Click Here to Find Your Aspire Team

Educational Articles

Educational Articles

  • 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.

  • 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.

  • 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.

  • 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.

  • 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.

  • 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.

  • 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.

  • 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.

  • 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.

  • 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.

  • 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.


We provide everything you need to plan for—and achieve—the retirement you want, including practical education, easy-to-use tools and useful information that can help you easily manage your retirement savings over time.

Follow Us

Sign Up for

Aspire News

Access Our

InvestDesign Center