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Personal Finance

Hedge funds: 6 investment concerns you shouldn't ignore

August 26, 2016

By Richard Barrington | MoneyRates.com Senior Financial Analyst, CFA

One by-product of a low interest rate environment is that investors may turn to alternative investments like hedge funds in a desperate search for better results. This includes both individuals and some major institutional investors. As seductive as the possibility of higher returns might be, most investors would do well to ignore the siren song of hedge funds.

The hedge fund industry got a huge black eye a few years ago from the Bernie Madoff scandal. But even short of actual wrongdoing, hedge funds often suffer from important conceptual flaws.

Here are six things you need to watch out for if you are contemplating hedge fund investments:

1. Hedge funds may not have risk protection

To begin with, the term "hedge fund" is often misleading. Hedging is supposed to involve some sort of risk protection, such as offsetting long and short investments. The reality is that in many cases hedge funds do not involve any sort of hedge that will counteract negative developments with positive returns. Instead, they often involve leverage in the form of options or the investments on margin.

This is the opposite of hedging, and can result in exaggerated losses. So, despite the name, when people invest in hedge funds, they should not assume that the investment represents a hedge against risk.

2. Be wary of return assumptions

One of the reasons why pension plans are interested in hedge funds these days is that they are under pressure to earn returns that will match or exceed their actuarial funding assumptions. Pension plans are funded on the assumption that they will earn at least a given rate of return, often in the neighborhood of 7.5 percent. If returns are lower, the plan sponsor has to contribute more money to the plan.

A 7.5 percent return assumption is a bit of a stretch at a time when money market rates are near zero, and Treasury bonds are yielding less than 3 percent. Plan sponsors can justify keeping their return assumptions high if they invest in alternative investments which theoretically might produce larger returns. However, this means basing return assumptions on what plan sponsors hope will happen, not what will probably happen.

If returns disappoint, using hedge funds to justify unrealistically high return assumptions will result in these pensions being seriously underfunded.

3. Data provided may not represent all funds' performance

A reason people are willing to believe in the return potential of hedge funds is that consultants promulgate databases that can inflate the average returns earned by these vehicles. Those databases can have a survivor bias - they consist of funds which are still around. As a result, the weakest-performing funds that went out of business are not represented in the average results.

In fact, many databases consist only of results that investment managers choose to report so they tend to represent the best-performing products investment managers have to offer at the time. However, the reports do not feature a full cross-section of how those managers actually did across the full product line.

4. Funds have limited liquidity

Another reason to take hedge fund performance with a grain of salt is the limited liquidity both the hedge funds themselves and their underlying investments often have. This means that stated prices might not reflect the actual value you could get from the investment if you tried to sell it.

Limited liquidity is especially problematic for hedge funds that have experienced rapid growth. Investment strategies that worked with a few million under management might not be viable with a few billion under management.

5. Performance may not meet typical results

Hedge funds are often presented as a distinct asset class. However, because of the amount of latitude they give their managers, their investment composition - and thus their results - tend to be very idiosyncratic. These are not good investments for someone constructing an investment program on the assumption that each asset class represented in the portfolio will perform reasonably closely to a corresponding market index.

6. The odds are against earning above-average returns

The fee structure of hedge funds really stacks the odds against success. The industry standard is a 2 percent annual management fee, plus profit participation through which the manager gets to keep 20 percent of any investment earnings.

This means a hedge fund has to have extraordinary returns in order for investors to do well after paying 2 percent plus 20 percent of the profits.

Hedge funds can give investment managers a degree of latitude they would not have with mutual funds. However, before you invest in a hedge fund, you have to decide whether the manager is going to use that latitude for your benefit or their own.

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Retirement saving: How being average puts you behind

August 25, 2016

By Richard Barrington | MoneyRates.com Senior Financial Analyst, CFA

It's not being mean, but there is some comfort in finding out that the guy next to you is worse off than you are. When it comes to retirement saving though, don't be too comforted by outperforming your peers.

The standard of retirement saving set by the average American worker is not nearly adequate. You could be above average in saving for retirement and still fall way short of what it takes to fund a comfortable retirement.

The following looks at the retirement saving standards being set by your peers in the workplace - and why you need to do much, much better than average.

Startling retirement saving stats

There is a myth that the hardships of the Great Recession years back made Americans more cautious and responsible about their money. However, the most recent Retirement Confidence Survey by the Employee Benefit Research Institute (EBRI) suggests this is not true when it comes to retirement saving.

Back in 2005, 69 percent of all workers surveyed had started saving for retirement. A little over a decade later, that figure stands at just 63 percent of participants who said they or their spouse were currently saving. Keep in mind that this is an example of a very low peer group standard. It simply asks whether or not people have started putting anything aside for retirement. The truth is, unless you are in your early 20s, you should be well beyond dollar one of retirement saving.

Why retirement saving is more crucial today

If anything, retirement saving is more important now than it was 10 years ago as interest rates decline. Back then, 6-month certificate of deposit rates averaged close to 4 percent. Now, they average 0.13 percent, according to the FDIC. With bank rates so low, it takes much more savings to produce the same amount of income. Thus people today need to save more for retirement than they would have expected 10 years ago, not less.

Low retirement expectations despite higher life expectancy

One reason some people fail to save adequately for retirement is that they set their sights way too low. The EBRI found that 21 percent of workers who performed a retirement savings calculation expect to fund a comfortable retirement on less than $250,000.

Consider that if you retire at age 65, you can expect to live close to 20 more years on average, and could easily live 30 years. How far do you expect $250,000 to stretch over 20 or 30 years - especially when you consider the impact that inflation will have between now and then?

Getting started with saving for retirement

People's retirement expectations are so far off target because most have not even tried to figure out how much money they will need in retirement. The EBRI found that only 48 percent had taken this most basic of retirement planning steps.

Naturally, the percentage of people who have calculated a retirement savings target is lowest among younger workers, but older workers are also prone to savings pitfalls like planning to figure out their retirement needs when they get there. Even among those aged 55 and over, 33 percent of workers said they had total savings and investments of less than $25,000.

If you fail to save enough for retirement, you clearly won't be alone in your misery. Even so, the comfort of having plenty of company won't help to pay your bills, so regardless of what those around you are doing, you should step up your retirement saving now.

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10 questions everyone should ask about savings and finances

August 22, 2016

By Richard Barrington | MoneyRates.com Senior Financial Analyst, CFA

You probably deal with money just about every day, but how well do you really know your financial situation? What you don't know could hurt you.

People have a bad habit of reacting to financial needs rather than planning for them. This tends to be a less rational, and often more expensive, way of making financial decisions. A better approach would be to ask yourself some fundamental questions about your finances before you are facing a deadline or a problem. Think of this as getting to know your finances a little better so you can manage them more effectively.

10 questions to get to know your finances

Here are 10 questions that will help you get to know your finances a little better:

1. Are you regularly surprised by running out of money?

It's one thing for money to be tight, but if you repeatedly are taken by surprise by coming up short on being able to pay your bills or by overdrafting your checking account, it is a sign that you are not in control of your budget. Step one is formulating a budget that lets you live within your means, and step two is putting controls in place to make sure you follow that budget.

2. Do you save up for big purchases or rely mostly on credit?

Borrowing may be necessary for major purchases like a house or a car. But if you find yourself making routine purchases on credit, you are making those items way more expensive than they need to be by adding interest to the cost. The more you can wait and save up in a savings account to buy things, the more you will be able to afford.

3. Have you formulated a retirement savings plan?

People tend to assume that buying a house is the biggest financial decision they will ever make, but chances are you will need even more money to retire on than it costs to buy a house. It takes years of effort to build up enough of a nest egg, and that effort starts with figuring out how you are going to save that money.

4. Is your retirement savings on track?

It may be hard to feel a sense of urgency about something that may be 20 or 30 years in the future, but if you wait until retirement saving becomes urgent, you will have left it too late. Start holding yourself accountable now, so you won't have to try playing catch up in the last few years of your career.

5. Do you have a written investment policy?

This should include a prioritization of goals, asset allocation parameters, and criteria for measuring performance. Otherwise, investing is like trying to do a job without knowing what the job description is.

6. How well have your investments performed?

People tend to focus on the big winners and losers in their portfolios, but what matters more is how everything has performed in aggregate. Performance measurement should focus not just on how well you have done, but whether your investments have behaved appropriately for the prevailing market conditions.

7. What is your credit score?

Banks, insurance companies and even prospective employers are going to know this about you, so you should probably know your credit score yourself.

8. What could you do to improve your credit score?

If your credit score is less than perfect, it could cost you in the form of higher interest rates, or even limit your ability to get credit. Identify what you need to do to address any problems so your score will improve over time.

9. How much demand is there for your job skills?

Sure, you know how much money you make, but your value in the marketplace is really determined by how much demand there is generally for your skills. Periodically checking employment ads for similar jobs will tell you whether you need new skills to improve your job security, and whether or not you are being paid what you are worth.

10. What would happen to your finances if you were out of work for 6 months?

It may seem tough to build up that big a cushion, but the median duration of unemployment peaked at nearly 26 weeks in the aftermath of the Great Recession. Knowing how close to the edge a period of joblessness would put you is a good test of your financial wellness.

Some of these are questions that people just neglect to ask. Others are questions they are afraid to ask, because they might not like the answers. However, you are going to come face to face with financial reality eventually, so better to ask these questions when you have the time and opportunity to deal with them constructively.

Comment: What other questions should you ask about your finances?

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The high price of student loan forgiveness

August 17, 2016

By Richard Barrington | MoneyRates.com Senior Financial Analyst, CFA

Finance has a way of turning useful tools into dangerous weapons. The U.S. saw this a decade ago with mortgages, and now a similar problem is shaping up with student loans.

A mushrooming of student debt

There is now $1.36 trillion of student debt outstanding, and what is most striking is the pace of increase. This debt has doubled in the past eight years, a rate of growth that is comparable to that of mortgage debt leading up to the housing crisis. On its way to reaching its peak level in mid-2008, mortgage debt roughly doubled over the prior seven years - and we all know how that turned out.

Not surprisingly, this mushrooming of student debt its taking its toll. According to Federal Reserve figures, some 11.8 percent of students with loans are officially considered to be in default.

The price of student loan forgiveness

A populist solution is to simply forgive part or all of the student loan debt. A common assumption behind this proposal is that profiteering banks have taken advantage of students by enticing them into loans they didn't understand and can't afford.

Here are four reasons why student loan forgiveness could be costly:

1. Taxpayers foot the bill

One problem with this is the U.S. government has guaranteed the vast majority of the student loan debt outstanding, so if loans are forgiven or students simply default on them, it is the U.S. taxpayer who will foot the bill, not some deep-pocketed bank. This would amount to a national subsidy of tuition, which is an idea worth discussion. But this solution is expensive enough that it should be planned in advance, not backed into after the fact.

2. Students who already paid back tuition wouldn't benefit

Also, deciding retroactively to broadly subsidize tuition would be patently unfair to those students who worked hard to earn tuition money or pay off their loans.

3. Government loan guarantee programs could disappear

Besides this unfairness, a general student loan repayment amnesty would have a couple of other hazards. It would most likely result in government loan guarantee programs being sharply curtailed in the future. Removing or scaling back government support for student loans would cause bank rates on those loans to skyrocket, especially given how high default rates have been.

4. Less accountability among schools

The other hazard is that simply forgiving student loans would not hold academic institutions accountable for making sure the tuition dollars their students are paying are well spent.

Real student loan reform

A big problem is that the aggressive marketing of some academic programs leads to heavy enrollment in schools or courses of study with low graduation rates, shaky career prospects or both.

To fix this, consider restricting government-backed student loans in the following ways:

  • By degree program. The government agonizes over how to create a workforce with the right skills. Restricting loans to degree programs with reasonable employment prospects would be one way of discouraging students from pursuing credentials for which there is no demand.
  • By school. Schools which consistently graduate a small percentage of their students are essentially conning young people out of their money - or ultimately, the government out of its money. Attendance at those schools should not be eligible for government-backed financing.

Shockingly, the federal government only requires schools to address high loan default rates when 30 percent of their former students are in default. If there is one lesson these schools can teach effectively, it is that the government cannot afford to be so forgiving.

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7 guidelines for transitioning your finances toward retirement

August 15, 2016

By Richard Barrington | MoneyRates.com Senior Financial Analyst, CFA

Retirement is likely to represent an inflection point in your finances, as you go from earning and accumulating money to spending down your wealth. Think of that extreme turnaround as a sharp, hairpin turn in the road - taking it smoothly doesn't depend solely on how you react when you are in the turn itself, but also on how you approach it and how you proceed on the other side of it.

In other words, transitioning your finances for retirement should not be something that happens all at once on the day you retire. You need to start planning this transition in the decade leading up to retirement, and then be prepared to continue to adapt to changing conditions as you move through your retirement years.

7 ways to transition finances for retirement

The following are 7 components of transitioning your finances for retirement:

1. Ramp up retirement savings

For many, the years leading up to retirement are their peak earnings years, so that period is a golden opportunity to ramp up your savings. Also, once you reach age 50 you can take advantage of higher contribution limits on 401(k) plans and individual retirement accounts (IRAs), so your savings can also benefit from additional tax deferrals.

2. Identify what lost benefits will cost you

Tracking your expenses is a basic building block for budgeting, but simply projecting your current expenses into the future might not work for retirement planning. If your job has generous medical and dental benefits, you may incur a sizable new expense once you retire and have to replace some of those benefits out of your own pocket. On the flip side, there may be expenses related to your work, such as commuting or wardrobe costs, that will be reduced once you retire. In any case, recognize that the nature of your spending is going to change when you retire, and plan around that.

3. Take the retirement budget challenge

Once you have an idea of how much you will need to spend in retirement, calculate what this represents as a percentage of your retirement savings so far. Financial planners have traditionally used 4 percent as a rule of thumb for a sustainable spending rate, though some have begun to question whether that number still works in an era of minuscule bond yields and even lower bank rates. In any case, if your annual spending needs represent more than 4 percent of your nest egg, it is a sign you need to save some more before you retire.

4. Re-think retirement age

Age 65 has traditionally been thought of as retirement age, though some professions have different targets. However, with people aging more healthily and living longer, it might make sense to challenge traditional retirement age thresholds. Every additional year you work is an opportunity to replace a year of spending with a year of earning. If you are in good health, you might not want to surrender your income so soon.

5. Assess your mortgage situation

The ideal situation is to synchronize your retirement with paying off your mortgage, so that a major expense goes away at about the same time your wages stop coming in. If this is not possible, then before you retire, take a good look at whether you could benefit from refinancing or a home equity loan. You might find it easier to qualify for a mortgage while you are still earning a steady income, so don't put these decisions off till after retirement.

6. Prepare for your liquidity needs

Make sure money is available when you need it by planning for how to efficiently withdraw funds from tax-advantaged plans, and how to create liquidity without forcing untimely security sales.

7. Don't get too financially conservative

Between the need for liquidity and the likelihood that your savings will go from positive to negative cash flow once you retire, your investment approach should become somewhat more conservative. Just don't go too far in the direction of stability and liquidity. You may still have decades ahead of you, and you will need some growth to keep up with inflation over that period.

One fundamental way that financial decisions are different in retirement is there is less room for error. Once you start depending on your nest egg, you no longer have years and years to ride out any investment volatility, nor do you have a weekly paycheck to shore up your savings. Financial decisions in retirement mean the rehearsals are over and the action is now live. The plus side is that in addition to a sizable savings account, you will have had many years by then to accumulate the experience needed to make good financial decisions.

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