PMG's "Wealth Management" Summer 2010 Newsletter

WEALTHM A N A G E M E N T

SUMMER 2010

Financial Reform

Will it Change the Landscape?

Why 4%It’s the Magic Number


795 ELA ROAD, SUITE 110 LAKE ZURICH, IL 60047

[P] 847-550-6100 [E] [email protected]

Greetings,

Hope everyone is having a good summer and enjoyed the Fourth with family. With many clients on vacation and enjoying the summer outside I decided it was best to merge the June and July issue’s of “Wealth Management” into one summer edition.

One hot topic, other than family time or the markets, has been the increased involvement of the U.S. Government in regulation of the financial system. The headline article for this issue discusses how the new Financial Reform Bill could change the financial landscape for the average consumer and retail investor. This is a timely article and one I’ve received many questions about from clients.

The second article this month digs deeper into where the general rule of a 4% withdrawal rate for a successful retirement income comes from. As clients focus on their retirement incomes this is a conversation I have a few times a week. If we haven’t discussed your retirement income projections in a while please let me know.

Lastly we will be moving our office at the end of the month to our new location in Hawthorn Woods. My three year lease is coming due shortly and a great location and opportunity came up that I couldn’t pass up. Later this month I will be sending everyone new business cards and the exact address of the new office. All my current phone and fax numbers along with email address information will remain the same. I’m excited for the move and think the new office will be home to this business for some time. Next month I’ll include pictures and more details about the new office.

Enjoy the rest of your summer and please let me know if you have any questions or concerns on your mind. Thanks again for your trust and confidence. Enjoy this month’s newsletter.

Phil Guerrero, CFP®President




FINANCIAL REFORM:THE TABLE IS SET.

Next month, President Obama will likely sign a bill into law ordering changes in the ways banks, credit card issuers and mortgage lenders inter-face with consumers. Here are the key features of the financial reform agreement that the Sen-ate and House of Representatives came to on June 24, with a vote pending.

#1: The Bureau of Consumer Financial Protection. This new consumer agency answering to the Federal Reserve would supervise mortgages, credit cards, student loans and the banks, credit unions and private lenders that issue them. Institutions holding less than $10 million in assets wouldn’t be regulated by the BCFP – but they would have to follow its rules. The BCFP would aim to make these products easier to comprehend for consumers and crack down on any possible deceptive practices.1,2

#2: See your credit score for free. If you are turned down for a mortgage or a loan, the new reforms would give you the power to see the credit score supplied to your lender. Right now, you can request three free credit reports each year but you can’t see your actual score.1,2

#3: Tougher rules for mortgage lenders. These rules should have come into play years ago, of course, but better late than never. Mortgage lenders would need to verify the assets and income of borrowers, thwarting any surreptitious comeback for “liar loans”. Loan officers and mortgage brokers would not be able to receive bonuses for guiding you into this or that loan. Borrowers with ARMs and other types of complex home loans could not be hit with pre-payment penalties should they want or need to pay off a mortgage before the end of its term.1,2

#4: Retail minimums for the use of credit cards. Score one for retailers, who don’t want to see people make $2 credit card purchases when the swipe fee alone cancels out the revenue. Under the new legislation, stores could set minimums for credit card use. The minimum transaction level could be as high as $10 if a store chooses; the Federal Reserve could raise that $10 limit on the minimum with time.1,2

Congress agrees on a bill. How would it change the financial landscape?




Alternately, stores could offer consumers discounts if they pay for items with cash or debit cards. (They wouldn’t be able to vary the discounts for different debit cards.)2

Additionally, the proposed reforms could allow colleges and universities and the U.S. government to set maximums for credit card transactions.2

#5: Brokers could be held to a fiduciary standard. Under the new reforms, the Securities and Exchange Commission now has the chance to hold brokers to the same fiduciary standard common to financial advisers – that is, investment brokers would have to put a client’s best interest first and not simply recommend a “suitable” investment to a client. That new standard may or may not come into play, however; the SEC is undertaking a six-month study to see if such a rule would amount to regulatory overlap or not.3

#6: The “Volcker Rule” would be put into play. This is the rule that would prevent banks from trading with their own money. It would kick in with small concessions. While the reforms would halt most proprietary trading by banks, some limited investment would be permitted – they could provide up to 3% of a fund’s equity, and invest up to 3% of Tier 1 capital in hedge or private equity funds.4

The big banks got another key concession from Congress: they don’t have to get rid of their swaps-trading desks (some legislators had contended that this decision would drive such trading to foreign markets). They can still be involved in foreign-exchange and interest-rate swaps dealing.5

#7: An Office of Credit Ratings would appear. It would oversee the actions of Moody’s, Standard and Poor’s and other big names, and one of its objectives would be to flag potential conflicts of interest that could influence ratings judgements.1

#8: The SEC would no longer regulate equity- indexed annuities. The promotion and sale of these annuity contracts has generated much flak in recent years. Interestingly, they would be overseen by state insurance regulators if the reform bill passes, and treated strictly as insurance products.2

Now, what about Fannie Mae and Freddie Mac? Good question. Nothing made it into the final reform bill to address that dilemma. Some analysts expect another bill will emerge in 2011 to propose their restructuring or elimination.

Citations1 – abcnews.go.com/Business/financial-reform-bill-means-big-consumers story?id=11012343 [6/25/10]2 – cnbc.com/id/37921188 [6/25/10]3 – nytimes.com/2010/06/26/your-money/26money.html?pagewanted=2 [6/26/10]4 – businessweek.com/news/2010-06-25/banks-dodged-a-bullet-as-congress-dilutes-rules.html [6/25/10]5 - cnbc.com/id/37927853 [6/25/10]6 - reuters.com/article/idUSTRE65O1BK20100625 [6/25/10]© Peter Montoya




When retirement planners try to estimate just how much money a couple or individual should take out of their savings annually, their model scenarios often assume a 4% annual withdrawal rate. Why is 4% used so frequent-ly? Was that percentage plucked out of thin air? No, it actually became popular back in the 1990s.

The “Trinity Study” helped popularize the 4% guideline. In 1998, a trio of professors at San Antonio’s Trinity University analyzed historical market data between 1925 and 1995 in search of a “sustainable” withdrawal rate. They used five different portfolio compositions - 100% stocks, 100% bonds, and 25/75, 50/50 and 75/25 mixes. (For purposes of the study, “stocks” equaled the S&P 500 and “bonds” equaled long-term, high-grade domestic debt instruments.) They tried to see which withdrawal rates would leave these portfolios with positive values at the end of 15, 20, 25 and 30 years.1

Why Four Percent?Why are retirement plans often created assuming a 4% withdrawal rate?

Their conclusion? If you are retired and withdraw more than 5% annually, you increase the chances of depleting your portfolio during your lifetime.

Subsequently, another such study was conducted by RetireEarly.com using financial market data from 1871 to 1998 – and that report reached the same conclusion.1

However, that wasn’t all the study had to say. The “Trinity Study” made some other conclusions that were not entirely in agreement. The profes-sors maintained that most retirees should have 50% or more of their portfolios in stocks. But they also noted that retirees withdrawing just 3-4% a year from stock-dominated portfolios may end up helping their heirs get rich while hurting their own standard of living.1

Perhaps most interestingly, the study concluded that an 8-9% withdrawal rate from a stock-heavy portfolio was sustainable for a period of 15 years or less – but not for longer periods.1 In other words, while our parents and grandparents could confidently withdraw 8-9%, we who might easily live to age 90 or 100 probably can’t.




So in Sharpe’s view, by adhering to a 4% rule, you either risk living too large or short-changing yourself. Therefore, it would be better to constantly fine-tune a withdrawal rate according to time horizon and market conditions.

While not necessarily a rule, 4% is a frequent recommendation. There is some compelling research to support the “4% rule”, and that is why financial advisers often cite it and tell retirees not to withdraw too much.

Would withdrawing 4% of your portfolio annually (with adjustments for inflation) allow you to live well? For some of us, the answer will be yes; others will need to address an income shortfall. As we retire, most of us will want to practice some degree of growth investing. Now may be the right time to talk about it.

Another 4% advocate: Bill Bengen. In 1994, CERTIFIED FINANCIAL PLANNER™ practitioner William P. Bengen published a landmark article in the Journal of Financial Planning presenting his own research findings on withdrawal rates from retirement savings. While Bengen published this article in the middle of a long bull market, he factored in the possibility of extended bear markets, minimal annual stock market gains and sustained high inflation.2

Looking at 75 years worth of stock market returns and retirement scenarios, Bengen concluded that a retiree who was 50-75% invested in stocks should draw down a portfolio by 4% or less per year. He felt that retirees who did this had a great chance of making their retirement money last a lifetime. In contrast, he felt that retirees taking 5% annual withdrawals had about a 30% possibility of eventually outliving their money. He put that risk at better than 50% for retirees withdrawing 6-7% per year.3

Over time, people began to call Bengen’s dictum the “4% drawdown rule”. The model 4% income distribution could be inflation-adjusted – in year one, 4% of a portfolio could be withdrawn, in year two that 4% withdrawal amount could be sweet-ened by .03% for 3% inflation, and so on.3 A dissenting view. In 2009, William Sharpe (one of the Nobel Prize-winning principals of Modern Portfolio Theory) published an article in the Journal of Investment Management contending that “it is time to replace the 4% rule with approaches better grounded in fundamen-tal economic analysis.” Sharpe thinks that “the 4% rule’s approach to spending and investing wastes a significant portion of a retiree’s savings and is thus prima facie inefficient.” If a portfolio underperforms, he notes, you have a spending shortfall; and if it surpasses per-formance expectations, you end up with a “wasted surplus”.4

Citations1 – newyorklife.com/nyl/v/index.jsp?vgnextoid=60d547bb939d2210a2b3019d221024301cacRCRD [6/21/10]2 – spwfe.fpanet.org:10005/public/Unclassified%20Records/FPA%20Journal%20March%20 2004%20-%20The%20Best%20of%2025%20Years_%20Determining%20Withdrawal%20 Rates%20Using%20Histo.pdf [3/04]3 – money.cnn.com/2002/06/28/retirement/q_drawdown/index.htm [6/28/02]4 – pittsburghlive.com/x/pittsburghtrib/business/s_682587.html [5/24/10]

© Peter Montoya Inc.




Upcoming Quarterly Market Outlook Luncheons

When: Wednesday, July 14thWhere: Vehe Barn, Deer Park, ILGuest Speaker: Byron Ramult of RS FundsTime: noon to 1:15 p.m.

When: Wednesday, October 6thWhere: TBDGuest Speaker: TBDTime: noon to 1:15 p.m.

3rd Quarter

4th Quarter

Other Tidbits…

Contact us for more information on these events or to suggest a topic for a future event. Thank you to those who attended our Second Quarter Luncheon in April. The relaxed setting opened up good dialogue and questions from the audience making it an informative and enjoyable hour.

President Lincoln signs executive order to cut the federal deficit

This was a photo I took recently at the Civil War Days held by Lake County. It was fun to step back in time and I was a little in awe to be in the presence of Abe Lincoln. It was a good family event.

SUMMER 2010



Securities offered through LPL Financial. Member FINRA/SIPC.

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PMG's "Wealth Management" Summer 2010 Newsletter