Top Issues to Address on Your Personal Finances For 2012

As we begin the New Year, it is a good time to think about some of the key issues you might want to consider this year. 

How to plan for the impact of tax rate increases:

We are living in a time of extreme uncertainty in the tax laws. Congress is close to the point of dysfunction.  At the end of 2012, the Bush tax cuts will expire... or might they be extended? What can you do now to plan for the potential of higher tax rates in the near future? Some of the strategies may seem counterintuitive, but could very well make sense for you given the coming tax law changes.

We all know about harvesting tax losses, but what about harvesting tax gains? With capital gain rates at 15% for federal and the possibility that they will go higher (up to 20% or maybe even higher,) you may be better off harvesting gains now and deferring your losses to future years to offset gains when the tax rates are higher. Accelerating income into 2012 to take advantage of the current lower rates may also make sense.   Alternatively, deductions are also worth more when rates are higher, so you may want to postpone deductions until after 2012.  Of course we probably won’t know the actual changes to tax laws until after the election in November.

Planning for retirement in the midst of investment volatility:

We have seen a lot of investment volatility since the 2008/2009 downturn.  This has created concerns among many about whether their assets will be sufficient to meet their needs for the rest of their lives. Can you plan on taking a 4-5% withdrawal rate from your portfolio and still be safe? Future investment returns and the sequence of those returns are critical. It is also important to consider where we are in the investment cycle and where stock market valuations currently stand (relatively low compared to historical norms).  It is also critical to be tax sensitive when you consider your portfolio drawdown strategy. You may have various buckets of assets - taxable, tax deferred, Roth, etc. What you take and what bucket you take it from is critical to preserving your wealth in retirement.

Estate planning challenges and opportunities:

Most people have heard about the increased federal estate tax exemption which now stands at $5,120,000. Again, as in the income tax area, we do not know what this will be after 2012. Since this estate tax exemption is now unified with the gift tax, taking advantage of this ability to make large gifts this year is worth considering.  Of course any such gifting program should be examined in light of your comfort with the sufficiency of your assets. In doing this analysis, you need to be very conservative in the assumptions about rates of return, inflation rates, and of course be honest about your personal cash flow needs. There is also the uncertainty of whether future law changes could impact gifts you have made in 2012. Nobody can predict the future, so it is generally best to focus on what the law is now.

The future of entitlement programs:

With the budget deficit issues that our country faces, it is hard to imagine that there will not be any changes to entitlement programs such as Social Security and Medicare. How to incorporate these into your financial planning is something that we deal with on a regular basis. We do not know what may occur, but there is a strong possibility that means testing may be part of the solution. Higher income individuals already pay more in Medicare part B premiums and a model like this is possible. It is probably a good idea to test your retirement planning scenarios with various levels of social security benefits to make sure you understand the impact of potential changes.

Desperately seeking yield:

While the long decline in interest rates has been welcome for borrowers, it has created real challenges for those with short term investments and cash reserves. It is very hard to earn any real return on cash equivalents, if you are retired and living off your portfolio, it is still important to have cash reserves of 2-3 years of living expenses. Unfortunately, there is no easy answer to this dilemma.  Lengthening out your fixed income some can help, but there is real risk with this in a rising rate environment.  International fixed income may also provide some additional yield, but it does so with added risks. Dividend paying stocks are another alternative that many are considering.  Unfortunately, while this might increase the yield, you are investing in a riskier asset class whose market value will fluctuate.

There is no doubt we are living in challenging times, and as is often the case, there are an array of potential issues that must be considered. All you can do is consider all of the known variables and plan as best you can given the current laws. Create "pivot points" in your planning that can give you the ability to act on changes as they develop. Flexibility is important when conditions are changing on a regular basis.

We are always available to help you consider these issues and think broadly about your planning as we move through 2012

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What role do bonds play in your portfolio?

It is certainly a challenging time in many parts of the investment world. Volatility is at very high levels in the equity markets. Interest rates are at historic lows and credit concerns continue to be a factor in the bond markets. We have seen a multi-decade decline in interest rates and it is hard to imagine them going much lower. Governments here and abroad are struggling with debt issues. Where does this leave a bond investor and is this an asset class that you simply should ignore going forward?

Traditionally, bonds have played the role of an asset diversifier in portfolios, providing returns that are uncorrelated with the stock market. This has certainly been the case in the recent past as bonds have performed very well as interest rates declined. Bonds also are often in a portfolio to generate income, and provide cash flow for those who need to use the income from their portfolio for living expenses. While neither of these roles will likely go away completely, there may be other reasons to include bonds in your portfolio.

Looking at bonds and more specifically certain categories of bonds on a total return basis may make sense going forward. When you look at the historic returns of various fixed income indices over the past 10 years, you will see a variability in returns that is similar to equities. There may be “tactical” reasons to have exposure to certain elements of the bond market over time.

 As you consider specific types of bonds in the current environment, there may be opportunities to uncover value. For instance, while municipalities and states certainly have ongoing financial concerns, the yields on municipal bonds on an after tax basis are equal to or above Treasury securities. If a manager understands the sources of payment on these bonds, they may not have the risk that seems to be painted on the entire asset class. Foreign bonds are another example of an area where opportunities may exist. Other countries where debt to GDP ratios are not as high as the US or other Western European countries may present opportunities.

The bond market is very large, many times larger and more complex than the stock market. We look to individual bond managers or mutual funds that invest in bonds to help our clients manage their bond allocation. While bond mutual funds have their own risks when we do ultimately see a rising rate environment, we find that this might be the best way to access certain classes of bonds or to get bond exposure for smaller accounts. This part of your investment strategy should always be grounded with a clear vision of your risk tolerance, return requirements, and cash flow needs.

Let us know if we can help you think about the role that bonds play in your portfolio.

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Portability of the Estate Tax Exemption

“Portability” has been touted as one of the most significant estate planning developments in the 2010 Tax Act. It is considered to be a way to “simplify” estate planning by allowing the estate tax exemption (which is now $5 million) to be used, even if estate planning was not done before death. Typically, a couple will create a trust in their will (often known as a credit shelter or bypass trust) to “capture” the exemption of the first spouse to die. Any future appreciation in that trust is not taxed on the death of the second spouse. If this is not done, all of the assets may end up in the estate of the second to die, creating a larger total estate that might be subject to an estate tax.

While conceptually, this simplification can be a nice idea, there are some complications that people should be aware of:

1. Portability does not apply for State Estate Tax (many states impose their own version of the estate tax,) Generation Skipping Tax (GST) and it also does not address post death appreciation.
2. One of the advantages of using a trust for assets in an estate plan is that it provides for asset protection from creditors. Relying on portability alone does not offer than same protection.
3. In order to use the portability provisions, a complete and timely estate tax return must be filed for the first spouse to die and you must elect to use the decedent’s unused exemption. If there are multiple, hard to value assets, the costs of doing a full estate tax return may be significant.
4. Today’s “modern family” often has conflicting goals between the surviving spouse, children from prior marriages, etc. This creates a situation that needs to be thought through carefully, with an understanding of the current and future family dynamics.
5. Taking this approach keeps the statute of limitations open indefinitely and the IRS could challenge valuations or other aspects of the returns.

Estate planning is a complex area that needs to be developed from the goals for the individual and the family. Tax considerations play an important, but not solitary role. While portability can help where the proper planning has not been done before death, it should not be a substitute for doing good estate planning during your lifetime. Let us know if we can help you look at your overall estate plan to make sure that it reflects your current desires. 

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Third Quarter 2011 Investment Thoughts

The third quarter of 2011 was a very challenging one for the equity markets. It seemed that fear really grabbed the markets as volatility rose dramatically. As we write this, the major indices have bounced back dramatically in the beginning of October. We recently wrote about our thoughts on the impact of the downgrade of US debt (link) and its impact on the economy. We always feel it is important to keep things in perspective in times like these. Since the market low in March, 2009, the S&P 500 index is up over 75%. It is never a straight line back up from market lows but throughout our history, stock markets have always recovered and grown over the long term.  There is no reason to believe this won’t be the case moving forward, even though there will likely continue to be more volatility than we have seen in the past.

From an economic perspective, you do not need to be an economist to know that the US is struggling to stay out of a second recession. The employment situation has not gotten much better. The monetary policy of the Fed seems to be running out of tools to address the situation. Europe may be in worse shape as Greece continues to seesaw between default and being saved almost daily. There is clearly a real lack of confidence in consumers here and abroad.

With interest rates as low as they are (the 10 year Treasury bill is under 2% as we speak), there is really no where for investors to go and earn any reasonable returns with safety. The struggle for income is a problem world wide as most markets have 10 year government bond yields that are a good bit lower than the dividend yields on the stock indices.  With cash reserves of almost $10 trillion, at some point a portion of this will be invested.  The problem with this is the lack of incentive for companies to invest this money.  With fear still gripping the markets and assurances from our government that interest rates will stay low through 2013, businesses and individuals have no incentive right now to invest this money. 

This could lead to slow economic growth over the next year or two but eventually rates will rise and businesses will begin to invest this cash which will help the economy grow faster.  Of course there is the risk in the meantime that any shocks to the system could push us into another recession, but most economists agree that this still has less than a 50% chance of happening.  Right now stock valuations and P/E ratios are very low and corporate profits are very strong.  Corporate profits drive growth and we continue to believe that the markets will persevere and grow in the long run.

What should you do in times like this? A couple of suggestions we would continue to make:

1. Make sure your cash reserves are sufficient to ride through a prolonged downturn. Keeping 2-3 years of cash flow needs in liquid, safe investments is never a bad idea.
2. Review your asset allocation to make sure it is still consistent with your goals. When we see dramatic differences between stock and bond returns, like this past quarter, it is easy to be out of line
3. Assess your exposure to alternative asset classes that may provide some uncorrelated returns to the stock markets. It is important to have your stock exposure diversified, but it may make sense to go beyond that and consider alternatives to help to smooth out the ride. 

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Financial and Estate Planning Ideas

1. Update your retirement planning – As we live with market volatility and future tax and entitlement program uncertainty, it might be a good time to check your planning assumptions and your progress toward those long term goals.
2. Reevaluate your education funding strategy – are you still on track to reach the education funding goals? It is important to make sure the asset allocation matches the child’s time horizon for needed funding. Will financial aid be a factor in funding education costs? 
3. Have there been any major changes in your life - Events like the death of a spouse or parent, birth of a child, divorce, marriage, etc. all have a profound impact on your planning and may cause the need for an update of your overall planning.
4. Have you thought about the decision on when to take Social Security benefits and Medicare coverage -  This is an area that can create some planning opportunities and headaches and needs to be thought through carefully
5. Take advantage of historically low interest rates – have you taken full advantage of this in the debt side of your balance sheet? What is the current rate on your home mortgage or any other debt you have in place?
6. Make sure your asset allocation is in line with your targets – if you have not looked at this in a while, it may be out of alignment with what makes sense for your risk tolerance and return goals. Are you well diversified across a wide variety of asset classes?
7. Have you incorporated alternative investments into your portfolio - Are they really providing diversification benefits at a reasonable expense and tax cost? Are they truly uncorrelated with your other asset classes? How have they performed in the past quarter?
8. Review where you stand for 2011 year end tax planning? This could be a year when mutual funds that have declined in value still payout capital gains, what can you do about this before year end? Are there losses you should be harvesting before year end to offset capital gains?
9. What to do now to plan for potentially higher income tax rates – We already know about the additional Medicare surtax on investment income starting in 2013, but it is very likely that you may also face higher income tax rates after 2012. Is there anything you can do to have future income taxed at today’s low rates that we have through the end of 2012?
10. Consider exercising stock options while tax rates and stock prices are low - If you are a corporate executive consider whether there is anything you should be doing now with your stock options and other compensation / stock based awards? If tax rates do rise after 2012, it may be better to bring income in before that time.
11. Review your existing life insurance policies – with the increased $5 million exemptions, you may not need the coverage that you put in place to pay estate tax. As our financial situation evolves over the years, it is important to make sure your insurance plan fits your goals. Are your life insurance trusts fully funded? You might want to use the expanded gift tax exemption to put in more cash.
12. Talk to your parents about their personal financial situations – too many times, we do not have these conversations until it is too late. With the volatile markets, low interest rates, and increasing health care costs, it is very important to make sure your older relatives are doing all of the planning they need to do.

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