Sigcat Software Showcase 1992/SIGCat Software Showcase 1992 - CD-ROM Strategies.ISO/research/docs/winter87.txt

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Tofias
Fleishman
Shapiro
& Co., P.C.                                                Winter
                                                           1987
Certified Public Accountants

205 Broadway, Cambridge, MA 02139 ■ [phone] ■ 66 Pearl Street,
Portland, ME 04101 ■ [phone]


PERSONAL FINANCIAL PLANNING QUARTERLY


COMMON SENSE AND CLOSED END FUNDS

A commonly employed marketing technique is to exert psychological
pressure by setting an early deadline by which action must be taken or
opportunity will be lost. The initial public offerings of several
closed end funds during the past few months offered occasions to observe
this in practice, as investors were urged to rush to participate before
the initial offering closed.

A closed end fund is a type of mutual fund. What distinguishes closed
end funds is that, unlike other mutual funds, they offer a fixed number
of shares. Consequently, while most mutual fund shares trade at a value
equivalent to a pro-rata share of the net asset within the fund
(adjusted for load, if any), the shares of closed end funds may trade at
a premium or discount.

Historically, most closed end funds have traded at a discount. The
phenomenon is so common that many financial advisors recommend buying
closed end shares only when they are trading for a larger discount than
usual. Since purchase during the initial offering is always at par
value, there is little apparent cause for urgency.

It is sometimes suggested that the purchase of closed end shares after
the initial public offering must be done through an exchange and
involves transaction costs. However, underwriting charges, including
marketing costs, will inevitably be deducted from an investment made
during the initial public offering. In any investment decision, the
suggested reasons for hurrying may be illusory. When there is not time
to make a thoughtful decision, perhaps no decision should be made.


THE REVOCABLE LIVING TRUST: AVOIDING PROBATE

A revocable living trust is an arrangement under which an individual
transfers assets to the management of a trustee, names one or more
income beneficiaries, and provides for the disposition of the assets at
the time of the last income beneficiary's death. The arrangement may be
altered or terminated at any time by its creator.

If the trust remains in effect until its creator's death, the trust
assets are governed by the terms of the trust agreement, not by its
creator's will. This provides an opportunity to maintain privacy with
regard to the disposition of assets contained within the trust. (A will

is a matter of public record, but a revocable living trust is a private
agreement.) The trust agreement may also be more difficult to challenge
than a will. A further advantage is that the assets avoid probate with
its delays and many of the attendant costs. (This feature may be
particularly beneficial to persons residing in states with complicated
and troublesome probate procedures.) A revocable living trust does not,
however, reduce taxes on the estate of its creator.

It is not unusual for the trust creator's will to provide for
additional assets to "pour-over" and be added to the trust. The trustee
may also be named as beneficiary of insurance on the trust creator's
life. The trust will continue in existence until the last surviving
income beneficiary dies, at which time its assets will be distributed to
the persons named in the trust to receive them.

The creator of a revocable trust can name himself of herself and/or
spouse as income beneficiaries of the trust and as co-trustees.
However, a frequent reason for establishing a revocable living trust is
to secure professional management for assets which the owner lacks
either the inclination or the ability to provide.


INVESTING FOR INCOME: TRAPS, TRICKS AND TRUTH

By reducing the maximum individual marginal tax bracket, the Tax Reform
Act of 1986 has made income a more attractive feature to many investors.
At the same time, falling interest rates have made planning more difficult
for those who must rely on investment income to provide for living expenses.
As yields have fallen, the continuing high level of the "real" interest
rate, the difference between the nominal rate and the rate of inflation,
has been a source of small comfort to these people. For while their
living costs may not be rising very dramatically, neither are they
dropping in tandem with reduced yields. In searching for an investment
vehicle which will generate increased cash flow, income investor ill
encounter promises of high yields and a multitude of competitive
products, the risk level of which is not always easily evaluated.


Comparing Yields

When comparing alternative investments in income producing securities
ranging from Certificates of Deposit to bond mutual funds, it is
important to be aware of tricks which can be played with numbers. The
following pointers may help in identifying inconsistencies in quoted
yield figures.

Certificates of Deposit - Notice whether the interest paid is simple or
compounded. Frequency of compounding significantly impacts yield.

Savings Accounts - Ask when interest will begin to be credited. A lag
from several days to several months may exist. (At least one credit
union pays interest only on funds which have been in a member's account
for the entire preceding quarter. Under such an arrangement, the
account-holder may fail to receive up to three months interest, if funds
are deposited shortly after a payment date.) Inquire about minimum
balance requirements. Will interest accrue on the average daily balance
or the lowest balance during the period?


Money-Market Funds - The yield on money market funds fluctuates
constantly and is typically quoted as the average yield over the seven
preceding days. Because of possible accounting method differences, when
comparing one fund with another, it is helpful to inquire also about
the yield over the prior thirty days.

Bonds and Bond/Option Funds - Try to avoid bonds which are trading at a
premium when interest rates are in a period of significant decline.
Falling rates tempt issuers to redeem bonds with higher than market
coupons. Since bonds are redeemed at face value, a loss of principal
will result.

Be aware that since no standard method of yield calculation is
presently required of bond funds, a considerable amount of manipulation
can and does occur to increase advertised yields. One such trick is to
include any capital gains realized by the fund in the income figure. The
quoted income yield should include only interest (or dividends), since
capital gains may be sporadic or non-recurring. Funds which sell
options on the bonds (or other securities, if a stock fund) held in
portfolio may include the sales proceeds in quoting yield. Remember that
while covered option writing may enhance the yield quotation, it
represents a trade-off of potential capital gains with no corresponding
decrease in downside risk. With bond funds this scenario provides
increased potential for the erosion of principal over time through
interest rate fluctuations.

Like stock mutual fund managers, bond fund managers may enhance their
reported performance by carefully selecting the time period on which the
figures are based. When interest rates are falling, for example,
extending the period on which "current yield" is computed will boost
the rate quoted (and reduce its predictive value). Use consistent
periods when comparing funds (over several years if possible) and look
at both the "yield" and "total return" figures. Place more weight on the
total return.

GNMA's and GNMA Funds - The yields of GNMA funds are not "guaranteed by
the U. S. Government." Although the federal government guarantees the
payment of principal and interest on the underlying mortgages, GNMA's
and GNMA funds fluctuate in value like bonds in response to interest
rate changes. And while bonds may be called when interest rates decline,
GNMA's are perhaps even more prone to prepayment because of heavy
mortgage refinancing as lower rates become available. Remember that the
yields quoted when GNMA's are purchased assume an average maturity of
about twelve years. The quoted yield will not be realized if maturities
are significantly shortened by refinancings, and any premium paid for
the securities will be lost. When investing in a GNMA fund, check the
annual or semi-annual report to determine whether many of the underlying
mortgages were purchased at a premium.

Risk and Return

In the case of high quality fixed income investments, most risk
derives from potential interest rate changes and is reflected in
fluctuations in a security's price. Bond prices vary inversely with
interest rates. The degree of variation depends on the bond's coupon and
its length to maturity.

("Duration" is a word used to encompass these two variables.) Holding
quality constant, long bonds with low coupons are subject to the most
dramatic fluctuations in price.

Income investors can reduce risk (potential principal loss) by
diversifying their portfolios not only between issues but also over
time. Shortening the average maturity of the portfolio will also reduce
yield, however.

Because time increases risk, it is helpful to examine the yield curve.
Often, as now, there is some intermediate position beyond which
extending maturities does not seem to be adequately rewarded.

Optimizing return within the constraints set by the investor's personal
risk tolerance is key to investing for income.


Mutual Fund Loads and Fees

Mutual funds have become extremely popular income investments because
of their diversification, regular payments of dividends and interest,
convenience and other features. Funds investment, however, has costs
which frequently are substantial relative to those of investment in
individual securities, and such costs should not be overlooked in the
investment decision. Some costs can be avoided or minimized through
careful fund selection. Others may be justified by performance, based on
the net return or other factors. The costs associated with fund
ownership generally fall into the following classifications.

Management Fees/Other Internal Charges - All funds assess fees
internally to compensate the fund's manager and to pay overhead
expenses. The fund's expense ratio will be revealed in the prospectus
and, in general, should not be much greater than 1% annually.

Front-End Loads - These commissions often range up to 4 1/2% for fixed
income funds and up to 8 1/2% for stock funds. Do not fall into the trap
of forgetting that this is real money. Your personal net worth is
immediately reduced by such a charge, as is the amount you have
available to generate income. In return you have received guidance in
fund selection. The performance of load funds in general is no better
than the performance of no-load funds.

Back-End Loads - Back-end commissions are withheld from your proceeds
when you withdraw your money from the fund. They typically start at 4%
to 6%, and gradually decline to zero in the fifth or sixth year. While
seemingly more palatable than front-end loads, the presence of a
back-end load restrains your ability to shift investments in response to
changed objectives or market conditions. And they are almost always
coupled with 12-b-1 fees.


12-b-1 Fees - These are internal fees levied annually by some funds for
"marketing" expenses (advertising, commissions, etc.). In order to
determine whether a fund you are considering imposes a 12-b-1 charge,
look in the fund prospectus under the heading "Plan of Distribution."
The prospectus must reveal the existence of a 12-b-1 assessment, if one
is to be made. The typical range of 12-b-1 charges is from 3/4% to 3%.
Over a holding period of several years, such charges can easily total to
more than a typical front-end load. Although many fund shareholders are
unaware of their existence, they reduce total return to the investor in
an amount which may be significant.

Low Loads - Some funds, including some which formerly were no-load,
impose a "low" front-end load of from 1% to 3%. In some instances, a
fund's strong performance and management, unique qualities or special
nature, are sufficient to justify investment in the fund despite the
load.

Exit Fees - A few funds, particularly aggressive growth stock funds,
impose an exit fee of from 1/2% to 1% to discourage frequent movement in
and out of the fund. These fees generally remain in the fund and benefit
other shareholders. They are virtually never seen in connection with
fixed income funds.


Substantial savings can be realized through the selection of no-load
and low-load funds which meet an investor's objectives. Both Forbes and
Money magazines publish annual or semi-annual comparisons of the
performance records of mutual funds. Another excellent source of
information concerning no-load funds is The Individual Investor's Guide
to No Load Mutual Funds published annually by the American Association
of Individual Investors, 612 North Michigan Avenue, Chicago, Illinois
60611. For those who desire personalized professional guidance, a
financial advisor who is compensated only by fees can be both objective
and cost-effective in designing a fund portfolio.

"Investing for Income" will continue in the summer issue of Fiscal
Fitness with a discussion of obtaining higher yields and providing for
growth in an income portfolio.


EDUCATIONAL PLANNING: NEW LAW - NEW TECHNIQUES

Among a lifetime's largest expenditures and second only to home ownership
is providing a college education for one's children. Today, the average
annual cost of attending a private college is $10,000. This cost may be
expected to increase to $19,000 by the year 2000, assuming a 5% inflation
rate. At that time parents will need to have an asset base of $76,000
available for each child who is to attend a four-year baccalaureate program.
Certain strategies may be helpful in accumulating these assets.

     ■  Start saving early and set aside funds on a consistent basis.
     ■  Insure the best possible return on principal after considering risk.
     ■  Be aware of the timing of investments to assure that funds are
        available when needed without risk of principal loss.
     ■  Consider shifting income when tax savings can be achieved.


Income Shifting

In the past the tax burden on funds accumulated for education could
often be reduced by shifting income from parents to children. The Tax
Reform Act of 1986 has eliminated many income shifting techniques.
Clifford and Spousal Remainder Trusts will no longer serve as means of
shifting income to the lower tax brackets of children. While prior law
provided that trust income be taxed to the beneficiary, under the new
law income generated by any trust created after 3/1/86 will be taxed at
the grantor's or parent's tax rate. Trusts created before 3/1/86 may
also be affected, since unearned income of children under 14 years of
age will be taxed at their parent's rate regardless of the source.

A few income shifting techniques are still available if you own a
family business. The employment of children by the family business may
generate earned income which is taxed at the child's marginal rate.
Stock in the family business can be transferred to a child. The
dividends will be taxed to the child after age 14 and can be used to
provide for college expenses.


Investment Vehicles

With income shifting severely limited as a means to reduce the taxation
of funds set aside for education, several investment vehicles may gain
popularity.


     ■  Zero coupon municipals -- Interest income accrues annually but is
        tax-exempt. Maturities can be staggered so that funds are available at
        the beginning of each year of college.
     ■  Municipal Bonds -- Interest income is tax-exempt, and maturities can
        be chosen which make these funds available when needed for college.
        However, the coupon payments of municipal bonds are subject to market
        conditions upon reinvestment.
     ■  Series EE savings bonds -- These government secured bonds allow the
        owner to defer the recognition of income until maturity, which may be
        after a child reaches age 14.
     ■  Growth stocks/mutual funds -- Those securities may pay small or no
        income dividends. If sold after the child reaches age 14, any gain will
        be taxed at the child's rate.
     ■  Single Premium Deferred Annuities -- Earnings within the annuity will
        accumulate tax-free until payout when the child starts college.  (An
        appropriate maturity date must be selected and early withdrawals avoided
        to escape penalty.)
     ■  Single Premium Whole Life Insurance -- This vehicle may provide
        insurance coverage on the parent's life and tax-deferred accumulation
        of cash value. When the child is ready for college, the cash value may
        be borrowed (often at a zero net cost). Note that cancellation of a
        policy after borrowing generates tax consequences.

Be aware when investing for college education that market conditions
at the time funds are needed or when securities mature may not be
favorable for liquidation or reinvestment.

Miscellaneous Techniques

Other ways to help defray the cost of college education include
scholarships, home equity loans and prepayment plans. The 1986 Tax
Reform Act taxes scholarships granted after 8/1/86 to the extent they
are not used to pay tuition and fees. The Act also provides that
interest on home equity loans, the proceeds of which are used for
educational purposes, will be fully deductible as long as the equity
loan and other loans on the property do not exceed the property's fair
market value. The deductibility of interest on home equity loans used
for other purposes (except medical expenses) is limited to the cost of
the property plus improvements.

Several colleges have recently begun prepayment plans whereby the
parent of a young child makes a lump sum payment to the college in
return for a guaranteed four years of future college education. Most
college prepayment plans have provisions requiring forfeiture of part or
all of the accumulated funds (including principal) if the child does
not attend that college. Several states have similar prepayment plans.
Attendance at one of the state's institutions is usually required.
Prepayment plans are a new funding vehicle; in the future the IRS could
require taxation on the earnings of these plans.