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Re-Evaluating Risk and Finding Income in Todays Economy Presented by: Marta Nystrom Nystrom & Associates.

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Presentation on theme: "Re-Evaluating Risk and Finding Income in Todays Economy Presented by: Marta Nystrom Nystrom & Associates."— Presentation transcript:

1 Re-Evaluating Risk and Finding Income in Todays Economy Presented by: Marta Nystrom Nystrom & Associates

2 Copyright 2009 Nystrom & Assoc What Were Covering Today The Risk in: –Treasuries –Bonds –Mutual Funds and Exchange Traded Funds Finding Income in this Economy: –Bonds versus bond funds –Master Limited Partnerships –Options Strategies –Fixed rate annuities –Annuity Lifetime Income Riders –Medical Arbitrage Strategies

3 Copyright 2009 Nystrom & Associates 3/5/2009 ALERT: New Bull Market or Bear Market Rally Imminent !!!

4 Copyright 2009 Nystrom & Associates The Relationship Between Price and Yield If interest rates increase during the term of your bond, the money invested will be earning less interest than it could elsewhere. As interest rates rise, the value of your Treasury or any bond will decline in the resale market for the same reason.

5 Copyright 2009 Nystrom & Associates 2 Ways to Lose Money in Treasuries and Bonds When you purchase at a low rate of interest due to excessive demand When you sell at a low resale rate due to excessive selling

6 Copyright 2009 Nystrom & Associates The Downside of Treasuries… In December 2008, world wide investors fled to long term US Treasury bonds. They hoped to obtain yields better than the near-zero (and occasionally negative) yields on short-term Treasury bills. The plan backfired, however, and instead of locking in 4-4.5% coupon yields, buyers paid such a significant premium that they ended up getting the lowest Treasury bond yield in history: a mere 2.52% on a 30 year Treasury bond. The problem then compounded when the value of these long term bonds plummeted (due to heavy selling by bond holders), delivering a market loss to these bond holders of 12.85%. The decline occurred over a short six weeks. The net loss was the equivalent of more than five years of interest in just six weeks. (12.85=2.52=5.3 years)

7 Copyright 2009 Nystrom & Associates On Wednesday, the Fed said it would buy up to $300 billion in longer-term Treasuries over the next six months "to help improve conditions in private credit markets. …The prospect of a 10-ton buyer entering the market sparked an enormous jump in the price of the 10-year Treasury notes. Its yield, which moves in the opposite direction, plunged to 2.5 percent on Wednesday from 3 percent Tuesday. …William Poole, former president of the St. Louis Fed, worries that by loading up its balance sheet with so many long-term Treasury and mortgage securities, the Fed is reducing the flexibility it says it needs to adapt to rapidly changing conditions. "I believe this is an unfortunate and dangerous policy the Fed is getting into," he said during a talk to the CFA Society of San Francisco last week… Kathleen Pender San Francisco Chronicle March 22, 2009 But The Situation Has Improved, Right?

8 Copyright 2009 Nystrom & Associates Corporate Bonds Secured or unsecured debt issued by a company to raise money. –Repayment is contingent upon the companys claims-paying ability. –Most corporations are experiencing reduced profits or losses.

9 Copyright 2009 Nystrom & Associates Municipal bonds Repayment is based upon the claims-paying ability of municipalities. –2 Types: GO (General obligation) Bonds Money to repay bonds comes from property taxes, income taxes, license fees, and sales tax revenue. How are these revenue sources faring in this economy? Revenue Bonds Payable from the specific earnings and net lease payments of revenue-producing facilities How are these revenue sources faring?

10 Copyright 2009 Nystrom & Associates But Munis Can Be Insured Municipal bond issuers can insure their securities principal and interest payments by buying insurance from the MBIA, AMBAC, CGIC, or FGIC and others Many cities, states and other entities that issue municipal bonds - to finance schools, roads and other public projects - are facing lower revenue as a result of the slowing economy, which could affect their ability to repay their bonds. Investors who bought munis that offered insurance if the issuer defaulted thought they were getting an extra layer of protection. But now the companies that issued these insurance policies are having their credit ratings cut. These ratings downgrades have caused the value of insured bonds to decline relative to uninsured bonds and have increased risk and uncertainty in the muni market. SF Gate June 12, 2008

11 Copyright 2009 Nystrom & Associates The Safety of Mutual Funds & ETFs From Wikipedia: –Diversification in finance is a risk management technique, related to hedging, that mixes a wide variety of investments within a portfolio. It is the spreading out investments to reduce risks. Because the fluctuations of a single security have less impact on a diverse portfolio, diversification (mitigates) the risk from any one investment.financerisk managementhedgingportfolio

12 Copyright 2009 Nystrom & Associates Mutual Funds & ETFs Versus Individual Stocks This is not a time to brag about the stock market performance of our prior year's list of the Platinum 400, the Best Big Companies in America. Thanks to the current bear market and the severe economic downturn, only 22 of the 400 companies on the list managed to produce a positive price change over the past year… Brian Zajac, Brian Zajac

13 Copyright 2009 Nystrom & Associates A Secular Bear Market

14 Copyright 2009 Nystrom & Assoc What to Do Now? Trailing Stops Absolute return portfolios Shift to income producing portfolio until the market full corrects

15 Copyright 2009 Nystrom & Associates Absolute Return Portfolios Buy and Hold is buy and hope. –John Mauldin study of markets from broken into 20 year blocks of time No 20 year period gave a 10% or better compounded ROR gave a compounded ROR of 9.9%. Every other high ROR period included the 1990s. Only the 1990s gave a compounded ROR > 20% Absolute return strategies aim to produce a positive absolute return regardless of the directions of financial markets. –Should incorporate an exit strategy, preferable to BOTH the upside and the downside.

16 Copyright 2009 Nystrom & Associates Absolute Returns Portfolios Keep one eye on returns and the other on risk. –Evaluate based upon draw down, i.e. peak to valley versus volatility as a measure of risk. –S&P closed at 1557 on 10/1/07; on 3/17/09 closed at 783. Represents a decline of 49%. Fees and Trading Expenses Typically Perform Better In Bear and Volatile Markets; Worse in Bull Markets –It is extremely difficult to know when one is in a bear/bull market until well into it, therefore adopting any strategy based on bull or bear market conditions may lead to unfavorable results Tax Ramifications –Short term trades mean short term capital gains and losses –Tax deferred accounts versus taxable accounts

17 Copyright 2009 Nystrom & Assoc Shifting To An Income Portfolio Bonds versus Bond Funds Master Limited Partnerships CDs versus Fixed Interest Annuities Options Strategies Lifetime Income Riders Medical Arbitrage Strategies

18 Copyright 2009 Nystrom & Associates Bonds versus Bond Funds Remember the teeter totter – bond holders must be agile in this economy. Average maturity – Why does it matter? Turnover – What is it? Does it help or hurt? Bond funds might be more liquid but what do fund managers do with the money flowing in and only low interest rate bonds to purchase? –Strategy, track record, managers experience, closed end or open end

19 Copyright 2009 Nystrom & Associates Master Limited Partnerships (MLPs) Yields of between 5-11% on average They must generate 90% of their income from activities relating to real estate, natural resources (timber, mining, energy), or commodities. They pay no income tax, so your dividends are taxed as ordinary income. Because they pay out such a high level of their income, they can become more easily strapped for cash and subject to the whims of the credit markets. May not be appropriate for retirement accounts due to Unrelated Business Income Tax (UBIT) on amounts over $1000. Must be shopped extremely carefully.

20 Copyright 2009 Nystrom & Associates CDs versus Fixed Interest Annuities CDs are issued by banks and brokerage firms. Annuities are issued by life insurance companies. 3/30/09 CD rates for 3 year term averaged between 2.7% -2.9% with high quality institutions 3/30/09 CD rates for 5 year term averaged between 3.3% - 3.5% with high quality institutions –CDs MAY be insured through FDIC. Only place your money with a highly rated company and understand the early surrender terms. –Withdraw the interest to increase cash flow. 3/30/09 Fixed annuity rate for 3 year term 4.6% with A rated company 3/30/09 Fixed annuity rate for 5 year term 5.0% with A rated company –Annuities are not insured through FDIC. They may be insured through a carriers reinsurance policy or through each states insurance guaranty fund. –Only place your money with a highly rated company and understand the early surrender terms. –Withdraw the interest to increase cash flow. –Check with your tax advisor to understand the tax ramifications of annuity deferrals and the tax ramifications when money is removed from an annuity after having been deferred.

21 Copyright 2009 Nystrom & Associates Options Strategies Basic Terms: Option Writer vs Seller, Strike Price, Expiration Date You must set up an options trading account with your brokerage firm and be approved to trade options. –Approval is determined at different risk levels. –Beginner traders usually limited to level 1 or level 2, which typically includes covered calls and may or may not include selling puts. –The use of options may be considered higher risk and may be limited to more experienced and/or affluent investors. Not the same as having a Margin Account. These strategies are not beginner strategies, but are viewed as a strategies to hedge and conserve portfolios. Selling covered calls (and often puts) are generally allowed inside retirement accounts as they are considered appropriately conservative by the IRS.

22 Copyright 2009 Nystrom & Associates Put Option Example You determine that XYZ Company would be a good holding, and you have sufficient funds in your account to purchase 100 shares of XYZ. XYZ is currently selling at $24/share and its 52 week low is $19/share. You SELL or WRITE a put option on XYZ for $20/share with an expiration of June, You RECEIVE a premium of $100 (or $1/share before transaction fees). This lowers your cost on XYZ to $19/share. Two possible outcomes by end of June: –XYZ is trading higher than $20/share and your option expires. You keep the $100 and can repeat this strategy. –XYZ is trading at or below $20/share and your option is assigned. You have now purchased XYZ at $20/share AND you keep the $100 premium.

23 Copyright 2009 Nystrom & Associates Call Option Example You own 100 shares of XYZ. You bought XYZ a couple years ago at $23/share. It went up to $34/share and is now back down to $24/share. You SELL or WRITE a call option on XYZ at a strike price of $27 with a June expiration. You receive $80 in premium. There are 3 possible outcomes: –XYZs price goes up to but doesnt make it to $27. The option expires worthless and you keep the $80. You can repeat the covered call sale. –XYZs price goes down below $24/share. You could unwind the transaction or just ride it out. You keep the $80 and can repeat the covered call sale. –XYZs price goes above $27. You must sell it at $27. You keep the $80 premium, but you have given up the difference between the $27 strike price and the market price.

24 Copyright 2009 Nystrom & Associates Lifetime Benefit Income Riders Annuity product –Provided by life insurance companies –Check financial health of the company –Understand fees and surrender charges –Work with an independent; complex products that come in a variety of flavors Variable versus fixed annuities –Typically higher fees in variable annuities, including life insurance fees –Understand HOW the life insurance works in variable plans –Variable products can go down in value; fixed products cannot –Variable products may offer more upside potential, depending upon market conditions Offers lifetime income without annuitization Probably best suits the age age bracket NOTE: Annuities may be highly illiquid and may have long surrender periods. Most restrict the amount of money that may be removed prior to the end of the surrender period. The GIBR annuities (above) are meant to be held permanently in order to obtain maximum benefit.

25 Copyright 2009 Nystrom & Associates How GIBR Annuities Work Account Value Side Grows at rate determined by various strategies. If variable annuity, could go down in value. Fees usually deducted from this side of annuity. This side is what beneficiaries would inherit if any left after income stream taken on Income Account. Income Account Side Grows at rate set by contract Grows tax-deferred until funds are removed After deferral period, allows you to take income stream at set rate even after account value funds are exhausted If account value funds are exhausted, beneficiaries receive nothing

26 Copyright 2009 Nystrom & Associates Arbitrage Strategies Arbitrage (as defined by Webster): The Purchase Of A Security, Commodity, or Foreign Exchange In One Market And Immediate Resale In Another Market To Profit From Price Discrepancies. The Arbitrage Strategies That Im Going To Share With You Today Are Unique, And Will Only Be Suitable In Certain Situations. Im Going To Explain These Concepts Through Several Examples:

27 Copyright 2009 Nystrom & Associates Arbitrage Strategy #1 Potentially Increase Income

28 Copyright 2009 Nystrom & Associates James Is A 67 Year Old With Two Homes. Neither Has A Mortgage. James Also Has $150,000 In CDs And Would Like Some Additional Income That Wont Vary. He Is Currently Making 2.5% On His CDs For An Annual Income of $3,750, All Of Which Is Taxable As Ordinary Income. James Is In A 25% Income Bracket.

29 Copyright 2009 Nystrom & Associates James Learns That He Can Take Out A Fixed Rate 30 Year Mortgage at 5.25%. He Takes Out a $120,000 Mortgage At Fixed Rate of 5.25%, Which Has An Annual Payment of $7, How Can James Increase His Income And Improve His Tax Situation?

30 Copyright 2009 Nystrom & Associates Step 2… James Then Takes $80,000 From His $150,000 In CDs And Combines It With The $120,000 From The Mortgage To Put Into A Lifetime Income Contract Of $200,000. This Creates An Annual Cash Flow of $16,848*. After The Mortgage Payment Of $7,951, James Has $8,896 Remaining. *Incomes Generated By Lifetime Income Contracts Will Vary Depending Upon A Number Of Different Factors.

31 Copyright 2009 Nystrom & Associates Step 3… James Wishes To Replace The Money Taken From The Mortgage In The Event That He Doesnt Live For 30 More Years. He Purchases A $120,000 Life Policy With A No-Lapse Guarantee For An Annual Premium Of $2,544. He Pays For The Premium With The Income Received From The Lifetime Income Contract. James Income After Making The Premium Payments On The Policy is $6,352.

32 Copyright 2009 Nystrom & Associates James Situation Before Implementing This Strategy: Gross Income From $2,000 $80,000 CD 2.5% Insurance Premium$0 Mortgage Payment$0 Net Income$1,500* *Assumes a 25% income tax. NOTE: Your situation may be different than that illustrated here.

33 Copyright 2009 Nystrom & Associates Heres What James Situation May Look Like After Implementing This Strategy: Gross Income From Lifetime $16,848 Income Contract* Tax Liability In 25% Tax Bracket$ 632 Based Upon Favorable Tax Treatment of Lifetime Income Contract Mortgage Payment$ 7,951 Insurance Premium$ 2,544 Net Income$ 5,721 * Lifetime Income Contract Based On A Rated Age Of 75. James Receives Some Additional Tax Benefits On The Mortgage Interest Deduction.

34 Copyright 2009 Nystrom & Associates Pros And Cons Of James Situation James has increased his net income by approximately $4200/year. But he has decreased his CD holdings by $80,000. James has received some income tax advantages from the tax laws on lifetime income contract and the mortgage interest deduction. Mortgage interest deductions could be erased by changes to the tax laws. James has replaced the value of the mortgage through life insurance, but not the value of the $80,000. –The mortgage will be paid off in 30 years, provided James lives that long. At that time, there will still be $120,000 in life insurance if James elects to keep it in force.

35 Copyright 2009 Nystrom & Associates How Does James Find Out If This Strategy Is Feasible Given His Situation? As Part Of A Feasibility Study James Gets Quotes On: A Medically Underwritten Immediate Annuity A New Life Insurance Policy

36 Copyright 2009 Nystrom & Associates Arbitrage Example #2

37 Copyright 2009 Nystrom & Associates Potential Problem! Taxes On Your IRA Presently Scheduled Estate Tax Rate % Repealed 55% $3,500,000 $1,000,000 Estate Tax IRD Tax 45%19%

38 Copyright 2009 Nystrom & Associates As An IRA Grows, So Do The Potential Taxes. Heres What A 5% Growth Rate In An Ira Would Look Like And What The Corresponding Tax Bill Would Look Like If the Ira Owner Took a Full Withdrawal. The Assumed Combined Tax Rate Is 25%

39 Copyright 2009 Nystrom & Associates Arbitrage Strategy #2 IRA Arbitrage Larry is a Married 64 Year Old Man (Wife is Brenda, age 63). Larry Has An IRA Account With A Value Of $600,000. Hed Like To Be Able To Improve His Income Situation, Reduce Taxes, And Also Be Able To Leave As Much Money As Possible To His Heirs.

40 Copyright 2009 Nystrom & Associates IRA Arbitrage Option #1 $45,702 Larry Is Uninsurable, But Brenda Was Offered Life Coverage From Almost Every Carrier Shopped With Offers Ranging From Preferred to Table C. Larry Decides To Place $500,000 Of The IRA Account Into A Lifetime Income Account For Brenda That Will Pay An Annual Income Of $45,702 For The Rest Of Her Life. $32,905. If Larry And Brenda Are In A Combined Tax Bracket Of 28%, The After-Tax Annual Payment From The Lifetime Income Account Will Be $32,905. *Annual Income Based on a Standard Card Rate for age 63 with an offset of plus one.

41 Copyright 2009 Nystrom & Associates Of The Annual After-tax Income Payment That They Receive Of $32,905 Brenda Is Going To Use $9,175 To Pay The Premium On A Life Insurance Policy With A Death Benefit Of $500,000 To Replace The Value Of Larrys IRA. This Leaves $23,730 Per Year After Tax For Larry And Brenda To Use To Meet Living Expenses Or Whatever They May Want To Use The Money For.

42 Copyright 2009 Nystrom & Associates Thats A Net Return to Larry and Brenda After Taxes of 4.74% And A Taxable Equivalent of 6.85%. Larry And Brenda Would Need to Get A 6.58% On Their Qualified Retirement Account In Order To Net 4.74% After Taxes. If The Life Insurance Is Owned In A Trust (Preferably With Dynastic Provisions) The Entire Death Benefit Would Be Income And Estate Tax Exempt.

43 Copyright 2009 Nystrom & Associates If Larry Decided To Keep That $500,000 In His IRA, Lived Another 20 Years And Received A 5% Fixed Rate Of Return, Heres What His Heirs Might Receive Upon His Death $500,000 $661,229 Family $231,430 IRS $429,799 Includes Estate & Income Tax This Is A Hypothetical Illustration And Doesnt Represent Any Specific Product.

44 Copyright 2009 Nystrom & Associates How Does Larry Find Out If This Solution Is Feasible Given His Situation? As part of a feasibility study, both Larry and Brenda get quotes on: –A Medically Underwritten Immediate Annuity –A New Life Insurance Policy.

45 Copyright 2009 Nystrom & Associates Additional Points on Arbitrage Strategies A lifetime income contract will cease upon the death of the annuitant. In order to replace the value, a life insurance policy must be purchased and maintained. Every situation is different. A thorough review of assets, exposure to estate taxes, objectives of the client, income sources, and health situation are required to see if an arbitrage strategy would benefit you. Because arbitrage strategies cannot be unwound, such a decision to enter into such a strategy must be carefully considered. Arbitrage strategies result in commission compensation for the representative as well as the company doing the feasibility studies.

46 Copyright 2009 Nystrom & Associates Adding Dynastic Trust Elements to the Arbitrage Strategies Lets Look At The Family Of Commodore Cornelius Vanderbilt Who Died With A Fortune Of $105,000,000 That He Left Largely To His Oldest Son William In The Year *Source:

47 Copyright 2009 Nystrom & Associates Years Later In January 1883, William Was Worth $194,000,000. William Did A Good Job Managing The Assets Left To Him By His Father. Years Later, In 1885, William H. Vanderbilt Died With A Net Worth Of $200,000,000.

48 Copyright 2009 Nystrom & Associates William Left Half His Fortune To His Sons, Cornelius And William K, Bringing Their Fortunes To $50,000,000 Each And The Remaining $100,000,000 Was Divided Among All Of His Children. Of All William Hs Children, Frederick, Who Inherited Only $10 Million, Did The Best Financially. At Fredericks Death In 1938, He Was Worth $78 Million. Federal Estate Taxes Consumed Over Half His Estate.

49 Copyright 2009 Nystrom & Associates According To Arthur T. Vanderbilt II, Author Of Fortunes Children: Fall Of The House Of Vanderbilt, There Was Not A Millionaire Among Them. When 120 Of Commodore Cornelius Vanderbilts Descendents Gathered For A Reunion In 1973 – There Was Not A Millionaire Among Them. The Succeeding Generations Of Vanderbilts Didnt Do As Well.

50 Copyright 2009 Nystrom & Associates Only % Of Family Assets On Average Survive To The 4th Generation. *Source: Family Firm Institute, Brookline, Massachusetts

51 Copyright 2009 Nystrom & Associates How a Trust with Dynastic Provisions Might Benefit Your Estate Plan Eliminate Estate Taxes on Your Life Insurance Death Benefit Divorce Protect Your Estate Creditor Protect Your Estate Lawsuit Protect Your Estate Allow future businesses and assets similar protection Preserve Your Estate for Future Generations –For up to 120 years in NM; up to 350 years or in perpetuity in some other states

52 Copyright 2009 Nystrom & Associates How Do You Set Up a Trust with Dynastic Provisions? If your attorney isnt familiar with this type of trust, you can work with your attorney in conjunction with another attorney who specializes in such trusts. Unless your estate attorney is unwilling to work with you on this, you do NOT need to dump your estate attorney. NOTE: The cost of establishing a trust with dynastic provisions could be higher than that of an ordinary Revocable Living Trust. It is a specialized field of estate law.

53 Copyright 2009 Nystrom & Assoc Where Do You Go From Here? What Is Your Risk Tolerance And Time Horizon? What Are Your Objectives? –Income? Tax Reduction? Estate Planning? What Is Your Outlook On The Economy And The Market? –Bull? Bear? Fence Sitter? What Strategies Appeal To You? –Bonds? Income Portfolios? Absolute Return Portfolios? Arbitrage Strategies? Get Personal Guidance, Make Your Plan And Implement It

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