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FDS Monthly Newsletter March 2020
NEWSHIGHLIGHTS
Page 6: Free Money May Exist WithThis Employee Benefit
Page 1
Page 1: Reassessing the InvestmentLandscape
Page 7: Health InsuranceComparison
Left to Right: Michelle Smalenberger, Steve Smalenberger, Rob Stoll, Trevore Meyer
A lot has happened since we published last month’sInvestment Newsletter. At that time, the S&P 500 wasmaking new record highs and economic data was solid.There were very few signs of trouble.
Fast forward three short weeks, and the landscape haschanged dramatically. The Coronavirus, which startedquietly in China back in January, rapidly expanded toSouth Korea and Italy at first. And eventually, to theUnited States. The stock market responded, enteringbear market territory by declining more than 20%.We’re not going to rehash all of our latest thoughts on thevirus’ impact. Our latest thoughts are on our blog.
Reassessing the Investment LandscapeWritten By: Rob Stoll, CFP®, CFA Instead, we think it’s important to consider the broader
ramifications of what we’ve just experienced in themarkets. Retirement plans, in particular, depend onmaking assumptions about future investment returns.With U.S. Government bond yields plunging to lessthan 1%, we need to take a step back and see how thatmight impact financial plans.
History of Investment ReturnsThe first place to start the conversation is to look at thelong-term history of investment returns. Credit Suisse,an investment bank from Switzerland – in partnershipwith the London School of Economics – publishesan annual report on investment returns dating back to1900.
Page 8: Events & Frequently AskedQuestions
FDS Monthly Newsletter March 2020
Page 2
The chart above looks at historical investment returns for U.S. stocks, government bonds, and short-term TreasuryBills. The chart on the left shows these returns before the impact of inflation (Nominal terms) while the chart on theright shows the same returns after the impact of inflation. For reference, inflation has averaged ~2.9% over the last120 years.
We’ll talk about investment returns in nominal terms (before inflation) since that’s an easier concept to think about.When we refer to Treasury Bills, think of money market or savings account rates.
Since 1900, stocks, bonds, and bills have generated the following average annual investment returns:
In the financial planning world, many advisors will assume that clients use a mix of 60% stocks and 40% bonds (a“60/40” portfolio) while they’re in retirement. This allocation has historically generated returns that allowed clientsto out-pace inflation while offering enough growth to fund spending needs.
Here are the expected returns from a 60/40 and 70/30 portfolio based on historical returns:
Stocks: +9.6%Bonds: +4.9%Bills: +3.7%
Investment returns in any given year can vary wildly from these averages. And the impact of advisory andfund management fees will reduce these numbers. But in general, long-term investors could assume investmentreturns of ~8% over their planning time horizon before fees.
FDS Monthly Newsletter March 2020
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Long-term Returns in a 1% WorldAs alluded to at the beginning of this Newsletter, long-term U.S. Government bond yields have plunged in recentweeks. They were already low to begin with, a hangover from the Global Financial Crisis of 2008-2009. But therecent Coronavirus scare has sent these yields even lower.
Resetting the BarSince current U.S. interest rates are far below the long-term average of 4.9%, we need to assess how this mayimpact future investment returns. For the sake of simplicity, we’ll assume that long-term returns for stocks remain attheir historical average of +9.6%. But in assessing 60/40 and 70/30 portfolios, we’ll assume that bond returns arejust 1.0%.
Making the somewhat draconian assumption that long-term interest rates stay at 1.0% forever, expected returns forthese two portfolios come down meaningfully. Almost 1.5% is slashed off the 60/40 portfolio’s expected return,while the 70/30 portfolio’s expected return declines by over 1.0%.
In our opinion this view of the world is too harsh. The United States is the most dynamic, wealth-creating country inthe world. While population growth has slowed and our society has aged, no other country boasts the type ofgrowth-driving innovation that we have.
Additionally, the nature of bond markets has changed dramatically in the last half century. Today, we have easyaccess to investment-grade corporate bonds and high-yield “junk” bonds. These bonds generate higher returns thangovernment bonds.
This “spread” – as it’s often called – over government bond yields can be volatile since corporate bonds havecredit risk, something government bonds do not. But just as (volatile) stocks have long-term historical averages wecan look at, investment grade and high yield corporate bonds also have historical “spreads” that we can use.
Interest rates under 1.0% are new for the UnitedStates, but not for Japan and parts ofEurope. Long-term rates in Japan have beenbelow 1.0% since 2011 and are currently-0.06%. Likewise, rates in Germany fell below1.0% in mid-2014 and are currently -0.55%.Both of those countries are plagued by loweconomic growth and population stagnation.
To get a sense of how unprecedented currentbond yields are, Yale professor Rober Schillercompiled a history of long-term interest rates inthe United States going back to 1871. Thecurrent level of rates is clearly much lower thananything we’ve ever seen in this country.
FDS Monthly Newsletter March 2020
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Put another way, if we were to assume 1.0%government bond rates, then we might expectinvestment grade corporate bonds to yield2.75% (1.0% + 1.75% “spread”) and high yieldbonds to yield 5.75%.
Investment Returns in a“New Normal”
Using the above data, we can now constructexpected returns in a “new normal”environment, which is characterized by lowereconomic growth and lower long-term interestrates.
Expected returns in this scenario are lower than what the last 120 years of history generated (see Figure 1 above) butthey’re better than assuming yields of 1.0% (Figure 2). What do these lower returns mean? For an investor with a25 year time horizon and a $100,000 portfolio, the expected value of their portfolio would look like this:
To do this, we’re going to construct a portfolio that includes three types of bonds: U.S. Governmentbonds, Investment Grade Corporate Bonds, and High Yield Bonds. We’ll also assume that U.S. Government bondsyield 2.0% in this “new normal” vs. the 1.0% they currently yield.
Clearly, lower long-term interest rates can have a real, negative impact on future investment returns.
HAPPY HOLIDAY!
FDS Monthly Newsletter March 2020
Page 5
When we are creating financial plans for clients,particularly those focused on retirement, there are acouple of important “inputs” that we focus on:1. Age at retirement2. Spending level in retirement3. Expected inflation of spending levels in retirement4. Investment returns
For the sake of this Newsletter, we’re going to focus on#3 and #4. As you can see in the first chart, inflationhas averaged 2.9% since 1900. There have beenyears where it was much higher than that, while recentyears have been lower. When we construct financialplans for FDS clients, we bake in inflation rates of atleast 3.0% and sometimes up to 3.5%. These levels arehigher (i.e. more conservative) than what’s actuallyplayed out historically. This “buffer” helps account forany future spending uncertainty (like long-term carecosts).
Impact on FDS Client Financial Plans
For #4 – Investment returns – FDS has used investmentrates of returns of between 5% and 6% when buildingretirement projections for clients. This compares to along-run average of +7.72% (Figure 1). We’ve intentionallybuilt in two buffers that account for the gap betweenour assumption and actual long-term average returns.
We’re going through a unique period for our country. Theinvestment landscape has changed and the need toadjust future expected investment returns seemsappropriate. The good news is that FDS already builtbuffers into financial plans to account forvarious uncertainties. No financial plan is the “finalanswer” about what the future will look like, just aroad map of what it might look like.
Takeaways
build that cost right into your long-term plan. Secondly,we’ve been cognizant that we’re in anunusual environment. Even before the Coronavirussituation, long-term interest rates were well below normalwith little sign of reverting back to average. While wehaven’t officially been making a call that future returnswould be lower, we had decided to at least build in somecushion in case these lower rates persisted.
Disclosure footnote:Financial Design Studio, Inc. (“FDS”) is a registered investment advisor offering advisory services in the State(s) of Illinois and in other jurisdictionswhere exempted. Registration does not imply a certain level of skill or training. Follow-up or individualized responses to consumers in a particular stateby FDS in the rendering of personalized investment advice for compensation shall not be made without our first complying with jurisdictionrequirements or pursuant an applicable state exemption.All written content is for information purposes only. Opinions expressed herein are solely those of FDS, unless otherwise specifically cited. Materialpresented is believed to be from reliable sources and no representations are made by our firm as to other parties’ informational accuracy orcompleteness. All information or ideas provided should be discussed in detail with an advisor, accountant or legal counsel prior to implementation.
First, we assume advisory and fund management fees. Ifyou’re paying us for advice, there’s a cost to that and we
What this means for you, FDS clients, is that this “NewNormal” does NOT mean we have to go back to thedrawing board on your financial plan. That doesn’t meanwe wash our hands and say, “We’re good!” As part of whatwe do for you, keeping your plan fresh and up to date isimportant. If you’ve experienced life changes since yourplan was done, let’s schedule a time in 2020 to reviewand model these changes. We’re here for you in theseturbulent times. Don’t ever forget that!
HAPPY HOLIDAY!
FDS Monthly Newsletter March 2020
Page 6
One final detail to clarify is which accounts yourcontributions get deposited into. You can make youremployee contributions into a Roth 401(k) if available. However, by law the employer contributions will bedeposited into your Traditional 401(k). The reason forthis is that your income you are making Rothcontributions from is being taxed in the year you earn it. It is not deducted from your total income earned like aTraditional 401(k) contribution. But the employercontributions made to you has not been taxed so itneeds to be put in the traditional 401(k) where it will betaxed when the funds are withdrawn in later years.
Let’s review the four things that make this money FREE: F: Make sure you’re Fully vested in order to get the total account value that has accumulated.R: The funds have to go into a Retirement account.E: These are contributions from your Employer to you as the employee.E: Excuse yourself from spending it today.
If we can help explain this so you know what is availableto you we are happy to walk through it with you.
Free Money May Exist WithThis Employee Benefit
We all like the idea of free money, so I want to walkyou through one area where there may be freemoney available which you are not taking advantageof.
In your employer's retirement account you arecontributing money yourself and then your employermay also be willing to put money in as well. Let’sassume this is all going into your 401(k) or 403(b). There are a couple of ways this actually happens. Here are the two most common types of plans: Employer match or profit sharing.
1. You may be eligible for an employer match. Thismay be explained as 100% of the first 3% youcontribute and then 50% up to 6%. This means youremployer is willing to put in 3% of your salary if youare contributing at least this amount. So they arematching it 100%. Then on the next 3% (up to 6%)they will contribute half of that (50%). With this planyou have to make a contribution to receive this FREEmoney.
2. Or you may be eligible for profit sharing. In thisplan a company doesn’t define a percentage they willmatch. A contribution by you, as the employee, isnot required. Instead this is based on a formula. Forexample they may contribute an amount equal toyour salary times the number of years or hours you’veworked or been with the company. In this type ofaccount the company isn’t required to make acontribution to you each year or even when theyhave a profit.
Written by: Michelle Smalenberger, CFP®
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HAPPY HOLIDAY!
FDS Monthly Newsletter March 2020
Page 7
Health Insurance Comparison Today we want to talk about your insurance and how to choose the right plan for you and your family. There are a lot
PremiumsFirst we want to talk about the premium. This isactually what we pay for the coverage on a regularand ongoing basis.
DeductiblesDeductibles are how much we cover of whateverexpense we incur before the insurance actuallycomes in and helps us cover some of thoseexpenses alongside us.
Out-Of-Pocket Maximum
Plan A Health Insurance ComparisonThis is going to have a $100 monthly premium. It’sgoing to have a $1,500 deductible. And an out ofpocket maximum of $5,000.
Plan B Health Insurance Comparison
It may seem as if Plan B is actually going to be a lot more expensive. It's as if we are paying twice as much as if wewould for Plan A. The interesting thing however is when we start incurring medical costs, we find that at the breakpoint of about $15,000 dollars, Plan B actually becomes our better option. That is because our out-of-pocketmaximum kicks in faster due to the gap between the $5,000 and the $3,000. And furthermore our co-insuranceperiod starts faster as well. We have an extra $750 to cover in Plan A, that we don’t have to cover in Plan B.
Plan A Ideal Health Insurance SituationIt is important to note that if you are someone who doesn’t have very many medical costs, doesn’t go to the doctorvery often, and there aren’t many chronic illnesses, something like Plan A could very well be a good option for you.
Plan B Ideal Health Insurance SituationHowever if there are consistent issues that you run into, or you are concerned about catastrophic care, where you areworried that for some reason something might happen to you, Plan B could end up being the better option. At theend of the day, determining the best plan for you and your family is a challenging task. But if you think we could behelpful, please let us know!
of factors that go into what we pay for health insurance and the three biggest ones that come to mind are your
premium, deductible, and out-of-pocket maximums. Let’s take a look at two different plans with different
variables and see how they impact us throughout the year.
This is how much we pay before our insurance
company will step in and cover the rest of the
cost for us.
Written By: Trevore Meyer, CFPⓇ CKAⓇ
This is going to cost a little bit more on a monthly basis,$200 per month. However the deductible is only goingto be $750 and the out-of-pocket maximum is $3,000.
- Winston Churchill
HAPPY HOLIDAY!
FDS Monthly Newsletter March 2020
21660 W. Field ParkwaySuite 118Deer Park, IL 60010
Save the Date: May 30, 2020 Frequently Asked Questions (FAQs)Saturday, May 30th we are hosting another eventwhere your whole family can come! We will havethings for your kids as well as for you. Mark it on your calendars now so you don't miss the fun!
WHO: The Whole FamilyWHEN: 10:30am - 12:30pm (Lunch provided)WHERE: Our office21660 W. Field Parkway, Suite 118Deer Park, IL 60010
We will update you on any need to postpone this. Wewould love for you to join us, so please save this date!
Are you a Fiduciary?Yes, we are! This means we have a duty to act inyour best interest. A person acting in a fiduciarycapacity is held to a high standard of honesty and fulldisclosure in regard to the client and must not obtaina personal benefit at the expense of the client.
You're Fee-Only: What does that mean?We have chosen to be a fee-only advisory firm. Thismeans we do not accept any fees or compensationbased on product sales. While we know our clientsneed products like insurance we do not receive anybenefit from any source when you buy a product.
