Volatility Returns to Investment Markets

Just when you felt comfortable with investment markets slow and steady feel-good growth over the last 5 months, the rollercoaster kicked in again this week with triple digit swings on the Dow Jones Industrial Average.  While the recent prolonged upswing seemed to give us enough respite to start to feel good again about putting our money to work for the long term, here are a few reasons why the rest of 2012 may see the volatility continue:

Election Year—Not just USA

It is important to remember that markets hate uncertainty.  The fact is that major leadership across the world may change hands throughout the next 12 months.  In addition to our own presidential election, heads of state in Russia (already changed), China, and France may all see a change of leadership at the top.  This, of course, leads to potential operational policy changes in 4 of the 5 UN Security Council member countries.

No News is Good News

Two moderate news stories have fueled the recent pullback in the last week.  The first was the fact that the employment numbers domestically are beginning to improve, but that they are favoring the older generation.  This report came in during the market’s closure for the holiday weekend last Friday.  Rather than focusing on the brighter side of the news, Dow Futures immediately dropped and Monday’s open saw a -200 point decline. 

The end of this past week had a report that China’s economy is growing by an annualized rate of 8.1% for the first quarter—down from the 8.9% seen in the fourth quarter of last year.   Markets had a similar reaction, dropping over 100 points, and contributing to the worst week of the year so far.  I use these two stories as examples because neither was particularly bad/negative, but they contribute to the idea that the economy will not recover at lightspeed—and that maybe the recent 5 month rally is a tad overbought.

Obamacare & Taxes—Uncertain Domestic Policies

The constitutionality of the hallmark accomplishment of President Obama’s first term is being argued in the Supreme Court.  This only provides more question marks for American businesses as they prepare for added employment cost.  Combine this with the fact that the current tax regime is set to expire at the end of the year, and it makes longer term business planning and hiring very difficult for small and medium sized businesses.  Further clarity on either of these issues would encourage businesses to invest in growth.

These and other factors will continue to contribute to the ebb and flow of investment markets.  Volatility alone is not a reason to pull your money from a long-term investment plan and bury your head in the sand.  Trying to time the market’s ups and downs is a losing proposition.  Take a risk-managed approach and be sure you are allocated in a multifaceted strategy.

Evaluating Sources of Income in Retirement

As you get ready to transition to retirement, it is very important that you have a very good understanding of where your income is going to come from, how that income has the potential to grow over time, and how much coverage of your expenses this will provide. It is only after this understanding that you can then structure your savings to guard against potential pitfalls of a lengthy period of your life with little to no earned income.

Social Security

While the system certainly has flaws and risks, it is a fairly decent bet that retirement benefits will “be there”— is some fashion— for the baby boom generation. Make sure that you know the effect taking early benefits may have on your income, as well as whether it would be worth it to wait until later to gain a higher income stream.

The taxation of your benefits is also a large consideration. Currently, an individual filer earning between $25, 000 and $34,000 would have 50% of their benefits subject to income tax. If the individual earns more than $34,000, then up to 85% of your benefit may be taxable. For joint filers, the 50% threshold is between $32,000 and $44,000. More than $44,000 is at the 85% level. Because of these adjustments to taxability, structuring your other income and investments efficiently becomes very important in retirement.

Defined Benefit Pension Plans

While these types of plans are becoming a rarity, some people who work for long-established corporations may still have some sort of income stream payable to their retirees after years of service. Additionally state and federal workers also generally have some type of “pension”. Understanding the income benefits to your surviving spouse, as well as any cost of living adjustment (inflation factor) are very important in evaluating these plans. Some state and federal pensions exclude or limit you from Social Security retirement benefits (largely because no payroll tax was contributed to the system in your earning years).

Other Sources of Income

While you may have rental property or plan to work part-time in retirement, these can both be less lucrative or consistent than you plan. Statistics have shown than plans to work in retirement can be dashed by a health event, or by being squeezed out of the workforce due to economic reality. While a rental can be good income, managing the upkeep and vacancy can cause inconsistencies in the income planning for these properties.


Ultimately, comfort and confidence are most important as you begin to plan for transition to retirement. A better understanding of all of your income sources can provide a needed clarity to structure your savings efficiently. This involves knowing your expenses inside and out, as well as how taxation is likely to affect you. You also should feel comfort with your guaranteed income coverage of those expenses, and how much gap there may be between your income and your necessary spending.

3 Largest Risks of Retirement Transition

I often speak to community groups about retirement planning, and more often than not, listeners are surprised when I talk of a phase I call “transition.”  We have been trained to be savers and the traditional retirement savings paradigm reminds us to accumulate to a point of critical mass, and then develop a distribution plan.  For those folks that work with our practice, it is transition planning that they are embracing—the idea that the 10 years pre retirement and 10 years post retirement are exposed to a unique set of risks, and therefore require a unique set of planning strategies.

The three largest risks a transitioning retiree is exposed to are longevity, behavior, and timing.  The statistics on the current age wave are staggering.  There is a 50% chance that one person in a 65 year old couple will live to age 92, and a 25% chance they will live to 97.  In 2004, Hallmark reported selling 85,000 100-year-old birthday cards.  With all of the advances in medicine and biotechnology, I believe that we will continue to live longer, and as life expectancy grows, so does the need for a larger nest egg for a longer retirement.

Clients often challenge me with the idea of behavioral risk, by stating that they were surely exposed to behavioral risk their entire investing experience.  I would argue back that this behavioral risk is heightened as your get closer to needing to use your assets to supplement income.  As the markets climb and fall, it can be difficult to stomach the volatility.  Part of putting together the right transition plan is to assume an investment strategy that can ride out the volatility more smoothly. 

Investment markets do not care when you decide you want to retire.  The economy moves in cycles from expansion to recession.  If the timing of your planned retirement happens to fall during the next recession, you need some sort of infrastructure in your plan to guard against this kind of timing. 

These three risks are often ignored until just before the move toward retirement.  The time to start building a protection infrastructure around your retirement nest egg is much earlier.  These challenges are real and must be faced head on.  Attention to retirement  transition planning is important.

Reflecting on College Funding Paradigm

Last week we offered our first client workshop centered on college savings plans and understanding the financial aid application process.  We had a good turnout, and a big thank you for all who attended.
As the FAFSA (the required form to apply for federal financial aid) deadline approaches, I thought I would take a moment to review the aid programs that are available, as well as discuss a quick overview of the tax-advantaged savings methods.  I think it is important to realize that many of the aid programs are created for those who need it the most.  Middle class families are expected to be able to contribute a significant portion toward the cost of tuition when it comes to these programs.

Aid Programs

Pell Grant—the Pell Grant is entirely needs-based.  It is free money, meaning that it does not to be paid back in the form of a loan.  It is only available to undergraduates.

Stafford Loan—the Stafford comes in two varieties:  the Subsidized Stafford loan is entirely needs-based and the interest does not start accruing until schooling is complete.  With the Unsubsidized Stafford, loan interest begins accruing at grant.  It must be repaid in 10 years, and payment begins within 60 days of final disbursement.

PLUS Loan—the PLUS loan is a loan entirely dependent on the parent’s credit score.  These tend to be at higher interest rates.

Federal Supplemental Education Opportunity Grant—the FSEOG is only available to those families with a low expected family contribution.  It is only paid out if the funds are available (whereas the Pell is not limited in the funds that are paid out).

Work Study—work study provides on or off campus employment to pay for the cost of tuition.

Perkins Loan—Perkins loans are available to families with exceptionally low expected family contributions.  The school acts as the lender with very low interest rates.  These loans are awarded on a limited basis

Savings Programs

Prepaid Tuition—This program allows you to pay for college tuition at today’s cost.  The advantage is that you are able to lock in today’s cost of tuition for future attendance.  The disadvantages are that your return on investment is caps at the tuition inflation rate (which is not a bad return as compared to recent years); if the child receives a scholarship, then only your principal investment is re-paid; and the school or school system you pre-pay may not have a program that is strong that matches up to your child’s interest.

529 Plan—This account allows saving of after-tax assets in a tax-sheltered account.  Assets can be withdrawn tax-free if they are for qualified educational expenses.  The contributor retains control of the asset if the child decides not to go to college, and can re-assign the account to another beneficiary.

Coverdell Educational Savings Account—The tax benefits of the Coverdell ESA are similar to the 529 plan, however annual contribution totals for these accounts are much lower, and donors are phased out of contributing with modified AGI of $190k-$220k (MFJ) and $95k-$110k (other filing statuses).  Coverdell ESA funds can also be used for private elementary and secondary school.

Custodial Accounts—Funds that are established under the fiduciary control of an adult, but taxed at the rate of the child.  Unfortunately, these accounts are considered an asset of the child—a significant negative difference when applying for federal financial aid.  These accounts can sometimes be subject to “kiddie” tax—pulling them back into the parent’s taxable rate.  These funds become the full property of the child at the age of majority.

Planning for education funding is a very important goal-based part of being fiscally fit.  If you plan to help your child by contributing toward the cost of their education, but have not ear-marked funds to do so, this can have a severe affect on your other financial planning goals—specifically retirement savings.  A popular funding tool for college expenses has become the Roth IRA; because you can access these funds prior to 59 ½ if they are for qualified educational expenses.  The problem with doing this is that you are eating into funds that you may have previously designated as retirement assets.  Just as with other financial goals, the rules for college savings are start early and stay fit.

Debating the Tax Efficiency of Retirement Income Planning

The traditional retirement savings paradigm has been—Defer…defer…defer. The theory of saving for retirement on a pre-tax basis is rooted in the idea that you are socking money away in your “prime earning years” and thus avoiding taxation on that money at high income tax rates. This theory presupposes that you will be in a lower tax bracket when you start withdrawing the funds you have saved in your retirement accounts. But what if we are in a rising income tax environment? What if you have done such a great job of saving, that the government’s mandated amount that you must withdraw (which begins at age 70) pushes you into that same bracket you were in in your earning years?

While the second question may be a good problem to have, “tax diversification” may be a good planning tool to make your retirement income plan more tax efficient. To achieve a tax-diverse savings, it can be a good idea to start an after-tax/taxable investment plan and/or look at starting or converting to a Roth IRA. It may also not be the best idea to wait on IRA withdrawals until age 70.

To achieve a “tax diversified” savings, annual evaluations should be made across all of your accounts taking under advisement the counsel of your tax advisor and your financial planner. These annual evaluations should begin in the years approaching your retirement, and continue through your first few years of retirement (when your taxes can vary widely). It is important to keep in mind that the taxation of your Social Security income is also highly dependent on your “other income.”

A Quick Breakdown on how the Various Types of Accounts fit into a Tax Diverse Plan:

Pre-Tax Plans (401k, IRA, 403b, etc.): These types of plans allow you to save on a pre-tax basis, meaning you lower your taxable income in your earning years. The assets grow tax-deferred, meaning you do not pay capital gains tax & ordinary income tax on the holdings as they grow. When you withdraw funds from these accounts, you are taxed as if you earned the income in that year; dollar for dollar. At age 70 ½ you the US Government requires that you begin withdrawing a determined amount from these types of accounts for the rest of your life.

After-Tax/Taxable Savings accounts: This is simply money set aside after you have paid income tax. Investments in these types of accounts are subject to capital gains tax & ordinary income tax as they accrue. It is for this reason that managing these accounts in a tax-sensitive way is important. Withdrawals from these types of accounts generally do not carry the same tax hit that pre-tax plans do because, generally speaking, you would be paying tax only on the growth of the asset, and typically at the capital gain rate.

Roth IRA: These types of accounts are funded with after tax dollars and growth accrues tax-deferred. Any withdrawals from these types of accounts are entirely income tax free.

It seems clear that have exposure across the different types of taxable accounts could potentially give your income plan the most flexibility.

2011 Winners & Losers

As a volatile financial year comes to a close, I thought it best to reflect on the large impacts to the financial landscape for 2011.  So I will give you my list of winners and losers for the year.  However, I want to take a different spin on this type of commentary by focusing on winners & losers within 4 major topics affecting the financial universe this year. 

News Networks – Those that read my blog, or work with me on their financial planning have more than likely heard me reference the “creation of crisis” that is created by the 24-hour news networks.  Well, 2011 provided no shortage of crisis.  Financial markets down one week had them proclaiming the return of financial armageddon (a la 2008); with a subsequent rebound rally 2 weeks later.  I often urge people to take headline news with a grain of salt when it comes to personal finance.  Financial reporters are unregulated financial pundits—meaning they can say whatever they want and they are not held to any standard.  This is not the case with those folks who hold any investment license, but reporters fall into an exempt category.  No wonder every week is a new crisis.  Compound that with every other commercial on these networks focused on selling gold to the viewer, and you have networks getting rich on selling fear.

Winners: Network Corporations   Losers: Nervous viewers cashing in their IRAs to buy gold 

Europe – When continental Europe entered into the single currency in 1999, it seemed like a fantastic idea. The prolonged issues in Europe over the last two years continue to revolve around no central decision making body to set fiscal policy for the Union, while the European Central Banks sets monetary policy. The debt crisis in Greece was like a virus that infected the world including Italy, Spain and France, scaring the global economy. On Dec. 5, French President Nicolas Sarkozy and German Chancellor Angela Merkel called for a new European Union treaty to help curb spending in an effort to end Europe's debt crisis and save the continent's euro currency.  As Europe turns (pretty much every week), US financial markets react with polarity.

Winners: Europe (if they can come up with a central policy/treaty)    Losers: US Banks 

Occupiers – Life isn’t fair…let’s put that out there straight away.  But when someone comes through a college graduation to spend the next few years of their life unemployed, it starts to take a toll.  Protracted unemployment has sapped the morale of the working American—and I believe that is what we are seeing in the Occupy protests.  Meanwhile corporate profits have continued to rise. One thing is for sure, companies will not invest in hiring until they have a clearer picture of their expenses to hire for the foreseeable future—and that remains difficult with health care legislation still in question and no long-term agenda for taxes. 

Winners: Are there any?                                  Losers: Everyone (Closing of West Coast ports as the ultimate example)

Polarized Washington – The failure of Congress to come to any swift conclusion on raising the debt ceiling resulted in S&P cutting the US credit rating from AAA.  But with the refusal of policy makers to address a number of issues, it was only a matter of time.  Entitlement reform, out of control deficits, tax reform—“compromise” is not in the vocabulary of any of these politicians.  The recent failure of the “Super-Committee” is just one more example of a year of political brinksmanship.  The leadership vacuum in Washington is quickly becoming a black hole.

Winners: Career politicians                            Losers: The next generation of Americans

It is difficult to isolate the “most important issues” of the year when you write one of these kinds of pieces, but I believe these will have the most lasting effects on us all.  The bright news for the start of 2012 is that the underpinnings of the US economy continue to foreshadow strength.  Cheers to a happy and healthy new year to all.

Asset Location is As Important as Asset Allocation

After a year in which the Euro vacillated between survival & collapse, democracy reached the shores of North Africa, and Wall Street got “occupied”, one thing remained sure & true: VOLATILITY.  As I meet with people every day, it is the ubiquitous item that is keeping people up at night as they prepare to transition to & through retirement.  

A 1991 study conducted by Brinson, Singer & Beebower showed that 91% of an investment portfolio's performance is determined by the allocation of its assets—meaning diversifying (& re-diversifying) your investments between different types of companies is the best way to assure long term performance gains & reduce risk.  More recently though, the increasing complexity of economic forces and the interdependence of global markets have contributed to significantly alter the investment landscape. The current market environment poses new hurdles: unprecedented volatility, economic forces putting pressure on equity markets, the prospect of a resurgence in inflation, & rising interest rates, all compounded by unfavorable demographic trends for most of the developed world. In short, to paraphrase an old saying, in today’s investment landscape, the only certainty is that nothing is certain.

Investors can no longer necessarily rely on traditional strategies to reach their financial goals. As a result, traditional diversification (or Asset Allocation, as it is called) may not be as effective as it once was in serving investors’ needs.  However, the concept of choosing investments based on how they correlate with one another—how their prices change in relation to each other—is still an integral part of investment planning. But asset class diversification alone may not get the job done.

What I call “Asset Location” has become just as (if not more) important as asset allocation.  Asset location is about diversifying across different investment vehicles to take advantage of possible tax advantages, income focus, or non-traditional investment classes.  While traditional asset allocation remains important for a significant portion of your portfolio, asset location can help you to build an infrastructure around your investment plan to help weather times of protracted volatility.

This is how financial planning benefits the investor—more specifically, it structures portfolios by combining different asset classes and investment vehicles in an attempt to provide more effective diversification in order to combat volatility, mitigate risk, overcome inflation and provide income in your retirement years.

Please remember that diversification, asset location and asset allocation do not guarantee profit nor protect against loss in a declining market.  They are methods used to help manage risk.