Our economic forecast for 2013 comes down to one simple phrase: "It all hinges on Washington." The President and Congress must decide whether tax rates rise or fall, whether fiscal stimulus or austerity rules the day, and whether the long term budget deficit issues (entitlements) will be addressed. The Federal Reserve has now promised to hold short term rates low until the unemployment rate falls to 6.5 percent, unless they determine inflation is likely to exceed 2.5 percent. Will the Fed's newest $85 billion monthly quantitative easing (bond buying) program continue to suppress longer maturity bond yields in 2013? To paraphrase the European Central Bank's Mario Draghi: "believe us, it'll be enough" to keep the U.S. Treasury 10 year bond yield from rising much in 2013.
We continue to view the Washington glass as "half full," so we expect fiscal cliff compromises will be reached by early 2013. Taxes will be raised on the "rich" (however that is defined) but the impact of tax increases on everyone else will be limited by extending the middle class tax cuts, "patching" the Alternative Minimum Tax, and gradually ending the FICA 2 percent payroll tax holiday. Alas, anyone who has a taxable investment account will pay more taxes through higher capital gains rates and higher tax rates on common stock dividends. Entitlement reform will likely be kicked down the road, but we expect the credit rating agencies will be assuaged by an agreement to create a Congressional commission, lessening the risk of a January ratings downgrade. Likewise, there should be just enough spending cuts to allow a compromise on raising the debt ceiling.
The downside risk from here hinges on Washington: policy errors that take us over the cliff might leave the economy crushed at the bottom of the gorge by another severe recession.
Sounds horrifying, doesn’t it? Well, it is — but we think this worst-case scenario is VERY unlikely. Even if taxes are raised, the increase shouldn't be too stiff and history shows that the impact on spending will be minor. Modestly higher capital gains rates also have a limited impact. Changes to corporate taxes and deductions will be a mix of plusses and minuses, as always. The regulatory burden only goes in one direction — heavier, but who could be surprised by that? Despite volatile gasoline prices, the CPI inflation rate has dropped to roughly 2 percent and that trend should continue in 2013. Energy prices should not rise significantly as increased supply meets very slow demand growth. With regard to consumers, housing activity and prices are on the upswing. In fact, residential construction has been additive to GDP for the past six consecutive quarters! Combined with the doubling of the S&P 500 since 2009 and decline in consumer debt outstanding, household net worth has improved sharply. Continued modest, but steady job growth should result in lower unemployment rates during 2013.
Basically, the economy can do one of three things: improve, stay the same, or get worse. The presence of feedback loops often determines which of these occurs. We began 2012 with a positive feedback loop — rising production of goods and services meant more hours worked, which meant incomes grew, which resulted in greater demand for goods and services, leading to rising production of goods and services! Unfortunately, fears arose during the year that caused great uncertainty for both businesses and consumers. Uncertainty weakens the links of a positive feedback loop and can eventually forge a negative chain. Fortunately, much of the current uncertainty should be alleviated by even a partial resolution of the fiscal cliff/budget deficit issues.
All in all, we expect a slow start to 2013 due to the hangover from Washington's partisan battles and going over the fiscal cliff (fiscal slope?) to some extent. However, as uncertainties are alleviated, we expect GDP growth to re-accelerate toward 2.5 percent+ in the second half.
Bob Leggett, CFA, is the Senior Investment Strategist at FirstMerit Wealth Management Services. Reach him at email@example.com or follow him on Twitter @firstmerit_mkt.
The opinions and information contained in this message have been derived from sources believed to be accurate and reliable, but FirstMerit Bank N.A. makes no representation as to their timeliness or completeness. This message does not constitute individual investment, legal or tax advice. All opinions are reflective of judgments made on the original date of publication and do not constitute a guarantee of present or future financial market conditions.
Here we are in December approaching the end of another year. My parents were correct when they told me that time goes by faster the older we get. It’s funny how time just slips by, and I often struggle with the passage of time. However, as I get my hands around the concept of time, it is not time I want to control; it’s controlling how I spend my time that’s most important. We start the New Year with a list of resolutions hoping that 2013 will bring a different outcome, streamline our goals and aspirations, and free up our time. Ironically, we believe that by making resolutions, these changes will automatically occur.
How does one affect some meaningful changes in the New Year? To get prepared, make a list and identify items in these general categories:
- What do you want to stop doing?
- What do you want to start doing?
- What do you want to continue doing?
Leave yourself room in each category, and then narrow down the choices to a few that you can successfully manage. Now that you have these entries on the lists in front of you, ask yourself what would you do with your time if you only had seven years left to live? What items are important? What items are imperative?
As you look at those items on your lists and you contemplate these questions thoroughly, do you feel your items on the lists coincide with the central core of your life’s purpose for the next seven years? Will the items on your lists achieve your purpose or are you just creating more items for your “to-do” list?
This illustration merely touches the surface of the inner work each one of you needs to pursue to make financial and life planning a thoroughly meaningful experience. Most people have only experienced the transactional dimension and walk away with no long-term meaningful solution. The transaction may have been only a temporary Band-Aid to the problem. The root of the problem needs to be addressed to complement your inner emotions, attitudes, values and purpose beneath that surface transaction. When those underlying emotions and purposes are identified and vocalized, the purpose then clarifies the choices.
In my definition of the world of personal financial and life planning, the transaction side of the equation overshadows the client-adviser conversation. The transaction driven-process is akin to where the adviser draws his convenient “arrow” from his quiver to solve your current problem. In today’s vernacular “I have an app for that.”
The purpose-side and value-side of the conversation is rarely entertained. The purpose-side involves the qualitative components of your wealth management journey. Wealth management and life planning is much more than just dollars and cents. Typically, people expect dollars and cents to dominate conversations they have with a wealth adviser, but when it comes to life planning, topics of discussion extend to matters far more personal than money, addressing your deepest life dreams and goals — and how to make them a reality through sound financial planning.
When developing a life plan with your RAV adviser, there are a few key factors that must come into alignment: mutual trust, understanding and working with a wealth adviser who has the integrity to tell you whether your current reality can support your future dreams. But you, as a client, also bear a large responsibility in the life-planning process — particularly if you long for a future that looks very different from your current reality. Investing time and energy in the discovery of your purpose and intention will make the journey more relevant and more powerful.
Vision and purpose go hand-in-hand. Vision is the definition of your tangible and intangible goals. Purpose drives your outcome, interrelated within your goals and objectives. So where do you want to be in 2020? Decide today to embark upon an experience where your purpose and vision are at the heart of your life-planning journey.
It is interesting in this age of technology that we want and can have immediate access to all types of information. Access to your innermost purpose takes a little longer to uncover, and it is essential to the personal and business financial and life-planning experience. Only then will you feel fulfilled in the outcomes of your decisions and choices.
So make a decision that by January 2020, your personal and family vision will be clearly 20/20. Hopefully, this will give you a time frame to unearth your inner destiny, so that a strategic financial and life plan will incorporate your unique values into its outcome.
You don’t have to wait to find a financial and life-planning firm. For more than 30 years, RAV Financial Services has been working in partnership with those individuals and families who understand that the road from success to significance is achieved by interweaving purpose, values, and intention into their financial and life-planning experience.
Wishing you a happy holiday and a healthy and prosperous New Year.
Robert A. Valente, CFP®, AEP®, is CEO and Managing Member of RAV Financial Services LLC. He can be reached at (216) 831-4900 or firstname.lastname@example.org.
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Credit insurance, which has been around for many years, is a custom financial tool that protects a business from losses due to insolvency or past due/slow pay from their customers.
This problem of insolvency or past due/slow pay from customers isn’t expected to stop any time soon, either. U.S. corporate default rates are expected to rise this year, as marginal companies that already refinanced debt in the last few years stumble because they didn’t reduce debt and just pushed out payment schedules, according to a USA Today article.
“This insurance product can be a cost-effective device for transferring risk — premiums are tax deductible while reductions in bad debt reserves are not,” says Shelley C. White, assistant vice president with SeibertKeck.
Smart Business spoke with White about why the value of this insurance is consistently being demonstrated during economic financial crisis time and time again.
How does credit insurance coverage work most effectively?
If your company does business in which it extends a line of credit for merchandise orders or other accounts payable, then this insurance protects you against losses because when you extend credit to a business, your own financial solvency gets tied in with that account. Coverage can apply to a single debtor or a greater spread of risk by including all of your unquestioned buyers in excess of a certain dollar amount. Annual sales of at least $1 million can make the program more cost effective.
Why should employers look into buying this type of coverage?
Business owners must be more attentive regarding the management of their accounts receivable in the face of this global economic climate. There are more business failures both domestically and internationally. This was borne out by increased worldwide demand for credit insurance across all geographies in the first quarter of 2012, according to the Global Insurance Market Quarterly Briefing. The United States saw a modest increase in demand of less than 10 percent, with the largest demand increase in Asia.
Credit insurance provides catastrophic loss protection that can be used by businesses of all sizes and by all business sectors. There are many benefits as to why a business owner will purchase this coverage. Some include:
- Increasing credit to your existing customer base and extending credit to new customers.
- Improving cash flow.
- Enhancing bank financing by increasing borrowing capacity. Banks will lend more against insured receivables.
- Reducing bad debt reserves and freeing up cash.
- Utilizing it as a risk management tool to improve business planning by elimination of unknown risk.
How does credit insurance protect you better than just looking at a customer’s payment history?
Unfortunately, payment history is not a valid predictor of default. Close to 50 percent of all payment defaults rise from stable and long-term customers. One sudden loss could have a devastating impact on you and your business. Consider that your receivables are a concentration of all your cost and profit, and in many cases, you create them based on a customer’s promise to pay. Therefore, there is a tremendous amount of risk facing your business. Credit insurance is a great tool to remove this disastrous risk from a balance sheet.
What do business owners need to know about purchasing this insurance?
The level of indemnity ranges from 80 to 100 percent depending on your credit management experience, accounts receivable portfolio and premium target. Policies are designed to fit a business owner’s need for coverage. Risk retention comes in the form of co-insurance and deductibles and helps in lowering the premium. Co-insurance is a percentage of the loss you retain on each insured account.
There are only a small handful of carriers that specialize in this type of coverage. Each will have their own risk appetite, underwriting philosophy, and method to how they structure and administer their policies.
Underwriters will research, approve and monitor the accounts you want to insure. They also will approve coverage limits on the customers you want to insure. You will want to provide underwriters with a balanced spread of risk that will offer best pricing and terms. It’s important to clarify with the underwriter your maximum terms of sale, lead times for customer orders and note any special circumstances that might require additional coverage.
You can insure the entire accounts receivable portfolio or a select number of accounts. The premium will be based on your loss history, customer credit quality, spread of risk, and deductible and co-insurance levels in the policy. Usually the premium is less than half of one percent of insured sales.
Your customers’ payment history is not a valid evaluator of their failure to pay. Having a carrier watching over your covered accounts and helping evaluate credit limits is a great advantage to a business owner’s risk management plan. Nonpayment and slow pay by your customers will weaken a company. Credit insurance can help protect a company’s biggest asset — your own business credit.
Shelley C. White is an assistant vice president with SeibertKeck. Reach her at (330) 867-3140 or email@example.com.
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When selecting a contractor for a job, it is important to choose the most fiscally responsible one for the construction project in order to mitigate and manage risk and ensure its timely completion.
Failing to do so puts your company at risk of economic devastation as you are gambling on a contractor or subcontractor whose level of commitment is uncertain or who could become bankrupt part way into the job. However, there is a solution to decrease your risk, says Jack Gaugler, vice president, surety bond specialist, at SeibertKeck Insurance Agency Inc. and the Jack Kohl Agency.
“Surety bonds offer an optimal solution. By providing financial security and construction assurance, they guarantee project owners that contractors are capable of performing the contract and paying specified subcontractors, laborers and material suppliers,” says Gaugler.
Smart Business spoke with Gaugler about how surety bonds can help protect you from a devastating loss.
What is a surety bond?
A surety bond is a three-party agreement in which a surety company assures the obligee (the owner) that the principal (the contractor) will complete a contract as promised.
There are three primary types of contract surety bonds: a bid bond, a performance bond and a payment bond.
A bid bond assures that a bid has been submitted in good faith, that the contractor intends to enter into the contract at the price bid and will provide the required performance and payment bond if awarded the contract. A performance bond protects a company from financial loss in the event that the contractor fails to perform in accordance with the terms and conditions of the contract. A payment bond assures that a contractor will provide certain workers, subcontractors and material suppliers and guarantees they will be paid for work performed under the contract.
Even if a contractor has been in business for 100 years and has a good reputation, past performance is no guarantee of future results. Risk lies in the uncontrollable, unpredictable and the unknown and it is never a good idea to gamble on something that could jeopardize your company’s future. The relationship that an owner has with a contractor is arm’s length, while the surety agent and bond company relationship is a day-to-day partner. A surety has a much greater insight as to contractor’s abilities to perform than an owner.
How is a contractor prequalified?
Surety companies back the performance bonds with their own assets, so they conduct a careful, rigorous prequalification review of the contractor. The goal for the contractor is to get a bond line set up. The bond underwriter’s analyses look at criteria including financial strength, annual and interim financial statements, investment strategies, cost control mechanisms, work in progress (both bonded and nonbonded), cash flow, net worth, working capital and bank and other credit relationships. The underwriter will also look at ability to perform, prior experience on similar projects, equipment and personnel — including strength of management and its structure, past and current workloads and a continuity plan. Finally, it will consider the contractor’s reputation with project owners, subcontractors, suppliers and lenders.
Weakness in any of these areas can cause a contractor to fail. Evaluating each of these areas allows the underwriter to become comfortable guaranteeing that a contractor will be able to complete the job as promised.
Who requires contract surety bonds?
Congress passed a law more than 100 years ago to protect taxpayers from contractor failure by guaranteeing payment from the primary contractor to subcontractors and suppliers. An update to this law, called the Miller Act of 1935, is the current federal law that mandates surety bonds on federal public work projects valued at $100,000 or more. The act removes the risk from the subcontractors involved in the project and places it on the surety company that issues the bond.
State and local governments also require these bonds on public construction projects and each state has its own ‘Little Miller Acts.’
Surety bonds for private projects, while not required by law, are highly recommended. Every major project that could potentially cripple an individual company or a financial institution should require a bid and performance bond for protection. The cost of the performance bond ranges from 0.5 percent to 3 percent of the total contract amount. There is no other risk transfer mechanism that guarantees a construction contract will be completed.
When compared with the cost of contractor failures, surety bonds are a low-cost investment, considering the protection that is provided by them. Thousands of contractors, whether they have been in business for two years or 100, whether they are large or small, fail each year, leaving behind unfinished construction projects with billions of dollars in losses to project owners.
What happens if a claim is made on a surety bond?
The surety company will first investigate the alleged contractor default by working with the principal to make a decision on whether it must perform under the terms of the bond.
Once it has determined default of a contractor under the performance bond, it could conduct a takeover in which it will hire a completion contractor. It could also perform a tender, where a new contractor will be provided to the obligee (owner).
Other options include retaining the original contractor and providing technical and/or financial assistance, or the surety could reimburse the owner by paying the penal sum of the bond.
Without the protection of a surety bond, none of these actions would be possible. To minimize your risk when dealing with contractors, seek the advice of an expert to help maximize your protection.
Jack Gaugler is vice president, surety bond specialist, at SeibertKeck Insurance Agency Inc. and the Jack Kohl Agency. Reach him at (330) 294-1352 or firstname.lastname@example.org.
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A fundamental investing concept is that investors need to be compensated for taking on additional risk. However, investors often do not anticipate operational risks, and as a result, are often not compensated for them, says Todd E. Crouthamel, director, Audit & Accounting, at Kreischer Miller, Horsham, Pa.
“Operational risk can be difficult to price into the risk premium because human error is unpredictable,” says Crouthamel. “Therefore, many investors are left to assume that human errors will be prevented by the managers’ systems and controls, in order to rationalize hiring that manager. However, this is not always the case.”
Smart Business spoke with Crouthamel about how to differentiate between investment risk and operational risk.
What is investment risk?
Investment risk can be defined simply as the risk that the actual return on an investment will be lower than the investor’s expectations. Many investors are able to assess investment track records and investment models to decide if the potential rewards are worth the perceived risks in an investment. This type of risk is also readily measurable using various statistical measures, including:
- Alpha, the excess return of an investment relative to the return of the benchmark
- Beta, the measure of a volatility relative to the overall market
- R-squared, the measure that represents the percentage of an asset’s movement that can be explained by movements in the benchmark
- Standard deviation, the measure of the dispersion of data from its mean
- Sharpe ratio, which describes how much excess return is generated for extra volatility of holding an asset
What is operational risk?
The ratios described above are all built on certain assumptions, including that volatility equals risk. These ratios all derive risk measures based on quantitative factors; however, they do not consider qualitative factors, including the investment manager’s internal controls, design and implementation of its systems, and oversight of its employees. This is operational risk.
Human error makes operational risk unpredictable. Many investors may assume that human errors are prevented by the managers’ systems and controls, but that is not always the case. Consider the following situations:
- You hire Manager A to manage a large cap equity portfolio, and instead, Manager A finds better opportunities in the small caps and rationalizes investing your portfolio in small caps in the interest of earning you a better return. This guideline violation results in your portfolio being overweighted in small caps and minimizes your exposure to large caps.
- Manager B was recently examined by the Securities and Exchange Commission (SEC) and the SEC concluded that Manager B’s compliance program was wholly inadequate.
- Manager C has a trader with inappropriate access rights to override controls in the compliance system. The trader executes trades that are in violation of the investment guidelines and conceals these through the inappropriate access rights so these securities are not identified as investment guideline violations.
These examples are real. While some of these risks may be identified in the risk measures described previously, many go undetected until disaster strikes and losses pile up.
How can investors protect themselves from operational risk?
Elimination of operational risk is virtually impossible; however, it can be mitigated with some additional due diligence. Consider the following best practices:
- Review the Form ADV. If your investment manager is registered with the SEC, go to www.adviserinfo.sec.gov and read the adviser’s Form ADV, which consists of two parts. Part I provides details on the business, ownership, client base, employees, affiliations and disciplinary actions. Part II is a narrative that describes the services offered, fees, conflicts of interest and the backgrounds of management. Make sure that this information is consistent with what you already know about the adviser. If you are uncomfortable with any of the disclosures, make additional inquiries of the investment manager. If you are still not satisfied, consider another manager.
- Read the investment manager’s most recent SEC examination letter. The SEC conducts routine examinations of investment managers’ compliance systems and issues a letter detailing violations and enhancements that the investment manager should make. If your investment adviser is reluctant to share this letter with you, consider another manager who is more transparent.
- Make inquiries of the investment manager regarding its systems and internal controls surrounding compliance with investment guidelines. The compliance system should be automated, and overrides of transactions outside of the investment guidelines should require more than one sign off, preferably by someone who is independent of the trading and investment management process.
- Make inquiries of the investment manager regarding the financial strength of the company. An investment manager that is having financial difficulties may be more likely to take bigger risks.
- Read the investment manager’s report on internal controls. Many investment managers have a report that is prepared by an independent third party that tests various internal controls surrounding establishing new accounts, trading, reconciliation and accounting. This report generally details the testing performed and the results.
- If you are not confident in your ability to conduct operational due diligence, consider hiring a third party to conduct it on your behalf.
While these best practices may reduce your exposure to operational risks, there is no substitute for a healthy dose of skepticism. If an investment manager’s returns look too good to be true, they probably are.
TODD CROUTHAMEL is a director, Audit & Accounting, and a member of the Investment Industry group at Kreischer Miller. Reach him at (215) 441-4600 or email@example.com.
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