Investing for Retirement: Retirement Accounts Overview

Retirement Basics: Common Sources of Retirement Income

Social Security Benefits
Though the future of social security is uncertain to say the least, right now the deal is that you pay into the system for as long as you work (6.2% up to the "wage base"--$102,00 in 2008), whether you're an employee or self-employed. In the case of the employed, the employer must also pay the same 6.2% on the worker's wages. In addition, both the employee and the employer must pay another 1.45% each on the total yearly income of the worker. The self-employed do not pay Social Security tax as such, but under a separate law are required to pay 15.3% of their total income; they basically pay both the employee and the employer shares of the Social Security tax, though they can deduct half (the employer's share) when they file their federal income taxes.

The calculation process for how much Social Security benefits a person will receive is ridiculously complex, so I won't get into it here, suffice it to say that it's based on the average of the worker's covered earnings (the largest amount covered in 2008 was $102,000) for the 35 years in which the worker earned the most.

Workers can begin receiving benefits at age 62, but they will be "reduced benefits." Workers are not eligible to receive the full benefits until the normal retirement age, which is currently defined as 67 years old for anyone born after 1960. For ever year after normal retirement age that a worker delays receiving benefits, the benefit amount will increase when they do begin accepting them.

Social Security also provides for the worker's spouse (though currently same-sex spouses are not covered) and children, and with a little maneuvering, it is even possible for the spouse and children to receive benefits even if the worker decides to continue working after his or her retirement age. A worker's widow or widower is similarly provided for, as is, in some cases, even a divorced spouse or divorced widow(er).

The problem is that even if (and it's a big IF) social security benefits are still around by the time we get to retirement age, it's doubtful they'll be enough to live comfortably on. Even now, the average individual's monthly social security check is only around $950, and it's taxable. Obviously, you're going to want to secure other sources of retirement income.

For more information about Social Security benefits visit their website.


Work Pension Plans/Employer-Sponsored Benefit Plans
There are two main types of employer-sponsored retirement plans: defined benefit plans and defined contribution plans.

A defined benefit plan promises a specified monthly benefit at retirement. The plan may state this promised benefit as an exact dollar amount, such as $100 per month at retirement. Or, more commonly, it may calculate a benefit through a plan formula that considers such factors as salary and service--for example, 1 percent of average salary for the last 5 years of employment for every year of service with an employer. The benefits in most traditional defined benefit plans are protected, within certain limitations, by federal insurance provided through the Pension Benefit Guaranty Corporation (PBGC).

A Cash Balance Plan is a defined benefit plan that defines the benefit in terms that are more characteristic of a defined contribution plan. In other words, a cash balance plan defines the promised benefit in terms of a stated account balance. In a typical cash balance plan, a participant's account is credited each year with a "pay credit" (such as 5 percent of compensation from his or her employer) and an "interest credit" (either a fixed rate or a variable rate that is linked to an index such as the one-year treasury bill rate). Increases and decreases in the value of the plan's investments do not directly affect the benefit amounts promised to participants. Thus, the investment risks and rewards on plan assets are borne solely by the employer. When a participant becomes entitled to receive benefits under a cash balance plan, the benefits that are received are defined in terms of an account balance. The benefits in most cash balance plans, as in most traditional defined benefit plans, are protected, within certain limitations, by federal insurance provided through the Pension Benefit Guaranty Corporation (PBGC).

A defined contribution plan, on the other hand, does not promise a specific amount of benefits at retirement. In these plans, the employee or the employer (or both) contribute to the employee's individual account under the plan, sometimes at a set rate, such as 5 percent of earnings annually. These contributions generally are invested on the employee's behalf. The employee will ultimately receive the balance in their account, which is based on contributions plus or minus investment gains or losses. The value of the account will fluctuate due to the changes in the value of the investments. Examples of defined contribution plans include 401(k) plans, 403(b) plans, employee stock ownership plans, and profit-sharing plans.

A Simplified Employee Pension Plan (SEP) is a relatively uncomplicated defined contribution plan geared towards the self-employed and owners of small businesses. A SEP allows individuals to make contributions (up to 25% of their annual earnings with a maximum of $49,000) on a tax-deferred basis to individual retirement accounts (IRAs). Fidelity has a good site with more detailed information regarding SEPs and even an SEP-IRA Contribution Calculator.

Savings Incentive Match Plan for Employees of Small Employers (SIMPLE)
Don't get confused, you're right--whoever thought up the acronym for this defined contribution plan cheated a bit. Nevertheless, that's what it is, even though it's easy to confuse with the Simplified Employee Pension Plan above. Whatever. There are two main options for this type of tax-deferred IRA: 1) the employer contributes 2% of the employee's pay each year and the employee is able to contribute up to $10,500 per year. 2) The employee contributes to the plan (with the same maximum contribution) by deferring a percentage of their salary, and the employer must match that contribution (up to 3% of the employee's salary).

A Profit Sharing Plan or Stock Bonus Plan is a defined contribution plan under which the plan may provide, or the employer may determine, annually, how much will be contributed to the plan (out of profits or otherwise). The plan contains a formula for allocating to each participant a portion of each annual contribution.

A 401(k) plan is a defined contribution plan where employees can elect to defer receiving a portion of their salary which is instead contributed on their behalf, before taxes, to the 401(k) account. Sometimes the employer may match these contributions. The money in the account is then invested in stocks, mutual funds, and/or other securities. There are special rules governing the operation of a 401(k) plan. For example, there is a dollar limit on the amount an employee may elect to defer each year. An employer must advise employees of any limits that may apply. Employees who participate in 401(k) plans assume responsibility for their retirement income by contributing part of their salary and, in many instances, by directing their own investments.

An Employee Stock Ownership Plan (ESOP) is a form of defined contribution plan in which the investments are primarily in employer stock.

A Money Purchase Pension Plan is a defined contribution plan that requires fixed annual contributions from the employer to the employee's individual account.

For non-retirement specific investment information, see our Investments Primer.

Related articles by Zemanta

• How to Fix 401(k)s (online.wsj.com)
• Government Insured Pension Limits Won't Increase in 2010 (usnews.com)
• Executives Eliminate Worker Pensions, Get $350 Million (usnews.com)

Annuities: What Are They and How Do I Find the Right One For Me?

When you buy an annuity, the bank or insurance company invests your money and agrees to pay you back according to the annuity's contract terms. In very basic terms, you make one or more (depending on the contract) payment to the bank/insurer as your investment, and they in turn agree to make a series of income payments to you, starting immediately or at some point in the future, for as long as you live.

Fixed annuities guarantee a set payment amount and are similar to CDs in that they have a fixed interest rate. Check around; often fixed annuities have higher interest rates than CDs.
Note: Always read the contract carefully. Some so-called fixed annuities only fix the interest rate for a specified period, such as one year, and the rate is variable after that.

Advantages

• Promises a steady stream of income when you retire.
  
• Guarantees a fixed payment amount and interest rate.
  
• Tax-deferred growth—interest is not taxed until you collect your money.
• Typically low investment minimums (as little as $1,000).
  

Disadvantages

• Not insured by the U.S. government or by the insurance company/bank where you buy them.
  
• Often come with high fees and a heavy penalty, called a surrender charge, for cashing before a designated period of time has passed.
  
• Payment amounts do not rise to keep pace with inflation, i.e. they will be worth less as time goes by.
  

Taxes
Some annuities help you set aside money on a tax-deferred basis. You don't pay taxes on the income (interest) earned by this money until you retire. Other annuities allow you to receive income immediately, but it won't be tax deferred.

How they work
An annuity has two phases: an accumulation phase and a payout phase. During the accumulation phase, you make purchase payments, which you can allocate to a number of investment options. For example, you could designate 40% of your purchase payments to a bond fund, 40% to a U.S. stock fund, and 20% to an international stock fund. In addition, variable annuities often allow you to allocate part of your purchase payments to a fixed account, which unlike a mutual fund, pays a fixed rate of interest. The insurance company may reset this interest rate periodically, but it will usually provide a guaranteed minimum. During the accumulation phase, you can typically transfer your money from one investment option to another without paying tax on your investment income and gains, although you may be charged transfer fees by the insurance company.

At the beginning of the payout phase, you may receive your purchase payments plus investment income and gains (if any) as a lump-sum payment, or you may choose to receive them as a stream of payments at regular intervals. If you choose to receive a stream of payments, you will often be able to choose how long the payments will last, e.g. for 20 years or for your lifetime. In addition, you may be able to choose to receive fixed payments or payments that vary based on the performance of your funds. The amount of each periodic payment will depend, in part, on the time period that you select for receiving payments.
Note: Some annuity contracts are structured as immediate annuities, which means that there is no accumulation phase and you start receiving payments as soon as you purchase the annuity. Annuities with an accumulation phase are called deferred annuities.
Many annuities carry a death benefit: if you die before the insurer has started making payments to you, your beneficiary is guaranteed to receive a specified amount—typically equal to your total payments. They also sometimes offer optional features (that carry extra charges), such as a guaranteed minimum income benefit, which guarantees a minimum payment amount even if you do not have enough money in your account (perhaps because of investment losses) to support that level of payments.

Fees, Charges, and Penalties
Annuities carry a number of standard fees as well as extra charges and penalties that can be incurred. Like mutual funds, variable annuities often carry some administrative fees (in addition to the administrative fees of the mutual funds it contains!).

A fairly standard charge for variable annuities is the mortality and expense risk charge, which is expressed as a percentage of your account value, typically around 1.25% per year. This charge compensates the insurance company for insurance risks it assumes under the annuity contract and is sometimes applied toward your financial professional's commission for selling the variable annuity to you. (Yes, they get commission; financial professionals get commissions from every investment product they sell you—which is why you need to make sure you understand for yourself the terms of any prospective investment and not just let your planner delegate your money to best suit their pocketbooks.)

Many variable annuities also have penalties for certain actions, such as early withdrawal. For instance, if you withdraw money from your account during the early years of the accumulation phase, you may have to pay a surrender charge, which is usually a percentage of the amount you withdraw (sometimes up to 15%), though many contracts allow for withdrawal of a certain percentage of your account value without incurring surrender charges. Surrender charges, when they do apply, generally decrease over time; for example, a 7% charge might apply in the first year after a purchase payment, 6% in the second year, 5% in the third year, and so on until the surrender period is over. In addition to surrender charges, you may have to pay a 10% federal tax penalty if you withdraw anything before the age of 59½.

Other fees, such as initial sales loads and transfer fees may also apply. Plus, any special features or options you choose for your variable annuity, such as a stepped-up death benefit, long-term care insurance, or the guaranteed minimum income benefit, normally carry additional charges. As with mutual funds, you can find a description of all charges in the prospectus.


Equity-Indexed Annuities (EIA)

The first thing you need to know about EIAs is to be careful with them. Investment advisers get big commissions when they sign people up for an EIA, so some unscrupulous advisers will push EIAs even when they're not the best option for their client. Furthermore, EIAs are not regulated by the National Association of Securities Dealers or the Securities and Exchange Commission (until 2011).

How they work
EIAs are almost always deferred annuities, and during the accumulation period, they credit your account with a return whose rate is based on the performance of a particular stock index. Most EIAs guarantee a minimum return, often 3%, during this period. After the accumulation period, the insurance company will make periodic payments (or one lump sum) to you under the terms of your contract.

It is important to note, however, that even with a guaranteed minimum return, you can lose money with an EIA if your guarantee is based on an amount that is less than the full amount of your purchase payments.

Factors affecting rate of return
The index
Some EIAs use a simple price index, which means they calculate the rate without counting reinvested dividends. This can make quite a difference to your ROR. For example, in the past forty years, the average S&P 500 gain is 3.8 percentage points higher with reinvested dividends than without.

Method of Calculating Index Changes
EIAs also employ different methods for calculating yearly changes in an index, which can produce wide disparities in returns. Three common methods are:

• Annual Reset (or Ratchet) - This method credits index-linked interest based on any increase in index value from the beginning to the end of the year.
  
  
• Point-to-Point - This method credits index-linked interest based on any increase in index value from the beginning to the end of the contract's term.
  
  
• High Water Mark - This method credits index-linked interest based on any increase in index value from the index level at the beginning of the contract's term to the highest index value at various points during the contract's term, often the anniversaries of the annuity's purchase date.

Caps
Caps are limits on the rate of interest the EIA can earn, regardless of the performance of the index.

Participation rates
The participation rate determines how much of the index's gain will be used to compute the index-linked interest rate. If it is less than 100%, you won't be getting the full index gain. For example, if the participation rate is 80% and the index increases 9%, the return credited to your annuity would be 7.2% (9% × 80% = 7.2%).

Between participation rates and caps, an EIA's earnings can be significantly lower than you might expect. Participation rates and caps may be changed annually, depending on your contract.

Principal Guarantee
Many EIAs provide that you'll receive at least 100% of your invested funds; others guarantee only 90%.

Taxes
Your EIA earnings are tax-deferred until you withdraw them, at which time they are taxed as income; gains from an S&P 500 index fund are taxed at lower capital gains rates.

Fees, Charges, and Penalties
Spread / Margin / Asset Fee
Some EIAs annually subtract a certain percentage of the index gain and call it a "margin," "spread," or "administrative fee." In the case of an annuity with a "spread" of 3%, assuming no cap and a participation rate of 100%, if the index gained 9%, the return credited to the annuity would be 6% (9% - 3% = 6%).

Surrender charges and tax penalties
You also may have to pay a significant surrender charge and/or tax penalties if you cancel early. In addition, in some cases insurance companies may not credit you with index-linked interest if you do not hold your contract to maturity. Also, if you make any withdrawals before the age of 59 1/2, you'll be charged a 10% tax penalty in addition to the income tax on the amount withdrawn.

The final word: Be very careful with EIAs. Read the contract meticulously, and do not rely solely on the assurances of the adviser or salesperson.

Variable Annuities
A variable annuity is part insurance/part security investment; the "variable" means that its value and your income from it is variable—it can move up and down, i.e. you can lose money. Since variable annuities are long-term investments that can tie up your money for many years, the younger you are, the better.

Taxes
Like 401(k)s and traditional IRAs, variable annuities are tax-deferred, which means you pay no taxes on the income and investment gains from your annuity until you withdraw your money. You may also transfer your money from one investment option to another within a variable annuity without paying tax at the time of the transfer. When you take your money out of a variable annuity, however, you will be taxed on the earnings at ordinary income tax rates rather than lower capital gains rates. In general, the benefits of tax deferral will outweigh the costs of a variable annuity only if you hold it as a long-term investment to meet retirement and other long-range goals.

Choosing an annuity
Like with any investment, before buying an annuity you should request and read the prospectus and compare the costs and earning potential to other variable annuities and to other types of investments, such as mutual funds. You'll also want to consider the financial strength of the insurance company, which can affect their ability to pay any benefits that are greater than the value of your account in mutual fund investment options, such as a death benefit, guaranteed minimum income benefit, or amounts you have allocated to a fixed account investment option.

For more information and helpful examples, see the SEC's page on variable annuities.


See also:
Stocks: What To Look For, How to Trade For Long-Term Gains

Bonds: The Basics

Funds: Mutual Funds, ETFs, Closed-end Funds, Hedge Funds, Oh My!

Investing main

Related articles by Zemanta

• Protecting grandpa from investing peril (money.cnn.com)
• Lower Fees Make Annuities More Attractive (online.wsj.com)

Funds

A fund is a pooled investment vehicle--where many individuals pool their money to purchase many investment products, each owning a percentage of the whole, or a share. There are three basic types of pooled investment vehicles: open-end funds, closed-end funds, and unit investments trusts (UITs).

Open-end funds are called open-ended because the number of shares they can sell is is not fixed; they continuously issue new shares and redeem existing ones. Mutual funds are the best-known examples of open-end funds.

Closed-end funds, unlike mutual funds, sell a fixed number of shares at one time (in an initial public offering) that later trade on a secondary market.

Unit Investment Trusts (UITs) make a one-time public offering of only a specific, fixed number of redeemable securities called "units," which will terminate and dissolve on a date specified at the creation of the UIT.

Exchange-traded funds (ETFs) can be either open-end funds or UITs and aim to achieve the same return as a particular market index.

**Hedge funds**
A "hedge fund" is a non-legal term meaning a private, unregistered investment pool traditionally limited to experienced, wealthy investors. Because hedge funds are not mutual funds, they are not subject to the regulations that govern mutual funds and therefore do not offer the same protection for investors.

There are even "funds of hedge funds," which often have lower minimum investment thresholds so that they can sell to more investors that traditional hedge funds, but offers more limited rights of redemption than mutual funds. Funds of hedge funds are usually not listed on any exchange.

Chances are, if you're reading this, you're not an experienced, wealthy investor, so you should probably steer clear of hedge funds for the time being. To learn more about hedge funds and funds of hedge funds, see FINRA's Investor Alert, "Funds of Hedge Funds--Higher Costs and Risks for Higher Potential Returns."

Mutual Funds (open-end funds)

How they work
Mutual funds are established so that individual investors can pool their money and create a diversified portfolio. When you buy mutual fund shares, you become a shareholder of a fund that holds a variety of investments. By diversifying, a mutual fund spreads risk across numerous investments sources (often including stocks, bonds, and money market assets) rather than relying on just one to perform well. Many investors choose to buy mutual funds that spread their investments across a range of industry sectors to further diversify their holdings, while others

Mutual funds have varying degrees of risk. They also have costs associated with owning them, such as management fees, that will vary depending on the type of investments the fund makes. The price that investors pay for a mutual fund share is called the NAV or net asset value per share, plus any shareholder fees such as sales loads. All mutual fund shares have a high degree of liquidity, meaning that investors can decide to sell their shares back to the fund at any time (at the current NAV plus any redemption fees and charges).

Mutual funds are run by investment professionals who decide which investments to buy or sell for the fund. Their decisions are guided by the fund's investment goals. For example, some mutual funds are designed for people who want to have easy access to their money and invest only for a short time. These funds invest primarily in government securities or very short-term bank CDs, where the investment risks are moderate. Other mutual funds appeal to people who are willing to take on more risk with the goal of a higher return. Such funds invest primarily in corporate or municipal bonds. Most mutual funds, however, are more diverse, offering a mix of investments. A typical fund portfolio includes between 30 and 300 different stocks, bonds, and other investments.

Since mutual funds are managed by financial professionals, they can be a good choice for a beginning investor. This is not to say, however, that mutual funds are risk-free because even financial investment planners aren't perfect (despite what they may tell you). But in general, the potential gains from investing in a mutual fund outweigh the potential losses if you're in it for the long haul.

Funds can earn money in 3 ways: dividend payments, capital gains distributions, and increased NAV.

• A fund may earn income in the form of dividends and interest on the securities in its portfolio. The fund then pays its shareholders the income (minus disclosed expenses) it has earned in the form of dividends, or the shareholder can choose to have the dividends reinvested in the fun to buy more shares.
• The price of the securities a fund owns may increase. When a fund sells a security that has increased in price, the fund has a capital gain. At the end of the year, most funds distribute these capital gains (minus any capital losses) to investors, unless the investor has chosen to have these earnings reinvested.
• If the market value of a fund's portfolio increases after deduction of expenses and liabilities, then the value (NAV) of the fund and its shares increases. This increase is not paid to the investor, but reflects the higher value of the investment.

Pricing
The share price (the price that investors pay to purchase mutual fund shares) is the approximate per share NAV, plus any fees that the fund imposes at purchase (such as sales loads or purchase fees, discussed below). The price that investors receive on redemptions is the approximate per share NAV at redemption, minus any fees that the fund deducts at that time (such as deferred sales loads or redemption fees, also discussed below).

Fees and Expenses
When choosing a mutual fund, you'll want to look at not only its holdings, stated goals, risks, and past rate-of-return, but also any fees and expenses incurred--all of which you can find in a fund's prospectus. All mutual funds charge fees (hey, those fund managers have to pay for their BMWs somehow), which are usually listed as a percentage of average net assets, called the total annual fund operating expense (aka expense ratio). Obviously, the lower the percentage, the better, as fees and taxes diminish a fund's return. Unfortunately, investors must pay the shareholder fees, sales charges, and other expenses (see below) regardless of the fund's performance. All shareholder fees and operating expenses (see below) must be displayed in a fund's prospectus in the fee table.

Shareholder Fees
A sales charge (aka front-end load) is a fee expressed as a percentage of your investment. For instance, if you want to invest $1,000 in a fund with a 5% sales charge, $50 will go to the broker for the front-end load and the remaining $950 will be invested. Some mutual funds reduce the front-end load as the size of your investment increases. Similar to the sales charge is the purchase fee, which some funds charge in order to pay some of the administrative costs of trading shares. When you sell your shares, another fee, called a deferred sales charge (aka back-end load), which goes to the broker who makes the sale. Usually it depends on the length of time the investor owned the shares (decreasing with time); this type of back-end load is called a contingent deferred sales load (aka CDSC or CDSL). A redemption fee is basically the same as a purchase fee, except that it's paid when you sell your shares rather than when you buy. Some funds charge what they call an account fee that they use for account maintenance and administration; it's usually imposed on accounts with a low value.

Note that even no-load funds may charge shareholder fees, such as purchase, redemption, and account fees, as well as operating expenses.

Breakpoints
Some mutual funds that charge front-end sales loads will charge lower sales loads for larger investments. The investment levels required to obtain a reduced sales load are commonly referred to as breakpoints. You should always ask how a fund you're interested in establishes eligibility for breakpoint discounts (if it has them), as well as what the fund's breakpoint amounts are. NASD's Mutual Fund Breakpoint Search Tool can help you determine whether you're entitled to breakpoint discounts.

Annual Fund Operating Expenses
These fees are paid out of fund assets. Management fees are administrative fees that go to the fund's adviser or manager; distribution (and/or service) fees (aka 12b-1 fees) cover the costs of marketing and selling shares and investor services. Other fees may be imposed to defer custodial, legal, and accounting expenses.

When choosing a fund, pay close attention to the fee tables as even a small difference in fees can translate into a big difference in returns over a long period of time. You can compare the fees and expenses of up to three mutual funds, or the share classes of the same mutual fund with FINRA's (Financial Industry Regulatory Authority) Mutual Fund Expense Analyzer. It also allows you to compare the fees and expenses of up to three mutual funds. Enter each fund's ticker symbol or select the fund through the drop down menu. If you can't remember the exact name of the fund, you can search for it using key words.

The SEC's (U.S. Securities and Exchange Commission) online interactive Mutual Fund Cost Calculator can also help you compare the costs of different mutual funds and understand the impact that many types of fees and expenses can have over time. Unlike NASD's Mutual Fund Expense Analyzer, you'll need to enter fee and expense information manually from a prospectus or other disclosure document when using this tool.

Share Classes
Many mutual funds have what they call share classes, usually denoted as Class A, Class B, etc. All the share classes of one fund will invest in the same portfolio and have the same investment goals, etc.; the difference is in the shareholder services and/or distribution arrangements (and correspondingly, different fees and expenses. In general, mutual fund class structures work like this:

Class A shares typically have a front-end sales load, a lower 12b-1 fee, and lower annual expenses than other share classes. If you're considering Class A shares, be sure to ask about breakpoints.

Class B shares typically do not have a front-end sales load, but may impose a contingent deferred sales load and a 12b-1 fee (along with other annual expenses). Class B shares also might convert automatically to a class with a lower 12b-1 fee if they're held long enough.

Class C shares may or may not have a 12b-1 fee and either a front- or back-end sales load, but the loads for Class C shares tends to be lower than other classes. This class of shares generally does not convert to another class and tends to have higher annual expenses than other classes.

Categories of Mutual Funds
There are thousands of mutual funds to choose from; most of them fall into one of three categories: money market funds, bond funds (aka fixed income funds), and stock funds (aka equity funds), each having different features, advantages, and disadvantages.

Money Market Mutual Funds (MMMFs)
MMMFs are low-risk, low-return mutual funds that invest in the short-term money market. By law, they can only invest in certain high-quality investments issued by the U.S. federal, state, and local governments, as well as U.S. corporations. Money market mutual funds pay dividends based on current short-term interest rates, and because returns for these funds are generally lower than for bond or stock funds, inflation risk can be a concern. Do not confuse a money market fund with a money market deposit account. The names are similar, but they are completely different:

Bond Funds
Bond funds usually have higher risks and higher returns that money market funds. These risks may include credit risk, interest rate risk, and prepayment risk. Credit risk, the possibility that the companies whose bonds the fund owns default on their debts (the bonds), can be kept low by choosing a fund that invests in insured bonds or bonds issued by the U.S. Treasury. Interest rate risk is the possibility that the market value of the individual bonds will go down when interest rates rise; longer-term bonds are generally at higher risk for this. If interest rates fall, a bond issuer may decide to pay off its debt (your bonds) early and issue new bonds paying a lower interest rate that is more in line with the market. Your fund will then have to try to reinvest that money in another set of bonds; the risk here is that if prepayment happens, the fund may not be able to find another bond that pays as high a return as the original bond (since interest rates have lowered). This is called prepayment risk, and since it depends on the market, there's really no way to prevent it.

Stock Funds (aka equity funds)
Stocks have historically performed better than bonds and treasury securities over the long run. The biggest risk with investing in stocks (and stock funds) is overall market risk--the danger that stock prices will go down because of the general state of the economy (as is happening now) or because of a fall in demand for particular products or services that the companies you've invested in provides.

Types of Stock Funds
There are several types of stock funds, including growth funds, which invest in stocks that have the potential for large capital gains but that may not pay regular dividends, income funds which instead focus on stocks the do pay regular dividends, index funds, which invest only in companies of a specific market index in hopes that the fund will achieve the same return as that index, and sector funds, which invest mainly in a particular industry, such as technology or energy.

There are three basic styles used by fund managers in choosing which stocks to include in their funds' portfolios: the value approach, the growth approach, and the blend approach. In the value approach, managers choose stocks that are undervalued compared to similar companies; in the growth approach, managers look for stocks that are growing faster than their competitors or than the market as a whole; these are often well-known, established companies. The blend approach is used to build a portfolio of both value and growth stocks.

The stocks in a fund's portfolio can be U.S. companies or foreign companies. Since in the past U.S. and international economies have not been in sync, i.e. their stocks experience, as a whole, growth at different times, most financial advisers recommend diversifying by choosing both domestic and international funds for your portfolio.

Depending on your investment goals, of course, it is usually wise to further diversify your asset allocation further between different types of funds (stocks, bonds, cash/stable value funds) and to include all three "caps" in your portfolio. Cap or capitalization is a measurement of the size of a company, and is relevant because size/worth is related to growth potential and risk. Generally, large-cap companies are worth over $5 billion, mid-cap companies are worth $500 million to $5 billion, and small-cap companies are worth less than $500 million. Larger cap funds tend to have slower but more stable growth and usually have relatively low risk, while smaller cap funds may have faster growth potential but also might carry a higher risk.

Trading Mutual Fund Shares
Once you've found a fund you want to buy in to, you can either contact the fund directly, your broker, financial planner, or bank.

Exchanging shares
Some funds offer exchange privileges within the fund family, a group of funds that share administrative and distribution systems but that may have different objectives, strategies, and risks. Not all funds are part of a family, but if they are, you can often transfer your holdings from one fund to another as your investment goals change, usually without any fees. Taxes consequences do apply on exchanges, though--you'll have to pay taxes on the capital gains of your old shares (or if you've lost, you'll be able to take a capital loss).

Tax Consequences of mutual funds
When you own individual stocks or bonds, you must pay income tax each year on the dividends or interest you receive, but you won't have to pay any capital gains tax until you actually sell and unless you make a profit. Mutual funds work differently. When you buy and hold mutual fund shares, you will owe income tax on any ordinary dividends in the year you receive or reinvest them, and when you sell your shares, you will owe taxes on any personal capital gains. You may even have to pay capital gains taxes each year you hold the shares (since law requires mutual funds to distribute capital gains to shareholders if they sell securities for a profit that can't be offset by a loss.)

Tax Exempt Mutual Funds
Though some or all of the dividends from tax-exempt funds such as municipal bond funds are exempt from federal (and sometimes state and local) income tax, you do have to pay taxes on capital gains.

Here's the trick: if you receive a capital gains distribution, you will probably have to pay taxes even if the fund has had a negative return since the point during the year when you purchased your shares. For this reason, you should contact the fund to find out when it makes distributions so you won't pay more than your fair share of taxes. Sometime that information can be found on the fund's website.


Comparing mutual funds
When comparing mutual funds, be sure to take each of the following into account:

• category/type of fund
  
• tax consequences
• fund objectives/goals and strategies
  
• level of risk vs. return
• share classes available
• dividends
• fees and expenses
• level of diversification
• types of holdings (industry, company size and health, etc.)
• past performance (though this is not necessarily a reliable indicator of future performance)
• price/affordability of shares
• minimum initial investment
• how shares are purchased and redeemed

You can find all this information (except perhaps the share price, which varies) in the fund's prospectus. Always request a prospectus (and read it!) before you invest in any fund.

Here's some of what you'll find in mutual fund prospectuses:

• Date of Issue — The date of the prospectus should appear on the front cover. Mutual funds must update their prospectuses at least once a year, so always check to make sure you're looking at the most recent version.
• Risk/Return Bar Chart and Table — Right after the fund's narrative description of its investment objectives or goals, strategies, and risks, you'll find a bar chart showing the fund's annual total returns for each of the last 10 years (or for the life of the fund if it is less than 10 years old). Except in limited circumstances, funds also must include a table that sets forth returns, both before and after taxes, for the past 1-, 5-, and 10-year periods. The table will also include the returns of an appropriate broad-based index for comparison purposes. Bear in mind that the bar chart and table for a multiple-class fund will typically show performance data and returns for only one class.
  
• Fee Table — The fee table includes an example that will help you compare costs among different funds by showing you the costs associated with investing a hypothetical $10,000 over a 1-, 3-, 5-, and 10-year period.
• Financial Highlights — This section contains audited data concerning the fund's financial performance for each of the past 5 years. Here you'll find net asset values (for both the beginning and end of each period), total returns, and various ratios, including the ratio of expenses to average net assets, the ratio of net income to average net assets, and the portfolio turnover rate.

Closed-End Funds
Generally, closed-end funds sell a fixed number of shares at one time (in an initial public offering) after which the shares typically trade on a secondary market, such as the NYSE or the Nasdaq. Closed-end fund shares are also generally not redeemable, i.e. the investment company is not required to buy its shares back from investors upon request. Some closed-end funds, commonly referred to as interval funds (see below), offer to repurchase their shares at specified intervals.

The investment portfolios of closed-end funds are usually not managed by the company itself, but by independent investment advisers that are registered with the SEC. Be aware that closed-end funds are permitted to invest in a greater amount of illiquid securities than are mutual funds. Because of this feature, funds that seek to invest in markets where the securities tend to be more illiquid are typically organized as closed-end funds.

Pricing
Unlike mutual funds, the prices of closed-end fund shares that trade on a secondary market after the initial public offering is determined by the market and may be greater or less than the fund's per share NAV.


Interval Funds
An interval fund is a type of investment company that periodically offers to repurchase a certain number of shares from its shareholders. Shareholders, however, are not required to accept these offers.

Even though interval funds are classified as closed-end funds, they differ from traditional closed-end funds in the following ways:

• Interval fund shares typically do not trade on the secondary market.
• Interval fund companies are permitted to continuously offer their shares at a priced based on the fund’s NAV.
• An interval fund will make periodic repurchase offers to its shareholders, generally every three, six, or twelve months, as disclosed in the fund’s prospectus and annual report. The interval fund also will periodically notify its shareholders of the upcoming repurchase dates. When the fund makes a repurchase offer to its shareholders, it will specify the last day shareholders are allowed to accept the repurchase offer. The actual repurchase will occur at a later, specified date.

Pricing
The price that shareholders will receive on a repurchase will be based on the per share NAV determined as of a specified (and disclosed) date. This date will occur sometime after the close of business on the date that shareholders must submit their acceptances of the repurchase offer (but generally not more than 14 days after the acceptance date).

Fees and expenses
Note that interval funds are permitted to deduct a redemption fee from the repurchase proceeds, not to exceed 2% of the proceeds. The fee is paid to the fund, and generally is intended to compensate the fund for expenses directly related to the repurchase. Interval funds may charge other fees as well.


Exchange-Traded Funds (ETFs)
Like index funds, ETFs seek to achieve the same return as a particular market index and primarily invest in either all of the securities or a representative sample of the securities of companies that are included in a that index. For example, one type of ETF, called a Spider or SPDR, invests in all of the stocks contained in the S&P 500 Composite Stock Price Index. ETFs, as their name suggests, are traded on exchanges, so you can purchase shares via a broker account (like individual stocks).

How they work
Exchange-traded funds, or ETFs, are investment companies that are legally classified as either open-end funds or UITs, but that differ from traditional open-end companies and UITs in the following respects:

• ETFs do not sell individual shares directly to investors and only issue their shares in large blocks that are known as creation units. Investors generally do not purchase creation units with cash. Instead, they buy creation units with a basket of securities that generally mirrors the ETF’s portfolio. Those who purchase creation units are frequently institutions.
• After purchasing a creation unit, an investor or institution often splits it up and sells the individual shares on a secondary market. This permits other investors to purchase individual shares (instead of creation units).
• Investors who want to sell their ETF shares have two options: (1) they can sell individual shares to other investors on the secondary market, or (2) they can sell the creation units back to the ETF.
• In addition, ETFs generally redeem creation units by giving investors the securities that comprise the portfolio instead of cash. So, for example, an ETF invested in the stocks contained in the Dow Jones Industrial Average (DJIA) would give a redeeming shareholder the actual securities that constitute the DJIA. Because of the limited redeemability of ETF shares, ETFs are not considered to be—and may not call themselves—mutual funds.

An ETF, like any other type of fund, will have a prospectus. All investors that purchase creation units receive a prospectus. Some ETFs also deliver a prospectus to secondary market purchasers. ETFs that do not deliver a prospectus are required to give investors a document known as a Product Description, which summarizes key information about the ETF and explains how to obtain a prospectus.

Fees and Expenses
An ETF will have annual operating expenses and may also impose certain shareholder's fees that are disclosed in the prospectus. However, ETFs are generally more cost efficient than mutual funds because they are based on an index, and do not need to be actively managed, thereby saving you management costs. Like stocks, investors can purchase ETF shares on margin, short sell shares, or hold onto them for the long haul.


See also:
Stocks: What To Look For, How to Trade For Long-Term Gains

Bonds: The Basics

Annuities: What Are They? How Do They Work? And How Do I Find the Right One For Me?

Investing main

Bonds

Image via Wikipedia

How they work
When you buy bonds, you are lending money to a federal or state agency, municipality, or other issuer, such as a corporation. A bond is like an IOU. The issuer promises to pay a stated rate of annual interest, called the coupon rate during the life of the bond and repay the entire face value when the bond comes due or reaches maturity. The interest a bond pays is based primarily on the credit quality of the issuer and current interest rates. When bonds are purchased, they may be held to maturity or traded. In general, bonds are lower risk investments that have lower returns than stocks.

A bond may be sold at face value, which is the amount returned to the investor at maturity, (also called par) or at a premium (higher price) or discount (lower price). For example, when prevailing interest rates are lower than the bond's stated rate, the selling price of the bond rises above its face value and can be sold at a premium. Conversely, when prevailing interest rates are higher than the bond's stated rate, the selling price of the bond is discounted below face value.

Yield-to-maturity is the effective yield of the bond from the current date until the bond reaches maturity and depends on the total interest payments remaining, and the difference between today’s market value (current price) and par value. Yield-to-call is the same calculation based on the total coupon interest payments remaining between now and the first call date (rather than the maturity date) as well as the difference between today’s market value (price) and the call price.

Risk
Bonds are fixed income products, meaning that the amount you will receive is set when you buy it. In this way, bonds are low-risk investments. The bond market as a whole has historically been less volatile than the stock market, as well. Corporate bonds are usually riskier than government, Treasury, or municipal bonds because there is the potential for the corporation to go under and not be able to afford to pay its bonds when they reach maturity. All bonds carry some risk, however, including inflation risk and interest rate risk (because bond prices generally decline when interest rates rise and vice versa.) These two types of risk are related in that inflation leads to higher interest rates. Bonds with the lowest coupons are at the highest risk when interest rates rise.

Short-term bonds (those with maturities of three years or less) usually have lower yields than longer-term bonds, especially those with maturities of ten or more years. This is because the longer a bond is held, the more subject the holder is to inflation and interest rate risk.

Inflation-indexed securities like Treasury Inflation Protection Securities (TIPS) are designed to get rid of inflation risk.

Ratings
Firms like Moodys Investor Service and Standard & Poor's rate bonds. With corporate bonds, the company's bond rating is based on its financial picture. The rating for municipal bonds is based on the creditworthiness of the governmental or other public entity that issues it. Issuers with the greatest likelihood of paying back the money have the highest ratings, and their bonds will pay an investor a lower interest rate. Remember, in general, the lower the risk, the lower the expected return.

Callable vs. Noncallable
The idea here is the same as with callable and non-callable CDs.


Types of Bonds
Government Savings bonds (EE/E or I bonds) are U.S. government-issued and backed. There are different types of government savings bonds, each with slightly different features and advantages. Series I bonds are indexed for inflation, meaning that they protect against the deterioration of your investment from inflation—the earnings rate on this type of bond combines a fixed rate of return with the annualized rate of inflation. Savings bonds can be purchased in denominations ranging from $50 to $10,000, and typically earn higher interest than savings accounts and CDs, but often lower than other types of bonds.

Ginnie Mae
The Government National Mortgage Association (GNMA aka Ginnie Mae) is a government agency that buys mortgages from lenders, pools them together, and sells shares of the pool to investors (or to brokers who then sell them to investors). The pools are called Mortgage Backed Securities (MBS) aka "pass-through" securities because the mortgage payments (from the home-owners who hold the mortgages) pass through banks (which take out a processing fee) to the investors who've bought the MBSs.

What makes Ginnie Mae MBSs unique is that since the GNMA is a government agency, they get special treatment such as low interest rates on any money they borrow from the government and tax-exempt status from (most) states and municipalities, and are therefore often able to offer higher yields than other MBSs. Plus, Ginnie Mae MBSs (unlike Freddie Mac's, Fannie Mae's, and other MBSs) are fully backed by the U.S. government, i.e. your money is as safe as houses (pun intended) no matter what happens with the housing market, various financial agencies, etc. This means that Ginnie Maes are just as safe as Treasuries but often pay higher interest.

Investors receive a monthly payment either of interest and a portion of principal or of interest only. In the latter case, the principal is paid in a lump sum when the mortgage matures. The minimum investment for Ginnie Maes is $25,000, making them out of reach (or just plain undesirable) for most of us, but that's where mutual funds and the secondary market come in. Like other bonds, Ginnie Maes can be sold by their current owners who are willing to unload them at a lower price because, for instance, their interests are low compared to newer issues or they're close to maturity and there isn't much principal left to be paid.

The risks for Ginnie Maes are minimal but existent. A bunch of the mortgage holders in the pool could decide sell their homes, pay their loans off early, or refinance, causing the investors to be paid back early. This isn't so much a risk as it is slightly unfortunate. You don't lose anything; you just don't get paid as much interest as you would if the mortgages were held to maturity.

Treasury bonds, bills and notes are sold by the U.S. Treasury to pay for an array of government activities and are backed by the federal government (like Ginnie Maes). Treasury bonds are securities with terms of more than 10 years and that pay interest semiannually. Treasury bills are short-term securities with maturities of three months, six months or one year and are sold at a discount from their face value. The difference between the cost and what you receive at their maturity is the interest you earn. Treasury notes are securities with maturities ranging from two to ten years that pay interest every six months. Treasury Inflation Protected Securities (TIPS) are securities that, like Series I government bonds, protect against inflation. With TIPS, interest is paid on the inflation-adjusted principal.

Treasury securities are sold in increments of $1,000, and along with government savings bonds, can be purchased online directly from the U.S. Treasury. There is no state or local income tax on the interest earned from Treasury and savings bonds

Municipal Bonds
Municipal bonds are issued by a state, state agency or authority, or a county, city, town or village. The money invested in the bonds is used by these entities primarily for public projects such as building or repairing schools, roads, highways, bridges, hospitals, and low income housing. This type of bonds is among the safest of investment types and is special because of its tax-exempt status. This feature makes munis especially attractive to investors in the highest tax brackets.

Taxes
The interest munis pay is often lower than that of other bonds, but since other bond interest is taxed, you will not actually receive that much. For a more accurate comparison of actual interest you would receive, use the muni's tax equivalent yield (TEY) for your tax bracket. The TEY will be higher than the stated yield; it's basically the pre-tax yield that a taxed bond would have to pay in order to equal that muni's stated yield. Discount muni bonds may be subject to capital gains tax when sold.

Corporate bonds are basically loans an investor makes to a company in exchange for interest. Buying bonds for a single company is much like owning stocks in a single company; if something happens to that corporation, you can lose some, if not all, of your investment. Bond mutual funds are an alternative that spread the risk among multiple companies. While bond funds can lose money as interest rates increase, they tend to offer greater protection from losses than single bonds or stock funds.


See also:
Stocks: What To Look For, How to Trade For Long-Term Gains

Funds: Mutual Funds, ETFs, Closed-end Funds, Hedge Funds, Oh My!

Annuities: What Are They? How Do They Work? And How Do I Find the Right One For Me?

Investing main

Related articles by Zemanta

• New to bond investing? Read this first. (money.cnn.com)
• Agency Mortgage Bonds Soar (online.wsj.com)
• Will Ballooning Size Crimp a Star Bond Fund? (online.wsj.com)

Stocks: Owning Part of a Company

Buying stock makes you a partial owner of that company. You're basically betting that the company will be successful. This can be exciting, especially if you're really interested in what the company does. But the most common, and best, advice about buying stocks is that you can't put all your eggs in one basket. In other words, do not, no matter how great the company is, put all your money into that one stock. The risk is just too much. It's generally advisable to diversity your portfolio, which means investing in many different companies and industries. To diversify a portfolio, an investor should own at least ten different stocks in different industries.

Unless you have loads of cash and are able to buy millions of dollars of diversified stocks, by nature owning stock directly carries a higher risk than investing in a mutual fund. The advantages are in the lack of management fees (because you do it yourself) and direct control over your investments.

How they work
When you buy stock, you become a part owner of the company and are known as a stockholder, or shareholder. Stockholders can make money in two ways--receiving dividend payments and selling stock that has appreciated. A dividend is an income distribution by a corporation to its shareholders, usually made quarterly. Stock appreciation is an increase in the value of stock in the company, generally based on its ability to make money and pay a dividend. However, if the company doesn't perform as expected, the stock's value may go down. There is no guarantee you will make money as a stockholder. In purchasing shares of stock, you take a risk on the company making a profit and paying a dividend or seeing the value of its stock go up.

Day-trading and other short-term stock holding techniques make for some very risky investments. The best way to minimize risk and maximize potential is to become a long-term investor. Plan on holding your stocks for years--at least five and preferably many more. The idea is that if you choose the right companies, over the years they will grow and continue to be successful and their stock will appreciate. The longer the investment term, the more the risk decreases since you're allowing time for any spikes in performance to even out to a slow growth.


Why Some Investments Make Money and Others Don't
You can potentially make money in an investment if:

• The company performs better than its competitors.
• Other investors recognize it's a good company, so that when it comes time to sell your investment, others want to buy it.
• The company makes profits, meaning they make enough money to pay you interest for your bond, or maybe dividends on your stock.

You can lose money if:

• The company's competitors are better than it is.
• Consumers don't want to buy the company’s products or services.
• The company's officers fail at managing the business well, they spend too much money, and their expenses are larger than their profits.
• Other investors that you would need to sell to think the company's stock is too expensive given its performance and future outlook.
• The people running the company are dishonest. They use your money to buy homes, clothes, and vacations, instead of using your money on the business.
• They lie about any aspect of the business: claim past or future profits that do not exist, claim it has contracts to sell its products when it doesn't, or make up fake numbers on their finances to dupe investors.
• The brokers who sell the company's stock manipulate the price so that it doesn't reflect the true value of the company. After they pump up the price, these brokers dump the stock, the price falls, and investors lose their money.
• For whatever reason, you have to sell your investment when the market is down.

Buying Stock: How to Pick 'Em
Before investing in a company, learn about its past financial performance, management, products, and how the stock has been valued in the past. Learn what the experts say about the company and the relationship of its financial performance and stock price. Successful investors are well informed.

Where do you find all that information? You could go to the company's website and try to find its financial statements and annual reports, then visit a bunch of financial news sites or get a free subscription to Investor's Business Daily. But if you're short on time, websites like Morningstar, TDAmeritrade, Scottrade, and Yahoo! Finance make the basic information you'll need easier to find. Each of these sites let you search stocks by ticker symbol and access profiles of that company and its stock. Most include of these sites include in each company's profile organized financial stats, analyst commentary, relevant news, and helpful charts. If you don't have a certain company in mind, all of the above sites have free customizable stock screeners which let you search stocks by various criteria.

No set of criteria will guarantee you a winning stock, but here are some tips:

1. Look for companies with high cash to debt ratios. Then look for mid-level payout ratios; too high could be dangerous because it could mean that the company is overreaching. You don’t want a company that pays out more than it can afford. A good average is around 40%.
   
2. Also avoid stocks with high dividend yields (for the market at the time). By nature of its definition, a stock's dividend yield falls when its price goes up, and vice versa. A yield above 6% could mean that share price is plummeting. Furthermore, high yields tend to indicate mature companies with little opportunity for growth.
3. This one might seem obvious, but it's important so it's getting listed anyway: profits. Look for companies with high profits, and more specifically high profits relative to revenues. If Company A and Company B both have 1-year profits of, say, $2 million, but Company A's revenue is lower, all else being equal, Company A's stock would be more desirable. Why? Because a higher percentage of the money it brings in directly benefits its shareholders by increasing the company's net worth.
   
4. Look for a high P/E (above 30). This tends to indicate a better growth rate and expectation of future profits. Particularly avoid stocks with low price-to-earnings ratios (below 15) because they tend towards slower growth and lower profit expectations.
   

Once you've found some stocks you're interested in, you can create a watchlist for them. A watchlist allows you to monitor stock prices, company news, etc. See the bottom of this page for step-by-step instructions on creating a free watchlist at Morningstar.com. Some of the above websites also let you set alerts to notify you when a stock price reaches or falls to a specified amount.

If you're serious about learning the details about a company, it's time to check out their financial statements and reports. Most of these you can access from the company's website and/or from the monitor/broker sites listed above.

Your first stop: the income statement. The income statement contains the following information:

• Revenue: how much money the company has earned
• Expenses: how much money the company has spent
  
• Gross profit: how much money the company has left after sales to pay its operating expenses (revenue − cost of sales)
  
• Net income: how much money is left after all expenses are paid, i.e. actual profit. Also called earnings, profit, "bottom line."
  
• Earnings per share (EPS): net income ÷ number of shares outstanding
  
• Equity aka stockholder's equity aka net assets aka net worth: how much more the company owns than it owes
  
• Market capitalization: a company's market value (stock price × shares outstanding)
  
• Gross margin: gross profits ÷ revenues
• Operating margin: operating profits ÷ revenues
• Net margin: net profits ÷ revenues
• Price to earnings ratio (P/E): very roughly, how expensive or cheap a stock is at the moment (stock price ÷ earnings per share). One way to gauge how a stock is valued relative to the market is to compare its P/E with the average S&P 500 P/E.
  
• Return on equity (ROE): net income ÷ equity
  
• Dividend Yield: annual dividends per share ÷ stock price
  

How to set up a free watch list on Morningstar:
(from the Morningstar.com website)

1. Go to Morningstar.com and click on the tab labeled "Portfolio."
   
2. In the Portfolio Manager window, under "Create a Portfolio," click "New Portfolio."
3. You'll see a box labeled "Step 1." It's automatically set up to build a watch list, so click "Continue."
4. Pick a name for your portfolio, or just call it "watch list." Then, plug in the ticker symbols of the companies you want to watch. Click "Done."
5. In the following window, you'll see a list of updates, alerts, and tips that Morningstar will send you daily for the companies in your watch list. Click "Done" again.
6. Now you have a watch list that you can visit anytime by clicking the Portfolio tab on Morningstar.com.

See also:
Bonds: The Basics

Funds: Mutual Funds, ETFs, Closed-end Funds, Hedge Funds, Oh My!

Annuities: What Are They? How Do They Work? And How Do I Find the Right One For Me?

Investing main

Related articles by Zemanta

• Stocks With Steady Payouts (online.wsj.com)
• Why you should buy health care stocks now (money.cnn.com)
• Confessions of an Alleged Market Timer (usnews.com)

Certificates of Deposit (CDs)

A certificate of deposit, while technically a type of bank account called a time deposit, is more like a bond—a "product" that you buy for a specified amount and that earns a fixed interest rate until the end of its term. When the term is over, you can redeem your CD for the money you originally invested plus the accrued interest. Unlike other investments, CDs are federally insured up to $100,000. CDs are offered by traditional banks, online banks, credit unions.

How They Work
When you purchase a CD, you invest a fixed sum of money for a fixed period of time, called the term. CD terms can be almost any length, from 6 months to 20 years. In exchange for "lending" the bank your money (the principal), the bank pays you interest, typically at regular intervals, throughout the term. You get the total amount (principal plus interest) at the end of the term. However, if you redeem your CD before the end of the term (called its maturity), you typically have to pay an "early withdrawal" fee or forfeit part of the interest it earned.

Brokers
Traditionally, CDs were issued by local banks, but nowadays its common to also see them offered by brokerage firms or independent brokers, called "deposit brokers," who can sometimes negotiate a higher interest rate from the bank since they bring in so many customers. Note that deposit brokers do not have to be licensed, certified, or approved, so before engaging with one, do your research. Call your state securities regulator or check with FINRA's (the Financial Industry Regulatory Authority) Central Registration Depository to make sure 1) your broker is registered with them (allowed to trade securities) and 2) that they don't have any complaints filed against them.

You can find your state securities regulator at NASAA's (North American Securities Administrators Association) website or by calling (202) 737-0900.

To contact FINRA, call 1-800-289-9999 or use their online BrokerCheck tool

Also important when using a broker is to find out which institution issued your CD because there's a possibility that, if you're loaded and carry your other investments through that institution, your FDIC insurance might not cover everything. You see, the way FDIC insurance works is that its limited to $100,000 for each depositor at each bank. So if you've got $50,000 in one investment and $60,000 in another at the same bank, $10,000 or that is uninsured by the FDIC. Granted, considering this audience, this is highly unlikely, but it's good to know nonetheless.

One more thing--sometimes brokered CDs are held by a group of unrelated investors--each of them owning a piece of a large CD. For instance, a broker could offer you a 1-year $2,000 CD, but in reality you're getting 1/5 ownership of a 1-year $10,000 CD. The reason they do this is because banks usually offer higher interest rates for higher principals. Hence, it can be a good deal for you. Just be sure that you confirm with your broker exactly how your CD will be held and get a copy of the exact title of the CD. Always, always save all your paperwork. Not just with brokers or CDs but with any sort of investment.

Penalties for Early Withdrawal
Apologies for the vaguely dirty-sounding heading, but this is quite important. Before you invest in a CD, you need to make sure you can do without access to that money for the length of the term, because if you have to pull out (OK, that one was intentional), you could end up losing money. Always find out what the penalties are before you invest. And beware brokers who tell you their CDs have no early withdrawal penalties; it could be true or it could be a bit of a trick. You see, if you are sharing the CD with other customers, the broker has to sell your share to someone else. This may not be a problem if interest rates have gone down since you bought in, but if interest rates have risen, the broker might have to sell your portion at a discount, meaning that you lose some of your principal. It's not technically an early withdrawal penalty, but for all intents and purposes it is. (The reason that interest rate changes affect the ability of the broker to sell your portion is that CDs operate within a market. If your CD is locked in at 5% but rates have risen so that now there are other CDs available that earn 7%, no one is going to want to buy your lower-earning CD. Conversely, if rates have fallen, your 7%er might be quite an attractive buy. The moral of the story here is to ask questions and get everything in writing, so you know what you're getting in to.

Interest Rates
In general, the longer the term of a CD, the higher the interest it pays. While the CDs traditionally have had fixed interest rates, there are now also variable-rate CDs available. The variations all work differently, so you'll need to check with your bank or broker to make sure you understand how and when the rate will vary. For example, some feature a "multi-step "or "bonus rate" structure where the rates change over time according to a set schedule. For others, the rates change according to market performance; they're often linked to a specific market index, such as the Dow Jones Industrial Average or the S&P 500.

Before investing in a CD, whether variable-rate or not, be sure to get the interest rate (and how it will change) in writing from the bank or broker and find out how often interest is paid and when and how you will receive it.

Bankrate.com has a useful CD interest calculator where you can enter a deposit amount, an interest rate and type of compounding, and a length of time that the CD would be held, and the calculator will tell you the APY and what the ending balance would be. It also has a more general search function that gives you the basic info for CDs available in your area.

Money-rates.com is definitely the best CD (and savings account) search out there, updating every few minutes, and listing daily specials with rates way higher than usual. Some restrictions may apply on some of the specials. They also have separate pages with listings for short-term CDs (less than 1 year) and for longer term CDs. Good deals can be found. The search-by-state blog, however, is less helpful.

Callable and non-callable CDs
Some CDs give the issuing bank the right to "call" the CD back--effectively ending your agreement--after a set period of time. When that happens, the investor receives their full principle (the amount they paid for the CD) plus any interest that has accrued up until the call time. Banks won't always call a callable CD, but they're reserving the right. Because, naturally, investors do not want their investments to be terminated prematurely, callable CDs usually offer slightly higher interest rates to make them more attractive. It's a give-and-take situation. For instance, if interest rates fall, a bank might choose to call its higher interest CDs, and you'll be out of the game. However, if you've invested in a long-term fixed-interest CD and rates rise, you'll be locked in at that lower rate.

So, very basically, if you're worried rates might fall, you might look for noncallable, fixed-interest CDs; if you think they might rise, you might go for a callable, variable-interest CD. Either way, there's a risk, but compared to stocks, bonds, and mutual funds, it's fairly minimal.

Related articles by Zemanta

• Lunch, With a Side of Investment Advice (usnews.com)
• Locking In Returns You Like (online.wsj.com)
• A whopping .04% return on savings (money.cnn.com)

Savings Accounts

In addition to the regular savings account that we're all familiar with, other types of savings accounts include money markets and certificates of deposit, all of which are insured by the FDIC up to $100,000 (assuming your bank is member of the FDIC) and earn interest. Savings accounts are offered by credit unions as well as traditional banks and online banks.

How do you know which type of savings account is best for you? Here are some basic characteristics of each:

Regular savings

• Allows frequent transactions and transfers
• May require a minimum balance to avoid fees

High-yield savings

• Allows frequent transactions and transfers, though is geared toward deposits rather than withdrawals
  
• May require a minimum balance to avoid fees
• Pays higher interest than a regular savings account
• Often exclusively online
• Often requires a fairly high minimum initial deposit
• Potential 4-5 day lag in transferring funds
• May offer debit card, but typically not check-writing services
  

Money market

• Normally requires a fairly high minimum balance to avoid fees
  
• May offer check-writing or debit card services
• Pays higher interest than a regular savings account
• Allows a limited number of withdrawals per month
• Potential 7-day lag in accessing funds
  

Certificate of deposit (CD)

• Does not allow for withdrawals without an early withdrawal penalty
• Pays the principal and interest at the end of the term
• Is a relatively low-risk investment
• Typically offers a higher rate of interest than a regular savings account
  

A money market account is a type of deposit account, but which often includes the ability to write checks and use a debit card and typically earn a higher rate of interest than regular savings accounts. This type of account allows only 6 withdrawals (by check, debit or transfer) per month, only 3 of which can be by check; the limit may or may not include ATM withdrawals, depending on the bank.


Calculating Interest
Almost all savings accounts these days pay compound interest, which simply means that whatever interest you earn in one period is included in the principal for the next period, so that your interest is earning interest too. It's a good thing.

Here's a quick example. Say you put $1,000 in a high-yield savings account paying 5% interest compounded yearly for 3 years and you never deposit or withdraw anything in that 3 years. Here's what happens with compound interest:

Initial deposit: $1,000
End of Year 1: $1,000 x 1.05 = $1,050
End of Year 2: $1,050 x 1.05 = $1,102.50
End of Year 3: $1,102.50 x 1.05 = $1,157.63

Now, that's assuming interest is compounded annually, meaning that interest is calculated once a year. Other common interest periods are quarterly, monthly, and daily. The more often your interest is compounded, the more you'll earn. See for yourself. Try the calculator at MoneyChimp.com.


Resources
Want help finding banks near you that offer the best bang for your buck? MoneyAisle.com has an "online auction" service where banks make automated bids for your business, based on your initial deposit amount. Search for either high-yield savings accounts or CDs.

Investments Primer

An investment is anything you acquire for future income or other financial benefit. Investments increase by generating income (interest or dividends) and/or by growing (appreciating) in value.

It's important that you go into any investment in stocks, bonds, annuities, or mutual funds with a full understanding that you could lose some or all of your money in any one investment.

As you can see in the chart below, different kinds of investments generally provide different rates of return (as well as different risks—highest to lowest in the chart below). Note that average rates of return are not guaranteed; they only show what has happened historically.

Asset Class	Rate of Return*
Stocks of smaller companies	14%-16%
Common stocks	10%-13%
Long term corporate bonds	6.5%-8%
Long term US government bonds	5%-7.5%
Short term US Treasury bills	3.5%-5%

*Average rate of return since 1926, Ibbotson and Associates

When choosing an investment type (stocks, bonds, annuities, funds, etc.), start by figuring out how much risk you want to take. Yes, yes, obviously we all want low risk, but low risk generally means low returns, so in some cases it's worth the added risk to earn the added cash. Here are some questions to ask yourself to determine the amount of risk you should take:

1. Do you have a specific financial goal? An amount you need to accumulate over a given period? If not, ask yourself how much you'd like (realistically) to have in ten years, twenty years, forty years, etc. If you're hell-bent on becoming a millionaire (and good luck!), you might decide to opt for higher risk, higher return investments. Also, if you're saving for retirement and it's a ways away, you have more freedom to go with higher risk investments because you have longer to recoup your losses if things don't go your way.
   
   
2. When are you going to need money the most? In other words, how long can you leave your savings tied up in investments before you start needing to spend it? Are saving for your first house in a few years or are you planning on leaving your investments grow to support you in your retirement? Generally, the longer time horizon you have, the more risk you can tolerate because investments tend to have more even growth over long period of time.
   
   
3. How financial stable are you? Can you afford to lose some of your investment or will that leave you completely destitute? If you absolutely cannot take the chance of losing any of your money even if it means the chance of gaining more (yes, it's a gamble that way), choose lower risk investments.
   

Investors best protect themselves against risk by spreading their money among various investments, hoping that if one investment loses money, the other investments will more than make up for those losses. This strategy, called diversification, can be neatly summed up as, "Don't put all your eggs in one basket." Investors also protect themselves from the risk of investing all their money at the wrong time (think 1929--or recently) by following a consistent pattern of adding new money to their investments over long periods of time.


Monitoring Your Investments
Some people like to look at the stock quotations every day to see how their investments have done. That's probably too often. You may get too caught up in the ups and downs of the "trading" value of your investment, and sell when its value goes down temporarily--even though the performance of the company is still stellar. Remember, you're in for the long haul. Check monthly or quarterly instead.

Keep in mind, though, that it's not enough to simply check an investment's performance. You should compare that performance against an index of similar investments over the same period of time to see if you are getting the proper returns for the amount of risk that you are assuming. You should also compare the fees and commissions that you're paying to what other investment professionals charge. Look for a low expense ratio (below 1%).

Invest Wisely / Don't be stupid (adapted from SEC's "Invest Wisely")
Never:

• Send money to purchase an investment based simply on a telephone sales pitch.
• Make a check out to a sales representative personally.
• Send checks to an address different from the business address of the brokerage firm or a designated address listed in the prospectus.
  
• 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. When you receive them you should verify that the information in these statements is correct and file them away safely.
• Trust anyone who tells you, "Invest quickly or you will miss out on a once in a lifetime opportunity!"or otherwise puts pressure on you to make an investment quickly.
  

If your sales representative asks you to do any of these things, contact the branch manager or compliance officer of the brokerage firm.

Certain activities may indicate problems in the handling of your account and, possibly, violations of state and federal securities laws, such as:

• Recommendations from a sales representative based on "inside" or "confidential information," an "upcoming favorable research report," a "prospective merger or acquisition," or the announcement of a "dynamic new product."
• Representations of spectacular or specific profit, such as, "Your money will double in six months." Remember, if it sounds too good to be true, it probably is!
• "Guarantees" that you will not lose money on a particular securities transaction, or agreements by a sales representative to share in any losses in your account.
• An excessive number of transactions in your account. Such activity generates additional commissions for your sales representative, but may provide no better investment opportunities for you.
• A recommendation from your sales representative that you make a dramatic change in your investment strategy, such as moving from low risk investments to speculative securities, or concentrating your investments exclusively in a single product.
• Switching your investment in a mutual fund to a different fund with the same or similar investment objectives. Unless there is a legitimate investment purpose, a switch recommended by your sales representative may simply be an attempt to generate additional commissions for the sales representative.
• Pressure to trade the account in a manner that is inconsistent with your investment goals and the risk you want or can afford to take.
• Assurances from your sales representative that an error in your account is due solely to computer or clerical error. Insist that the branch manager or compliance officer promptly send you a written explanation. Verify that the problem has been corrected on your next account statement.

If You Have a Problem (adapted from SEC's "Invest Wisely")
If you have a problem with your sales representative or your account, promptly talk to the sales representative's manager or the firm's compliance officer. Confirm your complaint to the firm in writing. Keep written records of all conversations. Ask for written explanations.

If the problem is not resolved to your satisfaction, contact the appropriate regulators listed at the end of this document. Investor complaint information assists these regulators in identifying violations of the securities laws and prosecuting violators. However, none of these organizations is authorized to provide legal representation to individual investors or to get your money back for you.

Obtain information on using arbitration to resolve your dispute by contacting FINRA, the Financial Industry Regulatory Authority, the Municipal Securities Rulemaking Board, or the Chicago Board Options Exchange. Each of these organizations operates a forum to resolve disputes between brokerage firms and their customers. You may also wish to consult an attorney knowledgeable about securities laws. Your local bar association can assist you in locating a securities attorney.

Securities Regulators to Contact:

U.S. Securities and Exchange Commission
100 F Street, NE
Washington, DC 20549
Office of Investor Education and Advocacy
Online Complaint Form

North American Securities Administrators Association, Inc.
Suite 710
10 G Street, NE
Washington, DC 20002
(202) 737-0900
Web site

Each state has its own securities regulator. You can find your regulator at the website of the North American Securities Administrators Association.

For more specific information, click on one of the investment types in the menu on the left.

The ICI has a great set of educational resources for investors on their website, complete with charts, graphs, and worksheets to help you understand investing principles.


See also:
Stocks: What To Look For, How to Trade For Long-Term Gains

Bonds: The Basics

Funds: Mutual Funds, ETFs, Closed-end Funds, Hedge Funds, Oh My!

Annuities: What Are They? How Do They Work? And How Do I Find the Right One For Me?

Investing for Retirement: Retirement Accounts Overview

Related articles by Zemanta

• Suddenly, safe haven Treasurys get tricky (money.cnn.com)
• TIPS Buy Peace of Mind -- For a Price (online.wsj.com)
• Yes, There's Even a Risk in Treasuries (online.wsj.com)
• Treasurys pare gains on strong manufacturing data (money.cnn.com)
• As Bonds Look Risky, Finding Shelter in Covered Calls (online.wsj.com)