Tax Rate Reminder

May 9, 2013

From Wesley Gray at Turnkey Analyst comes a reminder about tax rates.  Tax rates are going up, and how your investment is taxed may be as important as how it performs.  Here’s his table of maximum rates for high-bracket investors:

TaxRates zpsf11c682c Tax Rate Reminder

Source: Turnkey Analyst      (click on image to enlarge)

Most advisors have a lot of clients in the highest tax bracket, so this is quite applicable.  It’s pretty clear that the most tax efficient way to get growth is through long-term capital gains, and the most efficient way to get an income stream is through tax-free bonds and qualified dividends.

Two things strike me about these tax rates.  1) I would rather not pay them, and 2) It makes sense to think about how to structure your investment accounts and investment strategies to be tax efficient.

Tax-deferred accounts like IRAs and 401ks are perhaps even more valuable now that rates have gone up.  It might make sense to stuff in as much as you can.  For taxable accounts, muni bonds are even more attractive than before.  And equity strategies that cut losses and let the winners run (like relative strength) are going to be helpful due to their tax efficiency.  It also occurs to me that ETFs, especially those with smart beta that aim for market-beating performance, could be very attractive because of their tax efficiency.  (I’m partial to PDP, PIZ, PIE, and DWAS, but the point is generally applicable.)

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Retirement Success

April 30, 2013

Financial Advisor had a recent article in which they discussed a retirement success study conducted by Putnam.  Quite logically, Putnam defined retirement success by being able to replace your income in retirement. They discovered three keys to retirement success:

  1. Working with a financial advisor
  2. Having access to an employer-sponsored retirement plan
  3. Being dedicated to personal savings

None of these things is particularly shocking, but taken together, they illustrate a pretty clear path to retirement success.

  • Investors who work with a financial advisor are on track to replace 80 percent of their income in retirement, Putnam says. Those who do not are on track to replace 56 percent.
  • Workers who are eligible for a workplace plan are on track to replace 73 percent of their income while those without access replace only 41 percent.
  • The ability to replace income in retirement is not tied to income level but rather to savings level, Putnam says. Those families that save 10 percent or more of their income, no matter what the income level, are on track to replace 106 percent of their income in retirement, which underscores the importance of consistent savings, the study says.

I added the bold.  It’s encouraging that retirement success is tied to savings level, not income level.  Everyone has a chance to succeed in retirement if they are willing to save and invest wisely.  It’s not just an opportunity restricted to top earners.  Although having a retirement plan at work is very convenient, you can still save on your own.

It’s also interesting to me how much working with a financial advisor can increase the ability to replace income in retirement.  Maybe advisors are helping clients invest more wisely, or maybe they are just nagging them to save more.  Whatever the combination of factors, it’s clearly making a big difference.  Given that the average income replacement level found in the study was 61%, working with an advisor moved clients from below average (56%) to well above average (80%) success.

This study, like pretty much every other study of retirement success, also shows that nothing trumps savings.  After all, no amount of clever investment management can help you if you have no capital to work with.  For investors, Savings is Job One.

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Investors’ #1 Problem: Not Saving Enough

April 12, 2013

The Wall Street Journal had a small piece on Americans’ retirement readiness.  In general, they’re not saving enough.  Here’s an excerpt:

A separate study released today by investment firm Edward Jones finds that 79% of 1,008 U.S. adults surveyed in February said that they have committed a money mistake – and of those, 26% reported not having saved enough for retirement as their No. 1 problem. Also on the list: not paying attention to spending and making bad investments.

The EBRI research found that Americans are coming to grips with the dramatic improvements they need to make in their saving habits, with 20% of workers saying they need to save between 20 and 29% of their income to achieve a financially secure retirement, and 23% saying they need to save 30% – or more.

I added the bold.  If you are a financial advisor, it’s really worth reading the entire EBRI research brief.  It is absolutely eye-opening.  You will discover that only 23% of workers ever obtained investment advice in the first place.

And, when they got advice, they ignored a lot of it!  Here’s the graphic from EBRI on follow-through:

advice zps59e7514a Investors #1 Problem: Not Saving Enough

Only 27% fully implemented the advice.  That makes about 6% of investors that got advice and followed it!  (Elsewhere in the report, you will discover that a minority of investors have even tried to figure out what they might need in the way of retirement savings.)  It seems obvious that you would have a large chance of falling short if you didn’t even have a goal.

As advisors, we often forget—as frustrated as we sometimes are with clients—that we are dealing with the cream of the crop.  We work with investors who 1) have sought out professional advice and 2) follow all or most of it.  We get cranky at anything less than 100% implementation, but many investors are doing less than that—if they bother to get advice at all.

So lighten up.  Keep nudging your clients to save more, because you know it is their #1 problem.  They might think you obnoxious, but they will thank you later.  Help them construct a reasonable portfolio.  And encourage them to get their friends and colleagues into some kind of planning and investment process.  Their odds of success will be better if they get some help.

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Underfunded Pension Plans

February 4, 2013

Many large corporations still carrying defined benefit plans for their workers have underfunded pension plans.  For example, here’s an excerpt from a Wall Street Journal article on the issue today:

“It is one of the top issues that companies are dealing with now,” said Michael Moran, pension strategist at investment adviser Goldman Sachs Asset Management.

The drain on corporate cash is a side effect of the U.S. monetary policy aimed at encouraging borrowing to stimulate the economy. Companies are required to calculate the present value of the future pension liabilities by using a so-called discount rate, based on corporate bond yields. As those rates fall, the liabilities rise.

If you think that underfunded pension plans are only a corporate or government problem, you would be wrong.  Chances are that the underfunded pension plan is a personal problem, even if (or especially if) you have a defined contribution plan like a 401k.  In a corporate plan, the corporation is on the hook for the money.  If you have a 401k plan, you are on the hook for the money.  And, since there is a contribution cap on 401ks, it may well be that you need to set aside additional money outside your retirement plan to make sure you hit your goals.

Figuring out whether your retirement is funded or not depends on some assumptions—and those assumptions are a moving target.  The one thing you know for sure is how much you have saved for retirement right now.  You might also have a handle on your current level on contributions.  What you don’t know exactly is how many years it will be until you retire, although you can generate scenarios for different ages.  What you don’t know at all is what the return on your retirement savings will be in those intervening years—or what the inflation rate will be during that time.

As interest rates fall, pensions are required to assume that their investment returns will fall too.  That means they have to contribute much more to reach their funding goals.

Guess what?  That means you should assume that you, too, will see lower returns and will need to save more money for retirement.  When stock and bond yields are low, it’s realistic to assume that returns will be lower going forward.  Investors right now, unfortunately, are stuck with rates that are near 50-year lows.  It puts a big burden on investors to get cracking and save as much as they can while they are working.  A qualified advisor should be able to give you some sense of your funding level so that you can plan for retirement.


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Timeless Portfolio Lessons

February 1, 2013

The only thing new under the sun is the history you haven’t read yet.—-Mark Twain

Investors often have the conceit that they are living in a new era.  They often resort to new-fangled theories, without realizing that all of the old-fangled things are still around mainly because they’ve worked for a long time.  While circumstances often change, human nature doesn’t change much, or very quickly.  You can generally count on people to behave in similar ways every market cycle.  Most portfolio lessons are timeless.

As proof, I offer a compendium of quotations from an old New York Times article:

WHEN you check the performance of your fund portfolio after reading about the rally in stocks, you may feel as if there is  a great party going on and you weren’t invited. Perhaps a better way to look at it is that you were invited, but showed up at the wrong time or the wrong address.

It isn’t just you. Research, especially lately, shows that many investors don’t match market performance, often by a wide margin, because they are out of sync with downturns and rallies.

Christine Benz, director of personal finance at Morningstar, agrees. “It’s always hard to speak generally about what’s motivating investors,” she said, “but it’s emotions, basically,” resulting in “a pattern we see repeated over and over in market cycles.”

Those emotions are responsible not only for drawing investors in and out of the broad market at inopportune times, but also for poor allocations to its niches.

Where investors should be allocated, many professionals say, is in a broad range of assets. That will smooth overall returns and limit the likelihood of big  losses resulting from  an excessive concentration in a plunging market. It also limits the chances of panicking and selling at the bottom.

In investing, as in party-going, it’s often safer to  let someone else drive.

This is not ground-breaking stuff.  In fact, investors are probably bored to hear this sort of advice over and over—but it gets repeated because investors ignore the advice repeatedly!  This same article could be written today, or written 20 years from now.

You can increase your odds of becoming a successful investor by constructing a reasonable portfolio that is diversified by volatility, by asset class, and by complementary strategy.  Relative strength strategies, for example, complement value and low-volatility equity strategies very nicely because the excess returns tend to be uncorrelated.  Adding alternative asset classes like commodities or stodgy asset classes like bonds can often benefit a portfolio because they respond to different return drivers than stocks.

As always, the bottom line is not to get carried away with your emotions.  Although this is certainly easier said than done, a diversified portfolio and a competent advisor can help a lot.

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Are You the Millionaire Next Door?

January 31, 2013

Clients, in general, are bad about even trying to figure out what their retirement number is—that is, the pool of assets they will need to maintain their standard of living in retirement.  Even more difficult is figuring out if they are on track.  One simple method is mentioned in The Millionaire Next Door, by Thomas Stanley and William Danko.  From Yahoo! Finance:

Thomas Stanley and William Danko, authors of the bestselling book “The Millionaire Next Door,” suggest that you simply take your age and multiply it by your current annual income before taxes from all sources (except for inheritances, which are only paid once). Divide the total by 10, and the quotient is what your net worth should be at that point in your life.

So, for example, if you are making $80,000 per year and you are now 45 years old, this simple formula suggests that to stay on track your net worth should be about $360,000.  There are a lot of assumptions that go into this, obviously, and there are better and more accurate ways to figure out if you are on track (for example, we use a % funded spreadsheet), but it’s a start.  Given current return expectations, this simple formula might understate what you will require, but anything that will motivate clients to get moving in the right direction is a help.


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Seven (Obvious) Steps to a Sound Retirement

December 11, 2012

When I first read this retirement article by Robert Powell at Marketwatch, I thought the advice was useful, but obvious.  Subsequent experience has led me to believe that while it may be obvious to a financial professional, it’s not always obvious to clients.  Clients, it seems, have pretty fuzzy thinking about retirement.

Here’s a retirement step that to me is obvious—but a lot of clients haven’t done it, or haven’t thought about it in a very complex way.  From Mr. Powell’s article:

1. Quantify assets and net worth

The first order of business is taking a tally of all that you own — your financial and non-financial assets, including your home and a self-owned business, and all that you owe. Your home, given that it might be your largest asset, could play an especially important part in your retirement, according to Abkemeier.

And at minimum, you should evaluate the many ways you can create income from your home, such as selling and renting; selling and moving in with family; taking out a home-equity loan; renting out a room or rooms; taking a reverse mortgage; and paying off your mortgage.

Another point that sometimes gets lost in the fray is that assets have to be converted into income and income streams need to be converted into assets. “When we think of assets and income, we need to remember that assets can be converted to a monthly income and that retirement savings are important as a generator of monthly income or spending power,” according to SOA’s report. “Likewise, income streams like pensions have a value comparable to an asset.”

One reason retirement planning is so difficult, according to SOA, is that many people are not able to readily think about assets and income with equivalent values and how to make a translation between the two. Assets often seem like a lot of money, particularly when people forget that they will be using them to meet regular expenses.

Consider, for instance, the notion that $100,000 in retirement savings might translate into just $4,000 per year in retirement income.

I put in bold a section that I think is particularly important.  With some effort, clients can usually get a handle on what their expenses are.  If they have pension income or Social Security benefits, it’s pretty easy to match income and expenses.  But if they have a lump sum in their 401k, it’s very difficult for them to understand what that asset means in terms of income.

After all, if they are just looking for an additional $3,000 per month in supplemental income, their $400,000 401k balance looks very large in comparison.  They figure that it will last at least ten years even if they just draw the funds out of a money market, so 20 years or more should be no problem with some growth.  At least I can only assume that’s what the thought process must be like.

Sustainable income is an entirely different matter, as clients almost never factor inflation into the thought process—and they are usually horrified by the thought of slowly liquidating their hard-earned assets.  No, they want their principal to remain intact.  They are often shocked when they are informed that, under current conditions, some practitioners consider a 4% or 5% income stream an aggressive assumption.

And, of course, all of this assumes that they have tallied up their retirement assets and net worth in the first place.  Lots of retirement “planning,” it turns out, works on the “I have a pretty good 401k, so I think I’ll be all right” principle.  I have a couple of thoughts about this whole problem.  What is now obvious to me is that clients need a lot of help understanding what a lump sum means in terms of sustainable income.  I’m sure that different advisors work with different assumptions, but they are still often not the assumptions your client is making.

Some practical steps for advisors occur to me.

  1. Encourage clients to track their assets and net worth, maybe quarterly, either on paper or on a spreadsheet.  At least they will know where they stand.  A surprising number of clients nowadays are carrying significant debt into retirement—and they don’t consider how that affects their net worth.
  2. Talk to them about what you consider reasonable assumptions for sustainable income.  Maybe you’re still using the good old 4% rule, or perhaps you’ve moved on to more sophisticated methods.  Whatever they are, start the conversation long before retirement so the client has a chance to build sufficient savings.

Sound retirement isn’t obvious, and planning for it isn’t simple or easy.

Note:  The rest of the article is equally worthwhile.

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Why We Need Financial Advisers

November 13, 2012

NPR’s Tess Vigeland on why financial advisers are needed now more than ever:

The system today demands so many more financial choices from all of us. We have to manage our own retirement accounts. We have to save enormous sums for college. We pay a far bigger chunk of our health care bills. We’re really on our own — and we’re terrified we’re not going to have enough. So we take risks with our money that we probably shouldn’t.

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CNBC: Public Enemy #1?

November 1, 2012

A recent article at AdvisorOne suggests that CNBC is detrimental to the well-being of your clients.  In truth, it didn’t really single out CNBC.  It was applicable to any steady diet of financial news.  Here’s what the article had to say about financial news and client stress:

Clients get stressed by things you wouldn’t predict. This is a classic example, uncovered at the Kansas State University (KSU) Financial Planning Research Center by Dr. Sonya Britt of KSU and Dr. John Grable, now at the University of Georgia, in their recent paper “Financial News and Client Stress.” They found that contrary to what you might think, client stress goes up when watching financial news, and hearing that the market went up causes stress levels to rise even higher. “Specifically, 67% of people watching four minutes of CNBC, Bloomberg, Fox Business News and CNN showed increased stress, while 75% of those who watched a positive-only news video exhibited an increase in stress,” they wrote.

Why? “Financial news was found to increase stress levels, particularly among men,” wrote Grable and Britt. Surprisingly, positive financial news, like reports of bullishness in the stock market, created the highest levels of stress, they found, suggesting that positive financial news may trigger regret among some people. The authors referred to previous studies of regret that found “people tend to feel most remorseful when they look back at a situation and realize that they failed to take action.” The authors’ conclusion: Financial advisors should think twice about having office TVs tuned to financial channels.

Surprising, isn’t it, to find out that clients were stressed even when the market was going up?  The ups and downs of the market appear to elicit client’s concerns about their financial decisions.  Anything that undermines their confidence is probably not a positive.  In fact, one of the important things advisors can do is help clients manage their investment behavior.  Financial news appears to work at cross-purposes to that.  (Other things do too; the full article has a host of useful thoughts on what stresses clients and how to reduce client stress.)

The relationship between high levels of stress and poor decision-making is well-known to psychologists, researchers and sports fans around the world. “Our brains operate on different levels, depending on circumstances,” Britt told me in an interview. “Under high levels of stress, our intellectual decision-making functions shut down, and our emotional flight or fight response kicks in.” Added Grable: “People will adapt to low levels of stress differently, but overwhelming stress results in predictable behavior. When we are stressed, our brains cannot move to make intellectual decisions.”

If we want to help our clients stay calm and stick with their plan, maybe we should ask about their family, their pets, and their hobbies in a relaxed setting rather than inundating them with market data.

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Net Wealth Shock and Portfolio Diversification

October 19, 2012

Professor Amir Sufi (University of Chicago Booth School of Business) is an interesting researcher.  He recently tweeted a picture of what he called “net wealth shock” to show how the recession had affected various families.  It’s reproduced below, but in effect, it shows that low and median net worth families have had a large negative impact from the recession while high net worth families have been impacted much less.  I think portfolio diversification has everything to do with it.

netwealthshock Net Wealth Shock and Portfolio Diversification

The Effect of Buying One Stock on Margin

Source: Amir Sufi    (click on image to enlarge)

For clues to why this happened, consider an earlier paper that Dr. Sufi co-wrote on household balance sheets.  I’ve linked to the entire paper here (you should read it for insight into very clever experimental design), but here’s the front end of the abstract:

The large accumulation of household debt prior to the recession in combination with the decline in house prices has been the primary explanation for the onset, severity, and length of the subsequent consumption collapse.

Later in the paper, he reiterates that it is the combination of these two things that is deadly.

The household balance sheet shock in high leverage counties came from two sources: high ex ante debt levels and a large decline in house prices. One natural question to ask is: could the decline in house prices alone explain the collapse in consumption in these areas?

Our answer to this question is a definitive no–it was the combination of house price declines and high debt levels that drove the consumption decline.

And he and his co-authors, through clever data analysis, proceed to explain why they believe that to be the case.

Now consider what this is saying from a portfolio management point of view: why was the impact of falling home prices so devastating to low and median net worth households?

The negative impact came primarily from lack of diversification.  Low and median net worth households had essentially one stock on margin.  I know people don’t think they are buying their house on margin, but the net effect of a home loan—magnifying gains and losses—is the same.  When that stock (their house) went south, their net worth went right along with it.

High net worth households were simply better diversified.  It’s not that their houses didn’t decline in value also; it’s just that their house was not their only asset.  In addition, they were less leveraged.

There are probably a couple of things to take away from this.

  • Diversify broadly.  It’s no fun to have everything in one asset when things go wrong, whether it’s your house or Enron stock in your pension plan.
  • Debt kills.  Having a single asset that nosedives is bad, but having it on margin is disastrous.  There’s no room for error with leverage—and no way to wait things out.

Perhaps high net worth families are more diversified simply because they have greater wealth.  Maybe they took the same path as everyone else and just got lucky not to have a recession in the middle of their journey.  However, I think it’s also worth contemplating the converse: maybe those families achieved greater wealth because they diversified more broadly and opted to use less leverage.

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Affluent Investors Settle Down

October 17, 2012

According to a Merrill Lynch survey of affluent investors, they are beginning to adapt to the current economic and market situation as the new normal, as opposed to looking at it as a temporary period of high volatility.  Perhaps because they’ve now made that psychological leap, affluent investors are beginning to feel that their situation is more stable.  From a Penta article:

To prepare for a more volatile environment, this affluent group also is making efforts to control what they can by spending less, paying down debt, and generally “putting their lives in check,” Durkin said. Of the families surveyed, 50% said they’ve taken steps to gain greater control of their finances, like sticking to a budget (32%), making more joint investment decisions with a spouse (29%), and setting tangible goals (28%). One third of respondents said they’re living “more within their means.”

In other words, the affluent are adapting by toggling back their lifestyle and saving more.

Making that psychological shift is critical because it allows a lot of good things to happen.  It’s also perhaps a realization that although you can’t control the markets, there is a lot you can control that will impact your eventual net worth—namely, living beneath your means and saving more.  Being affluent, in and of itself, won’t build net worth.

Once a client has good habits in place, compounding kicks in and net worth tends to grow more rapidly than clients expect.  Clients are usually delighted with this discovery!

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