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September 12, 2004

Selecting Beneficiaries for Life Insurance & Retirement Accounts

Many assets, including individual retirement accounts (IRAs), life insurance policies, and annuities, can have
beneficiaries designated to receive the asset after your death. Make these selections carefully, since they typically override any provisions in your will. Consider the following points:

  • Select the most appropriate
    person as beneficiary for each asset.
    First, list all assets
    with beneficiaries, noting the owner, primary beneficiary, and
    contingent beneficiary. Then determine whether you have selected
    the appropriate person as beneficiary for each asset. In some
    cases, tax and estate planning considerations may help dictate
    whom to select. For instance, spouses typically have more options
    when inheriting an IRA, so that may be the better choice for
    your IRA.

  • Name contingent beneficiaries. Without a named contingent beneficiary, the asset
    will be included in your probate estate if your primary beneficiary
    dies before you. Then, the asset may have to go through the probate
    process and may be distributed to someone you had not intended
    to receive the asset.

  • Indicate what percentage
    of the asset each beneficiary should receive.
    in the event a beneficiary dies before you, decide whether each
    beneficiary's share should be distributed to that person's heirs
    or divided among the remaining beneficiaries.

  • Assess whether beneficiaries
    are capable of managing the asset.
    If not, you may want
    to set up a trust to control the asset's distribution.

  • Periodically review
    your beneficiaries to see if changes are warranted.
    A divorce,
    remarriage, spouse's death, or child's birth are all events that
    may require changes to beneficiaries. You should also review
    your beneficiary choices if you make changes to your will.

Interest Rates and the Yield Curve

A yield curve is a graph plotting interest rates for the same type of bond for a series of maturities, typically
ranging from three months to over 25 years. Although yield curves can be plotted for any type of bond, they are most commonly seen for Treasury securities.

Bond investors typically use yield curves to help find a maturity that maximizes return at an acceptable
risk level. For instance, you may find increasing a bond's maturity by a couple of years will increase return significantly or committing funds for a long time does not bring much additional return.

Economists study yield curves to help predict inflation, interest rates, and recessions. To do so, you need
to understand what the various shapes in the yield curve indicate about the economy:

  • The yield curve's normal shape is upward sloping, since interest rates usually rise as the bond's maturity
    increases. An upward sloping yield curve indicates investors believe the economy is healthy and do not expect interest rates or inflation to increase significantly in the near future. The spread between a three-month Treasury bill and a 25+-year Treasury bond is typically 3% (Source: AAII Journal, May 2003).

  • A steep upward sloping yield curve indicates
    investors believe the economy will improve quickly in the future
    and is typically seen at the beginning of an economic expansion.
    Short-term rates are typically depressed due to a recent recession.
    Once economic activity starts to pick up and demand for capital
    increases, short-term rates typically increase so the curve becomes
    less steep.

  • A flat yield curve occurs when short-
    and long-term rates are almost the same. It generally indicates
    that an economic slowdown and lower interest rates will follow.

  • An inverted yield curve occurs when short-term
    interest rates are higher than long-term rates and is an indicator
    that a recession is likely to follow. An inverted yield curve
    typically means the Federal Reserve is increasing short-term
    rates in an attempt to slow the economy or investors are locking
    in long-term rates in anticipation of an economic downturn.

A Checklist for Bond Investors

Investments in bonds should be tailored
to your investment objectives, risk tolerance, and other personal
circumstances. Answering some fundamental questions will help
you determine the role bonds should have in your portfolio:

What are your overall
investment objectives?
Investors committed to growth are looking
for appreciation of capital, with little concern for income, so
bonds will have a minimal role in their portfolios. Total return
investors want a balance of income and capital appreciation, so
bonds will be more important in their portfolios. Income investors
are looking for interest or dividend income, with capital appreciation
a secondary concern, so bonds will have a significant role in
their portfolios.

What's your investment
time frame?
When selecting bonds, you should consider when you
need the principal. Typically, yield increases as the maturity
date lengthens, since you assume more risk by holding the bond
for a longer time. Investors are often tempted to purchase bonds
with long maturity dates to lock in higher yields. However, use
that strategy with care. If you purchase a long-term bond and
sell it before maturity, interest rate changes can significantly
affect the bond's market value. Although you can't control interest
rate changes, you can limit the effects of those changes by selecting
bonds with maturity dates close to when you need your principal.

What is your risk tolerance? Typically,
the higher a bond's return, the greater its risk. Thus, U.S. Treasury
securities, which are considered one of the safest bonds, typically
carry lower rates than municipal or corporate bonds. Make sure
you understand the risks involved before purchasing a specific

Are you concerned with
minimizing income taxes?
Interest income from U.S. Treasury securities
is exempt from state and local income taxes, but is subject to
federal income taxes. Interest income from municipal bonds is
exempt from federal income taxes, and typically is exempt from
state and local income taxes for residents in the issuing state.
Interest income from corporate bonds is subject to federal and
state income taxes. Investors in higher tax brackets typically
find tax exemption of interest income more valuable. Be aware
that any exemption from income taxes applies only to interest
income. Capital gains from the sale of a bond are still subject
to income taxes.

What variables should
you consider before purchasing a bond?
Before you purchase a specific bond, make sure you fully understand
its features and can answer the following questions:

  • What is the bond's maturity?

  • What is the bond's credit rating and is
    it insured?

  • Does the bond have call provisions?

  • What is the coupon rate?

  • What is the bond's price?

  • What is the yield to maturity?

  • How is the bond's interest income taxed?

The role of bonds in your portfolio will
depend on your answers to these questions.

Managing Bond Risks - Interest Rate Risk & More

All investments are subject to risk, although
the types of risk can vary. While you can't totally eliminate
these risks, you can develop strategies to reduce them. For bonds,
consider these strategies:

  • Interest rate risk - Interest rates and bond prices move in opposite directions. A bond's price will rise when interest rates fall and decrease when interest rates rise. This occurs because the existing bond's price must change to provide the same return as an equivalent, newly issued bond paying prevailing interest rates. The longer the bond's maturity, the greater the impact of interest rate changes. Also, the effects of interest rate changes tend to be less significant for bonds with higher-coupon interest rates.

    To reduce this risk, consider holding the
    bond to maturity. This eliminates the impact of interest rate
    changes, since the total principal value will be paid at maturity.
    Thus, selecting a maturity date that coincides with your cash
    needs will help reduce interest rate risk. However, you may still
    receive an interest income stream that is lower than current rates.
    Selecting shorter maturities or using a bond ladder can also help
    with this risk.

  • Reinvestment risk - You
    typically know what interest income you'll receive from a bond,
    but you must then take the periodic income and reinvest it, usually
    at varying interest rates. Your principal may also mature at a
    time when interest rates are low.

    Staggering maturities over a period of time
    (laddering) can lessen reinvestment risk. Since the bonds in your
    ladder mature every year or so, you reinvest the principal over
    a period of time instead of in one lump sum. You may also want
    to consider zero-coupon bonds, which sell at a deep discount from
    par value. The bond's interest rate is locked in at purchase,
    but no interest is paid until maturity. Thus, you don't have to
    deal with reinvestment risk for interest payments, since you don't
    receive the interest until maturity.

  • Inflation risk - Since
    bonds typically pay a fixed amount of interest and principal,
    the purchasing power of those payments decreases due to inflation,
    which is a major risk for intermediate- and long-term bonds.

    Investing in short-term bonds reduces inflation's
    impact, since you are frequently reinvesting at prevailing interest
    rates. You can also consider inflation-indexed securities issued
    by the U.S. government, which pay a real rate of return above

  • Default and credit risk - Default risk is the risk the issuer will not
    be able to pay the interest and/or principal. Credit risk is the
    risk the issuer's credit rating will be downgraded, which would
    probably decrease the bond's value.

    To minimize this risk, consider purchasing
    U.S. government bonds or bonds with investment-grade ratings.
    Continue to monitor the credit ratings of any bonds purchased.

  • Call risk - Call provisions allow bond issuers to replace
    high-coupon bonds with lower-coupon bonds when interest rates
    decrease. Since call provisions are generally only exercised when
    interest rates decrease, you are forced to reinvest principal
    at lower interest rates.

    U.S. government securities do not have call
    provisions, while most corporate and municipal bonds do. Review
    the call provisions before purchase to select those most favorable
    to you.

    Keep in mind that the assumption of risk
    is generally rewarded with higher return potential. One of the
    safest bond strategies is to only purchase three-month Treasury
    bills, but this typically results in the lowest return. To increase
    your return, decide which risks you are comfortable assuming and
    then implement a corresponding bond strategy.

Dealing with Current Rising Interest Rates & Interest Rate Risk

With interest rates still at historically
low levels and the economy picking up steam, the Fed has started
to raise interest rates. The question now is by how much and how
quickly the Fed will increase interest rates. The answer is especially
pertinent to bond investors who will find their bond values decreasing
as interest rates increase. But don't totally abandon bonds just
because their values may decrease in the near term. There are
still valid reasons to hold bonds in your portfolio.

  • Bonds add diversification
    to your portfolio.
    Many investors added bonds to their
    portfolios in the aftermath of the recent stock market declines.
    However, all investments move in cycles, with bonds now poised
    to decrease in value when interest rates increase. The whole
    point of diversification is to hold a mix of investments so when
    one investment type is declining, other investments will help
    offset those declines. Historically, stocks and bonds have a
    low positive correlation with each other.

  • Bonds offer fixed,
    periodic interest payments and your principal's return at maturity.

    even if current bond values decline, you receive some return
    in the form of interest payments and the return of your entire
    principal at maturity.

  • Bonds are often better
    suited for short- and medium-term financial goals.
    If you need your
    money in the next few years, you may not want to keep those funds
    invested in stocks, since a major stock decline could occur when
    you need the money

Rather than selling all your bonds, look
for strategies to use in a rising interest rate environment. Some
strategies to consider include:

  • Use a bond ladder. A bond ladder is a portfolio of bonds of similar
    amounts maturing in several different years. When one of the
    bonds matures, the principal is reinvested in another bond at
    the bond ladder's longest maturity. By spreading out maturity
    dates, you lessen the impact of interest rate changes. Holding
    the bond until maturity prevents interest rate changes from resulting
    in a loss when you sell the bond. Since your bonds mature every
    year or so, your principal is reinvested over a period of time
    instead of in one lump sum. If interest rates rise, you have
    principal maturing every year or so to reinvest at higher rates.
    In a declining interest rate environment, you have some funds
    in longer-term bonds with higher interest rates. But the main
    advantage is you don't continue to hold only short-term bonds
    while you wait for interest rates to peak, an event that is difficult
    to predict.

  • Consider a bond swap. A bond swap is simply the sale of one bond and
    the purchase of another. A rate anticipation swap is made to
    take advantage of changes in market interest rates. It typically
    involves swapping short- for long-term bonds or vice versa, depending
    on your beliefs about the future direction of interest rates.
    When you anticipate interest rates might increase, you might
    swap out of longer-term bonds into short-term bonds. Then, when
    interest rates do increase, you will have funds available to
    invest at the higher rates. Before executing a rate anticipation
    swap, make sure you understand all costs that will be incurred
    and whether the sale of your existing bond will result in a taxable
    gain or loss.

  • Invest in short- or
    intermediate-term bonds.
    When interest rates rise, bond values
    decrease the most for long-term bonds, since they have a long
    stream of interest payments that do not match current interest
    rates. Thus, for new bond purchases, you may want to shorten
    your maturity dates in the near term until rates stabilize at
    higher levels.

  • Compare all types of
    bonds before investing.
    If you have a bond maturing, don't
    just reinvest in the same type of bond without taking a look
    at other alternatives. For example, lately the spread between
    corporate and municipal bonds is very small, making municipal
    bonds an attractive alternative for investors in higher tax brackets.


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