Tuesday, August 30, 2011

4 Tips For Making Sure Your Insurance Is Up To Date

Here on the East Coast of the U.S., we recently were rocked by an earthquake and a hurricane within the span of less than a week.  Hopefully all of my intrepid readers out in cyberspace who live in the affected areas made it through without incident.  In the run up to the hurricane, there were a lot of articles with advice on how to prepare for an emergency.  However, making sure your insurance is updated is something that you have to do far in advance of an emergency.  Many insurance companies won't even issue new policies or updates if there is an impending event.  By the time something is impending, it is too late.  Therefore, it is better to make sure your insurance is up to date before you hear about the next disaster on CNN.  In other words, now is the time to do an insurance checkup.

1. If you are a renter, get renters' insurance

Many renters assume that if their apartment burns down that their landlord's insurance will reimburse them for their loss.  Not true.  Your landlord's insurance will reimburse your landlord for the loss of their property - not yours.  If you want to protect yourself against the loss of your personal belongings, you need to buy your own insurance.  Fortunately, renters' insurance is relatively cheap.  Your first stop should be to the same company through which you have your car insurance.  You might get a discount for having multiple policies.

2. If you are a homeowner, make sure your coverage amounts are up to date

Almost all homeowners have insurance to cover their property and belongings.  Primarily, this is because mortgages require it.  However, many people don't bother to keep it up to date.  The coverage amounts that you had when you bought your house may not be enough ten years later.  It may cost more to rebuild your house now than it did ten years ago.  You may have added an addition, upgraded your kitchen, remodeled your bathroom.   If your coverage amounts don't reflect this, you're going to be in trouble if you need to avail yourself of that coverage. 

Most insurance companies make it easy to update your coverage amounts.  Usually you give them the current characteristics of your house, and they will give you an estimate of how much it would cost to rebuild your house.  Some good insurance companies will even be proactive and ask you periodically if you need to update your coverage.

One thing to keep in mind, however, is that the appraised value of your house may not be the amount of coverage you should buy.  Your appraised value includes the value of your land as well as your dwelling.

3. Make sure you understand your policy's limits and exclusions, and buy extra coverage if necessary:

The biggest exclusion (and the one which affects those affected by the hurricane) is that your homeowners' policy does not cover flood damage.  Flood damage is covered by a separate policy aptly known as flood insurance.  The same insurer who sold your homeowners' policy probably can also sell you flood insurance.

Likewise, most insurance policies don't cover earthquakes either.  If you want earthquake insurance, you will have to buy an add-on to your policy.  Usually earthquake insurance policies have high deductibles, so they will pay in the event of a total loss but not if you just have incidental damage.

Insurance policies also have other limits and exclusions.  Some of the more common ones are limits on claims related to loss of jewelry, computers, collectibles, and other higher value items.  For instance, my policy limits what they will reimburse for jewelry is $10,000.  Therefore, if you have any items which exceed any of these limits, you should consider buying a separate policy to cover the additional value.

4. If you are considering changing or adding to your policy, do it when the sun is shining:

Many insurance companies have waiting periods from the time you buy the insurance to the time it goes into effect.  The most common one is the 30 day waiting period for flood insurance.  That means that you shouldn't expect to rush out and buy insurance just before a disaster the same way you can buy bottled water or D-cell batteries.  You need to buy the insurance that you need when the sun is still shining.

The old adage "be prepared" applies not just to making sure your pantry is stocked, but also to your insurance is up to date.  The time to prepare is now!

Saturday, August 20, 2011

In Defense of Elite Private Colleges

I've posted several times about the value of attending college.  I've even written some advice on choosing a college.  At the risk of beating this topic into the ground, I am compelled to respond to what I consider to be an ill-conceived article about why elite private colleges are not worth the money.  The article starts with the following premise:

"If you’re the parent of a high-achieving high school student prepared to spend whatever it takes to send your kid to an Ivy League college, authors Claudia Dreifus and Andrew Hacker have some unlikely advice: Don’t do it."

The main issue that I have with the article is that it perpetuates the dual myths that elite private colleges are more expensive than their public brethren and the education you get at an elite private school is no better.  I am here to inject some logic into this debate.

First of all, many elite private schools don't cost more.  Of course, if you compare what I call the sticker prices, Princeton's total cost($52,670) is higher than Rutgers' ($24,017 for NJ residents).  Therefore, I could see why, on the surface, one might conclude that Princeton costs more than Rutgers.  It doesn't take an Ivy League graduate to know that $52,670 is greater than $24,017.  However, the operative word in this discussion is sticker price.  Just as with car buying, most students don't pay the sticker price at Rutgers.

Princeton has an aid estimator which allows you to put in your financials and get an estimate of how much you will be expected to pay.  I entered information for a hypothetical family of four where the parents make $150,000 combined and $50,000 in non-retirement savings.  According to the aid estimator, such a family would be expected to contribute $28,300 towards college.  The rest would be covered by grants provided by Princeton (no loans, no work-study).  That is a mere $4,000 more than what they would shell out for Rutgers!  My example family isn't what you would call destitute either.  They are probably in the the upper middle class by most peoples' standards.  However, they would end up paying slightly more for a Princeton education than they would for a Rutgers education.  Families earning less obviously would end up paying less.

Princeton isn't alone in offering such lucrative aid packages.  Other Ivies have similar aid structures.  Consider the myth that a elite private college education is more expensive than a public education busted!

As far as the quality of education not being worth the money, the rest of the article gives reasons why the elite schools will not give you a good education.  Most of these reasons are sheer nonsense.  I'll address some of them:

Research universities are no place for undergraduates.  I do agree with this to a certain extent.  Most universities offer tenure based not upon teaching prowess but on the amount of research dollars brought into the school's coffers.  However, this problem is not limited to private elite colleges.  Most large public universities are also slaves to the old publish or perish mentality.  According to the Chronicle of Higher Education, three of the top five universities receiving the most research money are public universities.  Interestingly, there is not a single Ivy League school in the top five.

Colleges are overrun by administrators.  Again, this is not something that is exclusive to private elite schools.  I am not sure how this figures into the discussion at all.

The star professors touted in college brochures probably won’t be teaching your kid.  I don't have any statistics to prove or disprove this specific statement, although I would imagine that a star professor at any school, public or private, probably has a lighter teaching load. 

Your tuition may be subsidizing a college president’s $1 million-plus salary.  Ohio State's president made $1.6 million in 2009.  Harvard's president only made $775K.  Again, this is not exclusive to private schools.

High-powered athletic programs drain money from academics.  This seems like an argument against large public institutions.  How many large public universities have huge athletic departments?  Heck, the University of Texas (a public institution the last time I checked) is in the process of launching its own sports television network.  I don't even know if M.I.T. even has a football team (editor's note:  a quick google search shows that they apparently do).

As far as the overall quality of education goes, there are many good public universities, so it is hard to generalize about the quality.  However, one thing to consider is that public universities are subsidized by the taxpayers of that state.  The news regarding the financial situation of many states is grim.  With public pressure to cut budgets while simultaneous keeping tuitions affordable, something has to give.  That could mean cutting programs, increasing class sizes, and generally trying to do more with less.  I would imagine that the gap between the elite private schools and public universities is going to grow.  I know that if I could pay the same amount to attend Rutgers or Princeton, I would choose Princeton, no doubt about it!

Sunday, August 14, 2011

Annuities: Insurance For Living Too Long

Given the choice, most people would rather live to be 100 than 70.  By living to 100, you get 30 extra years to spend with your grandchildren (and maybe even great-grandchildren), to travel, to play golf, and generally enjoy life.  However, there is a definite risk to living too long:  the risk that you run out of money before you die.

It used to be that most people relied upon Social Security and pensions to get them through retirement.  Both guaranteed you a certain level of income each month for as long as you live.  Social Security even increases its payments every year to account for the rising cost of living.  No matter if you lived to be 80, 90, or even 100, you were content in the knowledge that you got a check each month upon which you could rely.

However, we have entered a world where people can't rely upon pensions and Social Security.  In the private sector pensions have gone the way of the dodo.  Pensions are still available to those who work in education or government, but even these are chronically underfunded.  Meanwhile, Social Security is under the microscope as the country's debt continues to rise.  What we have now is a situation where most people are reliant upon defined contribution plans (i.e. 401(k)'s, IRA's).  These plans do not guarantee any sort of monthly check.  You are free to spend as much or as little as you want each month.  However, once the money is gone, it's gone!

Most calculators estimate how much money you'll need to accumulate by the time you retire assume that you will live to a particular age (usually 90 or 95).  However, what happens if you are "lucky" enough to outlive this assumption.  If that happens, you'll be in a situation where you will run out of money before you run out of life.  Fortunately, there is a way to "roll your own" monthly pension.  You buy an annuity.

An annuity is an insurance product, similar to life insurance.  However, whereas life insurance protects your family financially if you die prematurely, an annuity protects you if you live too long.  In a typical annuity transaction, you give the insurance company some amount of money.  In return, the insurance company promises to pay you X dollars each month as long as you are alive.  If you live to be 150, you will be getting a check from your insurance company every month like clockwork.  On the flipside, however, if you drop dead the next day, the insurance company keeps your money (some annuities have a minimum payout so that your heirs might get some of the money back).

Just like life insurance, you don't buy an annuity to make money.  You buy it to protect yourself against outliving your money.  In other words, don't think of an annuity as an investment

There are many different types of annuities.  The simplest is an immediate annuity.  This is where you trade some lump sum of cash for a monthly check which starts immediately (hence the name immediate annuity).  In its purest form, you stop getting checks immediately when you die.  However, this situation is unpalatable for many people.  It opens up the possibility that you hand over $1 million on Monday and you die on Tuesday.  If that happens, you've just lost $1 million for your heirs.  In order to mitigate this risk, many annuities come with a feature which guarantees a certain number of payments regardless of how short you live.  You might not get back your entire $1 million, but at least you don't lose everything.  Of course, this option reduces your monthly payments because now the insurance company cover the cost of providing this option.

Another option is a cost of living adjustment.  This option provides for a increase in the amount of your monthly annuity check each year.  This can be based upon the rate of inflation or upon some fixed rate of interest.  Again, this option might reduce your monthly payments at the outset of the annuity since the insurance company has to cover the cost of providing this option.

Another form of annuity is longevity insurance.  In this form of annuity, you hand over your money to the insurance company, and they start paying you a monthly check when you reach a certain age (usually age 85).  If you die before that age, you get nothing.  Because of this waiting period, the amount that you would receive every month if you reach your target age is higher.  However, the probability that you get nothing is higher than it would be with an immediate annuity.

A third form of annuity is called a deferred annuity.  This adds a savings plan to the typical immediate annuity.  During your working years, you deposit money into an account that is held by the insurance company.  The money that you deposit accumulates tax-deferred in the account until you retire.  Once you retire, the money that has accumulated is returned to you in the form of an immediate annuity.

During the accumulation phase of the annuity, the money grows tax-deferred, meaning that you don't pay taxes on any interest that you earn on this money.  How much interest accumulates depends on the type of deferred annuity you own.  Some deferred annuities pay a guaranteed minimum rate of interest.  Others allow you to decide how to invest the money.  These annuities (often called variable annuities) allow you to allocate your money into various investments (stocks, bonds, etc), and the interest you earn is based upon how well your investments do.  However, many still offer some sort of minimum guaranteed rate of interest.  However, these often come with additional fees to pay for this option.

Generally speaking, you should be careful when you buy a deferred annuity.  There are a lot of different moving parts to them which make them hard to compare:  surrender fees, guaranteed interest rates, commissions, investment options, etc.  If you are considering an annuity, it may be simpler to allow your money to accumulate in a 401(k) or IRA and then buy a immediate annuity when the time comes.  The only time you might want to consider a deferred annuity is if you have already maxed out your other tax-deferred investment options.

Friday, August 12, 2011

Lower Credit Rating = Lower Borrowing Rate?

After S&P lowered the credit rating of the United States from AAA to AA+, I posted that I agreed with the counter intuitive theory that the US Government bond rate would drop, rather than rise.  This is counter intuitive because individuals, business, and governments with a lower credit rating generally have to borrow at higher rates because lenders see them as a higher credit risk.  Consider your own life:  if you have a high credit score, you usually have access to lenders' best rates.  On the other hand, if your credit score is "less than perfect", you usually must pay a higher rate of interest when you take out a loan.

However, if you are the United States, you live in a bizzaro world where you can borrow at a lower rate of interest when your credit score drops.  According to this, the 10 year Treasury rate (i.e. the rate of interest the US gets when taking out a ten year loan) started off the week at 2.5%.  However, on Friday, the 10 year rate had dropped to around 2.2%.  Why did this happen?  The most likely theory is that most people took this as a sign of uncertainty.  Therefore, they decided to move their money to the safest investment that they could think of:  US Treasury Bonds.  Meanwhile, although the stock market generally ended the week where it started, the week was filled with enough ups and downs to satisfy any roller coaster enthusiast.

This behavior is typical.  Uncertainty causes people to sell stocks (generally viewed as risky) and buy bonds (generally viewed as less safer).  However, in the context of the lower credit rating for Government Bonds, it does seem incongruous.

Sunday, August 7, 2011

S&P Lowers US Credit Rating: What Does It Mean For You?

On Friday August 5, 2011, Standards and Poor's lowered the credit rating of United States Bonds from 'AAA' to 'AA+'.  To some, this was viewed as a major blow to the U.S.  To others, it was viewed as a non-event.  However, there are some whose reaction was "what's does this mean, and what does it mean to me?" 

S&P, along with several others, are what people in the financial industry call rating agencies.  They "rate" the ability of bond issuers to be able to pay their creditors.  Remember that a bond is just a loan.  Just as a bank might look at your credit score to determine whether or not to loan you money, a bank might look at a companys' or countrys' credit rating in order to determine whether or not to buy its bonds.  Each rating agency has its own scoring methodology, but generally they look at a variety of factors to determine how likely it is that an issuer of bonds is going to not meet its obligations.

S&P gives each borrower a letter grade to indicate their credit-worthiness.  S&P's top rating is AAA.  A AAA rating means that the borrow has an "extremely strong capacity to meet financial commitments."  By downgrading the U.S. to AA+, S&P now thinks that the U.S Government only has a "very strong capacity to meet financial commitments."  They added a plus to indicate that the U.S. has a higher standing relative to other organizations in the AA category.  In other words, a AA+ rating doesn't mean that the U.S. is going to default on its loans anytime soon.  The rating is still quite good, although not as good as it could be.  Also note that both Moody's and Fitch are maintaining their AAA rating of the United States, so S&P's opinion still is in the minority.

So what does all this financial gooblety-gook mean to you.

If an individual were to take out a loan, their credit score helps to determine whether or not they get the "best" loan interest rate.  If you have a sterling credit score, you are likely to get a lender's best rates because odds are that you will be able to repay your loans.  If your score is less than perfect, you might be given a higher rate because there is a higher probability that you won't make good on repaying your loan.  This higher rate is to compensate the lender for the additional risk of lending to you.

In theory, the S&P credit rating could act in the same manner.  There may be some borrows who will demand that the U.S. Government pay a higher rate of interest on their bonds because there is a higher chance (in the opinion of S&P) that the United States will not make good on their obligations.  If this were to happen, that would mean that the United States would have to pay more interest in order to borrow.  Therefore, either they would have to spend less or take in more revenue through higher taxes in order to cover this higher interest expense (or they could just borrow more, but of course this money has to be paid back at some point).  That, of course, affects you right in your wallet or pocketbook. 

In addition, many loan rates are tied to the U.S. bond interest rate.  If bond rates go up due to a lower credit rating, that could cause mortgage rates, auto loan rates, etc to go up as well.  That, of course, also affects you right in your wallet or pocketbook.

A second possibility is that this rating downgrade affects nothing.  Bond investors might say "so what".  They might figure that even with this downgrade, U.S. Treasuries are still one of the safest investments around.  They certainly are safer than the bonds of many other Western countries.  In fact, there is a case to be made that the downgrade might actually cause interest rates to fall, which would be counter-intuitive.  The case goes something like this:

1. S&P downgrades U.S. bonds because they feel like the Government does not have a long term plan to control the size of the national debt.

2. Investors perceive this as a sign that the economy is on the ropes, so the stock market starts to drop on fears of another recession.

3. Investors start to move globs of money from the risky stock market for the relatively less risky U.S. Treasuries.

4. Because the demand of Treasuries spikes upward, the Government can borrow at even lower interest rates than before.

It seems crazy that this should take place, but I feel like this scenario is likely.  Despite the rating downgrade, most people will continue to view bonds as a safe haven for their money when the stock market is going down.  That perception is not likely to change anytime soon.

I do feel, however, that even though the rating downgrade might not have an effect on your money directly, it is a message that people are watching the actions of our politicians very closely to see how they are going to handle our mounting debt.  Hopefully, it will be a (relatively painless) wake-up call that some structural changes need to be made in order to stem the flow of red ink on our national balance sheet.

Thursday, August 4, 2011

Use the Right Benchmark

One of my first posts was about the relationship between risk and reward.  The premise was that if you are going to entice somebody to take a risk, you are going to have to offer them the possibility of a greater reward.  This holds true in all forms of investing.  If you are going to invest in something with risk (like stocks), you are going to demand that you will get a higher return over the long run than if you invested in something risk-free (like a Certificate of Deposit).  This is to compensate you for the additional risk over the short term.  Stated another way, if you earned the same rate of return from a risk-free CD as you would from a risky stock, you would pass on the stock and invest in the CD.  That is common sense.

However, common sense sometimes is uncommon when it comes to determining if your investments are doing "well".  Consider the following statement:

"Last year, the S&P 500 went up by 10%.  However my financial advisor only earned me 8%.  Therefore my financial advisor must be stupid/ignorant/the-second-coming-of-Madoff/etc." 

Is the financial advisor really ripping off our speaker?  After all, he could have earned more by buying an S&P 500 index mutual fund and saved on his adviser's fees, right?

Wrong.  This is an unfair comparison.

The S&P 500 is an index which tracks the stock values of the 500 largest U.S. public corporations.  It is 100% invested in large company stocks (large cap stocks in the investing vernacular).  Therefore, is it fair to compare your investment performance against this benchmark?  It is only fair if your own investment portfolio consists of only stocks from large U.S. corporations. 

Your financial advisor knows, based upon his conversations with you, that your goal is to retire in 10 years.  Since you will be needing to live off of your portfolio within the near future, he probably allocated only 60% of your portfolio to stocks.  The other 40% is invested in less volatile investments (bonds, money market funds, CD's).  Because this 40% is less risky, they returned less than the aforementioned S&P 500.  However, these investments have less risk of losing value, which is an important fact considering that you will need the money in 10 years.  Therefore, it is expected that you would earn less than the S&P 500 in some years.  In other years, the stock market might tank, but your investments won't go down as much because you have that 40% in safer investments.  In other words, you are trading potential upside in some years for less of a downside in others.  Less risk = less return over the long run.

A better comparison would be to compare the large U.S. stock portion of your portfolio with the S&P 500.  Perhaps out of the 60% stock portion of your portfolio, you might have half of that in large U.S. corporate stocks (the rest being in small company stocks, international stocks, etc).  Perhaps that large U.S. stock portion of your portfolio earned 10% this year because your financial advisor was wise enough to invest that part of your portfolio in an S&P 500 index fund.  Smart guy, that advisor of yours!

The lesson here is that you should choose the right benchmark to judge an adviser's performance before you call the S.E.C.