Tag Archives: financial planning

The Oracle of Charlotte

It’s been eight years since the market hit bottom.  As Morgan Housel of The Motley Fool wrote, “If you went back to 2008 and predicted that over the following eight years the stock market would triple, unemployment would plunge to 1990s levels, oil prices would fall 80%, and inflation would stay tame even while interest rates stayed at all-time lows — I’m telling you, not a single person would have believed you.”

Ok, I didn’t say that exactly, but I got the part right that mattered most.  It was in December 2008.  I was onboarding a new client.  His portfolio was in cash equivalents.  I believed that while we were in the midst of a financial crisis, stocks were oversold compared to intrinsic value.  I told my new client that I believed he had a unique opportunity to triple his money in 5 to 8 years.  Few people are so fortunate as to find themselves with cash at the bottom of a market.

in April of 2009, he fired me.  My mistake was to buy equities in the last days of February, within a week of the absolute bottom.  In retrospect, my timing was nearly perfect, but he couldn’t handle it.  I called him a couple of years ago.  He told me firing me was the biggest mistake he ever made.  I’m guessing it hasn’t gotten any better for him.

Beware the Pundits

Not much has changed since my last blog post, and I don’t have any revelations to share. Trump is still talking about the same issues he mentioned in his campaign. Real change happens slowly. But the drift is real, and that has unleashed animal spirits in the markets.

The gains to date are not purely about valuation. Currently, 70% of companies have reported 4Q earnings, and 2/3 have beaten estimates, according to Forbes. Earnings are improving and the real question is how steep and how long the trend will run.

All things being equal, higher valuations increase risk. If price-to-earnings multiples expand faster than earnings growth, the risk of a correction increases. Without calling names, geopolitical risk seems to be an ongoing factor, so it seems a matter of time until a crisis scares the bejeepers out of the market and everyone scurries to cash.

A Buffet saying comes to mind, “Be fearful when others are greedy, and greedy when others are fearful.” I’m sensing an increase in the greed factor as investors hate missing a rally. This might be a good time to think about harvesting positions you wouldn’t buy at today’s prices, and be very picky about your reinvestment options. Dry powder can go a long way in a correction.

Longer-term, the table is set for sustained and perhaps accelerating, earnings growth. In the 90’s, everyone thought the market would average 12% forever. Now the pundits agree 8% seems ambitious. When have the pundits ever gotten it right?

Finally, recognize that volatility is the price we pay for equity returns. Plan accordingly and stay the course.

On Raising the Fed Funds Rate

When you’re drinking beer, the goal can be to drink more.  That’s a problem for some people.  They do not recognize their disequilibrium.  Putting the glass down might not bring immediate gratification, but it is simply the right thing to do with any normal, long-term perspective.fredgraph Fed Funds Rate

The Fed needs to get off the sauce.  Current interest rates compromise reasonable capital allocation, and encourages uneconomic decisions.  The longer the distortion persists, the greater the risk.  Any investment decision that gets squeezed out because of a .25% interest rate increase, at current rates, was a bad idea anyway.  That represents net positive for the economy by discouraging inferior projects and speculation.

Interest rates are the cost of money.  It shouldn’t be virtually free.

Estate Tax Planning – A Legacy of Unintended Consequences

Estate taxes are likely remain in a state of flux for as long as Congress plays politics.  Combining this popular topic for procrastination (planning for death) and change, the result may be an accident waiting to happen.

A bit of housekeeping may be in order for those who took the good advice of their attorneys and financial advisors several years ago, and set up a Credit Shelter Trust, By-Pass Trust or AB Planning, as part of their estate planning to minimize estate taxes.  Changes in the law over the years have rendered much of that planning obsolete, and potentially dysfunctional.

Trusts can serve many purposes including creditor protection and control and management of assets after death.  From an estate tax perspective, however, many trusts were setup solely to receive and hold assets from the 1st spouse (of a married couple) at his or her death, preserving his or her estate tax exemption which would have been lost if all assets passed directly to the surviving spouse.  Assets in this Credit Shelter Trust could grow free of estate tax for the benefit of the surviving spouse and the couple’s children.

Legislation passed on January 2, 2013 renders this type of estate plan obsolete for a majority of married couples. Just ten years ago, an individual could transfer only $1,500,000 to a non-spouse beneficiary.

Under current law, that amount increased to $5.43 million and a surviving spouse can “port” the 1st-to-die’s estate tax exemption taxes by making an election on an estate tax return. Portability of the federal estate tax exemption means that a surviving spouse gets to use what their deceased spouse did not use as well as their own estate tax exemption. In other words, a married couple may now pass up to $10.86 million without having to pay estate taxes.

For the married couples who have not reviewed their estate plans since the passage of this new legislation, a Credit Shelter Trust may no longer be necessary and probably presents complexities and potentially avoidable capital gains taxes. For example, a common problem for the Credit Shelter Trust approach was the need to divide assets between spouses so that individually owned assets could fund the trusts. There is no need to separate assets to fund AB Trusts with the advent of portability.

Perhaps the most onerous unintended consequence of ignoring your old Credit Shelter Trust is the potential for unnecessary capital gains tax.  Consider that a person’s assets receive a step-up in basis at death.  However, assets that fund a Credit Shelter or By-Pass trust at a 1st spouse’s death will not be stepped up again at the 2nd spouse’s death, subjecting any appreciation of such assets to capital gains taxes when sold by the children after the surviving spouse’s death.

To illustrate, assume a couple’s estate is worth $2,000,000, with $1 million in each spouse’s name.  The husband dies.  His will says that his Credit Shelter Trust will be funded up to the “applicable exclusion amount,” so all of his assets go into trust for the benefit of his surviving spouse and children.  If his wife lives another 10 years, the trust assets could reasonably double.  Upon her death the trust’s assets will be paid to their children, but without the step-up in basis on the $1 million of gain.  The children will pay about $200,000 in capital gains taxes that could have been avoided if their parents had eliminated the Credit Shelter Trust planning.

If the objective of your Credit Shelter Trust planning is to minimize estate taxes, it might be a good idea to review your plans. Relying on portability rather than a Credit Shelter Trust requires careful analysis and thought (and there are pitfalls for the unknowing!), but an estate plan providing for distribution of all assets outright to the surviving spouse combined with the portability provision in the American Tax Relief Act of 2012, might accomplish the same estate tax relief without creating capital gains taxes unintentionally.

Many thanks to John W. Forneris, an estate planning attorney at Robinson Bradshaw & Hinson for reviewing this essay.

1 About Money.com, Exemption from Federal Estate Taxes: 1997-2015, Table Showing Federal Estate Tax Exemption and Rate: 1997 – 2015, http://wills.about.com/od/understandingestatetaxes/a/estatetaxchart.htm

2 Nothing in this essay should be construed as tax or legal advice.  This information is intended to highlight a potential issue with estate plans established in prior years. Consult your attorney, tax, or financial advisor to discuss your circumstances in the context of these developments. 

Social Security: Take or Defer?

I crunched the numbers on the question of deferring Social Security for a year to increase the payment by 8%, for each year it is deferred to age 70.  Most advice seems to favor deferral, unless health is an issue.

My numbers do not necessarily support that conclusion.  While the 8% increase can be viewed as a compelling guaranteed return, it also comes with a long payback.  The breakeven of deferring, if the safe investment rate is 3%, is about 17 years.  This may be the best case for waiting.

On the other hand, recipients with other sources of income might be able to invest their social security payments at a rate competitive with the 8% Social Security escalator.  In this case, there is little benefit for deferring.

In summary, if the first year’s SS payment is invested and earns 8%, then it is equal to the first payment if deferral is elected.  This process repeats for all payments, so the payment streams are equal.  When we consider a safe money reinvestment rate, there is a small benefit to deferral, but the payback period is long.  The decision is not as clear as I’d assumed.

My spreadsheet (in PDF format, so no formulas) is here, https://www.daltonfin.com/wp-content/uploads/2015/06/Take-or-Defer-Spreadsheet-Analysis.pdf.

Observations on Variable Annuities

A 64-year-old woman asked her financial advisor, “Why is the annuity a good idea?”  He replied that it gives her what she wants, a guaranteed income.  That is the key.  His approach solves problems by giving people what they want.  Wants are emotionally based.  Needs are comparatively fact-based.

Rather than pander to emotional desires, I try to convince clients to do what I would do if I were in their situation.  A fiduciary does not begin with the emotional component as the objective.

As interest rates increase over the next few years, it will be easier to generate income from a diversified portfolio.  While interest income will be taxed as ordinary income, capital gains and qualified dividends are currently taxed at lower rates.  Lower expenses, the step-up in basis for non-qualified (not in a retirement plan) assets, and access to a much wider investment universe are benefits of regular investing versus an annuity.

She is concerned about negative media. She believes everyone is expecting a market correction.  I responded that if most people are bearish, then that would be baked into prices already, reducing the risk of a correction.  Negative sentiment is healthy.  Exuberance is dangerous.  Markets are counter-intuitive, which explains why emotional investing is a bad idea.A Balanced Fund vs S&P 500

As reference, the above chart illustrates a popular, low-cost balanced fund (the blue, top line).  The 2000 – 2002 correction barely registers as a dip with the balanced fund.  The blue line shows that a 3 to 5-year reserve fund would have been sufficient to avoid selling at a loss during the 2008-2009 crisis.  The fund’s performance suggests that concerns referencing the last 2 major bear markets are more about the unknown than they are grounded in fact.  This is not unlike children being afraid of the monster under the bed.

The orange line below the blue line represents the S&P 500.  Investing in only the S&P 500 is not a good idea, but that seems to be the straw man argument many insurance companies use to sell annuities.

Finally, consider the commission.  How much is it and where does it come from?  This is not alchemy.

Past performance is not a guarantee of future results. Investing involves the risk of principal.  The chart illustrates the performance of a popular balanced fund from January, 1999 to April 27, 2015.  The fund may hold up to a 75% equity allocation.  The chart is intended to illustrate the performance of a diversified portfolio relative to the S&P 500 during the 2000 – 2002 and 2008 – 2009 bear markets.  Diversification does not guarantee against loss.  The balanced fund is the Dodge and Cox Balanced Fund, and the data is from Morningstar.

Rearview Mirror

In December, 2008, a client transferred his account to my practice.  He was in cash.  I advised that he had a special opportunity to, in all likelihood, double his account in about 5 years by buying cheap stocks during a market panic.  I couldn’t convince him.  He was nervous.  Just when I thought I’d saved him from himself, he ordered me to sell everything I’d implemented, on March 6, 2009.  Perfectly bad timing.  C’est la vie.

Since the U.S. stock market hit bottom on March 9, 2009, the S&P 500 Index had risen 248% as of the first quarter of this year. In little more than six years, the present bull market achieved third-place rank among the top 10 bull markets.

Bull Market Chart

 

Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, since you cannot invest directly in an index.

How to Prepare for the Next Crash

First let’s define “Crash”.  To most, the term implies a decline of severe magnitude. A key question is the duration of the impairment, or how long might it take to recover?  Another consideration is stock market valuation.

By my observation, there hasn’t been a stock market crash in the US in the last hundred years that began with stocks at historically reasonable valuations that persisted more than 5 years.  The risk of a crash depends on valuation.  The average PE ratio in 1929 was about 60 times earnings. Fifteen or sixteen is widely considered average, and implies a 6.25% to 6.67% earnings yield.  That’s reasonable.  Today, the PE for the S&P 500 is was 18.94 on 9/26/2014 according to the Wall Street Journal, and that’s a little above normal.  It implies expectations that the economy and growth will continue to accelerate from the anemic post mortgage crisis recovery.

So how do you prepare, just in case?  The conventional approach to hedging the stock market is to incorporate bonds to a portfolio.  You own bonds for either of two reasons; either you need income, or you want to reduce the volatility of a portfolio.  Currently the ability of bonds to generate income is diminished by Fed policy.  While bonds may still provide some stability in the event of a crash, it is widely recognized that interest rates are likely to rise and that will reduce the value of outstanding bonds with fixed coupons.  Choose your poison.

An alternative strategy is to focus on the likely duration of a downturn in the stock market, and plan for expected liquidity needs for that amount of time.  A key benefit of financial planning is that it identifies liquidity needs.  During a period of low interest rates, one can substitute a reserve strategy, often called the Bucket Approach, to provide for anticipated liquidity needs for as long as a crash/correction might be likely to persist.  This frees the remainder of the portfolio for management with a longer time horizon, and with focus of fundamental metrics like valuation and macroeconomic factors.

The Benefits of Rebalancing

If stocks historically have higher returns than bonds, then selling stocks to buy bonds reduces portfolio returns over the long-term.  Conversely, for those with the fortitude to sell bonds and buy stocks when there’s blood in the streets, the process reverses.  The effect is more likely reduced volatility than increased returns.

I’d rather build a portfolio by planning for liquidity needs rather than putting the client’s emotional IQ in control of his asset mix by managing to control volatility.  Warren Buffett doesn’t rebalance.  I prefer to manage risk in the context of valuation.  That, I can control.

A Better Financial Planning and Investment Process

When you meet with a financial planner, you might expect to answer a series of questions designed to measure your risk tolerance.  If you are a moderate risk investor, you’ll get a portfolio constructed to accept moderate volatility.  If you are conservative, you’ll get a safe portfolio with limited growth potential.  In other words, your emotional state dictates your investment strategy.

Emotional investing does not often lead to good outcomes.  As an investor, I believe emotions can be your worst enemy.  Evolution wired us as herd creatures based on the safety of numbers.  Straying from the herd is dangerous.  We seek affirmation, which leads to the tendency to buy high and sell low.  According to research from Morningstar Inc., investors routinely underperform the funds they invest in. It is hard to make money doing what everyone else is doing, but we like to buy things after they’ve already demonstrated good performance.

Investing based on an assessment of emotional condition puts disposition at the forefront of investing strategy.  This seems to be the way the financial planning profession approaches investment advice.

I believe that the most important aspect of financial planning is identification of goals and the liquidity required to fund those goals at the right time.  Rather than build the portfolio around an emotionally based risk number, I suggest starting with a rational assessment of liquidity needs.  The greatest risk is having to sell a security when the price is temporarily depressed, converting a temporary loss into a permanent loss.  Let’s address that risk by planning for liquidity events.  The remaining balance can be invested to maximize returns rather than pander to your emotional state.

Emphasize fundamentals like Warren Buffett.  Make tactical adjustments based on fundamentals, and try to keep emotions out of the equation.