Moment on Money

Letter to Clients: 2nd Quarter 2013

Dear Clients & Friends:
Would you prefer to receive this via email? As of this month you can now opt to receive an email instead of a paper letter. If you want to activate the email option just let me know. Otherwise, you will continue to receive the paper version. First Quarter Review At the end of March, U.S. stock markets crossed the all-time high reached in October of 2007. This was due to an exceptionally strong performance to start the year following the agreement by U.S. Congress in early January to avoid the fiscal cliff, which would have required dramatic reductions in spending and risked throwing the U.S. back into recession. Two things worth noting about first-quarter performance: Driven by a strong start in January, the U.S. market was up by over 10% in the first quarter, leading strong gains by equities globally. One word of caution: last year the U.S. market was up by 13% in the first three months before giving back almost all of those gains in the second quarter, in large measure due to concerns about Europe. I don't foresee a repeat of that kind of second quarter performance but optimism must be tempered. On the topic of Europe, in spite of recent headlines about the bank crisis in Cyprus and continuing issues in Greece, the European market was up by 7% (in local currency) in the first three months of 2013. While Cyprus and Greece got the headlines, the bulk of Europe's economic performance will continue to be driven by the larger and stronger countries. Here's how first-quarter performance looked: Monthly and Q1 Market Performance Across the Globe*   U.S. Europe Emerging markets World markets January 2013 5.3% 5.1% 1.0% 4.9% February 2013 1.3% 0.9% 0.0% 1.2% March 2013 3.8% 0.9% -0.8% 2.3% Q1 2013 10.7% 7.1% -0.2% 8.6% Returns to month end, all in local currency, including dividends. Warren Buffett's view: Stocks still offer value Warren Buffett is generally considered the greatest investor of all time. From 1966, when he began running Berkshire Hathaway, to the end of 2012, the overall U.S. stock market (including dividends) has returned an average of 9.4% annually. That means that $1,000 invested in the U.S. market in 1966 was worth just over $74,000 at the end of 2012. During that same time, the book value of Berkshire Hathaway increased by almost 20% per year, twice the U.S. market return. The result: that same $1,000 invested in Berkshire Hathaway's book value would have grown to over $5 million. That's why Warren Buffett's views are worth heeding. And that's also why his annual letter to investors is awaited each year with such anticipation. There were three key messages in this year's letter: 1. Invest in "wonderful" businesses Buffett is known for saying that he'd rather buy "a wonderful business at a fair price than a fair business at a wonderful price." He's written in depth about the competitive insulation that makes for a great business. (In another well-known turn of phrase, he's said that he wants to buy businesses "so wonderful that an idiot could run them, because some day an idiot will.") In this year's letter Buffett touched on Berkshire Hathaway's investment in American Express (of which he owns just under 14%) as well as Coca-Cola, IBM, and Wells Fargo, his other three big holdings in which he owns between 6% and 9%. In all four cases, he increased his stake in 2012; he quotes the Mae West line that "too much of a good thing is wonderful." 2. Look past today's uncertainty Buffett addressed the uncertainty that preoccupies many members of the media and has dampened the willingness of American business to invest. He points out that uncertainty has been a constant in the United States since 1776; the only variable is whether people ignore the uncertainty (which typically happens in boom times) or fixate on it. Buffett continues to express the same confidence in America's resiliency as he did in his public letter titled "Buy American. I Am.", which appeared in the New York Times close to stock market bottoms during the uncertainty in the aftermath of the global financial crisis. 3. Stay in the game In this year's letter, Buffett addressed the temptation to, in his words, "try to dance in and out (of the stock market) based upon the turn of tarot cards, the prediction of so-called experts or the ebb and flow of business activity." He went on to say that since the long-term outcome of investing in stocks is so overwhelmingly favorable, "the risks of being out of the game are huge compared to the risks of being in it." In this interview that followed the release of his letter, Buffett reiterated his view that since at some point interest rates will inevitably rise, stocks of quality businesses continue to offer good value relative to bonds, even in the face of the run-up in equity prices since last summer. He also repeated his skepticism about owning bonds, saying that today "the dumbest investment is a government bond." What this means for your portfolio At the end of last year, I outlined some guiding principles to follow in 2013. While many things have changed, the appropriateness of that advice has not. I encourage you to continue to: 1. Take the right level of risk. If your portfolio makes your feel comfortable and secure, your portfolio is on target. If the daily market fluctuations and gyrations cause you angst, we need to discuss alternative methods of achieving your goals. 2. Adhere to your plan. Always remember that the headlines will never be "Nothing significant happened today". The role of the media to amplify the significance of everything. That may be what sells newspapers but it should not serve as guidance for your financial decisions. I am always willing to discuss recent events and their impact on your money, both in the long and short term, whenever you have concerns. 3. Diversify your portfolios. The U.S. represents less than half of investing opportunities around the world. In addition, the rapid economic growth in markets like China, India, and Brazil is creating opportunities. For those reasons, I continue to recommend geographic diversification of portfolios. 4. Focus on dividends and cash flow. Amid the uncertainty surrounding economic growth and equity returns, I continue to place priority on the cash yield from investments. While the headlines talked about U.S. markets hitting new highs in March, investors who reinvested their dividends saw their account values exceed the 2007 peak significantly earlier. We also continue to seek yield from non-traditional sources such as REIT's, master limited partnerships, and Business Development Companies. Just three months ago I wrote "In many ways it feels like the economy is ready to run… As evidence of a stronger economy presents during the first half of the year, we expect momentum to build in the second half of the year." Momentum is building. Value still exists in the marketplace. Short term predictions are extremely unreliable but I am optimistic for the remainder of 2013. I hope you found this overview helpful. Should you have questions about anything in this note or about any other issue, please feel free to give me or one of the members of my team a call. And as always, thank you for the opportunity to serve as your financial advisor. Sincerely, Art Dinkin, CFP®

Financial Fallout from Divorce

In America, there is a divorce every 13 seconds; approximately half of all marriages end in divorce. Given the high number of divorces, it is important to understand the financial implications of taking one financial unit, a married couple, and splitting them into two separate financial units, two individuals. Most people involved in a divorce seek professional council from a divorce attorney, but I would also suggest that prior to the divorce both spouses should also seek advice from an experienced financial professional knowledgeable in the nuances of the financial split. Working in tandem with the attorney, the financial planning professional can anticipate potential financial issues the attorney may not consider.

Splitting Assets is the first issue everyone considers and it first it seems easy to find a fair split based on current values. However, not all asset values are equivalent. For example, is this fair? What if one spouse receives a savings account with $100,000 while the other spouse receives a mature fixed non-qualified annuity with $100,000? On paper the values are equivalent, until you consider taxes. Withdrawing the $100,000 from the savings account has no tax implications. Interest received on the savings account is taxed every year as it is accumulated but annuities are tax deferred. When interest is paid in the annuity no taxes are due until the value is withdrawn. Let's say that in our example, the $100,000 annuity has grown from an initial deposit of $70,000. If the $100,000 is withdrawn the owner has to now pay taxes on the $30,000 of growth. If the owner is in the 25% tax bracket the annuity's net value is $100,000 minus 25% of $30,000 which is $92,500. So the two assets are not really equivalent.

Alimony and Child Support are typically the second financial considerations the divorcing spouses address. Experienced attorneys are well qualified to guide their clients in negotiating a fair agreement which fits the particular situation.

There are many Tax Issues to consider. Alimony paid is tax deductible by the person who writes the check and taxable to the recipient. Child support paid is generally not tax deductible to the payer or taxable to the recipient, however when child support is shared through custody, financially, or a combination of both an agreement has to be reached as to who gets to claim the child(ren) on their tax return. Our tax code provides no guidance on this other than a child may only be claimed by one parent and that the parent must provide support to the child. Common agreements include alternating years or, if multiple children are involved, splitting the children between parents for tax purposes. But this is just for the care and feeding of the kids, education is a different situation we will get to in a moment.

While we are on the topic of tax issues, one area I often see overlooked in the divorce agreement has to do with current year income. In a recent case, the married clients had a brokerage account with several investments in it. The divorce agreement directed that the account be split into two individual accounts, each to receive half of each investment. Again at first glance, everything seems fair and equal. But at the end of the year the joint account generated a 1099 for income received prior to the account being split. Since the former husband's social security number was listed first on the account, he was burdened with income tax from the 1099. Unfortunately the divorce agreement did not address this issue and he decided it wasn't worth the time, frustration, expense and potential ramifications to ask his ex-wife to pay her fair share after the fact.

Retirement Plans are typically divided using a Qualified Domestic Relations Order (QDRO) which directs retirement plan trustees to take retirement money from one spouse and transfer it to the other spouse without creating tax implications. With QDRO's, particular care needs to be taken in the exact wording agreed upon in the divorce agreement. I remember a particular case in 2000 where I was working with the ex-wife. Her ex-husband had approximately $200,000 in his 401(k) and their divorce agreement dictated that she was to receive $100,000 from his 401(k). You may recall that the markets were falling in from 2000 until mid-2002. She took her time and waited patiently to file the QDRO. Out of spite, she intentionally waited and let her former husband take the market risk until the markets began to show signs of improvement and only then did she request her $100,000 from his 401(k)! Suppose the original $200,000 was now worth only $150,000; she takes her $100,000 and he is left with $50,000. What was supposed to be a 50-50 split ended up as a 1/3 – 2/3 split. Of course, if the market was rising the reverse would have been true but I doubt she would have been as patient in that situation. I generally suggest that QDRO's be declared in percentages instead of dollar values to avoid such exploitations. Another often overlooked aspect of QDRO's are any fees or charges assessed when making the withdrawal from a retirement account. A typical example would be surrender charges from an IRA held in a variable annuity. Especially if the QDRO directs a specific dollar amount, the spouse surrendering the money may have to withdraw more than the amount transferred to cover those charges.

If there are any debts of the marriage, the divorce agreement typically details who will take responsibility for particular debts. But the divorce agreement is not binding to the lender. Suppose a couple has a joint credit card with a balance of $2000 and a credit limit of $10,000. The agreement may direct that one spouse has responsibility for that account but if the other spouse does not have their name removed from the account, the lender could seek repayment from them even for charges made after the divorce. Typically the innocent spouse is unaware of the issue until the lender tracks them down demanding payment or they find their credit scores damaged enough to deny them access to credit of their own.

Finally, let's revisit Education for the children. As with most other aspects of a divorce, there is no standard agreement. It is entirely negotiable between the two parents. One of the best starting points I have ever seen was a formula given to me by an attorney when he was representing the client in the divorce and they had engaged me to consult with them on the financial issues. Here is the formula:

A = the cost of attending the in-state public school to include tuition, fees, books, room and board

B = any scholarships and grants awarded to the student excluding student loan programs

C = A – B … the net cost of attending school after scholarships and grants are considered

D = ½ C … each parents financial responsibility

E = 1/3 A ... the maximum amount a parent can be ordered to pay pursuant to Iowa code

As long as the student attends an in-state public school each parent pays the lesser of D or E. If the student attends an out-of-state school or a private university, A then becomes the average cost of University of Iowa, Iowa State University, and University of Northern Iowa and each parent still pays the lesser of D or E.

The student's responsibility is any remaining costs not paid under this formula including transportation, entertainment, clothing, and supplies

The key to successfully dividing a marriage financially is an educated understanding of all the facts and implications. It is important to get financial advice in coordination with legal advice before a divorce settlement is reached.