Record Retention: Keep critical documents and records safe and secure but accessible in a time of need

Certain documents and records are too important to retain in an ordinary file drawer. Fortunately, they are also the ones you tend to need least frequently. If they are stolen or destroyed by a catastrophe such as flood or fire, replacing them could be extraordinarily difficult, if not impossible. One of the best places to retain such items is a safety deposit box. These can be rented for a small monthly fee at many banks. The boxes are actually locked drawers within the bank's vault. Various sizes are often available to meet individual needs. A home safe is another option, provided that it is adequately rated to protect contents from fire, water, explosions (gas leaks), and other calamities. Documents deserving extra protection include:

• Property deeds
• Trust documents
• Insurance policies
• Automobile titles
• Stock and bond certificates
• Wills and estate plans
• Personal property inventory
• Marriage and birth certificates
• Military discharge papers
• Passports  

Keeping copies of vital records can save time, money, and headaches

There may be times when you need to know certain information contained on documents you've placed in safekeeping but don't need the actual document. Avoid the inconvenience of obtaining the original documents by making copies of them for your file.

  

Tip: Create one file that includes copies of all documents you've placed in safekeeping (e.g., a "Safety Deposit Box" file). Then, you not only can turn to it for vital facts, but if you are incapacitated, whoever handles your important affairs will be able to locate key documents quickly.

 Caution: The specific contents of some documents, such as wills and trusts, may be inappropriate to keep in more highly accessible home files. Instead of a photocopy, you might simply file a page containing those key facts that are less confidential in nature or obliterate very sensitive items on the copy.

  

Make backup copies of all computerized records

These days, many people keep important records on their personal computer. This can be an easy way to keep your records organized and updated, but it is important to keep a backup copy of these records in a safe place. If your hard drive has a meltdown, you'll need to be able to recreate the important financial information that was lost.

  

Financial management software can be beneficial in tracking your finances, but it will take some time to learn how to use it properly. Don't forget that you must still retain original documents as evidence of past transactions.

  

Save all essential records, receipts, and documents that your budgeting system requires

There are many reasons to save important records. If you apply for a loan (such as a mortgage, auto loan, or education loan), you will have to provide proof of your income. If you notice that money is disappearing out of your checking account, you'll need your bank statements to back up your claim of unauthorized transactions. If you own financial securities, capital gains taxes are based on the price you paid for them on the date purchased. You'll be required to verify this information. Potential tax audits will be far less intimidating if you have kept records to substantiate your tax return claims. An unsubstantiated claim will cost you not only the unpaid tax but interest charges and possibly, a hefty penalty.

  

Tip: Most of us realize it's important to keep expense records, but for those with income sources other than employers, a cash receipts log can be invaluable. A small notebook or a few sheets in a separate file folder will do for recording income as it arrives. If you don't recall later whether you received a particular dividend or rent payment, the log provides a quick answer.

  

Caution: Certain items, such as tips or business-related use of a car, require special tax treatment and records. Therefore, your record-keeping system must track these and retain any related documents.

  

Keep records as long as appropriate

Different records need to be saved for different periods of time. Divide your records into categories, such as short-term, medium-term, and long-term. There are no concrete rules about how long records must be saved, so you will often have to use your own judgment. The following guidelines may help:

  

Short-term (1-3 years)

• Household bills, except those that support tax deductions (items such as heat, water, and electricity are generally short-term unless you deduct them for home office use or a rental)
• Expired insurance policies   

Medium-term (6-7 years)

• Tax returns and supporting information
• Income and expense records (including lottery tickets and winnings)
• Bank and credit union statements
• Brokerage house statements
• Canceled checks and check registers (checks for major purchases may be kept longer)
• Paid-off loan documents
• Personal property sales receipts   

Long-term (indefinitely)

• Tax dispute records  
• Evidence of retirement plan contributions  
• Investment records  
• Medical history information  
• Pension/retirement plan documents
• Social Security information  

Other (as noted)

• Home ownership/sale documents: 7 years after sale or indefinitely  
• Home improvement records: 7 years after sale  

Caution: The IRS typically has three years after a return is filed to audit a return, or two years after you've paid the tax, whichever is later. However, if income was underreported by at least 25 percent, the IRS can look back six years after the return is filed, and there is no time limit for fraudulent tax returns. An audit requires that you provide documentation to substantiate the return being audited.

Tip: Canceled checks do not necessarily prove why a given payment was made, only that the payment was made. Having dated receipts, invoices, sales slips, credit card statements, and bank statements can provide valuable proof if needed, whether for an IRS auditor or an insurance claims adjuster.

Save space: Annually review retained records and discard those no longer needed

Some records and documents can be discarded after all potential usefulness has passed. Depending on circumstances, records can accumulate quickly and require extensive storage space. Discarding records that are no longer necessary saves space and makes finding a record you need easier.

Tip: Expired product warranties and insurance policies are excellent candidates for the trash can.

Tip: For easier future access, retain records for each year in separate files.

Caution: Keep your important records and financial files separate from information you might want to retain for other purposes. If you clip articles, jot notes, and save information you receive on items of potential interest, create a separate set of information files for them. These might contain vacation ideas, recipes, home improvement items, personal letters, or the kids' school papers. Keeping them apart from vital records and financial files makes both easier to find and manage.

The Patient Protection and Affordable Care Act (PPACA)

The Patient Protection and Affordable Care Act (PPACA), signed into law in 2010, makes significant changes to our health care delivery system. Some of these reforms took effect in 2010 while many others take place in 2011. The following is a brief description of some of the most important provisions of the health care reform legislation that take effect this year.


Individual and group health insurance plans are required to extend dependent coverage for adult children up to age 26. While this requirement was effective November 2010 for active employees, enrollment elections made during the 2011 open enrollment period will be effective on January 1, 2011.

The cost of over-the-counter drugs not prescribed by a doctor can no longer be reimbursed through a Health Reimbursement Account or a health Flexible Spending account, nor can these costs be reimbursed on a tax-free basis through a Health Savings Account or Archer Medical Savings Account. Also, the additional tax on distributions from health savings accounts or Archer MSAs that are not used for qualified medical expenses increases to 20%.

Medicare Part D participants will receive a 50% discount on brand-name prescriptions filled in the coverage gap (i.e., the donut hole) from pharmaceutical manufacturers, and federal subsidies for generic prescriptions filled in the coverage gap will start to be phased in.

Health plans that do not spend at least a minimum percentage of premiums (85% for plans in the large group market and 80% for plans in the individual or small group markets) on health care services must provide a rebate to consumers.

Certain preventive services covered by Medicare are no longer subject to cost-sharing (co-payments); the deductible is waived for Medicare-covered colorectal cancer screening tests; and Medicare now covers personalized prevention plans including a comprehensive health risk assessment.

High income ($85,000 for individuals, $170,000 for married filing jointly) enrollees in Medicare Part B and Part D coverage will likely see their premiums increase. The income thresholds used to determine Medicare Part B and Part D premiums for higher income individuals is frozen at 2010 income rates through 2019 and will not be adjusted for inflation. Also, the federal subsidy for high income Part D participants is reduced, resulting in increased premiums based on income levels that exceed the applicable threshold.

Medicare Advantage (MA) plans can no longer impose higher cost-sharing for some Medicare-covered benefits than would be imposed by traditional Medicare Parts A or B insurance. Also, Medicare Advantage plans cannot exceed a mandatory maximum out-of-pocket amount for Medicare Parts A and B services. The maximum amount in 2011 is $6,700, but MA plans can voluntarily offer lower out-of-pocket amounts. Also, the annual enrollment period for MA plans is changed to October 15 to December 7 each year beginning in 2011 for plan year 2012.

Community Living Assistance Services and Supports Program (CLASS) is to be established to provide national long-term care insurance funded by voluntary participant premiums that can be paid through payroll deductions.

The disclosure of the nutritional content of standard menu items offered through chain restaurants and vending machines is required.

The requirement that employers report the total value of employer-sponsored health benefits on employees' W-2s was to begin in 2011. However, the IRS has deferred this requirement for 2011 so employers will not be subject to penalties for failure to meet this requirement.

These changes may impact your health insurance benefits and costs. To learn more about health care reforms occurring in 2011, consult with your financial professional.

The Year in Review

The Year in Review


Themes in 2010

In retrospect, it was a good year for globally diversified investors. But if investors had shaped their market expectations and decisions according to economic news, they likely would not have expected positive returns. The following are a few dominant themes during the year.

Mixed Economic Signals

Although investors in the US and Europe awaited signs of a rebound, economic news was mixed, with some measures showing gradual improvement and others offering evidence that the economy remains vulnerable. Favorable news included moderate economic expansion in the US, Euro zone, and Australia, as well as rising factory orders and manufacturing activity, rebounding auto sales and automaker profits, slowing growth in US bankruptcies, declining home foreclosures, and an improving financial services sector. In late Q3, US corporate cash levels reached $1.9 trillion, which, as a percentage of total corporate assets, is the highest since 1959. In late Q4, initial claims for unemployment fell to the lowest level in two years.

Negative news included continuing high jobless rates in the US and other developed markets. US unemployment began the year at 9.7%, dipped to 9.5% in July, but climbed to 9.8% in November. Personal bankruptcies in the US increased 9%, reaching their highest level since 2005. Also, bank failures in 2010 were the worst since 1992, during the savings and loan crisis.

Housing and Real Estate

The global property decline that helped trigger the 2008 financial crisis began to ease in 2010. Home prices improved in the UK but remained weak in the US, with monthly sales of new homes falling at one point to the lowest level since tracking was initiated in 1963. Foreclosures increased dramatically in the first half of 2010 before improving in Q4. However, 2010 proved to be another successful year for REITs, despite recurring predictions of a brewing commercial real estate collapse that would trigger a financial crisis.

Quantitative Easing and Fiscal Stimulus

Governments and central banks took additional actions to stimulate economies and shore up financial markets. The most direct support came as central banks supported government bond markets in the US and Europe. The Federal Reserve's November announcement of a second round of quantitative easing (known as "QE2") sparked concern that additional monetary stimulus would stoke inflation and debase the dollar. According to some, the actions helped lift stocks and corporate bond markets. In December, the extension of the Bush-era tax cuts and a 2% reduction in Social Security payroll taxes in 2011 improved economic expectations.

Sovereign Debt Worries

During the year, the weakening finances of some European states, including Portugal, Ireland, Italy, Greece, Spain, and Belgium, raised concern that the financial crisis had moved from private-sector banks to public-sector balance sheets. These concerns led to the downgrading of certain government debt and widening of bond yield spreads. The Euro zone countries and International Monetary Fund responded with loans that were conditional on some sovereign borrowers taking drastic austerity measures.

Inflation vs. Deflation

Despite moderate inflation in most economies during 2010, economists warned that continued government budget deficits and monetary expansion would drive up prices. Conversely, the US central bank was concerned that inflation was so low that the economy might slip into a deflationary cycle. In fact, potential deflation was one of the main reasons the Fed implemented QE2 and pumped $600 billion into the banking system. By year end, the Fed indicated that the deflation threat was easing.

Higher Commodity Prices

Commodities climbed during 2010, with many sectors reaching price levels not seen in decades. Copper prices, which are considered a bellwether of economic activity, rose 33%, and oil gained 15% to finish 2010 over $91 a barrel. Agricultural commodities, a traditionally volatile sector, saw even more extreme price swings. Concern about a weakening dollar drove up precious metals, with gold exceeding $1,400 per ounce and silver up 81% for the year.

Investor Confidence

In the wake of the financial crisis, investors who have become more risk averse or accepted the tenets of a "new normal" in the economy and markets chose to remain in fixed income assets. Bond funds in the US received a massive net inflow of money in the past two years, suggesting that many investors who fled stocks may have missed out on much of the rebound in equities. Throughout most of 2010, investment flows were leaving the US stock market and moving to emerging markets. In December, flows turned sharply positive in the US, with an estimated $22 billion directed to US stock funds.

2010 Investment Overview

After a slow start and a tough second quarter, most markets in the world ended the year with positive results. The US market indices accounted for most of the top performance, with the Russell 2000 Growth Index delivering a 29.09% return for the year. US small cap and small value also were among the top performers. (All returns are in US dollars.)

Most developed markets around the world logged positive returns, with thirty-seven of the forty-five countries that MSCI tracks gaining ground in both local currency and US dollar terms. Scandinavia and Asia had particularly high returns. Overall, the MSCI World ex USA index gained 9%, and the MSCI Emerging Markets Index gained 19% for the year.

In the last few months of the year, the highest returns were generally experienced by countries whose economies are dominated by oil and commodity exports—for example, Canada, Norway, Russia, and South Africa. Other emerging markets, such as Thailand, Philippines, Chile, and Peru had strong returns. China, despite its continued high profile and news of economic growth, was one of the lowest-performing emerging markets.

The US dollar lost ground against the Canadian dollar and most Pacific Rim currencies, which helped dollar-denominated equity returns from those countries. The US dollar gained against the euro and British pound.

Along the market capitalization dimension, small caps outperformed large caps by substantial margins in the US, developed, and emerging markets. Value stocks underperformed growth stocks across all market capitalization segments in the US and had more mixed results in international developed and emerging markets.

Fixed income performed generally well, especially for investors who took term and credit risk, with long-term, high-yield bonds returning more than 20%. Real estate securities had excellent returns, performing comparably to the equity asset classes.

Health-Care Reform: Considerations for Seniors

The enactment of the new health-care reform legislation contains some provisions that directly affect our nation's older population. If you're a senior, you may be concerned about how these reforms may affect your access to health care and the benefits you are currently receiving.


Medicare spending cuts

Not surprisingly, the concerns of retirees and seniors generally center on potential cuts in Medicare benefits. At the outset, the new legislation does not affect Medicare's guaranteed benefits. However, a goal of the new health-care legislation is to slow the increasing cost of Medicare premiums paid by beneficiaries, and to ensure that Medicare will not run out of funds. To help achieve these goals, cuts in Medicare spending will occur over a ten-year period, beginning in 2011, particularly targeting Medicare Advantage programs––Medicare programs provided through private insurers but subsidized by the federal government. These cuts could reduce or eliminate some of the extra benefits Medicare Advantage plans may offer, such as dental or vision care, and some insurers may choose to increase premiums. But Medicare Advantage plans cannot reduce primary Medicare benefits, nor can they impose deductibles and co-payments that are greater than what is allowed under the traditional Medicare program for comparable benefits. And, some of the federal funds previously earmarked for Medicare will be reallocated to doctors and surgeons as an incentive to treat Medicare patients.

Medicare Part D drug program changes

Some Medicare Part D beneficiaries are surprised to find that they have to pay for the entire cost of prescription drugs out-of-pocket after reaching a gap in their annual coverage, referred to as the "donut hole." Currently, if you're a Medicare Part D beneficiary, you may pay up to an additional $3,610, out-of-pocket, for medicines after reaching an initial threshold of $2,830 in total prescription drug costs (including Part D payments, beneficiary co-pays, and deductibles). But, beginning in 2010, beneficiaries who fall in the donut hole will receive a $250 rebate, and, in 2011, they will receive a 50% discount on brand-name drugs. By 2020, a combination of federal subsidies and a reduction in co-payments will completely eliminate the donut hole. However, individuals with annual incomes greater than $85,000, and couples with incomes exceeding $170,000, will see their Part D premiums increase as the federal subsidy offsetting some of the cost of Medicare Part D premiums is reduced.

Benefits added to Medicare

The leglislation also improves some traditional Medicare benefits. For example, Medicare beneficiaries will receive free wellness and preventive care beginning in 2011.

Increased access to home-based care

Often, people with disabilities or illnesses would rather receive care at home instead of at a hospital or nursing home. The new health-care reform law provides for programs and incentives for greater access to in-home care. The Community Living Assistance Services and Support program (CLASS) will be established sometime after 2011 (depending on when final regulations are published) as a voluntary insurance program, financed through payroll deductions and available to all working adults who choose to participate. This national program allows participants with functional limitations to maintain their personal and financial independence and live in the community by providing a cash benefit of at least $50 per day (after a five-year vesting period) for nonmedical services, such as home-care services, family caregiver support, and adult day-care or residential-care services. In order to qualify, a participant must need help with at least two activities of daily living, such as eating, toileting, transferring, bathing, dressing, or continence.

Also in 2011, the Community First Choice Option will be available to states to add to their Medicaid programs. This option will provide benefits to Medicaid-eligible individuals for community-based care instead of placement in a nursing home. In addition, the State Balancing Incentive Program, to be established in 2011, will provide increased federal funds to qualifying states that offer Medicaid benefits to disabled individuals seeking long-term care services at home, or in the community, instead of in a nursing home. The Independence at Home demonstration program, available in 2012, will be a test program that provides Medicare beneficiaries with chronic conditions the opportunity to receive primary care services at home. That is intended to reduce costs associated with emergency room visits and hospital readmissions, and generally improve the efficiency of care.

Rebalancing Act

Global diversification gives investors a valuable tool for managing risk and volatility in a portfolio. But smart diversification has an important side effect. It requires maintenance.


In a given period, asset classes experience divergent performance. This is inevitable and, in fact, desirable. A portfolio that holds assets that do not perform similarly (i.e., with low return correlation) will experience less overall volatility. That results in a smoother ride over time. However, dissimilar performance also changes the integrity of your asset mix, or allocation—a condition known as “asset drift.” As some assets appreciate in value and others lose value, your portfolio’s allocation changes, which affects its risk and return qualities. If you let the allocation drift far enough away from your original target, you end up with a different portfolio.

Once you form a portfolio to match your current investment goals and risk tolerance, you should preserve its structural integrity since asset allocation accounts for most of a portfolio’s return.1 This is a strategic priority, like portfolio design or investment manager selection. To efficiently pursue investment goals, you must manage asset drift.

Rebalancing is the remedy. To rebalance, you sell assets that have risen in value and buy more assets that have dropped in value. The purpose of rebalancing is to move a portfolio back to its original target allocation. This restores strategic structure in the portfolio and puts you back on track to pursue long-term goals.

Why rebalance?

At first glance, rebalancing seems counter-productive. Why sell a portion of outperforming asset groups and acquire a larger share of underperforming ones? Intuition might suggest that selling previous winners may hinder returns in the future. This logic is flawed, however, since past performance may not continue in the future—and there’s no reliable way to predict future returns.

Equally important, remember that you chose your original asset allocation to reflect your risk and return preferences. Rebalancing realigns your portfolio to these priorities by using structure, not recent performance, to drive investment decisions. Periodic rebalancing also encourages dispassionate decision making—an essential quality during times of market volatility. Moreover, if and when your overall financial goals or risk tolerance change, you have a foundation for making adjustments. In the absence of a plan, adjustments are a matter of guesswork.

Challenges and decision factors

In the real world, portfolio allocations are usually complex, incorporating not only fixed income and equity, but also the multiple asset groups within equity investing. The more complex a portfolio’s allocation, the greater is the need for maintenance.

Determining when and how to effectively rebalance requires careful monitoring of performance and awareness of your tax status, cash flow, financial goals, and risk tolerance. Rebalancing also incurs transaction fees and potential capital gains in taxable accounts. Thus, while there are good reasons to rebalance, the benefits must outweigh the costs.

Given these challenges, a practical rebalancing approach will establish asset drift triggering points while leaving enough flexibility to manage costs effectively.

Defining triggering points helps investors decide when to rebalance. Most experts recommend rebalancing when asset group weightings move outside a specified range of their target allocations. This may be widely defined according to stock-bond mix, or more appropriately, according to a percentage drift away from target weightings for categories like small cap stocks, international stocks, and the like.

While rebalancing costs are unavoidable, several strategies can help minimize the impact:

• Rebalance with new cash. Rather than selling over-weighted assets that have appreciated, use new cash to buy more under-weighted assets. This reduces transaction costs and the tax consequences of selling assets.

• Whenever possible, rebalance in the tax-deferred or tax-exempt accounts where capital gains are not realized.

• Incorporate tax management within taxable accounts, such as cost basis management, strategic loss harvesting, dividend management, gain/loss matching, and similar considerations.

• Implement an integrated portfolio strategy. Rather than maintaining rigid barriers between component asset classes and accounts, manage the portfolio as a whole.

Rebalancing incurs real costs that can detract from returns. We can help investors define ranges within which investment components can acceptably drift, and adopt cost-saving strategies during rebalancing, paying particular attention to tax-sensitive transactions. In helping our clients rebalance, we strive to develop a structured plan that remains flexible to each individual’s unique blend of goals, risk tolerances, cash flow, and tax status.

No one knows where the capital markets will go—and that’s the point. In an uncertain world, investors should have a well-defined, globally diversified strategy and manage their portfolio to implement it over time. Rebalancing is a crucial tool in this effort.

Endnotes

1 Gilbert L. Beebower , Gary P. Brinson, and L. Randolph Hood, “Determinants of Portfolio Performance ,” Financial Analysts Journal 42, no. 4 (July/August 1986): 15-29. Gilbert L. Beebower, Gary P. Brinson, and Brian D. Singer, “Determinants of Portfolio Performance II: An Update,” Financial Analysts Journal 47, no. 3 (May/June 1991): 40.

The information presented above was prepared by Dimensional Fund Advisors, a non-affiliated third party.

Disclosures

Although investors may form their expectations from the past, there is no assurance that future investment results will model historical performance.

Indexes are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio. Past performance is not a guarantee of future results.

Stocks offer a higher potential return as compensation for bearing higher risk. However, this premium is not a certainty, and investors should not expect to consistently receive higher returns from stocks. In fact, market history shows extended periods when stocks did not outperform bonds.

Diversification neither assures a profit nor guarantees against loss in a declining market.

A bond portfolio designed for income also carries significant risks, including default and term risk, call risk, and purchasing power (inflation) risk. Foreign securities also are exposed to currency movements.

Worth Noting

Special rules apply to charitable donations for Haiti relief efforts


If you make a qualified charitable contribution after January 11, 2010, and before March 1, 2010, for relief efforts associated with the January 12, 2010, earthquake in Haiti, you can treat the contribution as if it were made on December 31, 2009. As a result, if you itemize deductions on Form 1040, Schedule A, you can elect to claim the deduction for the Haitian relief contribution on your 2009 federal income tax return. To qualify, the contribution must be made in cash. To facilitate charitable donations made via text messages, a telephone bill showing the name of the organization, and the date and amount of the contribution, will satisfy charitable deduction recordkeeping requirements.

Time running out for first-time homebuyer's tax credit

If you're in the market for a new home and hope to take advantage of the first-time homebuyer tax credit, you'll need to purchase a principal residence before May 1, 2010 (or before July 1, 2010 if you enter into a written binding contract prior to May 1, 2010). If you--and your spouse, if you're married--did not own any other principal residence during the three-year period ending on the date of purchase, the credit is worth up to $8,000 ($4,000 if you're married and file separate returns). If you--and your spouse, if you're married--have maintained the same principal residence for at least five consecutive years in the eight-year period ending at the time you purchase a new principal residence, the credit is worth up to $6,500 ($3,250 if you're married and file separate returns).

The credit is reduced if your modified adjusted gross income (MAGI) exceeds $125,000 ($225,000 if married filing a joint return) and is completely eliminated if your MAGI reaches $145,000 ($245,000 if married filing a joint return). You can't claim the first-time homebuyer tax credit if the purchase price of your principal residence exceeds $800,000. Other limitations and provisions also apply.

President's proposed 2011 budget offers Congress multiple initiatives

The proposed 2011 budget submitted by President Obama offers multiple new initiatives, including several small business tax incentives, provisions intended to promote college affordability, and tax benefits targeting the middle class. The budget that ultimately emerges from Congress will likely differ significantly from that proposed by the President, but the proposed budget is valuable in that it provides a framework for discussion over the next few months. The proposed budget includes:

For businesses-- A new tax credit of $5,000 for each new hire made by an employer, a one-year extension of 2009 bonus depreciation and Section 179 expensing limits, and requirements for employers who do not offer retirement plans to implement automatic IRAs for employees

For students-- Expanded Pell Grant limits, a permanent American Opportunity tax credit, and a proposal to strengthen income-based repayment plans for student loans (overburdened borrowers would pay only 10% of discretionary income in loan payments and remaining debt would be forgiven after 20 years)

For individual taxpayers-- A return of the top two marginal tax rates to 39.6% and 36% in 2011, and an expanded 28% tax bracket; a permanent extension of the current 0% and 15% rates on long-term capital gain, with a new 20% rate for higher-income individuals; permanent extension of the federal estate tax and the alternative minimum tax (AMT) rules and exemption amounts, at 2009 levels

New credit card provisions effective this week

The Credit Card Accountability Responsibility and Disclosure (CARD) Act of 2009 included several provisions that became effective on February 22, 2010. Some of these changes could affect you:

Credit card companies are prohibited from increasing annual percentage rates (APRs) that apply to existing balances unless (1) the index on which the rate is based changes, (2) the APR was a promotional rate that has expired, (3) you failed to comply with a hardship workout plan, or (4) you're more than 60 days past due on the account; if an increase in APR is the result of you falling 60 days past due on the account, the rate will be restored to what it was before the increase if you make timely minimum payments for six months

If different APRs apply to separate portions of an outstanding balance, the amount of any payment beyond the minimum payment due must be applied to the portion of the balance with the highest APR

If you're under age 21, you won't be able to get credit unless you have a cosigner over age 21 or can demonstrate an ability to repay the debt

You can't be charged an over-the-limit fee unless you authorize the credit card company to complete the transaction that causes the balance to exceed your credit limit

Managing Inflation Risk

As the capital markets have improved, more investors have shifted their concern from weathering the financial crisis to anticipating the inflationary effects of rising federal spending and debt. Many people are asking how they can prepare for potentially higher inflation. This article explores two basic ways to address inflation uncertainty and highlights asset groups that may prove useful.

As you consider strategies, remember the difference between expected and unexpected inflation. Asset prices already reflect the market’s expectations about future inflation, given all available information. Inflation may turn out to be worse than expected, and this risk of unexpected inflation is what some investors may want to manage.

Hedging vs. Total Return Strategies

Investors can prepare for unexpected inflation by following one of two basic strategies—hedging the immediate effects of inflation or earning a total return that outpaces inflation over time.

Hedging involves choosing assets whose value tends to rise with inflation. Although holding these assets may reduce the total return of a portfolio, the positive correlation with inflation can help an investor keep up with rising consumer prices, at least over the short term. (Correlation refers to the co-movement of asset returns. When two assets are positively correlated, their returns tend to move together; when negatively correlated, their returns are dissimilar.)

Candidates for hedging include retirees, fixed income investors, and others who would experience a diminished living standard during an inflationary period. These investors are willing to forfeit long-term growth potential for more immediate inflation protection.

In a total return strategy, an investor attempts to outpace inflation by holding assets that are expected to earn higher real (inflation-adjusted) returns. This investor is willing to give up short-term inflation protection for an opportunity to grow real wealth. Younger investors are typically well suited for this strategy because they have many years until retirement and expect their earnings to advance faster than the inflation rate. As they save and invest for the future, they can accept more risk through greater exposure to higher-return assets, such as stocks.

To insulate a portfolio from unexpected inflation risk, both strategies may employ some combination of stocks, short-term fixed income, and Treasury Inflation-Protected Securities (TIPS). Let’s consider each of these:

Stocks

Equity securities have provided a positive inflation-adjusted return over the long term. From 1926 through 2008, the total US stock market, as measured by the CRSP 1-10 Index, outpaced inflation by an average of 6.16% per year.1 To achieve this higher expected real return in stocks, however, an investor had to accept more risk, as measured by greater volatility in returns, and endure periods when stocks did not outpace inflation. As a result, stocks may be less effective for hedging short-term inflation and more suitable for investors who want to beat long-term inflation by earning a higher total return.

Some investors assume that high inflation leads to lower stock market performance, while low inflation fuels higher stock returns. In reality, inflation is just one of many factors driving stock performance. US market history since 1926 shows that nominal annual stock returns are unrelated to inflation.

Fixed Income (Bonds)

Higher inflation can hurt bondholders in two ways—through falling bond market values triggered by rising interest rates, and through erosion in the real value of interest payments and principal at maturity. This inflation exposure tends to impact the prices of long-term bonds more than those of short-term bonds, and investors can mitigate the effects of rising interest rates by holding shorter-term instruments.

Many types of investors may benefit from holding short-term bonds. When interest rates are climbing, a portfolio with shorter-term maturities enables an investor to more frequently roll over principal at a higher interest rate. This can help inflation-sensitive investors keep up with short-term inflation and enable total return investors to reduce portfolio volatility, which can lead to higher compounded returns and growth of real wealth.

Treasury Inflation-Protected Securities (TIPS)

Issued by the US government, TIPS are fixed income securities whose principal is adjusted to reflect changes in the Consumer Price Index (CPI). When the CPI rises, the principal increases, which results in higher interest payments. At maturity, an investor receives the greater of the inflation-adjusted or original principal. The inflation provision enables TIPS to preserve real purchasing power and hedge against unexpected inflation.

TIPS are generally a good short-term inflation hedge since principal is adjusted for changes in the CPI. They are also a good portfolio diversifier for some long-term investors due to their negative correlation with equities and relatively low correlation with most types of fixed income assets. TIPS were introduced in 1997, so these correlations are based on a relatively short sample period.

However, keep in mind that TIPS prices also have been affected by changes in real interest rates, so TIPS may not track inflation one-to-one in the short term or over longer periods of time. In fact, TIPS can lose market value if real interest rates increase.

Commodities

Commodity futures, as well as gold and oil, are perceived as effective inflation hedges because their returns are positively correlated with inflation. But commodities are more volatile than stocks, and their returns do not always rise with inflation because of this significant volatility. So adding these assets to a portfolio may increase real return volatility, which could offset the benefits of hedging.

Investors should also consider the economic argument against holding commodities. Unlike stocks, commodity futures do not generate earnings or create business value. They are essentially a speculative bet in which there is a winner and loser at the end of each trade. Moreover, a broad-based stock portfolio already has significant commodity exposure through ownership of companies involved in energy, mining, agriculture, natural resources, and refined products.

Summary

While the media have featured divergent opinions and theories about the effects of recent government actions on inflation, no one really knows how consumer prices will respond to the complex forces at work in the economy and markets. Investors should carefully review their financial circumstances and investment goals before making changes to their portfolio.

As you assess your exposure to a high-inflation scenario and form a strategy that reflects your financial goals and risk tolerance, consider that:

• Expected inflation is built into asset prices. In our view, markets efficiently integrate all known information into prices. Thus, current prices already reflect expectations of future inflation. Only unexpected news will affect the inflation outlook.

• Hedging unexpected inflation has a cost. Investments traditionally regarded as effective short-term inflation hedges have lower historical returns than stocks—and some have much higher volatility.

• Volatility matters. Evaluating assets solely on their ability to track inflation disregards the effect of volatility on returns and risk. Some assets that are positively correlated with inflation have large return variances, and adding these to a stock and bond portfolio may increase overall volatility.

Even with the prospect for higher inflation, investors who take a total return approach may be better served than those who choose assets based on correlation with the CPI. By choosing assets with higher expected long-term returns and maintaining broad diversification, investors can seek to grow real wealth and preserve the purchasing power of their dollars.

Endnotes

1 Real return calculation: (1+CRSP 1-10 Index return)/(1 + US CPI)-1. The CRSP 1-10 Index is a market capitalization weighted index of all stocks listed on the NYSE, Amex, NASDAQ, and NYSE Arca stock exchanges. CRSP data provided by the Center for Research in Security Prices, University of Chicago.

The information presented above was prepared by Dimensional Fund Advisors, a non-affiliated third party.

Disclosures

Inflation is typically defined as the change in the non-seasonally adjusted, all-items Consumer Price Index (CPI) for all urban consumers. CPI data are available from the US Bureau of Labor Statistics.

Stock is the capital raised by a corporation through the issue of shares entitling holders to an ownership interest of the corporation. Treasury securities are negotiable debt issued by the United States Department of the Treasury. They are backed by the government’s full faith and credit and are exempt from state and local taxes.

CRSP is a non-profit center that also functions as a vendor of historical data. CRSP end-of-day historical data covers roughly 26,500 stocks, both active and inactive. OTC bulletin board stocks are not included.

The indices are not available for direct investment; therefore, their performance does not reflect the expenses associated with the management of an actual portfolio. Past performance is no guarantee of future results, and there is always the risk that an investor may lose money.

Diversification neither assures a profit nor guarantees against loss in a declining market.