How Exercise Can Make You a Better Investor

There are a lot of parallels between getting in shape and being a successful investor. Both take time and consistent effort to achieve results. We’d love to have overnight, instant results, but that isn’t how life works!

Here are five key factors to an effective exercise program that you can apply directly to helping you achieve your financial goals. If you are already doing great with your workout program, why not apply that same process to getting your finances in shape?

1. One pound at a time. Your goal may be to lose 30 pounds, but you can’t lose 30 pounds at once. You have to take it one day at a time and lose the first pound, then the second, and so on. In investing, everyone wants to be a millionaire, but you have to save that first thousand dollars, then the next thousand and so on. You can’t just wish for it, you have to work for it.

2. Set a goal. Having a specific goal such as “lose 20 pounds by March 1” or “achieve a BMI of 15 by January 1” is better than a vague goal such as “get in better shape”. Otherwise, how will you know if you achieve your goal? How will you know if you are on track? What is your motivation and sense of urgency?

A long-term goal creates short-term steps. If you want to lose X pounds in X weeks, you might use an app like myfitnesspal to calculate how much you need to workout and how many calories you can eat in a day. Your goal determines a path and mileposts. For investing, if your goal is to have $500,000 in your 401(k) at retirement, how much would you need to save from each paycheck to make that happen?

3. Make good choices. When you have a fitness goal, some decisions, like eating half of a cheesecake for dinner, will put you further away from your goals and negate all the hard work you have been doing. Similarly, if you have a financial goal, spending $15,000 on a European vacation may be inconsistent with that goal. When your goal is more important than the eating or spending, you learn to make better choices.

That’s not to say that you can’t indulge from time to time, but you can’t let those choices derail your progress. If you view these choices as a sacrifice or as deprivation, you will resent your fitness or financial goals. You may find it easier to stick to the plan when you observe and celebrate the positive results you are achieving.

4. Create new habits. For a workout program to get results, you have to stick to it and have it become an unchangeable part of your routine. Maybe you workout Monday through Friday at 7:30 am before work. Or maybe you spend your lunch hour on Tuesday and Thursdays at the Gym and then workout on Saturday and Sunday mornings. Maybe you learn to watch TV without eating food at the same time!

The point is that you create new habits that will help achieve your goals. For investors, people are more likely to be successful when they put their saving on autopilot. Have that money come directly out of your paycheck into your 401(k). Start a Roth IRA and establish a monthly draw of $400 from your checking account. Set up a 529 college savings plan and even if you only start with $50 a month, get going today!

5. Human support. You are more likely to succeed in your fitness goals if you are part of a group or have a coach to make sure you actually get to the gym! They can motivate you, applaud your progress, and help you regroup after the inevitable frustration of temporary set-backs. When you go it alone, your weekend choices may not be as good as someone who has a weigh-in on Monday morning with their trainer. Having someone who supports you, who can lend an ear, and can also provide objective guidance will help you get there faster.

When it comes to investing, many people make the same excuses as they have for fitness: I am too busy, exercise is too expensive, it’s so boring, my career/family/hobby is takes all my time… And yet, many of the busiest, most successful people I know manage to find time to workout and stay in shape. When it is an important priority, you figure out how to make it happen.

If you want to get in better shape financially, apply what you know works for exercise. We can help you identify realistic goals and put into motion new habits to help you achieve your objectives. You will learn about finances and you might even find that you enjoy yourself! But most of all, you will know that you are doing the right thing today and that your future self will thank you for not waiting another year to get started. You can schedule your call online here.

Beware: 2017 Fund Capital Gains Distributions

We are starting to receive estimates for year-end 2017 Capital Gains distributions from Mutual Funds, and no surprise, many funds are having large distributions to their shareholders this year. As a refresher, when a mutual fund sells a stock within its portfolio, the gain on that sale is passed through to the fund owners at the end of the year as a taxable event.

When you invest in a 401(k), IRA, or other qualified account, these capital gains distributions don’t create any additional taxes for you. If you reinvest your distributions, your dollar value of the fund remains the same, and you are unaffected by the capital gain. However, if you are investing in a taxable account, these distributions will cost you money in the form of increased taxes.

A quick look at estimates from American FundsColumbia, and Franklin-Templeton shows that many equity funds are having capital gains distributions of 3-10% this year. A few are even higher, such as the Columbia Acorn (17-21%) and Acorn USA (23-28%). Imagine if you made a $100,000 investment at the beginning of the year, your fund is up 16% and then you get a distribution for $28,000 in capital gains! Yes, capital gains distributions can exceed what a fund made in a year, when the fund sells positions which it owned for longer.

Capital Gains Distributions create a number of problems:

  • Even if you are a long-term shareholder, when the fund distributes short-term gains, you are taxed at the higher short-term tax rate.
  • If you didn’t sell any of your shares, you will need to find other money to pay the tax bill, which can run into the thousands each year if you have even just a $50,000 taxable portfolio.
  • If you are thinking of buying mutual fund shares in Q4 of this year, you could end up buying into a big December tax bill and paying for gains the fund had 6-12 months ago.
  • In addition to paying capital gains on fund distributions, you will still have to pay tax when you sell your shares.
  • Capital gains distributions are in addition to any dividends and interest a fund pays. In general, we want dividends and interest income as additions to our total return. Capital gains distributions, however, do not increase our return and are an unwelcome tax liability.

If you have a taxable account, or both taxable and retirement accounts, we may be able to save you a substantial amount of money on taxes. We can use tax-efficient investments like Exchange Traded Funds (ETFs), which typically have little or ZERO capital gains distributions at the end of the year. This puts us in control of when you want to sell and harvest your gains. When you have multiple types of accounts, we can place the investments into the best account to minimize your tax bill.

If you do presently have mutual funds in a taxable account, it may be a good idea to take a look at your potential exposure before the end of the year so you are not surprised. If you sell before the distribution is paid, you can avoid that distribution. Now that will mean paying capital gains based on the profit you have when you sell. But you definitely want to be planning ahead. When you’re ready to create a tax-managed portfolio that looks at all your accounts together, we can help you do that.

How Much Should You Contribute to Your 401(k)?

Answer: $18,000. If you are over age 50, $24,000.

Those are the maximum allowable contributions and it should be everyone’s goal to contribute the maximum, whenever possible. The more you save, the sooner you will reach your goals. The earlier you do this saving, the more likely you will reach or exceed your goals.

At a 4% withdrawal rate in retirement, a $1 million 401(k) account would provide only $40,000 a year or $3,333 a month in income. And since that income is taxable, you will probably need to withhold 10%, 15%, or maybe even 25% of that amount for income taxes. At 15% taxes, you’d be left with $2,833 a month in net income. That amount doesn’t strike me as especially extravagant, and that’s why we should all be trying to figure out how to get $1 million or more into our 401(k) before we do retire.

I’ve found that most people fall into four camps:
1) They don’t participate in the 401(k) at all.
2) They put in just enough to get the company match, maybe 4% or 5% of their income.
3) They contribute 10% because they heard it was a good rule of thumb to save 10%.
4) They put in the maximum every year.

How does that work over the duration of a career? If you could invest $18,000 a year for 30 years, and earn 8%, you’d end with $2,039,000 in your account. Drop that to $8,000 a year, and you’d only have $906,000 after 30 years. That seems pretty good, but what if you are getting a late start – or end up retiring early – and only put in 20 years of contributions to the 401(k)? At $8,000 a year in contributions, you’d only accumulate $366,000 after 20 years. Contribute the maximum of $18,000 and you’d finish with $823,000 at an 8% return.

I have yet to meet anyone who felt that they had accumulated too much money in their 401(k), but I certainly know many who wish they had more, had started earlier, or had made bigger contributions. Some people will ignore their 401(k) or just do the bare minimum. If their employer doesn’t match, many won’t participate at all.

Accumulators recognize the benefits of maximizing their contributions and find a way to make it happen.

  • Become financially independent sooner.
  • Bigger tax deduction today, pay less tax.
  • Have their investments growing tax deferred.
  • Enjoy a better lifestyle when they do retire. Or retire early!
  • Live within their means today.
  • 401(k)’s have higher contribution limits than IRAs and no income limits or restrictions.

Saving is the road to wealth. The investing part ends up being pretty straightforward once you have made the commitment to saving enough money. Make your goal to contribute as much as you can to your 401(k). Your future self will thank you for it!

Equifax and Your Cyber-Security

You work hard to protect your personal data only to learn that one of the top three credit reporting agencies was hacked and jeopardized private financial information of 143 million Americans. What can you do to safeguard your money, time, and credit score from theft and fraud?

1. Everyone should check to see if they have been impacted by the Equifax breach. Unless you are four years old, you probably have a file at each agency: Equifax, Experian, and TransUnion. To find out if your information was stolen from Equifax, go to this website:
https://www.equifaxsecurity2017.com/am-i-impacted/

2. If you have been impacted, Equifax will allow you to register for free for their protection service, TrustedID Premier. You should do this. Please note that when you request this the first time, it will give you a date to come back and register your membership. After you register, you will later be sent an email with instructions to activate your membership. If you skip these steps, you are not enrolled or protected. It took them two weeks from the time I first applied until my account was activated.

3. Consider putting a credit freeze on your account. This means that if anyone tries to open a credit card or take out a new loan using your identity, that the process will be stopped. That includes yourself – if you go out car shopping and decide to get a new Subaru, your loan will be rejected. You would want to unfreeze your credit a day or two before you do any of these things.

4. Please note that even if you go through this freeze process with Equifax and TrustedID, you may not be 100% safe unless you go through the same steps with Experian and TransUnion.

If you think there may have been unauthorized activity on your accounts, you can also place an Initial Fraud Alert on your account, which is free and lasts for 90 days. By placing an Alert with one agency, they notify the other two.
http://www.experian.com/blogs/ask-experian/what-is-the-difference-between-a-credit-freeze-and-fraud-alert/

5. You should check your credit report at least annually for errors or possible fraud. A free report is required by Federal Law and is available online from each agency at: https://www.annualcreditreport.com/index.action

6. Wallet security: Consider keeping one credit card at home so if your wallet is stolen, you still have one to use. Never keep your Social Security Card in your wallet. If a thief has your credit cards, drivers license, AND social security number, they can do a lot of damage. Keep a photocopy of your credit cards (front and back), drivers license, and passport at home in a safe. If those are lost, you at least know who to call.

7. Online security: Please don’t use passwords that are simple or easily guessed. Don’t use the same password for all accounts. Consider using a password storage software that will generate and store complex passwords for each account. Avoid public wifi when accessing financial accounts. Use two-factor authentication if available.

8. Computer security: 75% of computer breaches are due to “known vulnerabilities”. That means it could have been prevented by an available software update. Each Tuesday night, Microsoft releases patches for security issues. If you are on automatic updates, you are covered. By Wednesday, hackers from around the world try to reverse engineer the patches to uncover how they can break into computers which did not update. Keep your computer updated and use a good anti-virus software. Wipe your hard drives and phones before recycling.

9. Email security: Email is not a secure form of sending information. Avoid emailing your Social Security number, credit card information, tax forms, or account numbers. Hackers have found signatures on emailed PDFs and copied them to “sign” wire transfer requests and steal money from bank accounts.

10. Paper security: Avoid putting sensitive documents in the trash. Buy a shredder. Consider installing a mailbox with a lock.

We take cyber security very seriously and know that fraud and identity theft is a major source of stress. If you have a question about how to best protect your identity and safeguard your money, please give me a call.

Are You Making These 6 Market Timing Mistakes?

Market timing means moving in and out of the market or between assets based on a prediction of what the market will do. Given the extreme difficulty of predicting the future, market timing is frowned upon by most academics. Many studies have shown that the majority of investors who time the market under-perform those who stay invested.

Even though many people know intellectually that market timing is detrimental, it is actually pretty difficult to stay invested and not be influenced by market timing. Even for those who say they don’t time the market, there are a number of ways that investors inadvertently fall into this trap.

1. Being in Cash. “We are going to sit on X% in cash and wait for a buying opportunity.” Seems prudent, right? Except that investors who have been holding out for a 10% or 20% crash for two, three, four years or more have missed out on a huge move up in the market. Yes, there are rational reasons to say that the market is expensive today, but those who have been sitting in cash have definitely under-performed. Will they eventually be proved right? The market certainly has cycles of growth and contraction. This is normal and healthy. So, yes, there will be another bear market. The problem is that trying to predict when this will occur usually makes returns worse rather than better.

2. Greed and Fear. The human inclination is to want to invest when the market has done well and to sell when the market is in the doldrums. I remember investors who insisted in going to cash in November 2008 and March 2009, right at the bottom. In 1999, people were borrowing money to put into tech funds, which had given them returns of 30%, 50%, even 100% in a year. Our natural reaction is to buy high and sell low, the opposite of what we should be doing. It’s only in hindsight that we recognize these trades as mistakes.

3. Performance Chasing. Investors like to switch from Fund A to Fund B when Fund A does better. Who wouldn’t want to be in the better fund? This is why people give up on index funds. Index funds often only beat half of their peers in any given year, so it’s super easy to find a fund that is doing better. However, when we go to a five-year horizon, index funds are winning 80-90% of the time. That’s why switching to a fund with a better recent track record is often a mistake. (And then watch the fund you just sold soar…)

4. Sector and Country funds. Investors want to buy a sector or country fund when it is a standout. This is market timing! You are buying what is hot (expensive) rather than buying what is on sale. I have yet to have any client ever come to me and say “sector X is doing terrible, should we buy?”. Instead, some will ask me about biotech, or India, or some other high flyer. I remember when the ING Russia fund had the best 10-year track record of all mutual funds. If you bought it then, I think you would have regretted it immensely in the following years! When people buy sector or country funds, the decision is almost always a market timing error of extrapolating recent performance into the future, instead of recognizing that today’s leaders become tomorrow’s laggards.

5. Factor Investing. If you haven’t heard of Factor Funds, you will soon! Quantitative analysts look for a set of criteria which they can feed into a computer and it picks the best performing stocks. How do they come up with a winning formula? By back-testing strategies using historical stock prices. This sounds very scientific, and I admit that it looks promising, but there are still some market timing landmines for investors, including:

  • Historical anomalies. It’s possible that a strategy that worked great over the past 10 years might be a dud over the next 10. It is unknown which factors will perform best going forward and it seems naive to assume that the future will be the same as the past.
  • Choosing which factor. Low Volatility? Value? Momentum? Quality? Those all sound like good things. There are now so many flavors of factors, you have to have an opinion on the market in order to pick which factor will outperform. And that’s right back to market timing: investing based on your prediction of what the market will do. This isn’t Lake Woebegone, where all the factors are above average. Some factors are bound to do poorly for longer than you are likely to be willing to hold them.
  • Investor switching. In most single years, a factor does not have very exciting performance. I predict that many investors are going to buy a factor fund, and then switch when they see another factor outperform for a year or two. If you’re really going to buy into the factor philosophy, you need to buy and hold for many, many years. Even in back tests, there are quite a few years of under-performance. It was only over long time periods that factors were able to deliver improved returns.

6. Product development. Asset managers are paid on the assets they manage. It’s a business. They will always be coming out with a new, better product to attract new investors. You are being marketed to every day by companies who want your investment dollar. Many new funds will not survive the test of time and will disappear into financial history. Their poor track records will be erased from Morningstar, which is why we have “survivorship bias”, the fact that we only see the track records of the funds that survive. Please use caution when investing in a new fund. Is this new fund vital to your success as an investor or just a marketing ploy for a company to capitalize on the most recent fad?

At Good Life Wealth Management, we are fans of the tried and true and skeptical when it comes to the “new and improved”. We aim to avoid market timing errors by remaining invested and not trying to predict the future path of the market. We avoid emotional investing decisions, performance chasing, and sector/country funds. For the time being, we are watching factor funds with curiosity but a wait and see attitude.

How then do we choose investments and their weight in our asset allocation? Our tactical models are based on the valuation of each category. This is by its nature contrarian – when large cap becomes expensive, it becomes smaller in our portfolios. When small cap becomes cheap, its weighting is increased. We don’t predict whether those categories will go up or down in the near future, but only tilt towards the areas of better relative value. This is based on reversion to the mean and the unwavering belief that diversification remains our best defense.

If you’d like to talk about your portfolio, I’d welcome the chance to sit down and share our approach and philosophy. What keeps us from the Siren song of market timing is our belief in a disciplined and patient investment strategy.

Floods and Your Insurance

In the aftermath of Hurricane Harvey, many Texans are discovering that SURPRISE, homeowners insurance doesn’t cover flooding. The damage from Harvey was from torrential rains, not wind, and in most cases will not be covered by insurance. Only those with Federal Flood Insurance will be covered, but most people do not have flood insurance unless you live in a flood zone that requires it.

If you have a mortgage and thought that you’d be covered by your homeowner’s insurance or that the bank would forgive your loan, sorry, but even if your house is a total loss you still owe every penny of your mortgage balance. What can you do? For counties which are declared a disaster area by FEMA, you may be eligible for Federal Assistance.

FEMA’s Individuals and Households Program (IHP) provides grants to those in disaster counties. You can apply online at disasterassistance.gov or by phone at 800-621-FEMA (3362). To apply, you must have already filed a claim with your insurance and been denied. The IHP will not pay for your deductible, if the damage is covered. For those who receive a grant, you must agree to purchase and maintain Federal Flood Insurance on your property going forward.

The IHP offers two types of assistance:

1. Housing Assistance, including lodging expense reimbursement, rental assistance, and repair or replacement of your primary residence. The IHP only covers a primary residence and not a vacation home, rental property, or other type of property.

2. Other Needs Assistance, such as damage to household goods, vehicles, cleanup costs, medical expenses, child care, or funeral expenses.

The IHP is a terrific program to help cover disaster costs which are uninsured, however, the limit is only $33,000 and many homeowners will easily exceed this amount if their home has been sitting in three feet of water. A grant through the IHP is non-taxable and does not have to be repaid.

The Small Business Administration (SBA) offers Home and Property Disaster Loans of up to $200,000 to homeowners – and you do not need to be a small business owner. The loan must be used to repair or rebuild your home after it was damaged.

While homeowner’s insurance does not cover losses from flooding, most auto insurance policies do. Current estimates are that 500,000 cars will be total losses from Hurricane Harvey and most are covered by insurance. Rental companies, insurers, and car makers are already shipping significant numbers of vehicles to Texas to help people get back on the road.

If you’ve been impacted by Hurricane Harvey and have questions, please feel free to call or email me. And if you haven’t been impacted, it might be a good time to actually look at your insurance policies in some detail and figure out what is covered and what is not covered. No one likes surprises when it comes to insurance.

When Can I Retire?

There are a couple of approaches to determine retirement readiness, and while there is no one right answer to this question, that doesn’t mean we cannot make an intelligent examination of the issues facing retirement and create a thorough framework for examining the question.

1) The 4% approach. Figure out how much you need in annual pre-tax income. Subtract Social Security, Pensions, and Annuity payments from this amount to determine your required withdrawal. Multiply this annual amount by 25 (the reciprocal of 4%), and that’s your finish line.

For example, if you need $3,000 a month, or $36,000 a year, on top of Social Security, you would need a nest egg of $900,000. (A 4% withdrawal from $900,000 = $36,000 a year, to reverse it.) That’s a back of an envelope method to answer when you can retire.

2) Monte Carlo analysis. We can do better than the 4% approach above and give you an answer which more closely meets your individual situation. Using our planning software, we can create a future cash flow profile that will consider your financial needs each year.

Spouses retiring in different years? Wondering if starting Social Security early increases your odds of success? Have spending goals, such as travel, buying a second home, or a wedding to pay for? We can consider all of those questions, not to mention adjust for today’s (lower) expected returns.

The Monte Carlo analysis is a computer simulation which runs 1000 trials of randomly generated return paths. Markets may have an “average” return, but volatility means that some years or decades can have vastly different results. A Monte Carlo analysis can show us how a more aggressive approach might lead to a wider dispersion of outcomes, good and bad. Or how a too-conservative approach might actually increase the possibility that you run out of money.

It tells us your percentage chance of success as well as giving us an idea of the range of possible results. It’s a data set which provides a richer picture than just a binary, yes or no answer to whether or not you have enough money to retire.

Even with the elegance of the Monte Carlo results, the underlying assumptions that go into the equation are vital to the outcome. The answer to not outliving your money may depend more on unknowns like the future rate of return, your longevity, the rate of inflation, or government policy than on your age at retirement. Change one or two of these assumptions and what might seem like a minor adjustment can really swamp a plan when multiplied over a 30 year horizon.

Luckily, we don’t have to have a crystal ball to be able to answer the question of retirement age, nor is it an exercise in futility. That’s because managing your money doesn’t stop at retirement . There is still a crucial role to play in investing wisely, rebalancing, managing withdrawals, and revisiting your plan on an ongoing basis.

While all the attention seems to be paid to risks which might derail your retirement, there is a greater possibility that you will actually be able to withdraw more than 4%. After all, 4% was the lowest successful withdrawal rate for almost every 30 year period in history. It’s the worst case scenario of the past century. In most past retirement periods, you could have withdrawn more – sometimes significantly more – than 4% from a diversified portfolio.

If you are asking “When can I retire?”, we need to meet. And if you aren’t asking that question, even if you are 25, you should still be wondering “How much do I need to be financially independent?” Otherwise, you risk being on the treadmill of work forever, and there may just come a day in the distant future, or maybe not so distant future, when you wake up one morning and realize you’d like to do something else.

Income Planning by Retirement Age

What is often missing in most academic articles about retirement is a consideration of age at retirement. Most articles just assume that someone retires at 65 and has a 30 year time horizon. We know that is not always the case! If you retire early or later, how does that impact your retirement income strategy?

Let’s consider three age bands: early retirement, full retirement age, and longevity planning.

Early Retirement (age 50-64)

Fewer and fewer people are retiring early today. In fact, more than 70% of pre-retirees are planning to continue to work in retirement. Kind of makes you wonder what “retirement” even means today? However, I can see a lot of appeal to retiring early and there are plenty of people who could pull this off. Here are four considerations if you are thinking of retiring early:

  1. Healthcare. Most people who want to retire before 65 abandon their plans once they realize how much it will cost to fund health insurance without Medicare. Let’s say you have a monthly premium of $1250 and a $5000 deductible. That means you have $20,000 a year in potential medical expenses, before your insurance even pays a penny! If you want to retire at 55, you might need to set aside an additional $200,000 just to cover your expenses to get you to Medicare at 65. It’s a huge hurdle.
  2. If you have substantial assets, you will need to have both sufficient cash on hand for short-term needs (1-3 years), and equity investments for long-term growth. This is why time-segmentation strategies are popular with early retirees: setting aside buckets for short, medium, and long-term goals. While time segmentation does not actually protect you from market volatility or sequence of returns, there may be some benefit to a rising equity glide path, and it may be more realistic to recognize that spending in future decades will depend on equity performance, rather than assuming at 55 that your spending will be linear and tied to inflation.
  3. For those who do retire early, taking withdrawals often makes them very nervous, especially after you realize that you must invest aggressively (see #2) to meet your needs that are decades away. If you have $1 million and want to take a 4% withdrawal, that works out to $3333 a month. Taking that much out of your account each month is more nerve wracking than having $3333 in guaranteed income, which leads us to…
  4. A Pension. Most people I have met who retired in their fifties have a Pension. They worked for 20 or 30 years for a company, school district, municipality, branch of the military, etc. At 55 or so they realize they could collect 50% of their income for not working, which means that – in opportunity cost – if they continue to work it will only be for half the pay! It’s kind of a convoluted way of thinking, but the fact remains that a pension, combined with Social Security and Investments, is the strongest way to retire early.

Full Retirement Age (65-84)

  1. The primary approach for retirees is to combine Social Security with a systematic withdrawal strategy from their retirement and investments accounts. We choose a target asset allocation and withdraw maybe 4% or so each year. We often set this up as monthly automatic distributions. We increase our cash target to 4% (from 1%) and reduce our investment grade bonds by the same amount. Dividends and Interest are not reinvested, and at the end of the year, we rebalance and replenish cash as needed. That’s the plan.
  2. Depending on when you start retirement, I think you can adjust the withdrawal rate. The 4% rule assumes that you increase your withdrawals every year for inflation. It also assumes that you will never decrease your withdrawals in response to a bear market. What if we get rid of those two assumptions? In that case, I believe a 65 year old could aim for 5% withdrawals and a 75 year old for 6% withdrawals. This can work if you do not increase withdrawals unless the portfolio has increased. Also, a 75 year old will have a shorter withdrawal period, say 20 years versus 30 years for a 65 year old retiree.
  3. Although retirement accounts are available after age 59 1/2, most clients don’t want to touch their IRAs – and create taxable distributions – until age 70 1/2 when they must begin Required Minimum Distributions (RMDs). Investors who are limiting their withdrawals to RMDs are following an “actuarial method”, which ties your income level to a life expectancy. This is a good alternative to a systematic withdrawal plan.

Longevity Planning (85+)

  1. Many retirees today will live to age 90, 95, or longer. It is certainly prudent to start with this assumption, especially for couples.
  2. Social Security is the best friend of longevity planning. It’s a guaranteed source of lifetime income and unlike most Pensions or Annuities, Social Security adjusts for inflation through Cost of Living Adjustments. Without COLAs, what may have seemed like a generous pension at age 60 will lose half of its purchasing power by age 84 with just 3% inflation. If you want to help put yourself in the best possible position for longevity, do not take early Social Security at age 62. Do not take benefits at Full Retirement Age. Wait for as long as possible – to age 70. Delaying from 62 to 70 results in a 76% increase in monthly benefits.
  3. If you are concerned about living past 85 and would also like to reduce your Required Minimum Distributions at age 70 1/2, consider a Qualified Longevity Annuity Contract (QLAC). A QLAC will provide a guaranteed income stream that you cannot outlive. Details on a QLAC here.
  4. While equities are probably the best investment for a 60 year old to get to 85 years old, once you are 85, you may want to make things much more simple. There is, unfortunately, a significant amount of Elder abuse and fraud, and frankly, many people over age 85 will have a cognitive decline to where managing their money, paying bills, or trying to manage an investment portfolio will be overwhelming. Professionals can help.

There is no one-size-fits-all approach to retirement income. We have spent a lot of time helping people like you evaluate your choices, weigh the pros and cons of each strategy, and implement the best solution for you.

Bye Bye High Yield Bonds

We’re making a trade in our portfolio models this week and will be selling our high yield bond fund (SPDR Short-Term High Yield ETF, ticker SJNK). The last 18 months have been excellent for high yield bonds; so excellent, in fact, that at this point the now lower yields don’t justify the risks. For those who might be interested in our process behind this decision, please read on.

High Yield, or “Junk”, Bonds are highly cyclical and go through wide swings up and down. They have much higher volatility than other types of bonds, and in spite of their higher yields, have the potential for negative returns to a greater degree than most other types of bonds. Additionally, they have a fairly strong correlation to equities, meaning that when stock markets plunge, high yield bonds – which are issued by lower quality companies – are also likely to drop in value. In times of recession, several percent of high yield issuers will default on their bonds and go bankrupt each year.

How can we determine if high yield bonds are a good value? One of then most common ways is through Credit Spreads. A Credit Spread is the additional amount of yield a high yield bond will provide over a safe bond like a US Treasury.

As recently as January 2016, high yield bonds were paying 6-7 percent over Treasuries. Today, that spread has shrunk into the 3% range, a level which is closer to the lows of the past 20 years. You can see a chart of US Credit Spreads on the website of the Federal Reserve Bank of St. Louis.

Investors today are not being sufficiently compensated for taking the extra risk of high yield bonds, and given the headwinds of higher interest rates and a late-inning stock market, we believe it is time to remove the high yield position from our portfolio. They’ve done their job. While no one can predict if or when these bonds will have their next downturn, we’d rather make the change now.

This is a small trade in most portfolios; our 60/40 model, for example, has only a 4% position in high yield. The proceeds will be reinvested into other bond funds which have lower volatility and also a short duration.

In the future, if yield spreads widen, we might buy back into high yield bonds. When pessimism is at its highest, low prices on high yield bonds can be a great value for patient investors. And that’s the time to be a buyer, not today. Credit spreads are a unique consideration for high yield bonds, but know that we look at each category within our portfolio models closely and will not hesitate to make adjustments after cautious and deliberate study.

If you have any questions about high yield bonds, fixed income, or any other aspect of portfolio construction, please give me a call!

Tracking Your Home Improvements

When you eventually sell your home, it may be helpful to have a record of your home improvement expenses. Because people often own their homes for decades, this is an area where a lot of records and receipts are lost. Here is what you need to know.

At the time of a home sale, the difference between your purchase price and your sale price is a taxable capital gain. Luckily for most people, there is a significant capital gains exclusion from the IRS: $250,000 (single) or $500,000 (married), for your primary residence. If your gain falls below this amount, you will not owe any taxes. In order to qualify, the property must have been your primary residence for at least two of the previous five years, and you must not have taken this exclusion for another property for two years.

If you make a capital improvement (described below), that expense increases your cost basis in the home. But because of the large exclusion ($250,000 or $500,000), many people don’t even bother to keep track of their home improvement expenses. That may be a mistake. Here are a number of scenarios which could be a problem:

  • If you get divorced or your spouse passes away, your exclusion will decrease from $500,000 to $250,000.
  • If you make another property your primary residence for four years, you will lose the tax exclusion on the previous property.
  • If you own your property for the next 30 years, it is possible your capital gain ends up being higher than the $250/$500k limits. These amounts are not indexed for inflation.
  • Congress could reduce this tax break, although it would be very unpopular to do so. They are not likely to change the definition of cost basis and capital gains.

What constitutes a Capital Improvement which would increase your cost basis? In general, the improvement must be permanent (lasting more than one year), attached to the property (not removable or decorative), and add to the value, use, or function of the property. Maintenance and repairs are generally not capital improvements unless they prolong your home’s useful life. The IRS provides the following specific examples of expenses that are Capital Improvements:

  • Additions, such as a new bathroom, bedroom, deck, garage, porch, or patio.
  • Permanent outdoor improvements, including paved driveways, fences, retaining walls, landscaping, or a swimming pool.
  • Exterior features, such as new windows, doors, siding, or a roof.
  • Insulation for your attic, walls, floors, or plumbing.
  • Home systems, including heat/central air, wiring, sprinkler, or alarm systems.
  • Plumbing upgrades such as septic systems, hot water heaters, filtration systems, etc.
  • Interior improvements, including built-in appliances, flooring, carpet, kitchen remodeling, or a new fireplace.

While there are many expenses which count as improvements, repairs and upkeep do not. Painting, replacing broken fixtures, patching a roof, or fixing plumbing leaks are not improvements. Also, if you install something and later remove it, that expense may not be counted. For example, if you install new carpet and then later replace the carpet with wood floors, you cannot include the carpet expense in your cost basis.

For full information on calculating your gain or loss on a home, see IRS Publication 523. While most homeowners are focused on mitigating taxable gains, I should add that if your capital improvements are significant enough to make your home sale into a loss, that loss would be a valuable tax benefit as it could offset other income. Here’s an example:

Purchase Price: $240,000
Capital Improvements: $37,400
Cost Basis: $277,400

Sale Price: $279,000
Minus 6% Realtor Commission: -$16,740
Closing Costs: -$1,250
Net Proceeds: $261,010

LOSS = $16,390

If you just looked at your purchase price and sales price, you might think that you would have a small gain (under the exclusion amount), and there was no need to keep track of your improvements. However, in this example, you do indeed end up with a loss, which would be valuable to your taxes. As a reminder: capital losses can offset any capital gains. Additionally, you can use $3,000 a year of losses to offset ordinary income. Unused capital losses carry forward into future years indefinitely, until they are used up.

Unlike other receipts, which you only need to keep for seven years, you do need to keep records of your capital improvements for as long as you own the home, and then seven years after you file your tax return after the sale. Even if you think you are going to be under the $500,000 tax exclusion, I’d highly recommend you keep track of these capital improvements which increase your cost basis.