401(k) and certain other qualified employer-sponsored plans who are at least 50 years old are also permitted to make catch-up contributions of $5,500 in 2013 and adjusted annually for inflation thereafter. Participants in SIMPLE Plans who are aged 50 and older can make a catch-up contribution of $2,500 in 2013. Before investors can make catch-up contributions, they must first make the maximum regular contribution to their IRA or employer-sponsored plan.

    Estate Taxes

    For 2013, the estate tax exemption is $5.25 million and the maximum tax rate to 40%. In future years, these amounts may be indexed for inflation.

    Education Incentives

    Following is a summary of tax changes since inception of certain tax benefits for those saving for education. Note that certain education tax credits and deductions not discussed here have also been modified. Contact your tax or financial advisor for more information concerning those provisions.

    Coverdell Education Savings Accounts (formerly Education IRAs)

    • Maximum annual contributions increased to $2,000.
    • Qualified withdrawals are now eligible to be used to fund elementary and secondary education in addition to higher education expenses.
    • The income eligibility limits for Coverdells were raised for joint filers. The phaseout range is now $190,000 to $220,000.
    • The contribution deadline for Coverdells changed from December 31 each year to April 15 of the following year.
    • Age limits for contributions and withdrawals don't apply to special needs beneficiaries.

    529 Plans

    • Qualified distributions from 529 plans are now tax free. Formerly, participants in 529 plans enjoyed the benefit of tax deferral.
    • Investors may now transfer assets from one 529 plan to another on behalf of the same beneficiary without paying taxes on the distribution.

    Take the Next Step: Talk to a Pro

    Tax legislation often takes time to sort out -- particularly when there are as many sunset rules as there are in the recent tax acts. To be sure you understand the rules and how they apply to your situation, work with your financial and tax professional.

    Points to Remember

    1. Tax changes accelerate rate reductions on ordinary income. The top rate is now 39.6%.
    2. Rates on dividends paid by domestic and some qualified foreign corporations are 20% for taxpayer in the top income bracket, 15% for many others.
    3. The top tax rate on long-term capital gains is 20% for those in the top bracket, 15% for many others.
    4. The child tax credit on dependent children younger than 17 was raised to $1,000.

    Because of the possibility of human or mechanical error by S&P Capital IQ Financial Communications or its sources, neither S&P Capital IQ Financial Communications nor its sources guarantees the accuracy, adequacy, completeness or availability of any information and is not responsible for any errors or omissions or for the results obtained from the use of such information. In no event shall S&P Capital IQ Financial Communications be liable for any indirect, special or consequential damages in connection with subscriber's or others' use of the content.

    © 2013 S&P Capital IQ Financial Communications. All rights reserved.

  • An Introduction to Stock Options

    Key Points

    • The Basics of Stock Options
    • Components of an Option's Value
    • Employee Stock Options
    • Option Terminology
    • Consider Option Strategies Carefully
    • Points to Remember


     Options on stocks and stock indexes are derivative instruments. Stock investors may use stock options to hedge against a price decline, to lock in a future purchase price, or to speculate on the future price of a stock. Employees may also receive stock options through an employee compensation plan. For employees, stock options represent the potential for growth in value and the possibility that the increase in value will be taxed at a favorable capital-gains tax rate.

    The Basics of Stock Options

    A stock option is essentially a contract that gives one party the right to purchase or sell a stated number of shares of a stock at a specified price. The price at which the shares may be purchased or sold is known as the strike orexercise price. The right to exercise lasts for a stated period of time, which may be months or years, until theexpiration date. If not exercised on or before the expiration date, the option expires.

    Options come in two forms: calls and puts. A call option gives the option purchaser the right to buy the underlying stock. A put option gives the option purchaser the right to sell the underlying stock.

    A call option is valuable to the extent that the exercise price is below the market value of the underlying stock. For example, if a stock is trading at $100 per share and you hold a call option entitling you to buy the stock at $72 per share, your option has an immediate value to you of $100 - $72 = $28, before taking into account any tax consequences or transaction fees.

    A put option is the mirror image of a call option. A put option becomes more valuable as the price of the stock moves below the exercise price. For example, if you have purchased a put option with a strike price of $90 and the stock price moves to $80, you may choose to exercise the option and sell the underlying stock at $90 for an immediate unrealized per share gain of $90 - $80 = $10.

    With both calls and puts, the purchaser of the option has the right to exercise, while the option seller is obligated to respond if the option is exercised. The option purchaser pays an upfront fee known as the premium to the option seller in return for the right of exercise. The option buyer has a known investment risk - if the option expires unexercised, the purchaser of the option recognizes the premium paid as a loss. Conversely, the option seller undertakes potentially unlimited market risk in return for the premium received.

    Components of an Option's Value

    Option contracts are traded on regulated markets, and their values may fluctuate throughout the trading day. The price of an option at any given time is based on several factors, including the current price of the underlying stock, the price volatility of the underlying stock, the time to maturity, and interest rates.

    Intrinsic value -- the intrinsic value of the option is the difference between the exercise price and the price of the underlying security. An option is "in the money" when the intrinsic value is positive.

    Volatility -- part of an option's value reflects the volatility of the underlying security. If a stock price is highly volatile, there is a relatively greater chance that the option will be "in the money" at expiration, and therefore, the option will carry a higher premium than an option on a less volatile stock.

    Time value -- the more time remaining until the expiration date of the option, the greater the potential for a significant change to occur in the price of the underlying security and the greater the value of the option. Time value diminishes as the expiration date of the option approaches.

    Interest rates -- the option premium is a cash payment that can be invested by the option seller to generate interest income. Higher interest rates present opportunities for potentially greater earnings on the option premium.

    Intrinsic value, volatility, and time value can significantly affect an option's market value. An option with an exercise price above the current market value of the underlying security may still have considerable potential value.

    For example, if you hold a call option with an exercise price of $72 and the current share price is $65, your option would generate a loss if it were exercised today. However, as stated above, option contracts typically are valid for months or years, until the stated expiration date. The time value of the call option is the potential that the share price will rise over time and eventually exceed the option exercise price.

    Employee Stock Options

    Employee stock options are call options granted by an employer as part of an employee compensation plan. There are two main types of employee stock options: incentive stock options and nonqualified stock options. Incentive stock options offer special income tax benefits to the employee.

    An incentive stock option (ISO) must meet a number of criteria to qualify for favorable tax treatment. As long as the shares acquired through an ISO are held for at least one year following exercise and are not disposed of until at least two years after the option is granted, the difference between the option price and the sale price is taxed as a long-term gain. The tax is applied at the sale of the stock. If you don't meet the one-year holding-period requirement, the transaction is considered a "disqualifying disposition" and your gains are taxed as ordinary income.

    A nonqualified stock option (NSO) is an option that doesn't meet the ISO criteria. Gains on NSOs are taxed as ordinary income at the time of exercise.


     

     Option Terminology

    Call option An option that gives the option buyer the right to purchase the underlying security.
    Exercise date The date by which the option must be exercised.
    Expiration date The date that the option will expire (same as the exercise date).
    Intrinsic value The difference between the strike price and the current price of the underlying security.
    Premium An upfront fee paid by the option buyer to the option seller.
    Put option An option that gives the option buyer the right to sell the underlying security.
    Strike price The stated price at which the underlying security can be purchased or sold (also called the exercise price).
    Time value The component of an option's price that reflects the time left to expiration.
    Volatility The tendency of the underlying security to fluctuate in price.

    Consider Option Strategies Carefully

    Options are leveraged investments that can offer significant potential advantages and risks. As part of an overall investment strategy, put and call options may offer opportunities to temporarily alter the risk/return characteristics of a portfolio. Before investing in options, it is important to thoroughly understand the potential risks and benefits. You should consult a qualified tax advisor as to how option transactions may affect your tax situation. If you are an employee and have received stock options as employee compensation, you will want to carefully consider how exercise of your options may affect your cash flow and tax liability.

    Points to Remember

    1. An option is a contract entitling the option purchaser to buy or sell the underlying stock at the stated exercise price. A call option gives the holder the right to buy the underlying stock; a put option gives the holder the right to sell the underlying stock.
    2. The option purchaser's risk on the option is limited to the premium paid; the option seller's risk on the option is potentially unlimited.
    3. A call option is valuable to the extent that the exercise price is below the market value of the underlying stock at the time you choose to exercise the option by buying shares. The time value of the option is the potential that the share price will rise over time and eventually exceed the option exercise price.
    4. Employee stock options may be tax-qualified incentive stock options (ISOs) or nonqualified stock options (NSOs). If shares acquired through an ISO are held for at least one year following exercise and are not disposed of until at least two years after the option is granted, the difference between the option price and the sale price is taxed as a long-term gain. If you don't meet the one-year holding-period requirement, the transaction is considered a disqualifying disposition and your gains are taxed as ordinary income.
    5. Before implementing an investment strategy using options or before entering into any equity arrangements with an employer, consult your tax advisor.

    Because of the possibility of human or mechanical error by S&P Capital IQ Financial Communications or its sources, neither S&P Capital IQ Financial Communications nor its sources guarantees the accuracy, adequacy, completeness or availability of any information and is not responsible for any errors or omissions or for the results obtained from the use of such information. In no event shall S&P Capital IQ Financial Communications be liable for any indirect, special or consequential damages in connection with subscriber's or others' use of the content.

    © 2013 S&P Capital IQ Financial Communications. All rights reserved.

  • Retirement Plan Loans: Do They Make Sense for You?

    Key Points

    • Read the Rules First
    • Check the Rules Before You Borrow
    • Weigh the Pros ...
    • ... And Cons
    • Survey of 401(k) Plans on Plan Loans
    • Make the Most of Your Retirement Plan
    • Points to Remember


    Is there anything your 401(k) plan can't do? It allows for tax-deferred earnings in traditional accounts and tax-free earnings in Roth-style accounts. And traditional plans enable you to make contributions in pretax dollars, helping to reduce your taxable income. It even offers a menu of professionally managed investments from which to choose.

    But there may be another feature of your 401(k) (or a similar retirement plan) that you haven't considered: You may actually be able to borrow money from your account. In 2011, the Employee Benefit Research Institute revealed that 59% of 401(k) plans that were surveyed offered loans to participants.

    Read the Rules First

    The IRS currently allows you to borrow up to 50% of the total vested assets in your account, up to a maximum of $50,000. There may be loan minimums and certain other restrictions, depending on your plan's specific loan availability calculations.

    Here's how a 401(k) loan works: The 401(k) sponsor (your employer) sells a portion of the plan investments from your account equal in value to the loan amount. If your 401(k) account is invested 70% in a stock mutual fund and 30% in a fixed-income mutual fund, the assets will be sold in the same proportions. The loan payments you make will be reinvested in whatever your then-current allocations are.

    Money borrowed for other purposes, such as a new automobile, must generally be repaid within five years. However, you may be able to repay a loan taken to purchase a primary residence over a longer period. Specific terms of the loan -- frequency of payments and the interest rate -- will be determined by your company, which may allow you to make payments on a loan through payroll deduction. IRS rules require payments to be made at least quarterly.

    Check the Rules Before You Borrow

    • You can generally borrow up to half the vested amount in your account, but no more than $50,000.
    • The loan must generally be paid back within five years. If the loan is used to purchase a house, you may have more time to repay the balance.
    • If you leave the company before repaying the loan, the balance could be treated as distribution on which you'll be required to pay taxes and possibly a 10% early withdrawal penalty on all pretax contributions and earnings withdrawn.

    Weigh the Pros ...

    For some, the primary attraction of a 401(k) loan is the simplicity and privacy not generally associated with a bank or finance company. And unlike banks and other sources of loans, there is no need to fear being turned down for the money when borrowing from a 401(k) plan.

    Another benefit may be competitive interest rates, which are generally tied to the prime rate. This interest is not tax deductible, however, and may actually "cost" you more than some other types of financing, such as a home equity loan which may allow you to deduct interest. The interest you pay on a plan loan goes directly into your 401(k) account and can then continue to grow tax deferred or tax free for your long-term needs.

    ... And Cons

    While these advantages may make a retirement plan loan appealing, there are several other points you should consider. First, if you are separated from the company through which you took the loan before you fully repay the money, you may be required to pay the balance within 30 days or pay federal income taxes on it. You could also be charged a 10% early withdrawal penalty by the IRS.

    Second, be aware of the potential "opportunity cost" of borrowing from a 401(k) plan -- the cost of any potential return you'll miss out on if the interest rate on the loan is lower than the account's rate of return. For instance, if you borrow money from an account earning 10% and you pay 7% interest on the loan, you miss out on a potential 3% return on the balance of the loan. Over time, the missed earnings can add up and result in a lower balance in retirement savings. Also, keep in mind that returns in stock and bond markets are not constant -- the average return is often earned in a few market surges occurring over a few days or weeks. If your plan money is out of the market when those surges occur, your opportunity cost could be much higher than you expected.

    Also take note of any fees charged for retirement plan loans by your company. Finally, some companies set deadlines for applying for loans and may take up to two months to process the application.

    Survey of 401(k) Plans on Plan Loans

    • 87% of respondents had access to plan loans.
    • Only 21% of eligible participants had loans.
    • The average loan balance was $6,846.
    • Only 16% of participants with account balances of less than $10,000 had loans outstanding.

    Source: Employee Benefit Research Institute, 2011.

    Make the Most of Your Retirement Plan

    The primary reason to invest in an employer-sponsored qualified retirement plan, such as a 401(k) plan, is to pursue your long-term financial goals. Remember, the earlier you invest and the longer you stay invested, the more you'll potentially benefit from tax-deferred or tax-free compounding.

    But if you've accumulated assets in your account and you're in need of a loan, a retirement plan could be a source of funds.

    Points to Remember

    1. Under IRS rules, 401(k) participants can borrow half the amount in their account, up to a maximum of $50,000.
    2. Loans generally must be repaid within five years.
    3. Simplicity and privacy are considered benefits of 401(k) plan loans. Interest rates are also generally competitive.
    4. Participants who leave their company before fully repaying a loan could end up owing federal income taxes and a 10% early withdrawal penalty on the balance.
    5. Many companies charge fees for 401(k) plan loans.

    Because of the possibility of human or mechanical error by S&P Capital IQ Financial Communications or its sources, neither S&P Capital IQ Financial Communications nor its sources guarantees the accuracy, adequacy, completeness or availability of any information and is not responsible for any errors or omissions or for the results obtained from the use of such information. In no event shall S&P Capital IQ Financial Communications be liable for any indirect, special or consequential damages in connection with subscriber's or others' use of the content.

    © 2013 S&P Capital IQ Financial Communications. All rights reserved.

  • How Much Do You Need to Retire?

    Key Points

    • Sources of Retirement Income
    • Saving Is the Key Component of Retirement Income
    • Meeting Your Goals
    • How Much Do You Need to Retire in Style?
    • Pensions, Social Security, and Other Allies
    • Points to Remember


    Picturing yourself as a retiree may be hard if not impossible. But if you could envision those future years, you'd probably see a life full of activity and decades of health, happiness, and prosperity. No rocking chairs and lap shawls need apply.

    The reality, however, is probably somewhere in between. The problem with the picture is that the pleasure and comfort of your later years depend, to an ever-increasing degree, on the actions you take today.

    So many changing facets of the American workplace have made it more important than ever to take control of your financial future. By investing now with a long-term focus, you can greatly improve your chances of having a fulfilling retirement.

    Americans used to count on a pension plus Social Security to get them through those "golden years." These days, people change jobs more often, rely on dual incomes, and manage their own retirement funds through defined contribution plans. By most estimates, you'll need between 60% and 100% of your final working years' income to maintain your lifestyle after retiring.


    Sources of Retirement Income

    Sources of Retirement Income
    This chart represents a breakdown of income sources for all retirees (aged 65 and over).
    Source: Social Security Administration, 2012 (using 2010 data, most recent available).

    Saving Is the Key Component of Retirement Income

    The accompanying pie chart shows the importance of saving now toward a retirement fund. Not only are Social Security benefits less significant, but the sums are diminishing and the age at which you can begin to receive benefits is higher. You can contact Social Security at 1-800-772-1213 to learn what you can expect in benefits, and when. Benefits are calculated on your earnings, with certain variable factors.

    Alas, the responsibility for the bulk of your nest egg rests with you. Social Security represents approximately 37% of the aggregate income of Americans aged 65 and older, according to the Social Security Administration.

    Also, as you begin thinking about how much you'll need for a comfortable retirement, you may be startled to learn the impact of inflation. At an average inflation rate of 3%, your cost of living would double every 24 years. Your annual income will need to increase each year even during retirement in order to keep up with the gradual rise in prices of everyday goods.

    You'll also have to consider the likelihood of increased medical costs and health insurance as you grow older. The average nursing home stay, for instance, now costs more than $90,000 a year and could rise to over $150,000 per year by 2030, assuming an annual inflation rate of 3%.1

    Meeting Your Goals

    Now that you have an idea how much you'll need to finance your retirement years, of which there can easily be 25 or more, you may better understand the urgency to build your assets.

    How Much Do You Need to Retire in Style?

    Financial experts estimate that most of us will need about 60% to 100% of our annual preretirement income to live on each year after we retire. Find out how close you are to meeting this goal by completing the exercise below.

    1. Estimate your last working year's salary. Multiply your current salary by the inflation factor from the table below, based on the number of years you have until retirement. This represents the future value of your salary, assuming 3% annual inflation.

      Example: If you are currently making $40,000 and have 20 years until retirement, your formula is $40,000 x 1.81 = $72,400

    2. Determine what percentage of your current income you expect to need after retirement. If 100% seems high, consider that while you may be able to stop paying some expenses, like mortgage payments, other expenses will likely increase, such as health and travel expenses. Multiply that percentage by the amount in #1.

      Example: $72,400 x .80 = $57,920

    3. Estimate your future Social Security and retirement benefits. The best source for Social Security benefit projections is the Social Security Estimator at www.ssa.gov/estimator/. (If you cannot readily access the official calculator, you can also get a very rough estimate of your benefit from Table 2 below.)
      1. If you are using the calculator, multiply the monthly amount listed under "wait to start your benefits at your full retirement age" by 12, then multiply that figure by the inflation factor from Table 1 below.

        Example: If the calculator shows an estimated monthly benefit of $1,153, your formula is $1,153 x 12 x 1.81 = $25,043

      2. If you are using Table 2, take the number corresponding to your annual salary and years to retirement.

        Example: If you currently earn $40,000 and have 20 years to retirement, your estimated benefit would be $25,000

      3. Subtract your Social Security benefits and other retirement benefits from the annual amount calculated in #1. This will give you an estimate of how much of your own savings you will have to use each year in retirement.

        Example: $57,920 - $25,000 = $32,920

    4. Estimate the total amount that you will have to put aside in retirement accounts such as 401(k) plans, IRAs, and personal savings. To determine how much you will need to save, multiply 19.3 by the annual amount you calculated in #3. This multiplier represents how much savings you would need to last 28 years at 3% inflation and earning a 6% annual return. A healthy, 65-year-old male has a 10% chance of living longer than 28 years.

      Example: $32,920 x 19.3 = $635,356

    5. Enter the amount of your current savings and investments and multiply it by the growth factor from the accompanying table. This is what your savings would be worth by the time you reach retirement, assuming an 8% return compounded annually.

      Example: $30,000 x 4.66 = $139,800

    6. If line 5 is larger than line 4, congratulations! You are on your way to meeting your retirement goal. Keep saving! If line 4 is larger than line 5, subtract line 5 from line 4. Enter that amount here. This is the additional amount you'll need.

      Example: $635,356 - $139,800 = $495,556

    7. Divide #6 by the multiplier in the table below for the number of years until your retirement. The multiplier represents how large your savings will grow based on your annual contribution, assuming an 8% annual return. The result is the approximate amount you may want to set aside each year.

      Example: $495,556 ÷ 49.42 = $10,027

    Table 1 -- Factors*

    Years Inflation Growth Multiplier
    5 1.16 1.47 6.34
    10 1.34 2.16 15.65
    15 1.56 3.17 29.32
    20 1.81 4.66 49.42
    25 2.09 6.85 78.95
    30 2.43 10.06 122.35
    35 2.81 14.79 186.10
    40 3.26 21.72 279.78

    Table 2 -- Social Security Income

    Years to Retirement
    Current Salary 40 35 30 25 20 15 10 5
    $20,000 29,500 27,000 25,000 22,500 20,500 19,000 17,500 16,000
    30,000 32,500 30,000 27,500 25,000 22,500 21,000 19,000 17,500
    40,000 35,500 32,500 30,000 27,000 25,000 23,000 21,000 19,000
    50,000 38,500 35,500 32,500 29,500 27,000 25,000 22,500 21,000
    60,000 41,500 38,000 35,000 32,000 29,000 26,500 24,500 22,500
    70,000 44,500 41,000 37,500 34,000 31,000 28,500 26,000 24,000
    80,000 47,500 43,500 40,000 36,500 33,500 30,500 28,000 25,500
    90,000 50,500 46,500 42,500 39,000 35,500 32,500 29,500 27,500
    97,500 + 53,000 48,500 44,500 40,500 37,000 34,000 31,000 28,500
    *Assumes 3% annual inflation and a 5% annual return.

    Pensions, Social Security, and Other Allies

    Traditional pensions (private and government) are estimated to supply about 18% of the aggregate income of today's retirees, while Social Security is estimated to supply 37%, although nearly two-thirds of retirees rely on Social Security for 50% or more of their income, according to the Social Security Administration (2011; using 2009 data, most recent available). Still, you'll probably fall far short of your goal. A radically reduced standard of living for a quarter century or more is hardly the stuff "golden age" dreams are made of.

    Fortunately, you have some allies. First is the power of compounding, which takes advantage of time. Tax deferral is another ally. Using investment vehicles such as 401(k) plans or individual retirement accounts (IRAs), you can put off paying taxes on your earnings until you are retired and potentially in a lower tax bracket. Meanwhile, your contributions may be pretax or tax deductible, helping reduce current tax bills.

    For example, an investment of $10,000 would grow to more than $100,000 after 30 years, at an annual return of 8%, if all the returns were reinvested and the account grew tax deferred. As with all hypotheticals, this example does not represent the performance of any specific investment and the earnings would be subject to taxation upon withdrawal at then-current rates and subject to penalties for early withdrawal.

    The more time you have until retirement, the more fortunate you may be. Delaying just months -- never mind years -- can significantly reduce your results. Consider this example: Jane begins investing $100 a month in her employer-sponsored 401(k) plan when she's 25. Mark does the same -- beginning when he's 35. Assuming a 7.5% annual rate of return compounded monthly, when Mark retires at 65, he'll have $135,587. Jane will have $304,272.

    While this is only a hypothetical and there are no guarantees any investment will provide the same results, you can see the remarkable difference starting early can potentially make.

    By starting early, investing systematically, and benefiting from the potential of compounding and tax deferral, you may pack a lot more punch into your portfolio.

    Another advantage of today's retirement planning options is that you can control how your money is invested.

    Investment plans need to be customized because different people have different degrees of risk they will accept as well as varying time frames they intend to hold their investments. Keep in mind, all investments involve risk including the possible loss of principal. A tailor-made portfolio can be diversified to take these factors into account. It's a wise idea to consult a professional financial advisor for complete information.

    Points to Remember

    1. The rising cost of living means you need to plan on an annual retirement income that could be substantially higher than what you spend now.
    2. You may have higher expenses in some things such as medical care, but lower expenses in others. You can estimate your "personal inflation rate" by looking at your expected living costs in retirement.
    3. You may need between 60% and 100% of your final working years' salary.
    4. Retirement income may be made up of pension benefits, Social Security benefits, personal savings and investments, and income from part-time work.
    5. Your financial advisor can help you develop an estimate of your needs and a plan to help you accumulate a retirement fund to provide income you'll need.

    1Sources: MetLife Market Survey of Nursing Home and Assisted Living Costs, October 2011; Standard & Poor's, 2012.

    Because of the possibility of human or mechanical error by S&P Capital IQ Financial Communications or its sources, neither S&P Capital IQ Financial Communications nor its sources guarantees the accuracy, adequacy, completeness or availability of any information and is not responsible for any errors or omissions or for the results obtained from the use of such information. In no event shall S&P Capital IQ Financial Communications be liable for any indirect, special or consequential damages in connection with subscriber's or others' use of the content.

    © 2013 S&P Capital IQ Financial Communications. All rights reserved.

  • Money Market Funds Can Add Stability and Liquidity

    Key Points

    • The Money Market
    • High Quality, Low Market Risk
    • Money Market Investments
    • The Benefits of Money Market Funds
    • How a Money Market Fund Fits in Your Portfolio
    • Stability vs. Growth
    • Traditions May Change
    • Points to Remember


    When you begin to build a portfolio of investments, you need to consider your short-term goals as well as your long-term goals. For example, do you plan to take a vacation or buy a car during the next year? You must also think about what portion of your portfolio will need to be liquid, or easily accessible, in case of emergencies. In addition, consider how much stability your portfolio will need to allow you to feel comfortable as you pursue your longer-term goals.

    Typically offering higher rates of return than traditional bank deposit accounts (albeit without the federal insurance), money market mutual funds can serve short-term and emergency cash needs, as well as provide an element of stability to help diversify your portfolio.1

    The Money Market

    Some investors believe that money market mutual funds invest in stocks. In fact, they do not. Money market funds invest in short-term debt instruments purchased on what's known as the "money market."

    The money market is not a particular place, but rather how the U.S. government, banks, corporations, and other large institutions manage their short-term cash needs. For example, when the U.S. government needs money quickly, it borrows from the money market by issuing Treasury bills (T-bills) that institutions and extremely wealthy individuals will purchase. The T-bills represent the government's promise to pay back the loan.2 These investments mature, or come due, in short periods of time, when the government repays the loan.

    Similarly, banks will offer short-term debt instruments called certificates of deposit (CDs), and corporations will offer commercial paper.3 Other securities traded on the money market include repurchase agreements, banker's acceptances, and government-agency obligations. Money market investments also include short-term tax-exempt issues from municipalities and maturing municipal bonds.

    High Quality, Low Market Risk

    Money market investments generally have a high credit quality, which means that there is little risk that their issuers will not be able to repay their debt. Because of this high quality, they are considered low-risk investments. Money market mutual funds pool these securities in one investment vehicle that brings low-risk opportunities to the everyday investor.

    In addition, the securities held within a money market fund have short maturities, usually one year or less. These short maturities result in a low sensitivity to interest rates. In other words, as long as the fund can hold its securities to maturity, the value of the fund will not fluctuate due to changes in interest rates.

    Because of their low-risk holdings and their low susceptibility to changes in interest rates, money market mutual funds are able to offer shares at the net asset value of $1 and can strive to maintain this stable value, assuring investors of little risk to their principal.1

    Money Market Investments

    • Commercial Paper
    • Treasury Bills
    • Banker's Acceptances
    • Repurchase Agreements
    • Certificates of Deposit

    The Benefits of Money Market Funds

    In addition to providing stability and low risk, money market funds offer the following benefits:
    • Liquidity -- Money markets do not require you to invest your money for set amounts of time. You can access your money whenever you need it, without penalty. Other short-term, stable investments are not as liquid. For example, CDs charge penalties for early withdrawals, and cashing in bonds early could cause you to lose twofold: (1) you forgo any future income on the bond if you do not reinvest your money and (2) if the price of your bond has dropped since your original purchase, you lose money there, too.
    • Very low fees -- Because fund management is not as complex as it can be for other types of mutual funds, these funds can charge lower fees and expenses.
    • Daily valuation -- Dividends are credited to your account daily, which ensures that your earnings are always up-to-date and available.
    • Lower minimum investments -- Money market mutual funds generally offer lower initial investment minimums than other investments.
    • Check writing -- Many money market funds allow you to write checks against the balance, although there can be limits on this privilege.
    • Competitive interest rates -- During a high-interest-rate environment, money market mutual funds can offer competitive yields providing returns higher than bank savings and money market accounts.

    How Money Market Funds Seek to Maintain a Stable Net Asset Value

    Money market funds strive to maintain a reputation for safety by keeping the value of each fund share constant at $1. To achieve this, money market fund portfolio managers plan to hold each security they purchase until maturity, when the full principal is repaid by the issuer. If a portfolio manager has to sell a security before it matures, he or she runs the risk that it will have declined in value, either due to a general increase in interest rates or a decline in the credit quality of the issuer.

    While portfolio managers can control many factors, one thing they cannot control is fund redemptions. A sharp rise in interest rates could cause fund redemptions to surge -- requiring the fund manager to sell fund investments prior to their maturity, possibly "breaking the buck" (if the per-share value of the fund drops below $1).

    How a Money Market Fund Fits in Your Portfolio

    Within an investor's portfolio, money market funds can serve two main purposes: short-term cash needs and diversification.

    • Short-term cash needs: You can redeem shares of your money market funds for short-term savings and cash needs. Examples include larger-ticket expenses you will have over the next year, such as that new car or vacation. Also, retirees often find money market funds to be appropriate vehicles for managing current income and cash needs, and for cash needs one to three years distant. Higher income earners may want to consider tax-exempt money market funds.
    • Diversification: Money market funds can help bring stability to a portfolio heavily weighted in the riskier stock and bond investments. They can also serve as a convenient place to park substantial amounts of cash while you decide where you want to invest it.

    Stability vs. Growth

    While money market funds help short-term needs and diversification strategies, investors should remember that they are, certainly, conservative investments. Investing your portfolio too heavily in money market funds can hurt its potential for long-term growth. Investors who are primarily seeking high long-term returns may be best served by investing the majority of their money in bond and stock investments and a minority of emergency cash in money market funds. Because money market returns tend to just keep pace with inflation before taking taxes into account, money set aside in money market mutual funds can actually lose purchasing power after income taxes on annual returns are factored in.

    Also, investors need to evaluate the short-term interest-rate environment before they choose money market funds. While such funds respond quickly and positively to rising short-term rates, the same holds true for rate declines. In a low-interest-rate environment, investors will need to shop around to find the best returns for their short-term needs.

    Traditions May Change

    Historically, most people have turned to their community bank for their short-term savings and cash-management needs. As the benefits of money market mutual funds become more widely known, that tradition may change, exposing more people to the stability and liquidity benefits of these funds. Talk to your financial advisor about whether money market funds have a place in your portfolio.

    Points to Remember

    1. Money market funds are pools of short-term investments that usually mature within one year.
    2. Money market funds seek to maintain a stable net asset value of $1, but this is not guaranteed.
    3. The relative safety of money market funds must be balanced against the need for higher returns for long-term savings to outpace inflation.
    4. Money market funds can be excellent investments for short-term goals such as current cash needs, an upcoming vacation, or for retirees who may want to set aside several years' worth of annual living expenses.
    5. Individuals in higher income tax brackets may prefer tax-exempt money market funds, which invest in tax-exempt municipal bonds nearing maturity and short-term municipal issues.

    1Investment in a money market fund is neither insured nor guaranteed by the U.S. government, and there can be no guarantee that the fund will maintain a stable $1 share price. The fund's yield will vary.

    2Keep in mind that U.S. Treasury bills/U.S. government bonds are guaranteed as to principal and interest payments (although the funds that invest in them are not). However, the returns of U.S. Treasury bills/U.S. government bonds historically have not outpaced inflation by as great a margin as stocks, although past performance cannot guarantee future results.

    3CDs offer a guaranteed rate of return, guaranteed principal and interest, and are generally insured by the Federal Deposit Insurance Corp. (FDIC), but do not necessarily protect against the rising cost of living. While a money market fund aims to maintain a stable $1 share price, there can be no guarantee that the fund will achieve this objective, and its yield will vary.

    Because of the possibility of human or mechanical error by S&P Capital IQ Financial Communications or its sources, neither S&P Capital IQ Financial Communications nor its sources guarantees the accuracy, adequacy, completeness or availability of any information and is not responsible for any errors or omissions or for the results obtained from the use of such information. In no event shall S&P Capital IQ Financial Communications be liable for any indirect, special or consequential damages in connection with subscriber's or others' use of the content.

    © 2013 S&P Capital IQ Financial Communications. All rights reserved.

  • Retirement Account Distributions After Age 70½

    Key Points

    • Required Minimum Distributions During Your Lifetime
    • Additional Considerations for Employer-Sponsored Plans
    • Employer-Sponsored Retirement Plan Distribution Alternatives
    • Lump-Sum Distributions
    • Periodic Distributions
    • Uniform Lifetime Table for Required Minimum Distributions
    • Other Considerations
    • Conclusion
    • Points to Remember


     If you have assets in a qualified retirement plan, such as a company-sponsored 401(k) plan or a traditional individual retirement account (IRA), you'll want to be aware of several rules that may apply to you when you take a distribution.

    Required Minimum Distributions During Your Lifetime

    Many people begin withdrawing funds from qualified retirement accounts soon after they retire in order to provide annual retirement income. These withdrawals are discretionary in terms of timing and amount until the account holder reaches age 70½. After that, failure to withdraw the required minimum amount annually may result in substantial tax penalties. Thus, it may be prudent to familiarize yourself with the minimum distribution requirements.

    For traditional IRAs, individuals must generally begin taking required minimum distributions no later than April 1 following the year in which they turn 70½. The same generally holds true for 401(k)s and other qualified retirement plans. (Note that some plans may require plan participants to remove retirement assets at an earlier age.) However, required minimum distributions from a 401(k) can be delayed until retirement if the plan participant continues to be employed by the plan sponsor beyond age 70½ and does not own more than 5% of the company.

    In accordance with IRS regulations, minimum distributions are determined using one standard table based on the IRA owner's/plan participant's age and his or her account balance. Thus, required minimum distributions generally are no longer tied to a named beneficiary. There is one exception, however. IRA owners/plan participants who have a spousal beneficiary who is more than 10 years younger can base required minimum distributions on the joint life expectancy of the IRA owner/plan participant and spousal beneficiary.

    These minimum required distribution rules do not apply to Roth IRAs. Thus, during your lifetime, you are not required to receive distributions from your Roth IRA.

    Additional Considerations for Employer-Sponsored Plans

    The table below is general in nature and not a complete discussion of the options, advantages, and disadvantages of various distribution options. For example, there are different types of annuities, each entailing unique features, risks, and expenses. Be sure to talk to a tax or financial advisor about your particular situation and the options that may be best for you.

    Employer-Sponsored Retirement Plan Distribution Alternatives1

    Method Advantages Disadvantages
    Annuity A regular periodic payment, usually of a set amount, over the lifetime of the designated recipient. (Not available with some plans.) Assurance of lifetime income; option of spreading over joint life expectancy of you and your spouse.2 Not generally indexed for inflation.
    Periodic Payments Installment payments over a specific period, often 5 to 15 years. Relatively large payments over a limited time. Taxes may be due at highest rate.
    Lump Sum Full payment of the monies in one taxable year. Direct control of assets; may be eligible for 10-year forward averaging. Current taxation at potentially highest rate.
    IRA Rollover A transfer of funds to a traditional IRA (or Roth IRA if attributable to Roth 401(k) contributions). Direct control of assets; continued tax deferral on assets. Additional rules and limitations.

     
    In addition to required minimum distributions, removing money from an employer-sponsored retirement plan involves some other issues that need to be explored. Often, this may require the assistance of a tax or financial professional, who can evaluate the options available to you and analyze the tax consequences of various distribution options.

    Lump-Sum Distributions

    Retirees usually have the option of removing their retirement plan assets in one lump sum. Certain lump sums qualify for preferential tax treatment. To qualify, the payment of funds must meet requirements defined by the IRS:

    • The entire amount of the employee's balance in employer-sponsored retirement plans must be paid in a single tax year.
    • The amount must be paid after you turn 59½ or separate from service.
    • You must have participated in the plan for five tax years.

    A lump-sum distribution may qualify for preferential tax treatment if you were born before January 2, 1936. For instance, if you were born before January 2, 1936, you may qualify for 10-year forward income averaging on your lump-sum distribution, based on 1986 tax rates. With this option, the tax is calculated assuming the account balance is paid out in equal amounts over 10 years and taxed at the single taxpayer's rate. In addition, you may qualify for special 20% capital gains treatment on the pre-1974 portion of your lump sum.

    If you qualify for forward income averaging, you may want to figure your tax liability with and without averaging to see which method will save you more. Keep in mind that the amounts received as distributions are generally taxed as ordinary income.

    To the extent 10-year forward income averaging is available, the IRS also will give you a break (minimum distribution allowance) if your lump sum is less than $70,000. In such cases, taxes will only be due on a portion of the lump-sum distribution.

    If you roll over all or part of an account into an IRA, you will not be able to elect forward income averaging on the distribution. Also, the rollover will not count as a distribution in meeting required minimum distribution amounts.

    Periodic Distributions

    If you choose to receive periodic payments that will extend past the year your turn age 70½, the amount must be at least as much as your required minimum distribution, to avoid penalties.

    Uniform Lifetime Table for Required Minimum Distributions

    Age 70 75 80 85 90 95 100 105
    27.4 22.9 18.7 14.8 11.4 8.6 6.3 4.5

     This table shows required minimum distribution periods for tax-deferred accounts for unmarried owners, married owners whose spouses are not more than 10 years younger than the account owner, and married owners whose spouses are not the sole beneficiaries of their accounts.

    Source: IRS Publication 590.

    Other Considerations

    If your plan's beneficiary is not your spouse, keep in mind that the IRS will limit the recognized age gap between you and a younger nonspousal beneficiary to 10 years for the purposes of calculating required minimum distributions during your lifetime.

    Conclusion

    There are several considerations to make regarding your retirement plan distributions, and the changing laws and numerous exceptions do not make the decision any easier. It is important to consult competent financial advisors to determine which option is best for your personal situation.

    Points to Remember

    1. Distributions from a 401(k) can be delayed until retirement if a plan participant is still employed by the plan sponsor beyond age 70½ and if the plan participant does not own more than 5% of the company.
    2. After age 70½, failure to withdraw the required minimum amount annually may result in substantial tax penalties.
    3. A lump-sum distribution may qualify for 10-year forward income averaging.
    4. The IRS will give you a break (minimum distribution allowance) if your lump sum qualifies for 10-year forward averaging and is less than $70,000.
    5. You may be able to accelerate or minimize the disbursement of your retirement assets by how you choose to calculate periodic payment time periods.

    1Speak to a tax or financial advisor about your alternatives before making a decision.

    2Annuity guarantees are backed by the claims-paying ability of the issuing company.

    Because of the possibility of human or mechanical error by S&P Capital IQ Financial Communications or its sources, neither S&P Capital IQ Financial Communications nor its sources guarantees the accuracy, adequacy, completeness or availability of any information and is not responsible for any errors or omissions or for the results obtained from the use of such information. In no event shall S&P Capital IQ Financial Communications be liable for any indirect, special or consequential damages in connection with subscriber's or others' use of the content.

    © 2013 S&P Capital IQ Financial Communications. All rights reserved.

  • Understanding Your Plan Demographics

    Key Points

    • Tailoring Design Elements
    • The Safe Harbor Option
    • Avoiding the Nondiscrimination Tests
    • More Than Just Design
    • Points to Remember


     What do your employees want from a retirement savings plan? Although the answer depends on a number of factors, one of the most important is workforce demographics, particularly employee age and salary levels.

    Because retirement savings plan participation tends to increase with income and age, plan sponsors can use certain plan design options to attract lower-paid and younger employees who are the least likely to participate in the plan. In addition, adding plan design features that are attractive to other employee demographic groups can help the plan sponsor attract and retain those employees.

    Tailoring Design Elements

    Plan sponsors can tailor specific plan design elements based on employee demographics. For example, if a plan sponsor's workforce includes a large group of lower-skilled and lower-paid employees who find it difficult to make retirement savings a priority, the plan sponsor might modify the formula for its matching contributions to encourage these individuals to participate in the plan. In this case, replacing a matching contribution of 50% of the first 6% of pay with a match of 100% on the first 3% of pay stands a better chance of getting the attention of lower paid employees.

    Here are some other plan design elements that can be used to meet the needs of specific employees:

    Automatic enrollment. Because retirement savings plan participation rates tend to rise with employee income levels, plan sponsors with a large contingent of lower-paid workers might consider implementing an automatic enrollment feature to get more of these individuals into the plan.

    The Roth 401(k) feature. Although the Roth 401(k) is a new feature, initial research suggests that it is quite attractive to younger employees. After all, the Roth 401(k) allows individuals to make taxable contributions to the plan with the promise that those assets can be withdrawn in retirement tax free. It makes sense that younger employees who tend to be in a lower tax bracket would take advantage of this feature, especially if the plan sponsor provides targeted education about the benefits of the Roth 401(k). The Roth feature is also likely to appeal to higher income employees who earn too much money to qualify for a Roth IRA.

    Investment options. Finding the right number and type of investment options to offer through the plan is a bit of a balancing act. Too many options or options that are very sophisticated can intimidate certain segments of the employee population who are not used to making investment decisions. But at the same time, more financially savvy employees who want maximum control and choice may not be content choosing between just a few fund options. Your plan provider can help you put together a menu of options that is right for your employee base.

    Loans and hardship withdrawals. For some employee segments, particularly lower-paid employees, the flexibility to withdraw money in certain circumstances can eliminate a major deterrent to participation. Therefore, implementing and communicating plan loan and hardship withdrawal features can be another way to increase plan participation levels.

    Plan eligibility. A key decision in plan design is when employees will become eligible to participate in the plan. In many cases, plan sponsors aim to get employees enrolled in the plan as soon as possible. However, if a plan sponsor experiences high turnover among certain employee segments, delaying plan eligibility for a certain period of time can help keep plan administrative costs in line.

    The Safe Harbor Option

    One of the key reasons plan sponsors focus on increasing plan participation and contributions among certain employee segments is to make sure that the plan can pass required nondiscrimination tests and does not benefit highly paid employees more than lower-paid employees. However, in some cases, even the plan sponsor's best efforts at attracting all segments of employees to the plan are not enough.

    In these cases, plan sponsors have the option of implementing one of two so-called safe harbor plan designs that allow the plan sponsor to forgo nondiscrimination testing. The first design option requires the plan sponsor to match 100% of pretax contributions made by lower-paid employees up to 3% of pay, plus a 50% match on contributions equal to the next 2% of pay. Plan sponsors choosing the second design option must automatically contribute at least 3% of pay to the accounts of all lower-paid employees, whether or not those employees contribute to the plan on their own. On both cases, all company contributions must vest immediately.

    Avoiding the Nondiscrimination Tests

    Either of these safe harbor contribution options will permit the plan sponsor to forgo nondiscrimination testing. Note that employer contributions are immediately vested.

    Option 1 Sponsor matches 100% of pretax contributions made by lower-paid employees up to 3% of pay, plus 50% match on next 2% of pay
    Option 2 Sponsor contributes at least 3% of pay to all employees, regardless of whether they contribute

    More Than Just Design

    When it comes to demographics, there are two other things to keep in mind. First, plan design is not the only thing affected by employee demographics. Once the plan has been designed, demographics, including gender, age, salary level, education level, and cultural background/ethnicity, continue to influence a host of other issues, including participant education and communication.

    In addition, it is important to remember that demographics change over time. Plan sponsors cannot become complacent as workers age, the company's needs and goals change, and a new generation of workers enters the organization. The retirement savings plan must keep up with and reflect these changes in order to remain relevant to both the plan sponsor and its participants.

    Points to Remember

    1. Employee demographics - particularly age and salary levels - will influence plan design.
    2. Matching formulas, automatic enrollment, loans, and hardship withdrawals can all help improve participation among lower-paid and younger employees.
    3. The Roth 401(k) feature may be especially appealing to both younger employees and those who make too much money to contribute to a Roth IRA.
    4. Choosing the right menu of investment options will also depend on your workforce demographics. Too few options can deter sophisticated investors from participating, while too many can intimidate novice investors.
    5. Employers with high turnover rates may also want to think carefully about their eligibility rules. Delaying eligibility may help reduce administration costs.
    6. Workforce demographics will affect education and communication strategies, as well as plan design.

    Because of the possibility of human or mechanical error by S&P Capital IQ Financial Communications or its sources, neither S&P Capital IQ Financial Communications nor its sources guarantees the accuracy, adequacy, completeness or availability of any information and is not responsible for any errors or omissions or for the results obtained from the use of such information. In no event shall S&P Capital IQ Financial Communications be liable for any indirect, special or consequential damages in connection with subscriber's or others' use of the content.

    © 2013 S&P Capital IQ Financial Communications. All rights reserved.

  • The Role of Alternative Asset Classes

    Key Points

    • Risk Management and More
    • Hedge Funds
    • Real Estate
    • Caution Is Key
    • Points to Remember


    In an era of sub-par financial market performance and underfunded pension plans, defined benefit plan sponsors may be looking for alternative vehicles to help them manage their investment objectives. Hedge funds, real estate, and other sophisticated investment vehicles may offer diversification and return-enhancing benefits to the savvy pension fund manager; however, sponsors must be aware of the risks involved and may want to seek the assistance of a qualified financial advisor or pension plan consultant before allocating money to these largely unregulated asset classes.

    Risk Management and More

    Generally, alternative investments offer three potential advantages to a retirement plan portfolio: diversification, higher return potential, and access to innovative investment strategies.

    • Diversification: Alternative investments may have a low correlation to public stock and bond markets. This means that price movements in publicly traded stocks and bonds might not be mirrored by alternative investments, making them potentially strong portfolio diversifiers. In other words, there could be periods where publicly traded investments decline and alternative investments may gain or hold steady, and vice versa.
    • Enhanced performance potential: Alternative investments can help balance investment returns within a portfolio. When traditional stock and bond investments underperform, alternative investments may be gaining or holding steady.
    • Innovative investment strategies: Alternative investment managers often employ innovative strategies, not typically available through traditional investment options, to manage risk and pursue returns. Short selling, arbitrage, leverage, derivatives, and futures are just a few.

    Alternative investments cover a broad range of categories, styles, and philosophies that are as diverse as the managers who run them. Although they may differ in their individual risk/return features, they share some common characteristics.

    First, shareholders who choose alternative investments usually have a long investment horizon. Some alternative investments are contractual agreements that require investors to commit their capital for an extended period -- often five to seven years or longer. So if liquidity is a priority in your plans' holdings, you may want to think carefully about the amount of money to allocate to alternative investments.

    Second, the Securities and Exchange Commission (SEC) may limit access to certain alternative investments to "qualified" individual and institutional investors. The SEC spells out the qualifications in detail.

    Finally, managers of alternative investment vehicles typically have specialized knowledge about the investment and a level of understanding that goes beyond what is generally available to retail investors. In addition, managers of alternative investments often invest their own assets in the instrument, thereby strengthening their commitment to its performance.

    Following are brief descriptions of some popular investment alternatives. For more information on how these investments may fit into your retirement plan's investment policy, contact your plan consultant or financial advisor.

    Hedge Funds

    The term hedge fund is generally used to describe a professionally managed fund that follows aggressive investment strategies unavailable to ordinary mutual fund or portfolio managers. Hedge fund managers take an opportunistic approach to investing, exercising a wide variety of styles and strategies in pursuit of positive returns, regardless of market conditions.

    Compared with more traditional mutual funds, hedge fund managers are freer to pursue a broad investment mandate and to alter investment strategies at will. However, hedge fund managers generally are not required to report their performance data to any central regulatory body. For these reasons, plan sponsors have traditionally been hesitant to include hedge funds in their plans; however, high-quality hedge funds may prove beneficial for diversification and performance enhancement over the long term.

    Hedge fund managers are considered partners in a fund, and because their compensation is typically tied to the fund's performance, they are highly motivated to achieve maximum returns. In fact, many fund managers invest a significant portion of their own assets in a fund. Since the fund manager is typically the driving force behind a fund's performance, his or her expertise should be a key determinant when choosing a hedge fund.

    Real Estate

    Real estate can offer an attractive alternative to equity investments. It has the potential for attractive returns; it poses a number of tax advantages; and it can be a good portfolio diversifier.

    There are many ways to invest in real estate. For many retirement plans, the most appropriate vehicle is shares of a real estate investment trust (REIT). REITs are publicly traded on the major exchanges. They usually hold diversified portfolios -- many different types of properties in varied locations -- so that the exposure to any one property is limited. REITs are purchased more for their income and competitive yield than for their appreciation potential.

    When their income-generating capability is coupled with real estate's potential to appreciate in value, REITs may be considered an attractive investment from a total return perspective.

    Caution Is Key

    Alternative investments may play an important risk-management role in a strategically diversified pension plan portfolio; however, this sophisticated investment arena can prove risky for the uninitiated. Hedge funds often involve significant exposure to specific market segments and are subject to wide fluctuations in value when markets shift. Their lack of regulatory oversight further adds to their risk. REITs also entail risk, and are sensitive to economic cycles and tax and regulatory requirements. Accordingly, when choosing alternative investments for a pension plan, professional assistance is highly recommended.

    Points to Remember

    1. Alternative investment strategies may offer diversification and return-enhancing benefits to the savvy pension fund manager; however, sponsors must be well aware of the risks.
    2. Generally, alternative investments offer three potential advantages to a retirement plan portfolio: diversification, higher return potential, and access to innovative investment management.
    3. Although they may differ in their individual risk/return features, alternative investments share some common characteristics. First, they usually have a long investment horizon. Second, they are generally limited to "qualified" individual and institutional investors. Finally, the investment managers have specialized knowledge and often invest their own assets, thereby strengthening their commitment to performance.
    4. Hedge funds and real estate investment vehicles -- particularly real estate investment trusts (REITs) -- are investment alternatives sponsors may want to consider.
    5. Sponsors should seek the assistance of a qualified financial advisor or pension plan consultant before allocating money to these largely unregulated asset classes.

    Because of the possibility of human or mechanical error by S&P Capital IQ Financial Communications or its sources, neither S&P Capital IQ Financial Communications nor its sources guarantees the accuracy, adequacy, completeness or availability of any information and is not responsible for any errors or omissions or for the results obtained from the use of such information. In no event shall S&P Capital IQ Financial Communications be liable for any indirect, special or consequential damages in connection with subscriber's or others' use of the content.

    © 2013 S&P Capital IQ Financial Communications. All rights reserved.

  • Making the Most of Asset Allocation Funds -- A Guide for Plan Sponsors

    Key Points

    • Understanding Asset Allocation Funds
    • Points to Remember


    For many retirement plan participants, asset allocation may be the most important single factor they can control in their portfolios.


    But unfortunately, many participants plan their asset allocation poorly, if at all. Far from having diversified portfolios that are allocated according to time horizon and risk profile, some seem to be navigating their financial futures randomly rather than strategically.

    Fortunately, there is an efficient alternative to help participants make better allocation decisions. As a responsible plan sponsor, you can provide your participants with investment options that prepackage suitable allocations. And you can educate them in strategies to use these packages wisely.

    Professionally designed comprehensive investment portfolios are known variously as lifecycle funds, lifestyle funds, target date funds or target maturity funds. These funds feature blends of stock, bond and cash holdings that are mixed to produce specific risk profiles. As a class, they are intended to provide single-choice options that meet the allocation needs of participants who fit the profiles.

    But be careful. The mere addition of an asset allocation fund package to an investment menu may exacerbate allocation problems rather than address them. Why? Because poorly informed participants may misuse the funds -- for example, by adding them to existing portfolios rather than investing exclusively in them.

    Understanding Asset Allocation Funds

    Asset allocation funds fall into two broad categories -- those with static allocations and those with variable allocations. While each type of fund can serve similar functions as a core strategy for asset allocation, they should not be considered as fungible, i.e., interchangeable. In fact, each type has its own strengths and weaknesses in an investment menu.

    Static allocation funds are commonly known as lifestyle funds, and they are typically offered in an array representing a spectrum of risk profiles. These portfolios present more conservative risk/reward profiles as an investor progresses along the fund sequence. Investors working toward a distant time horizon have the option of shifting their assets from one step to the next in order to reduce their risk exposure as they approach their goal. Investors also have the option of selecting the portfolio that best fits their current risk preference regardless of where they might be on the age progression.

    If you choose to include lifestyle funds in your array, keep in mind that you should educate about the nomenclature. Lifestyle funds are sometimes labeled conservative or aggressive to reflect the personality of the fund's allocation - a conservative fund is meant for someone with a near-term horizon, an aggressive fund for a long-term horizon. The terms are not meant to describe the general investment preferences of any individual investor. Also keep in mind that lifestyle fund investors may need reminders at key junctures to roll over their portfolios into another fund.

    Variable allocation funds are commonly known as lifecycle or target funds. Lifecycle funds are meant to be single-choice, permanent solutions for their investors. An investor chooses the fund that matches up to his or her retirement date. Then, as the date approaches, the allocation of the fund is shifted gradually to achieve a more conservative profile -- with greater holdings of investment-grade bonds and cash-equivalent securities such as Treasury bills and reduced holdings of equities. Some lifecycle funds use a rigid glide path to shift their focus. Some use tactical asset allocation models to vary their relative asset exposure from time to time. These managers seek to enhance portfolio performance by overweighting those asset classes that may offer unusual short-term opportunity or by underweighting those classes that may pose abnormal short-run risk.

    Whatever asset allocation fund options you might consider for your investment menu, a detailed analysis of the funds will be especially important. Keep in mind that asset allocation portfolios are typically funds of funds, so you would be well advised to extend your due diligence to each of the underlying portfolios that comprise the package. You may also wish to consider how the asset allocation fund provider will deal with style drift or asset manager turnover in the subportfolios. And you should understand that the total package cost might include allocation advisory fees as well as asset management expenses.

    The bottom line is that asset allocation funds are designed to provide investors with an easy-to-use format for the efficient management of their retirement assets. Plan sponsors who add allocation funds to their menus can offer participants cost-effective, low-maintenance solutions for their retirement portfolio management needs.

    A Typical Lifecycle Fund's Glide Path


    A Typical Lifestyle Fund Family Progression
    A lifecycle fund offers an investor a no-maintenance, phased transition from a wealth-building allocation to a wealth-preserving allocation. A lifestyle fund provides a series of discrete steps that provide more flexibility but also require some degree of investor oversight to ensure that the selected allocation reflects current goals. Keep in mind that these allocations are illustrative only. Each asset allocation fund family establishes its own allocation policies.

    Points to Remember

    1. Asset allocation policy may be the most important single portfolio management issue for retirement plan participants. But unfortunately, many participants plan their asset allocation poorly, if at all.
    2. Asset allocation funds offer plan participants an efficient alternative. They provide participants with investment options that prepackage suitable asset allocations in easy-to-use formats.
    3. Lifestyle funds have static asset allocations. Each fund in the lifestyle array offers a different degree of risk and reward allowing the investor to customize his or her portfolio to meet particular goals or risk profiles.
    4. Lifecycle funds offer a phased transition from a growth-oriented but volatile allocation policy to a conservative, preservation-oriented policy as the investor moves closer to retirement. Lifecycle funds may also be known as target date funds or target maturity funds.
    5. Asset allocation funds in general are meant to be the sole investments in a portfolio. They are not intended to be held in conjunction with ordinary single-style mutual funds.

    Because of the possibility of human or mechanical error by S&P Capital IQ Financial Communications or its sources, neither S&P Capital IQ Financial Communications nor its sources guarantees the accuracy, adequacy, completeness or availability of any information and is not responsible for any errors or omissions or for the results obtained from the use of such information. In no event shall S&P Capital IQ Financial Communications be liable for any indirect, special or consequential damages in connection with subscriber's or others' use of the content.

    © 2013 S&P Capital IQ Financial Communications. All rights reserved.

  • Reviewing the Investment Lineup During a Merger

    Key Points

    • Still Bound by ERISA
    • Compare and Contrast
    • Don't Forget to Communicate
    • Seize the Moment
    • Points to Remember


     Plan mergers often create overlapping investment choices, which may result in inefficiency and increased costs. But while the procedures and rules for addressing other merger-related challenges are clearly codified, the strategies and tactics for conducting an investment menu review are largely at the discretion of plan sponsors.

    Still Bound by ERISA

    In many important ways, however, consolidating an investment lineup in the wake of a merger entails the same fiduciary responsibilities for plan officials as establishing a new plan's menu. For example, the Employee Retirement Income Security Act (ERISA) requires fiduciaries to act exclusively in the interests of plan participants and beneficiaries; to make decisions with the care, skill, and diligence characteristic of a "prudent" person knowledgeable about such matters; and to provide participants with a diversified range of investment alternatives.

    To satisfy the latter requirement, a plan -- whether merged or not -- must offer at least three investment options with materially different risk and return characteristics so that participants can customize asset allocations that are appropriate for their financial goals and risk tolerance. Therefore, the decision to remove investment options during a merger must be a carefully considered one.

    Compare and Contrast

    Whenever two plan sponsors merge, it's imperative to conduct a comprehensive comparison of the plans involved. The information and conclusions that arise from this initiative will not only provide insight about potential investment changes, but will also prove useful when it's time to communicate the rationale for any changes to participants.

    Steps plan sponsors may want to take when undergoing a merger include:

    • Create a matrix listing and compare each plan's investment lineup in order to assess similarities and differences.
    • Conduct a due diligence review of each investment option to identify any unique considerations, such as asset liquidity, GIC maturity dates, surrender charges, etc.
    • Study each plan's key documents, including investment management agreements, investment policies, insurance contracts, summary plan descriptions, IRS determination letters and back-up materials, the most recent 5500 forms, and any current financial or trustee reports.

    An obvious goal of such a review would be to eliminate redundancies by removing 'like' funds in similar asset classes. For example, if two merging plans each offer a small-cap value fund, it may not be necessary to keep both. Of course, fund names alone don't tell the entire story of an investment's risk and return potential. Before deciding which, if any, funds to remove, consider the following criteria:

    • Historical performance data, relative to an appropriate peer group
    • Risk-adjusted performance, relative to comparable investments
    • The makeup of portfolio management teams
    • Whether or not significant style drift has occurred
    • Fees and/or assets under management

    Employers that make frequent acquisitions might want to consider offering plans with many investment options in order to accommodate newly merged participants who are eager to maintain or closely replicate their previous portfolios.

    Don't Forget to Communicate

    The end users of a merged plan will be its participants, so keeping them informed about pending changes and revised investment offerings is of paramount importance. Since a merger or acquisition can be a stressful, uncertain time for employees, maintaining open lines of communication is a valuable strategy for smoothing the transition and reassuring participants about the ongoing value of their retirement plan.

    Remember, too, that if a merger will result in a plan blackout, participants must be given 30 days' notice before any of their rights are temporarily suspended. The Department of Labor also requires that plan administrators explain the reasons for the blackout, list the rights that will be suspended, specify the start and end dates of the blackout period, and encourage workers to evaluate their current investments in light of the blackout period.

    Seize the Moment

    Also, keep in mind that individuals previously responsible for oversight of an acquired plan may have valuable insights and "institutional memory" about subjects such as participant investment preferences and the implementation of past decisions. However, it is not uncommon for such individuals to leave an organization after a merger, so try to establish a working rapport with them as soon as possible in order to make the most of the relationship while you still can.

    And last, but certainly not least, be sure to notify the IRS about the merger, using Form 5310-A ("Notice of Plan Merger or Consolidation, Spin-Off, or Transfer of Plan Assets of Liabilities; Notice of Qualified Separate Lines of Business").

    Points to Remember

    1. When a corporate merger unites two retirement plans, the sponsor of the new plan should consider conducting a comprehensive review of the expanded investment lineup with an eye toward reducing redundancy and increasing efficiency.
    2. In many ways, the options and responsibilities facing sponsors in this scenario are similar to those encountered when creating a new plan from scratch. For example, ERISA requires fiduciaries to act exclusively in the interests of plan participants and beneficiaries and to provide a diversified mix of investment options.
    3. A comprehensive review of each merged plan's key features will help to identify potentially expendable investment options. It will also provide sponsors with the insights necessary to create the best possible participant communication strategies when it's time to announce any changes.
    4. When reviewing an investment lineup, be sure to evaluate each option's performance data, management team, fees, and peer group performance.
    5. If a merger will result in a plan blackout, sponsors must adhere to Department of Labor rules that require participants to be informed in advance about their rights and responsibilities before and during the blackout period.

    Because of the possibility of human or mechanical error by S&P Capital IQ Financial Communications or its sources, neither S&P Capital IQ Financial Communications nor its sources guarantees the accuracy, adequacy, completeness or availability of any information and is not responsible for any errors or omissions or for the results obtained from the use of such information. In no event shall S&P Capital IQ Financial Communications be liable for any indirect, special or consequential damages in connection with subscriber's or others' use of the content.

    © 2013 S&P Capital IQ Financial Communications. All rights reserved.

  • The Benefits of Alpha — A Look at the Growing Demand for Excess Return Strategies Among Plan Sponsors

    Key Points

    • Calculating Alpha
    • Understanding the Limitations of Alpha
    • Points to Remember


    As a plan sponsor, you need to know on a regular basis how well your investment portfolios are performing. An index such as the S&P 500 can offer some insight, but you may not have full information if you look only at whether a particular portfolio manager equals or beats a particular benchmark. After all, performance is related to risk, so a few quarters of relatively strong numbers could just indicate that the manager took some outsized risks with his or her portfolio investment selections. Fortunately, there is an objective methodology for assessing the impact of a manager's investment practices on performance. It is astatistic called alpha.


    The principle that underlies alpha is simple -- variations in the value of investments such as mutual funds are driven by a combination of the market's actions and the fund manager's actions. A benchmark index can tell you what the market's contribution to performance of your portfolios might be. Alpha measures how much of a portfolio's variation might be attributable to the decisions of the portfolio manager.

    The actual formula used to calculate alpha can be stated simply as well. Alpha is the portfolio's total return minus the market's risk-adjusted total return for the same period. Where alpha is positive, it indicates that the manager may have improved performance. Where alpha is negative, it suggests that the manager might have degraded performance.

    Calculating Alpha

    The theoretical formula for alpha is:

    Alpha = average actual portfolio return -- (portfolio volatility x average benchmark return)

    In other words, alpha can be calculated by subtracting the risk-adjusted benchmark return (aka expected return) from the fund's actual return for the same period. In the case of a typical large-cap domestic equity fund, for example, the risk-adjusted benchmark return is the average monthly return on the S&P 500 for the previous three years, multiplied by the beta of the fund.

    Beta is a statistic that represents the influence of market volatility on a fund's returns. A fund with a beta of 1.00, such as an index fund, shows periodic gains and losses equal to the market's gains and losses. A fund with a beta of less than 1 has returns that vary proportionately less than the market, while a fund with a beta of more than 1 has proportionately greater variation. A fund with a beta of exactly 1 whose returns precisely mirror the market, such as an S&P 500 index fund, will have an alpha of zero.

    Keep in mind that beta represents actual observations of fund behavior, so each fund's beta is unique to its particular portfolio composition. Even so, as a general rule, the betas for funds in any particular investment style tend to follow patterns. For example, value funds often have betas that are lower than the market average for the cap range, while growth funds often have betas that are greater than the market.

    Understanding the Limitations of Alpha

    As with many other statistics used in investment analysis, alpha (and beta, too, for that matter) can produce meaningful comparisons only among portfolios with disciplined and consistent investment styles. Each investment style has its own signature performance attributes for characteristics such as volatility, correlation, and cyclical behavior. Arithmetically combining those different signatures in a single calculation can dilute its precision. Equally important is the choice of market benchmark. Statistically meaningful alpha and beta analysis can only be performed when the portfolio has a high degree of correlation to its benchmark. Otherwise, any performance differences between the manager and benchmark could be statistically random, as the following charts illustrate:

    When portfolio returns are not correlated to the benchmark, any alpha will occur randomly:
    In this hypothetical example, the average deviation, or alpha, is an attractive +0.60%. But because the period-to-period variation is so wide, this statistic would suggest nothing meaningful about this manager.

    When portfolio returns are correlated to the benchmark, any alpha can be observed consistently:
    In this hypothetical example, the average deviation, or alpha, is a modest but meaningful +0.16%. Because the period-to-period variation is so small, it can be inferred that this manager may be consistently outperforming the benchmark on a risk-adjusted basis.


    Alpha is part of a field of investment analysis called performance attribution. For managers facing ever-increasing pressure to objectively quantify all aspects of their company's financial condition, the application of performance attribution techniques such as alpha can play a significant role in addressing the concerns of shareholders, regulators, and senior executives.

    Points to Remember

    1. Alpha provides an objective methodology for assessing the impact of a particular manager's investment practices on portfolio performance.
    2. It is based on the principle that variations in the value of investments such as mutual funds are driven by a combination of the market's actions and the fund manager's actions.
    3. In practice, alpha is a portfolio's total return minus the market's risk-adjusted total return for the same period.
    4. Alpha can produce meaningful comparisons only among portfolios with disciplined and consistent investment styles.
    5. Statistically meaningful alpha can only be calculated when a portfolio has a high degree of correlation to its benchmark.

    Because of the possibility of human or mechanical error by S&P Capital IQ Financial Communications or its sources, neither S&P Capital IQ Financial Communications nor its sources guarantees the accuracy, adequacy, completeness or availability of any information and is not responsible for any errors or omissions or for the results obtained from the use of such information. In no event shall S&P Capital IQ Financial Communications be liable for any indirect, special or consequential damages in connection with subscriber's or others' use of the content.

    © 2013 S&P Capital IQ Financial Communications. All rights reserved.


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