Thus far for the month of May, the performance of the stock market has been a disappointment and has made the old adage “sell in May and go away” look prophetic. However, most of us realize investing in equities should be a long-term venture and works especially well when investors systematically add to their investments. When markets fall, investors are buying low as they dollar-cost average and take advantage of the dip. This process can potentially enhance return. However, when investors are pulling money out of their accounts for income needs, they are essentially reverse-dollar-cost averaging.
If there is a down year and an investor takes a withdrawal for income, they are essentially locking in a loss on the amount withdrawn. The S&P 500 has averaged 7.16 percent*, including dividends, for the 20-year period that ended in 2018. If an investor had earned the full returns of the S&P 500 on their $1 million investment for the past 20 years and withdrew $60,000 per year (6 percent of initial investment) their account balance would have ended the period worth only $273,245. However, if the investor had earned a fixed 6 percent return each year and pulled out $60,000 per year their account would still be worth $1 million after the same 20 years.
The last 20 years has taught us that a more consistent lower return may wind up being much better for those who are taking income from their investments than higher return with greater volatility. Although the stock market averaged 7.13 percent* per year for the past 20 years, most investors earned far less due to management and trading costs, taxes and poor market timing decisions. Therefore, for those in or near retirement, when evaluating investment alternatives, evaluate not only the expected return but the expected volatility as well, and overweight choices with less volatility in order to help create a higher probability of success.
*Source Yahoo Finance
One of the largest sec¬tors of the U.S. economy is comprised of smaller private companies that typically generate between $50 million and $2.5 billion in revenues. These middle market companies exhib¬ited 7.8 percent revenue growth, for the 12-month period ended in 2018, compared to 4.7 percent for the S&P 500.
Banking regulations have changed over the last 20 years. These changes have made it much more difficult for traditional banks to make loans to companies in this arena. In 1995, 33 percent of banks were making loans to these companies, yet today, only 3.9 percent of banks are active in this space. These middle market companies are now forced to pay higher interest rates for access to capital needed to finance growth. Because of this need, Congress created a new type of lender to serve this market called business development corporations (BDC) to encourage capital flow to small and mid-sized companies.
Loans made to these companies are typically senior-secured floating rate, meaning they occupy the senior most position in a company’s capital structure. These loans are generally secured by a company’s property, plant equipment, or other collat¬eral, and have priority over a company’s shareholders and unsecured creditors.
What’s attractive about these loans for investors is they typically pay almost 4 percent more per year in interest than high-yield bonds; they also have had less default losses than high-yield bonds. At the end of 2018, the Cliffwater BDC index was yielding 10.7 percent compared to 6.5 percent for the Barclay’s High Yield Bond Index. Moreover, the interest rates float higher or lower with prevailing market interest rates.
Therefore, floating rate loans don’t have interest rate risk to the lender or investor. If interest rates rise, so does the interest paid to the investor. This asset class can provide a very nice yield to investors. However, the underwriting of these loans is critical, and investors should look for BDC’s with an excellent track record of low default rates.
When private companies decide to list their stock on a major stock exchange, they participate in what’s called an initial public offering (IPO). It’s a way for the company to create liquidity for shareholders and raise capital by selling shares of the company to the public. The company can then use the newly acquired capital to grow the company.
The investment bank that underwrites the IPO attempts to set the initial price at the fair market value to maximize the sale proceeds for the new public company. If they set it too low the price will rise once trading starts and the company will lose out on revenue that they could have made had they set the initial price higher.
Earlier this month Zoom Communications and Pinterest both had IPO’s with first-day gains of 72 percent and 28 percent respectively. However, most investors don’t have access to IPO shares at the pre-trading price. They must buy when the market opens. Investors who bought on the open actually lost 1.6 percent on Zoom and made 2.7 percent on Pinterest. Not all IPO’s work well. In fact, investors might do well to avoid the IPO’s with the most hype.
Lyft, the ride-sharing competitor to Uber fell more than 30 percent from the price it started trading at. Facebook, one of the most anticipated IPO’s in recent memory, actually lost more than half of its value from where it began trading before eventually doing quite well. In fact, according to Barron’s, IPO’s have underperformed the broad market by a decent margin since 1980.
Many accredited investors are allocating a portion of their investments to private equity funds. These funds invest in younger private companies before they go public, typically at a valuation much lower than the IPO price. With access to private capital many private companies are growing to a much higher valuation before they go public. This means that there could be less potential upside in IPO’s than there has been historically.
Blackstone Group LP has been counseling its clients to use specially designed cash value life insurance to avoid paying taxes on investment gains. Life insurance has always had tremendous tax treatment. With new tax laws that were passed at the end of 2017, the tax benefits are potentially even more valuable. All growth and dividends compound tax-free (IRC Section 72). Basis can be withdrawn tax-free and gains can be withdrawn as tax-free loans (IRC 72 and 7702).
Finally, all death benefits are income-tax-free. Many tax advisers have been advising high-net-worth clients to take advantage of the preferential tax treatment afforded to life insurance. Blackstone’s subsidiary Lombard International estimated that their clients have placed more than $3 billion into cash value life insurance contracts over the past year.
These specially designed life insurance contracts can be used to invest in aggressive assets such as hedge funds or more traditional investments. Investors looking for less market risk in addition to tax-free growth and future tax-free income frequently use specially designed index universal life contracts. These insurance contracts earn interest based on the returns of a stock index like the S&P 500 subject to a cap of approximately 12 percent, but the contracts do not lose in the years the index is down. Additionally, all gains are typically locked in on an annual basis.
One of the biggest drawbacks of traditional cash value life insurance is that traditional policies have very significant insurance costs, which will reduce returns. However, if designed correctly, insurance costs can be minimized to about 1 percent per year, which is much less than the taxes would have been. Many companies are allowing the death benefit to be accessed tax-free in the event of the need for long-term care. Most importantly, a future tax-free retirement income could be even more valuable if tax rates rise in the future.
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