Moment on Money

Letter to Clients – 2nd Quarter 2010

Dear Clients and Friends,

It is difficult to believe 2010 is already 25% (and by the time you receive this probably closer to a third) behind us. It was a record setting winter here in Iowa, and fortunately the markets have thawed along with the snow! The market's low point of the recent recession was March 9, 2009. Now that a full year has passed it is useful to look at the first quarter of 2010 in light of the market's progress in the last twelve months.

For the quarter, the major indices logged solid gains, with the S&P 500 up 5.4% and the Nasdaq Composite up 5.9%. The quarter continued to add to what was already one of the strongest cyclical bull markets in history, with the S&P 500 75% higher and the Nasdaq 84% higher than their lows of a year ago. Despite this run, however, the markets remain well off their secular highs achieved in the last decade, with the Nasdaq still 54% off its 2000 high.

There are many indications that the recovery, which began in the latter part of 2009, continues. According to the Financial Times, "economists are predicting the U.S. economy will see a surge of new jobs [in March], with some 300,000 positions being created after a loss of about 8.4 million jobs during the recession." The Federal Reserve statement that business spending on equipment and software had "risen significantly" and its reiteration that interest rates would be kept low for an "extended period" were also encouraging.

But there are several economic factors that may weigh on the recovery. Even with the modest job growth predicted for March, unemployment remains very high. Household spending continues to be constrained by flat income growth and tight credit, and this will likely affect retail sales as consumers remain cautious. Meanwhile the housing market still sits at record lows. Sales of new single-family homes in the U.S. declined a seasonally adjusted 11.2% in January, which represents the lowest sales pace since these records began in 1963.

There are also two larger trends, one historical and the other demographic, that may affect market returns going forward.

Cyclical Bull Market Trends. According to Ned Davis Research, the median gain of the S&P 500 in the first year of a cyclical bull market is 29% but the second year sees only 9% growth. Small cap and lower quality stocks, which tend to lead the broader market during periods of recovery, tend to give ground as recoveries mature into their second year. With the first year of the current cyclical bull market experiencing torrid gains, which is in line with this historical trend, many analysts are expecting to see this year's returns also follow the trend and come in below last year's while still remaining positive. Ned Davis Research believes there is still a good chance the markets could experience a drawn out correction in the second and third quarter, bringing the overall gain for the two years to be more in line with historical averages.

Inflows to Bond Funds. As mentioned in The Wall Street Journal, The Investment Company Institute reported that long-term mutual funds had net inflows for 52 weeks in a row as of March 18, a shift in assets totaling some $506.6 billion. Certainly some of this inflow represents money returning to the market in the wake of recent gains. But the bulk of investment in 2009 was in bonds, which accounted for $409 billion of the net inflows.

This reveals an interesting demographic trend that may also have implications for market growth in the coming months and years. As baby-boomers enter retirement, they tend to allocate a greater share of their portfolios to fixed-income securities. As the Journal goes on to report, another factor at work in this trend, "is a dip in risk tolerance. Investors, who have seen steep losses in two bear markets, have lost some of their appetite for risky investments. Additionally, the rising use of automatic asset allocation, which moves investments toward bonds as investors age, is driving inflows to bonds."

This suggests that older investors may be less likely to invest in equities even if the broader recovery proves strong. With so much money remaining on the sidelines, the massive inflows to equities that some predict may not materialize. Lower-than-expected inflows would likely have a dampening effect on equity prices. However, the broader inflow trend is definitely positive.

Predicting which of the above factors will most influence the market is difficult. The market may present opportunities, but it also contains risk. Investors may want to proceed with caution and diligence.

There is an old saying, "Good, fast, or cheap. Pick any two". We could almost rephrase it to the world of investing with, "Safe, liquid, or the potential for high returns. Pick any two." Managing investments in this environment requires balancing multiple objectives which are often in conflict with each other. Fortunately, there are new products and tools in the marketplace which have been developed specifically to address common concerns.

The first step in the process is to identify what your goals and concerns are and I am here to help you. Please contact me anytime you want to discuss your financial plans, dreams, and concerns. We can review what you have done so far and discuss any options you might want to consider.

As always, I thank you for the continued opportunity to work together.

¹ All returns sourced from Morningstar.com and Bloomberg Finance L.P.

² "Outlook for US economy upgraded," Financial Times, March 17, 2010

³ ibid

⁴ ibid

⁵ Chart of the Day, March 9, 2010, Ned Davis Research, Inc.

⁶ "Fund-Inflow Streak Makes It a Full Year," The Wall Street Journal, March 18, 2010

⁷ ibid

And the times, they are a-changing

I knew it would happen sooner or later.

I was at a social function and someone came up to me and asked why I had not been writing very much. I wish I had a good excuse, but I don't.

It is simply a fact that we are in a time of change and transition. The old perspectives can no longer just be assumed. Clients and planners alike must question everything and reassess their portfolios, goals, and risks. It is a time of uncertainty but also a time of great opportunity. As of the beginning of this year I have been in practice for over twenty years, and never before have I experienced such a strong demand for my time.

Last year, in Managing the Road to Retirement from the TransAmerica Center for Retirement Studies, survey respondents were asked how much money they believe they will need to have saved by retirement to feel secure. Here are the survey results:

Ages 20 - 29	$750,000
Ages 30 - 39	$1,000,000
Ages 40 - 49	$800,000
Ages 50 – 59	$500,000
Ages 60 +	$500,000

With the exception of the youngest group, it makes sense that younger respondents felt like they would need to have more money saved to feel secure in retirement. Over time, inflation demands retirees have more available savings to pay for the same retirement.

The real eye-opener for me was the follow up question where the same respondents were asked to admit if they had just guessed at that amount. The percentages who admitted to guessing were:

Ages 20 – 29	63%
Ages 30 – 39	50%
Ages 40 – 49	49%
Ages 50 – 59	45%
Ages 60 +	37%

Again, those closest to retirement seemed more certain of their responses but still… more than 1/3 of pre-retirees have no idea how much money they will need for a successful retirement. Add to that an uncertain stock market, talk of potential tax increases, and fears of inflation. Is it any wonder many people are seeking professional advice?

Monte Carlo Simulations are Not Perfect

Monte Carlo simulation is a complex statistical modeling method which can be useful in financial planning. The goal of Monte Carlo analysis is to apply statistical realities over multiple simulations and conclude how many of those iterations had a successful result. As I have said many times, financial planning is as much an art as is it a science. Unfortunately there are no absolutes or guarantees even with proper planning. Past performance is not an indicator of future results, so relying on historical averages can be misleading. Analysis is a tool, but only the proper use of the tool combined with skilled interpretation provides any value.

The May 2nd article, "Odds-On Imperfection: Monte Carlo Simulation" in the Wall Street Journal explores using Monte Carlo analysis as a planning tool. Specifically, it points out that a dramatic downturn in the market like the one we have been living for the past year or so, would generally be ignored in a Monte Carlo simulation since it is statistically unlikely to occur. The article argues that once-in-a-lifetime market events are occurring with greater frequency and therefore the best analysis tools should give catastrophic episodes greater importance.

One solution to the problem is to continue using Monte Carlo analysis with "fat-tailed" distributions. Ordinarily, extreme events occur on the outer edges of a bell shaped curve. The more extreme, the less likely it is to occur. A fat-tailed curve allows for a greater probability of an extreme downtown than an extreme period of growth. Another solution is to use a large number of simulations in a Monte Carlo analysis. The article suggests using 10,000 simulations or more.

Some critics think these limitations of Monte Carlo analysis prove that it is an invalid tool. I disagree. Monte Carlo analysis has never been perfect, and it never will be. As we grow in our experiences it is only natural that we discover limitations that we had previously not considered. The wisdom is in learning and adapting to make the tool better.

As for my clients, the Monte Carlo simulations I use already employ 10,000 iterations. According to the manufacturer of the software I use, they will be making "fat-tailed" distributions available in a few weeks. This has the potential to make the tool better, but still imperfect. No one can predict the future financial markets with certainty, but we can use the best tools available to plan for potential scenarios.

Roulette Wheel by John Wardell (Netinho)

Dissecting a Capital Transfer Plan

Every regulatory authority, designation grantor, and of course the State of Iowa have different continuing education requirements which I must comply with. Long ago, one of my early role models told me "if you are going to be a real professional in this field, you will constantly need to be taking continuing education courses. Forget about the minimums. Just go out there and learn." I have followed his wise advice ever since and absorb as much CE as I can fit into my schedule.

Recently I was at a CE program titled capital transfer planning. The presenter examined various methods of conservatively passing money from one generation to the next (ignoring the impact of estate taxes – that is another subject entirely). As an example, the presenter assumed a 65 year old male client with $100,000 of "idle assets" and an assumed 25% marginal tax rate. First, let's define an "idle asset" as money which is not planned for consumption during the client's lifetime. Many people have assets which they never intend to spend and leave to their heirs.

The course examined three options:

1. A CD @ 2% (interest from CD's is generally taxable)
2. A Fixed Annuity @ 4% (annuities offer tax deferral on interest)
3. A modified endowment contract (MEC). Modified endowments are life insurance policies which are heavily funded early on. Since this comparison assumes a single premium of $100,000 and no additional premiums, this life insurance policy would definitely be a modified endowment. Having a modified endowment has no impact on the death benefit but does have implications on withdrawing any cash value while the insured is still alive.

We were provided a worksheet which shows what the heirs would receive, net after tax, from each option in 5, 10, 15, and 20 years. For simplicity, the presenter called this amount the death benefit and it is labeled DB on the chart. The Yield is the average annualized return. For example, since the CD provides the heirs with $110,408 (after tax in 5 years) the chart indicates that would have been equivalent to earning 2.08% each year on the money. The formula for this calculation is to take the average gain per year divided by the initial deposit; (($110,408 - $100,000)/5)/$100,000.

DB = Death Benefit AY = Annualized Yield	Taxable CD @ 2.0%	Tax Deferred Fixed Annuity @ 4%	Modified Endowment Life Insurance Policy
After 5 Years	DB: $110,408 AY: 2.08%	DB: $112,999 AY: 2.6%	DB: $396,244 AY: 59.2%
After 10 Years	DB: $121,899 AY: 2.19%	DB: $128,814 AY: 2.88%	DB: $396,244 AY: 29.6%
After 15 Years	DB: $134,587 AY: 2.3%	DB: $148,056 AY: 3.2%	DB: $396,244 AY: 19.74%
After 20 Years	DB: $148,595 AY: 2.43%	DB: $171,467 AY: 3.57%	DB: $396,244 AY: 14.81%

The conclusion is obvious – even though the yields of the CD and the annuity are rising and the yield of the MEC is falling, this person cannot live long enough for the modified endowment to be surpassed by either the CD or the fixed annuity. The case for a MEC is further supported because the yield on the MEC is known in advance while the interest rates on the CD and fixed annuity will fluctuate with economic conditions. But does that mean a modified endowment life insurance policy is the best option for all idle assets?

The presenter of the CE program obviously thinks so, but I think there are two key factors which must be considered. First, is the person insurable? If the person has health issues the effectiveness of life insurance may be reduced (or not even available). Probably more important is determining the certainty that this asset will never be touched.

Aldous Huxley said "Hell isn't merely paved with good intentions; it's walled and roofed with them. Yes, and furnished too." While a capital transfer plan employing a MEC can be attractive, one has to consider the certainty that they will never need liquidity from those funds again. With surrender charges applicable to most life insurance contracts, chances are the CD or even the fixed annuity would win if we compared accessing the cash values across the same timeframe. With this in mind, I would only support this type of capital transfer plan if there were other sources of liquidity and the client had adequate protection in place for unforeseen financial stresses such as the need for long term care.

Definition of Marginal and Effective Tax Rates

In January someone told me that most people have broken their New Year's resolutions by the end of February. Armed with that trivia and the knowledge that my resolution to post to this blog once a week wasn't broken until April provides no solace. I "owe" you guys a couple of posts and will be posting some extra ones soon.

Everyone knows tax day was yesterday, April 15^th, so it seems appropriate that we discuss an often misunderstood element of taxes and financial planning – tax brackets.

Our tax system is a progressive tax. That means that you pay an increasing percentage of your income as taxes as your income increases. But moving up to a new tax bracket only affects the additional dollars you have earned. It does not increase your tax liability on all your income¹. For example, let's study the 2008 Married Filing Jointly tax brackets.

Taxable Income Over…	But Less Than…	The Tax Is…	Of the Amount Over…
$0	$16,500	$0 + 10%	$0
$16,050	$65,100	$1,605 + 15%	$16,050
$65,100	$131,450	$8,962.50 + 25%	$65,100
$131,450	$200,300	$25,550 + 33%	$131,450
$200,300	$357,700	$44,828 + 33%	$200,300
$357,700	And Over	$96,770 + 35%	$357,700

So how do you read this chart?

Start with your taxable income or the amount of income you are actually taxed on after taking all your legal deductions and exemptions. Chances are you earn much more than your taxable income. For example, let us examine a married couple. He is self employed and has gross earnings of $105,604 and his wife is a W-2 employee with gross earnings (after pre-tax deductions like 401(k) and health insurance) of $49,228. Their banker saw $154,832 flow through their checking account but after business expenses and self employed retirement savings they are able to reduce their adjusted gross income (AGI) down to $112,705. Their taxable income is even lower at $70,241 which is found by starting with their AGI and subtracting itemized deductions and personal exemption amounts.

Now we can look at the chart. The taxable income is over $65,100 and less than $131,450 so we use the third line. The total tax due is $10,247.75 which and this it is calculated $8,962.50 + 25% of ($70,241 - $65,100). In other words, they are pay 25% only on the amount over $65,100.

What tax bracket is this couple in? The third line down is the 25% bracket, but they paid nothing close to $38,708 which is 25% of $154,832 which is why we must distinguish between marginal and effective tax rates.

Marginal tax rate is the amount of tax you would pay on the next dollar you earn. For this couple that is 25%.

Effective tax rate is the percentage of taxable income actually paid in taxes. This couple has an effective tax rate of 14.6%.

In financial planning, we most often use marginal tax rates. Financial planners think "if my client had an opportunity to increase their income by $1000, they would owe $250 in additional taxes and would net $750", but when you file your tax return, effective tax rates are the most accurate measurement of your tax liability.

AIC does not give legal or tax advice. For specific information applying a strategy consult your attorney or tax professional.

¹ An increase in adjusted gross income can increase your tax liability by disqualifying various deductions and credits.

CFP® Board Ethical Standards and Disciplinary Procedures

The CFP^® Board of Standards released a 12 minute video today about the ethical standards required of Certified Financial Planner™ practitioners. It also covers a CFP^® designee's fiduciary responsibility and explains the CFP® Board of Standard's disciplinary procedures used to enforce their standards.

I will grant you that this is not the most exciting video you will probably see this year, but I think it goes a long way to explain why a Certified Financial Planner™ professional is diligent in representing the best interests of their clients.

The Key to Tomorrow

I recently had the opportunity to listen to a presentation by Dr. Paul Stoltz, author of the book The Adversity Advantage, about a concept he calls the Adversity Quotient or AQ. In a nut shell, AQ is a measurement of how well someone deals with adversity and he believes that resilience is the single most important indicator of success. Given the adversity which faces us each and every day in today's economy, everyone gave Dr. Stoltz their full attention.

The message is as significant as it is simple. Everything is a matter of cause (situation) and effect (response). We cannot control the situation, but our resilience can help shape our response. As it specifically relates to the financial crisis Dr. Stoltz said "We cannot turn the dial on the world economy, but there are a number of things we can do." It was a defining moment. He is right. The economy is a fact. The market has suffered losses. History is beyond our control. Now, What are you going to do next?

If you are hoping to find a one-size-fits-all solution or a quick fix, let me know when you find it. I do not have an easy answer. But I can recommend that this is an excellent to time to reassess and look at your financial position from a distance. Are you still in line to meet your financial goals? If not, what needs to change? Maybe the goal is no longer realistic or maybe it is.

Most of my time these days has been devoted to helping clients assess their retirement plans and discussing the alternatives. Sometimes they decide to change their plans by postponing retirement. Other times they are willing to allocate more resources towards meeting the original goal. And others have decided to redefine their retirement. Everyone has reconsidered their exposure to risk. No decision is right and no decision is wrong. The biggest potential mistake is choosing to ignore the situation and do nothing.

I am incredibly excited about the future. I always remember the words of Peter Lynch (paraphrased) "I have no idea which direction the next 1000, 2000 or 4000 points in the market will be, but I am confident that the next 10,000, 20,000 and 40,000 points will be up." I do not think market recovery is the question. The question is when.

I leave you today with The Portable Pep Talk by James J. Metcalfe:

I get discouraged now and then when there are clouds of gray,

Until I think about the things that happened yesterday.

I do not mean the day before, or those from months ago.

But all the yesterdays in which I had a chance to grow.

I think of opportunities that I allowed to fall aside

And those I took advantage of before they passed me by.

And I remember that the past presented quite a plight.

But somehow I endured it and the future seemed all right.

And I remind myself that I am capable and free,

And my success and happiness are really up to me.

 

You control your response. What are you going to do next?

 

The Key of my mind… by ul_Marga

Client Letter - First Quarter 2009

Dear Clients and Friends:

The headlines from the Fourth Quarter 2008 are still fresh in our minds: global financial crisis, market turmoil, brand-name Wall Street firms disappearing or restructuring, massive government bailouts. The result was a massive market decline unmatched in decades, with the S&P 500 Index posting a -21.94% loss for the quarter, - 37% loss for the year, and a -42.74% loss from October 9, 2007 through November 30, 2008¹.

The question on everyone's mind is: what next? While no one can answer that question with complete certainty, I believe there are two important trends to consider as we look forward to 2009. The first is the pace of market recoveries after previous bear markets, and the second is rooted in the unusual nature of the September-October 2008 decline in which many asset classes that traditionally act independently declined more or less in unison. Let's take a look at both.

 

After a Bear: Pace of Recovery

History is not a guarantee of future performance, but it may offer a potential framework for setting expectations. The table below shows each decline in the S&P 500 of greater than 20% since 1950, with the subsequent market performance 1 year and 2 years afterwards:

After each bear market, the market showed a robust rebound, having often earned back the bear market's losses by the end of the first twelve month period. One lesson to consider is that investors who suffered the decline, then retreated to the sidelines "waiting for the market to turn around" probably missed some of the gain.

Is the bear market over? Are we in a recovery period? That remains to be seen, but there are positive signs. A number of commentators are suggesting that mid- to late November 2008 represented a potential market bottom. Since November 20 through December 31, 2008, the S&P 500 returned a brisk 20.47%¹. There are clearly challenges ahead, but the near panic of the fall may potentially be subsiding.

 

A Return to Diversified Correlations?

The second possible trend requires some explanation. In portfolio management, the degree to which asset classes track each other's returns is called correlation. Highly correlated classes rise and fall together, while highly uncorrelated classes tend to perform independently, with one class rising as the other falls.

One of the arts of portfolio management is piecing together asset classes that perform differently in a given environment, so that we can attempt to control risk and gain return opportunities. Unfortunately, one of the challenges at the end of the third quarter and into the fourth was that many equity asset classes became very closely correlated. In other words, the financial storm was strong enough to knock everything down, leaving few places to provide shelter.

This high degree of correlation is very unusual. Over the next few months, however, expect to see correlations spreading as some asset classes, industries, sectors or regions begin to recover more quickly than others, while others slump further.

What this means for you is that while the real economy is expected to face continued difficulties in the coming year, and the capital markets can be expected to rise, fall and drift as well, we can potentially expect to see increasing opportunities for risk management and increased returns. Spreading correlations create space for portfolio strategists and investment management firms to find potential value on your behalf.

 

Thank you for your trust

Certainly the past few months may have raised questions or concerns. Separately, your objectives or circumstances may have changed. Please do not hesitate to contact me; I will be happy to review your investment plan with you. By working together, I will be able to help you achieve your financial goals. Please call me at 515-457-1222 if you would like to discuss your portfolio and financial objectives.

For all of you who responded so favorably to my transition to fee based financial planning, thank you not only for your support but also for your patience as I am still finalizing several plans from the end of the year.

2008 was a tough year, and the last months, including the Fourth Quarter, offered an unprecedented combination of challenges and headlines. I want to thank you for the trust you have placed in me and reaffirm my commitment to working hard on your behalf in the coming year.

Change To My Practice

In my New Years post I promised I would explain what has recently changed in my practice which kept me so busy at the end of the year.

For many years I resisted implementing fees for financial planning, but the financial services marketplace of today is very different than it used to be. The very nature of the economy coupled with the complexity of modern products requires increasing regulation and tougher standards than ever before. To ensure my clients experience nothing less than excellence in my fiduciary standards, there needs to be a distinction between my roles as a financial planner and product provider. The best way to accomplish this is through implementing fee based financial planning services. At the same time it was very important to me to make this transition with as little impact to my existing clients as possible.

 

As of the beginning of this year, I am now charging to provide a written financial plan (see complete fee schedule). In most situations I will provide complementary complimentary annual updates to the plan keeping it up to date. To minimize the effect on my existing clients I have been writing financial plans for everyone who wanted before the fees went into effect.

 

I am very excited about this new facet to my practice. The fee itself should not be a barrier to most potential new clients and provides an avenue to work with clients who already have product relationships with an insurance agent or stock broker which they do not want to terminate.

So far the reaction from my clients has been very positive.

I do not even want to count the plans I have written in the last eight weeks except to know that it has been both busy and productive.

Numbers by mollycakes

Nice Try, But…

One of my clients called with an interesting question.

"I need to take the money out of my IRA" he explained. "I know I have to pay income tax, but I think I found a way to avoid paying the penalty" he continued. He certainly got my attention and I was all ears. "What I want to do is convert my IRA to a Roth IRA. I will pay the income tax on the conversion. Since after the conversion I can withdraw my Roth contributions at any time without penalty, I can liquidate the Roth right away and avoid the 10% penalty" he explained.

For a while I was stumped because, at first glance, it seemed logical. But something in the back of my mind told me there was a rule or regulation that prohibited that very circumstance. So I called a good friend and former co-worker of mine, Dave Breuer, CFP®. Dave and I worked together ten years ago when we were both Advanced Market Consultants at the same company. Our job was to provide advice and support for the company's advisors who's clients had complex estate planning, business planning, and retirement planning issues. We were partners when the Roth IRA went into effect and we had both spent considerable time studying the intricacies of program when the tax code was our only resource.

Dave was quick to find the answer (I knew he would be). Distributions from a Roth IRA conversion are still subject to the 10% penalty for 5 years after the conversion.

But Dave and I never give up at the first roadblock. We even considered the potential for avoiding the penalty by converting an IRA into a Roth IRA which was already over 5 years old but unfortunately someone else had thought of that before we did and closed that potential loophole too. If converted IRA contributions are co-mingled with ordinary Roth contributions, distributions from that Roth are treated as FIFO (first in, first out). You can withdraw the ordinary contributions without paying the penalty only up to the amount in the Roth prior to the conversion. If that amount is exceeded, then the 5 year limitation is applied.

I have to give a lot of credit to my client for his creative thinking, but thankfully he checked with me before he put his plan into action. I was able to save him from a nasty 10% surprise next April.

Nice Try by YoLoPey