Tuesday, August 10, 2010

Q&A Series - Week One - A Special Series Devoted to Answering Your Burning Financial Questions

We've received some great submissions from our readers in response to our special Q&A series. This week's questions come from Mike, a long-term client and Rollins Financial Blog subscriber. Mike and his wife are in their 60's. He is still working and she is recently retired. Both are drawing Social Security benefits.

Q: We tend to gravitate toward high dividend stocks in our personal investments. Can you discuss the pros and cons of this approach, especially considering the fact that many dividends have disappeared with the economic issues at hand?

A: Dividend stocks are a great alternative to interest bearing accounts. For instance, the large telecommunications companies, AT&T and Verizon, both pay dividend yields in excess of 6%. Given that most institutions are paying interest income of less than 1% on non-jumbo money market accounts, a 6% dividend rate certainly appears attractive. If Congress leaves the Bush tax cuts in place for couples making less than $250,000, which is what they're saying right now, these dividends also currently have preferred income tax rates of a maximum rate of 15%. One of the major benefits of dividend stocks is that they pay a high rate of return, while a major drawback is that these stocks are unlikely to appreciate much over time. Basically, since the companies pay out a large portion of their income in dividends, they do not seek stock appreciation. Rather, they provide income return to their shareholders.

Of course, those of us with bank stocks suffered terrible losses in 2007 and 2008. They were once high dividend payers, but in many cases, those dividends went away. Today the exact opposite is occurring. Corporate profitability is at historically high levels and a concentration of cash in corporations has never been greater. There's been an absolute explosion of companies increasing their dividends over the last six months due to their high profitability and even higher cash levels. Since stocks are trading at historically low multiples, major U.S. corporations are increasing their dividends almost monthly.

The major disadvantage of dividend stocks is that you can't just fall asleep on them -- they must be actively managed. In other words, it's imperative that the companies be reviewed on a periodic basis to determine whether their economic future continues to be bright. While dividend stocks are great income producers, they can also be major losers if the company's economic situation changes while you are holding the stock. The greatest positive is, of course, earning a 4% to 6% dividend yield when interest rates are paying virtually nothing and inflation is even lower.

In a nutshell, dividend stocks are a great way to go if you are of a certain age and are looking for income rather than growth.

Q: How should retirement planning change to adjust to the fact that there may be less Social Security benefits in the future?

A: Those who are presently drawing Social Security benefits have almost zero chance of their benefits being cut. Social Security is one of the few sacred cows that politicians just don't seem to have the courage to address for fear of public backlash. While changes to the program are clearly necessary, it's doubtful that any cuts would have an effect on those who are currently drawing benefits. There's no question that the retirement age for drawing Social Security will increase at some point in the future. It also wouldn't surprise me to see a needs-based Social Security system implemented at some point in the future. However, those who are currently over the age of 55 are highly unlikely to face any benefit reductions.

Tara Siegel Bernard's recent article in the New York Times, Social Security Jitters? Better Prepare Now, provides excellent illustrations of the repercussions of benefit cuts to a 35-year old, a 45-year old and a 55-year old. As for those who might be affected, my suggestion is that you meet with a qualified financial advisor to develop a strategic retirement plan. Your plan should be designed based on your specific background with your needs and goals in mind.

My advice to younger individuals is save enough through an individual retirement account, a company sponsored profit sharing plan or some other retirement savings account to provide for their retirement needs. Then, any amounts they receive in Social Security benefits will just be gravy.

My hope is that everyone under the age of 50 saves enough to provide adequate income from their own assets for their retirement years notwithstanding Social Security payments. That way, what is collected through Social Security will just be extra money to vacation with and have some fun.

Q: Are reverse mortgages ever a viable option for people 65 and older?

A: I have heard nothing but bad experiences regarding reverse mortgages. First and foremost, the upfront fees on these types of programs are prohibitive, and you can almost understand why when you take into account what a bank is doing in this type of transaction.

A reverse mortgage enables older homeowners (in a typical scenario, someone who is 62-years old or older) who own their homes free and clear (or close to it) to exchange part of the equity in their homes into tax-free cash without having to sell the home, give up title, or take on a new monthly mortgage payment. In other words, the payment stream is “reversed” -- the bank pays the homeowner each month and gets the equity in their home in return.

In a reverse mortgage, the bank is basically taking a risk on how long you will live. Therefore, in the event that the homeowner lives longer than the bank anticipates, the bank cushions the transaction by charging expensive upfront costs, monthly interest charges, and, in most cases, a monthly servicing fee.

A major problem with reverse mortgages today is that the bank can only pay the homeowner an interest rate commensurate with what it can earn on its own investments. Given that the return on U.S. Treasury bonds and other types of investments is so low, you cannot expect significant payouts on a reverse mortgage regardless of the term.

Instead of obtaining a cost prohibitive reverse mortgage, I recommend that homeowners obtain a standard loan to value mortgage; those loans are currently being offered at rates in the 4% range. This money could then be used to make house payments and pay other bills for years into the future.

We have also seen many clients establish short-term home equity lines-of-credit to have available cash in the event of an emergency. I like this idea, too.

With the availability of the various lending products available in America today, it seems to me that a reverse mortgage is the least desirable.

Q: With mortgage rates extremely low and houses relatively cheap, would it make sense for a couple in their 60's to invest in rental property or other real estate?

A:  While low mortgage rates and cheap housing definitely make real estate more desirable, there are two major negatives to investing in rental property and other real estate. Two of the major determinations of value in real estate are scarcity and inflation. Since there is such a large supply of houses on the market, housing prices will remain cheap for several more years. Something that has always made real estate more valuable is that inflation impacts everything that goes into building a house. The higher the rate of inflation, the more likely that real estate will appreciate. Given that, in all likelihood, we are facing a very low inflationary period for the next five to ten years, it's unlikely that a house will appreciate due to inflation.

Another negative of investing in real estate is its lack of liquidity. Even though an investment property may have value, it is difficult to quickly cash it out. In other words, you can't use a house to buy groceries. Rental properties are also risky because there is a chance it will be vacant. With that, you incur the risk of paying the mortgage payment, property taxes, and repairs without having any rental income.

In summary, investing in real estate is a good option for younger people who have a high income from other sources, and not for retirees who may need their cash for living expenses and medical needs.

Thanks for your thought provoking questions, Mike. We hope our answers have been useful to you and to our other readers. Again, we encourage all of our readers to submit questions for this special series. If it proves to be popular, we may make it a more permanent fixture on our blog.

Best regards,
Joe Rollins

Interesting Trivia:

August of 2010 has been a very unique month in that it has five Sundays, five Mondays and five Tuesdays. This rare calendar occurrence last occurred 823 years ago. So, this "month of fives" business makes this sweltering hot month feel even longer this year. In any event, at least we can look forward to an extra weekend of 95-degree plus temperatures! Great!! I think I'll go visit Miami Beach, where the temperatures are cooler.

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