05/07/2001

Financial Potpourri

There are so many financial subjects to cover that some months it is hard to pick just one. Therefore, for only the second time, I am wiring an article that covers a variety of financial subjects. Not all subjects will apply to you, but some certainly will and most will over time. So read on and then let me know which one struck home with you.

1. Bonus Annuities - Bonus annuities seem to be a new "hot" product. What is a bonus annuity? It is an annuity contract that adds a certain percentage to your contract value on the date of purchase. For example, you invest $100,000 into a 3% bonus annuity, your contract value on day one will be $103,000. The $100,000 you invested plus the 3% bonus. Sounds like an easy way to make 3%, but is this truly a good deal for the investor The answer, of course, is "It depends."

   First, please know that in every bonus annuity contract I have seen, there is an additional annual fee if you select the bonus option. In other words, you are paying for the bonus. With some contracts, this additional fee ends after a set period of time. With other contracts, the additional charge is built in for the life of the contract. So the first task in deciding upon the bonus annuity is to know the total cost to you.

   With some contracts, the insurer offering the annuity will actually tell you how much your investments need to return to make the bonus a good deal. For example, assume a contract charges an additional fee for a 4% annuity contract with this fee ending after a seven-year period. The insurer might inform you that you would need to earn better than 8% a year for the first seven years for the bonus to be advantageous, net of expenses. This example is purely hypothetical, but if you can get this information you will know your breakeven point and this can help you determine if the bonus might be a good "gamble" for you.

2. Sector Diversification - Have your reviewed your portfolio to know how you are diversified by sector (health, technology, energy, etc.)? If not, you should. A great deal has been written about asset class diversification. Asset class diversification means having the right balance of investments in your portfolio within each asset class according to your risk tolerance, years to invest, etc. Various asset classes include income (bonds), growth and income, growth (large cap stocks/stocks funds), high yield, aggressive growth (small cap and sector funds), etc.

   However, I contend that if you are a mutual fund investor you should also be looking closely at your sector diversification as well. By sector I mean the economic sector or industry your mutual funds are invested in. Certainly you expect a "sector" mutual fund such as a technology fund to be predominately invested in the technology sector. What you don't expect, but often will find, is that a general growth fund or mid-cap fund or even an equity income fund, is heavily weighted in one or two sectors. For example, I have uncovered large cap growth funds with over 40% of their holdings in technology. If you aggregate all of you mutual fund holdings together it can be an interesting exercise to see how your investments are weighted according to each sector. This exercise will show you how much technology, health, financials, etc. you own as a percentage of your overall portfolio. Because, many fund managers have gotten overweighted in one sector, so have you and probably without your noticing.

3. Value vs. Growth - Another review you should be making of your mutual fund holdings is how balanced you are with the investment style of the funds you hold. A growth investment approach generally proved more successful in the 90s but the market upheaval showed how important it is to also be investing for value. Investors need to know the balance of investment approaches they have and make adjustments as necessary. A balance of each is often recommended.

4. New Required Minimum Distribution Rules - Just in case you haven't heard, the IRS has proposed substantial revisions to the rules that govern Required Minimum Distributions (RMDs) and the process for designating a beneficiary. The new rules go into effect January 1, 2002 and may be used to calculate your RMDs for 2001. I will probably write an in-depth piece on the subject next month, but for now I just want to make you aware of this legislation. The new rules are greatly simplified which is a true blessing. Furthermore, if you have already started taking RMDs, you can change how those amounts are calculated and in most cases reduce the amount you are required to withdraw.

5. Monte Carlo Plans - Most of us have had a financial plan done at some point in our lives. To date, most financial plan software has used "straight-line" projections. An example of a straight-line projection in a financial plan would be the rate of return factored in for your assets. Most planners will use an average rate of return based on the balance of holdings in your portfolio. For example, with a growth portfolio a planner might use an average projected rate-of-return of 9 or 10%. The planning software then factors in this set rate-of-return for every year, year after year. That is a straight-line projection.

If you care about accuracy, then you should consider a plan that offers Monte Carlo simulations. But be prepared to pay more for this high caliber financial plan.

Please send questions or comments to dcoffin46333@wradvisors.com.