How to Structure an IRA or Retirement Account

by: The Patient Investor

Social Security and many retirement accounts not being fully funded, it is more important than ever to earn a high rate of return on your retirement accounts. Those of us in the baby boom generation and after will not receive the type of governmental funding that our parents received. My parents, as well as my wife's, paid in about $100,000 in Social Security and Medicare payments, and these funds earned about $95,000 in interest. The government paid out about $400,000 in benefits to them, and my dad is still alive at 86 and receiving benefits. The average age of our parents at passing is 81 and still counting. I was in an investment club of 12 members who were primarily of the WWII generation. Their average age at passing is over 84 and counting. Their combined payments made and benefits received are even worse than our parents from Social Security and Medicare.

Rule number one in investing your retirement money is: do not under any circumstances invest in any federal, state or local debt (with very few exceptions). I was a state examiner on the financial audit team for a state auditor's office, and, in my opinion, you are buying subprime debt (junk bonds) that is rated AAA to A. This is the subprime and Mortgage Collateralized Debt Obligations (CDOs) problem all over again. Moody's, Standard and Poor and the other debt raters either do not understand the debt rating situation of the Federal Government, states, and local governments, or they are relying on the full faith and credit of these governments. These governments are in horrible financial shape and will never repay many of the debts outstanding and/or provide the services promised unless they start doing something today, which, it appears, most are not willing to do (witness - the Bush tax cut extension). The coming baby boomer retirement plans, health care, and social security crisis, will make the subprime mortgage crisis look like a real picnic in the park. If you do decide to invest in government debt, the interest rates should be in excess of 8% to reflect the risk you are assuming for most of this debt.

You will find links supporting my assumptions above and in the CITIZEN’S GUIDE TO THE 2010 FINANCIAL REPORT OF THE UNITED STATES GOVERNMENT. The General Accounting Office (GAO) has not been able to EXPRESS A CLEAN AUDITOR'S OPINION for the past FOURTEEN YEARS! See page 27 of this year's report - the GAO auditor's opinion report. The GAO tries very hard and produces a very professional report, but other agencies don't take it seriously like they should. Fourteen years and no clean opinion! If any for-profit corporation or nonprofit corporation did not have a clean auditor's opinion for this period of time, they generally would not be considered credit worthy and would not be able to borrow any money. Lend money to the Federal Government at your own risk - caveat emptor (buyer beware).

Now that we have eliminated the federal government and other governmental entities from our retirement investments, we need to eliminate some other items as well. During the next 25 years you need to be as liquid as possible. You do not, under any circumstances, want to invest in anything that you cannot sell and get a reasonable amount of cash out of in three days or less. This is because of potential problems with almost all governments in the world. Most are in very bad financial condition, and this can affect your investments as it has at times for the last 9 months.

It is important to have an understanding of what will happen in the next six to eight years in the markets and the global and US economies. This is what I expect to happen:

  1. The stock market will increase in value similar to what it did in the 80's and 90's.
  2. However, this may be stopped by the governmental problems noted above. I expect these problems to come to a head sometime between 2019 and 2023, but it could be much sooner if the rating agencies start downgrading US and other major foreign debt. This could also be avoided if the President and Congress take action, but I don't think they will do anything until it is too late.
  3. The federal reserve will start raising interest rates in the summer to fall of 2012. It will take this long because of problems in the housing sector, which will linger until 2013 to 2015 in most parts of the country; In some places it could take much longer. Rates will rise either 2% or 3% at first and then higher.
  4. There will be high inflation except in housing and wages, which will be muted by the current crisis. This inflation will be similar to the 1970's and 1980's (caused by the baby boom generation), except the underlying reason will be emerging nations like China, India, Russia, Brazil, Eastern European and other nations. You cannot move 2/3s of the world's population into the modern world and expand demand by over 2.5 to 3 times without inflation. If the central banks fight inflation like they did in the late 1970's and early 1980's, then we will go into a depression (winter of the Kondratiev wave) caused by high interest rates and massive government debt. If they only raise interest rates moderately, we will survive until the baby boom crisis in the 2020's.
  5. Because of the possibilities of 2 and 4 coming to pass, you want to remain liquid. If you invest in real estate, do it in real estate investment trusts, not actual real estate.

Now down to actual investments. If you are 50 or under and do not have time to research and review your investments but want to invest the funds yourself, then you need to invest in no load mutual funds and/or ETFs (Exchange Traded Funds). After interest rates rise, you should also consider closed end mutual funds. The reason you want to wait on closed end funds is most have debt that will increase as interest rates rise. This will lower returns within the fund, which will decrease the price of the fund until the fund assets are reinvested at higher rates.

In setting up your no load mutual funds, closed end funds and/or ETFs, use different categories of funds or ETFs: a large cap, small cap, and micro cap fund for stocks. For no load bond mutal funds or bond ETFs, select a shorter maturity fund when interest rates may rise, like in the current economic situation. Also, as the economy improves and after interest rates rise, choosing a high yield fund may be appropriate if you have a higher risk tolerance. Depending on your specific situation and the overall economic situation, you could select some selector funds that invest in stocks in emerging markets, oil, gold, silver or other sectors. Using a screener, you can research the various mutual funds here, and closed end funds and ETFs here or on Seeking Alpha here.

You need to diversify by fund type and should make every effort to get into better rated funds. Most major financial websites have some mutual fund rating system such as Morningstar. If you are in a 401(k) and don't have access to the better no load mutual funds, change fund advisors, if at all possible. Talk to your employer - this is very important over the long run. If you are stuck, pick out the best options available to you and hope for the best. Try to invest on a monthly or quarterly basis, if possible. If you see items 2 or 4 above starting to happen, then go into cash or the safest short term investment available to you. I think item 2 will definitely happen; it is only a matter of when, not if.

For those 50 and over, I would use the old rule of thumb: deduct your age from 100 to determine what should be in stocks and adjust a little for size of portfolio, what is happening in the economy and market and for your risk tolerance. For instance, if you are 60 and have a tolerance for risk, maybe you want to be 50% in stocks or even 60% and 40% fixed income instead 40% stocks and 60% fixed income. Later in the cycle, if I am right, in 6 or 7 years you may want to switch to more fixed income and less stocks. At the present time, I would be in shorter maturity fixed income, because interest rates are most likely not going to rise, and the price of longer term bonds/fixed income assets are going to decline over the next few years. I would have a tendency to be in no load mutual bonds - fixed income funds of shorter maturity, four to six years. These type of funds give you maximum liquidity.

For those of you with the time and the desire to do your own investing, I will set up and give you a $100,000 dollar IRA investment portfolio, then explain why I would invest this way. The portfolio below needs to be actively managed and investments bought and sold on a daily basis, so I am not suggesting you actually invest in this portfolio. This is just to offer ideas on how to structure a portfolio with both interest and capital gain stocks. Note: This is a very high risk investment strategy at the present time.

Sample IRA Portfolio
Name of Stock & symbol number of shares Current Price Market value
Apple (NASDAQ:AAPL) 20 351.55 7031
Amtrust Financial (NASDAQ:AFSI) 300 18.44 5532
Ares Financial (NASDAQ:ARCC) 500 16.57 8285
Bowood Energy (OTC:ROAOF) 2000 .49 980
Connacher Oil (OTC:CLLZF) 1000 1.46 1460
Brigham (BEXP) 200 35.29 7058
Delphi Financial (NYSE:DFG) 200 30.09 6018
Delphi Fin Preferred (NYSE:DFP) 300 24.17 7251
Lexington Realty Trust Pref (LXP-D) 300 23.89 7167
Neuberger and Berman High Yield Fund (NYSEMKT:NHS) 500 14.38 7190
Flaherty Crumrine/Claymore Preferred Fund (NYSE:FFC) 500 17.16 8580
Pioneer High Income Tr (NYSE:PHT) 500 16.57 8285
Fifth Street Finance (NYSE:FSC) 500 13.34 6670
Novus Energy (OTC:NOVUF) 2000 1.28 2560
Pennantpark Invt Corp (NASDAQ:PNNT) 800 11.74 9392
SandRidge Energy (NYSE:SD) 500 12.14 6070
Total 99,529

This portfolio will generate $5,740 in income a year and should generate about $8,000 to $9,000 in capital gains during the next year.

I would expect it to pay out about $6,000 to $7,000 in income over the next ten years and have a portfolio value of around $200,000, if the market performs as I expect in item 1 above. I would not be holding many, if any, of these securities three years from now, but I would most likely be using a similar strategy.

If items 2 or 4 above happens, I would be in foreign stocks or bonds, contra ETFs and maybe metals - gold and silver depending on how everything unfolds. If interest rates are moderate and by some miracle Congress and the President get serious about balancing the budget and getting the current financial situation under control, then I would be more into regular stocks and less into interest bearing instruments. You can employ a similar strategy by selecting no load mutal funds, and closed end funds and ETFs as the stocks and funds listed above.

One of my clients asked me to invest his IRA funds once he retired. I used an investment strategy similar to what I have described above. He retired in January of 1999 with $330,000, and at the present time he has $560,000 in his account. He has withdrawn an average of about $38,000 a year over the last 12 years. I have a similar investment return on my retirement accounts.

A word about investment advisors: most have a tendency to invest in only one or two types of investment instruments like common stocks, bonds, mutual funds, closed end funds, ETFs or preferreds. I switch between all of these types of investments, depending on what I expect the market, economy and interest rates to do over the next year to two years. If you are using an advisor or broker, ask a lot of questions, meet with him or her regularly and don't be afraid to change advisors or brokers if you are not getting the results you think you should.

Disclosure: I am long AAPL, AFSI, ARCC, ROAOF.PK, CLLZF.PK, BEXP, DFG, DFP, LXP-D, NHS, FFC, PHT, FSC, NOVUF.PK, PNNT, and SD. I may buy or sell at any time some or all of these companies shares mentioned in this article based on world events or specific news about the company. Also remember that you should not fall in love with any stock and you need to diversify you portfolio. Not all stocks are appropriate for all individuals and you should consult your advisers and brokers for a second or third opinion before purchasing any stocks.