Variable Student Loan Interest Rates Increase

Variable student loan interest rates increased on July 1st

On July 1, 2007, the interest rates on variable federal Stafford and PLUS loans increased slightly. These new rates apply only to loans issued on or after July 1, 1998 and before July 1, 2006.

The interest rate on Stafford loans in repayment will increase to 7.22% from 7.14%. The interest rate on in-school, grace, or deferment status Stafford loans will increase to 6.62% from 6.54%. And the interest rate on PLUS loans will increase to 8.02% from 7.94%. These rates will be in effect through June 30, 2008. The Department of Education sets the rates once each year based on the last three-month Treasury bill auction held in May.

For all Stafford and PLUS loans issued on or after July 1, 2006, the loans will have a fixed interest rate--6.8% for Stafford loans and 8.5% for PLUS loans.

Send us an email, if you would like more information on, click here:

o Comparison of Federal Higher Education Loans
o Federal Student Loans
o Repaying Student Loans
o Student Loan Basics
o How Student Loans Impact Your Credit

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June Seminars

For the month of June 2007, we will be hosting two College Financial Aid workshops.

Entitled 123College.com, the workshops provide revealing inside secrets on how to receive the most money possible in funding for College!

You will—

• Learn how to increase your eligibility for financial aid

• Learn how to pick colleges that will best suit your child and will give you the best possible financial aid package

• Learn how you may send your child to an expensive private university for less that a state college

LOCATIONS:

Tuesday, June 26^th

Millrose Restaurant & Brewing Co.
45 South Barrington Rd
South Barrington IL 60010

Time: 7:00 pm

Wednesday, June 27^th

Concordia University
Koehneke Community Center
7400 Augusta Blvd
River Forest IL 60305

Time: 7:00 pm

Refreshments will be served at both workshops

It is recommended that both parents attend

To make your reservation and for directions,

CALL 1-800-582-4195

(Please RSVP, as seating is limited!)

If you are unable to attend either of our Seminar Workshops, please call

708-386-2790 x 211

To schedule a one-on-one, no cost – no obligation appointment or for future 123College.com event locations.

Please note that programs held at a University, College or School facility are NOT being sponsored by the institution.

--See Disclaimer--

Final IRC Section 409A Regulations

IRS Issues Final 409A Regulations

On April 17, 2007, the IRS issued its long-awaited final regulations under Section 409A of the Internal Revenue Code. The comprehensive regulations (over 400 pages in length) make numerous changes to the proposed regulations in an effort to make compliance less burdensome.

While the final regulations aren't effective until taxable years beginning on or after January 1, 2008 (later for collectively bargained plans), employers may rely on them immediately. Alternatively, employers may rely on the Service's prior guidance until the effective date.

Employers must amend their plans to comply with Section 409A no later than December 31, 2007. The plan document needs only to bring the plan into compliance as of January 1, 2008. Retroactive amendment to reflect pre-2008 plan administration (including reliance on any transition rules) isn't required (although taxpayers must be able to demonstrate that amounts were deferred or paid in compliance with any applicable transition rules).

The following summarizes some of the key provisions of the final regulations (focusing on areas where the final regulations differ from the proposed rules). For a general discussion of Section 409A, see our full topic discussion Internal Revenue Code Section 409A (Governing Nonqualified Deferred Compensation Plans).

Nonqualified deferred compensation in general

IRC Section 409A applies only to plans that provide for a deferral of compensation. Deferred compensation is compensation that a service provider has a legally binding right to receive from a service recipient, and that is payable to, or on behalf of, the service provider in a later year. (Since in most cases the relationship between the service provider and the service recipient will be that of employer/employee, for convenience these terms are used throughout the rest of this update. Keep in mind, however, that Section 409A applies to other relationships as well.)

• The final regulations clarify that a deferral of compensation exists if a payment will be made upon an event that could occur after the year in which the legally binding right to the payment arises. For example, where an employee has a right under a plan to payment upon separation from service, a deferral of compensation exists even if the employee separates from service and receives the payment in the same year as the grant (because payment is conditioned on an event that could occur in a subsequent year).
• The final regulations contain an anti-abuse rule that allows the IRS to treat any plan as a nonqualified deferred compensation subject to Section 409A if the IRS determines that a principal purpose of the plan is to achieve a result that's inconsistent with the purposes of Section 409A.

Independent contractors

Section 409A generally doesn't apply to an amount deferred under an arrangement between a independent contractor and an unrelated employer in any tax year if the independent contractor provides significant services to two or more employers (who are unrelated to the independent contractor and to each another). Under a safe harbor in the proposed regulations, an independent contractor is deemed to provide significant services to two or more employers if no more than 70% of the contractor's total revenues during the year come from any one employer.

The IRS recognized that the safe harbor was of limited value, as independent contractors might not know if they actually satisfied the safe harbor requirements any particular year until the end of that year. As a result, the final regulations provide a new lookback rule: an independent contractor that has satisfied the 70% threshold in the three immediately previous years is deemed to meet the 70% threshold for the current year. However, this lookback rule is available only if, at the time compensation is deferred, the independent contractor doesn't know, or have reason to anticipate, that he or she will fail to meet the 70% threshold in the current year.

Short-term deferrals

Under the proposed and final regulations Section 409A doesn't apply to short-term deferrals. A short-term deferral generally exists if payment is made no later than 2½ months following the end of the tax year in which the compensation vests (in technical terms, when the compensation is no longer subject to a substantial risk of forfeiture). However, the short-term deferral exception is only available if the plan doesn't provide for a deferral of the payment beyond the 2½ month deadline.

The final regulations clarify that the short-term deferral exclusion is not available if the plan specifies a payment event or date that will or may occur after the end of the short-term deferral period. For example, if an arrangement provides that compensation will be paid upon an employee's separation from service, which may occur in a future year, the arrangement will be deemed to provide for a deferred payment, and the short-term deferral rule will not be available, even if payment is in fact made within the applicable 2½ month period.

Stock options and stock appreciation rights

Nonqualified stock options are generally exempt from Section 409A if: (a) the exercise price is never less than the fair market value of the underlying stock on the grant date; (b) taxation of the options is governed by IRC Section 83; and (c) there are no deferral features (other than the deferral of recognition of income until the exercise or disposition of the option). Stock appreciate rights (SARs) are generally treated the same as nonqualified stock options for Section 409A purposes. The regulations refer to nonqualified stock options and SARs collectively as "stock rights." For the exclusion from Section 409A to apply, a stock right must relate to "service recipient stock."

• The final regulations expand the classes of stock that qualify as "service recipient stock," generally providing that any class of stock that qualifies as common stock under IRC Section 305 may be used, regardless of whether another class of common stock is publicly traded or has a higher aggregate value outstanding, and regardless of whether the class of stock is subject to transferability restrictions or buyback rights.
• The final regulations also provide that "service recipient stock" includes not only stock of the corporation for which the employee was providing services at the date of grant, but also the stock of any upstream corporation in the employer's controlled group. For this purpose, control is generally determined using a 50% ownership interest (rather than the 80% general rule), although 20% can be used if the employer establishes that use of the stock is based upon legitimate business criteria (as defined in the regulations). The stock of a downstream member of the controlled group, or of a brother/sister corporation, can't be used.
• The final regulations provide that a stock right won't become subject to Section 409A solely because the stock right's exercise period is extended, but not beyond the earlier of (a) the original maximum term of the stock right or (b) 10 years from the original date of grant. However, if a stock right is "underwater" (i.e., the fair market value of the underlying stock at the time of the extension is less than or equal to the exercise price) the exercise period can be extended without limit.

Separation pay plans

Separation pay plans are generally exempt from Section 409A if the separation pay (a) is payable no later than two years after the year separation from service occurs, and (b) is limited to the lesser of two times the employee's annual compensation or two times the section 401(a)(17) compensation limit. This exception applies only where the payment is made due to the employee's involuntary separation from service or participation in a window program. The exception doesn't apply to a plan providing for a payment upon voluntary separation from service or other event. The proposed regulations also provide that Section 409A doesn't apply to separation payments that don't exceed $5,000 in the aggregate.

• The final regulations provide that where a plan qualifies for this exemption, except that the separation pay exceeds the "two times pay" limit, only the excess over the limit will be subject to Section 409A. The right to payment up to the applicable limit will not be subject to Section 409A. As a result, the six month delay for payments to specified employees on account of separation from service will not be required for payments up to the "two times pay" limit.
• The final regulations clarify that separation pay refers only to compensation that an employee is entitled to upon a separation from service (including a separation from service due to death or disability) and not to compensation he or she could have received without separating from service (such as an amount that's also payable to the employee upon a change in control, as a result of an unforeseeable emergency, or on a date certain).
• The final regulations expand the separation pay exemption by permitting a voluntary termination for good reason to be treated as an involuntary separation if certain requirements are met (and avoidance of Section 409A is not the goal).
• The final regulations increase the small benefit exemption amount from $5,000 to the IRC section 402(g) deferral limit ($15,000 in 2007).

Reimbursement plans

The proposed and final regulations generally provide that Section 409A will not apply to an employer's reimbursement of certain expenses (such as reasonable outplacement expenses, reasonable moving expenses, and medical expenses). The regulations generally require that eligible expenses be incurred by the employee no later than the end of the second year following the year in which the employee terminates employment.

• The final regulations clarify that the right to a nontaxable benefit (for example, reimbursement of nontaxable medical expenses) is not subject to Section 409A.
• The final regulations extend the period of time that taxable medical expenses may be reimbursed. These reimbursements will not be subject to Section 409A during the period the employee would be entitled to COBRA coverage if he or she elected such coverage and paid the applicable premiums.
• Even though reimbursed expenses must generally be incurred by the end of the second year following separation from service, the final regulations generally extend the period during which reimbursements can be paid to the end of the third year following separation from service.
• The regulations clarify that reasonable moving expenses include the reimbursement of a loss incurred by an employee due to the sale of his or her primary residence.

Plan aggregation rules

The proposed regulations generally provide that all amounts deferred with respect to an employee under all plans of an employer of the same type are treated as deferred under a single plan. The proposed regulations defined four types of plans for purposes of these aggregation rules: account balance plans, non-account balance plans (for example, defined benefit plans), separation pay plans, and all other plans (for example, non-exempt stock right plans).

The final regulations provide additional categories for split-dollar life insurance arrangements, certain reimbursement plans, certain foreign plans, and stock right plans subject to Section 409A. The final regulations also generally require that account balance plans be subdivided into elective and non-elective arrangements.

Written plan requirement

Section 409A requires that a nonqualified deferred compensation plan be in writing.

• The final regulations generally provide that a plan will satisfy this requirement if the document or documents constituting the plan specify the amount of compensation the employee has a right to be paid, the payment schedule or payment triggering events, the conditions under which a deferral election may be made, and provisions describing the six-month delay applicable to payments to "specified employees" upon separation from service.
• A plan generally doesn't need to specify the conditions under which accelerated payments may be made, but the employer must demonstrate that an accelerated payment complies with the requirements of Section 409A and the final regulations.

• The final regulations clarify that a "savings clause" contained in a plan document will not protect a plan that contains provisions that don't meet Section 409A's requirements.

Deferral election rules

In order to be a valid deferral, an employee's initial election to defer compensation must be made prior to the year the compensation is earned. The proposed regulations contain a special rule for newly eligible employees. The individuals can make an initial deferral election within 30 days after first becoming a participant. Elections to defer performance-based compensation may be made up until six months before the end of the performance period.

• The final regulations expand the new-participant rule in two ways. First, if an employee was formerly a participant in the plan, was paid all amounts deferred under the plan, and was not eligible to continue to participate in the plan after the last payment, the plan can treat that employee as a new participant if he or she again becomes eligible to participate in the plan. Second, a plan participant who becomes ineligible to participate in the plan for a period of at least 24 months may be treated as a new participant if he or she again becomes eligible to participate (regardless of whether or not the employee has separated from service and regardless of whether or not the employee has received payment of his or her account balance).
• The final regulations clarify that a portion of an award can be performance-based compensation even if the award contains a non performance-based component, but only if the portion that qualifies as performance-based compensation is separately identifiable under the terms of the plan.

• The final regulations require that an election to defer performance-based compensation must be made before the amount of the compensation is readily ascertainable (as defined in the regulations). The proposed regulations had required that the election be made before the compensation had become substantially certain to be paid.

Time and form of payment

An employee's initial deferral election must specify the time and form of distribution. Alternatively, the plan itself can specify when and how payment will be made. Section 409A provides that distribution from a NQDC plan can occur upon separation from service, death, disability, change in control, unforeseeable emergency, or at a fixed date or pursuant to a fixed schedule. In general, a plan can't make a distribution on account of an unforeseeable emergency if the hardship need can be satisfied from the individual's other assets (unless liquidation of those assets would itself cause a severe financial hardship).

• The proposed regulations provide that a payment is treated as made on a fixed date if the payment is made by the end of the calendar year containing that date or, if later, the 15th day of the third month following that date. The final regulations clarify that the same flexibility applies when making a payment on account of a payment event. So, for example, where a payment is scheduled to be made upon an employee's death, the payment is timely if made on or before the later of December 31 of the calendar year in which death occurs, or the 15th day of the third month following the date of death.
• The final regulations provide that a right to a tax gross-up payment will satisfy Section 409A if the plan provides that payment will be made, and the payment is actually made, by the end of the year following the year the related taxes are paid to the taxing authority.
• The final regulations simplify the rules for determining when an employee separates from service. In general, whether the employee has terminated employment is based on whether the employee and employer reasonably anticipate either that (a) no further services will be performed after a certain date, or (b) that the level of bona fide services the employee will perform after that date (whether as an employee or as an independent contractor) will permanently decrease to no more than 20% of the average level of services performed over the immediately preceding 36-month period (or the full period the employee provided services to the employer if the employee has been providing services for less than 36 months). A plan can substitute a percentage ranging from 20% to 50% under certain conditions.
• The final regulations clarify the definition of "employer" for purposes of determining whether a separation from service has occurred. The employer is defined as including all entities that would be treated as part of the employer's controlled group under section IRC section 414(b) and (c), but using a 50%, instead of 80%, ownership level. A plan may instead use an ownership level ranging from 20% to 80%, but an ownership level of less than 50% may be used only where such use is based on legitimate business criteria, as defined in the regulations.
• Plans can adopt a "same desk" rule for Section 409A purposes under the final regulations, allowing unrelated parties to an asset purchase agreement to decide whether employees of the selling corporation that continue in their same positions with the purchaser of the assets will be treated as separating from service. The plan must treat all employees consistently (regardless of position at the seller), and that treatment must be specified no later than the closing date of the asset purchase transaction. For this purpose, a sale of assets refers to a transfer of substantial assets, such as a plant or division or substantially all of the assets of a trade or business.
• The final regulations clarify that elections with respect to the time and form of payment to a beneficiary after an employee's death are subject to the general rules governing subsequent deferrals and accelerated payments, whether those elections may be made by the employee or the beneficiary (special rules apply to qualified domestic relations orders).
• A domestic relations order may provide for a new time and form of payment to an employee's spouse or former spouse, or may give the spouse or former spouse the discretion to elect the time and form of payment. Section 409A rules will not apply.
• The final regulations provide that a payment due to an unforeseeable emergency may be made even though the financial need could instead be satisfied through an available distribution from a grandfathered nonqualified deferred compensation plan, or from another nonqualified deferred compensation plan that's subject to Section 409A.
• The Pension Protection Act of 2006 provides that where an event would constitute an unforeseeable emergency under the plan if it occurred with respect to the employee's spouse or dependent, such event will (if the plan so provides) also constitute an unforeseeable emergency if it occurs with respect to the employee's plan beneficiary. The final regulations reflect these new rules.

6-month delay for specified employees on separation from service

Under Section 409A a payment of deferred compensation to a "specified employee" on account of separation from service generally must be delayed for six months following the date of separation from service. A specified employee is a key employee of a corporation whose stock is publicly traded.

• The final regulations clarify that the six-month delay applies to an employee of a company whose stock is publicly traded solely on a foreign exchange, or is traded on a U.S. exchange only as ADRs.
• In order to avoid undercounting specified employees, a plan may provide that payments to all plan participants upon separation from service will be delayed for six months, regardless of whether the employee is a specified employee.
• The final regulations let a plan use an alternative method for identifying specified employees, provided that the alternative method (a) is reasonably designed to include all specified employees, the alternative method, (b) is an objectively determinable standard, (c) doesn't provide a direct or indirect election to any employee regarding the application of the rule, and (d) results in no more than 200 employees being identified as specified employees as of any date.
• The final regulations significantly alter the proposed rules governing the identification of specified employees following a corporate transaction, such as a merger or spin-off.
• The final regulations clarify that where a payment is made to a specified employee on account of disability, a change in control event, or an unforeseeable emergency, the payment need not be delayed merely because that individual separates from service after incurring the disability or unforeseeable emergency, or after the change in control event.
• The final regulations also provide that Section 409A is not violated where payment to a specified employee is made before the end of the six-month period due to a domestic relations order, to satisfy a Federal, state, local, or foreign ethics law, or to pay certain employment taxes.

Anti-acceleration rule

Section 409A prohibits a plan from accelerating the payment of an employee's plan benefit except as permitted by the IRS. The proposed regulations allow the acceleration of benefits from a plan in the following limited circumstances:

1. To satisfy a qualified domestic relations order (QDRO)
2. To comply with a conflict of interest divestiture
3. To pay certain FICA taxes relating to the deferred compensation
4. To pay income taxes due to the vesting of benefits in a Section 457(f) plan
5. To cash out small benefits ($10,000 or less) upon an employee's separation from service.

• The final regulations provide that a plan may give the employer, but not the employee, the discretion to accelerate a deferred payment upon the occurrence of one of the permitted acceleration events.
• The final regulations provide that benefit payments can also be accelerated to pay state and local taxes, RRTA taxes, and foreign taxes.
• The final regulations increase the small benefit limit from $10,000 to the limit on elective deferrals under IRC Section 402(g) ($15,000 in 2007). The final regulations, unlike the proposed regulations, provide that an employer can cash out the employee's benefit even if the employee hasn't separated from service--the employer may exercise its discretion any time an employee's benefit is less than the 402(g) limit. The plan aggregation rules apply, so an employer can't use this rule to cash out an amount under one arrangement but not another arrangement where the two arrangements are treated as a single plan.
• The final regulations generally provide that where an employer makes a payment to an employee that's a substitute for a payment of deferred compensation, then that payment will be treated as a payment of deferred compensation subject to section 409A and its anti-acceleration provisions. Similarly, if an employee's rights to deferred compensation are subject to anticipation, alienation, sale, transfer, assignment, pledge, encumbrance, attachment, or garnishment by creditors of the service provider or the service provider's beneficiary, the employee's benefits are treated as having been paid to the employee, again invoking Section 409A's anti-acceleration rules.
• The final regulations provide that the addition of death, disability, or an unforeseeable emergency as a potentially earlier payment event is a permissible acceleration. This rule does not apply to the addition of death, disability, or an unforeseeable emergency as a potentially later payment event. Nor would it allow a plan to substitute, for example, an employee's death as a new payment event instead of a fixed payment date. The regulations provide that in those cases, the rules governing subsequent deferral elections (i.e., "second elections") apply.

Plan termination and liquidation

Under the proposed regulations an employer may generally terminate a plan if the employer (a) terminates all plans of the same type, (b) distributes benefits to all participants within 12 months of the termination date, and (c) doesn't adopt a new plan of the same type within 5 years. A termination covered by this rule would not be treated as violating Section 409A's anti-acceleration provisions.

• The final regulations clarify that the termination and liquidation of a nonqualified deferred compensation plan involves both the amendment of the plan to cease deferrals under the plan, and to provide for payment of all benefits accrued under the plan.
• The final regulations shorten the period of time during which an employer may not establish a new plan after terminating and liquidating a nonqualified deferred compensation plan has been shortened from five years to three years. The regulations also provide that a discretionary plan termination and liquidation will not qualify for this exception if it is proximate in time to a downturn in the financial health of the employer.
• The final regulations clarify the rules under which a deferred compensation plan may be terminated and liquidated upon a change in control event.

Information is derived from sources we believe to be reliable however its accuracy cannot be guaranteed.

-See Disclaimer-

Death of a Family Member Checklist

Losing a loved one can be a difficult experience. Yet, during this time, you must complete a variety of tasks and make important financial decisions. You may need to make final arrangements, notify various businesses and government agencies, settle the individual's estate, and provide for your own financial security. The following checklist may help guide you through the matters that must be attended to upon the death of a family member.

Note: Some of the following tasks may be completed by the estate's executor.

Initial tasks

• Upon the death of your loved one, call close family members, friends, and clergy first--you'll need their emotional support.

• Arrange the funeral, burial or cremation, and memorial service. Hopefully, the deceased will have made arrangements ahead of time. Look among his or her papers for a letter of instruction containing final wishes. Arrange any cultural rituals, and make any anatomical gifts.

• Notify family and friends of the final arrangements.

• Alert your loved one's place of work, union, and professional organizations, and any organizations where he or she may have volunteered.

• Contact your own employer and arrange for bereavement leave.

• Place an obituary in the local paper.

• Obtain certified copies of the death certificate. The family doctor or medical examiner should provide you with the death certificate within 24 hours of the death. The funeral home should complete the form and file it with the state. Get several certified copies (photocopies may not be accepted)--you will need them when applying for benefits and settling the estate.



• Review your family member's financial affairs, and look for estate planning documents, such as a will and trusts, and other relevant documents, such as deeds and titles. Also locate any marriage certificate, birth or adoption certificates of children, and military discharge papers, which you may need to apply for benefits. These documents may be found in a safe-deposit box, or the deceased's attorney may have copies.

• Report the death to Social Security by calling 1-800-772-1213. If your loved one was receiving benefits via direct deposit, request that the bank return funds received for the month of death and thereafter to Social Security. Do not cash any Social Security checks received by mail. Return all checks to Social Security as soon as possible. Surviving spouses and other family members may be eligible for a $255 lump-sum death benefit and/or survivor's benefits. Go to www.ssa.gov for more information.

• Make a list of the deceased's assets. Put safeguards in place to protect any property. Make sure mortgage and insurance payments continue to be made while the estate is being settled.

• Arrange to retrieve your loved one's belongings from his or her workplace. Collect any salary, vacation, or sick pay owed to your loved one, and be sure to ask about continuing health insurance coverage and potential survivor's benefits for a spouse or children. Unions and professional organizations may also offer death benefits. If the death was work-related, you may be entitled to worker's compensation benefits.

• Contact past employers regarding pension plans, and contact any IRA custodians or trustees. Review designated beneficiaries and post-death distribution options.

• Locate insurance policies. The policies could include individual and group life insurance, mortgage insurance, auto credit life insurance, accidental death and dismemberment, credit card insurance, and annuities. Contact all insurance companies to file claims.

• Contact all credit card companies and let them know of the death. Cancel all cards unless you're named on the account and wish to retain the card.

• Retitle jointly held assets, such as bank accounts, automobiles, stocks and bonds, and real estate.

• If the deceased owned, controlled, or was a principal in a business, check to see if there are any buy-sell agreements under which his or her interest must be sold.

Within 3 to 9 months after death

• File the will with the appropriate probate court. If real estate was owned out of state, file ancillary probate in that state also. If there is no will, contact the probate court for instructions, or contact a probate attorney for assistance.



• Notify the deceased's creditors by mail and by placing a notice in the newspaper. Claims must be made within the statute of limitations, which varies from state to state (30 days from actual notice is common). Insist upon proof of all claims.

• Distribute the estate to the beneficiaries.

• A federal estate tax return may need to be filed within 9 months of death. State laws vary, but state estate tax and/or inheritance tax returns may also need to be filed. Federal and state income taxes are due for the year of death on the normal filing date, unless an extension is requested. If there are trusts, separate income tax returns may need to be filed. You may want to seek the advice of a tax professional.

Within 9 to 12 months after death

• Update your own will if your loved one was a beneficiary.

• Reevaluate your budget, and short-term and long-term finances.

• Reevaluate your insurance needs, and update beneficiary designations on insurance policies on which the deceased was the named beneficiary.

• Reevaluate investment options.

To find out more click here.

-See Disclaimer-

Bonds, Interest Rates, and the Impact of Inflation

There are two fundamental ways that you can profit from owning bonds: from the interest that bonds pay, or from any increase in the bond's price. Many people who invest in bonds because they want a steady stream of income are surprised to learn that bond prices can fluctuate, just as they do with any security traded in the secondary market. If you sell a bond before its maturity date, you may get more than its face value; you could also receive less if you must sell when bond prices are down. The closer the bond is to its maturity date, the closer to its face value the price is likely to be.

Though the ups and downs of the bond market are not usually as dramatic as the movements of the stock market, they can still have a significant impact on your overall return. If you're considering investing in bonds, either directly or through a mutual fund or exchange-traded fund, it's important to understand how bonds behave and what can affect your investment in them.

The price-yield seesaw and interest rates

Just as a bond's price can fluctuate, so can its yield--its overall percentage rate of return on your investment at any given time. A typical bond's coupon rate--the annual interest rate it pays--is fixed. However, the yield isn't, because the yield percentage depends not only on a bond's coupon rate but also on changes in its price.

Both bond prices and yields go up and down, but there's an important rule to remember about the relationship between the two: They move in opposite directions, much like a seesaw. When a bond's price goes up, its yield goes down, even though the coupon rate hasn't changed. The opposite is true as well: When a bond's price drops, its yield goes up.

That's true not only for individual bonds but also the bond market as a whole. When bond prices rise, yields in general fall, and vice versa.

What moves the seesaw?

In some cases, a bond's price is affected by something that is unique to its issuer--for example, a change in the bond's rating. However, other factors have an impact on all bonds. The twin factors that affect a bond's price are inflation and changing interest rates. A rise in either interest rates or the inflation rate will tend to cause bond prices to drop. Inflation and interest rates behave similarly to bond yields, moving in the opposite direction from bond prices.

If inflation means higher prices, why do bond prices drop?

The answer has to do with the relative value of the interest that a specific bond pays. Rising prices over time reduce the purchasing power of each interest payment a bond makes. Let's say a five-year bond pays $400 every six months. Inflation means that $400 will buy less five years from now. When investors worry that a bond's yield won't keep up with the rising costs of inflation, the price of the bond drops because there is less investor demand for it.

Why watch the Fed?

Inflation also affects interest rates. If you've heard a news commentator talk about the Federal Reserve Board raising or lowering interest rates, you may not have paid much attention unless you were about to buy a house or take out a loan. However, the Fed's decisions on interest rates can also have an impact on the market value of your bonds.

The Fed takes an active role in trying to prevent inflation from spiraling out of control. When the Fed gets concerned that the rate of inflation is rising, it may decide to raise interest rates. Why? To try to slow the economy by making it more expensive to borrow money. For example, when interest rates on mortgages go up, fewer people can afford to buy homes. That tends to dampen the housing market, which in turn can affect the economy.

When the Fed raises its target interest rate, other interest rates and bond yields typically rise as well. That's because bond issuers must pay a competitive interest rate to get people to buy their bonds. New bonds paying higher interest rates mean existing bonds with lower rates are less valuable. Prices of existing bonds fall.

That's why bond prices can drop even though the economy may be growing. An overheated economy can lead to inflation, and investors begin to worry that the Fed may have to raise interest rates, which would hurt bond prices even though yields are higher.

Falling interest rates: good news, bad news

Just the opposite happens when interest rates are falling. When rates are dropping, bonds issued today will typically pay a lower interest rate than similar bonds issued when rates were higher. Those older bonds with higher yields become more valuable to investors, who are willing to pay a higher price to get that greater income stream. As a result, prices for existing bonds with higher interest rates tend to rise.

Example: Jane buys a newly issued 10-year corporate bond that has a 4% coupon rate--that is, its annual payments equal 4% of the bond's principal. Three years later, she wants to sell the bond. However, interest rates have risen; corporate bonds being issued now are paying interest rates of 6%. As a result, investors won't pay Jane as much for her bond, since they could buy a newer bond that would pay them more interest. If interest rates later begin to fall, the value of Jane's bond would rise again--especially if interest rates fall below 4%.

When interest rates begin to drop, it's often because the Fed believes the economy has begun to slow. That may or may not be good for bonds. The good news: Bond prices may go up. However, a slowing economy also increases the chance that some borrowers may default on their bonds. Also, when interest rates fall, some bond issuers may redeem existing debt and issue new bonds at a lower interest rate, just as you might refinance a mortgage. If you plan to reinvest any of your bond income, it may be a challenge to generate the same amount of income without adjusting your investment strategy.

All bond investments are not alike

Inflation and interest rate changes don't affect all bonds equally. Under normal conditions, short-term interest rates may feel the effects of any Fed action almost immediately, but longer-term bonds likely will see the greatest price changes.

Also, a bond mutual fund may be affected somewhat differently than an individual bond. For example, a bond fund's manager may be able to alter the fund's holdings to minimize the impact of rate changes. Your financial professional may do something similar if you hold individual bonds.

Focus on your goals, not on interest rates alone

Though it's useful to understand generally how bond prices are influenced by interest rates and inflation, it probably doesn't make sense to obsess over what the Fed's next decision will be. Interest rate cycles tend to occur over months and even years. Also, the relationship between interest rates, inflation, and bond prices is complex, and can be affected by factors other than the ones outlined here.

Your bond investments need to be tailored to your individual financial goals, and take into account your other investments. A financial professional can help you design your portfolio to accommodate changing economic circumstances.

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Understanding Risk (Overview)

What is risk?

In general

Risk is all around us, and we all take risks every day. Some people consider driving a car risky. Others don't seem to mind driving but don't like flying in an airplane--even though statistics show you're far more likely to die in a car than in an airplane. Some of us, like racecar drivers, cliff divers, and bungee jumpers, actually thrive on risk. Others go to great lengths to reduce risk.

Risk is multidimensional with many factors interacting. For example, an athlete in top physical condition may suffer a fatal heart attack while exercising because he or she has a family history of heart disease.

Some risks are more apparent than others. For instance, walking a high wire is quite obviously a risk. On the other hand, the danger of being struck by lightning is not so obvious.

The bottom line is that you can't live without taking some risks. Since you cannot totally eliminate them, the best you can do is try to reduce them as much as possible. That's why we avoid people with colds, eat healthy diets, wear life jackets when we go boating, and buy life insurance.

Risk in the investment world

Some people view risk as a negative, others as a positive. Ask any group of people what risk means to them, and you are likely to get some of these answers:

• Danger
• Possible loss
• Uncertainty
• Challenge
• Opportunity
• Thrill

In the investment world, however, risk means uncertainty. It refers to the possibility that you will lose your investment or that an investment will yield less than its anticipated return. More simply stated, risk refers to the probability that an investment will make or lose money. Every investment carries some degree of risk because its returns are unpredictable. The degree of risk associated with a particular investment is known as its volatility.

The relationship between risk and return

When you invest, you plan to make money on that investment or, more accurately, earn a return. Risk and return are directly related. The higher the risk, the higher the return potential. If you want a higher rate of return, you will have to accept a higher risk. Conversely, you may accept a lower risk, but the return potential is lower.

The relationship between risk and time, or the time horizon

The length of time that you plan to remain in a particular investment vehicle is known as your investment planning time horizon. Generally speaking, the longer your time horizon, the more you can afford to invest more aggressively, in higher-risk investments. This is because the longer you can remain invested, the more time you'll have to ride out fluctuations in the hope of getting a greater reward in the future. Of course, there is no assurance that any investment will not lose money.

Risk-taking propensity

Each of us is able to accept a certain amount of investment risk. This is known as our risk-taking propensity. Those of us who can accept a relatively great amount of risk are referred to as risk tolerant. On the other end of the spectrum, those who can accept very little risk are known as risk averse. Those who hold the middle ground are risk neutral or risk indifferent.

There are ways to measure your risk tolerance, using tests to assess how you react to different types of risk, such as monetary, physical, social, and ethical. These tests aren't foolproof, since we are essentially talking about psychological behaviors that may vary under different conditions. However, the results from these tests are generally considered reliable and valid.

Your risk-taking propensity is as important in determining which investments match your risk-return expectations as the risk of the investment itself.

How do you evaluate the risk of a specific investment?

Before you can evaluate the risk of a specific investment, you must understand the types of risk that exist and how to measure them.

As in your day-to-day life, risks are prevalent in the investment world, and some are more apparent than others. Each investment is subject to all of the general uncertainties associated with that type of investment. These are known as systematic risks and include market, interest rate, and purchasing power risk, among others. Risk also arises from factors and circumstances that are specific to a particular company, industry, or class of investments. These are known as diversifiable or unsystematic risks. Diversifiable risks include business, financial, and default risk, among others.

Measuring risk involves analyzing the different types of risk using an array of mathematical tools and techniques (e.g., the standard deviation, Beta, Alpha, and so forth). The statistics obtained provide an investor with some standardized measurements with which to make an educated decision.

Rating services

You don't need to measure risk yourself. Ratings services, such as Standard & Poor's, Fitch, Moody's, Value Line, and Morningstar, compile and publish risk and return statistics for many types of investments. These services provide an investor with key information and statistics in a condensed and easy-to-read format.

To obtain rating service reports, check with your public library. It may subscribe to some or all of these services. If not, you may have to subscribe yourself, for an annual fee. Some services offer a free trial period.

Research

For specific investments, you may be able to view an annual report, prospectus, or proxy statement with financial information and outlined business strategies. To obtain copies of these documents, contact the issuer of the security.

You may find helpful information in books, newspapers, magazines, journals, newsletters, or on the radio, television, or Internet.

How do you reduce risk?

Diversify

One of the best ways to reduce risk is to develop a portfolio of investments that is balanced in terms of the types of assets in which you invest. In other words, don't put all your eggs in one basket. This is known as diversification or asset allocation. A portfolio that mixes a variety of asset classes (e.g., cash, bonds, domestic and foreign stocks, and real estate) has a lower risk for a given level of return than does a portfolio that consists of only one. Diversification works because it broadens your investment base. It can be achieved by company, industry, type of security, markets, or by investment objective.

How an investor diversifies depends upon his or her own situation. An investor can be aggressive (investing mostly in high-risk vehicles), conservative (investing mostly in low-risk vehicles), or somewhere in between.

Allow for the passage of time

Historically, time has had a dampening effect on the riskiness of investments (though there is no guarantee this will continue in the future). In "investmentspeak," the standard deviation associated with the average rate of return on an investment has decreased with the square root of time. In plain English, the longer the investor remained invested--or the longer the investor's time horizon--the less risky the investment has become.

Do your homework

You may be able to reduce some risk simply by being diligent. For example, have real estate inspected and appraised before you buy it, or investigate a company's financial condition before you purchase stock in it.

Gauge the economy by identifying trends in overall business conditions. These trends are indicated regularly (weekly or monthly) by figures on inventories, prices, employment, and the GDP. Is the economy on an upswing or downswing? Knowing this will help you choose an investment more likely to appreciate under the given conditions.

Choose investments that make sense to you. For example, buy stock in a company with relatively stable earnings, or one whose sales are likely to keep up with inflation, or one whose products are in great demand, or one who sells a product for which the demand is constant, such as food.

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Handling Market Volatility

Conventional wisdom says that what goes up, must come down. But even if you view market volatility as a normal occurrence, it can be tough to handle when it's your money at stake. Though there's no foolproof way to handle the ups and downs of the stock market, the following common sense tips can help.

Don't put your eggs all in one basket

Diversifying your investment portfolio is one of the key ways you can handle market volatility. Because asset classes typically perform differently under different market conditions, spreading your assets across a variety of investments such as stocks, bonds, and cash equivalents (e.g., money market funds, CDs, and other short-term instruments), has the potential to help reduce your overall risk. Ideally, a decline in one type of asset will be balanced out by a gain in another, but diversification can't eliminate the possibility of market loss.

One way to diversify your portfolio is through asset allocation. Asset allocation involves identifying the asset classes that are appropriate for you and allocating a certain percentage of your investment dollars to each class (e.g., 70 percent to stocks, 20 percent to bonds, 10 percent to cash equivalents). An easy way to decide on an appropriate mix of investments is to use a worksheet or an interactive tool that suggests a model or sample allocation based on your investment objectives, risk tolerance level, and investment time horizon.

Focus on the forest, not on the trees

As the market goes up and down, it's easy to become too focused on day-to-day returns. Instead, keep your eyes on your long-term investing goals and your overall portfolio. Although only you can decide how much investment risk you can handle, if you still have years to invest, don't overestimate the effect of short-term price fluctuations on your portfolio.

Look before you leap

When the market goes down and investment losses pile up, you may be tempted to pull out of the stock market altogether and look for less volatile investments. The small returns that typically accompany low-risk investments may seem attractive when more risky investments are posting negative returns.

But before you leap into a different investment strategy, make sure you're doing it for the right reasons. How you choose to invest your money should be consistent with your goals and time horizon.

For instance, putting a larger percentage of your investment dollars into vehicles that offer safety of principal and liquidity (the opportunity to easily access your funds) may be the right strategy for you if your investment goals are short-term (e.g., you'll need the money soon to buy a house) or if you're growing close to reaching a long-term goal such as retirement. But if you still have years to invest, keep in mind that stocks have historically outperformed stable value investments over time, although past performance is no guarantee of future results. If you move most or all of your investment dollars into conservative investments, you've not only locked in any losses you might have, but you've also sacrificed the potential for higher returns.

Look for the silver lining

A down market, like every cloud, has a silver lining. The silver lining of a down market is the opportunity you have to buy shares of stock at lower prices.

One of the ways you can do this is by using dollar cost averaging. With dollar cost averaging, you don't try to "time the market" by buying shares at the moment when the price is lowest. In fact, you don't worry about price at all. Instead, you invest money at regular intervals over time.

When the price is higher, your investment dollars buy fewer shares of stock, but when the price is lower, the same dollar amount will buy you more shares.

For example, let's say that you decided to invest $300 each month towards your child's college education. As the illustration shows, your regular monthly investment of $300 bought more shares when the price was low and fewer shares when the price was high:

Although dollar cost averaging can't guarantee you a profit or avoid a loss, a regular fixed dollar investment may result in a lower average price per share over time, assuming you continue to invest through all types of markets. You should consider your financial ability to make ongoing purchases, regardless of price fluctuations, however.

(This hypothetical example is for illustrative purposes only and does not represent the performance of any particular investment. Actual results will vary.)

Don't stick your head in the sand

While focusing too much on short-term gains or losses is unwise, so is ignoring your investments. You should check up on your portfolio at least once a year, more frequently if the market is particularly volatile or when there have been significant changes in your life. You may need to rebalance your portfolio to bring it back in line with your investment goals and risk tolerance. A financial professional can help you decide which investment options are right for you.

Don't count your chickens before they hatch

As the market recovers from a down cycle, elation quickly sets in. If the upswing lasts long enough, it's easy to believe that investing in the stock market is a sure thing. But, of course, it never is. As many investors have learned the hard way, becoming overly optimistic about investing during the good times can be as detrimental as worrying too much during the bad times. The right approach during all kinds of markets is to be realistic. Have a plan, stick with it, and strike a comfortable balance between risk and return.

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