Plan and Prepare – June 18, 2012

On Wednesday, May 16, 2012, Cascade Investment Group had the privilege of serving on an investment Q&A panel for several key business leaders and executives in Colorado Springs. It was an excellent dialog and we received very good feedback from the attendees. We were able to get most of the questions answered and thought it would be beneficial to all our readers to share what questions other people are asking and what answers Cascade Investment Group can provide. The most common theme we addressed was how to successfully invest in what has become a prolonged low interest rate environment. The questions offered by the audience were excellent and represent exactly the type of questions that Bernanke and his team at the Federal Reserve would like us to be asking right now; They want to force people to make the decision to head northeast on the risk/reward chart, and potentially earn something, or stay right where they are and see real (purchasing power) value disappear slowly over time. In theory, none of us is going to sit idly by and let inflation rob the value right out from under our mattresses. Current policy is depending on that theory and is set to force the issue by “tightening the screws” on the saving class. This is accomplished by offering little to no return on low-risk investments.

Below is a recap of the popular questions and our answers to those questions:

Q: If a conservative investor came to you tomorrow morning with $100,000 in cash that he had just dug up in his back yard (actually cashed a very low interest CD) and handed you the $100,000 and said invest it.  Where would you go with it? Assume that this would be money not needed for retirement-just investment, with a better potential than CD revenue.

A: With the current treasury rates offering a lower return than expected inflation over the next 10 years, the market is demonstrating extreme risk aversion. It is Cascade’s view that this fear and pessimism is unjustified and we believe that the Spring pullback is presenting a buying opportunity. We are not ignorant of the global macroeconomic risks that exist, namely the Euro zone situation, the still fragile but strengthening recovery in US Housing, and the commodity swoon of the past year or so. We believe these risks will challenge upward movement in risk assets but that in the end, they will be overcome by a new wave of innovation and efficiency. 60% of the S&P 500 issues yield a dividend greater than the US 10-yr. Note. This is unwarranted fear. A conservative investor who has funds set aside for investment has to choose between two risks; a decrease in purchasing power as a result of inflation that is greater than the available CD rates (a likely scenario in our opinion) or a decrease in principal due to equity valuation declines. The respective rewards for the aforementioned risks are; none that we can find, the potential to participate in the prosperity of solid businesses with solid balance sheets and growing sales and profits specifically in the way of dividend income, but also in the way of capital appreciation. In other words, a conservative investor should reevaluate their time horizon and determine sum certain amounts that will be needed within the next 10 years and put that money in conservative (and low to no return) asset classes. For undesignated funds, with a greater than 10-year time horizon, the conservative investor needs to consider allocating to high-quality, US based equities that offer compelling value and growth momentum going forward.

Q: If given a choice in a defined benefit plan at time of retirement between an annuity (with no future increases for inflation) or a lump sum cash payout, how do you determine which to take?

A: Let’s assume that the fixed annuity payout is $12,000 annually ($1,000/month) for life. Let’s also assume a 30 year retirement (retire at 60 with a life expectancy of 90) and a constant 2.5% annual rate of inflation. Now let’s also assume that annual living expenses are $12,000 or equal to the annual annuity payout. This will be fine in year 1, but by year 2 the fixed annuity income will only cover 98% of expenses (due to inflation). By year 3 it will only cover 95% of expenses and so on. Looking 10 years out, the income will cover 80% expenses, 20 years out the income will cover 63% of expenses and by the 30th year, the annuity income will only cover 49% of expenses. The inflation risk in this scenario is too great. In fact, the only way to make the $12,000/year cover the necessary expenses for the entire 30 years is if the annual expenses are just over $8,500 (or 71.5% of income) and you can reinvest the extra money in the early years at the amount of inflation. Alternatively, taking the lump sum payout would hinge on the discount rate that is used to calculate the present value of the payments. To sum it up, this is not an easy question to deal with and it ultimately comes down to effectively managing inflation and investment risk.

Q: What investments do you think are the safest now and for the next 5 years?

A: This is an excellent question and it gets at a key concept that must be addressed when investing money; Time Horizon. If I have a future expense and I know the exact amount of it, then I must ensure that capital is liquid and available at that time. An example of this would be a down payment for a house in 2 years or a car purchase next year. Trying to buy Facebook stock today so you can double your house down payment by next year is foolish. Rather, you would purchase a 2-year treasury note which wouldn’t yield much right now, but would ensure that you had the money to accomplish that specific goal. On the flip side, if money is undesignated as of yet and will be used at some future point, then it is imperative to at least keep up with inflation. Indeed, if money is not needed for 20 years and it is kept in cash for the next 5 years, it is going to feel safe, but in reality a guaranteed loss is happening each time prices at the store go up. The analogy of slowly boiling a frog vs. dropping it into boiling water comes to mind. So to answer the question, more directly, if you have a sum-certain expense in 5 years, figure out a way to pull together the amount and don’t expect much more than 2-3% return on your principal. If you have longer-term and undesignated money and want to invest it wisely for the next 5-years, we are recommending a stronger allocation to high-quality and income producing (dividend) equities at this point based on the info above.

Q: What do you suggest for protection against high inflation?

A: The best way to answer this question is dig into some data. Every August, Thornburg Investment Management produces their research on what they call real real returns. They look at the past 30 years and calculate a nominal return on 10 key asset classes from commodities to Real Estate to Large-cap US stocks. They then adjust the nominal returns for taxes, inflation, and investment expenses to produce the real return. The most recent report (published in 2011) covers the 30-year period ending December 2010 and the results might surprise you. The highest real return over this period was 5.23% which was generated by Large-Cap US stocks. Looking at the various asset classes, we find commodities, often thought to be a hedge against inflation, actually had a negative real return to the tune of -3.01%. Corporate Bonds, Long-Term Government Bonds, and Municipal bonds produced real returns between 2 and 4 percent. When we bring this historical data together with our forward looking, macroeconomic research, we produce an allocation that includes pieces of Large-Cap US stocks, International Stocks, and bonds. As indicated in the answers to the questions above, we are overweight in high-quality Large-Cap US stocks right now and underweight in fixed income.

Patrick Rudy CFP,^® CPA, AIF^® is a Senior Investment Consultant with Cascade Investment Group, member FINRA & SIPC. Cascade Investment Group is not a tax or legal advisor. You should always consult with your tax advisor or attorney before taking any actions that may have tax consequences.