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icon-faq.gif (581 bytes)Click on any of the questions in the Table of Contents listed below, to go directly to the answer. You can return to the FAQ menu by clicking the "TABLE OF CONTENTS" link under each FAQ or by pressing "HOME".

TABLE OF CONTENTS

INVESTMENT OPTIONS

STOCKS

BONDS

ANNUITIES

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 
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Q.   What are the steps in the investment process?

  

 A. The investment process is comprised of several steps, which will enable you to select a portfolio appropriate to your risk tolerance and desired return. The primary steps in this process are: (To get more information on any of these steps, just click on the item) 
  • Determine your desired return and risk tolerance
  • Develop an asset allocation plan
  • Select diversified investments within each asset class
  • Monitor your investments
Q: How are risk and return related?

A: Risk and return are positively related. The higher the risk of an investment, the higher a return it must offer in order to compensate for the risk. Risks comes in many forms such as the volatility of the market, inflation risk, interest rate risk, and business risk. You must determine the degree of risk that you are willing to tolerate. Your investment professional can assist you in this process.

In basic terms you should select the level of risk that permits you to sleep at night. If you have a long investment horizon, year to year fluctuations should not be a concern and you can focus more on your desired return. Over the long term stocks have generated annual returns of about 10 to 11% and have had the highest level of risk while long term government bonds have had long term returns of 5 to 6% and have had the lowest level of risk. The more risk you can tolerate or the higher your desired rate of return, the higher the portion of your portfolio invested in stocks should be.

Q:   What is an asset allocation plan?

A:   Asset allocation is the distribution of investments among asset classes. Asset classes include different types of stocks, bonds, and mutual funds. It is a significant factor in determining your investment return relative to risk. Proper asset allocation maximizes returns and minimizes risk. This is because different classes of assets react differently to economic upswings or downswings. Allocation differs from diversification in that it balances a portfolio among different classes of assets—e.g., growth stocks, long bonds, and large-company stocks—while diversification focuses on variety within an asset class. Generally, allocation among six or seven asset classes is recommended.

Q:   What is diversification?

A:   Diversification is the selection of multiple investments within a portfolio. For example, investing in a portfolio of 30 stocks rather than in just a few. By maintaining a diversified, varied portfolio, you are minimizing risk. True, you’re less likely to make that "big killing." At the same time, when individual investments take nose-dive, you won’t take a big hit.

Q: How can I best monitor my investments?

A: Examine carefully and promptly any written confirmations of trades that you receive from your broker, as well as all periodic account statements. Make sure each trade was completed in accordance with your instructions. And check to see how much commission you were charged, to make sure it is in line with what you were led to believe you would pay. If commission rates are to be increased, or if charges such as custodial fees are to be imposed, you should be informed in advance.

If securities are held for you in street name, you may request that dividends or interest payments be forwarded to you or put into an interest-bearing account, if available, as soon as they are received, rather than at the end of the month or after some other lengthy period of time.

TIP TIP: Set up a file where you can store information relating to your investment activities, such as confirmation slips and monthly statements sent by your broker. Keep notes of any specific instructions given to your account executive or brokerage firm. Good records regarding your investments are important for tax purposes, and also in the event of a dispute about a specific transaction.

Periodically, ask yourself the following questions about your investment:

  • Is this investment performing as I was told it would?
  • How much money will I get if I sell it today?
  • How much am I paying in commissions or fees?
  • Have my investment goals changed? If so, is the investment still suitable?
  • Have I decided what contingencies need to happen for me to sell the investment (i.e., a certain percentage decrease in value)?
 




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Q.   What types of risks are involved in investing?

  
A. Nobody invests to lose money. However, investments always entail some degree of risk.  Be aware that:
  1. The higher the expected rate of return, the greater the risk; depending on market developments, you could lose some or all of your initial investment, or a greater amount.
  2. Some investments cannot easily be sold or converted to cash. Check to see if there is any penalty or charge if you must sell an investment quickly or before its maturity date.
  3. Investments in securities issued by a company with little or no operating history or published information may involve greater risk.
  4. Securities investments, including mutual funds, are not federally insured against a loss in market value.
  5. Securities you own may be subject to tender offers, mergers, reorganizations, or third party actions that can affect the value of your ownership interest. Pay careful attention to public announcements and information sent to you about such transactions. They involve complex investment decisions. Be sure you fully understand the terms of any offer to exchange or sell your shares before you act. In some cases, such as partial or two-tier tender offers, failure to act can have detrimental effects on your investment.
  6. The past success of a particular investment is no guarantee of future performance.
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Q.   What steps can I take to avoid unnecessary risks?

  
A. Never give in to high pressure. A high pressure sales pitch can mean trouble. Be suspicious of anyone who tells you, "Invest quickly or you will miss out on a once in a lifetime opportunity."

Never send money to purchase an investment based simply on a telephone sales pitch.

Never make a check out to a sales representative.

Never send checks to an address different from the business address of the brokerage firm or a designated address listed in the prospectus.
TIP TIP: If your broker asks you to do any of these things, contact the branch manager or compliance officer of the brokerage firm.
Never allow your transaction confirmations and account statements to be delivered or mailed to your sales representative as a substitute for receiving them yourself. These documents are your official record of the date, time, amount, and price of each security purchased or sold. Verify that the information in these statements is correct.




 

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Q.   What questions should I ask before making any investment?

  
A. Have this list of questions with you the next time you talk to your broker. Write down the answers you get and the action you decide to take. Your notes may come in handy later if there is a dispute or a problem. A good broker will be happy to answer your questions, and will be impressed with your seriousness and professionalism.
  • Is this investment registered with the SEC and a state securities agency?
  • Does the investment match my investment goals?
  • How will the investment make money for me (dividends, interest, capital gains)?
  • What set of circumstances have to occur for the value of the investment to go up? To go down? (e.g., must interest rates rise?)
  • What fees do I have to pay to buy, maintain, and sell the investment? After fees, how much does the value have to increase by before I make a profit?
  • How easy is it for me to unload this investment in a hurry, should I need the money?
  • What risks does the investment carry—i.e., how much of your investment could you lose? What are the specific risks, e.g., the risk that rising interest rates will devalue your investment, or the risk that an economic recession could decrease its value.
  • Is the company experienced at what it is doing? How long has it been in business? What is their track record? Who are their competitors?
  • Can I get more information: a prospectus, the latest SEC filings, or the latest annual report?

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Q.   What questions should I ask before making a mutual fund
investment?

  
A. Here is a list of potential questions to ask before making a mutual fund investment:
  • How has the fund performed over the long run? Where can I get an independent evaluation of it?
  • What specific risks are associated with it?
  • What type of securities does the fund hold?
  • How often does the portfolio change?
  • Does this fund invest in derivatives, or in any other type of investment that could cause rapid changes in the NAV?
  • How does the fund’s performance compare to other funds of its type, or to an index of similar investments?
  • How much of a fee will I have to pay to buy shares? To maintain shares?
  • How often will I get statements? Can you explain what the statement tells me about the investment?
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Q.   What investment hazards should I look out for?

 
A. There are no magic formulas for successful investing. It takes a disciplined, reasoned approach, a commitment to follow some basic, solid rules that have proved effective over time, and to stay in it for the long haul.

Here are some specific tips.

Don’t Let Greed Cloud Your Better Judgment. A disciplined approach, taking into account your investment objectives, will pay dividends in more ways than one. Investors who are constantly chasing the jackpot usually lose in the long run.

Don’t Rely on Tips. The "hot tip" is the bane of investors. There may be short-term gain in some cases, but in this regard, it’s generally wise to follow the maxim, "What goes up must come down."

Be Resolute. Develop a comprehensive, reasoned plan with your adviser, and stick to it, despite the temptation to "take a flyer." When you have developed your plan, and in the absence of other factors, follow it.

Consider All Your Needs and Get a Plan That Fits. For financial planning to be truly effective, all your needs must be considered: money management, tax planning, retirement planning, estate planning, insurance, etc.

Evaluate Investments Periodically. An investment program is not static and unchanging. Your financial situation and objectives may change, as does the economic situation. Review your plan with your adviser and, if necessary, update it to reflect your current and long-term needs.

Monitor your investments. Stay informed. Don’t rely on others to "take care of" your portfolio. Keep up with your reading, whether in newsletters, magazines, or the internet.

Read Broker-Account Forms With Care. Many investors pay scant attention to the forms involved in opening and maintaining a brokerage account. As pointed out earlier, many investors are not aware that much of the paperwork is intended, at least in part, to protect the broker and the form against any complaints they might bring.

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Q.   What should I invest my IRA in?

  
A. Like any other investment, you should match the portfolio with your desired return, risk tolerance and investment time horizon. The higher your desired return, risk tolerance and the longer your time horizon the greater the portion of your portfolio should be in equity investments such as common stocks. Since IRAs are generally long term investments equity investments are generally appropriate for a portion of the account.

For those with a lower risk tolerance, short-term fixed income investment would be appropriate. Many people have their IRAs invested in CDs. This is appropriate only for those with a very short time horizon or very low risk tolerance. IRA money, like any other investment, should be invested in something that will provide a decent return. 

Municipal bonds should never be used within an IRA. In doing so you sacrifice return and may convert otherwise tax-free income to taxable income when you withdraw the funds.

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Q.   What are derivatives and options?

  
A. Options are known as "derivative" investment instruments because their value derives from the security on which they are based. Options are a useful tool for enhancing a portfolio’s income and in many cases reducing risk. Other type of derivatives are futures contracts or swap agreements which are generally only appropriate for the most sophisticated investors.

Stock options are contracts giving the purchaser the right to buy or sell—at a specific price and within a certain period of time—100 shares of corporate stock (known as the underlying security). These options are traded on a number of stock exchanges and on the Chicago Board Options Exchange.

When investors buy an option contract, they pay a premium—the price of the option as well as a commission on the trade. If they buy a "call" option, they are speculating that the price of the underlying security will rise before the option period expires. If they buy a "put" option, they are speculating that the price will fall.

TIP TIP: While options trading can be very useful as part of an overall investment strategy, it can also be very complicated and sometimes extremely risky. If you plan to trade in options, make sure that you understand basic options strategy and that your register representative is qualified In this area.

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Q.   How can I avoid the most frequent money-losing mistakes?

  
A. Here are the top mistakes that cause investors to lose money unnecessarily. 
  • Using a cookie-cutter approach
  • Taking unnecessary risks
  • Allowing fees and commissions to ear up profits
  • Not starting early enough
  • Ignoring the costs of taxes
  • Letting emotion govern your investing

Q: Should I use a standard asset allocation formula such as those seen in many popular finance magazines?

A: Most investors are satisfied with a one-size-fits-all investment plan. However, your individual needs as an investor must govern any plans you make. For instance, how much of your investment can you risk losing? What is your investment timetable? (i.e., are you retired or a young professional?) The allocation of your portfolio’s assets among various types of investments should match your particular needs.

Q: Can I make a decent return without taking unnecessary risks?

A: You do not have to risk your capital to make a decent return on your money. While all investments have some degree or risk, many investments that offer a return that beats inflation without unduly jeopardizing your hard-earned money. For instance, Treasuries, the safest possible investment, offer a decent return with very little risk.

Q: What is the downside of high fees and commissions?

A: Many investors allow brokers’ commissions and other return-eating costs to cut into their returns. Be aware of the fees your are paying and make certain they are appropriate for the services you are receiving. The more you pay in fees the lower your net return will be.

Q: When should I start investing?

A: Today. Many investors are not cognizant of the power of interest compounding. By starting out early enough with your investment plan, you can invest less, and still come out with double or even quadruple the amount you would have had if you started later.

Q: What is the impact of taxes on my investment returns?

A: Net profits on your share of your mutual funds’ stock sales are taxable to you as capital gains. Unless you are in a tax-deferred retirement account, the taxes will eat into your profits. What to do: Invest in funds that have low turnover (i.e., in which shares are bought and sold less frequently). Your portfolio, overall, should have a turnover of 10% or less per year.

Q: Should I let my emotions affect my investments?

A: Never give in to pressure from a broker to invest in a "hot" security or to sell a fund and get into another one. The key to a successful portfolio lies in planning, discipline, and reason. Emotion and impulse have no role to play. Try to stay in a security or fund for the long haul. (On the other hand, when it’s time to unload a loser, then let go of it.) Finally, do not fall prey to the myth of "market timing." This is the belief that by getting into or out of a security at exactly the right moment, we can retire rich. Market timing does not work. 

Instead, use the investment strategies that do work: a balanced allocation of your portfolio’s assets among securities that suit your individual needs, the use of dollar-cost averaging and dividend-reinvestment programs, and a well-disciplined, long-haul approach to saving and investment.

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Q.   What is the difference between my cumulative return and
annualized return?

  
A. Suppose Mr. N. Vestor invests $100 in an investment that earns 10% this year and 10% the next year. What is his cumulative return? The answer is 21%.

Here's why. N. Vestor’s 10% gain makes his $100 grow to $110. Next year, he earns another 10%, leaving him with $121. His investment has earned a cumulative 21% return over two years. His annualized return, however, is 10%.

The fact that the cumulative return of 21% is greater than twice the 10% annual return is due to the effect of compounding—which means that your yearly earnings are added to your original investment before the current year’s earnings are applied.

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Q.   What is the rule of 72?

  
A. The rule of 72 is a way of finding out long it will take for your investment to double. Divide an investment’s annual return into 72, and you will have the number of years necessary to double your investment.

Note

 Example: An investment’s annual return is 10%. Ten percent divided into 72 is 7.2, so your investment will double in 7.2 year.
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Q.   What is "Total Return" and why is it important?

  
A.  If you reinvest all of your gains, including dividends and interest, you will be getting the most from compounding. The percentage you achieve is termed "total return." It includes appreciation, interest and dividends. It is particularly important in examining the past and current performance of mutual funds.

Mutual funds must, by law, distribute almost all of their capital gain and dividend income each year. Many investors reinvest these distributions, using them to buy more fund shares. Because the fund’s share price is reduced after a fund makes a distribution, the long-term price trend of a fund’s shares may not accurately reflect the fund's performance. However, the fund’s total return, which takes into account reinvested dividends, is often a more accurate reflector of the fund’s performance.

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Q.   How does "yield" differ from "total return"?

  
A. Yield is the amount of dividends or interest paid annually by an investment. The yield is usually expressed as a percentage of the investment’s current price. It does not consider appreciation.

Because certificates of deposit and money-market funds maintain the same value, their total return does not differ much from their yield. But because stocks and bonds fluctuate in price, there can be a large difference between yield and total return.

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Q.   Can I measure my return as the increase in the value of my
portfolio over a given period?

  
A. Investors often take the following shortcut, which often yields misleading results. Instead of  looking at total return, they simply compare their year-end portfolio value with the value at the beginning of the year, and attribute the entire growth to investment gains.

The reason this shortcut may be misleading is that any additional investments or withdrawals made during the year are not taken into account.

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Q.   How are stocks traded?

  
A. Generally, stocks are traded in blocks or multiples of 100 shares, which are called round lots. An amount of stock consisting of fewer than 100 shares is said to be an odd lot.

On an exchange, an order that involves both a round lot and an odd lot—say 175 shares—will be treated as two different trades and may be executed at different prices.

Your broker will charge you a different commission on each trade, and will confirm each of them separately.

These distinctions do not generally apply to trades executed in the OTC market.

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Q.   What are the differences between over-the-counter trades and
stock-exchange trades?

  
A. To be traded on an exchange such as the New York Stock Exchange or the American Stock Exchange, the issuing company must meet the exchange's listing standards; these may include requirements on the company's assets, number of shares publicly held, and number of stockholders. Organized markets for other instruments, including standardized options, impose similar restrictions.

Many securities are not traded on an exchange but are said to be traded over the counter (OTC) through a large network of securities brokers and dealers. In the National Association of Securities Dealers' Automated Quotation System (NASDAQ), operated by the National Association of Securities Dealers (NASD), trading in OTC stocks is accomplished through on-line computer listings of bid and asked prices and completed transactions.

Like the exchanges, NASDAQ has certain listing standards which must be met for securities to be traded in that market.

Investors who buy or sell securities on an exchange or over the counter usually will do so with the aid of a broker-dealer firm. The registered representative is the link between the investor and the traders and dealers who actually buy and sell securities on the floor of the exchange or elsewhere.

Market prices for stocks traded over the counter and for those traded on exchanges are established in somewhat different ways. The exchanges centralize trading in each security at one location—the floor of the exchange. There, auction principles of trading establish the market price of a security according to the current buying and selling interests. If such interests do not balance, designated floor members known as specialists are expected to step in to buy or sell for their own account, to a reasonable degree, as necessary to maintain an orderly market.

In the OTC market, brokers acting on behalf of their customers (the investors) contact a brokerage firm which holds itself out as a market-maker in the specific security, and negotiate the most favorable purchase or sale price. Commissions received by brokers are then added to the purchase price or deducted from the sale price to arrive at the net price to the customer.

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Q.   Are my mutual fund investments protected by insurance?

  
A. There are no guarantees for investors. No matter how you buy a fund—through a brokerage firm, a bank, an insurance agency, a financial planning firm, or directly through the mail, bond funds, unlike bank deposits, are not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Nor are they guaranteed by the bank or other financial institution through which you make your investment. Mutual funds involve investment risk, including the possible loss of principal. Of course, investment risk always includes the potential for greater reward.

Even though mutual funds are not insured, there are some protections. Mutual funds are highly regulated by both the federal government—primarily through the Securities and Exchange Commission—and each of the state governments.

For example, all funds must meet certain operating standards, observe strict antifraud rules, and disclose specific information to potential investors. After you invest, funds must provide you with reports at least twice a year that describe how the fund fared during the period covered.

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Q.   Should I hold my securities in certificate or electronic form and in
my own name or in street name?

  
A. Today, many debt securities are in electronic book-entry form. Ownership is transferred via computer rather than via actual transfer of paper certificates, reducing the possibility of loss, theft, or mutilation of the certificates. In the future, more and more securities certificates will be in this electronic form.

There are still, however, many securities that are in certificate form. Certificates representing your ownership of stocks or bonds are valuable documents and should be kept in a safe place. If a certificate is lost or destroyed, it may prove time-consuming and costly to obtain a replacement. Furthermore, some securities certificates may not be replaceable at all.

If you buy stock through a brokerage, you’ll usually have several choices as to how your stock will be handled:

(1) Certificates may be made out in your name, and kept in your possession. When you sell the stock, the certificates must be endorsed and delivered to the selling broker.

(2) Certificates may also be held by the brokerage firm in what is known as "street name." In this case, the brokerage firm is recorded on the list of shareholders of the corporation even though the customer is the actual owner. Thus, any communication from the company to its shareholders—such as annual reports and proxy materials—would be sent to the broker, not to the customer. The broker then must forward the material to each owner, unless shareholders have given permission for issuers of shares to communicate with them directly.

Most investors have the broker hold stock in street name. The advantages of doing so:

  • If the broker takes responsibility for safeguarding the certificate, your account is protected by SIPC, and the transfer process is facilitated should the stock be sold.
  • If you own more than a few stocks, having the stocks in street name cuts down on record-keeping chores.
  • Trades are accomplished more easily—especially now that trades must be settled in three days.
  • Some brokerages are now charging a fee if investors want to keep certificates.

On the other hand, you may not receive shareholder information as quickly because it is sent first to the broker; in addition, if an account is not actively traded, the broker may impose a custodial fee.

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Q.   What are the differences between preferred stock and common
stock?

  
A. Stocks may be designated as common—the most widely known form—or as preferred. With preferred shares, holders have some priority over owners of common stock regarding dividends (and also in the distribution of assets if the company is liquidated or reorganized in bankruptcy).

Preferred stocks generally do not have the voting rights that common shares do. Preferred shares generally have a stated dividend, while common stock dividend are based upon company performance.

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Q.   What are restricted securities?

  
A. Some stocks are "restricted" or "unregistered"—so designated because they were originally issued in a private sale or other transaction where they were not registered with the SEC. Restricted or unregistered securities may not be freely resold unless a registration statement is filed with the SEC or unless an exemption under the law permits resale.

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Q.   How can foreign stocks be bought?

  
A. Foreign corporations wishing to sell securities in the United States must register those securities with the SEC. They are generally subject to the same rules and regulations that apply to securities of U.S. companies, although the nature of information foreign companies make available to investors may be somewhat different.

U.S. investors who are interested in foreign securities may also purchase American Depositary Receipts (ADRs). These are negotiable receipts, registered in the name of a U.S. citizen, which represent a specific number of shares of a foreign corporation.

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Q.   What are dividend reinvestment plans and should I invest in
them?

  
A. With a dividend reinvestment plan, you can make small, regular cash investments in participating companies without paying prohibitive transaction fees. Further, all or a part of your dividends can be reinvested and used to purchase more shares. Some plans permit optional periodic cash purchases of securities. 

For additional information see:

  • How do I acquire initial shares of stock to enter a dividend
    reinvestment plan?
  • How do I enroll in a dividend reinvestment plan?
  • Can I use dividend reinvestment plans in my IRA?
  • Must I pay taxes on reinvested dividends?
  • What are "Super DRPs"? Should I use them to invest?
Q: How to I acquire initial shares of stock to enter a dividend reinvestment plan?

A. Some companies allow you to invest directly, providing what are called "Super DRP" plans. (Others allow only residents of certain states to do so.) However, most companies that offer DRPs require you to already own stock—usually as little as one share, but sometimes more—before you can participate.

You must hold the stock in your own name, not in "street name." If you own shares of a company in street name, just ask your broker to have the shares reissued in your own name.

If you do not own stock, buy the required number of shares through a broker.

An alternative to using a broker is to use an enrollment service. Two enrollment services are Temper’s and the National Association of Investment Clubs. Temper’s can be used for most companies, while the NAIC serves a more limited group of companies.

Temper of the Times Communications, Inc.
P.O. Box 558
Mamaroneck, NY 10543
Tel. 914-381-4500

Some DRPs send you a certificate, and then enroll you in the plan. Others use book entry ownership of the share to enroll you, and keep your one share in the plan. It is more convenient to be enrolled on a book entry basis.

Related FG TIP: Treat your decision to enroll in a DRP just as seriously as you would a decision to invest in a company. Before investing, subject the company to your usual research and analysis.


Q: How do I enroll in a dividend reinvestment plan?

A. To enroll in the DRP, contact the transfer agent or the company’s shareholder relations department, and ask for an enrollment form. Then return the form, usually along with your first optional cash investment, to the company.

Once you are enrolled, you can invest more money directly through the company’s transfer agent. Many companies offer an automatic investment service—they will automatically withdraw a pre-set amount from your bank account to make optional cash investments. Some charge a fee for this service.

Q: Can I use dividend reinvestment plans in my IRA

A. A small number of companies will open IRAs through their plans. Otherwise, if you wish to invest IRA funds through DRPs, you will have to have a bank act as custodian of your IRA.

Q: Must I pay taxes on reinvested dividends?

A. The dividends are taxable income even though you reinvest them.

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Q.   What are super DRPs and should I invest in them?

  
A. There are now about 100 U.S. companies with direct stock-purchase programs—programs that allow investors to buy a company's shares directly from the company in stead of using a broker. Direct stock purchase programs are sometimes called "Super DRPs." Like DRPs, direct-purchase plans cost an investor less, since there is no broker commission to pay, and often no fee.

A Super DRP program makes buying shares easy. Some programs have automatic-investment options, which will debit a set amount each month from an investor’s bank account.

Super-DRPs are less trouble to invest in than regular DRPs, which are offered by about 1,000 companies. With a regular DRIP, investors must (in most cases) buy at least one share of stock through a broker or an investment club such as National Association of Investors Corp. in Madison Heights, Michigan. Further, although most DRPs allow participants to buy additional shares directly, most allow purchases only once a month or once a quarter.

Super DRPs are easier to use and allow investors more flexibility. Investors can buy shares weekly or bi-monthly, and shares can be sold with a telephone redemption service. With regular DRPs, requests to sell must usually be sent by mail.

As with regular DRPs, dividend reinvestment isn't mandatory. Investors can receive dividend payments, and they can be automatically deposited in a bank account. Some companies that offer direct-purchase programs do not pay dividends.

Now that we’ve seen the benefits of Super DRPs—convenience, investment flexibility, and low cost—here are some of the negatives.

First, investors may prefer the convenience of having all of their holdings in one brokerage account. Many brokerage firms provide free dividend reinvestment for some or all clients.

Investors should also be aware that many direct-purchase programs charge fees ranging from $1 to $15 when investors buy or sell shares, and a few also impose set-up fees of $5 to $8.50, or similar small annual fees.

Another possible negative for Super DRPs (and DRPs as well) is that calculation of capital-gains taxes becomes complex when dividends have been reinvested over the years, and lots have been bought at varying prices. This can be remedied by carefully keeping track of the cost basis of shares when dividends are reinvested. Further, investors who invest through an IRA, need not deal with the problem of calculating capital gains taxes at all. Not all of the Super DRP programs offer tax-deferred individual retirement accounts.

If you like the independence and money-saving aspects of direct investment, Super DRPs may be for you. Perhaps you would like to supplement a diversified mutual-fund portfolio with some individual holdings. Super DRPs, like no-load mutual funds, are inexpensive and convenient.

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Q.   What are the various types of bonds?

  
A.  A bond is a certificate promising to repay, no later than a specified date, a sum of money which the investor or bondholder has loaned to the company. In return for the use of the money, the company (or municipality or other government entity) also agrees to pay bondholders a certain amount of interest each year, which is usually a percentage of the amount loaned.

Since bondholders are not owners of the company, they do not share in dividend payments or vote on company matters. The return on their investment is not usually dependent on how successful the company is. Bondholders are entitled to receive the amount of interest originally agreed upon, as well as a return of the principal amount of the bond, if they hold the bond for the time period specified.

Corporate bonds generally are issued in denominations of $1,000. This is the face value of the bond, and is the amount the company agrees to repay to the bondholder when the bond matures.

The prices at which bonds trade may differ from their face values because the price or value of a bond is closely related to the movement of interest rates in the economy. As interest rates change, so too will the value of the bond. So if you need to sell the bond before it matures, it may be worth more or less at that time than the price you paid for it.

Some bonds are callable, which means that the issuer can elect to buy them back from holders—at the face amount—before the date of maturity.

Bonds are classified in three ways: by the issuing organization, by their maturity, and by their quality.

Issuing Organization. The U.S. government sells bonds through the Treasury to finance the national debt and through various federal agencies for special purposes. State and local municipalities sell bonds to finance schools, hospitals, highways, bridges, airports, and the like. Corporations sell bonds to finance long-term capital project— new plants or equipment.

Maturity. Maturity means the length of time until the principal is repaid.

Short-term bonds mature in less than two years. Note that short-term may be used to mean less than one year.

Long-term bonds mature in more than ten years.

Intermediate-term bonds, as the name implies, mature between short- and long-term debt.

Treasury bills have maturates of one year or less, Treasury notes mature between one and ten years, and Treasury bonds have maturates of ten years or longer.

TIP TIP: As a general rule, the longer the bond’s maturity, the greater the interest-rate risk.

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Q.   What is meant by the term "bond quality"?

  
A. Bond quality means the creditworthiness of the issuing organization—the likelihood that it will be able to repay its debt. Independent rating services, such as Moody's Investors Service, Inc. or Standard & Poor’s Corporation, publish directories (available in most large libraries) that rate bond quality. A lower rating means the service associates a greater credit risk with that particular bond issue. Rating agencies use a combination of letters A though D to estimate the risk for prospective investors. For example, AAA (or Aaa) is the highest quality bond while C or D rated bonds are in default of payment.
Note NOTE: The ratings are not meant to measure the attractiveness of the bond as an investment, but rather the risk—how likely the principal will be paid if held to maturity.
Related FG TIP: Only the U.S. Treasury's debt is considered free of credit risk.

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Q.   What is a "bond call provision"?

  
A. Investors considering long-term bonds should be alert to the possibility of a "call" (or redemption) feature in the bonds, which can frustrate their expectation of a high yield over the life of the bonds. Such a call feature gives the issuing corporation the right to call in (redeem) its bonds after a specified number of years have elapsed. (Growing numbers of corporations are reserving such early redemption features in their bonds in hopes of refinancing later at the lower interest rates.) The call feature has three effects:
  • It makes uncertain the continuation of the high yield after the call date.
  • It may limit the appreciation of the bonds.
  • It creates the risk, where the purchase price is higher than the redemption price, that part of the investment will be lost.

There are a number of different call provisions, some of which are complex and hard to understand.

What to do: Seek bonds which either have no call feature or bonds which have the latest possible redemption date.

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Q.   What do the various bond ratings mean?

  

A.  The table below provides a summary of the ratings:

Moody’s Rating:

Indicates:

Standard & Poor’s Rating:

 Aaa Highest Quality AAA
Aa High Quality AA
A Good Quality A
Baa Medium Quality BBB
Ba Speculative Elements BB
B Speculative B
Caa More Speculative CCC
Ca Highly Speculative CC
— In Default D
N Not Rated N

For more detailed definitions of each rating, consult the publications of the rating services.

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Q.   What factors affect bond prices?

  

 A. Think of bond prices and interest rates as opposite ends of a see-saw. When rates fall, prices rise. When rates rise, prices fall. Why does it work this way?
Note Example: You buy a bond worth $10,000, which pays 9% interest until maturity in 30 years. Suppose you need to sell that bond after only 10 years, at which time, the interest rates on new loans is 11%. Why should investors buy your bond paying only 9% when they can get 11% elsewhere? 

To sell it, you'll need to drop the price of the bond below the price you paid for it. Then, when the bond matures, your buyer will get more than he or she paid for it, making up for the lower-than-market interest payments received meanwhile. 

Suppose, on the other hand, you needed to sell it when the prevailing interest rates on new loans was 7%. You could charge a premium price for your bond, which is paying a more favorable 9%. Your buyer will receive less than he or she paid for it when the bond matures, making up for the higher-than-marketplace interest payments received in the interim.

Bond mutual fund share values generally reflect bond prices. Fund managers decide which bonds to buy and sell, and when, in accordance with the fund's investment objective. (Of course, you can redeem, or liquidate, your shares at any time.)

Bond prices are also influenced by maturity. The extent of the change in bond price is also influenced by the maturity of the bond. The longer the maturity, the greater the change in price for a given change in interest rates. For example, a rise in interest rates will bring about a larger drop in price for a 20-year bond than for an otherwise equivalent 10-year bond.

Bond fund managers try to lengthen or shorten the fund's average maturity (within the fund's overall investment objectives) to anticipate changing interest rates.

Changes in bond fund prices due to changing interest rates do not reflect on the creditworthiness of the bond issuers. If, however, their creditworthiness changes, bond fund prices may also change—this type of price volatility is known as credit risk.

Related FG TIP: This is one good reason to invest in bond funds. Because a fund consists of a pool of bonds from an array of organizations, the effect of one default on the share price of the entire fund is not nearly as great as it would be for an investor who held only that single bond.

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Q.   Should I buy bond funds directly or through a mutual fund?

 

A. The biggest difference between an individual bond and a bond mutual fund is this: Because the bond fund contains many different bonds, neither the dividend payments you receive nor the maturity date is fixed. So you cannot "lock in" your principal or your payment rate.

Let's examine the implications of this difference.

A bond mutual fund is an investment company of which the sole business is managing a portfolio of individual bonds. Investors purchase ownership shares in the fund, with each share representing ownership in all the bonds in the fund's portfolio. Thus, a pool of shareholders owns a pool of bonds. Professional money managers use shareholders’ investments to buy and sell bonds for the portfolio in accordance with the fund's investment objective.

Due to pooled resources and the professional money management, bond fund shareholders can invest in far more bonds than could the average individual investor. For example, you would need to pay $25,000 for a single Government National Mortgage Association (GNMA or Ginnie Mae) bond, for instance, but you can invest in most GNMA bond mutual funds for only $1,000.

Liquidity is another important difference between an individual bond and a bond fund. By law, the bond fund must buy back your shares at any time. You may receive more or less than your purchase price, depending on how the value of the fund's underlying portfolio has changed.

In contrast, for an individual bond, if you invested in it directly, you would need to find your own buyer if you wanted to sell it before it matured.

Bond fund portfolios can contain many different types of bonds of different maturates and varying quality. Risks also vary depending on the type of fund. All bond funds are subject to interest rate risk, and most are subject to credit risk. There may be other types of risk as well. Each fund's investment objective, the types of bonds it invests in, related risks, fees, and other information can be found in the fund's prospectus.

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Q.   What are the various types of bond funds?

  

 A. The table below shows eight common types of bond funds and some of their key characteristics.

Type of Bond Fund

Goals

Invest Primarily In

  Principal Risks
Corporate Bond Income, Capital Preservation Corporate Debt Interest Rate, Some Credit
Global Bond Capital Appreciation U.S. and non-U.S. Corporate and Government Debt Currency, Policy, Interest Rate, Some Credit
Ginnie Mae (GNMA) Income Mortgage Securities backed by the Government National Mortgage Association
 		Prepayment, Interest Rate
High-Yield Income, Capital Appreciation Corporate Bond
 		Lower Quality Corporate Debt Credit, Interest Rate
Income (Bond) Income, Capital Preservation Corporate and Government Debt Interest Rate, Some Credit
Long-Term Municipal Bond Federal Tax-exempt Income, Capital Preservation
 		State and Local Government Debt Interest Rate, Some Credit
State Long-term Municipal Bond Federal and State Tax-exempt Income, Capital Preservation State and Local Government Debt of Only One State  Interest Rate, Some Credit
U.S. Government Income Capital Preservation, Income U.S. Treasury and Other Government Securities  Interest Rate
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Q.   What are municipal bonds?

  

 A. Bonds issued by states, cities, or certain agencies of local governments (such as school districts) are called municipal bonds. An important feature of these bonds is that the interest a bondholder receives is not subject to federal income tax. In addition, the interest is also exempt from state and local tax if the bondholder lives in the jurisdiction of the issuing authority. Because of the tax advantages, however, the interest rate paid on municipal bonds is generally lower than that paid on corporate bonds.

Rating agencies evaluate bonds issued by state and local governments and their agencies, taking into consideration such factors as the tax base, population statistics, total debt outstanding, and the area's general economic climate.

There are different types of municipal bonds. Some are general obligation bonds that are secured by the full faith and credit of a state or local government, and are backed by its taxing power. Others are revenue bonds that are issued to finance specified public works, such as bridges or tunnels, and are directly backed by the income from the specific project.

Prices of most municipal bonds are not usually quoted in daily newspapers.

Related FG TIP: If you are interested in a particular bond issue, consult bond dealers for their current prices. Your public library may also have copies of a municipal bond guide or a "Blue List."


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Q.   What do I need to know about U.S. Government bonds?

  

 A. Like state and local governments, the U.S. Government also issues debt securities to raise funds. Because these are backed by the federal government itself, they are considered to have maximum safety characteristics.

Government debt securities include Treasury bills with maturates of up to one year, Treasury notes with maturates between one and ten years, and Treasury bonds with maturates between ten and thirty years.

Other U.S. Government agencies issue bonds, notes, debentures, and participation certificates.

While government securities do not have to be registered with the SEC, transactions involving them are subject to the antifraud provisions of the securities laws and SEC rules.

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Q. Can I buy treasury bonds without a broker?

A. Treasury bills, notes, and bonds can be purchased directly from the Federal Reserve. Call the Federal Reserve branch nearest you and ask them to mail you information on purchasing through the Treasury Direct program.

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Q.   What are variable annuities?

  

A. Variable annuity contracts are sold by insurance companies. Purchasers pay a premium of, for example, $10,000 for a single payment variable annuity or $50 a month for a periodic payment variable annuity. The insurance company deposits these premiums in an account which is invested in a portfolio of securities. The value of the portfolio goes up or down as the prices of its securities rise or fall.

After a specified period of time, often coinciding with the year the purchaser becomes age 65, the assets are converted into annuity payments. These payments are variable, since they depend an the periodic performance of the underlying securities.

Almost all variable annuity contracts carry sales charges, administrative charges, and asset charges. The amounts differ from one contract to another and from one insurance company to another.

Fixed annuity contracts are not considered securities and are not regulated by the SEC.

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Q.   How do annuities work?

  

A. The annuity, in essence, is insurance against "living too long." In contrast, traditional life insurance guards against "dying too soon." Here is a summary of how annuities function. An investor hands over funds to an insurance company. The insurer invests the funds. At the end of the annuity’s term, the insurer pays the investor his or her investment plus the earnings. The amount paid at maturity may be a lump sum or an annuity—a set of periodic payments that are guaranteed as to amount and payment period.

The earnings that occur during the term of the annuity are tax-deferred. The investor is not taxed on them until the amounts are paid out. Because of the tax deferral, your funds have the chance to grow more quickly than they would in a taxable investment.

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Q.   Should I invest in annuities?

  

A. The two reasons to use an annuity as an investment vehicle are as follows:

  1. You want to save money for a long-range goal, and/or
  2. You want a guaranteed stream of income for a certain period of time.

Annuities lend themselves well to funding retirement, and, in certain cases, education costs.

One negative aspect of an annuity is that you cannot get to your money during the growth period without incurring taxes and penalties. The tax code imposes a 10% premature withdrawal penalty on money taken out of a tax-deferred annuity before age 59-1/2, and insurers impose penalties on withdrawals made before the term of the annuity is up. The insurers’ penalties are termed "surrender charges," and they usually apply for the first seven years of the annuity contract.

These penalties lead to a de facto restriction on the use of annuities as an investment. It really only makes sense to put your money in an annuity if you can leave it there for at least ten years, and only when the withdrawals are scheduled to occur after age 59-1/2. This is why annuities work well mostly for retirement needs, or for education funding in cases where the depositor will be at least 59-1/2 when withdrawals begin.

Annuities can also be effective in funding education costs where the annuity is held in the child’s name under the provisions of the Uniform Gifts to Minors Act. The child would then pay tax on the earnings when the time came for withdrawals. A major drawback to this planning technique is that the child is free to use the money for any purpose, not just education costs.

If an investment adviser recommends a tax-deferred variable annuity, should you invest it? Or would a regular taxable investment be better?

Generally, you should be aware that tax-deferred annuities very often yield less than regular investments. They have higher expenses than regular investments, and these expenses eat into your returns. (On the plus side, the annuity provides a death benefit.)

Overall, you’re probably better off going with a regular mutual fund. Tax-deferred annuities are generally only worthwhile if you are planning to leave the money in the vehicle for at least ten years, and to take it out over a long period.

Be aware that your investment counselor may be entitled to a commission on the product he or she is recommending. If so, proceed with great caution. Do not rely on the counselor’s comparison of the product’s return with taxable investments; do your own analysis.

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Q.   What are the different types of annuity products?

  

 A. The annuity products available vary in terms of (1) how money is paid into the annuity contract, (2) how money is withdrawn, and (3) how the funds are invested.

Single premium annuities. Suppose you have a lump sum from a retirement plan payout. You can purchase a single premium annuity, in which the investment is made all at once. The minimum investment is usually $5,000 or $10,000.

Flexible premium annuities. With the flexible premium annuity, the annuity is funded with a series of payments. The first payment can be quite small.

Immediate annuity. The immediate annuity starts payments right after the annuity is funded. It is usually funded with a single premium, and usually purchased by retirees with funds they have accumulated for retirement.

Deferred annuities. With a deferred annuity, payouts begin many years after the annuity contract is issued. You can choose to take the scheduled payments either in a lump sum or as an annuity—i.e., as regular annuity payments over some guaranteed period.

Fixed annuities. With a fixed annuity contract, the insurance company puts your funds into conservative, fixed income investments such as bonds. Your principal is guaranteed, and the insurance company gives you an interest rate that is guaranteed for a certain minimum period—from a month to a year, or more. Thus, the fixed annuity contract is similar to a CD or a money market fund, depending on length of the period during which interest is guaranteed. The fixed annuity is considered a low risk investment vehicle.

This guaranteed interest rate is adjusted upwards or downwards at the end of the guarantee period.

All fixed annuities also guarantee you a certain minimum rate of interest of 3 to 5 percent for the entirety of the contract.

The fixed annuity is a good annuity choice for investors with a low risk tolerance and a short-term investing time horizon. The growth that will occur will be relatively low. In times of falling interest rates, fixed annuity investors benefit, while in times of rising interest rates they do not.

Variable annuities. The variable annuity, which is considered to carry with it higher risks than the fixed annuity—about the same risk level as a mutual fund investment— gives you the ability to choose how to allocate your money among several different managed funds. There are usually three types of funds: stocks, bonds, and cash-equivalents. Unlike the fixed annuity, there are no guarantees of principal or interest. However, the variable annuity does benefit from tax deferral on the earnings.

You can switch your allocations from time to time for a small fee or sometimes for free.

The variable annuity is a good annuity choice for investors with a moderate to high risk tolerance and a long-term investing time horizon.

Related FG TIP: Today, insurers make available annuities that combine both fixed and variable features.

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Q.   Should a retiree purchase an immediate annuity?

  

A. At first glance, the immediate annuity would seem to make sense for retirees with lump-sum distributions from retirement plans. After all, an initial lump-sum premium can be converted into a series of monthly, quarterly or yearly payments, representing a portion of principal plus interest, and guaranteed to last for life. The portion of the periodic payout that is a return of principal is excluded from taxable income.

However, there are risks. For one thing, when lock yourself into a lifetime of level payments, you aren't guarding against inflation. You are also gambling that you will live long enough to get your money back. Thus, if you buy a $150,000 annuity and die after collecting only $60,000, the insurer often gets to keep the rest. Unlike other investments, the balance doesn't go to your heirs. Furthermore, since the interest rate is fixed by the insurer when you buy it, you are locking into today's low rates.

You can hedge your bets by opting for a "certain period," which, in the event of your death, guarantees payment for some years to your beneficiaries. There are also "joint-and-survivor" options, which pay your spouse for the remainder of his or her life after you die, or a "refund" feature, in which some of all of the remaining principal is resumed to your beneficiaries.

There are also some plans that offer quasi-inflation adjusted payments. One company offers a guaranteed increase in payments of 10 percent at three-year intervals for the first 15 years. Payments then get an annual cost-of-living adjustment, with a 3 percent maximum. However, for these enhancements to apply, you will have to settle for much lower monthly payments than the simple version.

Recently, a few companies have introduced immediate annuities that offer potentially higher returns in return for some market risk. These "variable, immediate annuities" convert an initial premium into a lifetime income; however, they tie the monthly payments to the returns on a basket of mutual funds.

If you want a comfortable retirement income, your best bet is a balanced portfolio of mutual funds. If you want to guarantee that you will not outlive your money, you can plan your withdrawals over a longer time horizon.

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Q. What form of annuity payouts should I choose?

A. When it’s time to begin taking withdrawals from your deferred annuity, you have various choices. Most people choose a monthly annuity-type payment, although a lump sum withdrawal is possible. The size of your monthly payment depends on
  1. The size of the amount in your annuity contract,
  2. Whether there are minimum required payments,
  3. The annuitant’s life expectancy, and
  4. Whether payments continue after the annuitant’s death.

Here are summaries of the most common forms of payment (settlement options). Once you have chosen a payment option, you cannot change your mind.

Fixed amount. This type gives you a fixed monthly amount—chosen by you—-that continues until your annuity is used up. The risk of using a fixed amount option is that you will live longer than your money lasts. Thus, if the annuity is your only source of income, the fixed amount is not a good choice. If you die before your annuity is exhausted, your beneficiary gets the rest.

Fixed period. This option pays you a fixed amount over the time period you choose. For example, you might choose to have the annuity paid out over ten years. If you are planning for retirement income needs before some other benefits start, this may be a good option. If you die before the period is up, your beneficiary gets the remaining amount.

Lifetime or straight life. This form of payments continues until you die. There are no payments to survivors. The life annuity gives you the highest monthly benefit of the options listed here. The risk is that you will die early, thus leaving the insurance company with some of your funds. The life annuity is a good choice if (1) you do not need the annuity funds to provide for the needs of a beneficiary, and (2) you want to maximize your monthly income.

Life with period certain. This form of payment gives you payments as long as you live, as does the life annuity, but there is a minimum period during which you or your beneficiary will receive payments, even if you die earlier than expected. The longer the guarantee period, the lower the monthly benefit.

Installment-refund. This option pays you as long as you live and guarantees that, should you die early, whatever is left of your original investment will be paid to a beneficiary. Monthly payments are less than with a straight life annuity.

Joint and survivor. This pays you as long as you live, and then pays your spouse or other beneficiary until his or her death. The amount of the monthly payments depends on your age, your beneficiary’s age, and whether you want your survivor’s payment to be 100% of your own or some lesser percentage.

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Q. How will my annuity payouts be taxed?

A. The way your payouts are taxed is different for qualified and non-qualified plans. Here is a summary of the two different types of plans. 

Qualified And Non-Qualified Annuities

A tax-qualified annuity is one used to fund a qualified retirement plan, such as an IRA, Keogh plan, 401(k) plan, SEP (simplified employee pension), or some other retirement plan. The tax-qualified annuity, when used as a retirement savings vehicle, is entitled to all of the tax benefits—and penalties—that Congress saw fit to attach to such plans.

The tax benefits are:

  1. The amount you put into the plan is not subject to income tax, and/or
  2. The earnings on your investment are not taxed until withdrawal.

The tax rules say that you cannot make withdrawals before age 59-1/2 without paying an additional tax of 10% of the amount withdrawn. Further, you must begin taking withdrawals in certain minimum amounts once you reach the age of 70-1/2.

A non-qualified annuity, on the other hand, is purchased with after-tax dollars. You still get the benefit of tax deferral on the earnings.

Tax Rules

When you withdraw money from a qualified plan annuity that was funded with pre-tax dollars, you must pay income tax on the entire amount withdrawn.

Once you reach age 70-1/2, you will have to start taking withdrawals, in certain minimum amounts specified by the tax law.

With a non-qualified plan annuity that was funded with after-tax dollars, you pay tax only on the part of the withdrawal that represents earnings on your original investment.

If you make a withdrawal before the age of 59-1/2, you will pay the 10% penalty only on the portion of the withdrawal that represents earnings.

With a non-qualified annuity, you are not subject to the minimum distribution rules that apply to qualified plans after you reach age 70-1/2. 

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Q.   How can I get the "best buy" on an annuity?

  

A.  Although annuities are issued by insurance companies, they may be purchased through banks, insurance agents, or stockbrokers. The "load" (commission) you will pay to the middle-man will vary from 3% to 8% of your investment. The commission reduces the return you can get on your investment.

Some insurance companies sell "no-load" (no commission) annuities directly to the investor. With the no-load annuity, all of your money goes to work for you earning interest or dividends.

There is considerable variation in the amount of fees that you will pay for a given annuity, as well in the quality of the product. Thus, it is important to compare costs and quality before buying an annuity.

Before checking out the product, it is important to make sure whether the insurance company offering the product is financially sound. Because annuity investments are not federally guaranteed, the soundness of the insurance company is the only thing you have to bank on. Consult services such as Best’s, Moody’s, Standard & Poor’s, Duff & Phelps, and Fitch’s to find out how the insurer is rated. These are available in larger libraries. Choose only companies that are top-rated, after familiarizing yourself with the service’s rating system.

The way you should go about comparing annuity contracts varies with the type of annuity.

With immediate annuities, compare the settlement options. For each $1,000 invested, how much of a monthly payout will you get? Be sure to consider the interest rate, and any penalties and charges.

With deferred annuities, you should compare the rate, the length of guarantee period, and a five-year history of rates paid on the contract. It’s important to consider all three of these factors, and not to be swayed by high interest rates alone.

In the case of variable annuities, check out the past performance of the funds involved. 

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Q.   What fees are found in annuity contracts?

  

 A. There are a variety of fees such as: 

Sales Commission

Be sure to ask for details on any commissions you will be paying. What percentage is the commission? Anything above 3 - 5% should be unacceptable. Is the commission deducted as a front-end load? If so, your investment is directly reduced by the amount of the commission. A no-load annuity contract, or at least a low-load contract, is the best choice.

Surrender Penalties

Find out how much the surrender charges—amounts charged for early withdrawals—are. The typical charge is 7% for first-year withdrawals, 6% for the second year, and so on, with no charges after the seventh year. Charges that go beyond seven years, or that exceed the above amounts, should not be acceptable.

Related FG TIP: Be sure the surrender charge "clock" starts running with the date your contract begins, not with each new investment.

Other Fees and Costs

Be sure to ask about all other fees. With variable annuities, the fees must be disclosed in the prospectus. Fees lower your return, so it’s important to know about them. Fees might include:

  • Mortality fees of 1 to 1.35 of your account (protection for the insurer in case you live a long time),
  • Maintenance fees of $20 to $30 per year, and
  • Investment advisory fees of 0.3% to 1% of the assets in the annuity’s portfolios.
Extras

These provisions are not costs, but should be asked about before you invest in the contract.

Some annuity contracts offer "bail-out" provisions, allowing you to cash in the annuity if interest rates fall below a stated amount, without paying surrender charges.

There may also be a "persistency" bonus for annuitants who keep their annuities for a certain minimum length of time are rewarded.

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