First Quarter 2013 Investment Thoughts

The first quarter of 2013 was a very strong one for the equity markets. US stocks led the way with returns of 12.4% for the smaller company stocks in the Russell 2000 and 10.6% for the larger companies in the S&P 500. The performance of the international markets was not as strong; Europe continued to struggle and the effects of the Cyprus bailout were felt across the continent. The EAFE index, which measures performance of developed markets outside the US, was up 5.3%, while emerging markets were down 1.8%. In the continued low interest rate environment, bonds were essentially flat for the quarter. REITS (Real Estate Investment Trusts) also had a strong quarter and were up 8.1% while commodities were down 1.8%.

As the economy continues to improve, the Federal Reserve’s actions to keep interest rates low have had a strong influence on the record breaking stock market rally. Many economists are concerned the Fed is painting itself in a corner by doing so much to keep rates low. While the unemployment rate is still high, we have recovered ¾ of the jobs that were lost during the recession. Low interest rates continue to be a concern for bond investors but fixed income remains an important part of a well balanced portfolio.  There are many areas of the fixed income markets that offer less correlation to the benchmark 10 year Treasury.  Having a diversified fixed income portfolio is just as important as being diversified on the equity side.

As we always see in times when one asset class performs better than others, it is very important to reassess your asset allocation. If your allocation to equities has gone well above your target, you may be taking on more risk with the portfolio than you originally intended. As hard as it can be to sell an asset class that is doing very well, it is the right thing to do if you want to keep your risk level consistent. As you look at the 10 year return charts attached, you can see clearly that over the past decade investors have been rewarded for taking risk.  Riskier asset classes have the best longer term returns, despite the short term ups and downs.

If you’d like us to take a look at your portfolio to see if any rebalancing is in order, feel free to contact us at 410-494-6680 or send us a quick e-mail.

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A Reality Check for Your Portfolio

The financial news has been filled lately with a series of record highs for the Dow Jones Industrial Average and historic highs for other indices. These have been accomplished in spite of an economy that does not feel terribly strong and continued uncertainty in Washington DC over the budget issues. Times like these continue to remind us how important it is to make sure your investment strategy is consistent with your goals, return requirements, and risk tolerance.

We have always stressed the importance of making sure your asset allocation is consistent with your goals. Diversification has been a key component of this approach, not as a way to boost returns, but to reduce your risk. Over the long term, we still believe diversification works across a wide variety of asset classes that have various degrees of correlation with each other. When we are in financial crises like 2008/2009, many asset classes moved together, but bonds (and especially T-Bills) rose sharply.

Having elements of your portfolio positioned to do well in various economic scenarios is an important part of a well diversified approach. If the economy continues to expand, stocks and real estate should do well. If we go into a recession and see a downturn in stocks, bonds typically have performed well. Many people are concerned about inflation becoming an issue, so having some of your portfolio in asset classes that would do well in that scenario (TIPS, commodities, real estate, etc.) might make sense. If we see deflation, stocks and bonds (especially Treasury bonds) would hold up better.

Over the past 10 years, we have seen a wide variety of returns on different asset classes. This chart shows this and also highlights the fact that an asset allocation blend of the various asset classes helps to smooth out the volatility. If you look at the 5, 10, and 20 year rolling time periods in this chart you see that a 50/50 mix of stocks/bonds would not have lost money in any of these rolling time periods. Again, the benefits of diversification may not always be clear, but they are clear over the long term.

Our goal has always been to help you stay focused on your long term goals and not react to short term events. We do not believe you can successfully time the market over the short term. It might be tempting to increase your equity holdings when you see such large gains everyday.  On the flipside you might try to time your exit from equities at the top.  Instead, you should simply rebalance any positions that have gotten out of balance with your asset allocation targets.  This can help you balance your portfolio without the pressure of deciding how or when to buy/sell.  It is easy for your portfolio to get out of balance when we have dramatically different returns on different asset classes, like we saw in 2012.

If you would like us to help you take a closer look at your portfolio in light of your goals and objectives, please let us know.

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2012 Year End Investment Review

Despite what you might have seen on the news last year, the world didn’t come to an end, Europe didn’t collapse, and we didn’t fall off a cliff.  In fact, 2012 was a great year in the stock markets around the world, with returns ranging from 16% - 20% for the year, well above the long term averages. Bonds had a more typical year with returns generally in the 4%-6% range, but emerging market debt and high yield bonds were up over 15%. Many investors stayed away from the equity markets throughout 2012 but they are returning in record numbers in the first few weeks of 2013 as a result of last year’s strong returns.

The last minute Fiscal Cliff agreement gave us some level of certainty on income and estate tax rates for 2013 and beyond.  Tax rates will go up for higher income taxpayers, but keep in mind these rates are still below long-term averages. While most of the tax increases were targeted at higher income taxpayers, the lack of an extension of the payroll tax cut means that most Americans will pay higher taxes in 2013 and this could put a fair amount of drag on the economy. At some point, the impact of rising interest rates on fixed income investments and the potential for rising inflation will also impact the economy and should be considered when evaluating your portfolio.

It is important to keep in mind that time and diversification really are your friends in times like these. From 1950-2012, the annual average total return on stocks is close to 11% per year. Bonds have returned over 6% per year and a balanced portfolio of 50/50 stocks/bonds returned almost 9% per year. Over 20 year rolling periods, the returns on that balanced portfolio ranged from a low of 5% to a high of 14%. The power of compounding over longer terms is very powerful and having a well diversified portfolio with low volatility is the best way to take advantage of this.

The start of a new year is always a great time to step back and assess where you are with your investment portfolio. Just as you might take time to come up with New Year’s resolutions, you should sit down with your year end investment reports and come up with financial goals for 2013.  We still believe your risk tolerance and return requirements should be the primary factors in determining your asset allocation. Last year we saw a wide range of returns among different asset classes so you need to make sure your asset allocation is still in line with your goals. Are you really as well diversified as you should be? Are there any asset classes that you do not have in your portfolio that perhaps should be in there?  Did strong returns in one asset class last year leave your portfolio unbalanced?  These are all questions you should be asking. 

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Personal Financial Planning Implications of the 2012 Tax Act

We covered the highlights of the recently passed American Taxpayer Relief Act earlier this month. Now we thought it would be helpful to pass along our initial thoughts on how this bill will impact your personal finances. There are still many questions left to be answered on the technical details of the bill and we will fill you in as they become available. Based on what we know right now, here are some of our thoughts:

Income tax planning just got a lot more complex

While you certainly heard about the last hour resolution of the Fiscal Cliff and how the Republicans and Democrats met in the middle on the income limits for increased tax rates.  Unfortunately, the new tax structure for 2013 is anything but simple. One of the most important aspects to understand is the different income levels for the various changes. Ordinary income is taxed at 39.6% for joint taxpayers with taxable income over $450,000 (for single taxpayers, the threshold is $400,000). Long term capital gains and dividends are taxed at a higher 20% rate for taxpayers in these higher brackets, but you might also be subject to the Medicare surtax of 3.8% which affects married taxpayers with modified adjusted gross income above $250,000 ($200,000 for single taxpayers). On the deduction side, the phase out of itemized deductions and personal exemptions starts at $300,000 for married taxpayers ($250,000 for single taxpayers). The first step in tax planning is knowing what new rules affect your situation in 2013.

You may need to go back and reassess your personal financial planning assumptions in light of the new tax rates

Individuals who are subject to these higher rates could be seeing a significant increase in their tax burden; especially if their income is primarily investment income. (It could have been worse as the expiration of the Bush tax cuts would have taxed dividends at the highest marginal rate.) When you do your financial planning and asset sufficiency analysis, you make certain assumptions about rates of return, inflation rates, and tax rates. If you are impacted by these new higher tax rates, you should go back and make sure your tax rate assumptions are still valid. A higher tax burden can have a big impact on your planning over the long haul.

We now have permanent estate tax rules – for the first time in a decade – but did you do all that gifting for naught?

We now have a permanent $5 million per person estate and gift tax exemption that is adjusted for inflation each year (making it $5.25 million this year). The estate tax rate is now 40% and it has been reported that well over 99% of the population will not be subject to the estate tax. But don’t forget that many states have an exemption that is well below the $5 million level and state estate tax rates range from 5-16% across the country. Many people scrambled to make gifts in 2011 and 2012 to try to take advantage of the $5 million exemption under the fear that it might be dramatically reduced. Hopefully, if you did this gifting, you went through an analysis to make sure you could afford to do so. Even though we now know the law would have allowed you to do it this year and beyond, getting these assets (and more importantly the future appreciation on these assets) out of your estate could still benefit you down the road.

Should your investment strategy change in light of the new tax structure?

We have always believed the “tax tail should not wag the investment dog”. You do not want tax policy to impact your basic asset allocation and investment strategy, but with potentially higher tax on your investment income, you at least want to consider the impact. Look at your various “investment buckets” to see where your bond and stock investments reside. Which are in tax sheltered retirement accounts, Roth IRA’s vs. taxable accounts? Based on the current tax rates on your various types of investment income, is this the most appropriate place for them?

Is it really over yet?

Unfortunately, Congress did not really address the budget deficit and the looming debt ceiling. Another heated battle over spending cuts will no doubt ensue in the next few months. How this would further impact the tax structure remains to be seen. We will keep you posted as things continue to develop in Washington.

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12 Planning Ideas for the rest of 2012

The election is over but there are many issues still to be resolved. The tax picture for 2013 was not much clearer on the morning after the election than it was the day before. With just six weeks left until year end, there are a number of income tax and estate planning ideas that you might want to consider. Everyone’s situation is unique but this year could be the most important we have ever seen when it comes to integrating your tax planning with your personal financial plan.  We’ve already explained all the changes that are coming, so here are 12 specific ideas that you might want to think about before the ball drops on 2012:

Income Tax Planning

• Accelerate income into 2012 – For higher income taxpayers, it is very likely that your tax rate will be higher in 2013 than it is this year. What income can you shift into this year? If you are a corporate executive, accelerating stock options, restricted stock, etc. might make sense. Individuals are cash basis taxpayers so if you have income that you would get in early 2013, you should look at bringing it into this year if you might pay less tax on the income.
• Harvest capital gains at the 15% (or lower) rates of 2012 – Selling an asset to realize the gain presents a tradeoff – pay tax at the lower rate, but pay it sooner than you might in the future. This can be analyzed as a return on investment question and we can help you think about what would make this tradeoff worthwhile. If you are going to sell the asset in the near future anyway, harvesting the gain now probably makes sense. If you are in the 0% capital gain tax bracket, this might be gone next year. If you have large capital loss carryovers, you might be better to use them in the future to offset gains that will be taxed at higher rates.
• Consider a Roth conversion of your IRA – Doing this in 2012 may incur tax at the lowest rate you will see for many years. This could also help you reduce your income in the future since you do not need to take RMD’s from your Roth. There are many reasons to consider a Roth conversion; these include using it to tactically take advantage of tax attributes like an NOL carryover or opportunistically to take advantage of short term stock market volatility.
• Decide what to do about itemized deductions – This presents an interesting dilemma. If rates go up, you would be better to defer deductions to 2013 to get benefits at higher rates. However, the Obama Administration has proposed various limits on deductions. If that happens, you might lose some of the benefit of the deductions in future year.

Medicare Surtax Planning

• Review you situation to see if the new 3.8% Medicare surtax applies – This is an additional tax on investment income, so it can drive your tax rate on dividends up to 43.8% or capital gains to 23.8%. (From the current 15 %!). Types of income that are subject to the tax include taxable interest, dividends, annuity income, passive royalties, and rents.
• Lower your “threshold amount” if you are close to this level – The surtax applies when your modified adjusted gross income is above the threshold amounts ($250,000 for married filing joint; $200,000 for single taxpayers; and $11,650 for estates and trusts)
• Reduce your net investment income to reduce the impact – Shifting taxable interest income to tax exempt investments would avoid the tax. We also may see resurgence in life insurance and annuity vehicles that provide shelter from this additional tax.

 Estate and Gift Planning 

• Consider making large gifts in 2012 – With an estate and gift tax exemption of $5.12 million this year and the possibility that it could be much lower on January 1, many people are looking at this strategy to reduce their estates and move wealth to the next generation. You first need to make sure your assets are sufficient enough to be able to afford to do this. This planning takes time, irrevocable gifts must be considered carefully, and trusts and other entities might be needed.
• Utilize the current low interest rates in your estate planning – With rates still at historic levels, setting up a Grantor Retained Annuity Trust (GRAT) might make sense. Here the grantor transfers property while retaining the right to receive an annuity for a fixed term of years. If the property outperforms the low interest rates, the excess passes to your heirs.
• Consider the impact of valuation discounts to enable you to gift more – This is a strategy that has been under attack from various angles and it may be lost in the near future. When you give a minority interest that is not liquid, it is simply not worth the full value. You need to get an appraisal to support this, something that might be tough to do before year end.
• Take advantage of the continuing benefit of a grantor trust – If you make your gifts to a grantor trust, you continue to pay the tax on the gifted assets. Sounds like a bad deal until you realize that the payment of these taxes are moving more assets out of your estate, without being treated as a gift!
• Consider using a spousal limited access trust for gifts you make in 2012 – The idea here is to give away property for transfer tax purposes, but to retain the possibility that the spouse could receive distributions in the future. This is a complex area, but should be considered if you are making large gifts and have this concern.

Everyone’s goals and objectives are as different as their personal financial situation. We are working with many of our clients to see if any of these strategies make sense for them. Of course, you don’t want to let the “tax tail” wag the dog, so make sure that any strategies you use make sense in your overall planning. Let us know if you would like to discuss your own tax situation as we approach year end. 

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