Tuesday, May 12, 2015

How do annuities alleviate the risk of outliving your money?

An annuity is a stream of income paid to the client over a specified time period.  Generally, annuities can be either:
  1. Fixed or variable-where the amount paid is based on the nature of the underlying investments,
  2. Single premium or flexible premium-how the annuity fee is paid,
  3. Immediate payout or deferred payout- which determines when the annuity payments begin.
Aside from these basic categories, annuities have a broad range of additional options available to customize the type of policy for the appropriate needs of the client.  Annuities have four main parties:
  1. The insurance company providing the annuity contract,
  2. The owner who purchases the annuity contract,
  3. The annuitant over whose life benefits are paid, and,
  4. The beneficiary who may receive payments after the death of the annuitant. 
Payouts are determined based on the life expectancy of the annuitant.  Payments are initially made to the annuitant then finally to the beneficiary based on the payout and survivor benefits selected.  Payouts can be for a certain period of time (term certain) or for the life of the annuitant with some portion to the remainder beneficiary.

Growth of annuity assets is tax deferred while the investments are in the annuity account. Tax treatment when benefits are distributed depends on the method of payment of the annuity contract. Non-qualified annuities are purchased with money on which income taxes have been paid. According to Section 72, withdrawals and annuity payments from a non-qualified annuity are taxed using an exclusion ration so that a portion of each payment is return of principal and a portion is taxable.  Return of principal (basis) is tax free while the rest is taxed at ordinary income. 

Qualified annuities are generally sponsored by employers, meaning that most of the purchase cost of the annuity contributions will be pre-tax (i.e. not taxed) when added to the account.  As such, they are subject to required minimum distributions at age 70.5 with taxes due on the entire distribution amount as ordinary income.  Distributions before age 59.5 are assessed a penalty and taxes for both non-qualified and qualified annuities.

Once the appropriate retirement spending need has been identified, it is possible to discern which expenses make up the base level of spending versus the discretionary level of spending.  One useful strategy is to purchase an annuity to provide the base level of expenses while keeping assets aside for the discretionary expenses and potential medical expense shocks that may occur. 

Specifically, an immediate life annuity could serve as the fixed income portion of the overall portfolio along with an equity portfolio.  An annuity is considered as an alternative to other fixed income because as explained by Pittman (2013, November) "Annuities are designed to perfectly hedge one's retirement spending liability, and they tend to have a higher yield to the retiree than a bond due to mortality credits" (p. 56).  Purchasing the immediate annuity could take place at multiple times depending on specific needs with consideration given to liquidity, bequest motives, longevity, and maximization of income.  Pittman (2013, November) confirms that this combination will allow the annuitant to:
  1. maintain liquidity for as long as possible, have the option to fulfill bequest motives for longer should death occur prior to the annuity purchase,
  2. secure income for core expenses through the remainder of their life thus partially transferring the longevity risk to the annuity company, and
  3. receive a higher income than a combination of bonds with equities by adding in the mortality credits from the annuity contract (p. 60).
Annuity contracts are complex investments and require considerable analysis to ensure the annuity contract purchased is the best vehicle for the client. We, at Paragon Financial Advisors, will assist in the analysis of those contracts. As fee only advisors, we do not sell annuities—we only attempt to verify they are in the best interests of our clients.  Paragon Financial Advisors is a fee-only registered investment advisory company located in College Station, Texas. We offer financial planning and investment management.

Pittman, S. (2013, November). Efficient retirement income strategies and the timing of annuity purchases. Journal of Financial Planning, 56-62.


Wednesday, April 22, 2015

Smart Beta

Beta, in the investing universe, is a measure of risk relative to a chosen benchmark. For example, if a stock has a beta of 1 vs. the S&P 500, it should move just as far up (or down) as the index itself does. The definition and calculation of investment indices have numerous components (see our previous discussion in Investment Strategies). The S&P 500 stock index is composed of the 500 largest companies (as defined by their market capitalization) in the US. The company’s market capitalization is determined by multiplying the number of corporate shares outstanding times the price of the stock. That calculation results in a relative concentration of large companies. In fact, the top 10 companies in the index (2% of the 500 companies) comprise approximately 17% of the index.

In April, 2005, a group of researchers (Rob Arnott, Jason Hsu, and Philip Moore) posited in the Financial Analysts Journal that there were better measures of a company than its market capitalization. They claimed to “show that the fundamentals weighted, non-capitalization based indexes consistently provide higher returns and lower risks than the traditional cap-weighted equity market indexes while retaining many of the benefits of traditional indexing.” They felt that measures such as revenues, book value, sales, dividends, cash flow, etc. should be better measures used in valuing a company. The basic intent was to decouple the price of a stock with its weight in an investment portfolio. That coupling, according to them, results in excessive holdings of large cap stocks in the funds that track a capitalization weighted index.

This fundamental weighting has led to a significant number of new “smart beta” or fundamental weighted mutual funds or exchange traded funds (ETFs). Some strategies are return oriented seeking to increase returns over a standard benchmark by using company revenue, earnings, momentum, size, etc. Other strategies seek to modify the risk level vs. the benchmark by employing other strategies.

There is significant disagreement among financial professionals about the usefulness of such strategies. In fact, are they truly “indexing” or another form of active management? Smart beta has generated a lot of interest in terms of new funds and ETFs; however are they sound investment principles or “marketing hype?” There are proponents on each side of the argument. The jury is still out on the final decision.

Smart beta investments usually charge a higher expense ratio than standard indexing investments; the investment methodology is usually more complex. That fee is in the 25-40 basis point range.

We, at Paragon Financial Advisors, believe you should invest in those things which you understand—and which lead to the attainment of your financial goals at your accepted risk level. We’ll be glad to discuss your investment options with you.  Paragon Financial Advisors is a fee-only registered investment advisory company located in College Station, Texas. We offer financial planning and investment management.


Monday, April 13, 2015

Investment Strategies

There has been much discussion about investment strategy. Is an active management strategy (where the investor or an investment manager actively selects the investments in the portfolio) or a passive strategy (simply trying to replicate a broad market index with selected investments) the better choice? Or does the best answer lie somewhere in between (a semi-active portfolio). Our attempt here is simply to discuss both. The ultimate decision lies with the individual investor.
Passive Investing
Passive investing usually involves trying to replicate the performance of some broad market index. The S&P 500 is one of the most common stock indices. If one chooses the passive approach, one should know the characteristics of the underlying investment. For example:

  1. How well does the index represent the desired asset population?
  2. What is the criteria for inclusion in the index (i.e. the specific characteristics of the stocks desired in the index universe)?
  3. How are the stocks weighted in the index?
  4. What is the computational method used in the index (i.e. does the index represent only the price change in the included stocks or does it include dividends (total return))?

Let’s look at index weighting. Stock in the index can usually be weighted in the following manner:

  1. Price Weighted- Each stock is weighted by its absolute price. A stock priced at $50 has twice as much weight in the index as a $25 stock. The index construction is relatively simple; however, there is obviously a price bias.
  2. Value (Market Capitalization) Weighted- Each stock is weighted according to the company’s market capitalization (the company’s price per share times the number of shares). The bias here is toward large capitalization companies. This bias can result in a less diversified portfolio concentrated in a relatively few companies. The S&P 500 is composed of the 500 US stocks with the largest market capitalization; however, the top 10 (2%) companies comprise about 17% of the index.
  3. Equal Weighted- Each stock is weighted equally in the index. In this case, small companies have the same weight as large companies.

The dominant passive approach is indexing. This approach assumes the financial markets are fairly priced with few opportunities for mispricing. The turnover in the portfolio is low (changing only when the index composition changes) and the internal expenses are generally low. The most popular investment vehicles are index mutual funds and exchange traded funds (ETFs).

Active Investing
 Active investing assumes there are strategies which can be used to yield a higher return the market index. Such strategies usually assume: 1) holding more of the higher return companies in the index, or 2) holding less of the lower return companies in the indices. This active strategy can include segmenting the market (growth stocks, value stocks, large cap stocks, small cap stocks, international stocks, etc.) and using complimentary investing strategies (selling stock short, using options, derivatives, etc.).

Which Is Best?
Much has been written and numerous academic studies have been conducted to answer that question. There have been periods when each method has been the better performer. Consider the “lost decade” in stocks. On January 3, 2000, the S&P 500 index was approximately 1468; on December 29, 2009 it was approximately 1114. However, in between it reached a low of 681 (March, 2009) and a high of 1565 (October, 2007). Therefore, indexing for that decade would have lost money. Active management could have yielded gains in the decade.

A more reasonable approach might be temper maximized investment returns with the client’s risk tolerance and the return necessary to reach the client’s goals. We, at Paragon Financial Advisors, will help our clients identify and realize this balance.  Paragon Financial Advisors is a fee-only registered investment advisory company located in College Station, Texas. We offer financial planning and investment management.

Tuesday, March 31, 2015

Paragon Perspectives

Retirement is a popular topic of discussion and, in some cases, an item of concern. There have been television commercials of “What is your number?” and “Do you have enough money for retirement?” This Quarter's newsletter discusses some of the factors that lead to a successful (financial) retirement. These factors can be complex and our discussion here is purely a cursory one.

We, at Paragon Financial Advisors, will be happy to have a more in-depth conversation with you about your personal circumstances. One particular success factor listed in Part 2 (portfolio expense) is one we monitor. Any mutual funds chosen for our client portfolios have no sales charges (for sales or purchases) and we try to select appropriate mutual funds with minimal expense ratios. For appropriate accounts, we select individual securities; this selection eliminates expense ratios completely.

 In addition, we at Paragon have negotiated lower security transaction fees for client transactions—again reducing the expense of investment management. The final item discussed is a graphical chart of funds flowing into and out of stock and bond mutual funds. The bottom line is most investors do the wrong thing—selling when they should be buying and vice versa.

If you did not receive a copy of this Quarter's Newsletter and would like to request one please email info@paragon-adv.com

Friday, March 27, 2015

Required Minimum Distributions

Have You Taken Your Required Minimum Distribution Yet?  The April 1st deadline is almost here!

Unfortunately, you cannot keep funds inside a Traditional IRA forever; eventually the IRS will require you to take taxable distributions.

What is an RMD?
During the calendar year you turn age 70 ½ is when the IRS mandates that you start taking annual taxable distributions from your Traditional IRA and Qualified Retirement Plans. Accounts that could possibly be affected are:

  • IRA
  • Rollover IRA
  • Profit Sharing Plan
  • Money Purchase Pension Plan
  • Individual 401(k)
  • 401(k)
  • 403(b)
  • Some beneficiary “Inherited” IRAs

Does this affect me?
The April 1st, 2015 deadline applies specifically to those individuals who turned 70 ½ in 2014.  If you have or are turning 70 ½ in 2015, your first RMD must be made by April 1, 2016.  It is very important to note that the April 1 deadline only applies to the first RMD; all subsequent withdrawals must be made by December 31st of that calendar year.

The April 1 deadline is mandatory for all owners of traditional IRAs and most participants in workplace retirement plans. However, some individuals with employer plans can wait longer to receive their RMD but this is usually because the individual is still working, and if their plan allows, can wait until April 1 after the year they officially retire.

How is an RMD calculated?
Affected taxpayers who turned 70 ½ during 2014 must figure the RMD for the first year using the life expectancy as of their birthday in 2014 and their account balance as of Dec. 31, 2013.  For all other years individuals must calculate the distribution by dividing the Year-End balance of their account by the Uniform Lifetime Factor, which is obtained from a standardized IRS Table. If you have more than one Traditional or qualified account then the calculation must be made separately on each of them. However, you can total these minimum amounts and take the total from any one or more of the IRAs.

Is there a penalty if I don’t?
Yes, IRS imposes a penalty for allowing excess amounts to accumulate, ie.. failing to take the required minimum distribution. If your distribution for the year is less than the required minimum you may have to pay a 50% excise tax for that year on the amount not distributed as required.

The Bottom Line
The good news is if you have chosen to take periodic withdraws from your traditional accounts you may have already surpassed the minimum distribution required by the IRS.  Here at Paragon Financial Advisors we want everyone to hang onto their hard earned money. Contact your advisor today to see if you are affected.  If you are turning 70 this year, CONGRATS! Now it’s time to plan for next year’s RMD.

Please consult with your tax advisor to discuss your particular situation. Paragon Financial Advisors is a fee-only registered investment advisory company located in College Station, Texas. We offer financial planning and investment management.

Resources and Further Reading
IRS Publication 590 (Individual Retirement Arrangements)
       - Page 34: When Must You Withdraw Assets (Required Minimum Distributions
IRS Publication 575 (Pension and Annuity Income)
       - Page 35: Tax on Excess Accumulation
IRS Form 5329 (Additional Taxes on Qualified Plans (Including IRAs) and Other Tax-Favored Accounts
       - Part 8: Additional Tax on Excess Accumulation



Monday, January 26, 2015

IRA Transfers

Happy New Year; 2014 is a year of memories and 2015 is a year of promises. Some of those promises might not be pleasant for individuals transferring an Individual Retirement Account (IRA) unless they follow very specific rules.

The Transfer

IRAs can be transferred to a new advisor or trustee in one of two ways:

  1. Direct transfer- where the IRA funds move from one trustee to another trustee without the account owner ever receiving the money, and
  2. Indirect transfer- where the account owner receives funds from the IRA in the form of a check made payable to the account owner. The account owner can then deposit the IRA check into another IRA within 60 days and have no tax obligation for the “rollover.”  This 60 day withdrawal has also been used by some IRA owners to temporarily access IRA funds for short term purposes. An account owner has been allowed to access each IRA account he/she owned once in a 12 month period with no tax consequences as long as the 60 day rule was met. This once per year rule was allowed for each IRA account an individual had.

The Change

There has been a major change in these IRA rollover rules beginning January 12, 2015. Now, only one IRA (defined as traditional IRAs, Roth IRAs, SEP IRAs, and Simple IRAs) can be transferred or accessed in the preceding twelve months regardless of the number of IRAs the individual has. A tax court case in early 2014 changed the interpretation of once per year per account to once per year per individual.

The Consequences

The result of this change is that any subsequent transfer or access to another IRA within the same 12 month period will be considered a taxable distribution—subject to income tax and 10% pre-mature distribution tax if applicable (i.e. the individual is under age 59 ½). There are no provisions for remediation of an erroneous second transfer in the same 12 months—the second transfer is taxable.

Consider the following example. An account owner accesses his/her account for a small distribution in March. In January of the following year, the account owner decides to transfer the same (or a different) IRA to another trustee. If the account owner receives the funds for the transfer, the second distribution is a taxable distribution. A significant tax burden may be incurred inadvertently.


Given the complexities involved, some clarifications are warranted. This rule does not apply to rollovers from an employer sponsored plan (401(k), 403(b), etc.) into a self-directed IRA. Rollovers from an IRA back into an employer plan are also exempt. Roth conversions (rolling funds from a traditional IRA to a Roth IRA) are excluded from the rule.

In Summary

In summary, individuals transferring IRA accounts to another trustee should always use a direct transfer (where funds are transferred directly from the old trustee to the new trustee or the check is made payable to the new trustee if it comes to the IRA owner). Short term, 60 day access to IRA funds should be done with great care—only once in any 12 month (not calendar year) period regardless of the number of IRA accounts owned.

We at Paragon Financial Advisors will assist our clients as they prepare for accessing their IRA accounts. Which accounts should be accessed first and asset allocation within accounts for investment purposes can have significant long term implications on your retirement planning. Consult your tax professional if you are contemplating indirectly transferring your IRA in this new year of “promise.”  Paragon Financial Advisors is a fee-only registered investment advisory company located in College Station, Texas. We offer financial planning and investment management.

Thursday, January 15, 2015

Retirement Plans

Corporate retirement plans have been, historically, either defined benefit (DB) or defined contribution (DC) plans. With a DB plan, the employer is “guaranteeing” a life-long retirement benefit to the employee at the time of retirement. That benefit is usually a function of the years worked at the company and the salary earned over a previous time period. Annual contributions are made into the DB by the employer to ensure that the plan will be able to pay benefits over the retiree’s life expectancy.
With a DC plan, the employer is guaranteeing only a certain “contribution” amount for the employee’s retirement. The actual benefit or amount received by the employee at retirement will be based on the amount to which the plan account has grown over the years until retirement. One can readily see that the shift to DCs (and it has been pronounced) from DBs places the investment burden on the employee and away from the employer. That shift in investment responsibility has been a primary driver of the elimination of DBs (pension plans) in favor of DCs (401(k), 403(b), etc.).
Since 401(k)s now require employee management, it behooves us to look at some of the factors affecting the final amount in the 401(k) that generates the income stream in retirement. Some of these factors include the following:
  1. Sign Up- Participation in the plan is usually voluntary and requires the employee to take action to participate. Most plans offer an “employer match” whereby the employer matches the employee’s contribution (i.e. the employee contributes 3% of his/her salary and the employer matches that 3% contribution). Every employee should at least contribute the maximum the employer will match; if not, the employee is leaving “money on the table.”
  2. Asset Allocation- The employee is responsible for investment selection in the 401(k) plan. How the money is invested (stocks, bonds, etc.) and in what percent is an employee choice. Again, this investment selection is critical for the long term benefit in the account.
  3. Plan Expenses- Most individuals are familiar with the preceding two items; they may not be as familiar with plan costs. Plan costs basically include the following:
    • Investment Management Expenses- These are the expenses charged by the individual mutual fund managers for investments in mutual funds allowed as investment options in the plan. It is the fund’s “expense ratio” and the pro-rated amount is deducted daily from the fund.
    • Administration Fees- These fees cover the costs associated with operating the plan: accounting, legal, record keeping, trustee services, etc.
    • Individual Fees- These fees cover charges associated with account owner actions (such as taking a loan against the 401(k)).
Who pays the fees associated with a 401(k)? It depends. The employer may pay a portion or all of the fees; however, the employer may shift some of the costs to the employee. For example: A common share class of mutual fund offered in retirement plans is the “R” class. However, that R share comes in several “flavors:” R1, R2, R3, etc. One popular mutual found in many 401(k)s—a four star, gold Morningstar rating—has seven separate share classes for the same fund. The difference in the R class is the expense ratio charged. Of the seven different classes, the highest expense ratio is 1.55%; the lowest expense ratio is 0.05%. The higher the expense ratio in the plan’s R class, the greater the proportion of plan expense shifted from the plan sponsor (the company) to the employee. Plan expenses are a significant concern. There is now a lawsuit working its way through the legal system to the Supreme Court; it was filed by an employee against his employer for excessive 401(k) fees (Glenn Tibble v. Edison International). There may be significant changes in plan expense structure as a result.

There are multiple items to consider toward maximizing your retirement plan results. Investments in retirement plans should be integrated with investments held outside retirement plans; this integration provides for a more diversified total portfolio.  

We at Paragon Financial Advisors are happy to help our clients evaluate their company retirement plan options and their potential consequences.  Please call us anytime to see if our services are a good fit with your needs.  Paragon Financial Advisors is a fee-only registered investment advisory company located in College Station, Texas. We offer financial planning and investment management.

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