$tarrBuck Report for September 24, 2006: Inverted Yield Curve?

                                September 24, 2006

$tarrBuck Report for September 24, 2006: Inverted Yield Curve?

by R. M. Starr
Stacey:  You know darling, a lot of our clients at Dewey Cheatam and Howe LLP are financial professionals: bankers, brokers, CFO’s.   They’re worried about the inverted yield curve.

Richard:  The inverted yield curve?   Well that’s definitely something to worry about.

Stacey:  Yeah, they think it leads to depression.

Richard:  Well if I were a banker, I’d be depressed too.   But in med school we’re still working on internal medicine.  We haven’t got to the behavioral medicine segment yet.

Stacey:  You really haven’t been listening to me at all.

Richard:  Yes, I have.   We’re talking about depression.  It’s a significant medical problem.

Stacey:  No we’re talking about the inverted yield curve.

Richard:  Well those guys must be in to some kinky things.  Inverted yields.  They must be really frustrated.  If they’re that kinky I guess that could lead to depression.

Stacey:  Darling!!!  Inverted yields is all about interest rates on government bonds.  It’s all about money.  It has nothing to do with kinky!!  What are you thinking about?

Richard:  Let’s try that again.  Interest rates on government bonds?

Stacey:  When the interest rate on short term government debt is higher than on long term government debt, then they say the yield curve is inverted — they mean it’s upside down from the way it usually works.  Usually long term debt carries a higher interest rate than short term debt.  The bankers worry that the upside down shape means that there’s an economic recession coming.

Richard:  Why are the bankers worried?  They’ve got lots of money.  Anyway, who cares what shape their curves are in?  There are lots more important curves to worry about;  we’re doing the GI tract in school now.  Those are important curves — get those wrong and you have a really bad tummy ache.

Stacey:  Yeah.  You’re right. Maybe it’s time for you to really crack the books.

The interest rate on short term government debt is pretty much set by the US Federal Reserve System’s Federal Open Market Committee (FOMC).   The FOMC tries to set interest rates to moderate economic growth and inflation.  The FOMC raises the short term interest rate when they think inflation is too high or they expect it to increase.  The FOMC reduces the short term rate when they think economic growth is too low or will be slower in the future.  The FOMC tries to adjust the short term interest rate to maintain a low predictable rate of inflation and sustainable economic growth.

Interest rates on longer term government debt — maturities from one year to thirty — are the result of the supply and demand for government bonds in the bond market.  Long term interest rates respond to how investors expect short term interest rates to move in the future.  There’s always a competition for investors’ money between short term and long term debt.

When investors expect the interest rate on short term government debt to be higher in the future, then they think it’s more profitable to hold short term debt now and roll it over into the next generation of short term debt in the future.  Then they’ll need a premium on long term interest rates now to lock up their money in long term debt.  Expecting an increase in the short term interest rate drives long term rates higher.

When investors expect the short term rate to move down in the future they’ll accept a lower interest rate now on long term bonds.   They can lock in the current yields and not have to worry about rolling over their investment in the future.  Usually long term interest rates are a bit higher than the short term rate, to compensate investors for locking up their money for a long time.   The way interest rates differ by the maturity of debt is what financial professionals call the yield curve.  Usually it’s upward sloping — longer maturities call for slightly higher yields.

Right now, the yield curve is inverted — upside down.  The interest rate on short term government debt is higher than on long term debt.  Three-month and six-month debt is yielding 5.0%.   Ten-year debt is yielding 4.6% .  What does that tell us about investor expectations?

Investors expect short-term interest rates to go down.   Rather than invest at 5.0% per year now, many are choosing to invest for ten years at 4.6% a year.  That means they expect the short term rate in the future to be lower than 5.0% .  They expect the FOMC to reduce the short-term rate, and reasonably soon.  That means they expect lower inflation, slower economic growth or a recession.  That’s what will induce the FOMC reduce the short term rate in the future.

So that’s why Stacey’s banker clients are worried.  But it’s their job to worry.  Is there an economic recession coming soon?  Could be.  But probably not.  If the FOMC is successful, it’s only that the inflation rate is coming down.  Enough so that the FOMC can reduce the short term interest rate in the future.

(c) R. M. Starr 2006

$tarrBuck Report for September 17, 2006: Let Your Umbrella Be Your Smile

September 17, 2006

$tarrBuck Report for September 17, 2006:  Let Your Umbrella Be Your Smile

by R. M. Starr

Stacey:  Goodbye darling, have a great day!

Richard:   See you later, I’ll be late this evening!

Stacey:  Got your jacket? Lunch?  Textbooks?

Richard:  Yeah, it’s all here.

Stacey:  What about your umbrella?

Richard: Stacey, Honey, it’s not raining.  The forecast says 0% chance.

Stacey:  No, Honey.  You still haven’t bought that insurance, have you?  That’s really a needless risk.

Richard:  Stacey, Honey.  You’re talking in riddles.

Stacey:  I told you to buy umbrella insurance.  At my firm, Dewey Cheatem and Howe LLP, we’re very careful of guys with that coverage.  They have deep pockets to mount a defense.

Richard:  What does your firm have to do with insuring my umbrella?   It’s not even a rare umbrella — I got it at Macy’s.

Stacey:  Richard, darling, my slow-learning angel,  it’s personal liability umbrella insurance.  “Umbrella” means that it covers all risks.  Well not really all.  They list the ones they won’t cover.  Your employer’s liability insurance should cover work-related liability. But any time someone threatens to sue you, like for slander or sexual harassment or for an accident for more than your automobile policy covers, that’s when the umbrella policy kicks in.

Richard:  Sexual harassment — not that I ever would — but isn’t that my employer’s risk?

Stacey:  Darling.  You haven’t been listening.  At Dewey Cheatem and Howe LLP we deal with that all the time.  Individual liability is a serious issue with regard to sexual
harassment. Under many state laws, individuals do have liability, and it is
common for supervisors, managers, or team leaders to be named in claims. Juries have awarded damages against individual supervisors (as well as other employees) for individual acts of sexual harassment.
Your employer may  provide a legal defense for you.  But they don’t have to repay you (we call it “indemnify”) if you’re found liable.

Richard:  That’s the pits.  This insurance sounds good.  The insurance company provides the defense and pays the damages?

Stacey:  You got it.  You’re not such a slow learner after all.

Richard:  Well now I am.  I’m going to be late for class.  Later, darling.

Stacey has it right.  A personal liability umbrella policy covers you against virtually all damages you may become legally obliged to pay.  The umbrella insuror will probably require that you carry automobile and homeowner’s liability insurance with them for high coverage.  Then the umbrella policy kicks in.  Up to several million dollars.

The exclusions are spelled out.  Any personal liability not specifically excluded is covered by an umbrella policy.  That includes claims of libel, defamation, slander,  automobile liability outside of USA, sexual harassment.  It excludes malpractice of a business or profession and criminal acts.

If you have very little wealth or income, then there’s no point in carrying umbrella insurance;  you’re judgment proof.  But if you have significant income or wealth, someone (either greedy or crazy or injured) may try to sue  you for much more than your primary insurance (homeowner’s and automobile) covers, or for risks, like libel, that they don’t cover at all.  Then it’s time for an umbrella policy.

Check it out.

(c) R. M. Starr 2006

$tarrBuck Report for September 10, 2006: Variable Annuity?

September 10, 2006

$tarrBuck Report for September 10, 2006:  Variable Annuity?

by R. M. Starr

Variable annuity?
A variable annuity is a hybrid beast:  it’s a mutual fund portfolio living inside a life insurance annuity contract.  Because the annuity includes mutual funds, a securities market investment, disclosure requirements are set by the US Securities and Exchange Commission (SEC).   To get the SEC’s advice to individual investors go to http://www.sec.gov/investor/pubs/varannty.htm  .  For “SmartMoney”’s advice go to http://www.smartmoney.com/retirement/investing/index.cfm?story=wrongannuities  .  For advice from the National Association of Securities Dealers (NASD), go to http://www.nasd.com/InvestorInformation/InvestorAlerts/AnnuitiesandInsurance/VariableAnnuitiesBeyondtheHardSell/index.htm  .

The Hard Sell
Financial professionals often strongly encourage clients to buy a variable annuity.  Why the hard sell?  Variable annuities are often very profitable for the seller.  Sales charges paid to the salesman average 6% of the purchase price (and may be double that).  On a $100,000 contract, that’s $6000 in commissions for a few hours work.  The sales job will include an optimistic projection of profits and withdrawals decades into the future, along with the warning “hypothetical performance shown is not a guarantee of future results and actual performance may be lower.”

Accumulation Period
You pay a lump sum at the start.  The variable annuity invests your money in one or several mutual funds (you choose from the insurer’s menu of in-house funds).   As time goes on, earnings of the portfolio are reinvested.   Considering the time value of money, its no surprise that over time the value of the portfolio can double and redouble.

Why choose a variable annuity?
The obvious alternative to a variable annuity is to hold mutual funds directly.  Why should you hold them through an annuity wrapper?  There are two major attractions of a variable annuity:  lifetime annuity payments; tax deferral during the accumulation period.  The variable annuity, like any annuity using the lifetime payments, can offer an income you won’t outlive.  It’s insurance against outliving your money.  That’s true of any life annuity.   The principal reason for buying an annuity is to insure against outliving your money.   If you’re rich enough or old enough to ignore that risk, an annuity is a waste of money, and thinking about it is a waste of your time and attention.

In addition, the variable annuity — because it is treated as an insurance contract during the accumulation period — acts as a tax shelter.  Profits on the mutual fund portfolio are not taxed during the accumulation period, allowing them to grow with the speed of tax deferral.   Most tax-deferred investments, IRAs, Keoghs, 401(k)’s, 403(b)’s, 457(b)’s, …, have annual limits on contributions.  If you’re really straining for tax deferral, those limits can keep you from sheltering as much income as you’d like.  There is no legal limit on the amount you can pay into a variable annuity.  That doesn’t give you tax deferral on the money you’ve paid in, but all of the profits accumulate tax deferred.

Payout period
During the payout period, starting at a date set in the contract, you can choose to take a lump sum payout, annual payments for a fixed term, or a life annuity.   How much can you reasonably expect?  Remember the power of compound interest.  What if you’d put $100,000 into a variable annuity twenty-five years ago, in 1981, at age 40?  If you chose 100% common stock mutual funds, you could reasonably expect your account now to be worth about $ 1.5 million.  That would support an annual payout of $80,000 to start.  And  the payout would grow with the value of your investment even during the payout period.  If you live for twenty years, to age 85, the payout could total $ 2.4 million.  Is this magic?  The genius of the annuity?  No, nothing fancy.  It’s just the usual miracle of compound interest and the good luck of a bull market in the 1980s and 1990s.

Income Tax treatment
Though the annuity provides tax-deferral during the accumulation period, there are still taxes to be paid.   The most obvious are income taxes.  The growth in value of the annuity is taxed as ordinary income.  Federal tax rates go up to 35%, and state taxes are added on top of that.   A lot of the increase in value of the investment portfolio may have been in the form of capital gains.  But in the annuity payout, you won’t get the advantageous 15% Federal capital gains tax treatment.  All of increase in value is ordinary income.  There will be additional penalty taxes on earnings withdrawn before age 59 and a half.

That’s bad enough.  It can still get worse.  Some states and territories assess premium taxes on the money going into a variable annuity; at their peak, a 4% tax on your investment as it goes into the annuity contract.

Estate Tax treatment
Estate taxes these days are unpredictable whenever Congress is in session.  But if you’re worried about estate taxes, an annuity may be attractive.  A life annuity (over your lifetime or your’s and a spouse’s) takes the cost of the annuity out of the estate.  This is particularly attractive for tax-sheltered money (IRA, 401(k), etc.) which is subject both to estate and income tax and receives no step up in basis (unlike other assets in the estate).

What if I need the money?
Annuity contracts generally allow small withdrawals without penalty.  Larger withdrawals incur a “surrender charge” of up to 7% of the amount of the withdrawal in the early years of the contract, declining to no penalty after many years, sometimes a decade.  Annuity money is locked up.

What are the expenses?
The sales charges have to paid from somewhere: Distribution fee.  Then there are the mortality and expense risks fees, the daily administration fee, and the administrative expenses of the in-house mutual funds.   Investing your money in a variable annuity could cost around 3% a year in fees and charges.   Remember, you don’t have to buy an annuity.   The alternatives include tax efficient index funds with administrative expenses as low as 0.20 % annually.

My money is already in a tax shelter!
Money that’s in an IRA, 401(k), or other tax-deferred defined contribution plan can be rolled over, without income tax liability, into an annuity contract.  But the IRA and 401(k) were already tax-deferred.  There’s no additional tax advantage of rolling them over.  Of course, the salesman receives the sales charge; there is an advantage to the annuity salesman.

Avoiding the hard sell
There are low-fee variable annuities without sales charges available, notably from TIAA-CREF and Vanguard.  If you want a variable annuity, you’ve decided to buy; don’t pay for the sales job.

When’s a good time to buy?
There’s no free lunch.  The cost of the annuity will be larger than the present discounted value of your expected payouts.  How come? Adverse selection — only the healthy buy life annuities so the lifespan of annuitants is longer on average than the typical person’s. The annuity will cost less up front if you buy it when you’re older — but you’ll have less time to receive the payout.

Should I buy a variable annuity with a sales charge?
For most investors, most of the time, prior to retirement, the answer is “no.”

I would not buy it on a train,
I would not buy it on a plane,
I would not buy it here or there,
I would not buy it anywhere.

Tax smart sound investment policy is to max out contributions to tax shelters:  IRAs, 401(k)’s, etc.  When retirement comes, if you want to insure against outliving your money, a low fee variable annuity without sales charge, may be a good investment.  Rolling over the tax-sheltered money into an annuity may be a very sound plan. Like any investment in the financial markets, it will carry risk.  The alternative is a fixed annuity — see the $tarrbuck Report of August 6, 2006.

The hard sell is a tip-off.  If it sounds too good to be true, it probably is.  If it’s too complicated to understand, it’s probably a shell game.

(c) Copyright R. M. Starr 2006

$tarrBuck Report, September 3, 2006: Credit Cards for College-Age Kids

September 3, 2006

$tarrBuck Report, September 3, 2006: Credit Cards for College-Age Kids

by K. Antonovics

Stacey and her mother Marcia are talking on the phone. Stacey’s younger brother Junior is going off as a freshman to Ann Arbor.

Stacey: Hi Mom! Is Junior all packed and ready to go?

Marcia: Well, we’ve had a heart to heart laundromat instruction session. He understands the wash cycle — I don’t think he gets separating the whites from the colors. He’s ready. It’s going to be awfully quiet here without him.

Stacey: Have you thought about getting Junior a credit card that he can use in Ann Arbor?

Marcia: Don’t be ridiculous! Junior doesn’t need a credit card! We’re already paying for his room and board!

Stacey: But what about emergencies?

Marcia: He can phone home.

Stacey: I think he’ll need a credit card. Besides, that’s how he can get a credit history. They keep track of those things. When I was at Michigan, I didn’t have a credit card and my credit rating was lousy when I got out, because there was no history. I had to pay an extra $60 a month in car payments just because they wouldn’t give me a good interest rate.

Should you give your kid a credit card for college?
Well, the first thing to recognize is that you may not have any choice over whether your college-age kid gets a credit card. Credit card companies aggressively market to college students, and in most states, students over 18 do not need their parents to cosign in order to get a credit card. In a 2005 study of the credit card use among college students,
Nellie Mae, the student loan corporation, found that, by their senior year, 91 percent of all college students have one or more credit cards. Further, according to a report completed by The Education Resources Institute and The Institute for Higher Education Policy, only about 17 percent of college students obtained their first credit card from their parents. So, your college-bound son or daughter is very likely to end up with a credit card whether you give it to them or not. Since credit card use is a reality among college students, the best thing for you to do is to talk to your kid about the benefits and dangers of having a credit card.

Plastic paradise
There are lots of good reasons to have a credit card in college. For one thing, a credit card can be useful in an emergency. In addition, at some point in his or her adult life, your kid will need to establish a good credit history in order get car loans, mortgages and other forms of credit, and a great way to build a good credit history is to get a credit
card (at least, provided your kid makes the monthly payments on time). Further, it may be hard for your kid to get a credit card after college if he or she didn’t get one in college. This doesn’t mean it’s impossible for someone to get their first credit card after college, but it may take more work. For example, your kid may need to apply for a gas card or a department store card (which are easier to get than standard credit cards) in order to build a credit history. Alternatively, as their parent, you could co-sign on a credit card for your kid.

Plastic pandemonium:
Of course, credit cards are dangerous things, and many college kids (like many adults) get into serious trouble with credit card debt. According to Nellie Mae, in 2004 the average outstanding balance on undergraduate credit cards was $2,169, and more than half of all college students had outstanding balances over $1000. While this may not necessarily seem like a lot of money, college students generally have very little income, and many college students don’t understand the costs of carrying a balance forward. Nellie Mae says that only 21 percent of college students pay their monthly balance in full, and 23 percent of college students report making the minimum payment or less. Carrying forward these balances can be extremely costly. Suppose, for example, that your kid has a credit card balance of $1,000 on a credit card with an annual interest rate of 17 percent. If they only make the minimum monthly payment of $25, it will take 5 years to pay off the balance, and over that time, they will have paid about $486 in interest, so the total payment ends up being $1,486. Explaining these facts to your kids may make them less likely to charge more on their credit cards than they can afford. It’s also important to explain to them that even after they graduate and have a job, their disposable income may be less than they expect. By the time they factor in taxes, rent, student loans, gas and food, there may be little leftover to pay off credit card debt incurred in college.

And, of course, if one of the primary reasons for getting a credit card is to establish a good credit history, then unmanageable credit card debt is the last thing your college-age kid needs, and a bad credit history can make it difficult for your kid to do everything from getting a car loan to renting an apartment.

What to look for in a credit card:
When talking to your kid about credit cards, remind them to look for a credit card with:
* No annual fee
* A low interest rate
* A low spending limit

In addition, explain to them that they are less likely to get into trouble with debt if they have only one credit card. Nonetheless, Nellie Mae estimates that a whopping 56 percent of college seniors have four or more credit cards.

The bottom line:
Getting a credit card in college can be a good thing, especially for building a credit history. Many college students, however, don’t understand the perils of credit card debt. Talk to your kids about what to look for in a credit card and the costs associated with not paying the full balance every month.

Stacey and Marcia are wrapping up the phone call:

Marcia: OK. We’ll give it a try. He’ll get a credit card. But from what I’ve seen, Junior isn’t exactly good at saving money ­– with a credit card he may end up ruining his credit history!!

Stacey: Yeah. You’re right. Credit’s probably a chance he’ll have to take. I’m afraid it’s going to be like his sex life. We can’t control it. We’ll try to remind him to keep it happy and safe.

Marcia: OW!!! Did you have to say that?? Oh, it’s going to be a really long semester!!

(c) Copyright K. Antonovics 2006