Retiring Soon? How to Handle Market Corrections.

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I was recently asked “How would you protect a soon to be retired investor against the inevitable market correction that will occur in the next couple of years?” It’s a great question and I think it’s very important that investors understand the risks they take when investing. Having not had a significant correction in six years, we may be well overdue. Of course, some forecasters have been calling for a correction for a couple of years, and yet the S&P 500 was up 13% last year and 32% the year before. That’s the problem with trying to time the market – it’s not possible to predict the future and it’s too easy to miss good returns by sitting on the sidelines. So, how should investors position their money if they’re a couple years from retirement?

The first thing is to frame the investment portfolio in a broader context. Someone who is four years from retirement does not have a four-year time horizon, but more likely, a 30-year time horizon, so we want to focus on finding the best solution for the whole 30-year period. That means we have to balance the desire for short-term safety with the long-term need to keep up with inflation and not run out of money. While retirement may be a one-time event, retirement planning is an on-going process.

In addition to withdrawals from accounts, retirees will have other, guaranteed, sources of income, such as Social Security, Pensions, or Annuity payments. These may cover a significant amount of fixed expenses, which allows the investment portfolio to be used in a somewhat discretionary manner during retirement. With corrections occurring every 5 to 6 years on average, a retiree could experience five or more corrections over the course of a 30-year retirement.

The reality is that we have to be willing to accept some level of volatility in a portfolio in exchange for the potential for a higher long-term rate of return. We start with a risk tolerance questionnaire to get to know each client and help select a target asset allocation that will be the most likely to accomplish their financial objectives with the least amount of risk. There’s no magic bullet to give investors a great return and no risk, so it truly is a decision of selecting an acceptable level of risk that will fulfill their planning needs. Almost everyone needs to have a mix of safer assets and assets which offer an opportunity for higher long-term growth. Some of my clients have 50 percent or more in bonds, and that may work for their situation.

With the portfolio construction, I am very focused on creating a strong risk/return profile for each of my models. We diversify broadly to reduce correlation of assets and systematically rebalance each portfolio on an annual basis. Rebalancing provides a discipline of selling assets which have run up and buying assets which are cheaper. We can eliminate some types of risk altogether, including company-specific risks (by owning the whole market rather than a handful of individual stocks), and manager risks. We know that typically 65-80% of equity managers under perform their benchmark over five years, but since we don’t know which managers outperform in advance, choosing managers is simply not a good bet to be making. That’s why we use index funds rather than selecting “five star” fund managers for our core holdings – it puts the odds in your favor.

We buy Low Volatility ETFs for some client portfolios, and I think many investors would be interested in learning about ways to reduce market fluctuations. Low Volatility funds select a basket of the least risky stocks from a larger index. They’re designed to offer a return similar to traditional indexes over time, but with a noticeably lower standard deviation of returns. They’re fairly new strategy (available the last three years or so), but I think are one of the more compelling ideas in portfolio management today. Read more here:

Lastly, when working with a new client, we can dollar cost average over six months, so if we do have a pullback in the fall (as we did last October), we would have cash to put to work. The key is that even someone who is planning on retiring in the next couple of years needs to have a clear plan that addresses both their accumulation needs and a retirement income strategy. That’s our focus at Good Life Wealth Management and we’d be happy to meet with you and discuss how to accomplish your retirement goals.


4 Strategies to Reduce the Medicare Surtax


It’s tax season and we’re always on the lookout for ways to save on taxes for our clients. 2014 was the second year under the new Medicare surtax system, but there are still questions as to what the tax is and how to reduce its impact.

The Medicare surtax has two parts and is levied on earnings above $200,000, if single, or $250,000, if married filing jointly. The first part is a 0.9% tax on earned income (wages) that exceeds the thresholds above. Second, there is a 3.8% tax on net investment income above the threshold. Net investment income includes dividends, interest, capital gains, royalties, rental income, and other passive income. (It does not include Social Security, pension payments, or withdrawals from retirement accounts.)

Employers will withhold the additional 0.9% if your individual pay exceeds the threshold. However, employers don’t know a couple’s joint income, so in a situation where both spouses make $150,000 there would not be any additional payroll withholding, even though their joint income of $300,000 will trigger the surtax. In that situation, you may need to direct your HR department to withhold an additional amount for taxes or make quarterly estimated payments directly to the IRS.

With the top tax bracket back up to 39.6%, the surtaxes create a top marginal rate of 40.5% on earned income and 43.4% on investment income. With such high tax rates, it pays to make sure we turn over every stone in search of any possible way to reduce these taxes.

Below are four strategies which can lower your exposure to the new Medicare surtaxes. If you can reduce your taxable income to below the threshold amount, the surtaxes can be avoided altogether.

1) Maximize your 401(k) or employer sponsored retirement plan. Your pre-tax contributions will lower your taxable income. While that’s pretty obvious, we still find that many families are not contributing every dollar they’re eligible to invest. For example, make sure you are taking advantage of catch-up contributions in the year you turn age 50. For couples, make sure both spouses are making the full contribution amount to their retirement plan.

Deductions for Traditional IRAs are generally not available if you are subject to a Medicare surtax, unless both spouses are not covered by an employer-sponsored retirement plan. However, if you have self-employment income, you can contribute to a SEP-IRA for your self-employment, in addition to making contributions to a 401(k) at your regular job. And if you’re self-employed and have a high income, you may be a candidate for a Defined Benefit plan, which can offer a higher contribution limit than a Defined Contribution plan like a 401(k).

2) Health Savings Account (HSA). If you select an HSA-eligible high deductible health insurance plan, you can contribute to a pre-tax Health Savings Account. For 2015, the HSA contribution limits are $3,350 for a single participant, or $6,650 for a family plan. Holders age 55 or above can contribute an additional $1,000.

3) Choose Municipal Bonds. Interest from tax-free municipal bonds is not subject to the Medicare surtax. While their interest rates are lower than some other types of bonds, their tax-effective rate is attractive for taxpayers in higher tax brackets. Here at Good Life Wealth Management, we can help you select a municipal bond mutual fund, exchange traded fund (ETF), closed end fund, or even buy individual muni bonds directly for your account.

4) Employ a Tax-Efficient Portfolio approach. There are four ways we can reduce taxes from a portfolio. First, we can use low-turnover funds (such as index funds or ETFs) which do not distribute capital gains. Second, we can be judicious about buying and selling positions and creating unnecessary capital gains. Third, we can harvest losses annually to offset any gains. Lastly, we can use asset location to place income generating investments into a qualified account, such as an IRA, where the income will not create a taxable event. Tax-efficiency is not an afterthought for us, it’s a cornerstone of our investment process.

None of these methods are going to eliminate the Medicare surtaxes for everyone, but they can certainly help reduce your tax bill. It’s not too early to put these in place for 2015, so don’t wait until next January to take action if you might be subject to the Medicare surtaxes this year.

Proposed Federal Budget Takes Aim at Investors

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It was Presidents’ Day yesterday, a day to reflect on the great thinkers and leaders who founded our remarkable nation and have molded its course across the centuries. I try to avoid political commentary here on this blog as my job is to help clients find financial independence so they can be able to retire one day, send their children to college, and not spend the rest of their lives worrying about money.

However, I think my clients and readers should hear about the President’s proposed 2016 budget, which contains a number of never heard before provisions that take aim directly at middle-class investors. The administration says that they are looking to close “loopholes for the rich”, but these proposals aren’t going to increase taxes for Warren Buffet, Bill Gates, or the latest hedge fund billionaire; they’re going to be funded by working professionals who are trying to make a better life for their families.

When I think about closing loopholes to raise taxes, the first thing I think about are eliminating corporate incentives and subsidies, so I was shocked that these proposals are squarely aimed at the wallets of individual investors and primarily their retirement plans. Here are some of the proposals which would impact investors like you.

  1. The first proposal was to eliminate 529 College Savings Plans. I’m sure there are some wealthy elderly grandparents who use 529’s to reduce their estate taxes, but most of the 529 accounts I have seen are barely enough to pay for a year or two of state school, let alone pay for 4 years of SMU, Medical School, or an MBA. But instead of suggesting that we reduce the maximum caps on 529 contributions, the proposal was to eliminate the tax benefits altogether for everyone! Luckily, after widespread outrage, the administration nixed the proposal days later.
  2. Another proposal is to eliminate the “Back Door Roth IRA”. This has been one of my favorite strategies since 2010 and I look for any client who might be eligible. I’ve mentioned the Back Door approach a couple of times in this blog and described it in some detail here. I believe the government should encourage people to save more for retirement, but when you start taking away benefits, it makes it even more of a challenge.
  3. The 2016 budget would also require investors in a Roth IRA to take Required Minimum Distributions after age 70 and 1/2. Currently, you can let a Roth account grow tax free for as long as you’d like, and even leave those assets to your spouse or heirs income tax-free. The only relief the budget provides is that if all of your retirement accounts (all types) are under $100,000, you would not have to take RMDs.
  4. The 2016 budget would eliminate the “Stretch IRA”. Today, if you inherit an IRA from a non-spouse (such as a parent), you can take only RMDs and continue to let the money grow. Under the proposal, the Stretch IRA (also called Beneficiary IRA or Inherited IRA) goes away, and all the money must be withdrawn within 5 years. If it’s a sizable IRA, that could be quite a tax hit, pushing an heir into a high tax bracket. It means that more of your IRA will end up with the IRS and less with your heirs. Instead of encouraging heirs to manage the inheritance as a long-term program, it will force them to take the money out quickly.
  5. The proposed budget would cap the tax benefit of retirement contributions to 28%. So, if your family is in the 39.6% tax bracket (actually 40.5% when you include the 0.9% Medicare surtax), you will only get a partial deduction for the money you contribute to your 401(k) or IRA.

In all, there were a dozen proposals that would impact investors in retirement accounts. And since my business is focused on retirement planning, you bet I’m concerned. You should be too. Luckily the proposed budget is little more than a wish-list or starting point. Hopefully, few of these will make it into law for 2016. If they do, investors in the future are likely to have a different mix of retirement accounts and “taxable” accounts. Luckily, we’re already skilled at creating tax-efficient investment portfolios with low-turnover ETFs and municipal bonds.

In the mean while, you can still fund a Back Door Roth for 2014 (through April 15) and 2015, or take advantage of any of the current programs. I know what I would prefer to happen with these proposals, but no matter what does occur, we will learn, adapt, and still be successful. I still believe that there is no better place on Earth to become wealthy than America.

Get Off the Sidelines: 3 Ways to Put Cash to Work


I know there are many investors who have a lot of cash on the sidelines. They may have raised cash fearing a pullback in 2014. Or maybe they made contributions to their IRA and didn’t invest the money because the market was at or near a high. Others sold positions once they reached their price targets and have been sitting in cash ever since.

Looking at today’s valuations, it’s a lot tougher to find bargains that seemed plentiful a few years ago. Unfortunately, holding cash cost investors plenty last year, when the S&P 500 Index was up more than 13%. And that’s the problem with trying to time the market with your purchases: you can miss a lot of upside by being on the sidelines, even if you’re out for a relatively short period.

If you have a significant level of cash in your portfolio that will not be needed in the next couple of years, it probably makes sense to put your cash to work. And while there’s no guarantee (ever) that the market will be higher in a month or a year from now, that’s the uncertainty that we have to accept in order to make more than the risk-free rate over time.

I can understand that putting a lot of cash to work at once is daunting when the market is up like it is today. So rather than thinking in black and white terms of all-in or all-out, let’s consider three strategies to help you get that excess cash invested prudently.

1. Dollar Cost Average. We invest in three tranches, 90 days apart, investing 1/3 of the cash position each time. This gives us the advantage of getting an average price over time. If prices drop, we can pick up more shares at a lower price.

Dollar Cost Averaging worked well in the second half of 2014, as we had cash to invest in October when the market was down 7%. Of course, there are also times when the market rises, and the lowest prices were available at the first trade date. In that case, Dollar Cost Averaging can increase your average cost basis.

2. ETF Limit Orders. One of the advantages of Exchange Traded Funds (ETFs) compared to Mutual Funds is the ability to use limit orders. If you believe there might be a pullback in 2015, place a limit order to buy ETFs at a set price or percentage below the current values.

For example, if you think there might be an 8% correction, we could set limit orders that are 8% below the current price of each ETF. This way we have a plan in place that will automatically invest cash if the market does in fact drop. Even though there is no guarantee we will have such a drop, this is still a much better plan than saying “Let’s wait and see what happens”, because when the market is down, people don’t feel good about making purchases. And recently, any corrections in the market have been short-lived, so there has been only a small window of opportunity.

3. Use “Low Volatility” ETFs. If the primary concern is market volatility, there are Low Volatility products can help reduce that risk today. These are funds which quantitatively select stocks from a broader index, choosing only the stocks which are exhibiting a lower level of fluctuations and risk. Low volatility funds are available in most core categories today, such as large cap, small cap, foreign stock, and emerging markets.

Over time, a Low Volatility index may be able to offer  similar returns to a traditional index, but with measurably lower standard deviation of returns. These ETFs have been available for only a couple of years, so this belief is largely based on back testing, and there’s no guarantee this strategy will work in the immediate future.

We should also note that a Low Volatility strategy is likely under perform in Bull Markets (think late 90’s, or 2009), and could lag other strategies for an extended period of time. Additionally, Low Volatility does not prevent losses, so the strategy could certainly lose money like any other equity investment in a bear market.

With those caveats in mind, I am happy to use Low Volatility funds if they give an investor some more comfort with their equity positions and the willingness to put cash to work. Time will tell if these funds are successful in achieving their stated objectives, but in my opinion, Low Volatility funds are among the more compelling ideas offered to investors in the past several years.

Each of these three strategies has advantages and disadvantages, and there is no magic solution to the conundrum of how to get cash off the sidelines today. My role is to work with each investor to find the best individual solution to move forward and have a plan to accomplish your personal goals. Luckily, we have a number of tools and techniques available to help address your concerns.

Indexing Wins Again in 2014


2014 was another strong year for Index funds. According to the Wall Street Journal, only 13% of actively managed large cap funds exceeded the 13.7% total return of the S&P 500 Index for the year. It seems like each year, when index funds outshine active managers, we hear different excuses why. This time, market breadth was blamed, as a high correlation of returns meant that there were few stand-out stocks for managers to make profitable trades. In previous years, we heard managers complain about a “junk rally”, or that “our style is out of favor this year”. And of course, each year, we also hear why the new year is going to finally be a stock pickers market.

We use index funds as the core of our Good Life Wealth model portfolios. Indexing works. I think the misconception about indexing is that it means settling for average returns or that it’s a lazy approach. The reality is that using index funds actually increases your chances of achieving good performance. Index funds outperform 60-80% of actively managed funds over the long-term.

Of course, some actively managed funds do beat the indices. Why not just select those funds? Unfortunately, past returns are not a reliable indicator of future performance. We know this is true – and not just my opinion – through the Standard and Poors Persistence Scorecard, which rigorously measures the persistence of fund performance. Updated in December, the Persistence Scorecard found that of 421 domestic equity funds in the top quartile (top 25%) over five years, only 20.43% remained in the top quartile for the subsequent five-year period.

Top Quartile funds based on 5-year performance (as of September 2009). Over the next 5 years, through September 2014:

  • 20.43% of the funds remained top quartile
  • 19.95% fell into the second quartile
  • 22.33% dropped into the third quartile
  • 27.09% sunk to the bottom quartile
  • 10.21% of the funds were merged or liquidated

If long-term performance was a reflection of manager skill, why are so few funds able to continue to be above average? The results above suggest that instead of high-performing funds remaining at the top, their subsequent returns are almost randomly distributed. In fact, top quartile funds are more likely to be at the bottom (27%) than to remain at the top (20%). And surprisingly, 10% of those top funds don’t even exist in five years. Unfortunately, buying that 5-star fund that has been killing the market often turns out to be a poor decision in a few years time. Then the investor switches to a new hot fund, and the cycle of hope and disappointment begins again.

Indexing avoids these pitfalls. It’s a smart way to invest. And when you look at the tax efficiency of index funds compared to active funds, indexing looks even smarter. (Don’t even ask about the tax consequences of trading mutual funds every couple of years.) But using index funds isn’t a once and done event. We carefully create our asset allocation each year in consideration of valuations, risks, and potential returns for the year ahead. Even when we don’t make any changes to the portfolio models, we still monitor client portfolios and rebalance annually to make sure your holdings stay in line with our target weightings. Perhaps most importantly, the indexing approach allows investors to focus their energy on saving and planning decisions, rather than monitoring managers or searching for the next hot fund.

How to Become a Millionaire in 10 Years

Don't Just Stand There

Answer: save $5,466 a month and earn 8%.

I thought about ending the article there, because that’s all you actually need to do. Investing is simple, but it isn’t easy. No one likes the answer above, even though it really is that simple. When confronted with a difficult task, our brains are wired to look for an easier way, a shortcut. Many investors waste a vast amount of time and energy trying to improve their return by timing the market, buying last year’s hot fund, or day-trading stocks.

Unfortunately, these attempts at finding a shortcut don’t work. It’s like someone who wants to run a marathon but not train for it. There isn’t a shortcut, you just have to do the right things, stick to the training schedule, and put in the miles. You have to earn it. Yet there are entire magazines, TV networks, and firms who make their living from telling people that the shortcut is to trade frequently, and that beating the market is the sure path to prosperity.

The truth that no one wants to hear is that investors would be more successful in achieving their financial goals if they instead focused on how much they save. Let’s step back and consider what we actually can control when it comes to our investment portfolios:

  • how much we save and invest
  • our asset allocation and diversification
  • investment expenses
  • tax efficiency, which can reduce (although not eliminate) taxes

We cannot control what the market will do this month or year, so ultimately we have to accept the ups and downs of each market cycle. We have many studies which consistently show that the majority of active fund managers under perform their benchmarks over time. We also have compelling evidence that the average investor significantly lags the indices due to poor decisions and fund selection.

Few people are able to save $5,500 a month. It’s not easy, but that is the way to get to $1,000,000 in 10 years. For a family making $200,000 a year, this would require you to save one-third ($66,000) of your pre-tax income. Again, not easy, but possible. After all, there are many families who are able to “get by” on $134,000 (or much less), so it is certainly possible for a family with an income of $200,000 to save $66,000. While there are many families in Dallas who make this amount or more, saving is viewed by some negatively, as a sacrifice, rather than with pride and recognition that it is the key to accomplishing your financial goals.

If you did the math, saving $5,500 a month, or $66,000 a year for 10 years is asking you to save $660,000 over 10 years. So even at an 8% return, the market performance is not the main source of your accumulation. Your saving is the main driver of your accumulation.

However, in the next decade, after you have achieved your first million, things become much more interesting. Compounding is your new best friend. At $1 million, an 8% return means you’re up $80,000, and you’re now making more from the portfolio than you contribute annually. Continue to invest $5,466 a month for another 10 years at 8%, and you’re looking at a portfolio with over $3.2 million.

And that’s why I get very excited talking about saving with high-income professionals. If you can commit to that aggressive level of saving, your success will be inevitable. Is an assumed 8% return realistic? No one knows for 2015, but I think 8% is likely to be attainable for 10 years and almost a certainty over 20 years. 8% isn’t going to happen every year, but historically, it is possible to average that rate of return over time. In the long-run, the returns can take care of themselves when you stick with a sensible, diversified approach. The factor which needs more attention, and which you can control, is your savings rate.

Should You Invest in Real Estate?

modern house

Almost everyone has wondered at sometime: should we invest in real estate? Perhaps it sounds appealing compared to the intangibility and lack of control in the stock market. However, for 90% of the people I meet, I think the answer is a definite no. I’m going to tell you why, and for the 10% of you who might still want to invest in real estate, I’m going to tell you how.

First, let’s get this on the table. Most financial advisors make their living from recommending or managing stocks and bonds, so yes, we have a conflict of interest. Unlike many advisors though, I have some first hand knowledge of real estate. Growing up, my parents purchased, managed, and sold 10 apartments, which in retrospect, was no small feat on teachers’ salaries. The proceeds from selling one property (which contained four apartments) comprised their entire contribution to my college education.  It didn’t cover everything (the rest came from student loans, work study, and graduate assistantships), but I know that real estate investing does work and can be a wealth generator. I’m not fundamentally opposed to the idea of real estate investing for the right person who does it wisely.

During my childhood, we spent many weekends mowing lawns, doing maintenance, and interviewing prospective tenants. We cleaned, painted, did plumbing work, and whatever else was needed. The first thing that any potential investor needs to understand is that real estate is not a passive investment; it is a business which makes demands on your time, resources, and patience. Being a landlord is not about bricks and mortar, it’s a people business. Your job is to find, manage, and retain good tenants. Inevitably, you will still encounter the Tenant from Hell who doesn’t pay the rent, steals, vandalizes, and then moves out in the middle of the night owing you thousands. It can be frustrating, time consuming, and at times incredibly stressful.

You’ll never get a call in the middle of the night from your mutual fund because the hot water heater blew up. So trying to compare a real estate business to a passive investment program is apples and oranges. Don’t expect real estate to be easy, regardless of what “reality” program you saw on HGTV. For most people, you are already stretched too thin juggling your career, family, and other interests to want to tackle being a direct investor in real estate. It can detract from your quality of life, and there’s no guarantee of success.

As a stock investor, you can own the whole market with an index ETF and be very diversified. You can buy the same stocks as Warren Buffet, if you want, and get the same return. A person with $10,000 in a fund will receive the same return as someone with $10 million. Fund investing is liquid, requires no effort, and is very democratic, if you will. Real estate, on the other hand, is completely idiosyncratic. Every deal is different. Your neighbor might do well, and you could do poorly. A house in one city might appreciate significantly, but might depreciate in another city. Thinking that you have control over real estate, because it is a tangible item, is an illusion. Buying a house in 2005 could have created a substantial loss, while buying the same house in 2010 may have created a large gain. You have no control over the underlying economic factors which drive real estate prices, just like we have no control over the factors which drive stocks and bonds.

In the last downturn, I know several smart, hard-working people who went into personal bankruptcy because of their real estate investing. It can be risky. If you still want to own real estate, I suggest having it be only a portion of your portfolio, and keep your retirement accounts invested in stocks and bonds. Here are seven tips to keep your investment safe:

1) Get rich slow. Forget about flipping houses. Buy residential properties to rent and plan to hold them for years or decades. Make sure you are investing and not speculating. Buy a house that has good ratio of rent compared to its costs. A $100,000 house that generates $1000 a month in rent is obviously better than a $200,000 house that rents for $1600. The property is an investment, and not for your personal taste, so it does not have to be a luxury home. Wealthy people are not your target tenants. Look for clean, well-maintained properties with access to good schools.

2) Focus on building equity. Use your tenant’s money to pay down the mortgage – that’s how you create wealth in real estate. Get a short note (15 or 20 years) rather than a long mortgage, an interest-only loan, or balloon. Each year, your equity in the property will increase and the amount of interest you pay will decrease. Eventually, you can sell the house for a large gain, or you will pay off the note and then you can bank the rent each month. Don’t make it your goal to have high cash flow from the property for your own income. Invest that cash flow into the equity. And whatever you do, don’t quit your job thinking you will live off your real estate investing – that’s often a disastrous idea. Inflation (rising home prices) should be the icing on the cake; your primary objective is to build equity by paying down debt.

3) Do it yourself. Profit margins are razor thin in real estate. After you pay property taxes, insurance, the mortgage, and maintenance, there is almost nothing leftover. If you plan to hire a handyman every time you need to change a light bulb, you can easily slip into a negative cash flow situation. You have to save money where ever you can, so be prepared to be hands-on. No one will care more about your property than you. Don’t be a long-distance landlord; aim to buy properties within a 10-mile radius of your home. If the idea of sweat equity is a turn-off, real estate is probably not for you.

4) Use leverage wisely. If you have $100,000 to invest in real estate, you could pay cash for one $100,000 house. Or, you could make $20,000 down payments on five houses. Owning five houses will give you better diversification and a much better long-term return because of the leverage. It really is smarter to use the bank’s money for real estate, especially with today’s low interest rates.

5) Keep a strong cash reserve. You will have unexpected expenses, and they can be large. Real estate investors must have a sizable cash position and cannot be living from month to month. Budget for maintenance and vacancy. Will you be okay if you have to spend $10,000 on a new roof or HVAC system? Can you survive if the property is vacant two or four months a year? Know the occupancy rates and market rent rates in your area.

6) Be super organized. Everything needs to be in writing, including applications and lease agreements. Check references for prospective tenants. Keep all receipts and work with a good accountant to track your deductions, depreciation, cost basis, and other tax benefits. This is a business, not a hobby. Treat it seriously.

7) Appreciate your good tenants. They make your life easy, take care of your property, and keep your account in the black. Do nice things for your good tenants and make them want to stay. Their money is building your wealth.

As for me, I spent enough time with apartments to know I’d rather stick with stocks and bonds. It’s a better fit for my schedule and I know myself well enough to know that my efforts are better directed elsewhere. And over the previous 30 years, the nominal return of residential real estate was 4.38% versus 11.09% for large cap stocks. When we include taxes, inflation, and expenses, single family homes returned only 0.80% over those 30 years, compared to 5.97% for large cap stocks. So real estate is often not the home run that people believe it will be.

If you’re thinking about real estate investing, let’s get together and discuss what it entails before you get started.

A Business Owner’s Guide to Social Security

Keyboard Hands

For many small business owners I meet, their business is their retirement plan. They expect that either they will be able to receive an income while handing off day-to-day management to an employee or they hope to sell the business and use the proceeds to fund their retirement. Both approaches carry a high degree of risk as the success of one business will make or break their retirement. As a financial planner, I want to help business owners achieve financial independence autonomous from their business.

Social Security plays a part in their retirement planning, but for most people covers only a portion of their expenses. While the Social Security Administration observes that 65% of participants receive more than half of their income from Social Security, the average Social Security benefit today is only $1294 a month and $648 for a spouse.

Five Social Security Considerations for Business Owners

For the sake of simplifying the points below, I am assuming that the business owner is the husband, but anyplace I use “he”, this could of course be “she”. Age 66 is the Full Retirement Age (FRA) for individuals born between 1943-1954, however, the FRA increases from 66 to 67 for individual born between 1955 and 1960.

1) Salary versus Distributions

While sole proprietorships generally pay self-employment tax on all earnings, business owners who have established as an entity such as a corporation or LLC may receive income from salary as well as distributions or dividends. Only salary is countable towards your Social Security benefit; other forms of entity income, such as distributions or dividends are not subject to Social Security taxes and therefore not used in determining your Social Security benefit amount. (Benefits are calculated based on your highest 35 years of income, inflation adjusted; the Social Security maximum wage base for 2014 was $117,000.)

Avoiding Social Security taxes (15.3%) is often a consideration in selecting an entity structure. For example, we may see an owner pay himself $50,000 in salary and take another $100,000 in distributions from the company profits, rather than taking all $150,000 as salary. At retirement, a business owner’s Social Security benefit amount is only based on their salary, so in the example above, his benefit amount will be less than a worker who received the full $150,000 as salary. I’m not suggesting that business owners should forgo these tax savings and take more income as salary, however, they should consult with their financial planner to estimate their Social Security benefits and create other vehicles to save and invest their tax savings to make up for the lower SS benefits they will receive as a result of taking a lower salary.

2) SS between 62 and FRA

Approximately half of SS participants start taking benefits immediately at age 62; 74% of current recipients are receiving a reduced benefit from starting before FRA. Starting at age 62 will cause a 25% reduction in benefits versus starting at age 66. While SSA will automatically recalculate your benefits if you continue to work while receiving benefits, the actuarial reduction (up to 25%) remains in place for life.

3) Survivor Benefits

Many people consider their own life expectancy in deciding when to start Social Security. The payback for deferring SS benefits from age 66 to 70 may take until age 79 or 80, depending on your estimate of COLAs. If the owner is concerned that they will not live past 79 or 80, they often take benefits at 66. However, there is an additional vital consideration which is survivorship benefits for your spouse.

A surviving spouse will receive the higher of their own benefit or the deceased spouse’s benefit. The higher earner’s benefit will end up being the benefit for both lives. Therefore, it often makes sense to maximize the higher earner’s benefit amount by delaying to age 70, especially if the spouse is younger and has a longer life expectancy. For each year you wait past age 66, you receive an 8% increase in benefits (delayed retirement credits or DRCs), which is a good return. When people take early benefits based solely on their own life expectancy, they fail to consider that their benefit also impacts their survivor’s benefit amount.

4) File and Suspend

One of the problems with delaying to age 70 is that the owner’s spouse will be unable to receive a spousal benefit until the owner files for his benefit. This is generally not an issue if the spouse has a substantial benefit based on her own earnings. If she does not, however, there is a solution to enable the spouse to receive her spousal benefit while the husband delays until age 70. In a “File and Suspend” strategy, the business owner files for benefits at age 66, to allow his spouse to receive her spousal benefit, (the full amount, provided she is also age 66 or higher). The owner then immediately suspends his benefit, which entitles him to earn the deferred retirement credits until age 70.

DRCs do not apply to the spousal benefit, so if the spousal benefit applies (spousal is higher than her own benefit, or she does not have a benefit based upon her own work record), she should not delay past age 66. That’s why it is essential to know if a spouse will receive their own benefit or a spousal benefit. The spouse should never delay past age 66 if receiving a spousal benefit – you’re losing years of benefits with no increase in amount.

To recap: File and Suspend works best when the spouse is the same age or older and has little or no earnings history on her own.

5) Claim Now, Claim More Later

For a business owner who is still working, but whose spouse has already filed for her own SS benefit, at his FRA, he can restrict his application to his spousal benefit and receive just a spousal benefit. This will allow him to still receive DRCs and delay his own benefits until age 70, while receiving a spousal benefit without penalty. That’s free money. (Note: this only works when spouse is already receiving benefits and he is at FRA. You cannot restrict an application to the spousal benefit prior to FRA.)

I can help you to compare different Social Security timing strategies to make the best decision for your situation. Before we get started, you will need to first download the current Social Security statements online at for both yourself and your spouse. A Social Security statement never shows any spousal benefit amounts, and the calculators on the SSA website do not consider file and suspend strategies, so you cannot consider these scenarios without using other tools.

Are Equities Overvalued?


In last week’s blog, we reviewed the fixed income market and discussed how we are positioned for the year ahead.  Today, we will turn our attention to the equity portion of our portfolios.  Perhaps the top question on most investors’ minds is whether the 5-year bull market can continue in 2015.  At this point, are equities overvalued or do they still have room to run?

I don’t think it’s useful to try to make predictions about what the market will do in the near future, but I’m certainly interested in understanding what risks we face and what areas may offer the best value for our Good Life Wealth model portfolios.  We use a “Core + Satellite” approach which holds low-cost index funds as long-term “Core” positions, and tactically selects “Satellite” funds which we believe may enhance the portfolio over the medium-term (12-months to a couple of years).

The US stock market was a top performer globally in 2014.  The S&P 500 Index was up over 13% for the year, and US REITs (Real Estate Investment Trusts) returned 30%.  Those are remarkable numbers, especially on the heels of a 32% return for the S&P in 2013.  With six years in a row of positive returns, valuations have increased noticeably for US stocks.  The S&P now has a forward P/E (Price/Earnings ratio) of 18, slightly above the long term average of 15-16.

While US stocks are no longer cheap, that doesn’t automatically mean that the party is over.  With a strong dollar, foreign investors are continuing to buy US equities (and enjoyed a greater than 13% gain in 2014, in their local currency).  The US economic recovery is ahead of Europe, where growth remains elusive and structural challenges are firmly in place.   Compared to many of the Emerging Market countries, the US economy is very stable.  Emerging economies face a number of economic and political issues, and struggle with declining energy prices, often their largest export.

US Stocks remain the most sought-after.  While today’s P/E is above average, “average” is not a ceiling.  Bull Markets can certainly exceed the average P/E for an extended period.  And given today’s unprecedented low bond yields, it’s tough to make a comparison to past stock markets; equities are the only place we can hope to find growth.  Current valuations are not in bubble territory, but it seems prudent to set lower expectations for 2015 than what we achieved in the previous five years.  And of course, stocks do not only go up; there are any number of possible events which could cause stocks to drop in 2015.

Given the current strength of the US market, you might wonder why we own foreign stocks at all.  They certainly were a drag on performance in 2014.  In Behavioral Finance, there is a cognitive error called “recency bias”, which means that our brains tend to automatically overweight our most recent experiences.  For example, if we did a coin-toss  and came up with “heads” four times in a row, we’d be more likely to bet that the fifth toss would also be heads, even though statistically, the odds remain 50/50 for heads or tails.

Checking valuations is a important step to avoid making these types of mistakes.  Looking at the current markets, Foreign Developed Stocks do indeed have better value than US stocks, with a P/E of 15.5 versus 18.  And Emerging Market stocks, which were expensive a few short years ago, now trade at an attractive P/E of 13.  We cannot simply look at which stocks are performing best to create an optimal portfolio allocation.  Diversification remains best not just because we don’t know what will happen next year, but because we want to buy tomorrow’s top performers when they are on sale today.

Our greatest tool then is rebalancing, which trims the positions which have soared (and become expensive), to purchase the laggards (which have often become cheap).  So we’re making very few changes to the models for 2015, because we want to own what is cheap and want to avoid buying more of what is expensive, even if it does continue to work.  We will slightly reduce International Small Cap, and add the proceeds to US Large Cap Value.  US Small Cap has become quite expensive, but small cap value now trades at a bit of a discount (or is less over-valued, perhaps), so that is another shift we will make this year.

Each year, I do an in-depth review of our portfolio models and I always find the process interesting and worthwhile.  This year, looking at relative valuations in equities reminds me that our best path is to remain diversified, even if owning out-of-favor categories appears to be contrarian in the short-term.

The Dangers Facing Fixed Income in 2015


Although returns were largely positive, 2014 did little to ease the risks in Fixed Income, and in some categories, made the situation decidedly more precarious.  Looking at the funds and ETFs I follow, municipal bonds, foreign bonds, and long-term treasuries saw their yields fall, with prices markedly higher.  Bonds with the longest duration experienced the greatest change in price.

We are now several years into a low interest rate environment which central banks, like the Federal Reserve, manufactured through their interest rate policies and quantitative easing (bond buying) mechanisms.  The market consensus was that these depressed interest rates were like a coiled spring, ready to shoot higher and eventually cause bond investors to endure painful losses.  The flip side of some bonds gaining 10-20% in value this year is that if interest rates were to increase by 1-2% in 2015, those same investors could potentially see 20% or higher losses in their positions.

A strong return in 2014 creates a challenging situation – if those categories were overvalued before, they’re even more expensive now.  Although the potential for interest rate risk is now higher than ever, the market is beginning to recognize that without increased signs of inflation, we might be stuck with these low rates for an unprecedented number of years. While the yield on the US 10-year Treasury is around 2.2% today, the equivalent 10-year government bond yields less than 1% in Germany, Japan, and a number of other countries. To accept such a low rate suggests that deflation remains a greater concern than inflation for investors in some locations.

Investors positioned defensively in short-term bonds, floating rate, high yield bonds, or TIPS, all lagged the Barclays Aggregate Bond Index in 2014.  How should we position for 2015 then?  In our Good Life Wealth model portfolios, we are taking a three-prong approach.

1) We don’t try to predict interest rates or speculate on bonds. The role of Fixed Income in our portfolios is to mitigate the risk of our Equity positions.  We are looking to have lower interest rate risk (“duration”) than the overall bond market. This means we will make less if interest rates continue to fall, but we will also lose less if or when rates eventually rise.

2) We will underweight areas where yields are too low to compensate for the potential risks.  For now, this means we avoid foreign and US treasuries and TIPS.  We keep cash to a minimum, to 1% or the amount required for 12 months of withdrawals.

3) We consider each Fixed Income category in terms of its potential rewards and risks.  For example, a fund with an SEC yield of 3 and a duration of 3, would have a ratio of 1; a fund with a yield of 2 and a duration of 4, would have a ratio of 0.5, which is less desirable.  That’s not to say that we can simplify our selection process to a single step, but it does help inform how quickly we would recover from potential losses, so we can be better positioned if interest rates were to rise.

Although bond prices can be volatile in the short-term, the beauty of bonds is that their Yield to Maturity is a very strong predictor of how the bonds will behave over their lifetime.  Our primary focus then is on the opportunity each bond category will provide over time rather than what might occur in the short-term.

With US Stocks sitting at or near all-time highs, bonds may be an after-thought for some investors.  And with today’s paltry yields, it’s no wonder.  However, bonds have an important role in protecting our portfolios and creating income to contribute to our total return.  We’re not going to ignore the risks in bonds, so you can count on our Fixed Income allocation to continue to be tactical in the years ahead.